Tuesday, November 13, 2012

The Dole and How to Swing It

I’ve given you the libertarian argument: screw you, it’s my money, and redistributing it according to your preferences rather than mine is robbery, plain and simple.  I’ve also given you the empirical economic argument that a larger welfare state makes us all poorer by leading us all to work less, as is the case in Europe.  This perhaps overstated the case –one might argue that an expansion of the welfare state, financed by taxing the rich, could leave the rest of us in between no better or worse off, and amount to a simple transfer from rich to poor.  That proposition seems to me to be the chief domestic policy promise of the Obama campaign.  If this proposition is true, and we are somehow unmoved by the libertarian argument that redistribution is theft, then the middle class can buy its virtue on the cheap by simply supporting the welfare state.  A vote for Obama establishes that you care; at bottom all you care about is having other people support the poor, but of course you get credit beyond this.  To the extent that middle class may have just done precisely this – bought its virtue on the cheap – it is about to find out that it will be a lot more expensive than it anticipated.

Raising taxes has 2 possible effects on labor supply decisions: 1) you work more because you need to work more to achieve the same standard of living (income effect); or 2) you work less because leisure, which cannot be taxed, becomes relatively more attractive (substitution effect).  A few posts ago I discussed the economic research that indicated the second effect dominates when the extra tax revenues finance transfers that provide to us things we would otherwise purchase for ourselves by working more, and therefore the tendency is for all to work less.  This is a dynamic that affects not just those at the bottom – it affects the vast set of people who receive middle class entitlements, such as education and retirement benefits. 

But the extent to which this dynamic is in play for different income groups is a function of how the taxes and benefits are distributed across groups, and of course the doling out of benefits is not uniform across income classes.  A new tax that is levied on only the rich to finance transfers to the poor does not change the tax picture for the poor, but it does change the tradeoff between work and leisure.  An unskilled laborer who can find a job in the market for $10 an hour views staying idle more and more attractive if the effective wage for staying idle increases.  To paraphrase Milton Friedman, the surest way to increase the supply of unemployed people is to pay them more money.  In my experience, I think that many liberals simply reject that such incentives really affect the labor decisions of the poor.  In their view, all people are earnestly seeking employment to earn a living and be self-sufficient.  That is, many liberals I know seem to think that such pride among the poor is there, and that the simple economic calculus does not apply to their labor decisions. 

Consider someone in that low-income set, with little education, busting to scratch out a living at a low wage rate, who sees a neighbor living at a similar standard with no hassles.  I think it would take a rather admirable level of pride for someone in that situation to eschew the easy path; we can all understand the frustration someone in that situation would feel in thinking that all of his efforts get him nowhere.  The only break against giving in to the obvious incentive to not work is pride – the desire to be self-sufficient and not dependent on others.  Rather than celebrating those cases where such pride has kept people off of the dole despite their hard work providing them little or no benefit over the dole – the federal government actively engages in efforts to argue people out of such pride.  There should be a stigma to being dependent – and indeed there is a stigma, otherwise the feds wouldn’t have to run around convincing people otherwise.

A too generous safety net, on pure economic grounds, creates a clear incentive to not seek employment – increasing the benefits derived from not working is equivalent to increasing the effective marginal tax rate for working – few of us face a situation with as steep a marginal tax rate as those at the lowest rung of the economic ladder.  For these people, there is basically no “income” effect from the decision not to work, and of course there is a huge substitution effect.  In supply and demand terms in the market for unskilled labor, the supply curve shifts to the left.  If demand is unaffected (a big if, as I will discuss), the wage rate for unskilled labor goes up, but total employment for unskilled labor goes down.  This may not show up as increased unemployment, because to be considered unemployed you have to be seeking a job.  Nonetheless, many people who are capable of learning on the job, becoming more skilled, and growing in income simply step off the ladder.   When you increase the benefits of the welfare state, you increase the number of people seeking to be beneficiaries via the reduction in labor supply. 

