Tag Archives: tax rates

Why We Need a Tax AND Spending Cut

Republicans are talking a lot about certainty. But even if they had won some sort of a victory where they got the current tax rates written in stone, spending is on such an unsustainable path in terms of entitlements, it really isn’t certain at all.

That is me in the NYT. If I had had more space and more eloquence, I might have said something similar to this:

If you hate taxes, cut spending! …Short-term, uncertain duration “tax cuts” are not tax cuts at all, but deficit-financed spending.

That’s Mike Munger, economist and political scientist from Duke University. There is more here and here

What is the economic logic behind this result? Why is it that a tax cut without a concomitant spending cut might not improve the economy? There are two economic models that predict just such an outcome:

Extreme Case:

In what might be called an “extreme case”, a tax cut without a spending cut has zero effect on the economy. This is an extreme case because it requires a rather generous view of humans: it assumes we are all super-logical forward-looking processing machines (all of us, of course, except for politicians; the model assumes they don’t have a clue). The model works something like this:

Step 1. Government cuts (lump-sum) taxes without cutting spending.

Step 2.  This requires an increase in government borrowing.

Step 3.  Forward-looking taxpayers recognize that deficits are future taxes (Munger uses the helpful acronym DAFT). Because of this, they reduce current consumption in order to save for the taxes.

Step 4.  The reduction in taxpayers’ consumption completely offsets the deficit-financed government consumption. And the increase in taxpayers’ savings completely offsets government’s increase in borrowing.

In the end, switching from taxes today to taxes in the future has no effect on interest rates, national savings, current consumption, exchange rates, future domestic production, or future national income.

Economists will recognize this as the Ricardian Equivalence theorem. Non-economists will likely find this a tad implausible.

But we don’t have to rely on such an extreme model to find that a tax cut without a spending cut might not be much help. Consider another, less-extreme, model:

The Less-Extreme Case:  

Step 1.  Government cuts (lump-sum) taxes without cutting spending.

Step 2.  This requires an increase in government borrowing.

Step 3.  Only some taxpayers recognize the deficits as future taxes. As a result, these taxpayers reduce their consumption and increase their savings. But these actions only partly offset government’s deficit-financed consumption.

Step 4.  Since the public’s increased appetite for savings isn’t enough to fully finance all of the extra government borrowing, government has to get its money from somewhere. It therefore draws on two sources:

  1. Government can borrow more domestically, but has to pay a higher price in the form of a higher interest rate (under the Ricardian model, the public wants to save more, so government doesn’t have to pay a higher price). Higher interest rates make it more difficult for private investors to fund their own projects (private investment is crowded-out), lowering the nation’s capital stock.
  2. Government borrows the money from foreigners. Under this scenario, interest rates may not rise, but future national income falls because of the burden of repaying the increased borrowing from abroad.

Step 5.  Because the nation’s capital stock shrinks, future growth suffers.

Under either scenario, a reduction in lump-sum taxes—unaccompanied by a reduction in spending—fails to jump-start the economy the way politicians hope that it might.

A Big Assumption:

There is one other assumption that I have smuggled into the analysis above. Note that “Step 1” under both scenarios is a reduction in “lump sum” taxes. A lump sum tax is a tax that everyone has to pay, regardless of how much they work or consume. Economists often use it as a benchmark for efficient taxation because if the tax isn’t associated with working or consuming, then it won’t affect peoples’ decisions to work or to consume, and therefore won’t do economic harm.

It is standard for economists to assume lump sum taxation when they are talking about deficits because it makes the analysis cleaner. But, of course, taxes are not lump sum. In the real world, most of government’s revenue is derived from income taxation.

And we know from theory and data that high marginal tax rates reduce the incentive to work, save, and invest, harming economic growth. Moreover, we have reason to believe the effect can be quite large.   

