Tuesday, December 18, 2012

Texting, Marginals, and Tax Rates on the Rich

When I was in the fourth grade my teacher said I was marginal. Being confused I immediately took out my ipad and went to Wikipedia. No not really – at that time the wheel had not been invented yet and fire was a new concept. But we did have a huge paper weight in our house that was called a Dickshunary so I asked my mom to help me research marginal. At that time little did I know how much would be riding on something called marginal tax rates. This post explores the importance of marginal tax rates and concludes that little good can come from increasing marginal tax rates on the rich. Raising average tax rates for the rich might be better in economic terms. Unfortunately politics seems to matter more than economics these days.

MY exploration in the dictionary didn’t help much . One definition said that marginal is something found only at the outer limits and therefore is not of central importance. Another definition referred to something on the edge. A third applied the term to apparently less important words written in the margins of a page. Since I had not yet taken on the habit of JD I had little to relieve my marginal headache. I felt even worse when I found the following example of the use of the word marginal – “having reviewed the test, there are two students below the required standard and three more who were marginal.” I wondered who those other students were.  The confusion is that while marginal often refers to things that are not very important – when you have been branded "marginal" like these students – that seems pretty important. It might mean the difference between moving on to the next grade or staying another year with the same mean, ugly, and hateful fourth grade teacher at Coconut Grove Elementary School.

When I took my first economics course at Georgia Tech, Professor Schaffer told me that marginal was critical to understanding decisions. Marginal helps to concentrate the most important factors when making a decision. So let’s suppose we are trying to decide whether or not to walk down the street while texting. On the one hand, there are benefits from this course of action. I can walk down the sidewalk and Tweet to all my friends about how wonderful I feel walking down the street. Let’s call that the marginal benefit of the decision. On the other hand, there are also new costs associated with this decisions. It is quite possible that while I am texting I might walk into a tree or a parked Vespa. Then I would have to go to the hospital. 

Hospitals are costly. Let’s call that the marginal cost of the decision.  I can’t speak for you but let’s say I believe the MB is greater than the MC. Then I make the decision to go ahead and text while walking. Of course if the MC is greater to you than the MB, then you decide not to text while walking. Advanced math explanation:
·         MB > MC then do the action
·         MB< MC then do not do the action
·         MC is an important concept despite the marginal stuff written about it in the dictionary

Last week my post was critical of plans to increase marginal tax rates on the rich. After 396 pages of detailed and insightful analysis, I left out a couple of things. I mentioned that an increase in the marginal tax rate for the upper 2% might not be good for the economy. I suggested it could lead to another recession in the USA as soon as 2013. But I didn’t explain why. So let me carry on that argument.  

Let’s suppose on some planet that resembles Earth that the marginal tax rate for incomes above $200,000 per year was 100%. Let’s call that planet Obiden. The marginal tax rate for incomes equal to or less than $200,000 on Obiden is 35%.  Jim lives on Obiden and runs a manufacturing company that makes Obiden T-shirts. Jim loves to surf on the Han River in his spare time and also enjoys spending time with his family playing checkers and Mass Effect 2.

Jim’s business is doing well and he is thinking of hiring more people and adding a new manufacturing location in a right-to-work state named Michi on Obiden. Michi looks a lot like the outline of my left foot. Anyway, Jim has a crack accountant named Kilt who explains over a couple of Heffe Weitzens that if his income goes above $200,000 he will not get a penny of the increase. With the 100% marginal tax rate on incomes above $200,000 any income he earned above $200,000 would all go to the government for good deeds.  Jim would pay 35% of $200,000 (=$70,000) as his tax. If he made, for example $250,000, he would pay the $70,000 in tax plus another $50,000.Thus his average tax rate would increase to 48%. In this example the government raises revenue, it raises the average tax rate, and it does it by increasing the marginal tax rate.

My liberal friends who are still awake would scream – Larry – no one is proposing a marginal tax rate of 100%. Then they would call me a lot of names and hang up on me. But extremes are often used to make legitimate points. For example, Democrats often depict rich people as selfish and beyond any real empathy for the poor. That extreme view of rich people makes it easier for them to want to punish rich people and confiscate their income and wealth.

