The labor incentive effects of raising income taxes--a personal view

I like the stuff I buy.  If you raise my taxes, I will probably consult a little more so I can keep buying that stuff. This is the income effect being more important than the substitution effect.  I know that it is for me, and I am pretty sure it is for lots of others, as well.

"We are all in it together," and benefits taxes.

Tyler Cowen says that the Republican Party should propose raising taxes on everyone because, "we are all in it together."

To some extent, this is a benefits tax view--a view that we should pay to society our fair share of what we get from society.  But the implication of this is not necessarily that everyone should sacrifice in order to put us all on a sustainable fiscal path.

With Ronald Reagan's election in 1980, the US saw a sea change in tax and regulatory policy.  While the policy was suppose to benefit everyone, it clearly hasn't.  For the bottom quintile of the income distribution, income has risen about 5 percent since 1982 (the first year in which Reagan's policies bit); for the next quintile, it has risen 8 percent; for the next, 11 percent, for the next, 20 percent, and for the highest, 45 percent.  But most of the highest quintile didn't do so well--the top 5 percent has seen average household income rise by 68 percent.

These data are before tax, and come from the US Census, Table H-3.  Before anyone suggests that this means that everyone has benefited, I should point out that average income in the lowest quintile of the income distribution is $11,239, which is right at the Federal Poverty Level for a single person household.  In a benefits tax view of the world, people who haven't sufficient income to live should not be taxed (they are living at subsistence levels as it is, and taxing them makes thing worse).

So let's begin by holding the bottom quintile harmless in doing any kind of deficit reduction.  But what of the remaining quintiles?  If we look at the share of income growth by quintile (excluding the meager income growth of the bottom quintile), we find that 3 percent went to the second quintile from the bottom; 7 percent to the next; 18 percent to the next, and 73 percent to the top quintile.  So little has gone to the second and third quintile from the bottom that one could make a case that they should be left along as well.

The fourth quintile, though, has seen a material improvement in incomes, so it is probably OK to ask this group for something--this includes people who nearly everyone would consider middle class.  Nevertheless, the lion's share of the benefits of the policy changes of the early 1980s has appeared to go to the top quintile, and so the top quntile should pay the most to put us on a sustainable fiscal path.

One last calculation--the top 5 percent got 57 percent of the income growth within its quintile.

It is true that households move in and out of quintiles, but as Dalton Conley shows, not as much as we would like to think,  In any event, we have not been all in it together when it has come to benefitting from the policies of the past 30 years.

California leads

From California's Legislative Analyst's Office:

The 18th annual edition of the LAO's Fiscal Outlook--a forecast of the state's budget condition over the next five years--shows that California's budget situation has improved sharply. The state's economic recovery, prior budget cuts, and the additional, temporary taxes provided by Proposition 30 have combined to bring California to a promising moment: the possible end of a decade of acute state budget challenges. Our economic and budgetary forecast indicates that California's leaders face a dramatically smaller budget problem in 2013-14 compared to recent years. Furthermore, assuming steady economic growth and restraint in augmenting current program funding levels, there is a strong possibility of multibillion-dollar operating surpluses within a few years.

The voters of California raised taxes on themselves. Most of the revenue will come from income taxes on the top 3 percent of the income distribution; there is also a small hike in the sales tax.

Will Google, Apple, Intel, Disney, etc. run away because of this?  I rather doubt it.  And comparisons to Greece now look particularly ridiculous.

John Griffith on why Gretchen Morgenson should not trust Edward Pinto

He writes in American Banker:

The onslaught began last month after the agency released a sobering financial report, then accelerated last week when the New York Times reported on an alleged "pattern of risky lending" in the agency's mortgage insurance program.

The Times piece, penned by columnist Gretchen Morgenson, relays the findings of a controversial new report from Edward Pinto of the conservative American Enterprise Institute. Pinto's study takes on an important issue—the performance of FHA-insured home loans—but draws conclusions based on ideology rather than a cold appraisal of the facts. By relying entirely on one man's misleading data and unfounded opinions, Morgenson has done a grave disservice to a critical federal program.

The report in question argues that the FHA is "financing failure" for working-class families by peddling high-risk loans to unworthy borrowers, based on an analysis of loans insured in 2009 and 2010. Pinto concludes that the agency's basic business model—insuring long-term, low-down-payment loans to borrowers with less-than-perfect credit—puts homeowners at an unacceptably high risk of default with negative consequences for communities.

Nothing could be further from the truth....

.... Pinto focuses on the cost of foreclosure without considering the FHA's contribution to these neighborhoods since the crisis began. If FHA insurance weren't available under reasonable terms, it would have been much more difficult for low- and moderate-income families to get mortgage credit since the crisis began. As a result, home prices would have declined precipitously beyond already-depressed levels – by as much as 25%,according to one estimate from Moody’s Analytics – leading to far more foreclosures on all homes, not to mention additional job loss, lost household wealth and a far deeper or more prolonged recession.

