Next up: Tax Reform

Hopefully the tax reform law to be adopted by Congress in the coming months will closely resemble The Better Way Tax proposed outline by Congressmen Paul Ryan and Kevin Brady on June 24, 2016. Their plan would be revenue neutral (i.e., would raise the same revenue as existing income tax laws by a combination of a broadened tax base and lower marginal tax rates), and would dramatically simplify returns for both individuals and companies. It would remove many distortions in investment and resource allocation decisions and thus promote growth and fairness. It would include an incentive to repatriate the U.S. corporate profits held abroad, estimated in 2015 to be $2.6 trillion, and by basing taxes on income earned in the U.S., it would eliminate the tax minimization strategy of shifting production abroad.

Unlike tax systems in most other countries, both U.S. individual and corporate income taxes are currently source based, meaning broadly speaking that an American’s income is taxed on his or her income wherever it is earned. Even Americans living and earning income abroad pay U.S. income taxes on it. Similarly companies operating in the U.S. pay U.S. taxes on their income no matter where it is earned. However, it is not taxed until they bring it home. This unusual approach to taxation for companies operating globally has given rise to all kinds of strategies for reducing U.S. taxes by earning income in (or attributing it to) low tax jurisdictions.

Under the Better Way proposals business income will be taxed on a territorial or destination rather than source bases. In addition to removing a tax bias for debt financing (by eliminating the deduction of interest costs) and expensing capital investments rather than amortizing them over their estimated life, businesses will be taxed on the basis of their income from domestic sales only. Their so-called Destination Based Cash Flow Tax comes close to being a consumption tax (the gold standard tax bases among economists). https://works.bepress.com/warren_coats/47/  Cayman Financial Review, July 2013. A key feature of their proposal is that the tax would be levied on business revenue from domestic sales of goods and services and not on goods and services sold abroad. For domestic sales the tax would be the same whether they are imports or were produced domestically.

This would remove the existing tax subsidy for imports. As congressman Brady put it in a June 24, 2016 WSJ article: “And because ’Made in America’ products and services currently face a price disadvantage both at home and abroad, American exports will no longer be taxed, and imports will not be subsidized. Competition will occur on price, quality and service—rather than tax regimes.” “The GOP plan for tax sanity.” It would also remove the existing double taxation of exports, the income from which is now taxable as part of American business income and is taxed again at whatever rates apply in the country receiving them.

This is all very sensible and in fact the practice of most other countries that rely heavily on VATs (Value Added Taxes). Regrettably for public understanding, this proposed treatment has been dubbed a “Border Adjustment Tax” by which imports are taxed and exports are exempted from U.S. taxation. This sounds rather different, but it isn’t. It suggests punitive (protectionist) treatment of imports when in fact, as explained above, it gives imports the same tax treatment as received by domestically produced goods.

Some have argued that by removing the import subsidy (i.e. by taxing them at the same rate as domestically produced goods), American consumers of “cheap” imports will have to pay more. It is certainly true that subsidies encourage consumption in excess of a competitive market rate just as subsidizing debt (by deducting interest costs from taxable income) encourages excessive borrowing. So if people import less because they must pay more for such imports without their subsidy, resource allocation and economic efficiency will be improved. However, the reduced demand for foreign currency needed to pay for imports and the increased supply of those currencies to buy larger amounts of American exports are expected to appreciate the exchange rate of the dollar for these currencies. An appreciated exchange value of the dollar will reduce the cost of imports and increase the cost to foreigners of American exports. The impact on import and export prices of the “Border Adjustment Tax” and the resulting exchange rate adjustment are expected to approximately off set each other.

It is tempting for each affected group to evaluate the fairness of proposed tax reforms on the basis of whether it increases their taxes or lowers them (and thus increases someone else’s taxes). On that basis any tax change will always have proponents and opponents. The proper basis for judging a reform’s fairness is in relation to a broadly agreed concept of fairness. This calls for a John Rawlsian veil of ignorance, i.e., judging the fairness of a tax system without knowing in whose shoes you will stand.

There is much more to the prospective tax reform proposals, including unfortunately changes that might be made to buy off special interests affected one way or another, and it promises to be an interesting debate. I hope that it is more open and considered by all (Republicans and Democrats) than was the case for the now (temporarily) abandoned effort to reform Obamacare. And in the end I hope that something very close to the Better Way proposals of last year is adopted. The reality of a bipartisan approach to Tax reform is unfortunately unlikely under the current climate, but we can always hope and dream.

Econ 101 – Jobs and Income Growth

At long last the economy has more or less reached full employment. The December 2016 unemployment rate was 4.7 percent while the Federal Reserve’s assessment of normal full employment (NAIRU—non-accelerating inflation rate of unemployment) is 4.8 percent. More over, wage growth has picked up, increasing 2.9 percent over a year earlier. The producer price index increased 0.3 percent in December (4.3% annualized). The economy is heating up. The Federal Reserve raised its overnight interbank interest rate target (Fed Funds rate) from 0.5 to 0.75 percent in December.

