Archive for November, 2012

Raising Tax Rates on the Rich: Some Empirical Evidence

November 29, 2012 1 comment

John Cochrane is an economist in the business school at the University of Chicago. He maintains a blog which I highly recommend (check out The Grumpy Economist), a blog which contains articles using a lighthearted approach to the analysis of economics issues. This blog contains some empirical evidence on the response of rich taxpayers to an increase in their marginal income tax rate (MTR).

The evidence comes from the United Kingdom where the MTR was recently raised to 50 percent. The evidence is that, within a year of the increased MTR, the number of UK residents reporting a very high pre-tax income declined from 16,000 to 6,000 (see this post). You may recall that, in a previous article, I suggested that revenues to be raised from the rich from higher tax rates are overstated. This empirical evidence shows why those estimates are too high.

The rich tend to be smart (think Bill Gates), and they can afford first-rate tax advice. They also have the ability to change the timing of their income. For example, there are now reports in the press that dividend payments are being accelerated into the current tax year when dividends will be taxed at a lower rate compared to next year. Finally, the rich can always change their country of residence. What is surprising to an economist is how rapidly the rich seem to respond to a higher MTR. Usually, economists argue that it takes time for economic agents to respond to a shift in incentives for the simple reason that time is required to process new information. This empirical evidence reveals how quickly the rich can respond to new incentives.

The moral of the story is that increasing the MTR on the rich will generate considerably less revenue than is assumed by the federal government. The Laffer Curve (the notion that higher tax rates reduce tax revenue) is alive and well at least as far as the rich are concerned.

Tax Rates and the The Fiscal Cliff

November 26, 2012 2 comments

The public has been deluged with reporting about the “fiscal cliff” and I admit to some concerns about my contributing to this barrage of information. But while there has been, as usual, lots of reporting about the business cycle effects of the fiscal cliff, I have seen little systematic analysis of exactly what will happen without action by the federal government.

The Tax Policy Center of the Urban Institute and the Brookings Institution has provided what appears to me to be the most thorough analysis of what will happen to tax rates if the federal government does not act. The complete analysis is Toppling-off-the-fiscal-cliff but this is likely to be overkill for most readers. To simplify, I have extracted Tax-Tables-Toppling-off-the-Fiscal-Cliff from the report so that readers can see the effect of federal inaction on personal income tax rates. You will note that nearly every tax bracket will rise by about ten percent. And note that these are marginal tax rates which are the tax rates that affect economic incentives. Thus the returns to saving, investment, and labor supply will go down for nearly every taxpayer.

In addition, the Tax Policy Center report notes that there will be additional tax increases associated with estate taxes, Social Security, the Alternative Minimum Tax, and Obamacare (and this is not an exhaustive list of all tax increases that will occur) so that 90 percent of all taxpayers will see an increase of some sort in their tax bills. What will be the consequences of these increase in tax rates? There will likely be a recession next year and real output will fall permanently (see my previous post on this subject). But there is a larger issue underlying all of this.

The President has stressed raising tax rates on the rich. There are estimates in the media that he wants an increase in tax rates that would generate about $80 Billion in additional tax revenue. In the first month of the federal government’s fiscal year, the federal government deficit was $120 Billion. So even if the tax revenue forecast is accurate (and it is almost certainly an overestimate), the tax increases favored by the President will not cover even one month of the federal government’s deficit. This illustrates the magnitude of the financial problems that we face as a nation.

The public must realize that, without entitlement reform, the entitlements promised by the federal government will require higher tax payments by all taxpayers if we are to avoid insolvency. It is simply delusional to think that a tax increase on the rich will solve our financial problems. Is the public ready to pay more? Your guess is as good as mine.

Price Controls and the Drug Industry

November 20, 2012 1 comment

In an earlier blog post, I pointed out that price controls imposed by the federal government were causing shortages of drugs designed to fight cancer. Cancer Drugs and Price Controls is another article describing the shortages caused by government-imposed price controls. While it is routine for economists to point to shortages as a consequence of price controls, there is another problem caused by price controls that often gets much less attention. Price controls can cause firms to cease production of the product subject to price controls.

Awi Federgruen is a faculty member at Columbia University. In The_Drug_Shortage_Debacle, Professor Federgruen points out that in 1967, there were 26 firms producing drugs in the U.S. whereas, today, there are only six. The managers of publicly-owned firms have a fiduciary responsibility to earn profits for the benefits of stockholders, the owners of the firm. If price controls make it unprofitable to produce a drug subject to price controls, the only rational response by the firm’s managers is to cease production of unprofitable drugs. To do otherwise would result in the firing of the managers responsible for the production of unprofitable drugs and these managers may even be subject to lawsuits by the stockholders who have incurred these losses. As firms leave an industry due to price controls, shortages grow in size as fewer and fewer firms are willing to produce drugs at the controlled prices.

