Pigou and the Anthropophagi

Why does the salmon here cost more than the chicken? There ought to be a tax on chicken.

Why?

On chicken and meat and eggs and dairy products.

Why?

Because farm animals are bad for the environment.

How?

They contribute to global warming.

How?

They produce methane, which gets in the atmosphere and adds to the greenhouse effect.

People produce methane, too, you know.

That's why I think there should be a tax on people also. Cannibals need more vegetables in their diet anyhow.

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

Tax That Guy Behind the Tree

Megan McArdle is right (here and here), and Henry Farrell and Mark Kleiman are -- perhaps not exactly wrong, but as far as I can tell, they are either misunderstanding what she says or quibbling on minor points of semantics while apparently believing themselves to have a substantive point. The question is, "Do people want their own taxes raised?" My answer comes more from introspection than from logic or economics. Perhaps Henry Farrell and Mark Kleiman want their taxes raised, but I certainly don't want mine raised. However, I am willing to have my taxes raised in exchange for certain things that I do prefer -- in particular, I'm willing to have my taxes raised in exchange for an increase in everyone else's taxes.

I want to make it quite clear that I will oppose any law that tries to raise my taxes by $300 -- unless that law also contains provisions that I support and that are worth $300 to me. Would a provision requiring my compatriots to kick in a total of $6,000,000,000 to the National Science Foundation be sufficient to gain my support for the package? Hell, yes! I would support the package because the provision that I like (a $6,000,000,000 increase in taxes from everyone else, to finance the NSF) far outweighs the provision that I don't like (a $300 increase in my own taxes). That doesn't mean I like paying $300 more in taxes. When I refuse to make an autonomous contribution to support NSF-like research, I am indeed revealing my preference for not paying more taxes. (And by the way, if someone proposes to exempt, say, people who were, as of February 2008, blogging using a vowelless pseudonym, from a new tax, I will support the amendment, because I really would prefer not to pay more taxes.)

It seems to me that much of the popularity of the anti-tax movement that began with Reagan-Kemp-Roth (or did it begin with Kennedy-Johnson?) was based on an appeal to people's genuine preference for lowering their own taxes, combined with a sort of mental cover-up of the implications of taxing other people. Basically, get people to think about the $300 question and ignore the $6,000,000,000 question. On the pro-tax side, it is precisely the failure to acknowledge that people don't want to pay higher taxes that made it difficult to counter the appeal of the anti-taxers. The pro-taxers insistence on philosophical mumbo-jumbo about collective action and such covered up the fact that they had a very strong common-sense case that they were somehow unwilling to press.

There is a valid concern that revenue doesn't quite rise linearly with tax rates and that high taxes can produce certain economic inefficiencies, but to me the basic math has always looked very good for taxes (in a large country like the US): even if the money is spent very inefficiently and not on my own priorities, $6,000,000,000 is a hell of a lot. The government would really have to make an incredibly huge mess of its spending in order for that not to be worth $300 to a reasonable person. (But again, if you could get it for free, that would be even better.)

Marginal Taxes on the Rich

In response to the opening sentence of my last post, Greg Mankiw asks:

Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?

I'll outsource the first part of the answer to "a student of economics," who comments on Greg's post via the comments section of my last post:

Greg asks the wrong question in an effort to get the answer he seeks.

The correct question should be, "would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

It's not clear that I would do anything different if all my options improved by the same amount. There are only so many hours in day. In fact, perhaps I would actually work less and play more if I were twice as rich (assuming, of course, all gov't services magically continued without cost).

I do recall once having two job offers at comparable pay, and I'm sure that, if the one I rejected had paid twice as much, I would have taken that one instead. But it's pretty obvious that has nothing to do with taxation; it has to with what other opportunities are available. If both jobs had paid twice as much, I would have made the same choice that I did.

Part-time opportunities are a separate issue. I don't have a clear memory on this point, but it's quite possible that I've turned down consulting work that I would have accepted if it paid twice as much (though again, if all opportunities paid twice as much, I'm not sure how the income and substitution effects would sort out). In my case, though, the example (if there is one) would make my second point: that the incentive effects of higher marginal tax rates are not all bad. If I did turn down an assignment, it would be a job in support of one side or the other in a legal case or an interest arbitration. Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high. In this case, the tax is Pigovian, and I'm confident that it's nowhere near high enough to equate the private rewards with the social value of such work. I've made a similar point before.


[UPDATE: Boy, my two sentences introducing a different topic are generating quite a large tangent. PGL at Angry Bear has this to say.]


UPDATE2: In a Update, Greg gets into the whole income and substitution effects business and argues that he is asking the right question because he is isolating the substitution effect, which is what matters for deadweight loss. But for most real-life examples, he's still wrong. It's fairly obvious in my example of having two job offers, but it's true in a lot of more subtle cases too, that one is not really making a substitution between labor and leisure; rather, one is substituting one labor opportunity for another. Usually, one doesn't have a firm offer for the alternative opportunity, but one has some reasonable idea of what opportunity may become available. If a job offer gets doubled, it becomes unrefusable simply because one will never get another offer so big.