For those who pay – in this example the rich – there is nothing coming back to them in the form of a recycled benefit.  For them, both the income and the substitution effect are equally in play, and therefore there is a chance the income effect will dominate so that the rich do not decrease their work input, and tax revenues go up.  This is clearly the hope of the current administration.  I have made the argument that the substitution effect will dominate in these cases – that the rich will simply work less, and that the increased welfare state will require that the taxes trickle down to the lower income categories.  When I’ve made this argument to liberal friends, they reject that this is a likely response to increased taxation.  In this view, either the rich cannot scale back their labor (i.e. due to employer’s not allowing it), or their sense of vocation in their work makes them unresponsive to such incentives. 

If you consider a high paid employee of a bank, as an example, the increased tax rate may have no effect – he cannot say to his boss that he would like to cut back from 60 hours to 40 hours a week, otherwise he would simply be let go.  But in many cases that same banker will have a spouse, also well-educated and highly skilled, whose decision to work is much more malleable.  Entering the workforce, that person faces the 15 percent payroll taxes (yes, I know, the employer “pays” half of this – but this is the statutory incidence of the tax, not the economic incidence – it comes out of your pocket) right off the bat, in addition to coming in at the top marginal tax rate for federal (currently 35 percent) and applicable state taxes (let’s say 5 percent for arguments sake).  Prior to any tax increase from the current status quo, this person works half of the year to pay taxes.  But it’s worse than that, because that couple faces costs that it could otherwise avoid if one person stayed out of the labor market: child care or a nanny, increased commuting costs, increased wardrobe costs, increased stress, the likelihood of dining out more often, landscaping and other routine house maintenance costs.   The marginal tax rate for a well-to-do two income family can easily be over 75 percent – there is not a huge incentive for the spouse to work under those circumstances.  As a result, trying to inch up the marginal tax rate on this couple may eek a few more dollars out of the bread winner, while giving up all of the tax revenues it might otherwise receive from the spouse. 

So we have two problems right away – we’ve caused some people to drop out of the labor market to go on the dole, with the promise of having to increase only the taxes of the rich.  But the rich don’t play ball, and are likely to cut back their own supply of labor, which leaves tax revenues insufficient for the promised benefits.  There seemed to be only one platform objective of the Obama campaign – increase the taxes on the rich in order to finance the enlargement of the welfare state.  This is based on fantasy.  In order to finance the increased benefits, the taxes have to trickle down.  This trickle down can lead to yet more decisions to become a one income family, further reducing the tax base.

The story so far is all about the effects of the change in policy on labor supply for both rich and poor.  But that is not the whole story – recall the “non-tax” elements of the marginal decision for the spouse – all of the added expenses of going to work.  By dropping out of the labor force, the loss of the take home income is partially offset by avoiding exactly those transactions – the family commutes less, fires the nanny and housecleaning service, cooks at home, cuts the lawn themselves, etc.  All of these decisions reduce the demand for low-skilled workers.   This reduction in demand leads to yet lower employment numbers for the low-skilled workers, and increases the number of people on the dole.  And, of course, this requires yet more tax revenues.

The demand effects of trying to tax the rich are limited to low-skilled workers.  As a quasi-entrepreneur in a service business, scaling up and hiring employees is a decision that is affected by marginal tax rates.  The hope in any such hiring decision is that I can bill sufficient hours of the employee’s time so that I earn some profit.  The risk is that I cannot; and contrary to the Scrooge like image of businessmen firing employees as soon as things look grim, in my experience quite the opposite is true – the entrepreneur will hold on in the hopes that things will improve and delay the firing decision - especially for a well-liked employee.  That means that every employer understands there is a significant risk of loss in hiring an employee; you increase the taxes on the employer in cases where he makes a successful hire, and you’ve reduced the potential payoff to taking such risks.  Ergo, you take fewer risks.  This scenario is worse yet outside of service businesses, where significant capital investments are required as a precursor to hiring more people, and the risks of expanding employment increase significantly.  With less demand among business owners for laborers at all levels of skill, everyone is impacted negatively.

Rich people are like the rich kid whose parents get him the brand new leather basketball. You play by that kid's rules, or the kid takes his ball and goes home, and you don't play at all. If you tell him that half of his points won't count, or will count for the other team, he will surely pick up his ball and go home. You may not like that rich kid, but the game depends on him. If rich people don't invest, because they are rightfully afraid that any gains from the risks they take will be taxed away, we not only are deprived of the ball, we don't even have a court to play on.

