2008-09-03

Comments on Feldstein & Taylor's WSJ column

[Here's an e-mail I was provoked into writing on the topic. Sorry for the formatting.]

First things first, read the preply by Obama's advisors Furman & Goolsbee that came out a few weeks ago:
http://online.wsj.com/article/SB121867201724238901.html

Second, the best independent analysis of the candidates' tax plans is from the Tax Policy Center:
http://www.taxpolicycenter.org/UploadedPDF/411741_updated_candidates.pdf
If you take the time to read it you'll find some excellent criticism of both sets of proposals, and comparison of their comparative effects. For those with less time, check out the following (or at least the ones I've starred):
*Table 1 (p.6)
Table R3 (p.26)
Figure 1 (p.38)
Figure 2 (p.39)
*Tables R4 & R5 (p.42-43)
*Figure 3 (p.46)
(I should note that I disagree agree with TPC's gloss on the aims of the candidates' proposals ["growth" vs "progressivity"].)

Here are links to a few commentaries I read on the column:
http://www.economist.com/blogs/freeexchange/2008/09/maconomics.cfm
http://econ4obama.blogspot.com/2008/09/obama-vs-mccain-on-taxes-feldstein-and.html

The following are also helpful:
http://www.nytimes.com/2008/08/27/opinion/27weds2.html
http://robertreich.blogspot.com/2008/07/short-primer-on-mccainomics-versus.html

I'll try to stitch together some of this into a coherent response to the column.

As the TPC analysis makes clear, McCain's tax plan would barely increase after-tax incomes for most Americans while massively increasing after-tax incomes for those at the top of the income scale, both in absolute and percentage-of-income terms. Those in the bottom three quintiles would see their after-tax incomes rise by 1% (give or take) or on average a few hundred dollars; those in the top quintile would see their after-tax rise by almost 6% or an average of over $12k. For those in the top 1%, with an average income of over $600k, McCain's plan would increase their after-tax income by an average of 8.2% or over $100k. He is offering the Bush model of tax cuts, only more so.

These tax cuts will result in a massive decrease in government revenues. Over ten years, the TPC estimates this decrease at almost $7 trillion. The figure for Obama is around $2.5 trillion. Now McCain has claimed that, despite his tax cuts and increases in spending on the military and health care etc., he will balance the budget by the end of his first term. This simply will not happen, no matter who controls congress. Balancing the budget would require cuts equivalent to slashing Social Security and Medicare by 60%, returning government spending as a percentage of GDP to what it was under *Eisenhower*. Even with realistic spending cuts, McCain's plan will result in large increases in deficit spending, far more so than under Obama's plan -- it is Obama who is the fiscal conservative in this race. McCain is offering the Bush model of deficit spending, only more so. Remember, deficit spending is just paying for current spending by borrowing from future taxpayers, e.g. us and our children.

The question, then, is whether McCain's tax cuts (primarily directed at the highest earners) will foster sufficient economic growth to justify such massive deficit spending. There are good reasons to think it will not.

First, a similar strategy, the Bush tax cuts, did not produce broad-based economic growth; despite seeing strong GDP growth, the average income of working (i.e. not retired) households has actually fallen since 2000. Growth did not trickle down. Under the Bush tax cuts, the people who received the least benefit from economic growth will be responsible for paying back a larger share (as percentage of income) of the accrued debt than those who benefitted most.

Second, while lower marginal tax rates do incentivize additional earning and growth, empirical studies have shown that the effect is less than economic theory would predict. There are surely many reasons for this. Among them is the fact that salaried employees, and hourly employees who are already working as much as they can, are not able to earn more by working more (without switching jobs), so additional gain from more work is largely irrelevant to them. (It is relevant to those working less than they can, e.g. part-timers or people able to take another job, etc.) Most working Americans are substantially insulated from the incentivizing effects of lower marginal tax rates.

Third, while lowering average tax rates does increase spending and investment, everyone does not spend or invest in ways which benefit the economy equally. Lower income earners spend a higher percentage of their incomes on domestic goods and services, and invest more at home, i.e. in their homes, educations, etc. Higher income earners spend a higher percentage of their income abroad (on foreign made luxury goods, travel, etc.) and invest more abroad as well (in foreign stockmarkets, vacation homes, etc.). McCain's tax cuts thus return money to those who are least likely to spend and invest that money in the domestic economy.

Fourth, increasing the debt raises the risk of impeding economic growth in the future when taxes have to be increased to finance repayment.

Taking these four factors together, McCain's plan is unlikely to increase lasting, broad-based economic growth and, even if it does, it will not be the most efficient way to encourage that growth. We would get more bang for our buck (more growth per dollar of tax cuts) by cutting taxes on those who are most likely to save and invest in the domestic economy which, not coincidentally, is what Obama has proposed.

It's worth noting that something closer to McCain's strategy might be better in other circumstances, for example when tax rates were much higher. The top marginal rate was over 90% for many years from 1944 to 1963, peaking at 94%! Reagan cut the top rate from 69% to 50% in 1982, and again to 38.5% in 1987. The disincentive of such extremely high marginal rates undoubtedly impeded growth significantly -- overall, those were good tax cuts. But the top marginal rate today is 35%. Cutting or raising marginal tax rates from their current level would not affect incentives or economic growth nearly so much.

