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Posts Tagged ‘incentives’

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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Greetings from frigid Minnesota. I’m in this misplaced part of the North Pole to testify before both the Senate and House Tax Committees today on issues related to the Laffer Curve.

In other words, I will be discussing how governments should measure the revenue impact of changes in tax policy – what is sometimes known as the dynamic scoring vs static scoring debate.

Most governments, including the folks in Washington, assume that tax policy has no impact on the economy. As such, it is relatively easy to measure how much revenue will rise or fall when tax policy is altered. After all, there are only two moving parts – tax rates and tax revenue.

So if tax rates double, revenues climb by 100 percent. If tax rates are reduced by 50 percent, tax revenues drop by one-half.

This is a slight over-simplification, but it does capture the basics of conventional revenue estimating. And it also shows why “static scoring” is deeply flawed. In the real world, people respond to incentives. When tax rates rise and fall, people change their behavior.

When tax rates are punitive, for instance, people earn and/or declare less income to the government. And when tax rates are reasonable, by contrast, people earn and/or declare more income to the government. In other words, there are actually three moving parts – tax rates, tax revenue, and taxable income.

Figuring out the relationship of these three variables is known as “dynamic scoring” and it is much more challenging that static scoring, but it is much more likely to give lawmakers correct information.

It does not mean, by the way, that “tax cuts pay for themselves” or that “tax increases lose revenue,” as GOPers sometimes claim. That only happens in rare circumstances.

If you want to understand this issue and be more knowledgeable than 99 percent of the people in government (not very difficult, so don’t let it go to your head), watch this three-part series on the Laffer Curve.

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The Wall Street Journal uses the clash between the Steelers and Packers as an opportunity to make a much-need point about taxes. Because of Pennsylvania’s flat tax, Ben Roethlisberger keeps a greater percentage of his salary than Aaron Rodgers, who gets raped by Wisconsin’s “progressive” tax system. Packers fans shouldn’t worry about this, though, since even I’m not willing to claim that the negative impact of high tax rates on incentives will have any effect on the outcome of the game.

We won’t predict the winner of this Sunday’s Super Bowl between the Pittsburgh Steelers and Green Bay Packers. But we can report this much: The Steelers will get to keep a lot more of their season earnings, though both team’s players would be a lot richer if they played all of their home games in Dallas. Take the Packers’ fleet-footed quarterback Aaron Rodgers. He made $8.6 million in 2009, according to USA Today’s database of player salaries. Of that, we calculate he paid roughly $680,000 in state and $3.1 million in federal income and payroll taxes. Steeler quarterback Ben Roethlisberger didn’t earn as much, but he got to keep a relatively larger chunk of his haul—$4.6 million of his $7.7 million salary. (This excludes taxes paid to states that tax players visiting on away games.) Unlike Wisconsin, which has a graduated income tax that charges top earners 7.75% on earnings over $220,000, Pennsylvania has a 3% flat rate. Even football players can behold the merit of a flat tax. Of course, both players would keep a lot more of their earnings if like quarterback Tony Romo (salary: $625,000) they played for the Cowboys since Texas levies no state income tax. On the other hand, Packer and Steeler fans will pay if they travel to Texas for the game since Texas’s beer tax is more than twice as high as their home state’s.

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I write about the Laffer Curve so often that I’m surprised people don’t run away screaming. But I’ll continue to be a pest because I want people to understand that you can’t just look at changes in tax rates when predicting changes in tax revenue. You also have to consider changes in taxable income.

Simply stated, my goal is for people to recognize that higher tax rates lower incentives to earn and report income and lower tax rates increase incentives to earn and report income. However, I also want people to understand that this doesn’t mean “all tax cuts pay for themselves.” That only happens in very rare cases. Moreover, it would be good if people recognized that there are lots of factors that influence the economy’s performance, and it’s therefore important to be cautious when making claims about the relationships between tax rates, taxable income, and tax revenue.

So we many not be able to precisely measure the impact of the Laffer Curve, we know it’s there and we know it can be very significant. We also know that economic incentives are not constrained by national borders. The Laffer Curve exists even in nations where politicians generally are not sympathetic to good tax policy. France naturally comes to mind, and here are some excerpts from a new report from Pierre Garello. He examines recent changes in tax rates and the tax base, and finds that better tax policy is having a positive impact.

In 2006 a major change was implemented in France regarding the income tax. Not only the top marginal rate was lowered (from 48.09% to 40.00%), but the same treatment was applied to the other rates. Also, the number of brackets was reduced from 7 to 5. As a result, whatever the level of taxable income, the rate applied was lower after the changes took place than before. …the tax base was also enlarged. In particular, while 20% of gross income from salaries was until then automatically deduced to compute the level taxable income, this was no longer the case with income earned in 2006 and after. …Based on data from the French Public Finances General Directorate (DGFiP) we can see that the impact was a minor drop in tax revenues from the 2006 personal income followed by a slightly higher increase in PIT revenues from 2007 earnings. As illustrated by the graph below, the successive cuts in marginal tax rates between 1995 and 2007 have resulted in higher tax revenues.

