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Posts Tagged ‘Taxation’

At the risk of over-simplifying, the difference between “supply-side economics” and “demand-side economics” is that the former is based on microeconomics (incentives, price theory) while the latter is based on macroeconomics (aggregate demand, Keynesianism).

When discussing the incentive-driven supply-side approach, I often focus on two key points.

  • Marginal tax rates matter more than average tax rates because the incentive to earn additional income (rather than enjoying leisure) is determined by whether the government grabs a small, medium, or large share of any extra earnings.
  • Some taxpayers such as investors, entrepreneurs, and business owners are especially sensitive to changes in marginal tax rates because they have considerable control over the timing, level, and composition of their income.

Today, let’s review some new research from Spain’s central bank confirms these supply-side insights.

Here’s what the authors investigated.

The impact of personal income taxes on the economic decisions of individuals is a key empirical question with important implications for the optimal design of tax policy. …the modern public finance literature has devoted significant efforts to study behavioral responses to changes in taxes on reported taxable income… Most of this work focuses on the elasticity of taxable income (ETI), which captures a broad set of real and reporting behavioral responses to taxation. Indeed, reported taxable income reflects not only individuals’ decisions on hours worked, but also work effort and career choices as well as the results of investment and entrepreneurship activities. Besides these real responses, the ETI also captures tax evasion and avoidance decisions of individuals to reduce their tax bill.

By the way, “elasticity” is econ-speak for sensitivity. In other words, if there’s high elasticity, it means taxpayers are very responsive to a change in tax rates.

Anyhow, here’s how authors designed their study.

In this paper, we estimate the elasticity of taxable income in Spain, an interesting country to study because during the last two decades it has implemented several major personal income tax reforms… In the empirical analysis, we use an administrative panel dataset of income tax returns… We calculate the MTR as a weighted average of the MTR applicable to each income source (labor, financial capital, real-estate capital, business income and capital gains).

You can see in Figure 1 that the 2003 reform was good for taxpayers and the 2012 reform was bad for taxpayers.

If nothing else, though, these changes created the opportunity for scholars to measure how taxpayers respond.

And here are the results.

We obtain estimates of the ETI around 0.35 using the Gruberand Saez (2002) estimation method, 0.54 using Kleven and Schultz (2014)’s method and 0.64 using Weber (2014)’s method. …In addition to the average estimates of the ETI, we analyze heterogeneous responses across groups of taxpayers and sources of income. …As expected, stronger responses are documented for groups of taxpayers with higher ability to respond. In particular, self-employed taxpayers have a higher ETI than wage employees, while real-estate capital and business income respond more strongly than labor income. …we find large responses on the tax deductions margin, especially private pension contributions.

In other words, taxpayers do respond to changes in tax policy.

And some taxpayers are very sensitive (high elasticity) to those changes.

Here’s Table 6 from the study. Much of it will be incomprehensible if you’re not familiar with econometrics. But all that matters is that I circled (in red) the measures of how elasticities vary based on the type of income (larger numbers mean more sensitive).

I’ll close with a very relevant observation about American fiscal policy.

Currently, upper-income taxpayers finance the vast majority of America’s medium-sized welfare state.

But what if the United States had a large-sized welfare state, like the ones that burden many European nations?

If you review the data, those large-sized welfare states are financed with stifling tax burdens on lower-income and middle-class taxpayers. Politicians in Europe learned that they couldn’t squeeze enough money out of the rich (in large part because of high elasticities).

Indeed, I wrote early this year about how taxes are confiscating the lion’s share of the income earned by ordinary workers in Spain.

And if we adopt the expanded welfare state envisioned by Bernie Sanders, Alexandria Ocasio-Cortez, and Kamala Harris, the same thing will happen to American workers.

P.S. I admire how Spanish taxpayers have figured out ways of escaping the tax net.

P.P.S. There’s also evidence about the impact of Spain’s corporate tax.

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In my libertarian fantasies, we dramatically shrink the size of the federal government and return to pre-1913 policy by getting rid of the income tax.

