Tuesday, January 16, 2018

The Republican Tax Reform: Part 2 —Why Tax Reform Only Occurs Occasionally

I’m not a political scientist, so I can’t tell you why they think this happens this way.

But I can 1) describe it, and 2) explain what economists think happens.

So, suppose we start at some point in time with a just-cleaned-up tax system. It’s sleek and efficient and makes people as happy as a tax system can.

What happens next? Politicians and bureaucrats find things they don’t like and try to fix them. Fair enough: we put them there to do something rather than do nothing.

Now, here’s the economics. There’s a subfield called public choice. One of its implications is that in representative government, these things get passed if they have concentrated benefits and diffused costs. You spread the cost over as big a group as possible, and it becomes so small that people don’t complain about it much. But you gather all those costs together and transfer that as a benefit to a smaller group. Now it’s concentrated, and those people can be very vocal.

Now … um … lather, rinse, repeat. A lot.

What you end up with over many years is a sleek and efficient tax system that has turned into a Frankenstein monster because you keep stitching new parts to it.

But now you run into a new problem, loss aversion, and the more complex form of that (brought into economics by psychologists) known as prospect theory. Basically, people don’t like perfectly even games like flipping coins because they worry more about losses than they feel good about gains.

So when we decide we need tax reform, the benefits are the part that is widely diffused, and the costs are often concentrated. Except because they are costs rather than benefits, those small group are going to be more vocal when undoing taxes than when they were being put together.

The result of this is a pattern of taxes getting incrementally worse for a long time, followed by a cathartic reform. It’s a very asymmetric process.

In the case of this tax reform, we really haven’t had a serious tax reform at the national level since 1986.

And it’s probably reasonable to not expect another one until you’re in middle age.

So this is a big deal.

The Republican Tax Reform: Part 1

This is the first of a multipart series on what macro students should make of the Republican tax reform that was passed at the end of 2017.

This post is kind of a table of contents for other posts, some of which are not written yet, and none of which are complete right now. So I may update this, and you should check it periodically.

Here are some of the issues I want to touch upon first:

  • Why tax reform only occurs occasionally
  • How major a reform is this, actually?
  • Grandstanding
  • Tax incidence vs. tax labeling
  • Keynesian thinking (about the demand side) and distortions (mostly on the supply side)
  • Average vs. marginal rates
  • Brackets and flat taxes
  • Progressive vs. regressive

And then I want to get to the major features of tax law that were changed:

  • Corporate tax rate reduction
  • Limits on SALT deductions
  • Increase in the standard deduction
  • Removal of the Obamacare penalty tax

Wednesday, January 10, 2018

Dolphin Production

Dolphins can be trained. In study centers, they train them to clean litter from their tanks: find litter, bring it to a trainer, get a fish. Simple, right?

The discussion below will fit in best with the last third of the semester and of the handbook. But, where I’m going with this is that economics is way more fundamental and basic to existence than most other fields you might study in college. As John Cochrane noted:

The sad paradox of free markets is that free markets do not need people to understand them to work.

The economics is there whether we want it to be, realize it, or sometime deny it. Hopefully, we recognize it and can explain it.

When we think about the economics of production, what we’re trying to do is formalize our thinking. At a very basic level, what production amounts to is combining things we’re willing to give up, to make something new, that we consume now (or sometimes save and invest, which ends up with consuming later).

At its most basic level, production combines labor and capital to produce output. Resources are a form of capital (but so are machines and tools … which we ultimately make out of labor and resources). And output is usually something we consume, right?

Back to the dolphins …

The dolphins combine their time and effort, with litter, and get fish to eat. Dolphins are the labor, litter is their capital, and fish are their output.

Big deal, right? Except that we study dolphins because they’re smart. So soon, they become not just labor, but skilled labor.

When we think about efficiently using our resources, what we are thinking about is combining fewer resources to get the same output, or the same resources to get more output.

And the dolphins … find litter, hide it, divide it into smaller pieces, and trade it for the same amount of fish. So they figured out a way to increase their marginal product of capital (MPK). Last time I checked what the generic social term “skilled labor” means when we formalize it is “able to get more production out of the same piece of capital than unskilled labor”.

