Thursday, May 15, 2008

ECON 365: A lingering EITC Question

In class, I wasn't 100% sure that the EITC was paid only once a year. It turns out it is, but you can also sign-up for the AEITC which is paid every month. The question -- which is better for recipients. Here's Mark Thoma:

Most people know about the Earned Income Tax Credit (EITC). Under this program, payments to qualifying individuals are made once a year. There is also something called the Advance Earned Income Tax Credit (AEITC) that allows qualifying individuals to receive the credit with each paycheck. But even though this program exists, most of the payments are made under the EITC and come around the time tax returns are filed.

I've often thought this was a potential disadvantage relative to the minimum wage for people living close to the margin. With a minimum wage, the extra income comes with every paycheck and helps with monthly bills, etc., but with the EITC, it comes as one large payment leaving families to struggle each month in return for a feast once a year. [Why more people don't enroll in the monthly payment plan I'm not sure, that seems like the better option (you can always save a bit of each monthly check and mimic the EITC plus interest), but I suspect it is partly the administrative hassles with getting the AEITC put into place, and the restrictions on who qualifies.]

But maybe this is a feature, not a bug, at least that's the argument below, i.e. that the once a year payment allows households to buy needed durable goods such as cars they wouldn't otherwise be able to purchase. Is it a feature? In essence, this is like forced saving (even under the AEITC only part of the credit is paid), requiring households to give up monthly consumption for one large annual payment. The fact that they are able to buy more durable goods - cars - with the one time payment is nice, and the argument is that this helps them find employment, but we need to know what they gave up each month before we can conclude they are better off.

More on the differences between left and right economists

This time from GWU economist Richard Green:

I like economics a lot. Every time a new issue of The Quarterly Journal of Economics (my favorite journal right now--AER is a strong second)comes out, I am very excited.

Yet I am a liberal. I think incentives are important (I support Welfare Reform and School Choice), but I also think that all working people should be able to live at a reasonably decent living standard (so I also support a generous EITC and minimum wage), and that we as a society as a whole should provide all manner of social insurance, including Social Security and universal health care. I therefore find myself disappointed when smart people like Kenneth Rogoff and Anne Krueger support McCain's economic policies--particularly since I took a class in graduate school from Rogoff and had the same dissertation adviser as Krueger.

But while I learned a lot from Rogoff, it struck me when I was a student that there was a fundamental difference between us (beyond the fact that he is an order of magnitude smarter than I), a difference that hit home when he lectured on his political business cycle work. While I think economics helps give us powerful insights into how humans behave, I think he believes that economics by itself explains how humans behave. And while I think that random shocks (such as being born smart, or in the United States) are at least as important as individual effort in determining our fate in life, I think he believes the converse.

We as a society do want to encourage effort, because it leaves us all better off. But as the recent natural disasters in Burma, China, and, yes, New Orleans have shown, we never will have anything like complete control of our lives. Those of us who have gotten good draws should have some empathy for those that haven't.

Tuesday, May 06, 2008

People are weird

Insurance = sacrifice to gods?

“It is an irony of the post-Enlightenment world,” they conclude, “that so many people who don’t believe in fate refuse to tempt it.” The psychologists first identified this reluctance last year by reconsidering a well-known superstition about lottery tickets. Experimenters had repeatedly found that once people were given a lottery ticket, they would refuse to trade it for another ticket despite being offered a cash bonus and reassured that the other ticket was just as likely to win.

This superstitious behavior had been explained with the theory of “anticipated regret”: Even though the people realized the odds were no different for any ticket, they anticipated feeling especially stupid if they traded away a winner, so they held on to their ticket just to avoid that regret.

But there’s also another reason, as Dr. Risen and Dr. Gilovich reported after running a complicated lottery game with cash prizes for competing teams. If a player watched his teammate (who was secretly a confederate of the researchers) trade away a lottery number, the player actually believed the new number was less likely to win, and he would hedge his bet accordingly.

