Another Example of "just because you can, doesn't mean you should"

This is a short post.   The chart at the left shows the associated taxes and fees attached to a projected car rental in Seattle.   I say projected because on a recent trip I finally decided that I would not use this rental company (fees for other companies are comparable) because of the almost 40% rate of tax on the rental.

Most all of these except the sales tax (at a whopping 9.5%) are adopted because the state and local governments think they can get away with it.   Seattle got talked into building a new sports stadium and car renters are asked to help pay for it.   The cost of the concession granted the rental company is amortized out over all the renters.   The rental car company even asks to have renters pay for the license plates.   Oh, and we also get to pay for funding regional transit.

The point here is that at some point travelers are going to be less likely to rent cars or stay in hotels or even visit places if the hidden taxes that residents of the city think they are shuffling off on visitors become even more onerous.   From my perspective a 40% tax is a bit too dear.   So on this trip I cancelled the reservation and used a shuttle.  The cost of the shuttle (which undoubtedly also had some of these taxes) was even less than the total tax bill on the projected car rental.  Too bad Seattle.

What Constitutes Democracy versus Democary

George Skelton is a long time reporter on politics for the LA Times.  He does not have much use for Proposition 13.   On the 3rd of July he proposed that the two thirds requirement for raising taxes and for approving local public works projects be lowered to 55%.   Skelton's real views are contained in the following quote - "Any supermajority vote requirement is illogical and contradictory when compared to the mere 50% plus one needed to pass statewide bond issues. But at least 55% gets much closer to majority rule."  Skelton has been around for a long time - he started in the Capitol about the time I did.  

Skelton's column amused me because it is so bereft of any understanding of voting theory and logic.   For him, the 55% rule, which he proposes has no basis in logic it is only justified because it is lower than two thirds.   The reporter could benefit from understanding some basic theory about voting.

In the American experience there was special concern paid to the potential errors of majority rule.  During the Eighteenth Century there was a lot of concern about the excesses of "democratic" revolutions - Edmund Burke wrote his reflections on the French Revolution and expressed that point of view -  the risks of not protecting the rights of the minority were well understood when the Constitution was adopted.  During the Nineteenth Century many states and localities used simple majority rules to do exactly what Skelton proposed in his article.  The result was a series of financing disasters.   Many of the rules for financing that limit the ability of entities to take on any debt and some of the voting requirements for adopting bond issues came about from the kinds of scandals that happened when a majority pushed through things without proper care.

When the fraction for school bonds was lowered to 55% I went back and looked at school bond issues which passed and those that did not after Proposition 13.  The ones, until the 55% rule was adopted, that explained why bonding was necessary and made a clear case for what the money would be used for - passed overwhelmingly.   The ones which were justified on some amorphous notion that if we just spent a bit more dough the schools would be better did not pass in as high a number.   The voters are not dumb.

There are other reasons for keeping the voting requirement high for adding taxes or spending money into the future.   First, it helps to recognize that future voters will be a part of the decision.   A higher voting requirement puts some brakes on those who would spend for almost anything.   Higher voting fractions also slow down the tendency to "cycle" - in pure majority votes the losing side will constantly be trying to get that extra one or two percent to their side and overturn a decision with which they disagree. 

For Skelton, neither the theory of protecting the rights of the minority nor the benefits of higher fractions for some decisions are important.  Were he pressed he would have a hard time demonstrating the pain inflicted by these requirements - except for those who think the public sector should be mostly unbridled.   But for voters who care about stability and rationality in public decisions, the theory and practice are quite important.

No-ing thyself - Aaron Wildavsky's notion applied to Tax Reform

Aaron Wildavsky was a remarkable scholar.   My experience with his work began as an undergraduate when I read one of his first books (The Politics of the Budgetary Process).   But it kicked into high gear during my doctoral studies.  One of my professors suggested that part of completing a doctorate was to be an active member of the scholarly community.   That was harder then than it is now but I none-the-less tried to do it.   I wrote a paper on power relationships which mentioned Wildavsky and so I sent him a copy of the paper.   He sent it back with some comments.   But I discovered that I also became part of his network.   Almost until he died I became a pre-reader of some of his books.   He wrote a book on risk theory and also one on taxation and expenditure.   In both cases I got a very early draft.   I made minor comments on the risk book - because I was just getting into the area - I now serve on an insurance company board and actually helped to set up a specialized insurance company based in part on some of the things I learned in his book.   But the one on taxation and expenditure I did a lot of comments - tax and finance were two key areas so I had a lot to say.   The version I got was a draft (an early one) and when he published the final one, it became a mainstay in the area.   I asked my professor (who had made the original suggestion) and he said "Yeah, the way Aaron writes books is he does some preliminary research, sends a draft out to a lot of people and then is great at reading the comments and synthesizing new ideas from all the people he sent the manuscript to" in essence we served as unpaid research assistants.

I mention that because about the time one of the ideas that Wildavsky was suggesting was to "No" thyself.   The idea was simple - establish elements in a fiscal constitution which would prevent wild and crazy excesses.   The 2/3 vote requirement in Proposition 13 is a good example of the principle.

This week the Chair and Vice Chair of the Senate Finance Committee (Max Baucus and Orrin Hatch) proposed a new twist on the idea.   They sent out a dear colleague letter which suggested that they wanted to start the process of tax reform.   And that rather than picking and choosing which elements should stay in the code, they would begin with the principle that everything would go out, everything!   If someone could make the case for something to stay in - they would consider it - but as a starting point everything would go out and every provision in the code would have to justify its existence.   If a provision cannot prove that it helps to grow the economy or make the code fairer or promotes some other important policy objective - it goes and stays out.

The code is now 74,000 pages/ 9 million words.   A George Mason Mercatus Center report suggested that tax compliance costs us all about a trillion dollars each year.   The complexity also loses something close to half a trillion annually in under or unreported income.   So simplification would be a big boost for all of us.

