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Posts Tagged ‘Payroll Taxation’

I wrote two days ago about how the White House is contemplating ideas to boost the economy.

This is somewhat worrisome since “stimulus” plans oftentimes are based on Keynesian economics, which has a terrible track record. But there are policies that could help growth and I comment on some of them in this interview.

The discussion jumped from one idea to the next, so let’s makes sense of the various proposals by ranking them from best to worst.

And I’m including a few ideas that are part of the discussion in Washington, but weren’t mentioned in the interview.

  1. Eliminate Trade Taxes – Trump’s various trade taxes have made America’s economy less efficient and less productive. And, as I explained in the interview, the president has unilateral power to undo his destructive protectionist policies.
  2. Index Capital Gains – The moral argument for using regulatory authority to index capital gains for inflation is just as strong as the economic argument, as far as I’m concerned. Potential legal challenges could create uncertainly and thus mute the beneficial impact.
  3. Lower Payroll Tax Rates – While it’s always a good idea to lower the marginal tax rate on work, politicians are only considering a temporary reduction, which would greatly reduce any potential benefits.
  4. Do Nothing – As of today, based on Trump’s statements, this may be the most likely option. And since “doing something” in Washington often means more power for government, there’s a strong argument for “doing nothing.”
  5. Infrastructure – This wasn’t mentioned in the interview, but I worry that Trump will join with Democrats (and some pork-oriented Republicans) to enact a boondoggle package of transportation spending.
  6. Easy Money from the Fed – Trump is browbeating the Federal Reserve in hopes that the central bank will use its powers to artificially reduce interest rates. The president apparently thinks Keynesian monetary policy will goose the economy. In reality, intervention by the Fed usually is the cause of economic instability.

In my ideal world, I would have included spending cuts. But I limited myself to ideas that with a greater-than-zero chance of getting implemented.

I’ll close with some observations on the state of the economy.

Economists have a terrible track record of predicting twists and turns in the economy. This is why I don’t make predictions and instead focus on analyzing how various policies will affect potential long-run growth.

That being said, it’s generally safe to assume that downturns are caused by bad economic policy, especially the Federal Reserve’s boom-bust monetary policy.

Ironically, some people then blame capitalism for the damage caused by government intervention (the Great Depression, the Financial Crisis, etc).

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There’s general agreement among public finance experts that personal income taxes and corporate income taxes, on a per-dollar-collected basis, do the most economic damage.

And I suspect there’s a lot of agreement that this is because these levies often have high marginal tax rates and often are accompanied by a significant bias against income that is saved and invested.

Payroll tax and consumption taxes, by contrast, are thought to be less damaging because they generally don’t have “progressive rates” and they are “neutral,” meaning they rarely involve any double taxation of saving and investment.

But “less damaging” is not the same as “no damage.”

Such taxes still drive a wedge between pre-tax income and post-tax consumption, so they do result in less economic activity (what economists refer to as “deadweight loss“).

And the deadweight loss can be significant if the overall tax burden is sufficiently onerous (as is the case in many European nations).

Interestingly, the (normally pro-tax) International Monetary Fund just released a study on this topic. It looked at the impact of taxes on work in the new member states (NMS) of the European Union. Here’s a summary of what the authors wanted to investigate.

Given demographic and pension pressures facing many EU28 countries amidst low labor market participation rates together with still high tax wedges, the call to review public policies has gained renewed prominence in the EU political debate. …tax wedges remain high and participation rates, while having increased importantly in a few countries over 2000-17 , are still around or below 70 percent in many of them. This hints at the need for addressing structural problems to improve economic fortunes. In this paper we focus our attention on hours worked (per working age population). …At country level, hours worked reflect labor supply decisions and could be thought of a measure of labor utilization. Long-run changes in labor supply are driven by incentives, of which taxes are perceived to be central. Assessing the importance of taxation on hours is key to provide new insights for potential policy actions.

And here’s what they found.

We study the role of taxes in accounting for differences in hours worked across NMS over the 1995-17 period… We find that consumption and labor taxes significantly discourage labor supply and can explain close to 21 percent of the observed variation of hours across NMS. …Higher tax rates reduce households’ net labor income and real purchasing power, inducing them to substitute consumption for leisure, which cannot be taxed. …Our findings show that, conditional on other factors, taxes are an important determinant of hours. Point estimates suggest a high elasticity of hours to taxes (close to 0.5), which is robust to the inclusion of other factors.

What’s interesting about the new member states of Eastern Europe is that many of them have flat taxes and low corporate rates.

So the personal and corporate income taxes are not a major burden.

But they so have relatively high payroll taxes (a.k.a., social insurance taxes) and relatively onerous value-added taxes.

So it’s hardly a surprise that these levies are the ones most associated with deadweight loss.