The fear of tempting fate showed up in further experiments with Cornell students. When told about an applicant to graduate school at Stanford who had been given a Stanford T-shirt by his mother, people assumed he would hurt his chances for admission if he had the hubris to wear it. And they believed that a professor was more likely to call on them in class if they didn’t do the assigned reading.

Even people who consciously reject superstitions seem to have these gut feelings, says Orit Tykocinski, a professor of psychology at the Interdisciplinary Center Herzliya in Israel. She found that rationalists were just as likely as superstitious people to believe that insurance would ward off accidents.

In one of her experiments, players drew colored balls out of an urn and lost all their money if they picked a blue one. Some players were randomly forced to buy insurance policies that let them keep half their money if they drew a blue one. These policies didn’t diminish their risk of drawing a blue ball — but the insured players rated their risk lower than the uninsured players rated theirs.

That same magical thinking was evident when Dr. Tykocinski asked some people to imagine buying travel insurance before getting on a plane, and others to imagine not buying it because they ran out of time at the airport. Sure enough, the ones with insurance figured they were less likely to lose their bags, get sick or have an accident.

These results presumably come as no surprise to marketers of travel insurance, which is now purchased by half of American leisure travelers — a fivefold increase since 2001, according to the United States Travel Insurance Association. As a purely economic investment, some of this insurance can be dubious, particularly the flight insurance policies. (For more on this, see

A magical belief in insurance sounds crazy because at a rational level we realize that our decision to forgo an insurance policy is not going to affect pilots or mechanics. But Dr. Risen and Dr. Gilovich say that there’s a logical explanation for this superstition: Because calamities are so vivid and easily brought to mind, we tend to overestimate their probability when we intuitively judge what will happen if we tempt fate.

Saturday, May 03, 2008

Economists' Disagreements, Part II

Here's another view on why economists disagree, this one from Dani Rodrick:

Non-economists are often baffled by the disagreements among professional economists on the issues of the day--from international trade to the minimum wage, from economic development to health policy.

I think the best way to understand the source of these disagreements is to recognize that there are two genres of economists. I call them "first-best economists" and "second-best economists." Here is my guide to them.

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic. The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best. No matter how technical, complex, and full of surprises these economists' own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect. The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions. Since they have given up on the textbook model, members of this group have an almost-infinite variety of "models" to choose from as they think of public-policy issues.

The first group's instinct is always to apply the first-best reasoning to the case, ignoring market imperfections in related markets, while the second group almost always presumes some market imperfections in the system. I am over-simplifying a bit, but not a whole lot.

Among commentators in the blogosphere, I think Gary Becker, Tyler Cowen, Greg Mankiw, and Brad De Long (more often than not) are first-best economists. In is commentary on globalization, Jagdish Bhagwati is an unadulterated first-best economist, even though his best scholarly work is solidly cast in the second-best mold. Meanwhile, the undisputed king of second-best economists is Joe Stiglitz. He is joined by George Akerlof, Bob Shiller, Alan Blinder (recently) and Paul Krugman (especially when he writes on deregulation and health policy, and increasingly, but not always, on trade). I am definitely in the second-best camp as well.

When first-best economists are taken to task for ignoring real world complications--i.e., second-best interactions--they provide a range of answers. One is to downplay the significance of these issues by arguing that they are not convinced of the presence of the market imperfections in question. Sure enough, empirical evidence is hardly ever strong enough to move prevailing priors.

A second argument is that the presence of additional market imperfections does not change the first-best logic; it simply calls for each market imperfection to be treated with its own first-best solution. This allows each expert in a field to propose first-best solutions in that field, leaving complications elsewhere to be dealt with by others. Larry Summers had a nice point to make about this approach in his comments on a paper on banking reform in China (Brookings Papers on Economic Activity, 2006:2):

Like experts in many fields who give policy advice, the authors show a preference for first-best, textbook approaches to the problems in their field, while leaving other messy objectives acknowledged but assigned to others. In this way, they are much like those public finance economists who oppose tax expenditures on principle, because they prefer direct expenditure programs, but do not really analyze the various difficulties with such programs; or like trade economists who know that the losers from trade surges need to be protected but regard this as not a problem for trade policy.

