Cafe Hayek

Beware Hidden Taxes

Writing in today's Boston Globe, former OIRA chief Susan Dudley (along with Jeff Rosen) warns -- very sensibly -- that we should beware of hidden taxes.

Some Unlucky Numbers for Opponents of Proposition 13

According to now-conventional wisdom, one of California's big problems is Proposition 13.  Passed in 1978, this Proposition strictly limits increases in property taxes in California - a restriction that those who are Conventionally Wise assert fuels California's fiscal problems.  For example, here's Harold Meyerson writing last month in the Washington Post:

To understand why the woes of California's economy threaten the nation's, we must understand the state's road to insolvency. The Age of Reagan did not commence with the Great Communicator's inauguration in 1981. For its real beginning, we need to go back to June 1978, when Californians went to the polls and enacted Proposition 13.

By passing Howard Jarvis's malign initiative, California voters reduced the Golden State to baser metal.

Well, turns out that Proposition 13 is an unlikely culprit, as Paul Jacob argues here.

The percentage increase in property-tax revenue reported in the article that Jacob links to is overstated, as the dollar figures from which it is calculated appear to be nominal rather than real (that is, these numbers do not appear to be adjusted for inflation).  Still, adjusting for inflation, although it changes the magnitude, does not change the conclusion.  In real dollars, property-tax revenue in California (between 1980 and 2007) rose by 170 percent (compared to a 58 percent increase in that state's population over the same time period).
....
A fuller post on this topic would examine also what happened over these years to other sources of revenue for government in California - especially to revenue from the Golden State's income tax.  But I'm too busy now to explore this question.  (I would be surprised if these other sources of revenue did not also rise, in real terms, so that the total take of revenue by government in California is now higher today than it was 30 years ago.)

A Tax By Any Other Name....

Wayne Crews and Ryan Young, with the Competitive Enterprise Institute, explain that regulation is a form of taxation.  Here are the opening paragraphs:

We need a breather to take it all in: TARP, a $787 billion stimulus bill and a projected $1.845 trillion budget deficit. But lost among all the spending commotion is yet another trillion-dollar poker hand — federal regulation.

Compliance costs from thousands of regulations — pouring out from over 60 departments, agencies and commissions — amounted to $1.17 trillion in 2008. The federal government spends an additional $49.1 billion just to administer and enforce its rules. This figure is on par with federal income tax revenue ($1.2 trillion) and Canada's entire 2006 GDP ($1.265 trillion).

(By the way, I'm proud to say that Wayne and Ryan each earned his Master's degrees at GMU Economics.)

The Economic Case for Tax Cuts

Here's a letter that I sent on Sunday to the New York Times:

You write as though the only reason to cut taxes is to promote more consumer demand ("The Sorry State of the States," May 24).  You're mistaken.

By far, the chief economic reason for cutting taxes is to increase the return to productive activity - to increase the return to investment, to risk-taking, to creativity, to work.  The economic justification for lower taxes rests squarely on the understanding that cutting marginal tax rates makes profitable many productive efforts, including hiring more workers, that are unprofitable at higher tax rates.

Why does this straightforward point seem so taxing to your editorial-writers' comprehension?

Sincerely,
Donald J. Boudreaux

Tea-d Off!

Here's Glenn Reynolds, writing in today's Wall Street Journal, on today's "Tea Parties."  His take on these events is decidedly different -- and far clearer, in my view -- than is Paul Krugman's take.  I sent the letter (below) to the New York Times in response to Krugman's take.

Paul Krugman criticizes the anti-tax tea parties to be held around the country on Wednesday ("Tea Parties Forever," April 13).  But Mr. Krugman's message never rises above tabloid journalism.  Rather than address the issues, he merely rehashes absurdities spewed (mostly years ago) by right-wingers such as Tom DeLay and Karl Rove.  The implication is that, because the likes of Messrs. DeLay and Rove oppose higher taxes, persons who attend these tea parties must be similarly crazy partisans.

But is it really so absurd for ordinary Americans to be furious that Uncle Sam now promises to run up $9.3 trillion in debt during the next decade - an unfathomable sum that will inevitably lead to much higher taxes or higher inflation or both?  Is it small-minded to oppose corporate welfare for automakers, banks, and insurance companies?  Is it lunatic to fear further socialization of medical-care provision?  Do these concerns really signal that those of us who hold them are, as Mr. Krugman alleges, "refusing to grow up"?

One need not agree with the tea-partiers to concede that these worries are ones that reasonable people can, and do, have.

Sincerely,
Donald J. Boudreaux

Section 162(m)

In the public-choice seminar that I teach this semester at GMU Law, my class and I had a splendid conversation yesterday about Sec. 162(m) of the U.S. tax code.  (Most of the splendor of the conversation was supplied by my students, not be me.)

This tax-code provision was created in 1993.  It prohibits firms from deducting from their taxable incomes amounts above $1M paid to top corporate executives unless these excess amounts are compensation for meeting performance-based measures.