What does this mean for PEOTUS Trump’s goal to create jobs and increase the economy’s growth rate? At his press conference January 11, 2017 he claimed to be: “The greatest jobs producer God ever created.”

A new job is created when a company demands an additional worker for some reason or other and the desired worker is supplied. More jobs (by which I mean more new ones than the loss of old ones, i.e., a net increase in jobs) can come from any of three sources: a) an increase in the labor participation rate (more people looking for work from those of working age who are physically able to work); b) more young people entering the labor force than retiring old people leaving it; and c) a net immigration of working age foreigners. An increase in the demand for workers that cannot be filled will put upward pressure on wages and ultimately on prices.

In December the labor participation rate rose to 62.7 percent from its low in November of 62.6. It had been around 66 percent in the years just before the great recession of 2008. While we don’t really understand why so many people have dropped out of the labor force, there is scope to increase employment if some of them return. Some of the new jobs are filled by immigrants, especially those jobs requiring information technology skills, which creates additional jobs to feed, cloth, and entertain the new residents. http://wapo.st/2irYDYW. While 7.4 million people were looking for work in November 2016 (latest available), there were 5.5 million unfilled vacancies. If you like data: 5.1 million were hired in October while 4.9 million left their jobs for a net increase in employment of 0.225 million. Of those leaving their jobs 0.372 retired or died.

In short, the economy does not lack jobs and the number of jobs is growing at about the rate of growth of the working age population. If the government increases employment for infrastructure projects, those workers must be attracted away from their existing jobs, which will require higher wages. Increasing employment at much faster rates would be inflationary. Higher inflation would undermine the real value of excessive nominal wage increases.

The problem—issue or challenge—is that the new jobs offered often require skills that do not match those of the workers looking for work. Most layoffs and discharges result from automation and other productivity improvements (not from trade), which increases the wages offered for the new jobs needed as a result. This process—increased worker productivity—is the source of per capita income growth, i.e. of our increasing standard of living. However, the benefits of increased productivity will only be broadly shared if workers are trained (or retrained) in the new jobs needed. In addition, the increased income inequality in the U.S. since the 1970s is largely the result of increased rent seeking from government as government regulations have expanded to protect the established companies from outside competition.

Faster income growth, therefore, will depend on improving productivity and its rate of growth over time (not creating more jobs). Improved and simplified regulations will free up some of the large armies of compliance officers to work in jobs that actually produce things we want. It will also increase market competition by reducing regulatory capture and related rent seeking. The same is true for any reforms in the provision of medical services that lower their cost (e.g. from greater transparency of costs of treatment options and patient responsibility for and interest in those costs). This is a different issue than who pays for medical care (insurance) but the nature and structure of medical insurance profoundly influences the incentives patients and doctors have to choose cost effective medical services. Tax reforms that lower the cost of investing in the U.S. will also increase productivity and income growth.

Investments in plant and equipment and new technology increase labor productivity and income in the future but require workers and materials to build them in the present. In an already more or less fully employed economy the resources used for investments must come from giving up other uses, primarily from producing consumption goods and services. To finance investment people will need to consume less and save more.

If none of the resources and their financing come from the government (and Trump plans the opposite), interest rates will need to rise in order to encourage more savings and to moderate the increase in investment. The Federal Reserve will have to raise its interest rate targets just to stay neutral (i.e. to keep inflation rates near their 2% per year target) as the tightening labor market puts upward pressure on wages and equilibrium interest rates. Thus interest rates will need to increase even more to encourage the additional savings needed to finance additional investment.

The new government has yet to propose its budget for the coming year, but Trump cannot simultaneously increase military spending and infrastructure spending and leave entitlement commitments unchanged (which imply significant increases in actual social security and medical outlays because of an ageing population and increased retirements relative to new entrants into the labor force) even if his tax reforms are revenue neutral (which current proposals are not). We don’t know yet which of his plans will have to give and to what extent. None of this takes into account the large impact not so far down the road of unfunded fiscal liabilities (unfunded social security, Medicare, and Medicaid obligations). https://wcoats.wordpress.com/2013/03/16/the-sequester/ https://wcoats.wordpress.com/2011/04/23/thinking-about-the-public-debt/ http://tinyurl.com/yjos2ed. Thus it is difficult to forecast how much interest rates will need to rise in order to keep inflation in check while crowding out private investment to finance the growing public debt.