There is a point where you can kill the golden goose.  Every communist country killed it long ago; the socialist welfare states of Europe haven’t entirely killed it, but they have it by the neck held under very cold water.  And yet such policies have an unbelievable degree of persistence, attributable to the simplistic Marxist view that the rich are in opposition to the poor.  As the simple logic of what I just conveyed plays itself out, people will double down on their strange belief that the rich are ripping them off.  It is the persistence of crappy economic policies that we need to fear. 


Anonymous Anonymous said...

Hatcher -

Spot on my man. I can personally vouch for a couple of your points in that Laura and I see where our tax rate is and that her working will ultimately lead to higher taxes and that there is no motivation for her to join in the workforce. We forego eating out and other luxary items that we might otherwise consider based both on this reduced earning potential and frankly the fear that the government will continue to take more away. In fact, we have taken a position that we will reduce/eliminate the charitable contributions we make as a response to the direction the countries heading in - let the gov't collect and dole the money.

An additional consideration is the impact changes to capital gains has on available/disposable income. We also watch this for tax rate purposes and will not convert stock gains simply to avoid the additional tax. As this tax rate is considered to be raised, you'll see two scenarios (neither of which are good for the country) - 1 - less dollars invested in capital (why should I get taxed twice at a high rate on money I've already been taxed on) and 2 - people simply will move their investments to investment arms that are better for taxes (probably a good thing for municipal bonds and other tax free investments).

8:57 AM  
Anonymous Ponikvar said...

As a liberal, I too am very worried about the entitlement culture in this country. But it’s not concern for the sense of entitlement the poor, elderly, students going to college, or Medicare recipients have regarding government assistance. I’m worried about the Leona Helmsley like sense of entitlement many conservatives display by railing against raising their tax rate to 40% to help reduce the debt. Conservatives would have you believe that our country is racing toward an economic precipice because Obama is wildly expanding entitlement programs that will bankrupt the country. But look at the data and you’ll see entitlement programs have very little to do with our economic problems.

No doubt, if we continue on the current path, without making any budget policy changes that affect revenue or expenditures, the amount of debt we’re projected to incur though the end of the decade is frightening. But, the fact of the matter is, according to Congressional Budget Office projections, an overwhelming majority of the debt we are currently projected to incur through the end of this decade is derived from (1) tax revenue shortfalls if the Bush era tax cuts are extended, (2) tax revenue shortfalls due to the on-going severe recession, and (3) ongoing outlays for the Iraq and Afghanistan wars. Extension of the Bush era tax cuts (a reduction in the top marginal tax rate from 40% to 35%) are, and will continue to be, the single largest contributor to our accumulation of debt by a wide margin, equaling an estimated 25% of GDP by 2019. The severe recession, which started during the waning years of Bush’s presidency, is also causing revenue shortfalls, for obvious reasons, and will equate to an estimated 15% of GDP by 2019. We’ll still be paying for Iraq and Afghanistan for years to come, totaling around 10% of GDP by 2019. While Afghanistan was necessary and fully justified, Iraq wasn’t. The Iraq war cost the U.S. dearly in terms of American lives lost (and hundred’s of thousands of innocent Iraqi lives), and hundreds of billions of dollars spent on a strategic blunder that will be written about for centuries to come.

While extensions for unemployment insurance, money spent to save teacher’s/fire fighter’s/policemen’s jobs, temporary increases in other mean’s tested programs as a response to the severe recession, and other stimulus spending will add to the debt long-term (approximately 8% of GDP by 2019), the amount pales in comparison to the issues I note above. I believe there’s a very strong moral argument to be made to incur debt now to help those less fortunate, but that’s a much larger argument I won’t address here. But, a great many conservatives believe, and want you to desperately believe, that all this newly accumulated debt is because we’re massively expanding incentives for lazy, unmotivated people not to work. But if you look at the numbers, you realize that’s absolute bulls*&t. Irresponsible Dubbya policies account for a vastly larger portion of the debt we’re projected to incur. Unless we roll back the tax cuts, which I address next.