(Come to think of it, is Larry Summers a first-best economist or a second-best economist?)

A third argument is that the government could never get complicated interventions right, so we are better off sticking with simple solutions. I have discussed this type of argument in an earlier post.

So at the end of the day, these disagreements are often grounded not in economics per se, but in strongly held prior views about the world in which we live in. Which is why non-economists are right to get exasperated with us.

Here's Tyler Cowen's response.

The Fundamental Differences Among Left and Right Leaning Economists

Greg Mankiw provides his view of the fundamental set of assumptions that divide left and right leaning economists:
Mark Thoma responds to this list here.

Friday, May 02, 2008

This is Just Sad

George Will is an elite pundit. I've never really understood what pundits are paid to produce, but, as near as I can tell, the job of a pundit is to be the "smart" folks who distill massive amounts of complicated news into digestible bites for the masses. His is paid enormous sums of money to do this.

I would expect, that as part of his job, Will is supposed to understand the basics of the topics he speaks about. Given that he talks primarily about politics and policy, I would assume that he would know most of the details covered in, say, a basic course in Public Economics. This assumption is clearly unfounded.

In this piece, Will seems determined to mislead his audience about the most basic implications of some of Obama's tax policies, and I am concerned that his employers (and consumers) don't seem to mind.

What's wrong with this statement (or rather questions for Obama)?
During the ABC debate, you acknowledged that when the capital gains rate was dropped first to 20 percent, then to 15 percent, government revenues from the tax increased and they declined in the 1980s when it was increased to 28 percent. Nevertheless, you said you would consider raising the rate "for purposes of fairness." How does decreasing the government's financial resources and punishing investors promote fairness? Are you aware that 20 percent of taxpayers reporting capital gains in 2006 had incomes of less than $50,000?
First, I've already discussed (here and in class) the short run responses to changes in the capital gains rate. These responses do not imply that we were on (or are near) the "wrong" side of the Laffer Curve (i.e., lowering rates increases revenue by increasing economic efficiency).

I'll also ignore the question about "fairness" (see textbook definition of both vertical and horizontal equity if you want my response) because that's a more normative issue.

Let's focus on the last part. In this part, Will implies (although he does not state directly) that Obama will increase the capital gains tax on 20% of those who earned less than $50,000.

Three important things here. First, Will asserts that 20% of those with reporting capital gains had incomes less than $50,000. Second, Will ignores the expected magnitude the impact of any potential increase in the capital gains tax rate (essentially implying that any increase no matter how trivial on these individuals is bad). Third, (and perhaps most importantly) Will implies that Obama will, in fact, raise these individuals taxes (Here's my summary of Will's point: Obama wants to increase cap gains taxes to 28%, people with less than $50,000 pay cap gains taxes therefore Obama wants to raise these individuals taxes on capital gains to 28%).

Let's break it down.

What share of people people paying capital gains taxes have incomes of less than $50,000? (Is this even the right question to ask? Aren't we more interested in the share of people with incomes less than $50K who pay capital gains taxes?)

Here's a slightly different look at the distribution of capital gains taxes than the table I linked to a few days ago.

In 2005, 13.7 M tax units reported capital gains and 24.6M tax units reported qualifying dividend income. Thus, 28 percent (3.8M) of those reporting capital gains taxes and 32 percent (7.9M) of those reporting dividend income had cash incomes less than $50K. So Will may be understating his fact.

His fact, though, is somewhat off the mark. Why should only people who pay these taxes be in the denominator? Isn't using the whole population more informative?

There are 92 million tax units (filers) with cash incomes of less than $50,000. Of these 92 million tax units, 7.9 million had dividend income and 3.8 million had capital gains income. Thus 8.6 percent of <$50K tax units paid dividend taxes and 4.1 percent paid capital gains taxes. It's not clear how much these two groups overlap, but it is pretty clear that, for the most part, people with incomes less than $50,000 don't pay these taxes.

Ok, but some with incomes of less than $50,000 do pay dividend and capital gains taxes, how much would those individuals' taxes rise?

