Land of The Free, Baby, Yeah (IRS Edition)

A few weeks ago, I wrote a post comparing the Japanese immigration system to America's USCIS. Today, it is the IRS that is in my sights. My accountants just provided me with my US returns for 2013, and for the second year in a row (and completely predictably), the accountants cost more than my entire US tax burden.

How did things break down this year? My US returns were 70 pages long this year, beating out last year's 63 pages. In both years, the US collected a whopping 0.3% of my income*, a tiny tax liability I incurred either by traveling to the US on business or having some small US-source income streams that Japan didn't tax.

In contrast, my Japanese returns for the two years were 6 and 8 pages respectively, including things like cover letters. The actual returns are about as long as a 1040-EZ. The Japanese, of course, actually captured the lion's share of the taxes, around 17% of my income in both years. So just like in the immigration systems, Japan again wins hands-down in terms of simplicity and ease of complying with its laws. There is nothing like living in a true Land of the Free, rather than a false one.

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*Note that payroll taxes are an entirely separate issue. I am only talking about income taxes. Fundamentally, I have a choice where to pay payroll tax, and I deliberately choose the US and participate in that system.

On Negotiation...

A term being thrown around the political arena a lot lately is the term "negotiate". The problem is that there isn't much actual negotiating going on. Rather, what we have been seeing is a whole lot of extortion and grandstanding. Republicans have shut down the government rather than negotiate. Obama (mistakenly, in my opinion) has said he is refusing to negotiate. And now our nation is stuck in the mud.

"Negotiating" with someone implies trying to reach agreement by mutual give-and-take. If you aren't offering anything of value to the other party, or if what you are "offering" is the lack of destruction of their or jointly-owned property, you are not negotiating. Indeed, the latter case is clearly extortion. Unfortunately, this is precisely what Republicans are doing today. Their "negotiations" have been nothing but constantly shifting their demands, while steadfastly refusing to offer anything in return. Repeal ACA? No? Ok, how about a delay. Or a repeal of some of the taxes? Or automatic spending cuts every time we refuse to sign a budget? And what are we offering in return that Democrats would want? Nothing, other than abiding by previously agreed-upon budgets and not defaulting on the debt!

Obama is infinitely better, but I think he has muffed the messaging. He should be very clear that he is (and has been) willing to negotiate and make major deals, under two conditions

1: That the government is running under the agreed-upon budgets with no immediate threat of shutdown, and that the debt ceiling is removed as an issue

2: That Republicans meet half way, and make concessions on taxes, military spending, and other Republican priorities

For the last five years, it has been Republicans who have refused to negotiate, balking at anything that even smells of a tax increase. Given our ultra-low tax rates (third lowest of the 34 OECD nations), there is no solution to our long-term problems that does not involve more revenue. Until Republicans realize this, and move beyond the childish extortion tactics they are currently engaged in, there will be no major progress politically. Republicans need to look back at the Ronald Reagan who actually existed and emulate him - a man who met Democrats in the middle, accepted a dozen tax increases, and made the nation a better place.

Substitution Effect, meet Income Effect

Assume for a moment that you have the complete ability to adjust your hours at work to any degree you want, with your pay rising or falling proportionately. Then one day, your boss walks in and tells you that you along with everyone else is getting a 20% pay cut.

After the change, do you work more hours or less hours?

The answer is non-obvious. You now have a lot less money, and need to work more to maintain your current lifestyle and have "enough". On the other hand, the lower hourly pay means that alternatives to work (such as leisure or spending time with your family) are now more attractive relative to work, and hence you might work less. These two effects are called the income effect and the substitution effect, respectively. Note that in this case, like almost all others, they are in opposition to each other: one causes people to work more in response to an economic change, the other less.

These two effects also occur due to changes in government policies, such as tax rate changes, welfare benefits, or pensions. Raising peoples' taxes, for example, is similar to the pay cut - hourly take-home pay drops, discouraging work, but having less money causes people to work harder. It is not clear at all which effect wins under which circumstance. Peoples' responses to such policies are extremely complex and cannot simply be summed up as "higher taxes cause people to work less". They might under some circumstances, they might not under others, due to income effects.

A simple way to see the power of the income effect is to imagine a scenario where your pay was absurd, perhaps $10,000 an hour. Would you work less over the course of your lifetime, or more, relative to what you would with your current pay? The answer is almost certainly less, as after a few years you would have more money than you would ever need. At least in this extreme case, the income effect is dominant. It is likely that a lot of high earners, such as medical specialists or corporate executives, actually work LESS over their lifetime than they might with lower pay (or higher taxes!) because by the time they are in their late 50's or early 60's, earning more money is superfluous.