Want to speculate on the unintended consequences of this Clinton-administration effort to "rein in" executive salaries?!

A, B, or C

Not having enough on his plate, the President is going to fix the tax code:

President Barack Obama is putting former Federal Reserve Chairman Paul Volcker in charge of a tax- code review aimed at closing loopholes, streamlining the law and generating revenue, budget Director Peter Orszag said.

Hmmm. Three goals. Wonder which one will get the most attention.

They don't have the votes

Will the President's budget pass? The cap-and-trade part is in trouble (HT: Drudge). But if the cap-and-trade part is dead, where is the money going to come from to begin to cover the increased expenditures? This is going to get interesting. Remember, the bottom 98% "won't pay an extra dime." Either that promise is going to get broken or the size of the budget will get smaller.

War, Taxation, and Inflation

Robert Higgs -- who explains that the Great Depression was not cured by the New Deal or by World War II -- is featured here in this 30-minute-long video on war, taxation, and inflation.

When is a trillion dollars not a lot of money?

So starting in 2011, Obama is proposing a trillion dollars in new taxes.

Sounds like a lot of money. But it's over ten years. So it's a measly $100 billion a year.

That's a drop in the bucket of red ink that he's promising. So for 2009 and 2010, no new taxes while deficits are in the trillions. There's no way that these taxes will get the job done.

I guess it depends on what you mean by "responsibility"

Obama, in announcing his budget with a projected deficit of $1.75 trillion, champions responsibility:

In a presidential message preceding a summary of the budget, Obama laid out elements of the current economic crisis that he said warrant massive government spending this year and next. In addition to the loss of more than 3.5 million jobs in the past 13 months, he said, another 8.8 million Americans are underemployed, manufacturing employment has hit a 60-year low, capital markets are "virtually frozen," and "trillions of dollars of wealth have been wiped out" in the stock markets.

"This crisis is neither the result of a normal turn of the business cycle nor an accident of history," Obama said. "We arrived at this point as a result of an era of profound irresponsibility that engulfed both private and public institutions from some of our largest companies' executive suites to the seats of power in Washington, D.C. . . . This irresponsibility precipitated the interlocking housing and financial crises that triggered this recession."

Saying that government has repeatedly failed to confront systemic problems as policymakers have chosen "temporary fixes," Obama declared: "The time has come to usher in . . . a new era of responsibility. . . . This budget is a first step in that journey."

More on the deficits that are coming

Obama has promised that the bottom 98% of taxpayers will not pay a dime in higher taxes for the new spending he has planned. He has also promised to cut the deficit in half by the end of his first term.

The new deficit number for 2009 came out today: $1.75 TRILLION. To cut that in half he needs to reduce spending or raise taxes by 800 billion. As I point out in this piece, let's assume he really can find $200 billion annually in spending cuts. That leaves $600 billion in tax increases for the top 2%. The top 2% currently pay about $500 billion in taxes. There are about three million taxpayers in the top 2%. They currently pay an average of about $167,000 a year in income taxes. So to cut the deficit in half (half--still leaving a deficit of over $800 billion) he will have to raise their tax burden by another $167,000.

At those levels, I think there are going to be some incentive effects.

So either taxes are going to go up on more than just the top 2% or he's going to keep running very large deficits. I wonder if the Treasury will be able to borrow that amount of money for that long.

We sure live in interesting times.

Comment of the week

Methinks writes about the top 2% paying for the increase of almost a trillion dollars flowing mostly to the other 98%:

I'm in the target group to do the paying. I won't do it.

I own my business and, unlike an employee, I have the option to work as much or as little as I like. At some tax rate, the marginal dollar won't be worth earning. I'll fire some employees, scale down the business or retire altogether and stick my money in tax advantaged muni bonds and do all the traveling and relaxing I can't do now. The tax advantage of muni bonds will NEVER go away because municipalities will scream bloody murder. If I'm not ready to retire and the tax rate gets too high, I may just immigrate to another country because it's very easy for me to get almost instant citizenship in any other country. I respond to incentives and I'm not incentivized by enslavement and neither is anyone I know. The specialness of this country is the lack of totalitarian regime and individual liberty. Once that's gone, this country is no longer all that special. You can call me evil or "not doing my part" because I'm not willing to work myself into the grave for your family instead of mine, but the reality is that unless you plan to start a Gulag, you can't make me.

The question is, why should I be expected to work and risk more than you to provide you with the lifestyle to which you have become accustomed?

Yes, it's sustainable to raise taxes on the most productive. However, it's not sustainable at a high standard of living. It's sustainable only at ever decreasing standards of living. France and Germany are good examples.

There's a difference between the natural altruism that occurs between family members and confiscation by the state. I feel great when I donate to charity. I feel really crappy when I write the check to the IRS. Maybe I should figure out how to receive one instead. Seems a lot less time consuming.