If the two senators are successful they might be able to halve the top rate for personal income taxes.    Most political observers have argued that the tax code is too tough to tackle because benefits are concentrated and costs are diffuse.  But this approach would put everything on an equal footing.   One wonders whether this is a variation on the strategy played in 1986 when the most significant tax bill of the last half century was adopted or whether this is simply a dodge.   For those who care about the real costs of the current code (and I count myself in that lot) this would be a good starting point.

There are two elements which argue against 2013 being 1986.   First, in 1986 you had a president who was willing to fight for the principle of simplification - against the opposition and members of his own party.   He also recognized that allies can come from strange places like Oregon (Bob Packwood), New Jersey (Bill Bradley) and Chicago ward politics (Dan Rostenkowski) and even Massachusetts local politics (Tip O'Neill).    Second, 1986 saw two things we may not have now - a House committed in part to significant reform (Bill Camp the chair of Ways and Means may be that person) and some public pressure for simplification.  

Were all the stars to align we might have the opportunity to put together a reprise of 1986 - which brought about more revenue and significant prospects for economic growth.  Most likely if this were to begin to advance it would be in an even numbered year (2014); but I would still say this bold no-ing thyself is a long shot.

Three charts one story

The Congressional Budget Office released a report on "tax expenditures" which purports to show one thing (the skewing of benefits to the highest quintiles in income) but actually shows something quite different.  This is not to say that the data is wrong - merely that it fails to account for a key fact.

The WP immediately seized on the story.  (Gee what a surprise.)

You may remember that Tax Expenditure theory is one of those delightful Washington creations which purports to measure the loss in tax revenue that is created by allowing taxpayers to exclude certain parts of income from their tax returns through deductions and credits and income exclusions.   For example, a large one (originally created when WWII wage and price limits were cutting into employment) is the exclusion from income of health benefits.   Many have distortive effects.   The health care system would probably be much better if we did not have that exclusion.  Tax Expenditure Theory was invented in large part by a former Assistant Secretary for Tax Policy who thought that rich folks did not pay enough tax.  It was one of those insider debates that is deceptively simple, but ultimately not very accurate.   The arithmetic is correct, but the thinking is distorted.

 The problem with these types of concepts was first pointed out by Adam Smith in the Theory of Moral Sentiments.  (Emphasis added)

"The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it."

Ultimately, while we may think we can calculate the effects of structural elements of the tax code - those calculations may have no ultimate relation to actual human behavior.  So here are the charts - the first two from the CBO report.   The first, with seeming great precision, seems to show that the highest 20% of taxpayers reap enormous benefits from the tax expenditures.

 The second attempts to show the distribution of benefits by type of of preference - exclusions from income, preferential treatment of income (for example capital gains) or tax credits.

The problem with all this seeming precision is that it fails to account for the ultimate structure of the how the income tax ultimately works.   In spite of these preferences the American tax system has two characteristics that are key.   First, it is highly progressive.  The distribution of tax payments skews significantly to higher income taxpayers.   The Tax Foundation has the most reliable data on who actually pays income tax.  Here is a chart divided by income.

Note the top 1% of taxpayers have a bit more than 18% of the adjusted gross income but pay 37% of the tax burden - so even if the CBO numbers are correct, they may not be important. The bottom 50% have just under 12% of the income and pay 2.4% of the tax.   By any measure that is a progressive system.

But wait, there is more.  According to the latest IRS data about 70% of the taxpayers do not itemize.   While it can be argued that some exclusions (like the one for health insurance) are accounted for in this data you will notice that those are skewed relatively evenly.   But the rest of the provisions in the code are supposed to be bundled up in the Standard Deduction for those who choose not to itemize.   But the CBO report does not seem to take that into account.  One final comment, about half the taxpayers pay no income tax - so the distribution of tax expenditures has no effect. But again the report ignores that detail.

After reading the report one is left with the question - so what?   Should the tax system be simplified?  Absolutely!   But do tax expenditures materially distort the fundamental progressive nature of the tax system?  Probably not.

Political Theater is to Theater as Military Music is to Music

This week Senator Carl Levin and his Homeland Security and Government Affairs Subcommittee held a hearing on tax practices for multinational corporations. (A copy of his opening statement is included in the hot link with his name.)  Note, the Senator is not a member of the Finance Committee, which writes tax legislation so the purpose of the hearing was not legislative in any real sense of the world.  Also note that he was able to pull out his own personal iPhone as a prop to make sure the media could snap a photo.

Levin's opening statement is a good example of his biases.   He called the Apple policies, which has operations all over the world, a "tax avoidance" strategy.   Levin seems to have no understanding of the monstrous tax code that he helped to create.  Nor does he seem to have any idea about the complexity of operating a corporation all over the world.   Corporations that do business in many countries have to deal with individual tax policies of the countries they operate in.  At the same time they need to work hard to deal with fluctuating exchange rates and a whole host of other challenges.    

Obviously, there are lots of US based companies that have subsidiaries outside of our borders.  One wonders (actually I do not wonder) why Senator Levin failed to include some other large multinationals in his web - for example, what about General Motors?

Tim Cook's opening statement was clear and unambiguous.  He said “We don’t depend on tax gimmicks. We don’t move intellectual property offshore and use it to sell our products back to the United States to avoid taxes. We don’t stash money on some Caribbean island. We don’t move our money from our foreign subsidiaries to fund our U.S. business in order to skirt the repatriation tax.”   Cook also pointed out that the APP store alone has created 300,000 jobs in the US and generated $9 billion for those developers.   Levin seems to have missed the point.   But then the point of this exercise was not to build understanding.

