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According to an article in the New York Times, the Obama Administration is seriously examining a proposal to reduce America’s anti-competitive 35 percent corporate tax rate.

The Obama administration is preparing to inject an unpredictable new variable into its economic policy clash with Republicans: a plan to overhaul corporate taxes. Economic advisers have nearly completed the process initiated in January by the Treasury secretary, Timothy F. Geithner, at President Obama’s behest. That process, intended to make the United States more competitive internationally, has explored the willingness of business leaders to sacrifice loopholes in return for lowering the top corporate tax rate, currently 35 percent. The approach officials are now discussing would drop the top rate as low as 26 percent, largely by curbing or eliminating tax breaks for depreciation and for domestic manufacturing.

This may be a worthwhile proposal, but this is an example where it would be wise to “look before you leap.” Or, for fans of Let’s Make a Deal, let’s see what’s behind Door Number 2.

To judge Obama’s plan, it is important to have the right benchmark. An ideal corporate tax system obviously should have a low tax rate. And it also should have no double taxation (tax corporate income at the business level or tax it at the individual level, but don’t tax it at both levels).

But it’s also important to have a simple and neutral system. The right definition of corporate income for any given year is (or should be) total revenue minus total costs. What’s left is income.

This may seem to be a statement of the obvious, but it’s not the way the corporate tax code works. The system has thousands of complicated provisions, some of which provide special loopholes (such as the corrupt ethanol credit) that allow firms to understate their income, and some of which impose discriminatory penalties by forcing companies to overstate their income.

Consider the case of depreciation. The vast majority of people understandably have no idea what this term means, but it sounds like a special tax break. After all, who wants big corporations to lower their tax bills by taking advantage of something that sounds so indecipherable.

In reality, though, depreciation simply refers to the tax treatment of investment costs. Let’s say a company buys a new machine (which would increase productivity and thus boost wages) for $10 million. Under a sensible and simple tax system, that company would include that $10 million when adding up all their costs, which then would be subtracted from total revenue to determine income.

But the corporate tax code doesn’t let companies properly recognize the cost of new investments. Instead, they are only allowed to deduct (depreciate) a fraction of the cost the first year, followed by more the next year, and so on and so on depending on the specific depreciation rules for different types of investments.

To keep the example simple, let’s say there is “10-year straight line depreciation” for the new machine. That means a company can only deduct $1 million each year and they have to wait an entire decade before getting to fully deduct the cost of the new machine.

Ultimately, the firm does deduct the full $10 million, but the delay (in some cases, about 40 years) means that a company, for all intents and purposes, is being taxed on a portion of its investment expenditures. This is because they lose the use of their money, and also because even low levels of inflation mean that deductions are worth significantly less in future years than they are today.

To put it in terms that are easy to understand, imagine if the government suddenly told you that you had to wait 10 years to deduct your personal exemption!

Let’s now circle back to President Obama’s proposal. With the information we now have, there is no way of determining whether this proposal is a net plus or a net minus. A lower rate is great, of course, but perhaps not if the government doesn’t let you accurately measure your expenses and therefore forces you to overstate your income.

I’ll hope for the best and prepare for the worst.

P.S. It’s also important to understand that a “deduction” in the business tax code does not imply loophole. If you remember the correct definition of business income (total revenue minus total costs), this means a business gets to “deduct” its expenses (such as wages paid to workers) from total revenue to determine taxable income. Some deductions are loopholes, of course, which is why a  simple, fair, and honest system should be based on cash flow. Which is how business are treated under the flat tax.

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Republicans are fighting about taxes. But they’re fighting with each other, not Democrats. I’ve already written about this topic once, but the issue has become more heated, and the stakes have become much larger. And this time I’m going to focus on the political implications.

First, some background. One side of this battle is led by Grover Norquist of Americans for Tax Reform, who is the organizer of the no-tax-increase pledge. Grover argues that America’s fiscal problem is too much spending and that higher taxes are economically and politically foolish.

The other side of the conflict is led by Senator Tom Coburn of Oklahoma, who argues that America’s fiscal problem is too much red ink and that higher taxes are a necessary price to strike a deal with Democrats that supposedly will reduce budget deficits.

The first  skirmish in this fight involved ethanol tax credits. Senator Coburn wanted to get rid of the credit, which everyone agrees is economically destructive and fundamentally corrupt.