What empirical evidence do we have about the responsiveness of high earners to tax rates? What is the reliability of that evidence? Either way, a tip of the hat to Methinks for the eloquence.

Now they're worried

An amusing moment in the SOTU address occurred when Obama said:

There is, of course, another responsibility we have to our children.  And that is the responsibility to ensure that we do not pass on to them a debt they cannot pay.  

The Republicans roared their agreement. It was the only real point in the speech when they showed genuine emotion. But then Obama continued:

With the deficit we inherited...

And the Democrats roared back, mocking the Republicans. (And I think there was an ad lib in the middle where Obama mentioned that this was an issue where there was bipartisan agreement.)

The Republicans deserve to be mocked. All of a sudden they're worried about big government and deficits. But it is ironic for the Democrats to do the mocking. They haven't exactly been pushing for balanced budgets or reduced spending over the last eight years.

Can he cut the deficit in half?

I doubt it.

Realism from David Leonhardt

Here. He argues that down the road, taxes are going to have to rise over time to fund Medicare, and not just on the top 1%. He presumes that Americans will continue to support Medicare and demand that it stay in place. He's probably right. He mentions in passing that the top 1% pay 25% of the Federal taxes. Not income taxes, because that number is almost 40% in the latest available data. I assume he is accounting for payroll taxes.

By the way, the share of income going to the top 1% and the share of taxes paid are both probably going to be lower in 2008 and 2009 than in years past, because of the recession and the Wall Street layoffs.

Libertarian Taxers?

At Economist.com, Jonathan Rauch is identified as a libertarian who (it is suggested wisely) believes that taxes might need to be raised.

Regardless of your opinion of libertarianism, at its core is a philosophical and moral commitment to individual freedom and, hence, to scaling government way back. Accepting the political reality of the welfare state might be good politics, even for a rejuvenated G.O.P., but it is not genuinely libertarian.

Also, if I understand what Rauch is arguing, even if it is politically pragmatic to accept the welfare state, it does not follow that taxes should not be cut. Unless Rauch is willing to argue that Uncle Sam's $3-plus trillion dollar budget is largely full of worthwhile programs and spending, he can argue for maintaining the welfare state and for tax cuts: get rid of the gargantuan amounts of wasteful (indeed, harmful) spending and transfer it instead to welfare programs. Problem solved.

If Rauch does not agree that most of Uncle Sam's current budget is wasteful, then he's not remotely close to being a libertarian.  (I don't know Rauch, but I admire his work and believe that he probably truly is a libertarian.  So he should recognize that government can get more revenue for program A not only by raising taxes but, instead, by cutting spending on programs B and C.)

(HT Karol Boudreaux)

Don't spend it all in one place

On the tax cut for individuals in the spending bill:

Officials estimated it would mean about $13 a week more in people's paychecks this year when withholding tables are adjusted in late spring. Next year, the measure could yield workers about $8 a week. Critics say that's unlikely to do much to boost consumption.

Or happiness.

Tranquilizing the Stimulators

The Competitive Enterprise Institute's Ryan Young and Drew Tidwell understand that there ain't no such thing as a free stimulus.  Here's a great letter by Ryan and Drew in the current issue of Time.  (You can find their letter on line by clicking here and scrolling down a bit.)  Oh, by the way: Ryan is working toward a graduate degree in Economics at GMU.

Kinsley's latest missive in time falls prey to one of the oldest traps in economics--Frédéric Bastiat's broken-window fallacy. Just as a broken window creates work for the glazier at the expense of the window owner, money that Kinsley hopes to inject into the economy must first be taken out of it. Add in collection costs and the usual political malfeasance, and we have a net loss to the economy. There's more: Kinsley argues that last summer's high oil prices were essentially a tax on consumers; the money just went to oil companies instead of the government. But he forgets that oil companies do not have control over their prices. If they did, then why would oil prices ever drop? Kinsley's logic does not follow.

Ryan Young and Drew Tidwell, Competitive Enterprise Institute, WASHINGTON

Good tax policy

Commenter jwilliams writes in response to my post arguing that the reduction in capital gains on housing in 1997 may have been the decisive event that started the rocketing upward of housing prices that created the mortgage mess and subsequent financial collapse:

What conclusions do you draw from this interpretation?

That the government should not have reduced taxes on home capital gains? That the taxes should have been decreased more gradually? That all capital gains taxes should be equal to avoid favoring one investment over the other?

The latter. You don't want to tax-advantage one investment over another or you induce a disproportionate flow of capital into that asset. That's the tragedy of the last ten years that's hidden. Tax policy and what came afterward caused trillions of dollars (not millions, not billions, but trillions) from China and here and elsewhere to go into building new and bigger houses rather than into more productive assets. It was a colossal mistake approved by a Republican Congress and signed by a Democratic president.

The defenders of such policies usually argue that you want more capital to flow into homes because home ownership creates a good society of responsible individuals. Maybe. Maybe not. But such talk is accepted most readily by those who benefit from the policies.

