Walter Williams Exploits Economic Ignorance: Tax Incidence

Walter Williams writes a column http://tinyurl.com/27yznyt on tax incidence and explains that politicians exploit the ignorance of the voters with respect to tax incidence. In the column, Williams commits the same offense that he decries.

Williams correctly explains that a tax is not necessarily borne by the entity on which it is levied. A tax on gasoline retailers is borne partially by consumers and partially by producers (i.e. employees or owners of the business). Either way, explains Williams, the tax is eventually borne by people, not corporations. Williams explains this to emphasize the point that President Obama's expressed intent to tax businesses will not be paid by said businesses but will be paid eventually by people, some rich and some not-so-rich.

Williams is correct in that a tax on business income ultimately is paid from the pockets of people. But he conveniently leaves out the rest of the story. What would be the result of not assessing a tax on business income? The result would be a subsidy. But that's good. Right? Shouldn't we be subsidizing business?

When the costs are not properly matched with an activity, it results in a subsidy to said activity thereby producing more of said activity than is best for society. It results in an inefficient allocation of resources. For example, there was a show on TV where a kid started a burrito business. He used his mom's credit to purchase the ingredients, prepared the burritos in his mom's kitchen and then sold them to his classmates. Without having to pay for the ingredients, the kid was making a good profit. The business was subsidized. The problem came when his mom noticed the charges. When the costs of the ingredients were considered, the boy's business was actually not profitable. In fact, the family lost money.

But taxes don't reflect a cost of a business. A tax is just the government taking what rightfully belongs to the business, people argue. Not so fast.

The purpose of tax is to provide funds for public goods. An example of a public good is a road. People drive on the road. Similar public goods are police, national defense and courts. It's possible to put up a toll booth at every intersection to pay for the upkeep of each road, but it's not practical. It's more efficient to get the money to pay for roads from taxes. Similarly, it's more efficient to pay for national defense through taxes. It's just not possible to calculate how much each person benefits from national defense and send them a bill.

Corporations use these public goods when conducting business. Corporations benefit from roads. Trucks transport goods on public roads. Workers commute on said public roads. Businesses benefit from public education by having an educated workforce. Thanks to Social Security and Medicare workers don't demand as much pay or retirement benefits thereby resulting in the government picking up the tab for a portion of worker compensation. Safe shipping lanes exist courtesy of our armed forces. Courts enforce contracts. Police provide safe neighborhoods thereby facilitating business.

The free market matches expenses with actions. If you want an ice cream cone, then you pay for an ice cream cone. A decision is made. I want that ice cream cone more than I want that money. With government provided goods, that decision is not made. The road is there. It's free. I can drive on it, and my action of using that road does not result in any additional cost to me.

In an ideal situation, the costs of something would be paid for by those benefiting. Because corporations and other businesses benefit from public goods, a tax is levied on their income. Theoretically the higher the income the more the entity benefits from the public goods. Thus, the higher their income, then the higher tax they pay.

But what's so bad about subsidizing business? It's still good to subsidize business, isn't it? A business that is not profitable, that is propped up by taxpayers is a drain on society. Subsidies for steel manufacturers sucked blood out of consumers and taxpayers for decades. The unprofitable steel companies avoided making necessary changes to make their businesses more efficient. Those that couldn't survive went bankrupt anyway leaving creditors holding millions in unpaid debt, leaving employees without jobs and retirees without their pensions.

Look at the auto companies. Bailout after subsidy after preferential tax treatment permitted the auto companies to overpay workers and fold to pressure from unions and make promises of post-retirement benefits that they had no way of paying. They've been struggling for decades, and subsidies have permitted them to continue their inefficient ways of doing business.

Another example is the homebuilding industry. The mortgage interest deduction provided a tax incentive, and there have been and still are plenty of other artificial government subsidies to the homebuilding industry. It created a bubble, artificially inflated home prices and profits for homebuilders, and allocated resources towards building houses that could have been allocated to more efficient uses (like building apartments).

Walter Williams wants his readers to believe that it doesn't matter who pays the tax. Individuals ultimately pay the tax anyway. But the absence of a tax directly on corporate income exaggerates corporate income thereby permitting unprofitable businesses to continue to suck blood out of society thereby resulting in an inefficient allocation of resources. 