Higher interest rates will also tend to strengthen (appreciate) the dollars’ exchange rate, which will increase our trade deficit unless Trump totally destroys our trade flows in a misguided effort to balance our trade account (balance imports and exports). A larger trade deficit would result in some of the increased investment being financed by foreign saving (capital inflow) and to that extent would reduce the upward pressure on interest rates. So far I have not taken account of possible changes in the economic conditions of the rest of the world. However, an appreciated dollar would improve the exports and thus economic activity of other trading partners but would increase their local currency cost of any borrowing their firms and citizens have done in dollars.

The bottom line is that any increase in economic growth in our fully employed economy will come from increases in productivity not increases in employment. Tax and regulatory reform should improve the allocation of our labor and capital resources to more productive uses. They should also lead to increased investment, which will enhance future productivity. Jawboning or pressuring the allocation of these resources into less productive uses (e.g. domestic production of goods that could be more cheaply imported) will reduce economic growth. Increased investment will require higher interest rates in order to generate the savings needed (reduction in consumption) to finance the additional investment. However, continued fiscal deficits will divert that amount of savings away from investment. Without significant cuts in future entitlement commitments (and/or defense spending) these deficits will grow larger at the expense of economic growth. New trade tariffs threatened by Trump or other new impediments to trade will also reduce our productivity and growth. While the Trump administration could increase our economic growth rate in the coming years, this outcome depends on it resolving existing internal contradictions in its proposed policies.

Work-Leisure Choice and growth

A recent dinner companion inquired whether an economy that was not growing was necessarily a problem. What she had in mind was whether people choosing more leisure to enjoy their incomes rather than continuing to work the same or longer hours created an economic problem. The short answer is no. I will explore that issue further and then make a point about the propriety of governments making work/leisure choices for us rather than leaving the choice to us.

Our incomes grow when we work longer hours, acquire improved skills, work with more tools, or work with better tools. The economy as a whole grows without individual incomes necessarily increasing when more people work (i.e., when the population grows). Unless you are very pessimistic about the prospects for continued innovation and technical improvements in each worker’s productivity, our incomes will continue to increase even if we don’t work longer hours.

Over the last 65 years the average annual hours worked by employed Americans dropped from 1,910 to 1,710 while real disposable personal income per capita (in 2009 dollars) increased from $10,000 to over $38,000. Over the longer period of a century or two the drop in hours worked and the increase in per capital income have been much more dramatic. This dramatic increase in income reflects better skills, more capital (tools) and better capital. But it is less than in would have been if people had not chosen to enjoy that income by working less and playing more. The over all economy can adjust to any of these – growing, stagnate, or shrinking income.

While Bernie Sanders may think that the best way to increase the standard of living for the poor is to redistribute to them some of the high income of the wealthy, most everyone else would agree that only economic growth has and can continue to lift large numbers of the poor out of poverty. Global poverty (per capita income below $1.25 per day) dropped from 50% in 1980 to 20% in 2011, an astonishing achievement totally beyond what any amount of redistribution could have accomplished. Most of us think that the proper purpose of redistributing income is for the better off to finance a safety net floor for those unable to work. This dramatic increase in income was the result of improvements in worker productivity (i.e., better skills and more and better capital) not working longer hours.

But what about the choices workers have made and are making about the hours they work vs. the hours they play with the proceeds of that work once they are well above poverty? Over time as most people’s incomes have grown they have generally reduced the long hours worked six or more days a week. Employers and workers strike deals that maximize the profits of the firm and the happiness and well-being of employees. Why then do many governments feel that they need to legislate the matter? Why, for example, did French Socialists feel compelled to legislate a 35-hour workweek a few years ago?

In limited cases, a public safety argument might make sense to over ride the preferences of workers and their employers, for example, if truck drivers felt included to push themselves more hours than they could safely stay awake at the wheel. Mr. Hollande’s French government is now proposing to remove the 35-hour limit and relax other labor market restrictions. I hope they succeed, as leaving more of such decisions with the people themselves will result in happier workers and a more productive economy.

This issue came up a few years ago in connection with the Greek financial crisis. Here are two of my blogs written three years apart on the situation in Greece: https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/,     https://wcoats.wordpress.com/2015/02/08/greece-debt-and-parenting/ To over generalize, it is often the case that people living in temperate climates (such as Greece and the Southern cone of the EU) work less and have lower incomes. If they are freely choosing to enjoy more leisure in the lovely climate in which they live, they are no doubt happier and better off because of it. Greece’s problem was not that its many Zorba’s had a great zest for life and played more than they worked. Its problem was that after getting away with playing on other peoples’ work/money, they thought they should be entitled to continue doing so. The balancing of work and leisure that is optimal is a person-by-person decision. The economy will be fine and will adjust to whatever these preferences are. People at different income levels and/or different preferences within the same economy will likely make different choices. There is no justification for the government to impose its notion of what is optimal uniformly on everyone. This is just another example of government over stepping its proper role.