It is also impossible for conservatives to argue that income effects are trivial, as they constantly invoke the income effect when they assert that giving out welfare or unemployment benefits discourage work. However, it is illogical to assert a priori that with respect to benefits and pensions, that income effects are very powerful and cause large changes in behavior, but with respect to tax policy changes, income effects are minimal and dominated by substitution effects. Yet this is ultimately what conservatives are claiming. The reality is much more complex.

Social Security vs Art Laffer

Do higher taxes slow down economic growth? The answer to this question is far from clear, with data to support just about any opinion on the matter readily found in both the academic literature and the political sphere. However, most of the data I have seen on this matter suffers from at least one of the two major flaws

1: The data fails to separate changes in tax policy with changes in deficit spending. In most cases, tax cuts are not paired with similarly-sized spending cuts, nor tax increases coupled with similar-sized spending increases. What happens in practice is that tax cuts are often paired with spending increases, thus causing a big increase in deficit spending. However, this makes it impossible to determine whether it was the change in tax policy that caused changes to economic growth, or the deficit spending itself, which seems like an obvious candidate for the causal factor. Of course you can goose your short term economy with borrowed money.

2: The data fails to account for reverse-causality. As often as not, we change tax policy in response to economic changes, not vice versa. So even if you find a weak correlation between lower tax rates in growth, it might be because we tend to cut taxes vigorously in response to economic slowdowns, allowing them to correlate to the rebound without causing it. Likewise, we seem to pass the most tax increases at the height of bubbles, when the populace is more flush with cash than usual and more tolerant of paying additional taxes.

However, there is one tax that suffers neither of these problems - Social Security (OASDI).  First, Social Security spending and revenues have been pretty close together as the program was phased in over over 50 years starting in 1937, thus giving us a rare example of more or less simultaneous tax increases and corresponding spending increase.

 

 

The exceptions to this can be found in the 50's, 80's, and 90's, where there were slightly faster increases in revenues than spending. However, these changes were slight, and given the fact that these were all economic boom years, are hardly evidence that an increase in tax rates harm the economy.

 

 The other great thing about Social Security is that the tax increases were planned years ahead of time and phased in slowly. Hence, we can be certain that these tax increases were not a response to economic conditions. If there is a correlation, the causality must run the other way. Additionally, there has been little political fiddling (until recently) with the OASDI system. Other than the gradually phased-in tax increases, its structure is the same now as in 1937.

 

So what does the data look like? Well, we can first look at a simple chart of OASDI revenue vs the statuatory tax rate. If the famous "Laffer Curve" is correct, revenues should not keep up with the tax rate - a 10% tax should not bring in twice the revenue of a 5% tax.

 

 

 

Is that what we see? Nope. Not at all. In fact, revenues correlate perfectly with the tax rate. No evidence of a "Laffer Curve" appear at all. It appears people aren't trying very hard to dodge the OASDI tax, despite it amounting to nearly 6% of the economy and constituting our single largest tax.

 

 

 

But wait! What if Social Security is harming the economy? We wouldn't see that in the above chart, so we have to look elsewhere. So I have prepared the two charts below. Both consist of one data point for each year, with the horizontal axis being the change in OASDI tax rate relative to the prior year. The vertical axis are the change in GDP growth, with the upper chart being the difference in growth in the subsequent year less the growth in the prior year, and the bottom chart being the growth in the three subsequent years minus the growth in the three prior years. Positive values on the vertical axis indicate accelerating growth. Most values fall at zero on the horizontal axis because most years saw no change in tax rate.

 

 

 

 

 

So there you have it. Our experience with Social Security shows no evidence at all of even a hint of a "Laffer Curve", or having an effect on economic growth, despite it being our largest individual tax. This is all the more compelling because the Social Security system is a rare example of a tax increase coupled with a corresponding spending increase AND not being a response to the current state of the economy. In appears unlikely that at anything approximating our current tax rates, further tax increase or tax cuts would have a substantial effect on the economy if those tax changes were coupled with a corresponding change in spending.

 





 



 

 

America is not a family

One particular analogy people bring up when talking about the government's budget is a "family" analogy.  They will claim that we are like a family with $40,000 in income each year, but who is spending $70,000 and has $250,000 in debt, or some such figures.  There are multiple reasons, however, that this analogy is flawed and leads to false conclusions.