But there’s a catch. when you get rid a tax preference, even an odious one, that means the government gets more money. In other words a tax increase. Senator Coburn has no problem with that outcome.

Grover Norquist says that all of the arguments against ethanol are correct, but he says that any proposal to get rid of the credit should be accompanied by a tax cut of equal magnitude.

If the ethanol credit is worth about $6 billion per year, as Senator Coburn’s office states, then find a tax cut of similar size, pair it with the ethanol credit, and kill two birds with one stone. Seems like the best of all possible outcomes, which is why Grover is correct from a policy perspective.

The fight over the ethanol credit may seem like a tempest in a teapot, but it was symbolically important – particularly since it is a precursor for the much bigger fight about whether GOPers should agree to a budget deal with Democrats.

Indeed, this may already be happening as part of the “Gang of Six” negotiations, with Senator Coburn and two other Republican Senators joining three Democrats in putting together some sort of grand compromise (presumably something similar to what was proposed by Obama’s Fiscal Commission).

In this case, the tax increase could be enormous, well over $1 trillion. No wonder this battle is getting heated. Here are some excerpts from a recent story in the Washington Post.

Republicans are feuding over whether to abandon the party’s long-held opposition to higher taxes in pursuit of a deficit-cutting deal with Democrats. …both sides say this cuts to the core of a quandary for the GOP: Will the cause of trimming deficits run aground on the conservative principle that the government must not increase the amount of money it takes in through taxes? …“If we don’t do something, what we’ve done is put the country at risk,” Coburn said in an interview. “I agree we ought to cut spending, but will we ever get the spending cut to the level that we need to without some type of compromise?” Norquist…argues that bipartisan deals struck by Presidents Ronald Reagan in 1982 and George H.W. Bush in 1990, both of which entailed increased taxes, resulted in bigger government rather than spending cuts that both men thought they had secured. “This is a fantasy on the part of the liberal Democrats that the Republicans would be stupid enough to repeat 1990 and throw away a winning hand politically,” Norquist said.

As the excerpt correctly acknowledges, this issue deals with both economics and politics. From an economic perspective, there are all sorts of important issues:

1. What is better for the economy, lower spending or higher taxes?

2. Is it possible to balance the budget without higher taxes?

3. Would tax increases be used for deficit reduction or more spending?

But I covered these issues in my earlier post, so lets’ look at the political implications. Grover asked, in the Washington Post article, “Why would you elect a Republican Senate if they just sat down with Obama and raised everyone’s taxes?” And I was quoted about how abandoning the no-tax-hike position would heavily damage the GOP.

How the debate among Republicans is resolved in the coming weeks will play a large role in determining whether a grand bipartisan bargain on deficit reduction is possible. “There’s a significant split over whether to put taxes on the table,” said Dan Mitchell, an economist at the libertarian Cato Institute and a Norquist ally. Mitchell said the disagreement largely pits House and Senate Republicans against each other and gives Democrats a potential political edge. “Obama has it within his power to drive a big wedge between House and Senate GOP-ers and turn the tax issue from something that works on behalf of Republicans into something that works against them,” he said.

To elaborate on the last point, the no-tax-increase pledge helps the GOP because it sends a signal to all voters that they will not be raped and pillaged (at least in excess of what is happening now).

This puts Democrats in a tough position. They can play the politics of class warfare (as Obama likes to do) and say only the “rich” will pay higher taxes, but voters don’t dislike their upper-income neighbors. Moreover, they probably suspect that Democrats have a very broad definition of what counts as rich, so they instinctively gravitate to the GOP position. After all, the only sure way of avoiding a tax hike on yourself is to oppose tax hikes for everyone.

If Republicans put tax increases on the table, however, the politics get turned upside down. Instead of being united against all tax increases, voters realize somebody is going to get mugged and they have an incentive to make sure they’re not the ones who get victimized.

That’s when soak-the-rich taxes become very appealing. Democrats, for all intents and purposes, can appeal to average voters by targeting the so-called rich. And even though voters will be skeptical about what Democrats really want, they don’t want to be the primary target of the political predators in Washington.

Think of it this way. You’re a wildebeest running away from a pack of hyenas, but you know one member of your herd will get caught and killed. You despise hyenas, but at that critical moment, you’re main goal is wanting another member of the herd to bite the dust.