That counter-cyclical support is a key part of the agency's mission, and it understandably comes with some costs. If the foreclosure crisis were a fire, Pinto would be blaming the firefighters for getting the house wet.

In the coming months, we hope there is a serious debate about the FHA's role in the housing market and the overall role of the government in housing finance. That will require us to sort facts from partisan nonsense, and here's hoping this report doesn't make the cut.

Matthew Yglesias says weather doesn't matter

I just caught up with his Valentine to Minneapolis:

People appear to be deterred from moving to Minneapolis on the grounds that it's very cold, but David Schkade and Daniel Kahneman have found that people's thinking about weather and happiness is dominated by "focusing illusion" in which "easily observed and distinctive differences between locations are given more weight in such judgments than they will have in reality." They specifically looked at the weather gap between California and the Midwest and found that while Midwesterners thought the good weather in California would make a huge difference in people's lives, it doesn't in reality.

OK, maybe I am idiosyncratic.  But as a person who lived most of his life in Wisconsin (not as cold as Minnesota), and who now lives in California, I can tell you the three reasons I will most likely never leave this place:

(1) My wife does cool and useful things here.
(2) I like the people I work with very much.
(3) Weather.

George Bittlingmayer on Buffet v Asness

From comments:

Under this theory, if gross-of-tax discount rates are 10% and an investment promises $10 per year, I'll plunk down $100 for it if tax rates are zero, and $100 if tax rates are 50% and I get only $5 per year. "To be tested." Recall also, if tax rates are on nominal returns, with even moderate inflation, the tax falls on what is a compensation for inflation. The effect of higher taxes seems like an empirical question, with all due respect to both Buffett & Asness, and Richard.

I agree, it is testable.  One thing that makes testing tough, though, is trying to figure out how the market discount rate change as a result of tax policy.  IN any event my principal criticism of Asness is that if you are going to change the numerator, you also need to change the denominator.

Hannah Green in Think Progress on trash

She writes:

In India, there is a thriving market for trash. People make lives for themselves collecting it, sorting it, buying it, selling it: making it useful once again.

While the community of trash workers occasionally gets attention from the American media, the focus often revolves around the initial realization that people can earn a living from garbage piles, and what this says about poverty levels.

Katherine Boo’s recent book related to the subject, Behind the Beautiful Forevers, went deeper, exploring the mechanisms of entrepreneurship and exploitation in India. However, there is also a more positive side to this story that often goes uncommented on. An efficient recycling system has a long-term positive effect on society as a whole, and is also something that North America and Europe generally lack. That is a significant part of what the trash economy in India is- an informal recycling system.

Who is right: Clifford Asness or Warren Buffet?

In a Wall Street Journal piece this morning, a man named Clifford Asness says that Warren Buffet is wrong when he says the impact of taxes on investment decisions is very small.  His argument:

Consider how every business-school student, investment banker and investment analyst on Earth has been taught to choose whether to invest in a specific project or company. You make a spreadsheet (a napkin will do sometimes). You put in your best guess of the future cash flows, and you discount those cash flows back to the present at some required rate of return you believe reflects the risk entailed. Of course, opinions about the future cash flows and the proper discount rate can vary widely, but the essential methodology is ubiquitous.

Now here's the kicker: Nobody who pays taxes and has ever done this exercise has failed (while sober) to use after-tax cash flows in this calculation. Somewhere in the spreadsheet there is a number, say 20%, or 28%, or a Gallic 75%, representing the taxes you'll pay on the assumed cash flow—and you only count the amount you'll get after paying this tax. If you turn the tax rate up high enough, projects or companies that looked like good investments become much less attractive and vice versa.

Here is the problem with this argument--it focuses on the numerator of the discounted cash flow calculation, but not the denominator.  The denominator contains the discount rate, which is the opportunity cost of capital.  One can do an analysis based on before tax cash flows, in which case the denominator is the before tax OCC.  The formula for before tax cash flow valuation is

Where CF is cash flow subscripted by time t,  r is the discount rate, and E is the expectations operator.

But if one is going to take taxes out of the denominator, he must also take it out of the numerator.  This means the ATDCF formula needs to be

The greek letter τ is the marginal income tax rate.  If we examine this formula, we see that for small t, value does in fact decline with an increase in taxes.  But now let us approximate a long term investment by looking at the perpetual annuity formula--one that has a constant cash flow for infinite t.

Now the formula for before tax valuation becomes:

Analogously, the formula for after tax valuation becomes:

Of course, the (1-τ) divides through, so the after tax and before tax values are the same.

But here is where I will add a kicker of my own: if it is really true that fiscal issues as creating uncertainty, resolving those issues should reduce the discount rate, and thus encourage investment.  People such as Mr. Asness should welcome greater certainty, and the investment opportunities it will doubtless induce.