The ranking member on the subcommittee, John McCain, took the same kind of one sided approach to looking at the situation.   McCain event went so far as to quote Senator Levin in his opening statement.   Levin seems to think that if all the operations of Apple were repatriated that all of his pet social programs would be better funded.   Here is the relevant quote from Levin's opening statement -

"Because of those cuts, children across the country won’t get early education from Head Start. Needy seniors will go without meals. Fighter jets sit idle on tarmacs because our military lacks the funding to keep pilots trained. Apple and the other companies exploiting tax loopholes depend on the safety, security and stability provided by the U.S. government. Their economic existence depends on the U.S. government’s energetic protection of their intellectual property – property which they develop here, and keep under the protection of the U.S. legal system, while shifting the income it generates overseas."

One member of the committee got it right about the purpose of the show trial that Levin called a hearing.



There are several problems with these types of media events.   They don't ever bother to deal with the kinds of issues that are fundamental like tax complexity.   They start with a conclusion hoping to generate not sound public policy but media coverage.   Second, they make many of the participants look like buffoons. (And that may not be a bad thing.)   After reading Senator Levin's opening statement and listening to his questions of Apple Executive Tim Cook, it is pretty clear that Levin never had a course in basic accounting.  Third, and most importantly they do nothing to advance a legislative agenda or to solve a problem.    The US Tax Code is overly complex and based on the last decade or so its rate structure is considerably higher than other nations.   That makes it a lot harder for US corporations to be successful.   Tim Cook's responsibility to shareholders is to assure that Apple is a profitable company not to fund Levin's pet social programs.   If Cook does his job well, the government will generate a lot of tax revenue.  (And based on the statement from Cook, they did.)  In Levin's ideal world some Senate staffer would have the responsibility to determine Apple's tax liability.

The oppressive nature of the AMT

Here is a short lesson in average and marginal rates on income taxes and why they matter.   An average rate on income taxes relates the amount of taxes you pay compared to your income.   If I make $50,000 and pay $12,500 in taxes my average rate is 25%.    The marginal rate is the rate applied to additional income.  In a progressive system the tax rates increase as your income increases.   For example the 2013 tax rate tables for a person who is married an filing jointly look like this -

• 10% on taxable income from $0 to $17,850, plus
• 15% on taxable income over $17,850 to $72,500, plus
• 25% on taxable income over $72,500 to $146,400, plus
• 28% on taxable income over $146,400 to $223,050, plus
• 33% on taxable income over $223,050 to $398,350, plus
• 35% on taxable income over $398,350 to $450,000, plus
• 39.6% on taxable income over $450,000.

As our income increases I pay at a higher rate.  Most people only think of the average rate they pay but marginal rates have a much greater effect on incentives to work.   If marginal rates are too high people will substitute non-income activities for income - they will take more vacations or (if they are dishonest) take some of their income under the table.   I am a conscientious taxpayer - I do not do all the tax games that some people do.  Indeed last year my average rate was 25% which was about 7% higher than the average rate paid by the President, who made considerably more than I did.

I came home yesterday to get a communication from the IRS which suggested that I had underpaid my 2011 taxes.   I went back to my files to figure out whether their assessment was correct and found that for some reason that I had failed to include one 1099 from an investment firm where I have multiple accounts.   The missing data showed I had about $4000 in additional income.   The incremental increase in taxes for that amount of income amounted to a marginal rate of 33%.

But then there is the kicker of the AMT (Alternative Minimum Tax) which is that bizarre remnant of tax policy which was put there to punish miscreants who (some people think) don't pay enough tax - or at least that was the theory.  The provision requires you to take all your income/deductions and figure your tax and then if you meet certain conditions an additional rate is assessed that rate is paid in addition to the tax you owe from the regular code.  The AMT complicates the code and at the same time is quite arbitrary.   The AMT assessment added another $2300 or a marginal rate of 58% (far higher than any of the posted rates) - the combination of the regular and AMT additions for this increase in my income amounted to an 88% marginal rate.   By any standard that sounds a wee bit excessive.

It is time to pull the plug on the mortgage interest deduction

As I was driving back from a meeting today I listened to a guy on the radio who said taking a 30 year mortgage in this rate environment makes no sense, especially if you do not itemize.   That accounts for about 70% of all taxpayers.   His argument is simple, a 30 year mortgage begins to pay more principal than interest in the eleventh year - thus for taxpayers who do not itemize the benefit of taking a long mortgage adds costs over the life of the loan and provides zero benefits, except a slightly smaller monthly payment.

The cost of the mortgage interest deduction is one of the most expensive provisions in the tax code.  Estimates come close to $100 billion in subsidy and that applies to some percentage of the remaining 30% of taxpayers that itemize.

When I was writing my dissertation I found that, at least at the time, there seemed to be two facts.   First, the evidence about whether the provision actually increased homeownership in the countries where it was in place, was uneven at best. From my view, the deduction was downright ineffective in encouraging home ownership.  Second, the distribution of benefits was not heavily skewed to upper income taxpayers.   (In essence the elasticity of demand for housing was not perfect - as incomes rise the price of one's housing to not rise in a parallel fashion.) In recent years, a lot of the discussion about this tax provision has been to cap the amount of interest that can be deducted.  Celia Chen, an analyst at Moody's argues that the deduction “hasn’t helped to expand homeownership, but it’s helped to support purchases of larger homes.”  The National Association of Realtors, despite the evidence, argues that the deduction should be preserved.  For example  “Our members believe tinkering with the mortgage interest deduction at the high end will trickle down,” said Lawrence Yun, chief economist of the National Association of Realtors.   They would be even more vociferous if current proposals were to eliminate the deduction entirely.

Since I wrote my dissertation (almost three decades ago) the number of non-itemizers has increased significantly.  Thus, a decreasing percentage of families avail themselves of the deduction.   Eliminating the deduction might also encourage home buyers to take out shorter mortgages.

For both policy provisions and for simplifying the tax code, eliminating the deduction entirely would seem to be timely and appropriate.

The California Comeback

In the last few days, Texas Governor Rick Perry has been touting the benefits of living in Texas (as opposed to California).   Perry ran for President, although not very credibly.  But in the $24K he spent on ads in California radio markets he says that Texas is a lot more friendly to business than California.   His ad campaign gave me pause for a couple of reasons.