In addition, the production of drugs must now be authorized by the Federal Drug Administration (FDA). If there are production problems that cause production to shut down in one firm, another firm cannot increase production until the FDA authorizes the additional production. Any bureaucratic delays at the FDA may also result in shortages.

These articles underscore the fact that the drug industry in the U.S. is now heavily regulated, much like it would be in a socialist or centrally-planned economy. It is not shocking to an economist that centrally planned industries are subject to shortages, containing firms that cannot respond to market incentives. These are precisely the types of problems caused by central planning.

Obamacare Taxes and Labor Markets

November 12, 2012 5 comments

Now that the election is over, the country continues to have divided government with the Republicans controlling the House and Democrats retaining control of the Senate and the Presidency.  As a result, Obamacare will not be repealed so the tax and spending effects of Obamacare will take effect beginning in 2013. One tax imposed by Obamacare is on medical device manufacturers.

Obamacare imposes a 2.3 percent tax on gross sales by these firms. This is a very simple tax to analyze using basic economics tools. The tax reduces the return to using labor in production since the government now takes a fraction of these returns. An optimizing or profit-seeking firm will use less of an input in production whose return has declined and so economic theory predicts a decline in the demand for labor. That means less labor used in production and thus there will be layoffs in the medical device industry. There is now accumulating evidence that these layoffs have already occurred, with more to come.

Freedom Works has compiled a list of firms that have announced layoffs as a result of this new tax. It appears that thousands of workers will lose their jobs and the article also points out the possibility that many firms will reduce their full-time employees, converting many to part-time status so as to avoid having to pay for health insurance.

In this blog, I plan to keep track of the additional economic wreckage caused by Obamacare in the future.

Tax Rates and Labor Supply

November 9, 2012 12 comments

With the election over, the political discussion has now changed to the government deficit and the impending increase in tax rates called the “fiscal cliff.” As part of this discussion, it is necessary to know how tax rates affect the labor supply decisions of the public so that, if tax rates are increased, political leaders will know the impact of higher tax rates on economic activity. The Congressional Budget Office (CBO) has provided a timely survey of empirical evidence by economists on the relationship between tax rates and labor supply.

First it needs to be stated that economists are interested in measuring the effects on labor supply of marginal tax rates. The marginal tax rate (MTR) is the increase in taxes paid in response to a one-dollar increase in pre-tax real wages, a number between zero and unity. Marginal tax rates are important for incentives in the labor market because variations in the MTR will change labor supply decisions. Economists assume that households are interested in what their money wages will buy in terms of goods and services so it is the after-tax real wage that affects labor supply decisions.

Second, it is important to state that economic theory does not say how labor supply will vary with the after-tax real wage. The reason is that there are conflicting substitution and income affects associated with changes in after-tax real wages. If the after-tax real wage rises, another unit of leisure (time spent not working) has become more expensive in terms of lost income so people substitute more labor supply for reduced leisure. But a higher after-tax real wage also makes the household richer which is likely to cause the household to take more leisure. The end result is that it takes empirical evidence to settle the issue of how tax rates affect labor supply. Read more…

Hurricane Sandy and Climate Change

November 2, 2012 4 comments

One of my pet peeves as a professional economist is how often I see individuals do economic analysis despite the fact that they have absolutely no credentials in the social science of economics. I regularly hear lay persons say economic nonsense when they do economics “without a license” but occasionally they do get it right. These expressions of ignorance occur with respect to other academic disciplines as well and climate science is one area where the public is regularly offered the opinions of individuals with no professional credentials in the field.

I recently observed comments in the media by Al Gore and Michael Bloomberg, neither of whom has professional expertise in climate science, that Hurricane Sandy provides evidence of climate change. There is absolutely no reason why any of us should be interested in their opinions on this subject, any more than we should be interested in their opinions on what medical treatment we should receive to cure any of the ailments that we have. We should be interested in the opinions of practicing professionals in the field of climate science and Roger Pielke, a professor at the University of Colorado, has recently written (see his article on hurricanes) on the lessons to be drawn, if any, from the latest hurricane to come ashore in the U.S. There are several noteworthy aspects of his article.

One is that he practices economics without credentials in the field but, in this case he gets it right when he says that by providing taxpayer-backed flood insurance at below-market rates, the government encourages people to locate in risky areas. That is, the insurance provides an incentive for individuals to take on more risk. I have previously written about this phenomenon on this blog when I discussed the economic notion of moral hazard. So this program by the government illustrates the perverse effects of economic incentives and, in the case of this program, we learn that the insurance results in riskier behavior by the owners of the insurance as compared to what the owners would do if they purchased unsubsidized insurance in private markets. Read more…

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