But if I’m forced to be at least vaguely realistic, the second-best option is scrapping the current tax code and replacing it with a simple and fair flat tax based on the “Holy Trinity” of good policy.

The third-best option (i.e., the best we can hope for in the real world) is to adopt incremental reforms that move the tax code in the right direction.

That happened in 2017. I’ve written many times about why it was a very good idea to reduce the tax rate on corporate income. And I’ve also lauded the 2017 law’s limitation on the state and local tax deduction.

Today, let’s focus on the changes in that law that reduced the tax preference for residential real estate.

The housing lobby (especially builders and realtors) tried to scare lawmakers that any reduction in their privileged tax status would cause a large amount of damage.

Yet, as reported last year by the New York Times, there was no adverse effect in the first year of the new tax law.

It wasn’t supposed to take long for the Trump tax cuts to hobble housing prices… Nearly nine months later, those warnings have not materialized. …Economists see only faint effects from the new law so far in housing data. They’re small, and they’re contained to a few high-priced, highly taxed ZIP codes, largely in blue states. They’re nothing close to the carnage that real estate groups warned about when the law was under debate last fall. …the tax law has unquestionably diminished the value of several federal subsidies for homeowners. It limits deductions for state and local taxes, including property taxes, to $10,000 per household, which hurts owners of expensive homes in high-tax states. It lowers the cap on the mortgage interest deduction, which raises housing prices by allowing homeowners to write off the interest payments from their loans, to $750,000 for new loans, down from $1 million.

To the extent the impact could even be measured, it was a net plus for the economy.

After the law passed, ZIP codes in the Boston area saw a 0.6 percentage point slowdown in home appreciation on the Massachusetts side — and a 0.1 percent acceleration on the New Hampshire side. The effect there is “not huge, it’s small,”… Experts say several forces are helping to counteract the diminished federal home-buying subsidies. …said Kevin Hassett, “…if you’re getting a lot of income growth, the income growth increases the demand for housing, and the mortgage interest deduction reduces it. And the effects offset.”

This chart from the story is particularly persuasive. If anything, it appears housing values rose faster after the law was changed (though presumably due to bad policies such as building restrictions and zoning laws, not just the faster growth caused by a a shift in tax policy).

There’s also no negative effect one year later. A report from today’s New York Times finds that the hysterical predictions of the housing lobby haven’t materialized.

Even though the tax preference was significantly reduced.

The mortgage-interest deduction, a beloved tax break bound tightly to the American dream of homeownership, once seemed politically invincible. Then it nearly vanished in middle-class neighborhoods across the country, and it appears that hardly anyone noticed. …The 2017 law nearly doubled the standard deduction — to $24,000 for a couple filing jointly — on federal income taxes, giving millions of households an incentive to stop claiming itemized deductions. As a result, far fewer families — and, in particular, far fewer middle-class families — are claiming the itemized deduction for mortgage interest. In 2018, about one in five taxpayers claimed the deduction, Internal Revenue Service statistics show. This year, that number fell to less than one in 10. The benefit, as it remains, is largely for high earners, and more limited than it once was: The 2017 law capped the maximum value of new mortgage debt eligible for the deduction at $750,000, down from $1 million.

Once again, the evidence shows good news.

…housing professionals, home buyers and sellers — and detailed statistics about the housing market — show no signs that the drop in the use of the tax break is weighing on prices or activity. …Such reactions challenge a longstanding American political consensus. For decades, the mortgage-interest deduction has been alternately hailed as a linchpin of support for homeownership (by the real estate industry)…. most economists on the left and the right…argued that the mortgage-interest deduction violated every rule of good policymaking. It was regressive, benefiting wealthy families… Studies repeatedly found that the deduction actually reduced ownership rates by helping to inflate home prices, making homes less affordable to first-time buyers. …In the debate over the tax law in 2017, the industry warned that the legislation could cause house prices to fall 10 percent or more in some parts of the country. …Places where a large share of middle-class taxpayers took the mortgage-interest deduction, for example, have not seen any meaningful difference in price increases from less-affected areas.