It's true that, to the extent that one has marginal opportunities, as in my consulting example, there may be labor-leisure tradeoff, but even there to a large extent it may actually be an intertemporal tradeoff between different labor opportunities given a more-or-less fixed amount of total leisure over time. And I would reiterate my point that the taxes in these marginal cases are often Pigovian.


[UPDATE3: While we're on the topic, let me point back to this post in which I argue that progressive taxation (though not high overall taxation) can actually encourage entrepreneurial activity.]

Marginal Taxes on the Poor

I've always been skeptical of the importance of the purported bad incentive effects of high marginal tax rates on high income earners. (I won't go into the details now, but I don't think the incentive effects are very strong -- at least at tax rates close to current tax rates -- and I don't think they're all bad.) For some time, though, I have been concerned about the effects of effective marginal taxes on low income earners. The problem is not the taxes they pay to the IRS (which they mostly don't, anyhow) but the effective taxes they pay to various subsidizers, price discriminators, and assistance providers in both the public and private sectors.

It has worried me that there might even be some point on the lower part of the income spectrum where the effective tax rate is greater than 100%. That is, you get more income; you no longer qualify for various assistance and subsidies; you slide up the "sliding scale" of various vendors and service providers who (officially or unofficially) give discounts for the financially challenged; you pay more in FICA and state and local taxes (even if you still don't pay Federal income taxes, which you might); and you end up worse off (even leaving aside any reduction in leisure) than when you had less income.

It turns out this was more than a theoretical possibility. Jeff Frankel (hat tip: Greg Mankiw) quotes Jeff Liebman with a story about a woman who "moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more." In her case it wasn't until after the (apparently irrevocable) decision that she discovered what a bad deal it was to make more money, so maybe the incentive effect per se wasn't a problem, but even someone like me, dubious as I am about "justice" as a moral concept, has a sense that this woman has been cheated and that what happened is "wrong." And eventually we have to assume that the incentive effects will matter: presumably Abraham Lincoln was right that you can't fool all of the people all of the time. Moreover, the incentive effects will matter even when the effective tax rate is "only" 80% or 90%. And it can only get worse when we begin to attempt universal health care on a national level.

In theory the solution is to consolidate all forms of public (and ideally, private) assistance into a single, fairly large grant, which can then be taxed away via the income tax at a reasonably slow rate for people who don't need it. That obviously isn't going to happen, and I don't have any other solutions to offer, but Jeff Frankel notes in passing that Jeff Liebman is an economic advisor to Barrack Obama. Given that Senator Obama is now the (not quite odds-on, as of this morning) favorite for the next presidency, I'm heartened that at least one of his economic advisors is thinking about the problem.


[UPDATE: My next post deals specifically with the issue raised in the first two sentences about high income earners. I guess it's hopeless, though, for me to get people to break that thread here and post comments on that more relevant entry.]

The Pigou Club on YouTube

This video was posted several months ago by Razela (i.r.l. Jamie Bernstein, but not apparently Leonard Bernstein's daughter of the same name) on YouTube, as a response to a video by Bill Richardson asking for ideas about energy.



She also has a blog with embedded videos, but I couldn't find this one on her blog.

Note to Congressional Democrats

(This means you, Senators Edwards and Clinton.)

If Congress passes a stimulus package full of new programs and all sorts of bells and whistles and tinsel and lights and stars and angels and golden balls with glitter on them, one that President Bush is almost certain to veto, and one that he, given his ideological preferences, could very easily justify vetoing, and indeed would have a hard time justifying singing signing, then it will be your fault, not his fault, if the recession turns out more severe than expected. I will hold you responsible. I suspect that voters will hold you responsible too.

If, on the other hand, Congress passes a simple if imperfect stimulus program that works on the revenue side -- say an across-the-board one-time tax rebate -- one that President Bush may not be happy with but will have a hard time justifying a veto, then if he does end up vetoing it, that will be his fault -- and all the more reason to elect a Democratic president. And if he signs it, well, I guess you'll just have to take the risk that the stimulus will actually work and that it will make things look a little better on election day than they otherwise would. A non-recessionary economy in 2008 -- seems to me that's a risk worth taking.


[Update: I should proofread these posts better. I don't think we're going to be seeing "Recession -- The Musical" any time soon.]

[Update2: ...and I should check my facts, too. Brock points out in the comments section that John Edwards is no longer in the Senate. Edwards does seem to have his own stimulus plan, though, and I hope he isn't thinking that it can wait until 2009 to be implemented. I guess I should include Senator Obama in my warning, too, but his suggestions have come closer to the sort of thing of which President Bush would have trouble justifying a veto, so I kind of felt he didn't need to be warned.]

Social Security

According to Greg Mankiw,

Concern about social security's future comes not from decades of scare-mongering by conservative ideologues but from decades of dispassionate analysis by some of the best policy economists.

He cites a 1998 statement by Bill Clinton and another by President Clinton’s Advisory Council on Social Security. Greg certainly has a point that Paul Krugman is stretching by using the word “decades,” since 1998 was less than a decade ago, and there were, at the time, clearly many relatively liberal policy analysts who were concerned about the future of Social Security (though I think the most vocal expressions of concern came from conservatives). But I think Greg is also being a bit disingenuous here.