Ever-increasing home ownership is not the American dream. It's the dream of the National Association of Home Builders.

A Haven of Sanity

Cato's Dan Mitchell does it again in this fine new series of short, entertaining, and informative videos on the virtues -- economic and ethical -- of tax havens.

The first is The Economic Case for Tax Havens.

Next is The Moral Case for Tax Havens.

Third is Tax Havens: Myth vs. Facts.

Taxes Haven't Been Cut Enough

Here's a letter I sent back in August to the Washington Post:

Dear Editor:

In "McCain's Problem Isn't His Tactics. It's GOP Ideas." (August 3), Greg Anrig portrays the past 30 years as a period of radically shrinking government and galloping laissez faire. Gee. Methinks he mistakes Ronald Reagan's rhetoric for reality.

In inflation-adjusted dollars, Uncle Sam's budget is now 110 percent larger than it was in 1980, the year of Reagan’s election. U.S. population since 1980 grew by only 33 percent. Although some useful deregulation has occurred during this time, the problem is hardly a retreat of government; it is, rather, government's continued insidious intrusion into ever more aspects of our lives - and, despite cuts in marginal tax rates, its continued growth. As Milton Friedman wisely pointed out, "If you cut taxes and revenues go up, you haven't cut taxes enough."

Revenues have gone up.  So tax cuts have been inadequate.

Sincerely,
Donald J. Boudreaux

Some bubble

I have mentioned the argument of Robert Shiller's that the housing boom of the last ten years was a bubble, a result of social contagion.
So what I have been doing over the last week is educating myself. Not being a housing expert, I've been digging around, trying to find out the role of government in the housing market and how it might have changed since 1997 when the "bubble" took off to see what role public policy might have had in the housing price increases and the subprime meltdown. Maybe it wasn't speculative mania. Maybe much of it was due to changes in public policy.

I am embarrassed to say that I missed a huge factor. Reader (and EconTalk listener) Russ Wood pointed out that in 1997, the tax on capital gains for housing was dramatically relaxed. As a real estate site describes the change, looking back from the present:

• First, by now you should have long ago forgotten the old $125,000 tax exclusion on capital gains for home owners older than 55 and the "rollover" law that allowed you to defer paying capital gains taxes provided you purchased another, more expensive home in time.

  Those laws are history. Forget them.    

• The relief act's primary provision for home sellers is the capital gains tax exclusion -- when you sell your home, if you qualify, you can keep, tax free, capital gains of up to $500,000 if you are married filing jointly or $250,000 for single taxpayers, or married taxpayers who file separately.

Do you think that had any effect on the price of housing? You bet it did. Vernon Smith pointed out the impact in December 2007:

The joint housing and mortgage-market crisis once again reminds us that all financial implosions stem from the same cause: borrowing short and lending long without enough equity to weather periodic storms in the gap between.

But this bubble was different. Besides being fueled by housing purchases and repackaged loans, each with inadequate equity -- doubling down with other people's money -- at the end of the capital-gains rainbow was the right to take up to $500,000 of profit, tax free.

Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.

Once again, try as we might and in spite of our political rhetoric, we have failed to help the poor in applauding government action intended to help ourselves.

The consumption binge is now over, and there is more than enough blame and souring loans to spread around. Congress, if its members can stop squabbling, wants desperately to sanctify it all with actions sure to launch at some future date the grandmother of all housing and mortgage-market bubbles. This august body has long forgotten that it set the stage for housing bubbles by creating those implicitly taxpayer-backed agencies, Fannie Mae and Freddie Mac, as housing lenders of last resort.

Financial market innovators who invented securitization as a mechanism for creating a liquid national market for mortgages are now criticized for having caused an "agency problem." This is jargon for management not having good incentives to provide investors with "truth in packaging" of the underlying economic risk. But what does truth matter at the height of a bubble? These critics would solve the agency problem with more government regulation. Excuse me, but does not the political process have the biggest agency problem of all?

And Chris Farrell at Business Week did a very nice job discussing it back in 2005:

What accounts for the housing boom? Economists have cited a number of fundamental factors, including low interest rates, favorable demographics, and restrictions on development. But the unappreciated force that may have infected a strong housing market with home-buying mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act of 1997, signed by President Clinton.

He continues with the real cost:

...capital gains on stocks and bonds carry a 15% levy (the capital gains tax rate had been 20% until the tax law change of 2003.). The powerful lure of tax-free profit is one reason that home prices have risen at a nearly 7% annual rate, vs. about 4% for the stock market since 1997. Sell a home with a $500,000 profit and owe Uncle Sam nothing. But realize a $500,000 gain on Nextbreakthroughtechnology.com and the federal government takes 15%. That's the kind of math most people can figure out.

The issue goes way beyond tax fairness. A growing number of economists are deeply concerned that residential real estate is absorbing far too many economic resources. Money is pouring into concrete foundations rather than high-tech innovation. "Residential investment accounted for 35% of private investment in the past year, a level not seen since the early 1970s," notes Martin Barnes, the perceptive financial-market observer at Bank Credit Analyst.

