Archive for category: Commentary

By Natasha Sarin and Lawrence H. Summers

March 29, 2019

Part Two

Over the last several weeks, we have paid careful attention to tax proposals by Representative Alexandria Ocasio-Cortez of New York, for a 70 percent marginal tax rate on top earners, and by Senator Elizabeth Warren of Massachusetts, for a wealth tax on those worth more than $50 million.

We share the lawmakers’ enthusiasm for progressive taxation that ensures that the wealthiest pay their fair share. But we believe that base-broadening, efficiency enhancing reforms are the right way to start raising revenue from the ultrarich. As Part One of this series illustrates, closing tax shelters alone raises more revenue than Ocasio-Cortez’s proposal. And our base-broadening reforms — rolling back President Trump’s tax plan, increasing tax compliance by the rich, closing shelters, eliminating stepped-up basis and deductions for the wealthy, and broadening the estate tax base — together raise more revenue than the wealth tax is estimated to. Most of these measures would be desirable even if they did not raise revenue, because they would improve investment efficiency and correspond to the basic notion of fairness: If two people are similarly situated economically, one of them should not be able to pay substantially less tax because of cheating or taking advantage of quirks in the law. In contrast, rate increases or wealth-tax proposals are unlikely to increase the efficiency of the economy.

Issues with using the wealth tax or rate hikes to curtail political power

Some argue for punitive taxation of the wealthy because the concentration of wealth leads to a concentration of political power. Professors Gabriel Zucman and Emmanuel Saez, who have played a major role in validating the wealth tax, advocate this view. They suggest that “high tax rates for sky-high incomes do not aim at funding Medicare for All” and instead “aim at preventing an oligarchic drift.” But framing tax policies as attacks on the wealthy rather than as ways of raising revenue is problematic on multiple levels.

We have sympathy with complaints that economic policy decision-making gives too much weight to the interests of affluent elites. But we are skeptical that large rate hikes or wealth taxes are the right way to address this problem.

First, these proposals do not get at the main ways in which the wealthy exercise influence. The whole apparatus of think tanks, research institutes, advocacy groups — organizations like the Federalist Society, which has transformed the judiciary — are supported by tax-deductible contributions that tax hikes will not discourage. Indeed, increases in tax rates or broad wealth taxation would make it cheaper in terms of forgone personal spending to support advocacy efforts or to create elite enclaves.

Second, even draconian tax hikes will not have a major impact on the ability of very wealthy Americans to be politically influential. For a few tens of million dollars, an individual or interest group can become a major political player. Even if you took away half the wealth of a billionaire, that person would still be able to invest $50 million a cycle in political activity without dipping into capital. Such an expenditure would make that billionaire the fourth largest donor in the 2018 midterms, right behind Sheldon Adelson, Michael Bloomberg, and Tom Steyer.

Third, many of the areas of special interest concern that seem most serious do not involve players who would be substantially impacted by recent tax proposals because they are not hugely wealthy. Think about the way the NRA distorts gun control debates or how community bankers resist consumer financial reform.

If the concern is with the excessive power wielded by wealthy elites, there are more effective strategies. Consideration should be given to limiting the deductibility of lobbying expenditures; restricting the ability of political organizations to have allied 50(c)(3) organizations that can receive tax-deductible contributions; and tightening the rules on donor-advised funds that enable the wealthy to get essentially all the benefits of foundations without any of the requirements to pay out resources or provide any public transparency.

Issues with respect to raising rates

Even increasing top rates to 70 percent would raise less than one third as much revenue as our base-broadening approach. Moreover, unless a base-broadening approach was adopted first, dramatic rate increasing would be quite inefficient.

An important parameter in tax analysis is the “elasticity of taxable income” — which measures how the tax base changes as tax rates change. The reported income of high-income taxpayers responds to tax changes in part because it changes how much income they generate but more so because it increases sheltering incentives. Economics literature suggests that a 1 percentage point increase in top income rates decreases reported taxable income by perhaps 0.6 percent. So more than half of the potential income from raising rates is dissipated as individuals increase their tax avoidance activities and perhaps also reduce their income earning. As a result, the ratio of economic distortion to revenue raised is likely to be very high for rates pushed up to 70 percent, especially when one recognizes that Ocasio-Cortez’s proposal would mean a top income tax rate of well over 80 percent for residents of New York City.

One benefit of the approaches we advocate is that broadening the income tax base may lead to lower elasticities by making it more difficult for the wealthy to shield income from taxation. Increasing top tax rates will have more potency in a world where the elasticity of the tax base to rate changes is lower.