First, I've been to Texas and while I agree that it has a better business climate, much of the state is not a place I would want to be (even with the California propensity to regulate and to tax).

But Second, and even more important, as California Common Sense has pointed out, is our ability to forecast revenues which ain't that hot.   California Common Sense is an interesting group.  It is a Stanford based nonprofit that is trying to improve the data about California government.  Since they were formed they have had a couple of very interesting short issue briefs on a variety of subjects.

One of the more recent ones dealt with how really lousy the revenue estimates from the Department of Finance have been.  Consider this interesting fact - since 1997-98 the professional forecasters have been within a 2% margin of error for their January estimates (the ones used to estimate the original budget) only twice. Let me reiterate that with emphasis - in more than a decade of tries our paid professionals who think about how much money we will gain from taxes have been within a pretty small margin of error ONLY TWICE!  One would expect that a 2% margin of error would be a pretty low bar to pass..  But in six of those years they were close to 10% off (either too optimistic or too pessimistic).   That kind of record could probably be obtained by using a group of chimps from the San Diego Zoo.

Admittedly, revenue forecasting is a tough business.   But the record of the Department of Finance is laughable.  So here is a chart from their report on revenue estimating.  It sort of looks like a set of random guesses.

What can you conclude about these substantial forecasting errors.   I think there are three things.  First, revenue estimating is like a lot of other economic forecasting tasks - very tough.  Even with that caveat, the DOF estimators are not particularly skilled at figuring out how much dough the state will have in the coming fiscal year.   Second, a good deal of the problem has been created by the increasing reliance of the state on highly volatile sources of revenue - i.e. the more you rely on  the income tax to fund activities, the less able you will be to estimate actual revenues.    Finally,  part of the reason that this task is so hard is that income is a highly discretionary concept.   People at the highest ranges of income are able to time their receipt of income more than the normal wage earner.   By raising rates on the highest income earners, one would expect that volatility would increase even more.   Even without that variable, the point that Governor Perry offers is that California, through its bizarre regulatory and tax climate is becoming less and less receptive to entrepreneurs.   The Governor (ours not Perry) sniffed today that Governor Perry was off base in making the commercials - maybe he was.   But the point about the stifling nature of our tax and regulatory environment cannot be ignored.

Memories

The National Debt Clock a couple of years after
this speech soon after this speech was delivered

I came across a statement made on the Senate Floor about an proposed increase in the debt ceiling made on March 16, 2006.  I've updated it a bit and included both some highlights (in red) and some annotations (in green) to bring it up to date.

Mr. President, I rise today to talk about America's debt problem. The fact that we are here today to debate raising America's debt limit is a sign of leadership failure. It is a sign that the U.S. Government can't pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies.

In my first two years federal debt increased by almost $3 trillion that amounts to a 10% advance in the percentage of GDP/debt in just two years.   By any measure that is a pretty stiff advance.  Over the past 5 4 years, our federal debt has increased by $3.5 trillion to $8.6 trillion ballooned to more than $16 trillion - or just a bit under double what I stated the debt was in 2006. (and then I thought it was a problem)  That is ''trillion'' with a ''T.'' That is money that we have borrowed from the Social Security trust fund, borrowed from China and Japan, borrowed from American taxpayers. And over the next 5 years, between now and 2011, the President's budget will increase the debt by almost another $3.5 trillion.  If you divide all that up and assign it on a per capita basis - that amounts to more than $52,000 for each of us.  That would be bad in itself, but there is more, our debt estimates do not include the unfunded liability of federal pension obligations ($7.3 trillion) or the long term liabilities of the Social Security Trust Fund ($18 trillion) or the projected Medicare deficiencies ($24 trillion).  When you add all of that up it comes to more than 100% of our combined net worth.  

Numbers that large are sometimes hard to understand. Some people may wonder why they matter. Here is why: This year, the Federal Government will spend $220 billion on interest. According to Erskine Bowles that is expected to grow to $1 trillion by 2020. That is more money to pay interest on our national debt than we'll spend on Medicaid and the State Children's Health Insurance Program. That is more money to pay interest on our debt this year than we will spend on education, homeland security, transportation, and veterans benefits combined. . . .  Put another way debt payments are now the fourth largest spending category in the federal budget.

Our debt also matters internationally. My friend, the ranking member of the Senate Budget Committee, likes to remind us that it took 42 Presidents 224 years to run up only $1 trillion of foreign-held debt. This My administration did more than that in just 5 4years, a lot more. Now, there is nothing wrong with borrowing from foreign countries. But we must remember that the more we depend on foreign nations to lend us money, the more our economic security is tied to the whims of foreign leaders whose interests might not be aligned with ours.

Increasing America's debt weakens us domestically and internationally. Leadership means that ''the buck stops here.'' Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better.

I therefore intend to oppose the effort to increase America's debt limit.

No, I won't even ask you to guess who said this (even unannotated).

So what about the Fiscal Cliff?

As I watched the Congress try to reconcile the Fiscal Cliff Discussions (from my perspective the President did little negotiation) a couple of things were clear.

First,  let's reconcile some numbers.  In January 2001, CBO produced a forecast that projected $5.6 trillion in surplus.  So what happened.  Well first of all the economy did worse (by $3.3 trillion) than the CBO projected - that was caused by two recessions (one mild, one terrible).   Then we adopted $2.8 trillion of tax cuts (the Bush Tax bill)- that is about half of what the CBO originally projected as surplus.  Then Congress appropriated a total of $4.3 trillion more than they had (or almost 50% more than the costs of the Bush tax) to things like Homeland Security, a couple of wars and the prescription drug benefit.   Finally, as a result of all that profligacy we paid $1.4 trillion in additional debt.  So that left us with $6.2 trillion of additional debt.  (Less than a third was the Bush tax cuts.)