A Profitable Lesson

Learning the lesson of this letter, appearing in today's edition of USA Today, would profit us all:

Let Big Oil reap profits

Richard Gibbard - Rapid City, Mich.

I hear a lot of people yelping about "obscene" oil company profits. What I don't hear is any valid reason why oil companies should not make these profits.

Profits are what keep the companies in business and employees on their payrolls. Let the companies profit.

Nobody is qualified to determine what is a reasonable or fair profit.

Tax facts to remember

From the Tax Foundation:

The latest release of Internal Revenue Service data on individual income taxes comes from calendar year 2006, a year in which the economy remained healthy and continued to grow, increasing individual income tax collections along with overall average effective tax rates.

This year's numbers show that both the income share earned by the top 1 percent of tax returns and the tax share paid by that top 1 percent have once again reached all-time highs. In 2006, the top 1 percent of tax returns paid 39.9 percent of all federal individual income taxes and earned 22.1 percent of adjusted gross income, both of which are significantly higher than 2004 when the top 1 percent earned 19 percent of adjusted gross income (AGI) and paid 36.9 percent of federal individual income taxes.

Wondering

Reading this op-ed in today's Washington Post -- an op-ed with several flaws and false premises -- causes me to wonder the following:

How many people who ridicule the idea that higher corporate taxes meaningfully reduce a country's total output of goods and services also believe that government subsidies meaningfully increase a country's total output of goods and services?

Soaring Case for the Flat Tax

Here's another former GMU PhD student making great good sense.  In particular, you can here see the Cato Institute's Dan Mitchell discuss the merits of a flat-tax system.

Caplan on the Gas-Tax Holiday

Think the proposed gas-tax holiday is a wacky idea?  My GMU colleague -- and EconLog's -- Bryan Caplan gives you good reason to think again.

More Mitchell on Tax Policy

Here's the third and final installment of the Cato Institute's Dan Mitchell's superb YouTube videos on the Laffer Curve.  (The first two installments can be found here and here.)

These are all superb.  I recommend them highly.

Laffer Curve: The Evidence

The second installment of the Cato Institute's three-part video series on the Laffer Curve (featuring Dan "Bulldawg" Mitchell) has just been released.  It is superb!  (You can find the first installment here.)

Learn the Laffer Curve

Dan Mitchell - former GMU student, current Cato Institute Senior Fellow, and one of the world's most die-hard Georgia Bulldogs fans - does an absolutely splendid job of explaining the logic of the Laffer Curve in this short video.  Enjoy and learn!

I Goofed, You Pay

This letter of mine was published in yesterday's edition of USA Today:

Raising taxes on private firms is a mistake

Donald J. Boudreaux, chairman, Department of Economics, George Mason University - Fairfax, Va.

Rep. Eric Cantor, R-Va., is correct that raising taxes on private equity firms is neither necessary nor appropriate for fixing the alternative minimum tax (AMT) ("Don't hike partnership taxes," Opposing view, Taxes debate, Dec. 6).

The reason, however, is more fundamental than the fact that such firms benefit ordinary Americans.

Not indexed for inflation, the AMT was never meant to tax the millions of Americans whom it will now tax if Congress doesn't fix it. In other words, taxing people in this way is a mistake.

What ethical argument justifies Congress shifting the costs of its mistake onto others?

If Jones mistakenly budgeted to spend dollars that he wrongly thought would come to him from Smith, is Jones entitled then to take this amount of dollars from Williams in order to "pay for" correcting his error?

David Henderson on Robert Frank

David Henderson, editor of the indispensable Concise Encyclopedia of Economics, takes on Robert Frank's idea that the modern American economy is infected with toxic levels of "keeping-up-with-the-Joneses."  Here an excerpt from David's Cato Policy Report essay:

A pillar of Frank's argument is that a large percentage of people care about their relative position. In Choosing the Right Pond, he defends that assumption by pointing to anomalies in the pay structure of various firms, anomalies that he attributes to people caring about relative position. Most of his anomalies have to do with pay structures that, Frank argues, are "flatter" than standard economics would predict. Standard economics states that workers are paid an amount roughly equal to the value of their marginal product--that is, the increment in value that is due to their being in the firm. But, notes Frank, if this were true, one would expect to see great disparities between the salaries of workers who have great differences in productivity. He points to, among other things, the University of Michigan pay scale for economists in 1983-84, where the highest salary was only a little more than double the lowest. He never mentions the fact that the University of Michigan is a government bureaucracy, making it not the best test of the standard economics account of freemarket wages. Nor does he mention that one of the main ways the stars of academic institutions are "paid" is with lower teaching loads and more research funds.