Issues with respect to wealth taxation

While the idea of wealth taxation has generated popular support in some quarters, we are skeptical as to how deep this support will prove to be.

The idea that taxing only the wealth of a few thousand people can generate significant revenue seems compelling.

However, arguments of this type have long been used to justify punitive estate taxes and estate taxes more generally and tend not to have proven effective. A long time has passed, but when Senator George McGovern proposed taxing estates to limit inheritances in a speech to the United Auto Workers in 1972, he was booed off the stage. During the 1990s, the Clinton administration found it difficult to mobilize enough congressional support to uphold the president’s veto of total estate tax repeal. And progressive countries like Australia, Canada, Norway, and Sweden do not have estate taxes.

The reluctance to embrace estate taxes reflects issues that also arise with respect to wealth taxes. There is the sense, perhaps misguided, that asking people to pay significant taxes at moments when they are not generating significant cash receipts is unjust. For example, imagine if the head of a family-owned auto dealership dies. Many believe that his children should not have to sell the dealership to cover their tax burden.

Wealth taxes are estate taxes on steroids because they are collected annually rather than at the end of life and thus raise almost 10 times as much revenue. Initial polls for are broadly positive; however, the wealth tax has not yet been opposed and attacked in the way that critics have successfully gone after estate taxes. And while there is significant enthusiasm for taxing the rich, there is much less enthusiasm for redistribution. Additionally, the share of Americans who think the wealthy pay too little in taxes has actually declined since the early 1990s.

Wealth taxation also raises practical concerns — for example, issues of valuation: Is a partnership in a law firm wealth? How will illiquid assets — like football teams or newspapers — be valued? And issues of liquidity: If someone owns 1 percent of Uber — still a private company — she will owe roughly $20 million in taxes each year, but it’s unclear where she can get this money. She can’t sell shares and, if involved with the operation of the company, is likely to be barred from borrowing against the value of her stock.

There are also family unit issues: If a couple files separately or gets divorced, do they get two $50 million exemptions? And issues of gaming: There will be incentives to use legal structures to relinquish direct ownership of assets while maintaining control of them. For example, owning assets in a trust or a nonprofit to benefit from wealth while avoiding tax liability. Granting that capital income should be taxed more heavily than it now is, and that unrealized capital gains going untaxed is a serious problem, there is also a question of just how a punitive tax is appropriate.

It is important not to be misled by the 2 percent annual rate: A 50-year old who has accumulated a substantial fortune can expect to pay more than half of it in taxes before she dies.

Imagine that a wealthy person invests in 10-year treasury bonds, with a 2.4 percent return. The wealth tax would extract 2 of the 2.4 percent return. Combined with income taxes levied at a 40 percent rate, the wealth tax could make the effective tax rate on capital income well over 100 percent. And then at the end of life would come the estate tax. While we are not aware of formal estimates of the loss in economic efficiency from wealth taxes, we suspect that if levied without concomitant reductions in income tax rates or estate tax rates, the ratio of burden on the economy to revenue raised would be far higher than with the base-broadening measures we advocate.

Of course, it might be objected that the wealthy invest in assets that are riskier than Treasuries and provide higher returns. Thinking about effective tax rates in the context of risky assets is complex because it needs to be recognized that income taxes, unlike wealth taxes, share risks as the government loses tax revenue when investments yield low returns. For this reason, research by one of us with Jeremy Bulow suggests that in thinking about the burden of wealth taxation it is appropriate to assume that investments earn the safe return. There is the further point that wealth taxes are likely to be burdensome on entrepreneurial businesses in their private phase, when entrepreneurs are liquidity-constrained. Perversely, this could disincentivize transformative innovation.

Any new tax has problems, and no doubt, with further reflection, the wealth tax’s can be addressed. However, we find international experience cautionary. Twelve countries had wealth taxes in 1990, and only three still do today.

The Organization for Economic Cooperation and Development recently assessed wealth taxation and concluded that “from both an efficiency and equity perspective, there are limited arguments for having a net wealth tax.” Of the three countries with a wealth tax, two — Norway and Spain — raise an average of 0.305 percent of GDP. These taxes generate less than one-third of what the wealth tax estimates despite having a much broader base: While precise data are hard to come by, we suspect that less than 10 percent of this revenue — or 0.03 percent of GDP — comes from those in the top 0.1 percent of the wealth distribution.

Only Switzerland raises the 1 percent of GDP that the wealth tax estimates, and the differences between our tax regimes make it unclear if extrapolating from their experience is reasonable. Switzerland has no capital gains tax, very low property taxes, and in many regions no estate tax. And in some regions 30 percent of Swiss taxpayers pay a wealth tax, which is fundamentally different than the wealth tax proposal (wealth tax for 0.06 percent of US taxpayers). Overall, we are skeptical that the wealth tax will raise close to the $2.75 trillion estimated.