Though I know little about the details of Social Security projections, I know something about the assumptions that go into them, and those assumptions, I’m pretty sure, have changed dramatically between 1997 (when the Advisory Council published its report) and 2007. The title of the report is “Report of the 1994-1996 Advisory Council on Social Security,” which suggests that the analysis was done before 1997, at a time when the US productivity slowdown that began in the 1970s still appeared to be an ongoing process. When productivity grows slowly, the outlook for Social Security looks bad.

Starting in the mid-1990s, but not fully apparent in available statistics until the decade was drawing to a close, US productivity accelerated to growth rates not seen since the 1960s. Productivity in the early 2000s appeared to accelerate even further. Over the past couple of years, productivity has appeared to decelerate again, but this deceleration is at least partly a cyclical phenomenon that is not expected to last (and, for the last two quarters, I might add, productivity has accelerated again, although that acceleration is also suspect). Certainly the average expectation of economists today would call for much faster productivity growth in the future than did the average expectation in 1996. When productivity grows quickly, the outlook for Social Security looks fine.

One could, however, make the point that, if we want to be honest with ourselves, we really don’t have much of a clue whether the Social Security system is in trouble or not. Any expectation – high, low, or in between – about the future rate of productivity growth is scarcely more than a slightly educated guess. To be truly conservative, we should make the worst reasonable assumption (based still on only a slightly educated guess as to what range of assumptions is reasonable), and use that assumption in the analysis, which will then tell us that Social Security is in trouble. So on this issue at least, the conservatives (and Barrack Obama) really are being conservative.

But I still have a problem with Senator Obama’s conservative position. As I understand it, the Medicare system fails even under fairly optimistic assumptions about productivity. If you make the assumptions bad enough to make Social Security require significant changes, you’ve made them so bad that the Medicare system requires a complete overhaul and damn near goes broke anyway. Given our limited analytic and political resources in coming up with and implementing solutions to these problems, doesn’t it make sense to spend those resources in such a way that we at least have a chance of coming out OK – that is, spend them on a Medicare overhaul that is almost surely necessary, rather than on a Social Security overhaul that may or may not be necessary?

Health Care Problems Exaggerated?

I’m a bit confused by Greg Mankiw’s latest blog post on the subject of health care. He seems to be arguing that, aside from redistribution issues and the perception of rising prices, the problem is relatively minor. (“...the magnitude of the problems we face are often exaggerated by those seeking more sweeping reforms...”) I suppose Greg regards the actuarial insolvency of the Medicare system as a problem of smaller magnitude than those alleged by reformers, or perhaps as a purely demographic problem that is only nominally related to the health care issue. But it seems to me, if the government has made a commitment to pay for certain things, the fact that the prices of those things are rising rapidly – regardless of whether quality is rising faster than prices – is a big problem.

I agree with Greg’s contention (in his New York Times piece) that it can be perfectly rational to spend a larger and larger fraction of our income on health care, but that doesn’t change the fact that, under current institutional arrangements, figuring out how to pay for it is a big, big problem. To put my point a little differently, those “pundits of the left” who pretend to be concerned about the health care system but really have a redistribution agenda, they would seem to be holding some pretty good cards right now, given that the government has already promised more free health care than it will be able to deliver under current fiscal arrangements.

When Greg asks the question, “What health reform would you favor if the reform were required to be distribution-neutral?” it is impossible to answer without making an assumption about how the distributions will be worked out under the current system. One possible assumption is that the Medicare problem will be solved by means testing. If so, one objection I have to the current system is that it will distort saving incentives by means-testing away the wealth that people have saved. That is an efficiency problem, not a distribution problem, but it’s hard to think how one might address that problem in a way that is both distribution-neutral and politically feasible. I believe (though Greg may disagree) that taxing rich workers is more efficient than taxing middle-class capitalists, but clearly that change is not distribution-neutral. I also believe (and Greg will probably agree) that taxing middle-class workers is more efficient than taxing middle-class capitalists, but…like that’s gonna happen.

I suspect that Greg is wrong about the motivation of radical health reform advocates. Redistribution, I would argue, is not the reason for health reform but the way to sell it. Somebody’s going to have to pay for Americans’ future health care, and if you say you’ll make the rich pay for it, the non-rich majority will be more willing to listen to the rest of your ideas.

I also suspect that Greg is wrong about why Americans are unhappy with the current system. I personally don’t mind rising prices, but I am unhappy with the current system. What makes me most unhappy (and has ever since I graduated college during a recession and had to apply for individual health insurance because I didn’t have a job yet) is the insecurity of it. Group health insurance (which most Americans get through their own or their spouse’s employer) is expensive but not prohibitively so. Individual health insurance is on average somewhat more expensive, but the problem is not the mean; the problem is the variance. If you don’t have access to group health insurance, there is no guarantee that you can be insured for any price.

There’s a distributional issue that’s important to me, too, but it’s not the rich vs. everyone else distribution that Greg talks about. And it isn’t the poor (in general) vs. everyone else either: the poor already have Medicaid. The category of people that I worry about are those who are poor, or who become poor, specifically because they (or people in their families) are sick. In some cases, it is probably their own fault for passing up health insurance when it was available. In other cases, I imagine, they never had a chance to become insured, or their insurance was cancelled.