First, macroeconomics.  A family is tiny relative to the economy.  Regardless of how diligently they save or how wildly they ring up the credit cards, the overall economy does not change meaningfully.  This means that the chances that they will be laid off, hired, or see a big boom in orders at their shop are unaffected by their own spending habits.  The government, however, is not small relative to the economy, making up more than a third of it.  If the government slashes spending...well, there is a lot less spending.  People get laid off.  Tax revenues go down.  People wind up on the dole.  After all is said and done, it is not even clear that the money saved via the reduced spending isn't lost completely due to the reduced revenues and new safety net spending.  Even if the government comes out ahead, it is only marginally so, and at the great cost of millions being laid off.

But won't the private sector pick up the slack?  Not when we are in a liquidity trap.  If you don't know what that is, you simply do not understand what has happened in our economy the last four years.  The mechanism by which the private sector normally "picks up the slack" is by falling interest rates, which stimulate investment.  But when you are in a liquidity trap and risk-free interest rates are already essentially zero, they can't fall any further (since you can hold cash instead, they can't really go negative).  So if the government cuts spending in a liquidity trap, it just adds more slack to the economy, and employment and GDP fall.

A second problem with the family analogy as normally presented is that those who present it seem to think the family income is fixed.  They never pause to consider that one solution might be to work more.  Indeed, a nearly perfect analogy exists between the family members' hours worked and tax rates, as both are essentially proportional to income and more or less voluntary.  Given that we have the third lowest taxes in the OECD, perhaps our "family" problem is that mom and dad only work 25 hours a week each.  Likewise, spending on automobiles for the family and defense for the government are pretty similar in size.  Since our defense spending is second highest in the OECD (per GDP), perhaps the family's problem is that mommy drives a $40,000 SUV and daddy has a BMW.

Yet just about every time someone presents this analogy, they never consider the macro effects, ignore the SUV and beemer, and not only dismiss the idea that mom and dad are lazy and could solve the entire problem if they just worked full time, but actively argue that mom and dad are just so hard-put that if they worked more, their productivity would drop so much that they would earn even less overall!    So instead of addressing these issues, the family must raid Junior's college fund, ignore the leaking roof, and skip their annual check-up.  Clearly, that's a one-way ticket to prosperity.

Social Security Sustainability

Any retirement system, when faced with increasing life spans, must resort to at least one of the following:

1:  Delayed retirements / increasing the retirement age
2:  Lower payments during retirement
3:  Higher savings rates or taxes when working

There is nothing wrong with this.  This is simply an obvious result of longer lifespans, and is equally true whether the retirement system in question is public or private.

Thirty years ago, Ronald Reagan and the Democratic Speaker of the House Tip O'Niell made a deal with regards to Social Security in order to deal with the gradual increase of life spans that had accumulated to that point, thus extending Social Security's actuarial balance into the 2030's by building up a reserve for the retiring baby boomers.  This was accomplished by a mix of tax increases and raising the retirement age, which was set to gradually increase to age 67 by 2022.

Thirty years later, we can see farther.  Our lifespans have increased even more, and therefore we either have to save more, retire still later, or try to spread the same amount of retirement dollars over a larger number of years.  What are Social Security's options for insuring its long-term stablity?  Actually, they are not all that bad, requiring modifications no worse than what Reagan and O'Niell chose.  There are plenty of options, such as raising the Social Security tax by 1% for both employer and employee, elimination of the earnings cap (currently $113,700, above which income you do not pay Social Security taxes), raising the retirement to 70, and a host of other smaller changes such as changing the cost-of-living-adjustment to be less generous, changing the payout formulas in order to reduce benefits to higher income workers, bring state and local government workers into the system, a straight benefit cut, etc.  Of course, these can be mixed and matched in any number of ways in order to hit the target.  For example, raising the retirement age one year, phasing in a 0.5% tax increase on both sides over ten years, and raising the cap 20% would put Social Security into balance for the entire 75 years that its actuaries calculate.  A group of policy wonks could crank out a bi-partisan, balanced solution over lunch. Given that Democrats hold the presidency and half of congress, and polls strongly indicate that the public prefers tax increases to benefit cuts in this matter, a fair deal would probably focus on the tax side.  The public, wisely in my opinion, realizes that this program is extremely valuable in ensuring a basic retirement for all, and is worth the price.

In the long run, Social Security can be thought of a system that transfers about 5% of the national income from current workers to current retirees.  It is self-evident that this is forever sustainable.  The only question is whether it would be better to shift this to around 6%, in order to maintain benefits at their current levels as the number of retirees increase, or whether to keep it at 5% and spread the money thinner.  Either way, Social Security is forever....or at least as long as we want it, which I hope is the same.