Incidentally, here’s a chart from the story. It shows that the rich have always been the biggest beneficiaries of the tax preference.

And now the deduction that remains is even more skewed toward upper-income households.

As far as I’m concerned, the tax code shouldn’t punish people simply because they earn a lot of money.

But neither should it give them special goodies.

For what it’s worth, the mortgage interest deduction is not a left-vs-right or statism-vs-libertarian issue.

I’ve crossed swords on a few occasions with Bill Gale of the Brooking Institute, but his column a few months ago in the Wall Street Journal wisely calls for full repeal of this tax preference.

With any luck, the 2017 tax overhaul will prove to be only the first step toward eventually replacing the century-old housing subsidy… This is a welcome change. The mortgage-interest deduction has existed since the income tax was created in 1913, but it has never been easy to justify. …Canada, the United Kingdom, and Australia have no mortgage-debt subsidies, yet their homeownership rates are slightly higher than in the U.S. A large reduction in the mortgage-interest deduction in Denmark in 1987 had virtually no effect on homeownership rates. …The next step should be to eliminate the deduction altogether. The phaseout should be gradual but complete.

Here’s another example.

Nobody would ever accuse the folks at Slate of being market friendly, so this article is another sign that there’s a consensus against using the tax code to tilt the playing field in favor of residential real estate.

One of the most remarkable things about the tax bill Republicans passed last year was how it took a rotary saw to the mortgage interest deduction. The benefit for homeowners was once considered a politically untouchable upper-middle-class entitlement, but the GOP aggressively curtailed it in order to pay for cuts elsewhere in the tax code. …just 13.8 million households will subtract mortgage interest from their 2018 returns, down from 32.3 million in 2017. …if Democrats ever get a chance to kill off the vestigial remains of the mortgage interest deduction down the line, they might as well. …any negative effect of the tax law seems to have been drowned out by a healthy economy.

I’ll close by digging into the archives at the Heritage Foundation and dusting off one of my studies from 1996.

Analyzing the flat tax and home values, I pointed out that rising levels of personal income were the key to a strong housing market, not the value of the tax deduction.

Everything that’s happened over the past 23 years – and especially the past two years – confirms my analysis.

Simply stated, economic growth is how we get more good things in society. That’s true for housing, as explained above, and it’s also true for charitable giving.

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When I write about Estonia, I generally have something nice to say.

Today, I want to add to my praise for this Baltic nation.

Unlike politicians in many other nations, lawmakers in Estonia responded wisely when they saw a tax increase was backfiring.

As Estonia tries to recover its alcohol customers lost to neighbouring Latvia due to high excise duty, the parliament in Tallinn has passed a 25% cut in excise duty rate. Estonian public broadcaster ERR reports that the bill was passed on Thursday, June 13, in the Riigikogu by landslide. In the final reading, the bill was passed by 70-9 MP in favour backing the cutting of the alcohol excise duty rates for beer, cider and hard liquor by 25% beginning July 1. The amendments to the Estonian Alcohol, Tobacco, Fuel and Electricity Excise Duty Law…are aimed at reducing cross-border trade of Estonians buying their drinks much cheaper in northern Latvia.

Of course, it’s worth pointing out that Estonian politicians shouldn’t have increased excise taxes on booze in the first place.

And they may have fixed the problem because they got on the wrong side of the Laffer Curve (i.e., tax revenue was falling), not because of a philosophical preference for lower tax rates.

But rectifying a mistake is definitely better than doubling down on a mistake, which is how politicians in many other nations probably would have reacted.

This approach, combined with the good policies listed above, helps to explain why Estonia is one of the few economic success stories to emerge from the collapse of the Soviet Empire.

Though, in closing, I’ll note that the country needs additional pro-market reform to deal with the challenge of demographic decline.