This is why surrendering to tax increases put Republicans in a no-win situation. They oppose class-warfare taxes because they understand the disproportionately damaging impact of higher top income tax rates and increased double taxation of dividends and capital gains. So when GOPers get bullied into agreeing to raise taxes, they want to target less destructive sources of revenue. But that usually means that taxes that are more likely to hit the middle class.

Needless to say, Democrats almost always win if there is a fight on whether to tax the middle class or to tax the rich.

Senator Coburn’s heart is in the right place, but he is creating a win-win situation for Democrats. By putting taxes on the table, he is giving Democrats a policy victory and a political victory.

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I suppose there are some good jokes to make about Pakistan employing transgender tax collectors in an attempt to coerce more money from taxpayers, but I’m enough of a policy wonk to have serious questions about the system.

First, why does the government need to “shame” people. Can’t they just arrest taxpayers and/or seize their property? Or do Pakistani taxpayers actually enjoy the presumption of innocence, unlike their oppressed American counterparts?

Second, I read stories about religious zealots in Pakistan killing Christians and stoning adulterers. How do these tax collectors escape persecution? Is it that they only operate in a big city, which is more tolerant, while the really awful stuff happens in rural areas?

Third, why does Pakistan even bother with an income tax. I commented last year about Hillary Clinton’s ideological advice to Pakistan about squeezing the so-called rich, but the CNN story excerpted below says only 1 percent of the population is affected. What’s the point? The tax obviously doesn’t generate much revenue. Why not get rid of an oppressive law and make the country a tax haven?

Miss your tax deadline in the United States this weekend, and you might get a nasty letter at your door. In Karachi, Pakistan’s largest city, you might get Riffee and the gang. They are “transgender” tax collectors — whose weapons include flamboyancy, surprise — and a little lipstick. In a move that speaks volumes about the lengths to which Pakistan is going to tackle tax evasion, Karachi officials are using Riffee – who like many people in South Asia works under a single name – and her team as enforcers with a difference. They are sent to the businesses or houses of debtors. The aim — in this very conservative Muslim society — to embarrass tax debtors into paying up. Riffee — like her tax-collector friends Sana and Kohan — is physically a man, but prefers to be called and dress as a woman. Their job is quite simple: each morning they turn up to work and get a list of missed payments. One by one, they make house-calls, causing trouble at each debtor’s home or office, trying to get them to pay up. It’s not clear how effective this tactic is, but officials insist they would not do it if it did not work. “Their appearance causes great embarrassment amongst the people,” said Sajid Hussein Bhatti, the tax superintendent who gives Riffee her orders every morning.

Pakistan does have a lot of tax evasion, to be sure, but the unwillingness to comply is actually just a symptom of high tax rates and and a corrupt government. People don’t like paying tax when they feel like they are getting ripped off to finance a wasteful public sector. That’s true in Pakistan, Greece, and just about every other nation. That’s why lower tax rates are the best way to boost compliance.

(h/t Pejman Yousefzadeh)

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After reading below about Argentina’s decline, several people have emailed to ask how Chile compares. Ask and ye shall receive. This post from last month shows shows Chile, Argentina, and Venezuela. Very powerful, which is why I gave the post such a grandiose title.

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There’s been a lot of coverage of the recent decision by Standard & Poor to warn that the United States has a “negative” outlook.

As Joe Biden would say, BFD. I’m stunned that anyone would care, particularly since the rating agencies have zero credibility. These clowns completely missed Enron. They missed the collapse of Europe. They blew it on the financial crisis, especially with regard to the corrupt government-created mess at Fannie Mae and Freddie Mac.

The fact that one of the rating agencies belatedly warns that America is heading in the wrong direction should elicit only one response, which is, “Where were you guys when Bush did no-bureaucrat-left-behind, the prescription drug entitlement and TARP? And where were you guys when Obama did the faux stimulus and government-run healthcare?”

One of the problems with the rating agencies in this regard is that they narrowly focus on the ostensible ability of an institution (such as a company or government) to repay debt. That’s an important consideration, especially if you are a bondholder, but (even if the rating agencies did a good job) it doesn’t tell us much about why a government is in good shape or bad shape.