The table below presents the distribution of gains when the capital gains taxes were lowered:

So when the capital gains rate fell by 5 percentage points, tax filers with AGI's of less than $50,000 saw their taxes decrease, on average, by $13.

Ok, ok, but most of these people have zero capital gains, so isn't your average skewed by the fact that your not looking at the real impact on the few people with incomes less than $50K who do realize capital gains?

Fine, the total value of the tax cut to all households was $1.2B, so the average cut to people with AGI <$50K who actually realized capital gains was roughly $200.

Thus, essentially, Will is implying that out, of the 90+ million tax units with incomes less than $50,000, the few million who have dividends or capital gains might see their taxes go up by an average of maybe $500 (a decrease 5 percentage points led to a $200 decline so an increase of 13 percentage points would probably more than double that).

Of course, this assumes that these people will see a 13 percentage point increase in their dividend/capital gains tax rate.

Obama's plan (as far as I can tell) only raises the TOP dividend and capital gains tax rate!

The top dividend and tax rate is the rate that applies to people who whose ordinary income tax rate is 25% or higher! Here's the current capital gains tax schedule:
Ordinary Income Rate Long-term Capital Gain Rate Short-term Capital Gain Rate Long-term Gain on Real Estate Long-term Gain on Collectibles Long-term Gain on Certain Small Business Stock
10% 0% 10% 10% 10% 10%
15% 0% 15% 15% 15% 15%
25% 15% 25% 25% 25% 25%
28% 15% 28% 25% 28% 28%
33% 15% 33% 25% 28% 28%
35% 15% 35% 25% 28% 28%

See how people with Ordinary Tax Rates of 10% or 15% don't pay the 15% tax on Long Term Capital Gains (for these people it fell from 5% to 0% in 2008 and is scheduled to return to 5% in 2010). As far as I can tell (and I couldn't find the details easily), Obama has only mentioned raising the top rate from 15% to 28%.

Thus people in the bottom two brackets won't see an increase in their capital gains tax (or if they will it won't be to 28% like Will mentions). Who are the people in those brackets? Almost everyone with an income of less than $50,000!

Marginal Tax Rate Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household
10% $0 – $8,025 $0 – $16,050 $0 – $8,025 $0 – $11,450
15% $8,026 – $32,550 $16,051 – $65,100 $8,026 – $32,550 $11,451 – $43,650
25% $32,551 – $78,850 $65,101 – $131,450 $32,551 – $65,725 $43,651 – $112,650

So the only people with taxable incomes of less than $50,000 who would see an increase are singles (or married filing separately) with taxable incomes between $32,550 and $50,000 or heads of households with taxable incomes between $43,651 and $50,000 WHO ALSO REALIZE CAPITAL GAINS. I'd be curious to know how many of these people there are.

That's some really pathetic (i.e., highly misleading) journalism.

But Will's not done yet:
You favor eliminating the cap on earnings subject to the 12.4 percent Social Security tax, which now covers only the first $102,000. A Chicago police officer married to a Chicago public-school teacher, each with 20 years on the job, have a household income of $147,501, so you would take another $5,642 from them. Are they undertaxed? Are they rich?
Here's the first thing that pops up when you type "how are social security taxes calculated" into google:

How are the Social Security taxes I pay with each paycheck calculated?

Your employer withholds 6.2% of your gross pay up to $102,000 (in 2008) for Social Security tax.
That's right folks -- social security taxes are paid by individuals, not households. Will's silly example isn't even correct. This household would not see their social security taxes rise at all if this change were made.

Furthermore, yes, a household making $150,000 per year is pretty rich. They make more than approximately 95% of the households in the US. $150,000 might not go as far as they'd like it to. There may still even have financial anxiety in their lives, but that anxiety is probably waaaay less than that felt by families making half than amount.

We have some serious problems with how we provide voters information in this country. This type of stuff should never, ever get published by a supposedly respected news organization. Sadly, while searching for the information used in this post, I found dozens of other examples of people misleading their readers about the implications of this particular tax change. Yet, instead of making correcting this misinformation the goal of their news organizations, our media focuses more of its resources to the salacious and trivial. It really is sad.