John has laid out the argument for why supply-side economists and many conservatives think raising the top marginal tax rate is a bad idea. The basic argument is higher taxes on the wealthiest leads to lower tax revenue due to (1) a disincentive for some wealthy to work harder, thus they earn less income, which lowers the tax base, and (2) follow on demand effects causing lower income workers to lose jobs, or cut back on hours, resulting in lower incomes, which lowers the tax base.

Since WWII, there have only been two Presidents who raised the top marginal income tax rate. HW Bush raised the rate from 28% to 31% in 1991. As a result, conservatives threw a hissy fit, which ushered in Clinton, who further raised the top margin rate from 31% to basically 40% in 1993. The top marginal tax rate stayed at 40% through 2000, then fell slightly to around 39% in 2001 and 2002 until Dubbya reduced it to 35% in 2003.

8:12 PM  
Anonymous Ponikvar said...

If you believed in supply-side economics, you’d have to believe that the 1990s experienced a decade of anemic economic growth, falling income tax revenues, and high unemployment as a result of the HW Bush and Clinton tax hikes. In fact, none of that happened. Real GDP grew at an average annual rate of 3.4% over the 1993 – 2002 period, when the top marginal tax rate hovered around 40%. In comparison, it only grew by an average annual rate of 1.6% over the 2003 – 2011 period, under Dubbya’s lower 35% tax rate, which Obama extended. So, clearly the economy seemed to do just fine under a higher top margin tax rate of 40%. Data is taken from the OMB’s 2013 budget report.

What about unemployment? Supply-side economics would have you believe that raising the top margin tax rates results in higher unemployment. But the data show that didn’t happen either. The unemployment rate stood at 7.3% in January 1993, Clinton’s first month in office, and fell to 3.8% by April 2000. Not only did unemployment not go up under Clinton’s higher marginal tax rate, it was almost cut in half. When Dubbya took office in January 2001, unemployment stood at 4.2%. The unemployment rate rose to 6.0% by June 2003, and then fell and held fairly steady at 4.5% over the next four years, but then shot up to 7.8% by the time Obama took office in January 2009.

What about tax receipts? Same basic story. Income tax revenue rose by an average annual rate of 8.6% over the 1993 – 2001 period. Clinton raised the top margin tax rate in 1993, and income tax revenue jumped 7.1% that year. Under Dubbya, when the top marginal tax rate was lowered to 35%, income tax revenue rose by an average annual rate of 5.3% over the 2003 – 2008 period. Dubbya lowered the rate in 2003, and the government collected 7.5% less in personal income tax that year, so a -7.5% rate. Data is taken from the OMB’s 2013 budget report.

So, all of the key supply-side predictions regarding economic growth, unemployment, and income tax revenues aren’t supported by the facts. The recession following 9/11 is an extenuating circumstance that may affect some of these numbers. But, based on the 1990s, it’s hard to argue that our country will fall into some supply-side recession if Obama raises the rate from 35% to 40%. And as I stated at the beginning, if we don’t raise the rate back to 40%, the shortfall in tax revenues will be the single largest contributor to the national debt over the next decade.

In the last few years of Clinton’s second term, the government was running annual budget surpluses, which were predicted to carry on if his policies remained intact. But then Dubbya was elected, and f&ck#d everything up by lowering the top marginal tax rate, throwing us right back into budget deficits (to be fair, spending on going to war in Afghanistan and the smaller recession post 9/11 contributed to the deficits as well).

Also, if such high marginal tax rates are so destructive to economic growth, employment, and government revenue, then how did this nation continue to grow to become the largest, richest economy the world has ever witnessed when the top marginal tax rate was between 70% and 90% from WWII through to Reagan’s first year in office? I’m certainly not advocating raising the rate anywhere near 70%, but it seems clear high rates don’t put a choke hold on economic growth or wealth creation, or else the U.S. wouldn’t currently be the world’s largest economy.

I thought listening to conservatives whine about losing the election would be fun, but it’s really starting to piss me off due to their obfuscations and morally dubious arguments. Setting the moral arguments aside, based on the economic facts alone, the impending doom conservatives are predicting is nothing more than a hissy fit. In the end, if supply-siders want to take your basketball and pull an Eric Cartman by saying “screw you guys, I’m going home,” history suggests we’re going to be just fine without your magic job creating leather basketball.

8:17 PM  

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