Now to the deal.   The chattering class has said it was a disaster for the GOP but I would think that it is a mixed deal for both parties.   Perhaps 82% of the Bush tax cuts were retained as "permanent" including a generous death tax exclusion (albeit with a slightly higher rate which is still below the rate before the Bush changes).   Both sides will still have to deal with entitlement reform.  As the chart to the right suggests what the deal did not do was actually reduce the deficit by any meaningful numbers (some have suggested that the pork in the bill actually spent more than will be collected if the revenue assumptions are actually real.

What is also troubling is that without substantial entitlement reform we will continue on the trend of increasing the ratio of our total debt to GDP.   Even the Center on Budget and Policy Priorities (which is not exactly a conservative organization) argues that the curve needs to be brought down by another $1.4 trillion over the next 10 years if we are to stabilize the long term prospects of government.

There are a couple of conclusions.  First, if we want decent economic growth it is unlikely that we would stabilize tax revenue at a level which is a significantly larger share of GDP than the numbers we had for the last couple of decades (18-20%).   Second, when even the CPPB begins to talk about significant entitlement reforms as a way to stabilize, it should be a wake up call.   Will Washington figure this one out?

Thoughts on the Big Issue on the California Ballot

I've spent the week as a Citizen Leader on Campus at the University of the Pacific.   That involves attending a group of classes and offering a couple of lectures.  I went there as an undergraduate and there are a lot of changes.   Most of them are positive.

One the questions I got in one of my lectures was about why someone who had spent his time in and around education could express doubts about the Governor's proposal to raise income and sales taxes to fill the hole in the budget created by the absurd budget assumptions in the budget that was adopted last year.

California has had a continuing problem in balancing its budget. Some commentators have argued that the problem was created when our former Governor repealed the fee on vehicle licenses that left a gap in the budget.   At the time I argued that the VLF was annoying but unimportant.  In essence what that Governor had done is give each of us a small reduction in taxes (which most of us did not notice) in exchange for a less stable revenue base.  

I was critical of the then Governor because I think he took the short term popular decision which cost us in the long term.   I think the same can be argued for this Governor and Proposition 30. California, before the passage of Proposition 30, has a revenue structure that is volatile in the extreme.   (As illustrated in the two charts to the left - which only go up to 2002-03 - note the volatility in revenues has done nothing but increase.)    The volatility comes from how people at the higher end make their money.   Most people assume that income taxes come from salary.   But as you go up the income scale income becomes more complex.   People begin to earn income from non-salary things like investments.   So income is income right?   Not exactly.   Salaries are pretty stable over time.   But investment income is much more volatile for two reasons.   First, risk capital is just that.  It involves risk.   But second, investors can decide when to claim the income when their investments go up in value.  If I have a big profit I can decide when to realize it.

There are some tax theorists that argue that we should begin to recognize what is called accreted income.  Accreted income includes things like the unrealized value of investments.   Indeed, at the beginning of the 1986 Tax Act discussions, a group of tax economists actually proposed something very close to that as a way to reform taxes.  They relied on an important book called An Expenditure Tax (Nicholas Kaldor) that many of us had to read in graduate school.   When President Reagan saw that proposal coming from his appointed task force he immediately recognized that what might be ideal in theory is often absurd in practice.   In the end, the 1986 tax act lowered rates and broadened the base of the tax system rather than including things like accreted income.  It was a wise decision.

So when you rely on high income taxpayers to bear the greatest burden, you commit to a more volatile revenue system and when planning for long term funding of programs, that is not a good idea.  Remember that under our current income tax system, the highest income taxpayers bear a disproportionate share of the burden (as they should under a progressive system) but since individuals can determine when to take income, the trick is to devise a system that encourages individuals to make more consistent tax payments.    In the end that means making hard decisions about broadening the base of tax systems (with fewer deductions and credits) and lower rates (which encourages more people to simply pay the tax rather than timing decisions in investments based on tax policy).

Governor Brown could have done the brave thing - which would have been to propose tax reform (which admittedly is not an easy task) but which would have reduced the volatility in the system and thus been a better long term fix of our budget problem.  

There are two other burdens created by Proposition 30 which also contributed to my opposition.   First, as you raise rates (to have California become one of the highest rate systems in the country and also one of the most complicated income tax systems in the country) high income taxpayers will make a decision to leave California for fundamentally more friendly tax climates.   Lose high income taxpayers and you reduce volatility, but you also lower the income tax base.   In the long term that does not bode well for the state's revenue structure.  Indeed, in the last few years we have seen a steady stream of very high income taxpayers leave the state.   But the Governor also proposed to increase sales taxes (again making our sales taxes were already among the highest in the nation).  

I understand the revenue models that project how much the state will collect with these new taxes but I am skeptical.  And more importantly, as rates for both income and sales taxes go up, the state becomes less friendly to attract new businesses and residents.    Who knows what the long term will bring?   Last year California actually grew at a slightly higher rate than the rest of the US (2.0 v 1.8%) but over the last decade California's wonderful growth engine has been tarnished.

The supporters of Proposition 30 could argue that our schools are in a horrible place - and indeed California's education system is in shambles compared to where it was earlier in our history.   They could point to the work of Charles Tiebout - who argued decades ago that people choose areas based on amenities not tax systems and better education coupled with our beautiful climate would allow us to have slightly higher tax regimes than less desirable places to live (like our neighbors to the east - Nevada).   But this is an argument about degrees.

From my perspective, Governor Brown took the easier path - ignore fundamental tax reform and tax the "rich."   It remains to be seen whether that easy path will actually solve the long term problems that the state faces.

Thomas Sowell Redux

A couple of decades ago Thomas Sowell, the Hoover Institution economist wrote a book called A Conflict of Visions which made the simple point that the two forces begin with fundamentally different language on key concepts.   Those visions allow the left and the right to talk through each other because they do not even mean the same thing about key terms like equality.

One of the memes that the President's supporters have tried to press today is that Governor Romney "lied" about his tax plan.   That is essentially the point made by so called "fact checkers" who are a mix between some writers who are trying to point out where politicians fudge the truth and some who want to present differences in perceptions as lies.