Even more interesting is how the world seems to have changed since Frank began writing about these issues and the contortions he goes through to sustain his argument for higher taxes. When he first began, he argued that relatively flat pay structures are indirect evidence for his view that people care a lot about relative position. But in his May 2007 testimony, Frank noted that the "anti-raiding norms of business have recently begun to unravel" so that, now, pay for top managers can be a huge multiple of pay for bottom managers. In other words, it would seem, many top managers are being paid an amount that approximates their marginal product. You might think that this would cause Frank to reexamine his earlier strongly held views. But he doesn't.

Instead, he comes up with a new argument for progressive consumption taxes. He now argues that too many people are vying for the top jobs because of the higher pay those jobs carry. They are fighting, he argues, over a fixed pie and, in a variant of the famous "tragedy of the commons," he compares the competition for the top jobs to gold prospecting. He testified that "the gold found by a newcomer to a crowded gold field is largely gold that would otherwise have been found by others." Similarly, he argues, "an increase in the number of aspiring hedge fund managers produces much less than a proportional increase in the amount of commissions on managed investments."

But he can't hold on to this argument for even a page. Just four paragraphs later, he testified: "A slightly more talented CEO or hedge fund manager can boost a large organization's annual bottom line by hundreds of millions of dollars or more." Exactly. It does make sense, therefore, for companies to look for small differences in talent because those differences can cause huge increases in profits. The problem with Frank's tragedy of the commons analogy is that there is no commons. The tragedy of the commons occurs when no one owns the resource: thus the word "commons." But those who hire hedgefund managers own their resources, so one would not expect overinvestment in being the manager. Frank implicitly admits this, writing, "To be sure, even those who fail to win the biggest prizes often go on to earn comfortable incomes." But in the very next sentence, he retreats to his old position, saying, "But career choices must be measured not in terms of absolute pay but relative to what might have been" (emphasis added). This is astounding. More than 20 years ago, Frank argued, as an empirical matter, that people care about relative income. Now in the face of evidence that absolute income matters a lot to them-- otherwise, why would anti-raiding norms have unraveled--he argues that it shouldn't-- thus his use of the word "must." If the people don't conform to his assumptions, it seems, we should tell them to.

Here is Bob Frank's webpage.

Just Fix It

Here's a letter that I sent today to the New York Times:

There's widespread agreement that the alternative minimum tax - because it is not indexed to inflation - is mistakenly raising the taxes of millions of Americans ("House Democrats Propose Tax Overhaul," October 25).  Happily, there's also widespread agreement that this mistake should be corrected.

So, given that the current operation of the AMT is a mistake, why do Rep. Charles Rangel and so many others talk of the need to "pay for" fixing the AMT?  A merchant who mistakenly overcharges customers is obliged to refund the money and stop overcharging, period.  This obligation kicks in whether or not the merchant devises some way of replacing the revenue that he loses by correcting his mistake.

Sincerely,
Donald J. Boudreaux

A Dearth of Taxes?

Yesterday's New York Times has an editorial that can only be described as jaw-droppingly dumb.  (HT: Laurence J. Dallaire)  I sent the following letter in response:

To the Editor:

Forget that Uncle Sam today rakes in tax revenues that are, in inflation-adjusted dollars, 25 percent larger than those that he took in 2001 - thus making a mockery of your claim that Washington's tax take today is "meager" ("The Dearth of Taxes," October 22).  And forget that the Wall Street Journal today reports that Congress has increased corporate welfare for the current fiscal year by nearly ten percent, to $100 billion.

When pleading for higher taxes, at least keep your story straight.  In your editorial you simultaneously blame government's alleged lack of funds for bringing many U.S. corporations "to the brink" AND you dismiss the recent growth in tax revenues as being due to "spectacular increase in corporate profits."  Such inconsistency taxes your readers' credulity.

Sincerely,
Donald J. Boudreaux

Frank Talk

In the latest EconTalk, I talk with Robert Frank about the virtues of learning economics via puzzles and stories rather than graphs and equations. I am a big fan of graphs but I'm a bigger fan of puzzles and storytelling and I believe that Frank is absolutely right that puzzling over puzzles and telling and listening to stories is a crucial way that many people learn and remember. We discuss a number of interesting puzzles from his new book, The Economic Naturalist including why people in New York might appear ruder than people in Topeka and why brides buy their dress and grooms often rent their tux even though brides usually never wear their dress again and grooms wear tuxes later on.

We spend a little time on the issue of whether people get pleasure from owning a big house or whether they only get pleasure when their house is bigger than their neighbors' houses. Frank sees the growing size of houses as an example of an arms race where the competition to have a bigger house is wasteful—yes, at first when you build a bigger house, you're better off. But when your neighbor builds a bigger house that matches yours, you're back to where you started. I see larger houses as an example of people living better with more living space. When I pressed him during the podcast on this issue, he answered by saying that both factors are relevant—it's an empirical question as to the magnitudes of the two effects.