So in evaluating the recently-struck tax deal, we have to weigh the “tax increases harm economic growth” evidence against the “deficits harm economic growth” evidence. In the end, I suspect we are better-off in the short-run without a major tax increase in two weeks. But in the long-run we need to cut BOTH taxes and spending. As Professor Munger puts it, the alternative is “DAFT.”

Would a Permanent Extension of Tax Rates Really Create Certainty?

In the late 1990s, there were typically fewer than a dozen tax provisions that had just a limited lease on life and needed to be renewed every year or so.

Today there are 141.

That is from today’s Wall Street Journal. If speculation is accurate, today’s Congressional vote will only exacerbate this trend. By my count, it creates temporary provisions for:

  • All income tax rates
  • Capital gains tax rates
  • Dividend tax rates
  • The Social Security payroll tax rate
  • The estate tax rate
  • Student loan tax credits
  • Per-child tax credits
  • The Earned Income Tax Credit
  • The tax credit for blending ethanol into gasoline
  • The $1.00 per gallon biodiesel tax credit
  • A tax credit to incentivize alternative fuel
  • A tax credit for maintaining railroad tracks (really?)
  • Expensing of business investments
  • And others (the WSJ refers to “dozens of corporate-tax provisions that already were subject to annual renewal”; some of these may or may not be in my list above). 

As my colleague, Jason Fichtner and his coauthor, Katelyn Christ, have recently written, uncertainty and tax policy are a fatal policy mix.

Previous research suggests that policy uncertainty can be very harmful to economic growth.

But all of this talk about temporary tax provisions obscures an important fact: Even if the Congress were to make current tax provisions permanent, there would still be an enormous amount of uncertainty in current tax policy. This is because, over the long run, government expenditures are on an unsustainable path and by the simple arithmetic of budgeting, taxes will eventually have to go (way) up or spending will have to go down.

If policy makers truly want to generate certainty and create an environment conducive for economic growth, they will need to reform the tax code, make the reforms permanent, and bring spending in line with taxes.

Rating State Business Tax Climates

Today the Tax Foundation released its annual State Business Tax Climate Index.

Good tax policy is not just about low rates. The Index’s author, Kail Padgitt, writes:

State lawmakers are always mindful of their states’ business tax climates but they are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition.

The public choice pressures that Dr. Padgitt is talking about encourage state policy makers to cut special tax deals for politically-important businesses and to keep rates high for those who are aren’t so well-connected. The Business Tax Climate report is a nice antidote to such thinking:

The goal of the index is to focus lawmakers’ attention on the importance of good tax fundamentals: enacting low tax rates and granting as few deductions, exemptions and credits as possible. This “broad base, low rate” approach is the antithesis of most efforts by state economic development departments who specialize in designing “packages” of short-term tax abatements, exemptions, and other give-aways for prospective employers who have announced that they would consider relocating. Those packages routinely include such large state and local exemptions that resident businesses must pay higher taxes to make up for the lost revenue.

The best climates: South Dakota, Alaska, Wyoming, Nevada, Florida, Montana, New Hampshire, Delaware, Utah and Indiana.

And the worst: New York, California, New Jersey, Connecticut, Ohio, Iowa, Maryland, Minnesota, Rhode Island and North Carolina.

Tax Cuts, or Hikes, Are a Sideshow

Washington State is considering implementing a personal income tax. Much like the federal debate over extending or expiring the Bush tax cuts, this debate is a sideshow to the real issue. In our recent Capitol Hill Campus course, Dr. Bruce Yandle laid out these two charts which point to the real problem in state and federal budgets; spending.

First, this chart tracks the top marginal tax rates versus federal revenue as a percent of GDP.

The government’s take of the economy has remained relatively constant since 1960, despite wild fluctuations in how we “soak the rich”. Washington’s proposed tax would only affect those house-holds making more than $200,000, so one should expect this pattern, or lack thereof, to hold for Washington’s gross state product.

The second part of the story is this; as government spending increases, there is a measurable decline in the economy.