But the general point is made. When it comes to the decision to expand Jim’s factory and hire more people on Obiden, it is the marginal tax rate that matters the most.  The definition of marginal is what Prof. Schaffer taught us smelly freshmen – the marginal tax rate is critical for making decisions since it applies to MORE or NEW incomes – not to all our income. When we raise the rate of taxation on wage income, on dividends, or on capital gains on the highest or last income earned – we are directly impacting decisions that involve change.  Changing average tax rates has no such extreme effect.

We don’t know what the critical marginal tax rate is for the USA. Maybe the current rates are already too high for economic expansion. Maybe they are too low. Maybe 39% is too high. No one knows for sure. But you are definitely flirting with danger when you raise these rates at a time when most people are predicting a slowdown in the US economy in the coming months.

When we say rich people we have some idea that these super rich individuals (with incomes over $200,000????) can easily and gleefully absorb the marginal tax increase. And maybe some would or could. But this defies Prof. Schaffer’s lessons. Marginal tax rates impact decisions. Raising MC relative to MB is never a good thing for output and employment. Think of the kinds of decisions that might be made as those with incomes above $200,000 react to the new and higher marginal tax rates:
·         Cut or do not expand output and employment
·         Delay output and employment to a future time when marginal rates might be lowered
·         Work less and take more leisure
·         Move output and employment to another location in Mexico or Canada
·         Consume less as you prefer to not sell stocks or bonds so as to postpone capital gains
·         Consume less as you move from dividend stocks to non-dividend stocks deferring gain to the future
·         Sell your worst stocks at a loss – the benefit of capital losses against taxes is now higher. This reduces your wealth and your desire to spend

These are a few behaviors to note but certainly there are more. The general idea is that raising marginal tax rates reduces the incentives to work, to produce, and to invest. Use the comment section on the blog to tell me what I missed. How else do increases in marginal tax rates cause negative effects?

The main idea should not be lost in the details – raising marginal tax rates create perverse incentives for economic growth. It is possible to raise revenues in such a way that these perverse impacts are minimized. If part of the political solution to current deficit/debt challenges is raising tax revenues on the wealthiest Americans, then more thought should be given as to how to do this. Capping deductions and similar schemes can impact the rich more than others and might have smaller undesirable impacts on economic growth. It goes without saying, however,  the more we restrain unbridled government spending the less has to be done in the way of tax revenues. But that’s another topic and you have shopping to do. So let’s carry this on later.

Tuesday, December 11, 2012

Uncle Vinny, Uncle Sam, and the proverbial rock/hard place

When people with responsibility and power make stupid public statements on film the press usually goes wild sort of like a swarm of bees after you just bumped into their nest.  Remember when Dan Quayle misspelled potato and when candidate Romney said something about the lower 47%. But when a prominent US Senator, Tammy Baldwin, explained in front of rolling cameras why Social Security could not be part of the coming budget negotiations because it was separate and fully funded until 2037, no one said a peep. The press looked like Marcel Marcaeu as Bip the Clown.

So pardon old Lar if he takes a big swig of JD and takes his chance to spout off a bit. Remember when our leading intellectual Al Gore mentioned the nation’s lock box a few years back? It is the same kind of disinformation. Is it stupidity or a clear attempt to mislead the public? Guys – there is a lock box. But unlike a real lock box that keeps the family treasures and a few naughty photos of grandma when she was 16, the USA lock box is full of a bunch of IOUs from the Federal government. Let’s suppose the Davidson family has a lock box with an IOU for a million dollars from Cousin Vinny. Vinny is in prison serving 90-100 years for financial fraud. Cousin Vinny owes a lot of people a lot of money.  What is that IOU worth to the Davidsons? Right! Zero, Nada, Zilch, Yung.  

It is the same thing with the US lock box. But in this case Uncle Vinny has been replaced with Uncle Sam. For years and years the Social Security system received more in revenues from tax payers than it paid out to prune-eating elderly. Did  Social Security invest those surplus dollar in GE stocks? In a portfolio of stocks? In anything that might come close to looking like an investment? Of course not.  Every year since I can remember SS lent the money to Uncle Vinny – er I mean Uncle Sam. Why? Because the US government has gone more than a half century spending more than it earned in the non-SS part of the government budget. That part of the budget is called "on-budget." That terminology makes no intuitive sense because all government spending, including SS, is included in the budget. 