In the tax arena there are real opportunities for mischief.  The President begins his thinking about the tax code as if it were a zero sum game.   If someone wins, someone else loses.  He also believes in a tax model that is based on static assumptions.  The the government makes a change in the tax code, all other things will hold constant.   Governor Romney has a more dynamic view of how taxes work.  The elements of the tax code are interactive.  If you raise rates too high - people will produce less income.  If you lower them, people will choose to include more of their activities as income.  

There are dangers in both approaches.  The static model (which is used by groups like the Tax Policy Center - which the President quoted last night) begin with a static model.   That will miss the dynamic effects of major tax changes like both Romney and Obama are proposing.   The danger with the dynamic model is that at times its supporters can get a bit exuberant.   They attribute more movement in the system than any rational person would suggest.   I tend to trust a more dynamic model - most Washington people rely on a more static one.   The differences in projected outcomes can be huge.   But they are not based on lies - more on differences in perceptions - visions - that Sowell so well described in his book.

I am getting tired of people on the left arguing that Romney is a "liar" because his vision of how the tax system works is different from the President's.   I thought Romney did a pretty good job of explaining his vision of how his tax policies would work.

Politicians and Tax Returns

A friend, who is also a priest, made the following post on Facebook today: "Reflection: Great leaders never ask their people to do something they, themselves, won't do. That's a nice yardstick to apply to political leaders. If, for example, the deficit is horrendous, a great leader should be willing to sacrifice his/her own vested economic interest for the good of the Country and pay an even greater price than that which others are called to pay. That's called leading."   It got my dander up a bit because there seemed to be a reference to one candidate (Romney) who in the last few days has released that he paid an average rate of 13% on taxes in the last decade.    That got me to look carefully at both candidate's income tax returns for the year of 2010.   You can see them by clicking on the names in the brackets. (Romney  Obama).  I also looked briefly at their 2011 returns.

Here are some interesting things I found from reviewing both returns.   First,  both candidates paid a lot of tax (the President paid a bit more than a quarter of his income to taxes, while Romney paid about 14%).  For Romney his tax payments in 2010 amounted to more than $3 million.  Both made a lot of money - the President made $1.7 million, including his salary as president.  Romney made $21.6 million.   But the structure of their incomes were different - Romney's was primarily from dividends ($4.9 million) and capital gains ($12.5 million).  Obama had a significant portion of his income ($1.4 million) from business income but he still got a lot from his salary as president.  The President, presumably because of his current position where things like housing and transportation are provided, may not have many of the deductions that most people would be able to utilize.

Both were generous in their donations.   Romney gave $1.5 million to his church but also gave $1.5 million in appreciated stock to a foundation which aids families of sick kids.  That amounts to about 14% of his AGI.  Obama gave only cash (almost $250,000), a major portion of that went to one foundation that helps families of veterans.   Obama's percentage is also 14%.   The average for taxpayers in the US is between 2% and 4%.

Romney took no deductions for mortgage interest while the President took just under $50,000.  Romney paid $232,000 in Alternative Minimum Tax, Obama paid none.

Note in 2011 Romney made a bit more than $20 million and paid 15% of his AGI in federal taxes and made donations which equal almost 20% of his AGI.    The President's income declined from 2010 ($789,000 - including $440,000 of business income) and he paid a bit more than 20% in taxes and also made donations which equal about 22% of his income.

There are a couple of issues that we should keep in focus.  First, both candidates make a lot of money and have complex lives AND pay a fair amount of their income to taxes - Romney does not earn a salary so the vast majority of his income comes from two sources (dividends and capital gains) which the current code favors in relation to salary income.  (I might add those things were adopted for sound policy reasons.)   Second, both are extraordinarily generous on charitable contributions.   As opposed to some earlier members of the political class - they seem to understand that charitable support is in addition to governmental support.  Finally, it needs to be repeated that people who earn these amounts of money have both the propensity and the likelihood of having significant variations in their income.  In one sense Romney's is more stable because most of his assets are contained in a series of blind trusts.  In any event the final conclusion I have is more simple.   A lot of the hubbub about income taxes is meant to rile people up not to add light to the discussion.   I am still concerned enough about privacy that I disagree with the dogmatic response of politicians to release all of their tax returns.  From my perspective a better approach would be to have a set of returns of a candidate be submitted to some tax experts who could then supply macro numbers and make judgments about whether the candidate had paid a fair share of taxes.   Oh, wait, we have that with the IRS already.  When candidates don't follow the law, just like other people, the IRS can (and does) audit them.

Pikkety-Saez Tax Policy

On this income tax day I wanted to discuss the income tax.  Two economists (Thomas Pikkety and Emmanual Saez) produced a paper at the turn of this century which argued that income distribution in the US had deteriorated from a fairness perspective.  Over the last decade their work has been widely publicized including in support of things like the Buffett rule.  Thomas Pikkety, who now resides in Paris, has even argued that the ideal rate for upper income taxpayers would be between 15 and 40 percent higher than that proposed by the president.

There are two flaws in their research.   First, their definition of income is a bit too narrow.  Indeed there has been some movement among higher and lower income people in the last couple of decades (BTW - that has happened in a lot of countries who have very different tax structures).  Alan Reynolds points out many of the oddities of the data set they use.   While there are legitimate disagreements about the national income accounts and how to use them you should not take Pikkety and Saez's assumptions on their face.

But second, the perspective ignores the substitution effect.  The tax code is gargantuan.   That is in part because every little interest has forced a provision into the code to solve their "problem."   Raising rates never generates as much money as supporters suggest it will.   That is because as you move up the income curve you have a lot more discretion about compensation - that is especially true for things like capital gains.   If rates are too high, I simply will sit on the gains I have accumulated in a stock or other asset.