No doubt the breadth of both of these problems – the problem of insecurity and the problem of people who are poor because of large health expenses – is exaggerated in my mind, but they make me very uncomfortable with the current system. And I don’t sense that the virtues of the current system (compared to those in other industrialized countries) are sufficient to justify the existence of these problems.

Incentive Effects of Progressive Taxation at the High End

Does progressive (labor) taxation at the high end reduce the incentive to engage in high-value activities? It seems to me that (to the extent that highly lucrative activities really are high value) it actually increases the incentive. Most of the people with the highest compensation -- movie stars, star athletes, CEOs of large corporations, successful hedge fund managers, successful entrepreneurs, etc. -- have that high compensation not just because of decisions to engage in (ostensibly) high-value activities but because of a combination of an intentional occupational choice decision and unpredictable outcome of success in that occupation. The ones who made the same occupational choices but weren't so successful -- ordinary actors, minor league athletes, middle managers of large corporations, hedge fund managers without a lot of assets under management, entrepreneurs with limited or no success, etc. -- don't get that ultra-high compensation.

How could the tax code encourage people to undertake these activities? If people were risk-neutral, the progressivity wouldn't make much difference, since any increase in taxation of the high rewards for being successful would be offset by a decrease in taxation of the lower rewards of being not-so-successful. But economists usually assume that people are risk-averse. If so, progressive taxation encourages people to enter high-risk, high-value occupations, because it provides a form of insurance for people who choose to do so. If you're successful, you make gobs of money, and you have to pay a lot in taxes, but you still end up with gobs of money; if you're not so successful, you don't make so much money, but you get an insurance payment in the form of a reduced tax bill. If the government were explicitly providing an at-cost insurance policy for actors, athletes, business people, hedge fund managers, and so on, I don't think there would be much question that the policy would encourage, rather than discourage, entry into these occupations.

Democratic and Republican Approaches to Social Security

Democrats want to raise the income ceiling to pay in, while Republicans want to means test payments. In other words, Democrats want to tax labor (since social security contributions are determined by labor income), while Republicans want to tax capital (since most of the recipients’ additional income, which would be subject to means testing, is income from capital, either directly or indirectly). So, remind me again: which party is the workers’ party, and which is the capitalists’ party?

Fiscal Policy and Changing Times

To anyone who is familiar with opinions I expressed (in real life) about fiscal policy during the 1980s and 1990s, it may appear that my opinions have changed dramatically, or indeed, that I have completely reversed myself. In particular, anyone who knows what I thought of the Reagan tax cuts (and how harshly a coauthor and I expressed it even 15 years later) will probably be surprised to hear me defending the Bush tax cuts even as Alan Greenspan tries to disown them (not to mention that I spent six posts last year on why I'm not convinced by various arguments for cutting the deficit and one on why the one convincing argument doesn't apply for the immediate future). But I don’t believe my opinions have changed much; what have changed are the economic conditions.

In particular, nominal interest rates have generally been much lower during the new millennium than they were during either of last two decades of the old millennium. (I have a vivid memory of walking through Kenmore Square in Boston in 1992 reading in the Wall Street Journal that traders weren’t willing to buy 10-year treasury notes at a yield below 7%. Today the notes yield 4.6%, and people are surprised how the yield has risen since the Fed meeting.) As I argued in two posts in July, nominal interest rates determine both the harm and the good that can potentially be done by budget deficits. When nominal interest rates are high, deficits are unambiguously harmful. When nominal interest rates are low, deficits may still be mildly harmful, but they can also be helpful and can even become critically necessary when rates fall to near zero.

This all seems to me a fairly straightforward application of textbook macroeconomics: when interest rates are high, budget deficits push them higher and crowd out private investment; when interest rates are low, budget deficits can provide a useful stimulus to keep employment high and avoid deflationary conditions, since monetary policy may not be able to provide a sufficient stimulus. Of course it’s more complicated for an open economy, but the same argument applies to the world as a whole, and the US is a big part of the world economy.

How to Solve the National Debt

More about knzn fiscal policy

Thanks to Mark Thoma for picking up my last post. I think I could fill my blog for a month with daily posts responding to Mark’s comment, the comments on my blog, and the comments on Mark's blog. For today, anyhow, I’m just going to address one issue. As Mark notes:

…there are two separate issues here, one is stabilization policy and for that part of fiscal policy I have no problem with requiring that the budget be balanced over the business cycle. The other is investments in, say, human and physical capital…

I’ll certainly agree there are (at least) two issues, and maybe in the future I will comment on how the two interact. For now, I want to address the first issue.