We find that social security contributions deter hours the most, followed by consumption taxes and, to a lesser extent, personal income taxes. …Consumption and personal income taxes are found to affect hours per worker, but not employment rates. On the other hand, social security contributions are negatively associated with employment rates, but do not seem to affect hours per worker. …In line with the literature, we document that women’s employment rate is more sensitive to changes in tax policies. We find the elasticity of employment rate to social security contributions to be 7 percent larger for women vis-à-vis men.

Here’s one of the charts from the study.

And here’s an explanation of what it means.

Figure 4 shows the evolution of hours and effective taxes. Hours worked increased substantially for Group 1, while it remained stable in Group 2 (Panel (a)). In both groups, the effect of the GFC is noticeable as hours sharply declined after 2008. Panel (b) shows the evolution of the average effective tax rate in each group. Interestingly, countries in Group 1, which observed an increase in hours, had lower effective tax rates (below 40 percent) throughout the period. In addition, we observe a negative correlation between hours and taxes for most of the sample. For Group 1, the large increase in hours – between year 2000 and the GFC – happened at the same time taxes declined

Here’s another chart from the IMF report.

And here’s some of the explanatory text.

Figure 5 depicts the relationship between hours worked and taxes across countries. In Panel (a), we observe a negative correlation between hours and taxes in levels for each group, with the negative correlation being stronger in Group 2 than in Group 1 (it has a steeper slope). Panel (b) shows total log changes in hours and taxes throughout the period. It also displays a negative correlation.

Looking at the conclusion, a key takeaway from the study is that there is a substantial loss of economic activity because of theoretically benign (but in reality onerous) taxes on consumption and labor.

Our modelling exercise shows that taxes influence the long-run trend in hours and our econometric exercise shows that the findings are robust to the inclusion of other labor market determinants. Furthermore, we document an elasticity of hours to overall taxes close to 0.5. We find that differences in tax burden can explain up to 21 percent in the variation of hours worked across NMS. The main takeaway of this study is that excessive tax burden, either in the form of consumption or labor taxes, can lead to substantial deadweight losses in terms of labor supply. .. overall tax burden – and not only labor taxes – should be considered when thinking about incentives from tax schemes.

Yes, incentives do matter.

And it’s good that an IMF report is providing good evidence for lower tax rates.

But I’m not optimistic we’ll get pro-growth changes. There’s been a lack of good reform this decade from the new member states from Eastern Europe. Combined with demographic decline (and the associated pressure for higher tax rates), this does not bode well.

P.S. While the professional economists at the IMF often produce good research and sensible advice, the bureaucracy’s political leaders almost always ignore those findings and instead push for bad tax policy. Including in the new member states from Eastern Europe.

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When I write about Social Security, I normally focus on two serious deficiencies.

  1. The program was never properly designed to deal with demographic change, which means there’s a gargantuan long-run budgetary shortfall of $44 trillion.
  2. The program is a very bad deal for workers (especially minorities), offering a paltry retirement benefit compared to what could be obtained with private savings.

I’ve neglected to explain, though, that there’s also an economic cost. All government spending is a burden since resources get diverted from the productive sector of the economy. Moreover, the associated payroll taxes have an adverse impact on incentives for employment.

Those taxes also have a negative effect on entrepreneurship, according to new research from three economists. Here are some excerpts from their study, which has been published by the National Bureau of Economic Research. We’ll start with a look at the methodology.

Entrepreneurship plays a central role in modern economies. In the US, for example, new businesses account for 20% of total gross job creation. While entrepreneurs can be very successful…, entrepreneurship remains one of the most economically risky lines of activity and can result in large wealth losses. …the marginal value of resources for entrepreneurs can be substantial, given how cash-constrained they often are. Therefore, mandating social insurance, while reducing risks,could significantly affect entrepreneurial activity. …In this paper, we…exploit quasi-experimental variation in the amount of social insurance contributions and…administrative data on the full population of Finnish entrepreneurs to address this question. …We use a standard differences-in-differences strategy and exploit a reform in 2011 that changed the ownership share rule from 50% to 30% to assess how relaxing the social insurance mandate affects entrepreneurial activity. …Overall, we find that social insurance contributions are reduced by an aver-age of 19% for the treatment group, which has more discretion over insurance contributions after the reform. This reduction represents a large cash windfall, equivalent to, on average, a 5 percentage-point reduction in corporate taxes.

Here are the key results, which show that payroll taxes have a decidedly negative effect on new firms.

…we observe a larger than average decrease in social insurance contributions by the owners of younger firms. The cash saved from the lower contributions is channeled into their firms, as we observe an increase in both employee compensations and other input costs, and an increase in turnover after the reform. …entrepreneurs in younger firms are more liquidity-constrained and have access to better growth opportunities than more mature firms. …Figure 2 shows the effect of the 2011 reform on business activity for young firms that are equal to or younger than five years old. …we estimate a 9.9% increase in turnover and a 6% increase in employee wage costs. Overall, these results imply that firms use the saved cash to pay for additional intermediate inputs and labor in order to increase turnover, and suggests that these firms might be facing liquidity constraints.