For example, in 2012 the so-called on-budget part of the US budget had a deficit of approximately $1.4 trillion dollars. In that year the Off-Budget (mostly SS) had a surplus of $67 billion. So in 2012 SS loaned approximately $67 billion to the US government for its on-budget deficit. In return the SS system got another IOU to add to approximately a half a century of similar IOU’s. Those IOUs were stacking up like hotcakes at Denny’s on Sunday morning. Now please tell me what the probability is of the US government paying SS back so it will be solvent through 2037? Can you say zero?

As the surplus in SS soon diminishes – it is expected to be down to $22 billion by 2017, the government will begin paying from the on-budget part of the budget money to cover the deficits in social security.  This is like Uncle Sam getting a loan from Greece.   Since the on-budget will be in deficit too – that just means that we borrow more money from the public.

So when anyone tells you that SS is solvent and does not need to be part of the government fiscal cliff deliberations, please grab your wallet and whatever other valuables you might have with you and run for the hills. These people are either ignorant or the evil man Mini-Me. Either way, get out of town fast.

I feel better now. But I still have another page to ruin so why stop now when we are having so much fun? Let’s talk next about the President’s insistence that marginal tax rates be increased for the millionaires or those in the top 2 percent of the income distribution. First, the overwhelming majority of those in the top 2% are not millionaires – so quit saying that. It is just plain wrong and totally misleading. STOP IT. Aim I yelling?
Second, the top 2% account for approximately (I had to extrapolate from the top 1% and top 5% data) 18% of all income earned in the USA and pay 47% of all income taxes. Okay – so these folks make about a fifth of the income and pay almost HALF of the taxes. So quit saying that don’t pay their fair share. This is bullcrap. Just say they should pay more. If you think they should pay more – just say it that way. Don’t disparage the people who pay for nearly half of all income taxes collected? Don’t bite the hand that feeds you. Just explain why you want them to pay more. Is that so much to ask?

Finally, if some folks are willing to sock it to the upper 2% then why won’t you come off your high horse and work with them? To most of us the difference between a marginal tax rate and an average tax break is the like the difference between nuclear fusion and nuclear fission.  Most of us don’t have a clue about the difference without a quick trip to Wikipedia. To a nuclear physicist about to build a bomb, the difference is pretty critical. To an economist about to promote a policy to strengthen economic growth the difference between marginal and average tax breaks is also very important. So let’s work on this a minute.

One party says they want the rich to pay more. So let’s suppose we agree that the rich paying even more than 50% of all taxes is okay.  Let’s assume the other party says they are ready to sock it to the upper 2% by increasing the average tax rate paid by rich people. The rich will pay more dollars AND the rich will pay more dollars as a percent of their incomes. You would think the first party would be elated. But NOOOOO, that  party sticks up its nose and calls the other party a bunch of stupid poopie-heads.

Why isn’t that party willing to accept an increase in average income tax rates paid by the upper 2%? Why is the ONLY WAY they want to impact the rich through raising the marginal tax rates or brackets of the upper 2%? There is no economic answer. You can sock it to the rich equally with average or marginal approaches yet the President and some in his party insist that it has to be one way and not the other.  I heard Charles Krauthammer the other night explain on television while visibly gritting his teeth the reason for his focus on marginal rates is that President Obama wants to cripple the Republican Party. He thinks by sticking with the very intuitive marginal tax bracket approach that he fulfills his election mandate and sticks up for the average American by raising marginal rates.

I don’t know if Krauthammer is right or wrong. But I do think the President is being disingenuous – and that is a hard word to type if you don’t actually know how to type according to the correct method. On one hand Obama says it is all about math – that you cannot raise enough money from the rich by changing their deductions and thus raising their average tax rates. But that is highly debatable. Furthermore he recently did a complete flip-flop and now says that changing deductions will hurt charities too much. He said exactly the opposite a few years ago. Aside from the flip flop this signals the real reason he doesn’t want to go in the average tax rate direction – he has finally admitted that tax loop holes exist for a purpose. Each loophole was legislated for an important purpose. If you close loopholes then someone gets hurt. He says one day that the tax code and the entitlement system must be restructured. But he is not being honest. Every so-called restructuring will hurt one group or another. Obama does not want to get into all that. It is much easier and politically more fun to go after the rich and rich only via marginal tax rates.