From a pure stabilization point of view, I don’t think that balancing the budget over the business cycle is a good idea, in part for reasons already discussed in my previous post, and in part because I’m not even sure I believe in the whole concept of a “business cycle” per se. Business, and the macroeconomy, unquestionably has its ups and downs, but so does, for example, the stock market. We don’t normally speak of a “stock market cycle” (although some people do). There are recessions, and there are depressions, and there are inflationary booms, and there are non-inflationary booms. Recessions are limited by definition, but depressions can persist for many years. Inflationary booms are self-limiting, but the jury is still out on non-inflationary booms. Even if recessions and inflationary booms were the only phenomena, they can’t necessarily be expected to alternate: you could have 3 recessions in a row, separated by incomplete recoveries, and followed by 2 inflationary booms in a row, separated by a “soft landing.” The word “cycle” suggests a symmetry which is not, in general, present.

On the purely semantic point, I can accept the use of the word “cycle” for want of a better term, but the argument to balance the budget over the business cycle seems to rest on a substantive presumption of symmetry. It presumes that the stimulus needed during times of economic weakness will be exactly compensated by the excess revenue available during times of economic strength.

You might argue this symmetry must apply in the very long run, because the government has to satisfy an intertemporal budget constraint. Even that point is debatable: in the very long run, the government’s budget constraint applies only if the interest rate is at least as high as the growth rate. Otherwise, if you look out far enough into the future, there will always eventually be enough revenue to pay off any debt the government might accumulate over any finite stretch of time. Some have argued that, empirically, the government typically has faced an interest rate that is less than the growth rate.

But that’s not really my point. I’m cognizant of Keynes’ famous warning about excessive concern with the long run. And a single “business cycle” isn’t much of a long run, anyhow. Conventional business cycle theory might argue for a certain symmetry based on the characteristics of the Phllips curve, under the assumptions that the curve is linear in the short run and vertical in the long run. Under those assumptions, deviations from the NAIRU in one direction are always compensated – let’s say in the medium run – by deviations in the other direction. For the sake of argument I’m willing to accept the vertical long-run Phillips curve, but the linear short-run curve seems to me to be more an econometric convenience than a credible assertion about reality. Back when people believed in static Phillips curves, they used to plot the curves. I’ve seen reproductions of such plots, I can’t remember ever seeing one that looked like a straight line.

Even if (counterfactually) the business cycle is symmetric, it isn’t well-defined, at least not until after the fact. The NBER can’t make the government retroactively balance the budget once it decides what the business cycle dates were. Even if our goal is to balance the budget over one “cycle,” there is no obvious policy that would result in such a balance. The closest we could come is perhaps to require the budget be balanced over, say, 5 calendar years, but that strikes me as a very bad policy: during the first 3 years, we won’t know in advance whether the next 2 are going to be stronger or weaker economically, so we won’t know whether to run a deficit or a surplus. Knowing Congress, I expect the tendency would be to declare the first 3 years a recession and run deficits, which would then require surpluses during the last 2 years and result in an actual recession.

So here’s my alternative proposal: pick a set of interest rates and make fiscal rules contingent on those interest rates. For example, when the 10-year Treasury yield rises above 4%, a deficit ceiling goes into effect; when it rises above 5%, pay-go rules go into effect; when it rises above 6%, a surtax and specific spending restraints go into effect; and so on. We can quibble about the details, and in any case they can be adjusted later if necessary. But this policy makes a lot more sense to me than some attempt to handicap a vague business cycle (or for that matter a vague “trend” in the debt-to-GDP ratio, which can also be hard to identify without benefit of hindsight).

Keynesian Fiscal Policy

A conventional “Keynesian” view of fiscal policy holds that the government should run deficits when the economy is weak and surpluses when the economy is strong. Some commentators suggest (as Andrew Samwick does here; hat tip: Brad DeLong) that the budget should be balanced over the business cycle, with no net accumulation of debt. I consider myself a Keynesian, but I think this conventional view is consistent neither with that of Keynes himself nor with what we have learned in the subsequent years.

My alternative view, which I submit for Lord Keynes’ posthumous approval, is that fiscal policy should depend on nominal interest rates. When interest rates are high, for example, it makes no sense to run deficits no matter how weak the economy is. When interest rates are high, the central bank has the option of stimulating the economy by creating more money and pushing interest rates down. If it isn’t doing so already (which, by assumption, it isn’t; otherwise interest rates wouldn’t be high), either the central bankers aren’t very smart (in which case why should we expect the fiscal authorities to be any smarter?) or else they are deliberately keeping the economy weak for some reason. In the latter case, they can be expected to react to any anticipated fiscal stimulus by tightening monetary policy and raising interest rates even further. Indeed, this is just what the Fed did in response the Kemp-Roth tax cut in 1981. I would have recommended running a surplus instead of a deficit under those conditions, even in the depths of the 1982 recession. A fiscal surplus would have minimized the damage done by the tight money policy, and, my guess is, it would not have slowed the recovery materially, because the weak demand would have brought inflation down more quickly, and consequently the Fed would have loosened more quickly.

Now consider an example where interest rates are low. In this case the central bank has the option of slowing down the economy by tightening the money supply and pushing interest rates up, but it may not have the option of stimulating the economy by creating more money and pushing interest rates down. If interest rates are already low, there isn’t much room to push interest rates down, and the stimulus that can be accomplished by this process may be inadequate. And the business cycle is not very predictable. Therefore, even if the economy appears to be growing adequately today, there is no guarantee that it will be doing so tomorrow. In times of low interest rates, fiscal policy should plan for the possibility of a recession by running a deficit, even if economists don’t see a recession as a strong possibility (which, after all, they seldom do, but somehow recessions happen anyway). As long as the central bank isn’t worried about a recession, it can use monetary policy to prevent the economy from overheating, but if it does begin to foresee weakness, it will have room for a stimulus, since the budget deficit will have prevented interest rates from getting too low.

