The best kind of fiscal stimulus

If we aren’t going to have monetary stimulus, what would be the best (or least bad) type of fiscal stimulus?  In my view the best would be cutting the employer share of the payroll tax, as that seems to be the only way to reduce real wage costs.  I view sticky nominal wages as one of the major causes of unemployment during recessions.  The traditional Keynesian argument against wage cuts is that it merely leads to more deflation, without reducing real wages.  I recall Gauti Eggertsson discussing this problem and Paul Krugman citing his argument.  But I don’t buy the argument.  The Fed controls the price level.

You might ask why if the Fed determines the price level, they don’t just go ahead and raise the price level, instead of letting the fiscal authorities run up trillions in budget deficits (stimulus plus cyclical deficits).  I can’t answer that; you’ll have to ask the inflation hawks at the Fed.  But for whatever reason, they’ve decided we have enough NGDP, and if Congress wants more they’ll have to do it the hard (and inefficient) way.

At least Bernanke made it pretty clear that he won’t allow further disinflation.  He hinted that there is a sort of ‘Bernanke put’ around 1% core inflation, roughly where we are now.  If this is the case, then any nominal wage cuts become real wage cuts.  For very complicated reasons it is hard to directly cut the nominal wages of workers.  But you can cut the nominal labor costs to companies very easily—just reduce payroll taxes.

Now that the Keynesian fiscal stimulus has not worked, the Obama team is looking at new ideas.  They are rediscovering the merits of sticky-wage theories of the business cycle, which I am one of the few economists to still adhere to (most now assume sticky-price versions of Keynesianism.)

The Washington Post reports that Obama is considering a $300,000,000,000 payroll tax cut.  No details are provided, but I’d guess that would finance a 2% cut for a couple years.  That would mean a 2% cut in wage costs, which should cause the recovery to speed up.  Of course one always must think about the monetary policy counterfactual.  The hawks may become horrified by the increased debt and tighten further.  But I think Bernanke can hold the line at 1% core inflation.  If so, it may be our best shot, even if it is far less efficient than monetary stimulus.

Here’s the WaPo:

With less than two months until the November elections, the White House is seriously weighing a package of business tax breaks – potentially worth hundreds of billions of dollars – to spur hiring and combat Republican charges that Democratic tax policies hurt small businesses, according to people with knowledge of the deliberations.

.   .   .

Permanently extending the research credit would cost roughly $100 billion over the next decade, tax analysts said. And depending on its form and duration, a payroll tax holiday could cost more than $300 billion. While significantly less than last year’s stimulus package, both ideas would be far more dramatic than anything the White House has so far acknowledged considering.

HT:  Tyler Cowen

Faulty arguments for the marriage penalty

I was surprised that a number of commenters actually defended the marriage penalty in the comment section of my recent tirade.  I thought it worth driving a nail into the coffin of one particularly popular but fallacious argument.

Some commenters argued something to the effect that “two can live almost as cheaply as one” (or more specifically at less than double the cost of one.)  First let’s consider someone born with the love of the sea.  It leads him to buy a sailboat as an adult. As a result, he has less income to spend on food, clothing, and shelter than the typical guy.  Should he pay a lower income tax rate, to compensate for his unusually high living expenses?

Now consider six young professional women.  Three are picky misanthropes who don’t like sharing bathrooms and kitchen counterspace with other women.  The other three women share a three bedroom apartment, thus having lower per person shelter costs.  How should we think about this situation?

Most people would say that the three women living alone are free to share an apartment with others if they wish, and thus must derive lots of utility of having their own private place.  I can certainly understand that, I was a picky misanthrope who lived alone for more than 15 years.  I can’t image anyone saying there should be different tax forms for the three women sharing an apartment, and that they should pay a higher tax rate than the other three.  Indeed, I don’t think people would want that to occur even if the government could costlessly ascertain who is living alone and who is not.  So why all the arguments for the marriage penalty based on the notion that it is cheaper to share an apartment with others?  I don’t get it.

Why is the government trying to force me to divorce my wife?

Over the next few months I plan to explain my deep hatred for the income tax.  What most bothers me about the tax is not the amount that I pay (although I believe my wife and I pay more than usual for people with our incomes) but rather the sheer insanity of the entire system.  We can certainly afford to pay our tax, so I am not trying to plead poverty.  What bothers me is that I must spend several days each year just doing the paperwork.  This year I finally relied on HR Block, and had to pay $610 dollars for the privilege.  I read that in Sweden the government simply sends you a bill.

Then there are the perverse incentives created by the tax.  Today I’ll discuss the marriage penalty.