With only one outlier in fifty-four years of data, this strong correlation indicates that spending cuts pay for themselves with a growing economy. In turn, that should produce more overall revenue with reasonable tax rates. If you live beyond your means, the problem isn’t your income, it’s your spending habit. Sometimes it’s better to take a small slice of the pie, but make the pie itself bigger.

Tax Foundation attorney Joe Henchman put the incentive mechanics this way:

Yes, such taxes will generally raise revenue in the short term without a sudden exodus of wealthy people fleeing to the state next door… . But over the medium term, the taxes will negatively impact location decisions. People expanding old businesses or creating new ones will incorporate the higher cost of doing business into their decision-making, and steer clear of the state.

States and the federal government need to break this destructive cycle.

The State of Laziness

According to Bloomberg, here are the top ten laziest states:

Louisiana, Mississippi, Arkansas, North Carolina, Tennessee, Kentucky, West Virginia, South Carolina, Alabama, Delaware.

(I have no idea whether this survey method is valid).

Though it is provocative to label the good people of Louisiana “lazy,” I suspect that much of the observed difference in behavior can be traced not to inherent differences in the people but to differences in the institutions in which those people operate: the laws, the economy, the culture, etc. that constrains and shapes their actions.

A few years back, the Nobel laureate economist Ed Prescott (of Arizona State) analyzed the difference between American and European working habits. There was a time, in the early 1970s, when Europeans worked more than Americans. Now this is reversed: “Americans work 50 percent more than do the Germans, French, and Italians.” Prescott finds that differences in marginal tax rates are the predominant factor. So Europeans aren’t any lazier than we; they just face different incentives.

I wonder what institutional differences can explain differences in work effort across the U.S. states?

One can’t help but notice the over-representation of the South. Two centuries ago, Montesquieu wrote:

You will find in the climates of the north, peoples with few vices, many virtues, sincerity and truthfulness. Approach the south, you will think you are leaving morality itself, the passions become more vivacious and multiply crimes… The heat can be so excessive that the body is totally without force. The resignation passes to the spirit and leads people to be without curiosity, nor the desire for noble enterprise.

I seem to recall a similar observation from John Adams, but can’t locate it just now…or maybe I just don’t want to put in the effort to find it.

Free Market Farmland

The Washington Post reports that across the country, new neighborhood developments are including farmland as an amenity for residents whose housing prices include funding for the provision of open space and readily available, hyper-local produce.

This trend demonstrates that developers, when legally permitted to do so, cater to the demands of their consumers. Recent changes in land use policy, allowing for more mixed-use development, have legalized the blending of residential and agricultural uses.

The article explains:

Most of these projects start with a matchup between a fine old farm to save and a smart developer with a vision, but in the case of Potomac Vegetable Farms (http://www.potomacvegetablefarms.com), west of Tysons Corner, the farmers saved it themselves. Hiu Newcomb and her family now have a co-housing project (a community with shared common areas and responsibilities) clustered in one area, but most of the popular farm remains.

In Northern Virginia and many areas of the country where development is being designed around farms, the concept is primarily a luxury for the Whole Foods set that values local farmers and produce. However, a similar trend is emerging in Detroit, as previously discussed here, as a way of putting deserted urban space to use.

Earlier this week, the Detroit City Planning Commission moved to codify this trend, working to update the zoning code to permit more agricultural uses within city limits. However, local television news station WLNS explains:

The draft includes recommendations such as allowing small projects to buy city land at reduced prices with lower tax rates. And it suggests larger farms would need to show how they would benefit the community to get such breaks.

The draft also suggests setting soil testing rules.

While allowing entrepreneurs to make valuable use of vacant land in Detroit makes great economic sense, the city should consider whether, particularly given its current budget condition, a subsidy program is advisable policy.