Here’s the aforementioned Figure 2, showing the both sales and wages are higher when social insurance taxes are lower.

The bottom line is clear.

…our findings imply that the social insurance mandate…crowds out business activity for young firms… the social insurance mandate for entrepreneurs has heterogeneous efficiency costs. Efficiency gains could be achieved by…lower social insurance contributions.

What is meant by efficiency gains?

That’s simply economic jargon for faster growth and higher living standards. And those results occur because entrepreneurs play a key role in driving innovation.

P.S. This issue is timely and important since politicians such as Bernie Sanders and Alexandria Ocasio-Cortez are pushing “Medicare for All” and other schemes that would require huge increases in payroll taxes.

P.P.S. Other Democrats, such as Barack Obama and Hillary Clinton, have urged higher payroll taxes that would deliberately target entrepreneurs, investors and business owners.

P.P.P.S. You can enjoy some Social Security cartoons here, here, and here. And we also have a Social Security joke if you appreciate grim humor.

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I argued last year that leftists should be nice to rich people because upper-income taxpayers finance the vast majority of the American welfare state according to government data.

Needless to say, my comment about being “nice” was somewhat sarcastic. But I was making a serious point about the United States having a very “progressive” fiscal system. The top-20 percent basically pay for government and those in the bottom half are net recipients of that involuntary largesse.

I also pointed out a huge difference between the United States and Europe. Governments on the other side of the Atlantic impose much higher burdens on lower-income and middle-class taxpayers.

Here’s some of what I wrote.

…the big difference between the United States and Europe is not taxes on the rich. We both impose similar tax burden on high-income taxpayers, though Europeans are more likely to collect revenue from the rich with higher income tax rates and the U.S. gets a greater share of revenue from upper-income taxpayers with double taxation on interest, dividends, and capital gains (we also have a very punitive corporate tax system, though it doesn’t collect that much revenue). The real difference between America and Europe is that America has a far lower tax burden on lower- and middle-income taxpayers. Tax rates in Europe, particularly the top rate, tend to take effect at much lower levels of income. European governments all levy onerous value-added taxes that raise costs for all consumers. Payroll tax burdens in many European nations are significantly higher than in the United States.

So do this mean European politician don’t like ordinary people?

I could make a snarky comment about the attitudes of the political elite, but I’ll resist that temptation and instead point out that taxes in Europe are much higher for the simple reason that government is much bigger and that means some segment of the population has to surrender more of its income.

But here’s the $64,000 question that we want to investigate today: Why are European governments pillaging lower-income and middle-class taxpayers instead of going after the “evil rich” and “greedy corporations”?

Part of the answer is that there aren’t enough rich people to finance big government. But the most important factor is the Laffer Curve. Politicians can impose higher tax rates on upper-income taxpayers and companies, but that doesn’t necessarily translate into higher revenue. Simply stated, well-to-do taxpayers have considerable ability to earn less income and/or report less income when tax burdens increase, and they do the opposite when tax burdens decrease.

That’s true in the United States, and it’s true in European countries such as Sweden, France, Russia, Denmark, and the United Kingdom.

So even if politicians want to fleece upper-income taxpayers, that’s not a successful method of generating a lot of revenue.

Which is why a shift from a medium-sized welfare state (such as what exists in the United States) to a large-sized welfare state (common in Europe) means huge tax increases on ordinary taxpayers.

I’ve made this point before, but now I have some additional evidence thanks to a new report from the Organization for Economic Cooperation and Development. The Paris-based bureaucracy is probably my least-favorite international organization because of its advocacy for statism, but it collects and publishes lots of useful statistics about fiscal policy in the industrialized world.

And here are three charts from the new study that tell a very persuasive story (and a depressing story for ordinary taxpayers).

First, we can see how the average tax burden has increased substantially over the past 50 years.

And who is paying all that additional money to politicians?

As you can see from this second chart, income tax revenues have become a less-important source of revenue over time while social insurance taxes (mostly paid by lower-income and middle-class taxpayers) have become a more-important source of revenue.

The third chart shows the evolution of the value-added tax burden. This levy takes a big bite out of the paychecks of ordinary people and the rate keeps climbing over time (and if we looked just at European governments that are part of the OECD, the numbers are even more depressing).

Now let’s put this data in context.

The United States now has a medium-sized welfare state financed mostly by upper-income taxpayers.

But because of dramatic demographic changes, we are doomed to have a large-sized welfare state. At least that’s what will happen if we don’t reform entitlement programs.

And if we leave policy on auto-pilot and there’s a substantial increase in the burden of government spending, it’s simply a matter of time before politicians figure out new ways of taking more money from lower-income and middle-class taxpayers.

Yes, they may also impose higher rates on “rich” taxpayers, but that will be mostly for symbolic purposes since those levies won’t generate substantial revenue.

Last but not least, don’t forget that European fiscal burdens will mean anemic European economic performance.

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