You might object, “What if interest rates stay low and the government keeps borrowing money? We don’t want to pass on these debts to our children (at least Andrew Samwick doesn’t).” My answer – and I think Keynes would have agreed – is, “So what?” For one thing, if interest rates are low, the cost of running a deficit is low. In fact, it can be argued that there is no cost to running a deficit when the interest rate is lower than the growth rate, because the revenue available to pay back the debt will be greater (relative to what needs to be paid) than the revenue available to avoid a deficit in the first place. My own belief is that marginal return on government investment will be sufficient to justify spending levels under these circumstances, but even if it isn’t, the harm done is not great. The harm done by not running sufficient deficits could be quite substantial. And recalling historical periods when interest rates remained low and the government continued borrowing money – the 1930s-1940s in the US and the 1990s-2000s in Japan – I don’t think they regretted the borrowing, and I think most economists would say they didn’t borrow enough.

Plus, I have a more fundamental objection to the idea that passing on debts to our children is unfair. Those who have read my blog from the beginning will feel a sense of déjà vu here, but: Is it unfair to bequeath your children a house with a mortgage? I don’t think so. And I expect there will always be a “house” to go along with the “mortgage” our government leaves to future generations of Americans. In the past it has almost always been the case (across times and places) that each generation left more net economic wealth to the following generation than it had received from the previous one. And in those rare situations where this wasn’t the case, it wasn’t because the generation in question had borrowed too much. My guess is it will continue to be the case in America’s future. If our generation does fail subsequent generations, it will perhaps be because we didn’t spend enough on finding solutions to global warming (or other problems that may plague future generations); it won’t be because we borrowed money to pay for those solutions.

Ways Fiscal Policy Can Cause Inflation

1. portfolio effects. I discussed this mechanism in my last post.
   
   
2. gradual loss of confidence in financial assets. (This could be considered an example of, or a justification for, portfolio effects, but I’ll treat it as a separate mechanism.) Ultimately, a looser fiscal policy may be unsustainable. If it is truly unsustainable, then it will eventually have to be reversed, and the reversal could take the form of either a fiscal contraction or a monetary expansion (the “inflation tax”). It is hard to know in advance whether a fiscal policy is truly unsustainable, and it is also hard to anticipate how it might eventually be corrected. As a loose fiscal policy continues (which is to say, as more time passes over which it is not corrected by fiscal means), the odds of its being corrected by monetary means will tend to rise. The greater the chance of a monetary expansion, the less valuable financial assets (money and bonds) are at any given interest rate. Thus there will be a gradual shift in portfolio preferences from financial assets to real assets. If the money supply is constant (or, more generally, if it grows with productivity) and the economy is at full employment, then prices will rise gradually over a long period of time: inflation.
   
   
3. gradual loss of confidence in the pricing structure. If price setting depends on expected price levels (as in New Classical and some New Keynesian models), the gradually increasing expectation of an eventual monetary stimulus will lead to a gradual shift in the Phillips curve, thus causing prices to rise gradually for any given level of nominal aggregate demand.
   
   
4. reduced productivity growth due to crowding out. At full employment, in a closed economy, a fiscal stimulus will crowd out private investment, thus causing the capital stock to grow more slowly. As a result, productivity will grow more slowly, and real income will grow more slowly. For any given path of money supply and money demand, this means the price level will rise more quickly.
   
   
5. a naïve Taylor rule. Thus far, I’ve assumed that the money supply is exogenous and inelastic. That’s clearly unrealistic. To get slightly more realistic, suppose that monetary policy follows a Taylor rule with a fixed estimate of the “netural interest rate.” A fiscal stimulus will raise the interest rate consistent with stable prices. If monetary policy continues to follow its Taylor rule, the equilibrium inflation rate will rise.
   
   
6. inertial inflation. In practice, when we observe increases in the price level, it’s very hard (even for economists, and all the more for naïve price-setting agents) to tell whether they are one-time increases or “true” inflation. When fiscal policy produces rising prices, these will therefore tend to increase expected inflation, and the increase in expected inflation will become a self-fulfilling prophecy.
   
   People are going to complain about #6, because the self-fulfilling prophecy ultimately requires monetary accommodation. Otherwise the rising rate of price growth will eventually result in a reduced level of output, and the expectations will eventually be corrected.
   
   But here is the thing: what we really mean by higher inflation – in this era of enlightened and hawkish monetary policy – is not a permanent increase in the rate of price growth; what we mean is an increase in the rate of price growth that will be of concern to a central bank that wants to prevent a permanent increase in the rate of price growth. When people complain about fiscal policy being inflationary, they don’t mean that it actually will result in persistent inflation; they mean that it will raise a red flag at the Fed. In a perfect world where price-setting agents were perfectly rational and could perfectly discriminate temporary from permanent changes in nominal demand (and where the simple version of the IS-LM model applied), a loosening of fiscal policy would not raise such a red flag. In the real world, it does.