In this editorial in the New York Times which I saw just after the interview was taped (HT: Rick Koch), Frank makes his case more forcefully and argues that the arms race for bigger houses justifies a steeply progressive consumption tax:

Consider a family that spends $10 million a year and is deciding whether to add a $2 million wing to its mansion. If the top marginal tax rate on consumption were 100 percent, the project would cost $4 million. The additional tax payment would reduce the federal deficit by $2 million. Alternatively, the family could scale back, building only a $1 million addition. Then it would pay $1 million in additional tax and could deposit $2 million in savings. The federal deficit would fall by $1 million, and the additional savings would stimulate investment, promoting growth. Either way, the nation would come out ahead with no real sacrifice required of the wealthy family, because when all build larger houses, the result is merely to redefine what constitutes acceptable housing. With a consumption tax in place, most neighbors would also scale back the new wings on their mansions.

I disagree with the premise that there is "no real sacrifice involved." I think people enjoy the larger house. By discouraging them from building the larger house, the tax reduces the happiness of  homeowners. But my real disagreement is with the claim that the additional savings would stimulate investment. Frank is assuming that everyone will work equally hard in a world where consumption is taxed at very high rates. I doubt it.

Frank goes on to argue for another benefit of high tax rates on consumption:

A progressive consumption tax would also reduce the growing financial pressures confronting middle-class families. Top earners, having received not only the greatest income gains over the last three decades but also substantial tax cuts, have been building larger houses simply because they have more money. Those houses have shifted the frame of reference for people with slightly lower incomes, leading them to build larger as well. The resulting expenditure cascade has affected families at all income levels.

The median new house in the United States, for example, now has over 2,300 square feet, over 40 percent more than in 1979, even though real median family earnings have risen little since then. The problem is not that middle-income families are trying to “keep up with the Gateses.” Rather, these families feel pressure to spend beyond what they can comfortably afford because more expensive neighborhoods tend to have better schools. A family that spends less than its peers on housing must thus send its children to lower-quality schools.

Now it turns out that 1979 was a very good year for family income, but even so, median family income rose 15% between 1979 and 2005 and rose almost 20% between 1980 and 2005. And the way the government measures income doesn't include fringe benefits which are an increasingly important part of compensation. And I don't think the price index that converts nominal into real dollars overstates inflation and understates the growth in real income. So I disagree with Frank that income is up only slightly. So when I see houses getting bigger, I see people spending a larger share of their income on something they care a lot about rather than people keeping up with the Gateses.

I think Frank is right about two things in his article on taxation. One, I think people do spend money on houses trying to get into better school districts and that bids up the price of houses artificially because houses are tied to schools. The way to fix that is to get rid of the connection between houses and schools. The second thing I agree with is that it's better to tax consumption rather than income. But I don't think steeply progressive rates are a good idea. I think they would have strong disincentive effects on productivity, creativity and innovation. I think part of the reason people work long hours and start new businesses and take second jobs is to have more stuff. Taxing the accumulation of stuff at very high rates reduces the incentive to work hard.

Jibbitzing in the Prosperity Pool

Earlier this month, Karol and Thomas and I vacationed at our favorite vacation spot: Cape Cod.

While there, Thomas and I bought our first pairs of Crocs.  They're wonderful shoes for casual wear.  The woman who sold them to us told us about something that we'd never before heard of: Jibbitz.  Jibbitz are little decorations that fit into any one of the many holes featured on each pair of Crocs.  These tiny items are mostly ornamental -- allowing each Croc wearer to express his or her individuality -- but they also are functional, for they can help to identify one pair of Crocs from another.

(Neither Thomas nor I wanted any Jibbitz, by the way.)

The fascinating thing about Jibbitz, though, is that the inventor turned this idea into a business that he and his wife sold for $20 million.  What a  wonderful outcome!

Note that this invention isn't high-tech -- it's about as simple as simple can be.  Yet it is indeed something that enough consumers choose to buy at prices that make the product profitable to produce.

Jibbitz -- another few drops of prosperity in our vast Prosperity Pool.

Tax Burden

My George Mason University colleague, law professor Todd Zywicki, has a wonderful op-ed appearing in today's edition of the Wall Street Journal.  (Unfortunately, a paid subscription to the WSJ is required to access this article.)  In this essay, Todd reports that the data show that the category of expenditure that has risen most, in both percentage terms and in absolute dollar terms, for the average American household over the past 30 years is taxes.

Here are the concluding paragraphs from Todd's not-to-be-missed op-ed:

Although income only rose 75%, and expenditures for the mortgage, car and health insurance rose by even less than that, the tax bill increased by $13,086 -- a whopping 140% increase. The percentage of family income dedicated to health insurance, mortgage and automobiles actually declined between the two periods.