But of course it is a big lie. If he raises his $1.6 trillion mostly from the rich do you really believe that won’t create another economic tailspin? Do you really believe that the 2013 recession will be short and modest? Do you really believe this won’t affect the average person greatly? No way Jose. One way or another – the US has to fix a half-century mess of living like Uncle Vinnie. This is the proverbial rock and a hard place. There are no easy solutions. To me we are better off starting down the path in the right direction with average tax rates. Marginal tax rates on the rich is a path to nowhere. 

Tuesday, December 4, 2012

Wealth, Income, and Keynesian Boobs

As I write the politicians of both parties are again throwing spears at one another with respect to a cliff.  Rather than complicate that mess further, I thought it might be a nice change of pace to focus on the difference between two economic concepts – income and wealth. Most of us would be happier if the economy grew faster. Faster growth would make solving the financial crisis a little easier. Our Keynesian predilection is to seek policies that aim at income and economic growth. Most of the stimulus policies focus on income. That’s the way we think because many of us were nursed on Keynesian boobs. Apparently we still aren’t weaned. A look at wealth might be more nourishing. 

Income is an intuitive concept. My Dad said that if I would do my chores I would get an allowance. The allowance was my income and while paltry it was worth a lot more than what he got out of me in the way of washing his car and drying the nightly dinner dishes. As an assistant professor at the Kelley School of Business in 1976 I earned a handsome sum of $15,000 in return for a year of confusing students and doing research that led to me to this glorious blog. We all know that we have to pay income taxes on what we earn and what is left to either spend or save is what we call disposable income. Let’s write that in big letters – DISPOSABLE INCOME. I write it in all caps to see if you are still awake. Also because it is the key to Keynesian economics. 

If the economy is weak, then Keynesian fiscal policy aims its bazookas at something that would increase disposable income. The government could give you a tax cut. Or perhaps the government could build a nice new and shiny bridge and pay construction company workers for the work – thereby increasing their take-home pay. A Keynesian monetary policy pours hot money into the financial system with the intent of lowering interest rates – causing homes, autos, and other interest-sensitive goods to be purchased and  produced – enriching with income those who produce all that stuff. So whether it is fiscal or monetary in nature, Keynesians are all about raising spending and disposable income.

That leads us to the four-letter word of the day – Wealth. Okay it is actually 4 letters with a “th” added to the end. Who am I Euclid? 4 letters 6 letters who cares? What matters is that wealth has become an ugly word. It has become an ugly word because most of the wealth – like much of the income -- is owned by a very small group of really rich people who live in castles and eat snails and sit in vaults and count their money over and over. Some even have their own television shows.

But what is wealth and why does it matter? It matters because there is more to economic growth than Keynesian preoccupations with income. Wealth is basically what must of us try to accumulate by earning income. My Dad gave me my allowance each week and said – Son, do not spend all your money and someday you will be a wealthy man. I laughed as I bought enough gum (and the enclosed free baseball cards) to make my dentist a wealthy man. Yes, as a young man I didn’t save a penny and my baseball collection didn’t amount to a hill of beans.

Saving is defined as the part or residual from your disposable income that you don’t spend. That’s easy. While it is true that much of the nation’s savings belongs to the wealthier people – most of us save or at least say we are going to save.  For example, much of our saving is done to provide for times when we no longer work – for bouts of unemployment and for our retirements. The saving that we and/or our employers do for our retirement is called a pension. 

As of 2011 the Federal Reserve estimated that Americans had about $13 trillion in pension reserve funds. We also save through our houses. We often think of the mortgage payments we make each month but the other side of the equation is that our homes are worth something.  The FRB estimates in 2011 U.S. households having homes worth a little more than $18 trillion. Of course we also hold our wealth in many other forms including bank deposits of about $8.6 trillion, equities or stocks worth about $9 trillion and various credit market instruments of almost $4 trillion. In total, the FRB estimates our total assets or wealth to equal about $73.6 trillion. Wealth data comes from the Federal Reserve Board Flow of Funds Accounts published in September 2012:  http://www.federalreserve.gov/releases/z1/Current/annuals/a2005-2011.pdf

Are you feeling rich? Want to buy a used hot tub? Don’t get too crazy. While we own all these assets we also incur a lot of loans or liabilities. If you borrow $1,000 to buy a cool new Fender electric guitar, your wealth has not really increased. You own a guitar but you also owe $1,000. When you pay off your loan in 47 years and your guitar is worth $35 dollars then you have some real wealth. When you subtract the liabilities from the assets, we get something called NET WEALTH. It is in caps because that is the important concept comparable to disposable income and because my Caps Lock key sticks sometimes.