In humans we’d note that we impart technological innovations to labor to make it more skilled. It’s not really that different than using some of the heat we used to lose from combustion in our engines to clean the exhaust further in a catalytic converter.

So dolphins are demonstrating technological growth. It gets better. Sea gulls are a nuisance to outdoor aquariums, and fortunately the dolphins view them as litter too. So instead of eating the gulls they catch, they trade them for fish (of course, big bird equals more fish). Then a dolphin invested: they saved some litter (instead of converting into fish), used it to bait the sea gulls, and then traded them for more fish … earning a rate of return.

Then then the dolphin who figured this out trained her calf and then others nearby. And now the technology is geographically correlated (within the dolphin culture of that tank), and temporally correlated (since dolphins today are better off than dolphins before).

Of course, not all of this was apparent to the journalist who wrote “Why Dolphins Are Deep Thinkers” for The Guardian. But George Mason University economist Alex Tabarrok picked up on some of the economics in “Dolphin Capital Theory”. And I’m telling you that there’s a growing macroeconomy at the Institute for Marine Mammal Studies inhabited by dolphins.

Go figure.

Saturday, December 30, 2017

Private vs. Social Returns: Education vs. Innovation

Fairly early in microeconomics you learn that the problem with externalities is that the marginal social cost and the marginal private cost need not be the same, and this is the source of problems. The same goes for marginal social benefit and marginal private benefit.

The classic example is pollution. Firms empty the dumpsters at the plant because the two costs are the same (and they pass the costs on to buyers of the final product as part of the price). Firms typically don’t adequately deal with smokestack pollution because the two costs diverge, and the buyers may be able to use markets to avoid the higher marginal social cost, so the firm does not pass those along.

But, what about innovation? In this case, the marginal private benefit to an inventor is how much they make from their invention, and the marginal social benefit is how much society gets from their invention. In equilibrium, they’d be the same. But with innovation, there’s usually knowledge spillovers. This is a positive externality to society (e.g., you did not have to invent Snapchat to benefit from it), but it’s a negative to innovators (e.g., Yik Yak, the killer social app for SUU students in Fall 2015 never turned a profit before being shut down).

This is a big deal in macroeconomics: technological progress is the key to improved living standards, and it won’t happen if too much of the marginal benefit is shifted from the innovator to society.† This is why economists think patents are a good thing: although the optimal length is poorly understood, patents help push marginal private benefit up towards marginal social benefit.

But, what about education. Here’s Bryan Caplan:

When we look at countries around the world, a year of education appears to raise an individual’s income by 8 to 11 percent. By contrast, increasing education across a country’s population by an average of one year per person raises the national income by only 1 to 3 percent. In other words, education enriches individuals much more than it enriches nations.

How is this possible? Credential inflation: As the average level of education rises, you need more education to convince employers you’re worthy of any specific job.

So, what’s the implication? Students like you want more invested in education because you’re the primary beneficiary. But society should not buy into that argument because their rates of return on that investment are not that high.

† This is a measurable problem with the appropriate data, and a subject of some research in macroeconomics.

Tuesday, December 26, 2017

Why Is Macro So Hard? A General Absence of People Who Are Smart Enough

This is from Patrick McKenzie’s twitter thread, where he mostly talks about high tech insights:

There is no hidden reserve of smart people who know what they're doing, anywhere. Not in government, not in science, not in tech, not at AppAmaGooBookSoft, nowhere. The world exists in the same glorious imperfection that it presents with.

Stop voting for, say, Clinton, because you believe she had a hidden reserve of smart people.

Stop voting for, say, Trump, because he has a different/better hidden reserve of smart people.

The world is a statistically noisy place, and it’s too big for even smart people to fathom completely. Stop pretending that they can, and stop believing them when they say they do.

In macro, there are no hard answers. Just heuristics. Get used to it.

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Tuesday, September 19, 2017

You Can Start Disbelieving the Nonsense About the 1% Getting Richer

In the U.S., the 1% are getting richer, and no one else is. Right? That, at least, has been the narrative over the last fifteen years or so. The first pass research on this, by Piketty and Saez in 2003, helped make them famous.