Supply Side Ignorance

“It” Is a Fiscal Problem

http://tinyurl.com/2dgo3qm
In Kudlow’s analysis of “the problem”, he is unable to look beyond the government. If it’s not a monetary problem, then it must be fiscal problem, concludes Kudlow. It never occurred to him that “the problem” might not be with the government. Maybe the worldwide recession isn’t a result of U.S. government tax rates but an imbalance that had been growing for decades. Maybe the fact that consumers are swamped in consumer debt has something to do with it. Maybe the fact that many homeowners are underwater in their mortgages has something to do with the sluggish recovery.

Kudlow calls himself a “supply-sider”. Like many supply-siders, Kudlow believes that the only engine of the economy is the supply side. Supply-Side Godfather Arthur Laffer writes in a recent book that demand is not a problem. There is never any lack of demand even in poor countries like Bangladesh. The problem is supply. I’d like to see Laffer open up a BMW dealership in a Bangladesh slum and see how high the demand is there.

Whether it fits your pre-drawn conclusions about economic growth or not, consumer demand has been a major engine in not just the U.S. economy but the world economy over the past decade. Look at China. Its double-digit economic growth over the past decade is a result primarily of producing products to be sold in the U.S. and European markets. In the past couple of years as U.S. consumers reduced consumption so much due to high debt levels that China’s economic growth has decreased considerably.

Back in 2002 after September 11 the Fed reduced interest rates to spur the economy. Consumers were able to borrow at extremely low interest rates to fund consumption. Auto dealerships were providing loans at zero percent interest rates. Then housing boomed. Low interest mortgages permitted people to buy more house for less monthly payments. The construction industry boomed as a result of this along with real estate brokers, mortgage brokers, the lending industry and title attorneys. This was all spurred by high demand. As housing values increased, homeowners were able to get low interest home equity loans to finance even more spending thereby fueling electronic, travel and tourism and other industries. President Bush reducing the top personal income tax bracket from 39% to 36% probably had very little to do with the booming economy of the mid-00s.

Then it crashed starting with home values. Those who has low interest adjustable mortgages saw the interest rates on their mortgages adjust upwards. People were able to refinance until real estate values tanked. Then they were stuck with high monthly payments. As real estate values tanked nationwide, consumers lost trillions in wealth. They reduced consumer spending considerably. No more new cars. No more big screen TVs. No expensive cruises or vacations. No new decks or new bathrooms or remodeling.

This is what caused the current depression, and the same parameters exist today. Millions of homeowners are underwater in their mortgages. Millions of people are unemployed. People who are employed are saving just in case they lose their jobs as business and local governments are strapped and looking for areas to cut.

The problem is not monetary. The problem was not caused or worsened by government fiscal inputs. The problem was and is a demand side problem and requires a demand side solution. It’s basically a hole, a deep, wide hole that’s going to take years to turn around and decades to recover from. Those that think that the economy rises and falls based on supply side factors only are only seeing half the picture.

Kudlow's War on Savings

http://tinyurl.com/26gvrwk

In a recent column, Lawrence Kudlow criticizes Treasury Secretary Geithner and Congressional Democrats for policies that discourage saving.

“The great flaw in the thinking of the Democrats,” writes Kudlow, “is that they are ignorant of the economic power of saving and investment.”

Kudlow goes on: “Saving is a good thing. Stocks, bonds, bank deposits, money-market funds, commercial paper, venture capital, private equity, real estate partnerships -- all that saving is channeled into business investment. And whether that capital goes into new start-ups or small businesses or large firms, it finances the kind of new investment in plants and equipment and software and buildings that ultimately creates jobs and family incomes. And that, in turn, spurs consumption… Without saving there can be no investment. And without investment there can be no enhanced productivity, which is the ultimate source of long-term prosperity and wealth.”

Kudlow goes on an on about how the policies proposed by Democrats (i.e. raising marginal tax rates by a mere 5%) is somehow going to doom the economy.

“My answer is to keep the incentives for investment,” writes Kudlow.