P.S. Read what Estonia’s Minister of Justice wrote about totalitarian socialism.

P.P.S. Also read about how Paul Krugman earned an “exploding cigar” with some sloppy analysis about Estonia.

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Assuming the goal is faster growth and higher living standards, there are three core principles of good tax policy.

You could call this list the Holy Trinity of supply-side economics. Simply stated, incentives matter, so it makes no sense for government to discourage the things that make a nation more prosperous.

Regarding low marginal tax rates, my left-leaning friends sometimes dismiss the importance of this principle by pointing out that they don’t pay much attention to their marginal tax rates.

I can sympathize with their skepticism. When I was first learning about public finance and studying supply-and-demand curves showing deadweight loss, I also wondered about the supply-side claim that marginal tax rates mattered. Even after I started working, I had doubts. Would I somehow work harder if my tax rate fell? Or goof off if my tax rate went up? It didn’t make much sense.

What I didn’t recognize, however, is that I was looking at the issue from the perspective of someone working a standard, 9-to-5 job with a modest income. And it is true that such workers are not very responsive (especially in the short run) to changes in tax rates.

In the real world, though, there are lots of people who don’t fit that profile. They have jobs that give them substantial control over the timing, level, and composition of their income.

And these people – such as business owners, professionals, second earners, investors, and entrepreneurs – often are very responsive to changes in marginal tax rates.

We have a new example of this phenomenon. Check out these excerpts from a story in the U.K.-based Times.

About three quarters of GPs and hospital consultants have cut or are planning to cut their hours… About 42 per cent of family doctors and 30 per cent of consultants have reduced their working times already, claiming that they are being financially penalised the more they work. A further 34 per cent and 40 per cent respectively have confirmed that they plan to reduce their hours in the coming months… The government has launched an urgent consultation over the issue, which is the result of changes to pension rules limiting the amount that those earning £110,000 or more can pay into their pensions before they are hit with a large tax bill.

In other words, high tax rates have made leisure more attractive than work. Why work long hours, after all, if the tax authority is the biggest beneficiary?

There are also indirect victims of these high tax rates.

Last month figures from NHS Providers, which represents hospitals, showed that waiting lists had climbed by up to 50 per cent since April as doctors stopped taking on extra shifts to avoid the financial penalties. Richard Vautrey, chairman of the BMA GPs’ committee, said: “These results show the extent to which GPs are being forced to reduce their hours or indeed leave the profession altogether because of pension taxes. …swift and decisive action is needed from the government to end this shambolic situation and to limit the damage that a punitive pensions taxation system is inflicting on doctors, their patients and across the NHS as a whole.”

The U.K.’s government-run health system already has plenty of problems, including long wait times and denial of care. The last thing it needs is for doctors and other professionals to cut back their hours because politicians are too greedy.

The moral of the story is that tax rates matter. Depending on the type of person, they can matter a lot.

This doesn’t mean tax rates need to be zero (though I like that idea).

It simply means that taxes impose costs, and those costs become increasingly apparent as tax rates climb.

P.S. If you want a horror story about marginal tax rates, check out what happened to Cam Newton, the quarterback of the Carolina Panthers.

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I’m not a big fan of the current tax system. I’m also not supportive of America’s bankrupt Social Security system.

The country would be much better off with fundamental reform of both the tax system and Social Security.

Some groups will be reap especially large rewards if that happens.

For instance, a new report from the National Bureau of Economic Research examines the impact of taxes and Social Security on female labor supply.

…we ask to what extent the fact that taxes and old age Social Security benefits depend on one’s marital status discourages female labor supply and affect welfare. …as couples file taxes jointly, the secondary earner in the married couple faces a higher marginal tax rate, which tends to discourage their labor supply. …reduced labor supply does not necessarily imply lower Social Security benefits. Since women have historically been the secondary earners, both provisions tend to discourage female labor supply… to what extent are these disincentives holding it back? …We estimate our dynamic structural model using…data from the Panel Study of Income Dynamics (PSID) and from the Health and Retirement Study (HRS) for the cohort born in 1941-1945 (the “1945” cohort). …we also estimate our model for the 1951-1955 cohort (the “1955” cohort),

This chart from the study shows that married women face a tax penalty – i.e., higher marginal tax rates – compared to single women.