Why is there so little discussion of the marriage penalty in the press?  And why do both political parties seem to favor it?  I can’t answer these questions, but will try to speculate anyway.  I’d also appreciate your thoughts.

I first became aware of this problem after I got married.  I noticed that the combined income of my wife and I pushed us up into higher tax brackets.  Initially the problem was trivial.  But as we got older and got promotions our income rose into the upper middle class range (low 6 figures) and then it became very noticeable.  Suddenly we had to pay the AMT, although if we were single we would not earn enough to trigger an AMT tax.  The official 15% capital gains tax rate became a joke, as the realization of significant capital gains can push you into the AMT, which can dramatically affect the tax on your non-capital gains income.  I won’t bore you with all the confusing details, but I am shocked each year when I compute how much lower our total tax would be if we were both single.

Indeed the new health care bill makes the marriage penalty even worse for married couples earning between $250,000 and $400,000.  Contrary to what Obama says, workers making $130,000 (married to each other) might have to pay higher taxes as a result of the health care bill.  So it isn’t just the “rich,” the upper middle class will also be affected.  Under the bill a cohabitating couple where each person makes $200,000 from interest, dividends, or rental income will pay an extra $5900 in taxes if married, but no extra taxes if “living in sin.”

You might think this is just some sort of unfortunate “glitch” in the tax code, and that it will be fixed once the authorities become aware of it.  I think they already are aware of it.  The marriage penalty has been around for decades; it would have been fixed if the government wanted to fix it.  But why would the government be so opposed to people getting married?  Isn’t marriage generally considered a good thing?  My theory is that both parties want to fix it, but they can’t agree on how to do so, so nothing gets done:

1.  The Republicans might prefer a flat tax, which would avoid the problem of people getting pushed into higher tax brackets after they get married.  But the Dems consider that sort of tax regime to be insufficiently progressive (especially given the regressive nature of payroll taxes.)

2. The Dems might be willing to allow married people to file as a single person, but Republicans oppose that because they think it would favor working moms over stay at home moms.  I.e. consider two families that live next door to each other.  In one family both husband and wife make $100,000.  In the other family the husband makes $200,000 and the wife is a homemaker.  Under current law they pay the same amount of taxes, and I think Republicans are OK with that.  If married people were free to file under the single person’s tax rates, then the family with two people each making $100,000 would pay less taxes than the person making $200,000.  Actually, that seems very fair to me, as a family with someone making $200,000 plus a homemaker is much better off economically than a family where each spouse makes $100,000.  In the latter case they still have all the chores to do at home, or else they’d have to hire maids and nannies.

Here is the bottom line.  The government is discriminating against people according to their marital status.  Two families that live side by side, each with two adults earning $130,000, might each pay very different amounts of taxes.  The family where the two adults are legally married pay more taxes than the next door neighbors, who might tell all their friends and relatives that they are married, but in fact secretly got a divorce and are now living in sin.  Does that seem fair?

BTW, this isn’t just a problem that affects the upper middle-class; low income workers also face a large implicit marriage penalty, as benefits like the EITC get phased out much more quickly if two low income people get married.  Indeed in percentage terms this probably affects them much more than me.  (Interestingly, as the marriage penalty got worse for low income workers, their marriage rate fell.)

My wife and I would be better off getting divorced.  Unfortunately, women tend to be rather sentimental about marriage.  So it may not be easy for me to convince my wife of the logic of this argument.  But here’s something I can say for sure.  If we did get divorced to save $80,000 to $100,000 in taxes over our lifetime, you’d never know about it.  It would be between us and the IRS.

As a good libertarian I oppose having any government policies hinge on whether people are married or not.  (I.e., governments should not recognize marital status.)  I believe all upper-middle class libertarian couples should stay single, to help “starve the beast.”  Let’s hope Megan McArdle’s recent ceremony was just for show, and that they “forgot” to have it formalized at City Hall.

Gay men may actually benefit when gay marriage is legalized at the Federal level, as the social pressure to get married is lower than for heterosexual couples.  So they will be able to more easily choose the marital status that best fits their particular tax status—assuming that society doesn’t start pressuring gays to get married.  Unfortunately, Americans often seem to want to either ban things or mandate them—with no in-between option of freedom.

I suppose some of my more conspiratorial readers think that Obama is increasing the marriage penalty because gays are an important part of the Democratic coalition.  Please spare me!  That would be about as likely as the first African-American President paying for health care with a tax that only hits white people.

PS.  I do know that many gays are actually hurt by being forced to file as single.