Kudlow’s incentives for investment involve low tax rates on investment by extending the W. Bush tax cuts for high income taxpayers. Kudlow is saying in his column that lower taxes on investment income will encourage people to save and invest. But does empirical evidence support it? As tax rates on investment have changed, has the personal savings rate also changed?

Capital gains tax rates have fluctuated over the years. In the 70s the top marginal capital gains tax rate was 39%. In the 80s it was reduced to 20% and then increased to 28% in 1986. In 1997 it was reduced back to 20%. In 2003 it was reduced to 15%. With the marginal tax rate on capital gains declining over 50% since the late 70s, Kudlow would expect the savings rate to have increased over that time as well.

But it didn’t. The Bureau of Economic Analysis keeps this statistic via its National Income and Product Accounts (“NIPA”) savings rate. The U.S. personal savings rate has declined considerably and steadily since the 1980s and is lower than most industrialized nations.

Kudlow’s claim that lower capital gains tax rates encourage savings is without evidence.

Nevertheless, investment in the U.S. has increased. The main reason is because investors from abroad have moved their assets to the U.S. Low marginal tax rates on capital gains can be a factor in this decision. Other things being equal, it’s better if income is taxed at 15% than at 20%. Investors have to ask themselves, “Do we want to invest in Europe or Asia or do we want to invest in the U.S.?” Reducing capital gains tax rate from 39% to 15% is a significant reduction.

But does it increase savings?

How much do I want to save for Chauncey’s education? How much do I want to save for retirement? Is a higher capital gains rate going to factor into the decision as to whether and how much I should save for Chauncey’s education? If the tax rate increases, am I going to decide to save less? If the tax rate decreases, am I going to decided to save more? It probably won’t have much effect. It will play a part into whether I invest my savings in capital assets or income producing assets, but it probably won’t affect how much I need to save or whether I decide to save. For Kudlow to suggest that a decrease in capital gains tax rates encourages people to save more is just not supported by the facts or by theory.

So what caused the savings rate in the nation to decline so dramatically?  There are a few primary causes.

First, the lessened need to save for retirement.  Americans expect to receive a monthly Social Security benefit that will fund at least part of their retirement.  Medicare reduces the need to save for medical expenses during retirement.  Since 2003 people don't even need to worry about prescription drug expenses.  Without these government programs, people would feel the need to save much more for retirement.

The housing boom also reduced the felt need to save.  As home prices skyrocketed, people expected to be able to sell their home and move into smaller, less expensive houses at retirement and use the difference to supplement their retirement.  Without rising home equities, people would feel more of a need to save.  It's not a coincidence that the savings rate increased immediately after housing prices tanked.

Another is the availability of credit.  With the United States as an attractive place for investment, it's no surprise that money poured into our economy from abroad.  Credit was readily available.  A statement often made was that consumers used their homes as ATM's.  Even without home equity, loans could be obtained even by people who had bad credit.  People with good credit could get low interest or no interest credit cards and auto loans.  It was no longer necessary to save up to buy that car or stereo.  Buy now.  Pay later.

It's later. And we're paying big time for our irresponsibility.

Et Tu, Laffer?

Subtitle: Arthur Laffer Makes Me Chuckle

A common mistake made by economists is assuming that economic policies have the same effect under all economic conditions. But it’s not true. It is a general principle that water will turn to ice if the temperature is reduced. But that general principle does not hold true if the temperature is reduced from 95 degrees to 40 degrees. Only when the temperature declines to 32 degrees or below will any ice form.

Similarly, the effectiveness of fiscal and monetary policy varies depending on current economic conditions. Policies to curb inflation are helpful during periods of high inflation, but during periods of deflation they could be harmful. Tax cuts generally result in increase net after tax income, but during periods of losses, there is no effect.

One would think that Arthur Laffer, an educated economist who has practiced the craft for decades, would get it. Instead he fails to consider the current economic conditions while advocating policies. Laffer writes a column http://tinyurl.com/2auuu6g in the Wall Street Journal advocating that unemployment insurance benefits cause higher unemployment.