The main takeaway is that this marriage penalty, combined with discriminatory features of Social Security, discourages women from working.

How big is the effect?

The report, authored by Margherita Borella, Mariacristina De Nardi, and Fang Yang, finds that government policies have a significant adverse impact on labor-force participation.

For the 1945 cohort, we find that Social Security spousal and survivor benefits and the current structure of joint income taxation provide strong disincentives to work to married women and single women who expect to get married… For instance, the elimination of all of these marriage-based rules raises participation at age 25 by over 20 percentage points for married women and by five percentage points for single women. At age 45, participation for these groups is, respectively, still 15 and 3 percentage point higher without these marital benefits provisions. In addition, these marriage-based rules reduce the participation of married men starting at age 55, resulting in a participation that is 8 percentage points lower by age 65. Finally, for these cohorts, these marital provisions decrease the savings of married couples by 20.3% at age 66.1 In terms of welfare, abolishing these marital provisions would benefit…over ninety percent of the people in this cohort. …We find that the effects for the 1955 cohort on participation, wages, earnings, and savings are large and similar to those in the 1945 cohort, thus indicating that the effects of marriage-related provisions are large also for cohorts in which the labor participation of married women is higher.

What if these discriminatory policies were fixed?

It depends, of course, on how the problems are addressed.

The report finds that a budget-neutral approach (i.e., returning any budgetary windfall to taxpayers) would be a significant net plus.

…there would also be large aggregate gains from removing marriage related provisions and reducing the income tax… Overall our policy experiments thus indicate that removing marriage related taxes and Social Security benefits would increase female labor supply and the welfare of the majority of the populations.

Here are a couple of charts from the study, showing both an increase in labor supply and an increase in labor income.

I’ll close with a final point about family structure.

Some people will argue that the current penalties in the tax code and Social Security system are desirable because they don’t punish stay-at-home moms as much as working women.

That’s a very strange argument. Sort of like the folks on the left, including the IMF, who advocate policies that hurt the poor if rich people suffer even more.

P.S. If there’s reform, older people also will enjoy significant gains.

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I’ve labeled the International Monetary Fund as the “dumpster fire” of the world economy.

I’ve also called the bureaucracy the “Dr. Kevorkian” of international economic policy, though that reference many not mean anything to younger readers.

My main complaint is that the IMF is always urging – or even extorting – nations to impose higher tax burdens.

Let’s look at a fresh example of this odious practice.

According to a Reuters report, IMF-supported tax increases are provoking economic strife in Pakistan.

Markets and wholesale merchants across Pakistan closed on Saturday in a strike by businesses against measures demanded by the International Monetary Fund… Markets and wholesale merchants across Pakistan closed on Saturday in a strike by businesses against measures demanded by the International Monetary Fund. …Prime Minister Imran Khan’s government..is having to impose tough austerity measures having been forced to turn to the IMF for Pakistan’s 13th bailout since the late 1980s. …Under the IMF bailout, signed this month, Pakistan is under heavy pressure to boost its tax revenues.

I’m not surprised the private sector is protesting against IMF-instigated tax hikes.

We see similar stories from all over the world.

But what really grabbed my attention was the reference to 13 bailouts. Good grief, you would think the IMF bureaucrats would learn after five or six attempts that they shouldn’t throw good money after bad.

That being said, I wondered if the IMF was pushing for big tax hikes because they had demanded – and received – big spending cuts in exchange for the previous 12 bailouts.

So I went to the IMF’s World Economic Outlook Database to peruse the numbers…and I discovered that the IMF’s repeated bailouts actually led to big increases in the burden of spending.

The IMF’s numbers, which go back to 1993, show that outlays have tripled. And that’s after adjusting for inflation!