Thursday, May 01, 2008

Is our income tax system really that progressive?

Justin Wolfers writes about average tax rates (after accounting for deductions and credits):

Well, let’s start with the ultra-rich. Bajillionaire Warren Buffett has argued that he isn’t being asked to pay his share. He went around his office, asking people what share of their income they pay in income taxes. Buffett’s 17.7 percent tax rate compared a bit too favorably with the 30 percent tax rate paid by his secretary.

So it appears that the tax system favors the super-rich over working stiffs.

And Buffett went a step further, putting his money where his mouth is. Last November he issued a challenge to his fellow billionaires:

I’ll bet a million dollars against any member of the Forbes 400 who challenges me that the average (federal tax rate including income and payroll taxes) for the Forbes 400 will be less than the average of their receptionists.

So far, no-one has taken him up on this bet.

What about those of us who are merely among the well-off, and not in the Buffett-stratosphere?

Now, I’m no Warren Buffett (believe me!), but I’ve just finished figuring out my federal taxes for the year. I live comfortably (one of the virtues of teaching in a business school), but was dismayed to learn that my federal taxes for 2007 amount to only 16 percent of my income.

This strikes me as astonishingly low. And it’s not like I have a fancy approach to tax minimization; I just write off a bunch of business-related expenses, and benefit enormously from deductions for mortgage interest and charitable giving. Obviously city and state taxes drive my total tax bill up a bit further, as do payroll taxes, although I plan on getting some of that back as social security in my old age.

But the point remains: I had never quite realized that the Warren Buffett problem extends far enough down the income distribution that even folks like myself aren’t paying their fair share.

So I repeated Warren Buffett’s experiment here at Wharton. And it appears that I’m paying lower taxes than the administrative staff in my department. And if it is true here, I suspect the same goes equally for most folks in the top 10 percent of income earners. (Incidentally, according to Piketty and Saez, around half of all income in the U.S. goes to those of us in the top decile — roughly anyone with a family income of six figures or more.)

ECON 365: Corporate Tax Policy and Offshoring

Here's a nice summary of the effects of US corporate tax policy on the offshoring of jobs.

Democratic presidential contenders Hillary Rodham Clinton and Barack Obama have cast it as an outrage that should be a key target for the next president: a tax break they say encourages employers to ship American jobs abroad.

The charge could be dismissed as typical campaign-trail exaggeration during a Democratic primary season marked by populism, except for one thing. Many analysts say it's true. "The U.S. tax system does provide an incentive to locate production offshore," says Martin Sullivan, a contributing editor to Tax Notes, a non-profit publication that tracks tax issues.

At issue is the U.S. tax code's treatment of profits earned by foreign subsidiaries of American corporations. Profits earned in the United States are subject to the 35% corporate tax. But multinational corporations can defer paying U.S. taxes on their overseas profits until they return them to the USA — transfers that often don't happen for years. General Electric, for example, has $62 billion in "undistributed earnings" parked offshore, according to recent Securities and Exchange Commission filings. Drug giant Pfizer boasts $60 billion. ExxonMobil has $56 billion.

"If you had two companies in Pittsburgh that both were going to expand capacity and create 100 jobs, our tax code puts the company who chooses to put the plant in Pittsburgh at a competitive disadvantage over the company that chooses to move to a tax haven," says former White House economist Gene Sperling, a Clinton adviser.

The Democrats, saying the United States has overlooked the costs to working Americans in its rush to embrace globalization, have vowed to eliminate any tax incentive for further offshoring ...

Finding Practice Statements

As I mentioned in class, I think it may be useful to find arguments on the internet and practice identifying the key assumptions in these arguments. There are lots of arguments out there, so they shouldn't be hard to find (see any op-ed section and the blogosphere).

Here are a few places to start:

The Ron Paul interview I discussed in class.

Overview of Obama's positions

Overview of Clinton's positions

Overview of McCain's positions

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