To be sure, as Bill Gates has recently noted, wealth taxes do respond to an important lacuna in our current tax system: Those who start businesses or invest wisely earn great wealth that is in the form of stock they do not sell. It seems wrong that such gains escape taxation.

However, the proposals for repealing stepped-up basis and reducing estate tax sheltering likely represent a sounder approach to this problem.

Ultimately, we agree with Warren and Ocasio-Cortez that there is a major need for tax increases that are borne by the most fortunate Americans. But it is important to be clear about the logic. There are essential public investments the United States needs to make and crucial safety nets that need to be preserved, and that this requires more revenue. At a time of increased inequality it seems natural to first look to those with the highest income in collecting this revenue.

Justifications for substantial increases in tax burdens as a tool to address “oligarchic drift” are problematic. First, given that most outlays to promote a political agenda are tax deductible, approaches like wealth taxation may actually increase oligarchic forces. But more broadly: If America had had more figures like Bill Gates, Warren Buffett, and Steve Jobs over the last generation, it would have been a good thing, associated with a stronger economy even if measured inequality increased. Bill Clinton was right when he said that he wanted to see an economy with more millionaires, because that meant an economy with more job-creating successful businesses. Turning the tax code into a vehicle for confronting what some call “oligarchic drift” would undermine business confidence, reduce investment, degrade economic efficiency, and punish success in ways unlikely to be good for the country or even to be appealing to most Americans.

While some may argue that a single broad stroke, like the wealth tax or the 70 percent top rate, has a better chance of political success than our broader agenda, we believe this may be a dangerous gamble. The wealth tax could well be found unconstitutional, and so substantial political effort might have gone to waste. And investing substantial political capital into a tax model that is untried in the United States and has failed internationally strikes us as unwise. We are unaware of any example where a single, clear soak-the-rich tax proposal has been successfully legislated in the United States.

The traditional tax reform approach of using the tax code to raise necessary government revenue as efficiently and progressively as possible, starting with base broadening, is the right first step forward. It may be that wealth taxes or very high-income tax rates are necessary to adequately fund appropriate government activities. But that is a conclusion should be reached carefully only after full exploitation of traditional alternatives, rather than in a spirit of joyous confrontation with the successful.

Excess austerity is a bigger risk than fiscal profligacy

When people are fundamentally healthy, they do not yet know what will cause their death. An economic recovery is healthy if it is not clear what will cause the next recession. By this standard, the recovery from the 2008 financial crisis, although disappointingly slow, has been healthy for most of the last decade.

This is now in serious doubt. Paul Samuelson’s quip that the stock market has predicted nine of the last five recessions cautions against overreacting to recent stock market moves. But credit spreads have widened considerably, commodity prices have softened and investors have started demanding higher yields for short-term US bonds than for those with longer terms. Unlike equity markets, “yield curve inversions” have not historically tended to produce false recession predictions. The overall judgment of financial markets is that recession is significantly more likely than not in the next two years.

Real economic indicators for the world’s largest economies, China and the US, also suggest considerable cause for concern. Almost every Chinese indicator in the last few months has come in below expectations. Beijing authorities now see the need for stimulus measures if they are to credibly report the attainment of growth targets. Revisions of economic forecasts tend to run in the same direction for protracted periods as forecasters adjust to emerging reality. This tendency is especially pronounced in China, given the extreme political sensitivity of economic statistics.

In the US, inflation is again running below the Federal Reserve’s 2 per cent target and comparisons of the yields on ordinary and inflation-adjusted bonds suggest investors expect this to continue for the next decade. While jobs growth remains strong, employment is usually a lagging statistic. Forward-looking indicators of business and consumer sentiment suggest that growth is likely to slow.

Perhaps the US economy will enjoy a soft landing: jobs growth would slow towards long run sustainable levels, and productivity growth would accelerate enough to allow continued gross domestic product growth of 2 per cent and increased wage growth without accelerating inflation. But this would require both policy skill and great luck. Given that we are starting from very high debt levels and low unemployment, a recession is the more likely outcome.

It is almost inconceivable that the global economy will remain healthy in the face of serious economic problems in both China and the US, even leaving aside their conflicts over trade and technology. Europe lacks economic energy and the uncertainties associated with Brexit, French protests, German political transition and Italian populism mean the continent is more likely to be a source of problems than a solution.