So how do you solve the problem?  There are two ways.  First, one could index the capitalization of capital - so that before you paid taxes on gains (or losses) you would calculate the effects of inflation on the asset.   That was tried once (in 1954) and discussed at the beginning of the 1986 Tax Act.  But it was dismissed as entirely too complicated.

The alternative is to lower rates below what the average taxpayer pays.  That is the wisdom of the capital gains exclusion.  And the evidence is that if you set it correctly, people actually are more willing to liquidate their investments in line with their wishes rather than tax policy considerations.

If the highest income individuals can decide when to take income (including income on capital gains) then raising rates is unlikely to raise much revenue.    The graph above gives you an idea why the Buffett rule or some variation proposed by Pikkety is pure folly.

Tax Fantasies

Sac Bee Cartoon - not related to the story

The Bee had a story yesterday titled "If Taxpayers Paid Up, the Deficit Would Disappear."   The Franchise Tax Board has estimated that $10 billion in state taxes go unpaid and the Board of Equalization estimates that an additional $2.3 billion in sales taxes do not get paid.  Were this true it would be a major story, but chalk this one up to absurd assumptions - fantasy.

Here are some claims made by tax analysts.  #1 - The Legislative Analyst found in a report that wage income gets reported about 90% of the time if it is withheld and only about 70% if it the tax is not withheld.     That might be close to correct.  The 10% breach on withheld income should get caught if the FTB is efficient - but a 90% compliance rate is pretty darn good.   I suspect that if one were able to separate out all the gray money payments that the non-withheld income gets reported at about the same rate.  In other words a lot of the non-reported income comes from things like drug deals.  The tax agencies claim they do not count illegal activity in the under-reporting statistics but that is a questionable claim.

#2 - A federal study found an 83.6% compliance rate (which in my estimation is still pretty good) for paying taxes that are due.  The federal study found that the major cause of under-reporting was precipitated by a small amount of direct fraud and a larger percentage of what they described as under-reporting.  Sure there are taxpayers who claim outrageous amounts for donations of used goods (even some former presidents) but those losses are minor.  There may be some evasion but I think a lot of the problem comes from complexity - it is hard to know what is the right thing to do.

#3 - The USE tax - under California law a taxpayer is required to pay the equivalent sales tax on something which was bought outside the state.    Tax agencies count that as evasion.  Saner people argue that taxes should not follow you anywhere.  The Use Tax concept is confused (and confusing).

Perfect tax compliance is a fantasy.  It began to be talked about when Stanley Surrey (President Johnson's Assistant Secretary for Tax Policy) began to formulate the notion of "tax expenditures."   That idea posited that just like appropriations we could track the value of changes in the tax code from an "ideal" frontier as if they were cash - were they not in the code the government would receive more dough.  The problem with the theory is that is needs to assume that all wealth is created by government.   While some people believe that no thinking person does.   At about the same time that Surrey was writing all the rage in tax was a book by Nicholas Kaldor (An Expenditure Tax) which argued that the most perfect tax system would count all flows into and out of a person (for example, the increase in valuation of one's house).  Amazon's summary says "This work explores the idea that the taxation of individuals should be based upon their expenditure, not on their income. It argues that if progressive taxation were levied this way, we could move towards an egalitarian society and improve efficiency and the progress of the economy."  The book was great theory but impossible to implement in real life.

Kaldor even had some influence on the task force that President Reagan convened at the beginning of the process that resulted in the 1986 Tax Reform Act.   In the first draft of the Bluebook (which was the comprehensive proposal for the changes) a Kaldoresque proposal was present for home appreciation.  Reagan and other politicians quickly realized that would not fly politically.

So what can we say about tax compliance and how to improve it?   First, government officials should assume there will always be some inefficiency in any system.   It is not possible (and probably not desirable) to get 100% compliance.  It is silly to assume that if everyone paid their "fair share" in taxes that the deficit(s) would be eliminated - the deficits come primarily from spending not from revenues.   If we matched our spending with our revenues we would not have a problem - but we don't.

Second, simplicity breeds compliance.   By simplifying the tax system (especially in the income tax) more people are likely to comply.   Tax loss carry forwards may look like good politics but they are terrible for conformity.

Third, the integration of data systems (the article mentions that the FTB matches no income tax filings with car registrations surmising that if you register a $100,000 car with no income, you probably are doing a bit of fudging) will continue and should help to assure that compliance is as good as it can be.

Is the President Real?

In the State of the Union, the President made the claim that he would work to find common ground with his GOP colleagues.    Taxes are a place where the President could walk the walk.   The President claims it is essential to increase rates on high income taxpayers.  He clearly would like to raise a bit more tax revenue.   But if he were serious about this he might take some of the ideas of former GOP Presidential candidate Jon Huntsman and reduce rates and eliminate deductions and credits.

When that was last done (1986) a couple of things happened.  First, tax revenues increased.  Second, rich people (the guys that Obama wants to target) actually paid more taxes.

If he is using this as a political ploy - then he will not try to think about how to co-opt the GOP - we get gridlock and lousy tax policy and he thinks he can win re-election with that nonsense.

Jon Huntsman and the GOP

Yesterday Former Utah Governor Jon Huntsman dropped out of the race for the GOP nomination.   In one sense that is not very important - the Governor never really caught on with a large portion of the GOP.   In another his withdrawal makes the nomination of former Governor Romney all the more likely.

But there are at least two reasons why his announcement was very important.   First, while nothing is inevitable in politics, the winnowing of the field of candidates will shine even more harsh light on the also-rans like Gingrich and Perry.  And it should.   There is a subtle divide between the positive effects that the primary race has had on the front-runner (Romney is a better candidate now than when he started) and the negative effects that continued shots could have on the fall campaign.  All of the Super-Pac money that is being spent now to develop snappy videos will be re-broadcast like political acid reflux by the Obama campaign.  In one sense it gives Romney a chance to try out themes but in the other Gingrich and Perry are just adding ammo to the other side.