During this period, the figures used by Ms. Warren and Ms. Tyagi [in their book The Two Income Trap: Why Middle Class Mothers and Fathers are Going Broke] indicate that annual mortgage obligations increased by $3,690, automobile obligations by $2,860 and health insurance payments by $620 (a total increase of $7,170). Those increases are not trivial -- but they are swamped by the increase in tax obligations. To put this in perspective, the increase in tax obligations is over three times as large as the increase in the mortgage payments and almost double the increase in the mortgage and automobile payments combined. Even the new expenditure on child care is about a quarter less than the increase in taxes.

Overall, the typical family in the 2000s pays substantially more in taxes than the combined expenses of their mortgage, automobile and health insurance. And the change in the tax obligation between the two periods is substantially greater than the change in mortgage, automobile expenses and health-insurance costs combined.

This suggests that the most important change in the balance sheets of middle-class households over the past three decades is a dramatically higher tax burden caused by the progressive nature of the American tax system. In turn it follows that the most effective way of alleviating the household budget crunch would be to adopt lower and flatter tax rates that would reduce the government's take. Another possibility, advocated by Prof. Edward J. McCaffery of the University of Southern California Law School, would eliminate the "secondary earner bias" in the tax system, which causes all of the wife's income to effectively be taxed at a much higher marginal tax rate than the husband's. Any of these reforms seem sensible.

Lower and flatter marginal tax rates generally are not advocated by those who dominate the American legal academy today. But for those who want to consider serious strategies for preventing bankruptcies, less money in Uncle Sam's pockets may mean more money in ours.

The Politics of Prohibition

Why did the U.S. government prohibit alcohol starting in 1920?  And why did it end this ignoble "experiment" in 1933?  I have a theory.  (Hint: the reason for both the launch and the sinking of alcohol prohibition centers on tax revenue.)

Where Externalities Lie

Here's a letter that I sent today to the Wall Street Journal.

To the Editor:

Like many others, Professor Hendrik Van den Berg insists that "we need to raise the price of gasoline by introducing a tax that reflects the congestion, environmental and national security costs of oil" (Letters, July 3).  I disagree.

First, government already taxes oil production and gasoline.  How does Prof. Van den Berg know that the current level of taxation is inadequate?  Second, government itself is a steamy swamp of negative externalities.  Not only do politicians and bureaucrats spend other people's money, they do so overwhelmingly while under the influence of special-interest groups.  The only tax that we should raise is one that increases the cost of using government.

Sincerely,
Donald J. Boudreaux

I am consistently amazed at the way so many persons -- including (especially?) economists -- cleverly identify real or imagined externalities in private markets and then propose political "solutions" for these alleged problems as if the government officials who will design and implement these "solutions" are wise, well-informed, and pure of motive.

Rabushka on the flat tax

Here is Alvin Rabushka talking about the flat tax, a radical proposal for tax reform that would eliminate all deductions other than the personal exemptions and tax all income at a single rate. I was surprised to learn how popular the idea is around the world. There is little political enthusiasm right now in the United States for fundamental tax reform. Which is a shame. Wouldn't it be wonderful if all the talented people who currently help rich people avoid taxes were instead encouraged to something productive?

Taxing the Rich

The top 1% paid 37% of the income taxes in the latest numbers from 2004.

Ari Fleischer points out other interesting aspects of the US income tax burden and how it has changed over time. The problem with his analysis is that he sort of neglects payroll taxes. Why do I say "sort of?" Because he acknowledges the existence of the payroll tax but misses one key point:

The usual rebuttal made by those who support raising top rates is that lower income Americans pay Social Security and Medicare taxes and therefore need "relief." Of course they pay these taxes. But then, they alone get a good return on their money.

Top earners, on the other hand, pay payroll taxes so their money can be redistributed to others. According to the CBO study, the top 20% of workers, those with incomes over $64,300, pay 44.2% of the payroll tax while the bottom 20%, those who make less than $17,300, pay 4.2%. In return, when it's time to retire, lower-income workers typically receive more in Social Security benefits than they paid in, while the wealthy, who paid the most in taxes, simply can't live long enough to get back what they paid. For much of the middle class and the wealthy, Social Security isn't a retirement program -- it's another program that redistributes their income.

As for Medicare, it doesn't matter that the rich paid far more in taxes; all recipients receive the same benefits. Think of it this way. If Medicare were a car, its price for a low-income worker would be $145 and its price for a millionaire would be $14,500, even though it's the very same car.

Here's why. A taxpayer who makes $1 million a year pays $14,500 in Medicare taxes while a worker who makes $10,000 a year pays $145. But when they retire and visit their doctors or go to the hospital, Medicare reimburses both an equal amount of money. That's a pretty big redistribution of income and a pretty good deal for the low-income worker.

What he misses is that payroll taxes are not user fees. There is a pretense that they fund social security and Medicare. But they don't. They fund everything right now. Right now payroll taxes cover more than the cost of those programs. The difference goes to fund everything else. So to correctly measure the effective tax burden by income, you really should just roll payroll taxes into the income tax collections. Those are the relevant numbers for looking at the political economy of taxation. But Fleischer makes some interesting observations. Just remember he's leaving out the payroll tax.