Budgeting Tactics for States

Tax Foundation state projects director Joe Henchman writes in today’s Daily Caller about five ideas to help states facing budget shortfalls (that is to say, virtually every state) get back in black:

  • Prioritize appropriations. When the majority-Democratic Arkansas Legislature votes to appropriate money, the money isn’t immediately spent. Instead, each appropriation goes to a legislative committee that ranks them in order of priority. Items are funded only to the extent money is available, forcing debate about how best to allocate limited resources while permitting a wish list if revenue exceeds expectations.
  • Review tax incentive programs. Although many states recognize they have burdensome tax systems, they use targeted incentives for particular industries rather than reducing burdens for everyone. Besides dumping a higher tax burden on everyone else, the jobs created are dependent on the handouts and often vanish when the incentives end. Tax incentive programs also often escape oversight and cost-benefit analysis. Iowa recently recommended elimination of several ineffective tax incentives after a review. Other states should do the same.
  • Broaden sales taxes and use the revenue to lower tax rates. A good sales tax applies to all final goods once and only once. Exempting clothing and groceries may seem like a good idea, but doing so causes year-to-year revenue instability and drives up the rate on everything else. Gross receipts taxes and taxes on business inputs cause distortions that harm economic growth. Adopting a sales tax base of all final products and services would enable both lower rates and more predictable revenue.
  • Reduce reliance on taxes on high-income earners and corporate profits. When deciding in which state to live or locate their business, one of the factors that top earners must weigh is the marginal tax rate they will face in each state. While high statutory tax rates on high incomes may bring a revenue increase in the short term, they can harm long-term economic growth as providers of jobs and capital choose to locate in lower-tax states. With these volatile revenue sources at a minimum, it may be perfect timing to minimize them.
  • Establish rainy day funds and spending restraints. To ride out recessions, states need to build a rainy day fund of 12 to 18 percent of their annual spending. Setting aside 2 to 3 percent of each year’s budget in good times can accomplish that, but those structures need to be in place now or else states will be in this mess again.

Joe discussed state tax policies on C-SPAN earlier this month.

Not Connecting the Dots

Public policy often seems that it should be intuitive. If a state needs more revenue, the easiest way to raise some is to increase taxes (easiest for elected officials, that is). Who has the most money to appropriate? Millionaires, obviously. Connect the dots, and raise taxes on millionaires.

Maryland did just that, but their experiment shows why political common sense and real life common sense are distinctly separate things. From the Wall Street Journal:

We reported in May that after passing a millionaire surtax nearly one-third of Maryland’s millionaires had gone missing, thus contributing to a decline in state revenues. The politicians in Annapolis had said they’d collect $106 million by raising its income tax rate on millionaire households to 6.25% from 4.75%. In cities like Baltimore and Bethesda, which apply add-on income taxes, the top tax rate with the surcharge now reaches as high as 9.3%—fifth highest in the nation. Liberals said this was based on incomplete data and that rich Marylanders hadn’t fled the state.

Well, the state comptroller’s office now has the final tax return data for 2008, the first year that the higher tax rates applied. The number of millionaire tax returns fell sharply to 5,529 from 7,898 in 2007, a 30% tumble. The taxes paid by rich filers fell by 22%, and instead of their payments increasing by $106 million, they fell by some $257 million.

Don’t feel sorry for the poor poor millionaires; that’s not the point I’m trying to make. Taxes are a serious driver of out-migration, be it small states like Maine, or more populous states like New Jersey:

New Jersey out‐migrants tend to move to states that have much lower property values (35% lower), property taxes (41% lower) and overall costs of living (17%lower). Destination states also have notably lower average incomes, substantially higher crime rates, higher infant and child mortality; slightly lower school quality, but somewhat warmer winters. Overall, it appears that net out‐migration is due to the high cost of living (especially the high cost of housing and property tax) in New Jersey.

Policy makers and their hangers-on have often regard taxpayers as little more than fiscal sheep, and periodically shear them. But people, unlike sheep, can vote with their wallets and feet. Usually the powers that be see this as something akin to letting the home team down, or not doing one’s “fair share.” The word “selfishness” is also thrown around.