Like generals fighting the last war, too many policymakers are focused on yesterday’s problems. The global economy is much more likely to suffer from a downturn than from overheating in the next two years. There is more likely to be too little credit flow than too much, asset price deflation is more probable than a bubble and excess austerity is a bigger risk than profligacy.

The critical challenge for monetary and fiscal policy will be to maintain sufficient demand amid immense geopolitical uncertainty, increasing protectionism, high accumulated debt levels and structural and demographic factors leading to increased private saving and reduced private investment.

The Fed should signal that it is determined to avoid a downturn that would assure another decade of below target inflation. The People’s Bank of China and other central banks should also make clear that they recognise that avoiding another recession is the most important thing they can contribute to financial stability.

Fiscal policymakers should realise the very low real yield on government bonds is a signal that more debt can be absorbed. It is not too soon to begin plans to launch large-scale infrastructure projects if a downturn comes. The largest economies should try to limit trade frictions and signal that they are committed to co-operating to support global growth by assuring adequate capital flows to emerging markets and avoiding a cycle of protectionism.

Even if my recession fears are excessive, a shift towards emphasising growth will contribute to bringing inflation up to target levels and can be reversed. If I am proved right, the costs of delay in the policy response could be catastrophic. It is the irony of our moment that prudence requires the rejection of austerity.

President Trump has publicly and harshly rebuked Federal Reserve Board Chairman Jerome H. Powell for what the president regards as misguided interest-rate increases that threaten continued economic expansion. As with much of what Trump says and does, this way of doing business is counterproductive — irrespective of whatever merit his underlying position may have.

No self-respecting central banker can be seen as yielding to pressure from a politician facing a difficult election. A central bank that appears subservient to political concerns will rapidly lose credibility in the markets, resulting in increases in inflation expectations and rising long-term interest rates. As those of us at the Treasury Department used to remind White House political staff during the Clinton administration: Fed bashing is a fool’s game — the Fed doesn’t cut short rates, and the market raises long-term rates. The sense that policy is being politicized increases uncertainty, which is likely to decrease investment and ultimately slow growth.

So Trump is surely making a serious error in his rhetorical approach to the Fed. Two questions remain. First, how rapidly should the Fed raise interest rates in coming months? Second, recognizing that public Fed-bashing is wrong, what should be the nature of relations between the central bank and the executive branch? On neither question does orthodox thinking seem quite right to me.

On the first question, it seems there is considerably more danger of the Fed raising rates too fast than too slowly over the next year. Inevitably, monetary policy is a judgment about competing risks. If the Fed raises rates too slowly, inflation will increase and remain clearly above the 2 percent target for a significant interval. This does not seem like it should be a dominant worry. Inflation has been below the target level for a decade, so above-target inflation is necessary if inflation over the long term is to average 2 percent.

Even with good luck and good policy, a recession will come along at some point and pull down the inflation rate. Two months ago, it might have been reasonable to worry about complacency in asset markets, but in light of recent volatility this seems a lower order problem.

On the other hand, the risks of excessive tightening seem substantial. Monetary policies affect the real economy with lags of a year or more. It is, therefore, easy for policy to tighten past the point at which the economy is thrown toward recession because of an absence of clear signals of slowing. Indeed, on almost every occasion in the past 50 years when the Fed has tightened in a sustained way, the result has been recession. The risks of a downturn now are greater than at any point in living memory because, given the zero lower bound on interest rates, the Fed would have limited room for easing, and because of the populist and protectionist pressures that would almost certainly accompany a downturn. Caution should be the order of the day.

Second, there is a need for pragmatism regarding the independence of central banks. It is important they resist the kind of pressure for inflationary policy that Trump has recently engaged in. But it is foolish to suppose that a nation’s financial policies should be conducted entirely independently of its elected officials.

Consider some examples: During the period of quantitative easing following the financial crisis, the Treasury was pursuing a strategy of extending the duration of U.S. government debt. At the same time, to pursue stimulus, the Fed was operating in the opposite direction, in effect, issuing short-term debt and buying long-term debt. Surely a coordinated policy would have reduced transactions costs and served the public interest?

Or take exchange rates, which are objects of international diplomacy and are determined, in substantial part, by monetary and reserve management policies. Should elected governments with responsibility for foreign affairs have to be removed from exchange-rate policy in the service of central bank independence?

Occasions when interest rates are constrained by a zero or near-zero floor are likely to recur in the future. In such circumstances, coordination of fiscal and monetary policies may be necessary. This is very difficult if central bank policy is entirely independent of budget policy.

The point is not that central banks should be made more subject to political pressure. That is Trump’s bad idea. It is that, as their activities expand beyond pure monetary policy, there will be a need for coordination between the banks and elected government.