Channeling James Tobin

Mark Thoma (with support from Frederic Mishkin) holds with those who insist that only money can cause inflation – at least if, by inflation, one means a sustained pattern of increases in the price level. I believe that, as a formal matter, the argument is somewhat circular tautological: the conclusion is based on comparative static models in which money is the only stock variable. Fiscal policy is, almost by definition, a one-shot deal in these models, so it cannot produce a sustained pattern of change in anything.

Consider the standard closed-economy IS-LM model, as I learned it in school:

IS curve:  Y = C(tY) + I(r) + G
LM curve:  M/P = L(r, Y)

where
Y = national output
C = consumption
I = private investment
G = government spending
t = tax rate
r = interest rate
M = money stock
P = price level

Applying the standard assumption of a vertical long-run Phillips curve, we can take the growth rate of Y as exogenous for our purposes. Without loss of generality, let’s assume Y is constant.

Now, we want to ask, can the growth rate of P (otherwise known as the inflation rate) be positive if M is constant? You can see immediately from the LM curve that, if P were rising and M were constant, either r or Y would have to be changing. Otherwise the left-hand side of the equation would be falling, while the right-hand side would be constant. However, we have assumed that Y is constant, and a look at the IS curve shows that, if r is changing, then one of the other flow variables (Y, G, or t) must also be changing. But, again, we have assumed Y is constant, so unless there is a constantly changing fiscal policy (e.g., the tax rate constantly falling or government spending constantly rising), the equations won’t balance. So without money growth, you would really have to do something bizarre to get sustained inflation.

But suppose we introduce a new stock variable, call it “B” for bonds (government bonds, that is). The stock of government bonds grows as the government accumulates deficits (or falls as it accumulates surpluses). Using the “d” operator to indicate a rate of change, we can describe this process as:

dB = G – tY

For completeness, we can add yet another stock variable, the capital stock (“K”). Without loss of generality, I’m going to ignore depreciation and just say:

dK = I

In principle, private investment depends not directly on the government bond interest rate but on the required return on private capital. Let’s call this required return “s” (for “stock market return” as a mnemonic, although you should understand that it is the general required return on private capital, not just for the stock market).

In the standard IS-LM model, it was assumed that s and r were in some fixed relation, but in a world where government competes with the private sector for capital, the relation between the two returns need not be fixed. Government bonds and private capital have different characteristics – different risks, different degrees of liquidity, and so on. Investors may have a preferred proportion of holdings between the two, and when the relative supply of one asset increases, they will require some compensation for changing their proportions. Call the difference in returns between the two assets “e” (for “equity premium”) and recognize that it will depend on the relative outstanding stocks of government bonds and private capital. That gives us the following model:

Y = C(tY) + I(s) + G
M/P = L(r, Y)
dB = G – tY
dK = I(s)
s = r + e(B, K)

We now have a wedge between money growth and inflation. As the government runs a constant (sufficiently large) deficit, B increases relative to K. Therefore e(B, K) increases, and s falls relative to r. In order for Y to remain constant in the IS curve, s has to be constant in absolute terms, so this means r has to rise. In the LM curve, as r rises, with Y and M constant, P has to rise. Fiscal policy does cause sustained inflation.

Does Romer & Romer mean that tax cuts are generally good for growth?

U.S. federal tax returns are due tomorrow, and the subject seems to be on the mind of bloggers. Greg Mankiw cites a recent study by Christina and David Romer, which finds a strong inverse association between exogenous tax changes and economic output:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

Greg cites the paper without comment, leaving readers to draw their own conclusions, and it appears that many readers have drawn conclusions that may not be warranted (and in some cases, clearly are not warranted) by the paper. The difficulty arises from taking the above finding out of context while failing to consider another important finding about the response to a tax increase:

…inflation appears to fall substantially. The point estimates show the impact reaching 2.2 percentage points after ten quarters, then spiking down to 3.1 percentage points in quarter 11 before returning to 2.2 percentage points in quarter 12.

There are two things to notice about this inflation impact. First, it goes in the opposite direction from what would be expected based on a supply-side explanation of the impact of tax changes: if tax increases reduced supply, the inflation rate should rise, not fall. Second, if we take the point estimates seriously, the effect on inflation is huge. Anyone expecting a tax cut to increase growth is going to have to take into account the fact that Ben Bernanke is also likely to read this study – and we all know what Ben is likely to do when he expects inflation.

To put it bluntly, Romer & Romer’s results are quite consistent with a world in which any future tax cut (unless it is offset by a spending cut) is likely to reduce growth, once the expected monetary policy response is taken into account. Their results do not allow us to decompose the tax impact into a supply-side effect and a demand-side effect, but they are at least consistent with the complete absence of a supply-side effect, whereas they are not consistent with the absence of a demand-side effect. If there is no supply-side effect, then there is no change in the economy’s potential growth rate in the short run. Therefore there will be no change in the Fed’s target level of output. Therefore (barring a liquidity trap) the Fed will act to fully offset the short-run impact of tax changes on output. And to do so, in response to a tax cut, the Fed will have to raise interest rates, increasing financing costs for businesses and discouraging investment. Unless the marginal propensity to consume is zero or the Fed makes a mistake, the path of investment will end up lower than what it would have been in the absence of the tax cut. Therefore the capital stock will end up lower, and long-run growth will end up lower.