The evidence for that has been based on individual tax returns. But tax rates change through the years. Looking at tax returns without considering the underlying rates (and how they might change behavior) is called the unadjusted approach. It shows the 1% getting much richer.

So what needs to be adjusted for?

  • The biggest tax reform of the last 50 years in 1986
  • Corporate profits, that are paid out as dividends at different rates depending on tax rates.
  • Value of employer provided health insurance.
  • Smaller household sizes, and lower marriage rates.
  • Government transfer payments

Now the tax experts have incorporated corrections for all of those. The big ones are that the treatment of corporate profits that were not paid out (but that rich people had access to, say, through corporate owned vacation property) was much larger in 1960, while it turns out that now the top 1% is actually supporting a bigger group of unreported dependents (rich families aren’t the ones getting smaller).

Piketty and Saez reported that the share of income taken in by the top 1% doubled since 1960. The new research by Auten and Splinter find that over 90% of Piketty and Saez’s increase is there because they didn’t adjust for that stuff. Basically, the 1% are a tiny bit richer. Not enough to worry about.

One thing that both studies find is that the share of the top 1% dropped significantly in the 1970’s. So their share is U-shaped. This is consistent with tons of evidence that business cycles hit the income of the rich the hardest, and there were 4 recessions in a 13 year period centered on the 70’s.

Over the last couple years, it’s also become common to remark that the share of income paid out to individuals has fallen, and that the share going to profits, interest, and rent has gone up. The adjusted “broad income” in this chart shows that’s not the case:

Income Shares Capture

What the new research corrects for is that about half of income is now coming from stuff other than wages and salaries:

Income Sources from Auten and Splinter Capture

Piketty and Saez were looking mostly as the center section.

This points to a good convention when thinking about news reports about inequality: if they focus on wages and salaries, they’re cherry-picking.

Wednesday, September 13, 2017

Second of Two Pieces on Income

Martin Feldstein is a macroeconomist from Harvard (probably their oldest). He’s been well-known since before I started college (he was one of Reagan’s economic advisors in the early 80’s).

In a September 8 op-ed piece in The Wall Street Journal entitled “We’re Richer Than We Realize” he argues that real GDP (and its growth rates) are understated.

The common assertion that middle-class households have seen no increase in real incomes for 30 years is simply not true. And contrary to a common fear, most members of the younger generation will have higher real incomes as adults than their parents had at the same age.

There are two reasons for this, and he argues that both of them are getting more severe.

First, government statisticians grossly understate the value of improvements in the quality of existing goods and services. More important, the government doesn’t even try to measure the full contribution of new goods and services.

On the first count, the government is basically “old school”. They view quality improvements as largely proportional to costs. This might make sense for home construction, but not so much for smartphones.

… In reality companies improve products in ways that don’t cost more to produce and may even cost less. That’s been true over the years for familiar products like television sets and audio speakers. The government therefore doesn’t really measure the value to consumers of the improved product, only the cost of the increased inputs. …

The official estimates of quality change are therefore mislabeled and misinterpreted. When it comes to quality change, what is called the growth of real output is really the growth of real inputs.

The second issue is about the introduction of new products. We’re OK at counting the value of the new products, but we don’t make much of an attempt to figure out how much richer we are from mitigating the problem the new product solved:

Think about statins, the remarkable class of drugs that lower cholesterol and reduce deaths from heart attacks. By 2003 statins were the best-selling pharmaceutical product in history. The total dollar amount of statin sales was counted in GDP, but the government’s measure of real income never included anything for improvements in health that resulted from statins—such as a one-third decrease in the death rate from heart disease among those over 65 between 2000 and 2007.

Think about that: one third of deaths from the biggest killer eliminated in 7 years. That’s a ridiculous improvement to leave unmeasured. But, of course, the techniques for counting GDP were developed before things like this happened regularly.

It is impossible to know how much the official statistics understate the true growth of real incomes. My own judgment is that the true annual growth rate could exceed the official figure by two percentage points or more, implying that the true annual rate of real per capita income growth during the past two decades has been much more than double the official 1.3%.

I don’t know if I’d go that high, but I wouldn’t even debate a 1% mismeasurement.