Looking closely at the chart, I suppose one could argue that Pakistan was semi-responsible up until the turn of the century. Yes, the spending burden increased, but at a relatively mild rate.

But the brakes definitely came off this century. Enabled by endless bailouts from the IMF, Pakistan’s politicians definitely aren’t complying with my Golden Rule.

I’ll close with one final point.

The IMF types, as well as others on the left, actually want people to believe that Pakistan should have a bigger burden of government spending.

According to this novel theory, the public sector in the country, which currently consumes more than 20 percent of GDP, is too small to finance the “investments” that are needed to enable more prosperity.

Yet if this theory is accurate, why is Pakistan’s economy stagnant when there are prosperous jurisdictions with smaller spending burdens, such as Hong Kong, Singapore, and Taiwan?

And if the theory is accurate, why did the United States and Western Europe become rich in the 1800s, back when governments only consumed about 10 percent of economic output?

This video tells you everything you need to know.

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I wrote last month about a group of leftist millionaires who said they should pay more in taxes.

My response was to ask why they aren’t taking advantage of the existing process that allows them to send extra money to the federal government? There’s even a special website that facilitates payments from people who want to voluntarily pay more tax.

Yet, in a glaring example of hypocrisy, these rich statists won’t “put their money where their mouths are.”

Now we have a new example of a rich leftist who says one thing and does another.

And he happens to be a former Vice President of the United States. Tax Notes reports that Joe Biden, who says he wants higher taxes if he wins the 2020 presidential election, has been very aggressive about minimizing the amount of his money that is taken by the IRS.

Former Vice President Joe Biden’s tax returns show he took advantage of a planning strategy that the Obama administration tried to shut down. The planning technique involves the use of an S corporation to allow only a small portion of an individual’s earnings to be subject to self-employment tax. On the portion that isn’t on the hook for self-employment taxes, in some cases it can also escape the 3.8 percent net investment income tax for high-income earners enacted into law during the Obama administration. “It’s truly astounding to me that Biden would take such an aggressive position while contemplating a run for president,” Steven Rosenthal of the Urban-Brookings Tax Policy Center said. “I don’t get it,” he added. …Biden, who is now a Democratic presidential candidate for 2020, released federal and state tax information on June 9 showing he and his wife, Jill, earned millions from speaking and writing engagements since leaving office.

Interesting, there are some Democrats who have chosen not to take advantage of this strategy.

…before becoming president, Barack Obama earned income as an author but listed it on Schedule C, subjecting it to self-employment tax. Sen. Elizabeth Warren, D-Mass., similarly earned income as author and listed the amounts on Schedule C.

What makes Biden’s hypocrisy so remarkable is that the Obama-Biden Administration proposed to make this type of avoidanceillegal.

In its proposed fiscal 2017 budget, the Obama administration would’ve expanded the 3.8 investment to passthrough income so it wouldn’t escape the 3.8 percent tax based on a technicality. The provision, included in a section entitled “loophole closers,” would have raised $271.7 billion over 10 years, according to the Treasury Department’s analysis of the proposal.

So Biden wanted to take away the right of other people to protect their money, yet he is perfectly happy to copy their tax-minimization tactics.

By the way, I should say, quite emphatically, that Biden made the right choice for his family.

Voluntarily giving more money to Washington would be wasteful and reckless. I’m not going to claim that politicians in D.C. are the worst people in the country. But I will assert that they’re the ones with the worst incentive to use money wisely.

In any event, there’s definitely something distasteful about a rich leftist politician behaving like a “greedy capitalist” in his private life. Especially since this politician in the past has asserted that it’s patriotic to pay more tax!

Does this make him a fiscal draft dodger? Is there smoke coming out of the Hypocrisy Meter?

And if so, does that mean John Kerry also is unpatriotic? And what about Bill and Hillary Clinton?

Though Governor Pritzker of Illinois may be the most aggressive example of taxes-for-thee-but-not-for-me.

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