As I said, the results do not allow us to rule out a supply-side effect, and it’s quite possible that the supply-side effect will be enough to offset the damage to growth from the Fed’s response to the demand-side effect. But I wouldn’t be in too much of a hurry to cite this study as a reason to extend the Bush tax cuts.

Income Distribution and Monopoly Rents

Maybe I am a lefty. In any case I find this discussion of income distribution (by Maynard of Creative Destruction) rather compelling:

I think one thing that's going on with the income distribution is this. With the development of communication and computer technology and the greater reach of large corporations in the last several decades, our productive technology is increasingly characterized by scale economies (I haven't read Rosen's Economics of Superstars, AER 1981, in awhile, but I think my argument is related to his). Two examples. Microsoft dominates the "market" for operating systems because of network effects: the more people who use Windows, the more valuable it becomes for the marginal user. Tom Hanks gets paid an outrageous amount of money because the distribution of his movies has become so sophisticated. It costs next to nothing at the margin to distribute one more copy of the same movie, so he is able by dint of a slight advantage in talent over a performer that no one has ever heard of to dominate the market. This means that there are huge monopoly rents that are up for grabs across huge swaths of the American economy. In the old days when the economy was insulated to some extent from the rest of the world and workers were represented by strong unions, you might have seen workers take a big chunk of these rents. But in the present environment, the rents go to those in the strongest bargaining position, namely the executives at large corporations and institutions and the performers who always have the recourse to walk away from the next film (or music, or sports) deal. So Brooks is right that our "meritocracy" is rewarding people based on individual talents, those who are organized, self-motivated, and socially adept. But the talent that is being rewarded is the talent to extract rents, not the talent to produce a higher quality product than the competition. Rewarding that particular talent produces no benefits for society; there is no economic argument to justify such a meritocracy, no economic basis for opposing, say, a steeply progressive tax system that would counteract some of the forces pushing us toward greater income inequality.

In fact, progressive taxation is more efficient. People in the bottom half of the income distribution aren’t getting much of the rents. They’re being paid roughly their marginal product, and taxes would distort their labor/leisure decision. People near the top of the distribution are the ones who have succeeded in capturing rents. They are being paid much more than their marginal product, and taxes actually correct a distortion in their labor/leisure decision.

Note, however, that these arguments don’t apply to capital taxation. (Maybe I’m not a lefty, after all.) If an individual has a lot of capital income, it is probably because that individual had a lot of capital to invest, not because she is capturing a disproportionate amount of rents in her capital income. So there is no efficiency justification for progressive taxes on capital income.

Da mihi castitatem, sed noli modo

If you look through my July archives (the early part of the month, which is lower on the page), you can see discussions of various arguments for cutting the US federal deficit and why I don’t find those arguments convincing. I’ve come up with an argument now that I do find convincing. That is, I would have found it convincing a few months ago, but now I think it is outweighed by other considerations. Here’s the gist of it:

Under current law, Medicare is going to become prohibitively expensive in another 10 or 20 years. The government will have to find a solution, and the solution will almost certainly involve either means testing or taxes. Economically, means testing is equivalent to a tax. Therefore, high taxes in the future are a virtual certainty. Optimal taxation theory says that, the higher a tax is already, the more damage is done by increasing it, and the more advantage there is to reducing it. Since taxes in the future will be high, there is a great advantage to anything we can do to reduce those taxes. One thing we can do to reduce those high future taxes is to cut the deficit today so as to reduce the debt burden that will have to be paid out of those taxes.

In general, I can’t argue with this logic, but the thing is, there is a good chance the US will go into a recession some time in the next year, and it could get quite ugly. Based on recent experience, I wouldn’t rule out a liquidity trap. So I have rather reversed my earlier position. My earlier view was, “All my logic says the arguments against the deficit are unconvincing, yet I still favor deficit cuts, because it seems intuitively like the right thing to do.” Now I would say, “I have a solid logical argument against the deficit, but I nonetheless oppose cutting it. Save the fiscal responsibility until the danger of recession has passed.”

Some people would say (1) a recession is the Fed’s problem, and the Fed can compensate for fiscal tightening, and (2) as for a liquidity trap, we can cross that bridge when we come to it, so (3) we should cut the deficit now, which will give us more of a chance to increase it later when it may be really necessary. But that strikes me as just the kind of timing mistake that has given macroeconomic fine tuning a bad name. Except for the dumb luck of the 2001 tax cut, fiscal stimulus during the post-World-War II period has always been applied much too late and succeeded only in accelerating already strong recoveries. This time around, why not try to prevent a recession? Or at least don’t deliberately make it worse. The Fed may need to bring the US to the brink of recession to maintain its credibility, but Congress has no credibility to lose. Somebody has to be the good cop.