Like disposable income, NET WEALTH gives you spending power. When all of our homes seemed to be worth a ton of money in 2006 because housing prices were making homes more valuable, we felt very wealthy and so we went out and bought groovy  pipes, sweaters with patches on the elbows, and we hired drivers for our all electric cars. NET WEALTH can have powerful impacts on the economy – just like disposable income.

That brings us back to now. US Net Wealth peaked at $66 trillion in 2007 and then subsequently fell to $53.5 trillion in 2008. That’s a decrease of almost $13 trillion or 19%. We felt a lot poorer! Even if a decrease in Net Wealth of $100 decreased spending by only $1, then this impact alone would have decreased GDP by more than $100 billion dollars in 2008. For that you can buy a lot of stinky fish and bindaetteok in Seoul. Much of that decline came from real estate and equities but pension funds and other asset values tumbled. When you see all your wealth vanishing you don’t run out and buy the most expensive Galaxy Note II.

So Net Wealth contributed to the recession we had in the USA in 2009 and 2010. As Einstein said, what goes down must come up. Or something like that. But the point is that Net Worth recovered and by 2011 it was estimated to have increased to about $60 trillion. Net Wealth recovered about half the value it lost after 2007 and was a positive force in the economic recovery. But we all know the recovery has been weaker than usual and we remain concerned that we are stuck at lackluster economic growth rates and high unemployment to boot.

Keynesians want to kick start disposable income. Since 2008 they have been stoking the fires of demand and disposable income and today Keynesians are pushing programs to keep government spending growing strongly and to pay for these increases by impaling rich people, or in modern terminology raising taxes on the rich. Vlad the Impaler would have been proud.  These programs have not been working and yet they keep asking for more taxes to support them.

An alternative approach is to think about New Wealth. If Net Wealth had already increased to its earlier value of $66 trillion it would have had a much bigger impact on the economy. Why didn’t Net Wealth return to its former value? To answer that we need to know a little more about the current market or the replacement value of wealth. Let’s suppose Aunt Lucy gave you some things when she passed in 1990. You received a house worth about $40,000, some stocks valued at about $2,000, and some long-term bonds worth $8,000. Is all that stuff worth a total of $50,000 today? Probably not – inflation has pushed the value of that house to about $120,000. Lower interest rates boosted bond prices so your bonds are now worth about $6000, and the growth in the overall stock market means that your stocks might be worth $24,000. 

Your wealth in this illustration increased to about $150,000 – an increase of $100,000. The point is that many factors can and do affect the prices of the assets we own.

So let’s use this understanding of net wealth in the context of recent policy to see why Net Wealth has not risen more in today’s policy environment.
Explosions of monetary policy contributed to an environment of lower interest rates and that has helped to stimulate housing and autos. But what if the increase in money also contributed to an increase in expectations about future inflation? Bonds and stocks do not do well in an inflationary environment so this contributed to lower expected future Net Worth. 
·         Furthermore, with interest rates so low and the economy recovering that means interest rates will likely rise – and will likely increase a lot. That will not be good for valuations of bond wealth. 
·         Policies that intend to hurt the rich by raising taxes on dividends and capital gains clearly are not good for stock market wealth.
·         A thicket of new regulations on companies specializing in housing, finance, nonrenewable energy, and health are not the best ways to increase the values of the stocks of those companies.
·         Finally, lackadaisical approaches to government deficit and debt moderation a la Europe clearly portend bad things for both bond and stock markets.

Keynesians and other macroeconomic policy liberals ignore the value of national Net Wealth to their peril. It seems fair to them to pay for more government spending for the middle class by taxing the rich. It seems like business as usual to keep middle class taxes low to stimulate disposable income to create growth.  An unrelenting force to redistribute income from the rich to the poor may well accomplish what they want in the short-term but the reality is that this will be bad for National Wealth and for the economy. As in other attempts to do such things, if these folks with their apparent mandates accomplish their policy goals – we as a nation might find fleeting equality but at a much lower level of wealth and income! It is like the guy with one bad foot who prayed that one day both his feet would again be equal. He got his wish and now both of his feet are bad!