PPS.  I am one of what Joe Biden calls the “super-rich” who will be hit by the planned expiration of the Bush tax cuts for upper income people, and I make well under $150,000.  So much for Obama’s promise not to raise taxes on people making less than $200,000.  My income is a bit more than a Boston cop, but a lot less than a Massachusetts turnpike cop.  I guess a Boston cop who is married to a highly-skilled nurse is also “super-rich.”  Again, the money doesn’t bother me, I have plenty since I am a high-saving nut.  What bothers me is the thought that when I retire I’ll be paying more taxes or getting less Social Security benefits to help those “unfortunate” guys who made just as much as me, but never saved anything.  The guys who have garages filled with expensive toys.

It just so happens that extended UI causes unemployment.

I am always a bit amazed by the way anti-supply-siders interpret certain stylized facts.  They seem to start with the premise that supply-side tax effects are not important.  If you raise taxes on the rich, you get lots more revenue.  And if you lower taxes on the rich, you get lots less revenue.  I try to imagine their thought process:

Yes, the huge increase in the top MTR under Hoover and Roosevelt didn’t raise much revenue, but that was because it “just so happened” that America’s income distribution got much more equal after 1930.  No supply-side effects there.  And yes, the Reagan tax cuts on the rich were actually associated with more revenue, but that’s because it “just so happened” that the income distribution got much less equal after 1980.  And yes the Europeans don’t actually raise much more revenue than we do, despite higher tax rates, but that’s because it “just so happens” that Europeans work less.  You say they work less for tax reasons?  Don’t be silly—it “just so happens” the Germans and French have lazy, happy-go-lucky cultures.  You say the French worked as hard as Americans in the 1960s?  It “just so happens” this distinctive French culture developed only in the past few decades, when their tax rates rose far above American levels.

And then there is the debate over extended benefits for the unemployed, which at 99 weeks is far longer than under any previous recession (that I can recall–does anyone have data?)  Unemployment benefits are of course an implicit tax on labor.  If the benefits are 77% as big as the wages in the best job you can find, then they are a 77% implicit tax rate.  That makes a big difference, particularly for workers in dead-end jobs.  Matt Yglesias recently challenged right-wing economists:

That’s because Congress is unwilling to extent UI eligibility beyond 99 weeks. Which means that soon enough we should see . . . something. But what? My guess is not much. My guess is that basically nobody wants to hire the vast majority of the current long-term unemployed. So my guess is that the labor market prospects of people who’ve been unemployed for 98 weeks will look an awful lot like people who’ve been unemployed for “only” 70 weeks. I wonder what people with a more right-of-center approach would predict? Are we going to see a surge in employment among people around the 99 week mark? Will they uncover hidden secret jobs that are stashed away somewhere?

Then a commenter named “wonks anonymous” provided me with a link where Casey Mulligan discusses just such a study by Stepan Jurajda and Frederick Tannery.  They looked at the number of weeks before unemployed Pittsburghers found jobs during the period from 1980 through 1985.  They choose this period because Pittsburgh had a horrible job market, with unemployment frequently over 10% and peaking at 16%.  They found that a few weeks before unemployment benefits were about to run out, roughly 3% of unemployed workers found a job each week.  Then the number of job finders jumped to 30% during the week their unemployment benefits ran out, and stayed somewhat above normal for another 9 weeks.  That’s pretty definitive evidence that incentives matter.

Why are liberals so often wrong about the supply-side effect of taxes?  Partly because these effects go against comment sense, and partly because they seem morally distasteful.  Unemployed people really are suffering (liberals are right about that), and claims that they could get jobs if they wanted to appear to be “blaming the victim.”  I think this is wrong, and that we need to avoid letting normative considerations distort our positive analysis of cause and effect, but it isn’t easy to do.

Another problem is that people visualize a period of high unemployment as one with very few new jobs being created.  This is not true; millions of jobs are being created all the time, even during recessions.  The problem during recessions is that many more people are looking for those jobs, and hence it is much more difficult for any given individual to find a job.  But it is certainly not impossible, as we know from the jobs created and jobs lost data.  My guess is that most of those suddenly finding jobs are less skilled workers who are accepting a lower-paying job out of desperation.  The low wage job market is widely known to have lots of turnover.

To summarize, common sense suggests that Matt Yglesias and Paul Krugman are right.  And those of us with empathy for the unemployed would like them to be right.  But it “just so happens” they are wrong.  Does this mean UI is a bad idea?  As you know, I favor the Singapore approach of self-funded UI accounts.  Given that we don’t have them, and given that millions have lost their jobs due to the incompetence of America’s macroeconomists (who keep insisting that monetary policy is out of ammunition, or that there is no problem of inadequate AD), then I think you can make a good argument for providing some additional help for the unemployed.