Policies like the levels of taxes, services, and entitlements that a government prescribes are hardly a form of science. Law makers and interest groups would like to portray them as a serious commitments, and not self-interested social experiments. Again from the Journal:

Thanks in part to its soak-the-rich theology, Maryland still has a $2 billion deficit and Montgomery County is $760 million in the red. Governor Martin O’Malley’s office tells us he wants the higher rates to expire “as scheduled at the end of 2010.” But there are bills in both chambers of the legislature to extend the surcharge. The state’s best hope is that politicians in other states are as self-destructive as those in Annapolis.

The “Soak the Rich” phenomenon is a common-sense argument for redistributive policies, but it has significant flaws beyond the simple fact that it doesn’t work. Take a look at this chart of how tax burdens are distributed in Federal taxation. (here, either insert or link to this: http://www.mint.com/blog/wp-content/uploads/2009/11/MINT-TAXES-R4.png)

Libertarians and liberals can mostly agree that there is too much money and influence in politics, but the policy prescriptions each group suggests are dramatically different. Advocates of punishing the rich ignore the simple fact that when a certain group bears so much of the tax burden, they have massive incentives to care about and influence politics. It’s that or leave the country, or just stop making money (by, for instance, not hiring new employees.)

See this graphic (or click below) for a good visual explanation:

Local Governments Taxing Online Travel Services?

A new study from the Tax Foundation looks at how local governments are attempting to change the way they calculate hotel occupancy taxes, from the amount paid to the hotel to the amount paid by the consumer to online travel services like Expedia and Priceline:

Local governments’ efforts to collect discriminatory taxes from online travel services amount to a revenue grab from out-of-staters and ultimately harm interstate commerce, according to a new Tax Foundation report.

City officials in 22 states have, with limited success, sought to reinterpret hotel occupancy taxes to apply to amounts paid by consumers for online travel booking services (such as Expedia, Orbitz and Priceline).

“Hotel taxes are attractive to local politicians because they are a way to shift the tax burden to ‘outsiders,'” said Joseph Henchman, the Tax Foundation’s Tax Counsel and Director of State Projects, who authored the report. “But because every U.S. city has a hotel tax, we’re all somebody else’s ‘outsider.’ And that means everyone is paying high hotel taxes everywhere.” Continue reading

Urban Farming

The collapse of Detroit’s auto industry and its related population loss have left the city with a large supply of vacant land, some of which has been returned to its historical use as farmland.  The LA Times reports:

Large gardens and small farms — usually 10 acres or less — have cropped up in thriving cities such as Berkeley, where land is tough to come by, and struggling Rust Belt communities such as Flint, Mich., which hopes to encourage green space development and residents to eat locally grown foods.

In Detroit, hundreds of backyard gardens and scores of community gardens have blossomed and helped feed students in at least 40 schools and hundreds of families.

While a widespread return to agriculture is unlikely to improve any American city’s prosperity, these cities demonstrate that flexible zoning and land use regulation allow entrepreneurs to find the most valuable use for any piece of land, benefiting local residents accordingly.  For areas where labor is relatively inexpensive and land is widely available, urban farming could be a viable short-term answer to economic growth.

Hantz Farms has found a way to profit amidst the economic turmoil and change in Detroit, profiting as a company and creating jobs simultaneously.  This success story demonstrates that job creation comes from the private sector. Producer profits lead to both new jobs and consumer surplus, whereas government “job creation” merely redistributes wealth, resulting in a deadweight loss.

However, Detroit city officials maintain reservations about urban farming.  The Times article explains:

Their concerns include figuring out who would pay for cleaning pollutants out of the soil and removing utility infrastructure, such as gas and sewer lines; how to rewrite the city’s zoning laws; and how to adjust property tax rates and property values to allow for commercial farming.