Finally there are broader macroeconomic forces to consider. There has been a lively debate among economist about the causes of rapidly rising income inequality since the early '80s, now equalling income inequality in the late 1920s. One prevalent explanation is that globalization has created a labor glut keeping wages of lower skilled workers from rising, while higher skill workers who do not face substantial competition from low wage countries have seen their incomes rise as their skills are in greater demand. This plausible explanation means that global economic forces are already bolstering the better off. By favoring the well off, Bush's and McCain's economic policies help those who are already experiencing heightened economic advantage. In contrast, those who globalization puts an an economic disadvantage see little help. This has fostered a constituency of lower skilled workers who oppose trade and globalization. For strong supporters of trade and globalization (like Bush and McCain; myself included) this is counterproductive. McCain's proposals only compound this problem. As Obama recognizes, for continued globalization and trade to be politically viable, some way must be found to assist those who experience the most extreme dislocations, like job loss, so everyone can continue to share that the broader benefits of globalization (cheaper goods, effective higher disposable incomes, higher growth rates, etc.). Obama's proposed tax increases on the highest earners are not a punishment for their success; rather, they eliminate the extra boost they received relative to other earners in the Bush tax cuts. Under Obama's proposals, the highest earners would still be far better off than they were in 2000, because larger economic forces, not just tax cuts, produced their rising incomes.

Now for some detailed criticism of the Feldstein/Taylor column.

While they are correct that the US corporate tax rate is the second highest in the OECD, they neglect to mention that the US has the fourth lowest amount of combined corporate income tax revenue relative to GDP. In other words, the US raises less from corporate tax (as a percentage of GDP) than most OECD countries and, on average, corporations pay less here (as a percentage of revenue) than in almost every other OECD country. There are probably many reasons for this, but among them is the fact that the US corporate tax base is narrower than elsewhere. Consequently, although the headline corporate tax rate is higher, it is unlikely that this puts the US at any disadvantage to other industrialized countries. The complexity of the tax code, which both McCain and Obama seek to improve by closing loopholes (i.e. raising taxes), is likely a larger factor.

Regarding "doubling the personal exemption to $7,000 from $3,500", this is misleading. According to the Tax Policy Center, “although this provision is sometimes described as a doubling of the personal exemption, that is true only in the first year, and then only for lower-income married couples,” leaving everyone else out. Every other family’s exemption is not fully phased in until 2016, and “because it is not refundable, it is worth nothing to poor families and little to many in the working-class.” (From http://thinkprogress.org/wonkroom/2008/09/02/wsj-all-americans/)

As for cutting taxes, the TPC analysis confirms assertions by Obama and his advisors that he offers tax cuts to 95% of taxpayers, and a net tax cut overall (give or take some trickiness to do with baselines). These are not one time rebates, as described by Feldstein/Taylor, but new refundable tax credits. Obama would raise the top marginal rates of income, dividend and capital gains tax, but only for families making over $250k ($160k for individuals? I forget). Nonetheless, Obama's proposed rates are still lower than the rates which prevailed under Clinton, and for most years under Reagan (depending on the tax in question).

Regarding health care, their claims are even more suspect. McCain does offer a $5k health care tax credit for families, $2.5k for individuals. This is largely paid for by taxing as income the cost of employer provided health care. This tax increase offsets, to some extent, the gain from the tax credit. Now, Feldstein & Taylor are correct that, if everyone's coverage stays the same, everyone will come out ahead with this tax credit. But everyone's coverage won't stay the same. McCain's plan creates an incentive for employers to drop health coverage, because health coverage will no longer be a tax efficient way of providing compensation. So many employers are likely to drop coverage. Even if they increase worker salaries by the same amount as health care had cost (keeping employer costs the same), employees will see a tax increase as they are now taxed on that additional income. And the employee will now have to buy coverage individually, potentially in the more expensive non-group market. What's the bottom line? In the best case scenario (wages increase in the amount of the employer contribution to coverage, and no increase in premium), the net subsidy is about half of McCain's tax credit. Everyone else, likely most people, will fare worse, and many will see their cost of insurance (after taxes and transfers) go up; in the worst case, the increase in costs would be in the thousands. (FYI, the average cost of a family health plan is $12k; $4.5k for an individual.) And it only gets worse from there, because McCain's credits aren't indexed to anything -- not inflation, not health care cost (higher than inflation), nothing -- so the value of McCain's credits will decrease over time. (See here for more info: http://econ4obama.blogspot.com/2008/04/mccains-health-care-plan.html)

Furthermore, there's the bang-for-buck issue again. According to the TPC's preliminary analysis, Obama's plan would cost $1.6 trillion over 10 years, with McCain's plan not far behind at $1.3 trillion. But Obama's plan would reduce the number of uninsured by 34 million in 2018, while McCain's would only reduce the number of uninsured by 5 million at peak in 2013 (before the declining value of his credits causes the number to go up). McCain spends almost an much but manages to cover almost 30 million fewer people -- why? Well, a huge reason is that the value of his subsidy (after taxes and transfers) isn't all that large. Beyond that, though, he creates a high-risk pool to provide government subsidized insurance for those who cannot obtain insurance in the private market -- that is, the government is the exclusive payer for the most expensive people to insure. So instead of having the cost of their care distributed widely across an insurance pool in the private market, they will be expensively insured by the government free of all market forces. Moreover, this structure creates an incentive for private insurers to refuse to cover people, forcing them into the government's high-risk pool and further increasing costs on the taxpayer.

Obama's health plan, though not perfect, avoids these pitfalls. Insurers are prohibited from refusing coverage, but the added cost of covering high-risk people is largely balanced by covering many currently uninsured low-risk people. The government offers a health plan, but private companies compete against the government in providing coverage through the insurance exchange. This approach is similar to the MA scheme -- Adam helpfully linked to the editorial describing the broadly positive results of MA's experiment.

That's enough for now. As far as I'm concerned (and as you have probably guessed), when it comes to economic and fiscal policy, there is only one serious candidate in this race.

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