[Update:  A commenter named “Defennder” pointed out that my statement about Singapore was completely inaccurate.  I apologize for this error, which probably appears in a few other posts.  I had recalled that the Singapore (CPF) forced savings plan could be used for health, retirement and unemployment insurance.  According to this link it can only be used for health, retirement, and buying a home.  From now on I’ll call it the UI system that Singapore should have.  The link also indicates that 96% workers in big companies (more than 25 workers) get some sort of severance package, but of course big companies can go bankrupt, and lots of workers are in smaller firms.  Severance packages are better in terms of incentives, but the coverage may be inadequate.  Singapore typically has very low unemployment rates.]

In the next post I will discuss why the extended UI benefits are worsening the recession.  Is there a way to help the unemployed without making the recession worse?  Perhaps the government might want to consider a large, one-time, lump sum payment to the unemployed, which is not in any way tied to the duration of unemployment.  I don’t know whether such an idea is feasible, but it seems better on both efficiency and humanitarian grounds than building dubious public works projects.

PS.  The preceding is not an endorsement of actual, real world, supply-side politicians.  They often do make far-fetched assertions, such as the claim that the Bush tax cuts boosted revenue.  Tax cuts usually do not boost revenue, and that isn’t even the question we should be asking.

PPS.  I don’t mean to suggest that Yglesias and I are far apart on taxes.  We both think a progressive consumption tax is optimal.

The real “long and variable lags” problem

One of the most overused cliches in monetary economics is that policy affects the economy with “long and variable lags.”  In fact, policymakers should be targeting price level or NGDP expectations, not the actual price level or NGDP.  And monetary policy affects expectations with a zero lag.  Even worse, future expected changes in NGDP have a powerful effect on current NGDP, so the so-called “policy lag problem” is a phony issue even if we did want to control actual NGDP.

There is one area where long and variable lags do exist, however, the supply-side effects of fiscal policy.  Consider an example where doctors require so much education that students won’t be willing to go through the arduous process of medical school and residency unless they can eventually earn twice as much as other white collar workers.  Let’s suppose that in a zero-tax world white collar workers earn $100,000 before and after taxes, and doctors earn $200,000 before and after taxes.

What would happen if the government suddenly put a 50% tax rate on incomes above $100,000/year?  Initially the effect would be small.  Doctors might work somewhat fewer hours, but since their medical education is a sunk cost this tax increase probably wouldn’t cause many to go back to school in order to learn accounting.  Over time fewer students would go to medical school, and in the long run a new equilibrium would be reached where doctors earned $300,000/year, i.e. $200,000 after taxes.

What can we learn from the previous example?

1.  It takes a very long time for the full effects of supply-side tax changes to fully impact the stock of physical and human capital.

2.  A tax that may appear to be paid by “the rich” might in fact be paid by the customers of the rich.

I am not saying that there aren’t some immediate effects of tax changes.  Nor am I denying that some taxes affect the rich more than others.  Part of wealth comes from IQ and ambition and luck, not investments in human capital.  Rather I am saying that the sort of government data often used to discuss these issues is nearly useless, as it measures the legal incidence of taxes, not the economic incidence.

Here is another example.  Let’s suppose that one state puts a high tax on individuals making more than $100,000/year.  What is the effect?  There are many possibilities.  One (which we just considered) is that skill levels in the state gradually decline.  Another possibility is that people leave the state, and move to lower tax states. But once again, this will occur very gradually over time.  A doctor with an established practice many not want to pick up and leave New Jersey, but if his son or daughter is just coming out of medical school, the tax increase may push him or her to a lower tax state.  And of course physical and cultural amenities can also influence location decisions, which is why New York City and California can get away with higher tax rates than Michigan, Ohio, upstate NY and Texas.  The strongest tax effects are people moving from boring high tax states in the rust belt to boring low tax states like Texas.

Because the lags in tax policy can stretch over decades, I am very suspicious of time series studies of taxes.  The best evidence comes from comparing incomes (PPP) in different developed countries.  This picks up differences in hours worked, and also differences in productivity associated with variations in human and physical capital.   BTW, the fact that productivity per hour in the US, France and Germany is fairly similar, actually reflects poorly on the two European countries.  You’d expect productivity to be higher where hours worked are lowest, as the least productive workers are those most likely to be unemployed.  This may explain some of the recent divergence in productivity between Germany and the US.   As employment in the US has fallen closer to German levels, and output in Germany has fallen faster than output in the US, productivity in the US must have risen rapidly relative to productivity in Germany.

I plan to do a series of posts on taxes.  The goal is to show the advantages of a progressive consumption tax (plus Pigou taxes and perhaps land taxes), and also the fact that bar charts showing the share of taxes paid by each income quintile are basically worthless.