Under healthy economic conditions, it’s a sound theory. Higher unemployment benefits make unemployment more attractive thereby increasing the incentive to remain unemployed and decreasing the incentive to look for a new job. Laffer imagines unemployment benefits of $150,000 per year and correctly guesses that the unemployment rate would be higher if such a generous unemployment benefit were offered.

Laffer offers a chart that shows the correlation between increased unemployment benefits and unemployment. A glance at the chart shows that the more unemployment benefits are paid, the higher the unemployment rate rises. Laffer uses this to prove that high unemployment benefit payments cause unemployment.


And this is what is most annoying. He wants his audience to conclude that unemployment benefits cause unemployment. Of course, a closer look at his chart shows that the unemployment rate actually rose BEFORE unemployment benefits rose. How can an increase in unemployment benefits in 1975 cause unemployment to rise in 1974? It’s clear from Laffer’s chart and from just plain common sense that high unemployment is the cause and high unemployment benefit payments are the effect. For Laffer to suggest otherwise tells me that he is being dishonest.

Another policy about which he is clueless is stimulus. He believes that if the government spends money on stimulus, such as unemployment benefits, then the money must come out of the pocket of some other productive participant in the economy. This assumption also holds true under normal circumstances. In order to pay Peter, the government must tax Paul. It makes sense.

But it’s not always true. Currently, financial institutions are hoarding trillions of dollars that are not being invested in the economy. This normally causes deflation. However, the Federal Reserve is operating an anti-deflation policy. Bonds issues to pay for the Federal deficit are being bought up by the Fed. The money for the stimulus is not being taken out of anyone’s pocket.

We’re all familiar with the Laffer Curve. Lower taxes leave more money for businesses and productive individuals to invest and create an incentive for businesses. That’s sound economic theory. I’ve always had a lot of respect for Laffer. But this column is pathetic, and his use of deceit and his display of ignorance with respect to economics causes me to question his integrity as well as his competence. 

Kudlow Wrong Again: Unemployment Benefits

As of June 30, Congress has not passed a bill to extend unemployment benefits to those chronically unemployed. For millions of Americans, their unemployment benefits may run out before they are able to find a job.

To Larry Kudlow, this is a good thing: http://tinyurl.com/yapyroo

It’s an economic principle that if you subsidize something, then you get more of it. If you pay people not to work, then some people would prefer to sit on the couch watching reruns of American Idol than get out and look for a job. It’s a sound economic theory.

But Kudlow is wrong. Unemployment is not a subsidy. It’s insurance. Employers pay insurance premiums. The premiums depend on number of employees, salaries and history. If an employer has a history of a lot of layoffs, then their premiums go up. The unemployed are merely collecting an insurance payout.

As Kevin Williamson explained in a recent column at NationalReview.com, “unemployment benefits are one of the better social safety-net programs we have in the United States. They’re not terribly expensive, in real terms; they reward work; and they have the happy effect of encouraging a dynamic labor market and supporting risk-takers who seek better lives in new jobs.”

It’s true that some jurisdictions have generous unemployment benefits. New Jersey pays up to $600 per month. That’s $30k per year pace. That’s nice. But you won’t get the full amount unless you’ve been making $50 k or more over the prior year. Minimum wage workers won’t be able to get the entire amount, only 60% of prior earnings. That’s still not bad. Certainly some people might be tempted to take the benefit rather than make a real effort in looking for work. One can understand how overly generous unemployment benefits might cause an increase in unemployment.

But like many sound economic theories, it only works under certain conditions. Under normal conditions, it’s valid. But in a depressed economy with high unemployment, its effect on unemployment is minimal. How many of those slackers would be able to find a job even if they tried? If the jobs aren’t available, then the unemployed aren’t going to be able to go back to work even if they wanted to. Cutting their benefits in an effort to reduce unemployment and stimulate the economy is ludicrous. Kudlow makes it seem as if there are employers out there unable to fill open positions because the millions of unemployed workers are happily collecting benefits and have no desire to return to work.

Under a healthy economy, long periods of generous unemployment benefits may cause a slight increase in unemployment. But in an economy with nearly 10% unemployment, little to no growth in private sector jobs and slow growth, it’s stupid to suggest that generous unemployment benefits are a significant factor in the high rate of unemployment.