The second is more subtle.   A major issue in this campaign should be tax policy.   Since 1986 our tax system has grown fat with preferences and complexities.   From my perspective Huntsman had a better tax plan than any other GOP candidate.   (While I do not agree with every part of the plan - it is very strong in its consistency and general direction.)   His plan would have lowered rates by eliminating deductions and credits; eliminated the Alternative Minimum Tax; Reduced the corporate rate by ten points - to 25% (to bring us more in line with other developed countries); introduced a territorial system of taxation which when coupled with his proposal to implement a tax holiday for repatriating capital back to the US would have simplified the business taxation for multi-nationals; and finally he would have reduced taxation on capital gains and dividends to zero.

Romney's plan looks a lot more like a committee document.  He would maintain current rates for both individual taxes and capital gains, interest and dividends.  And would eliminate those taxes for people under $200,000 income.   He would eliminate the "death tax."  Finally he would do the same shift from worldwide to territorial taxes for multinationals.   The three major differences between the plans are the elimination of inheritance taxes (Romney) and the carve out for incomes below $200,000 for interest, capital gains and dividends and Romney's plan does not attempt to dethatch the code (which is in sore need of cleanup).   Let's hope after the primary contests are over that Romney at least looks at the good ideas of another candidate.

A Tip to the Sacramento County Assessor

My wife and I own two properties in Sacramento County.   When property taxes come due we send them to be received on the 10th of December which is when the first installment is due.   This year for some strange reason I mixed the parcel numbers so that the first property had the second parcel number on it and vice versa.    This morning, as I was beginning some year end activity I noticed my mistake and checked to see if either check had cleared.   They did indeed.   And, wonder of wonders, the Tax Unit figured out which parcel to apply the tax to so that both properties paid their taxes on time.  Figuring out how to match these took a bit of effort - we hold both properties in a trust so the staffer who opened the check needed to find the appropriate property possibly by matching that the properties are held in the same name.   I realize that the tax unit gets a lot of checks in December; I am not sure how the match was made but I am appreciative.  

999 - too simple??

In the last few weeks GOP candidate Herman Cain has generated a lot of attention to his plan for reforming the tax system.   It would eliminate the current income and corporate tax systems in favor of a greatly simplified system which assessed personal and corporate income taxes on the basis of 9% and would simultaneously create a new tax on consumption of 9%.    A couple of caveats to the plan.  First, the income tax for individuals exempts investment income.   Second,  the new income tax would be greatly simplified.  All income (except investment income) taxed at 9%.   Cain is not clear as to whether there would be a zero bracket amount (a level of income which is not taxed to help protect equity in the system).

The left has begun to go ballistic on the plan.  They claim that because of the way the corporate tax is implemented that the poor will have an effective rate of 27% (they will pay on all three).  Interesting that I have never heard of the left arguing that all corporate taxes get shifted forward to the consumer.   They also claim that the tax would only raise about 14% of GDP (when the historic rate of tax revenue is about four points higher).  Not sure how they can be confident of those numbers.  

But as a conservative I also have some concerns about the proposed plan.  First, the record of adding one tax to substitute for another is not very promising.  The new consumption tax (and actually the income tax would function a bit like a consumption tax) would be added to the state levies so many consumers might end of paying up to 20% for purchases.   It is not clear from the plan whether services would be included in the plan.   That might well reduce the costs of compliance for taxes but the combined rate would put a significant damper on consumer expenditures.   My best guess, based on the make-up of the Congress (present or future) is that the consumption tax would have some exemptions to improve equity - so the rate might be pushed up to 10-12%.    Second, while the income tax looks an awful lot like a consumption tax, my suspicion is that at least a couple of the current parts of the tax code would survive.  High on my list would be some recognition of the charitable impulse (either as a deduction or a credit).   The realtors and construction industry would push for the mortgage interest deduction (which does not make a lot of economic sense but has a lot of political force around it).

So two questions - how do you play this against the President's Buffett rule?  And, what should be the alternative?   The President is clearly trying to suggest that his alternative, to raise rates, is the best alternative.   Anyone with half a brain can figure out that the tax code is as popular as a skunk at a picnic. So the best response for any other GOP candidate is to recognize that Cain's simplification of the tax system is a good first step.   As to the alternative, we need to begin to think about the outlines of the 1986 Tax Act - broaden the base and lower the rates.   In this year, where big government and big corporations are unpopular from all fronts that would seem like a winner.

The Buffett Rule - What about Averages

There are figures and then there are figures.   The President has been trying to make a case that the richest Americans pay less than the average joe.   Based on the data of averages by decile the American tax system, even when you include payroll taxes is progressive.    Rich people actually do pay more as a percentage of income than poor people do.   There are all sorts of charts that prove that.  But recently, among some of the writers on the left a new argument has emerged.  Indeed, these people say that the variability of tax rates among the highest income taxpayers is higher than for people in lower brackets.  (That is undoubtedly true because of the sources of income.)  AND, these same people argue that some middle income taxpayers may actually pay more than some very high income taxpayers.  (That may also be true.) 

But there are some serious caveats to the analysis.   First, averages are exactly what they are purported to be - averages.  And so there is some variation.  Second, part of the variation on tax rates, especially for the middle income taxpayers may be as a result of the alternative minimum tax (AMT) which affects people in the upper reaches of middle income hood or in the lower reaches of upper income hood.   For those taxpayers so affected their average rates rise.  A major difference between the two groups is the involuntary nature of the AMT.   Buffett argues that people in his lofty place on the income totem use the preferences for capital which can lower effective rates.  That is discretionary, the AMT is mostly not.

A final comment should be added about Buffett's fairy tale.  It is almost impossible to get to the percentages that Buffett claims for his employees.   Effective rates of 33-41% do not occur for people who are firmly in the middle class.   Either his co-workers were in a strange tax year (possible) or Buffett was merely creating the data (probable).

Ultimately, the best tax system is one which intrudes little in the lives of citizens - that would mean lower rates and a broader base.   But then that is not the point that the President or his tax raiser lapdog is trying to make.