This story – and the failure to recognize what’s truly important – is doubly irritating to me since I’m in Buenos Aires for the Mont Pelerin Society meetings. Many of the speakers have focused on the challenges in Latin America, with a lot of attention focused on what went wrong with Argentina.

If I was forced to compress all the analysis into one brief answer, the problem is crony capitalism. Argentina’s economy, for all intents and purposes, is one giant Fannie Mae/Freddie Mac/Obamacare/General Motors/Goldman Sachs Obamaesque dystopia. Government has enormous influence over every major economic decision. It’s like being in the middle of Atlas Shrugged, as political connections are the way to get rich.

This type of approach is far worse than the Scandinavian welfare state. Yes, the official size of government is bigger in places such as Sweden, but the negative role of government intervention is far more pervasive in Argentina.

What makes this so tragic is that Argentina used to be one of the world’s wealthiest countries. Last night, I had the privilege of listening to one of the nation’s leading free market advocates, Dr. Ricardo H. López Murphy, talk about Argentina’s history. In the 1800s and early 1900s, Argentina looked to the United States for inspiration (back in the days when government was a far smaller burden) and he noted that his country was remarkably successful.

Then, beginning around the 1940s, Argentina began to march in the wrong direction. As you can see from this chart, the consequences have been tragic. The nation’s relative ranking has declined precipitously. A country that used to be one of the world’s richest has now fallen way behind.

I also put Hong Kong on this chart to give further evidence that policy matters. Argentina has pursued an Obama policy of government intervention and has declined. Hong Kong has practiced laissez-faire economics and now is one of the world’s richest jurisdictions.

This is a warning to America. There is nothing magical about the United States. If we copy Argentina (actually, a very bad combination of Argentine-style crony capitalism and Swedish-style high-tax redistribution), we will suffer similar consequences.

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Economists often do a crummy job of teaching people about the impact of fiscal policy on the labor force, largely because we put people to sleep with boring discussions about “labor supply” decisions (my blog post from last year perhaps being an example of this tendency).

From now on, I will try to remember to use this cartoon. It’s a parody of Obama’s policies, but the last slide (or is it a panel?) is a great teaching tool about what happens when politicians turn the safety net into a hammock.

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Happy Tax Day! Or, if you’re like me, happy tax extension filing day.

In the past couple of days, I’ve posted about the benefits of a better tax system and the unfairness of the current system.

Those were compelling posts, at least I hope. But now let’s tie these themes together. Art Laffer has a column in the Wall Street Journal that explains the comprehensively awful burden of the internal revenue code – and also shows the promise of a better approach.

There is a lot more to taxes than simply paying the bill. Taxpayers must spend significantly more than $1 in order to provide $1 of income-tax revenue to the federal government.

To start with, individuals and businesses must pay the government the $1 in revenue plus the costs of their own time spent filing and complying with the tax code; plus the tax collection costs of the IRS; plus the tax compliance outlays that individuals and businesses pay to help them file their taxes.

In a study published last week by the Laffer Center, my colleagues Wayne Winegarden, John Childs and I estimate that these costs alone are a staggering $431 billion annually. This is a cost markup of 30 cents on every dollar paid in taxes. And this is not even a complete accounting of the costs of tax complexity.

…David Keating of the National Taxpayers Union provides a useful perspective on how big the tax compliance industry is. According to his research, as of 2009 the income-tax industry employed “more workers than are employed at the five biggest employers among Fortune 500 companies—more than all the workers at Wal-Mart Stores, United Parcel Service, McDonald’s, International Business Machines, and Citigroup combined.” Without diminishing in any way the professionalism of tax attorneys, accountants and financial planners, all of these efforts produce nothing other than, well, tax compliance.

…A tax reform to a simple flat-rate tax with no deductions would significantly reduce the current complexity inherent in our progressive tax system, which is full of loopholes, exemptions and special interest carve-outs. Based on the estimates from our new study, if a static, revenue-neutral flat-tax reform were to reduce the tax complexity in half, the long-term growth in our economy would increase by around one-half of 1% per year.

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Since it is tax-filing season and we all want to honor our wonderful tax system, let’s go into the archives and show this video from last year about the onerous compliance costs of the internal revenue code.

Narrated by Hiwa Alaghebandian of the American Enterprise Institute, the mini-documentary explains how needless complexity creates an added burden – sort of like a hidden tax that we pay for the supposed privilege of paying taxes.

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