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Alex Tabarrok has a fascinating article in the Wilson Quarterly about the history of bail bondsmen and their role in this privatized segment of the criminal justice system. Let’s start by excerpting some history of the system.

Bail began in medieval England as a progressive measure to help defendants get out of jail while they waited, sometimes for many months, for a roving judge to show up to conduct a trial. If the local sheriff knew the accused, he might release him on the defendant’s promise to return for the hearing. More often, however, the sheriff would release the accused to the custody of a surety, usually a brother or friend, who guaranteed that the defendant would present himself when the time came. So, in the common law, custody of the accused was never relinquished but instead was transferred to the surety—the brother became the keeper—which explains the origin of the strong rights bail bondsmen have to pursue and capture escaped defendants. Initially, the surety’s guarantee to the sheriff was simple: If the accused failed to show, the surety would take his place and be judged as if he were the offender.

The English system provided lots of incentives for sureties to make certain that the accused showed up for trial, but not a lot of incentive to be a surety. The risk to sureties was lessened when courts began to accept pledges of cash rather than of one’s person, but the system was not perfected until personal surety was slowly replaced by a commercial surety system in the United States. That system put incentives on both sides of the equation. Bondsmen had an incentive both to bail defendants out of jail and to chase them down should they flee. By the end of the 19th century, commercial sureties were the norm in the United States. (The Philippines is the only other country with a similar system.)

In recent decades, however, some states have begun to restrict or ban the use of private bail bondsmen. Not surprisingly, this hasn’t been good news. The cost to taxpayers rises and the effectiveness of the criminal justice system falls. Here’s another excerpt.

Every state now has some kind of pretrial services program, and four (Illinois, Kentucky, Oregon, and Wisconsin) have outlawed commercial bail altogether.

…Today, when a defendant fails to appear, an arrest warrant is issued. But if the defendant was released on his own recognizance or on government bail, very little else happens. In many states and cities, the police are overwhelmed with outstanding arrest warrants. In California, about two million warrants have gone unserved. Many are for minor offenses, but hundreds of thousands are for felonies, including thousands of homicides.

In Philadelphia, where commercial bail has been regulated out of existence, The Philadelphia Inquirer recently found that “fugitives jump bail . . . with virtual impunity.” At the end of 2009, the City of Brotherly Love had more than 47,000 unserved arrest warrants. About the only time the city’s bail jumpers are recaptured is when they are arrested for some other crime.

…Unserved warrants tend not to pile up in jurisdictions with commercial bondsmen. In those places, the bail bond agent is on the hook for the bond and thus has a strong incentive to bring those who jump bail to justice. My interest in commercial bail and bounty hunting began when economist Eric Helland and I used data on 36,231 felony defendants released between 1988 and 1996 to investigate the differences between the public and private systems of bail and fugitive recovery. Our study, published in The Journal of Law and Economics in 2004, is the largest and most comprehensive ever written on the bail system.

Our research backs up what I found on the street: Bail bondsmen and bounty hunters get their charges to show up for trial, and they recapture them quickly when they do flee. Nationally, the failure-to-appear rate for defendants released on commercial bail is 28 percent lower than the rate for defendants released on their own recognizance, and 18 percent lower than the rate for those released on government bond.

Even more important, when a defendant does skip town, the bounty hunters are the ones who pursue justice with the greatest determination and energy. Defendants sought by bounty hunters are a whopping 50 percent less likely to be on the loose after one year than other bail jumpers.

In addition to being effective, bail bondsmen and bounty hunters work at no cost to the taxpayers. The public reaps a double benefit, because when a bounty hunter fails to find his man, the bond is forfeit to the government.

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I don’t now why I bothered spending all that time perusing the writings of Paul Krugman and Larry Summers in order to produce my previous blog post when this Michael Ramirez cartoon makes the same point in a much simpler way.

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The two main political parties are sniping at each other about the just-concluded tax deal, largely because Republicans are happy and Democrats are displeased that all of the 2001/2003 tax cuts are being extended for all taxpayers.

Almost nobody is paying attention to the new spending that is in the agreement, however, most notably the 13-month extension of unemployment benefits. And to the extent anybody is paying attention, a small handful of fiscal conservatives wanted to offset that new spending by reducing spending someplace else.

That sentiment is laudable, but somebody should be pointing out that this policy actually is bad news for workers. Here are some excerpts from a Wall Street Journal story, which reports on a study from the San Francisco Federal Reserve Bank.

A recent study by the Federal Reserve Bank of San Francisco found the unemployment rate at the end of 2009 would have been nearly half a percentage point lower—9.6%, instead of 10%—if jobless benefits hadn’t been extended beyond their usual 26 weeks to as much as 99 weeks. …The extension of jobless benefits is likely to worsen that trend for at least several months. For one, individuals not actively searching for work or willing to take available jobs may claim they are unemployed in order to receive benefits. That could artificially boost the size of the labor force, which is used to determine the unemployment rate. Another concern, as the San Francisco Fed notes, is that the extension of jobless benefits may “reduce the intensity” with which the unemployed search for work. Longer term, this could lead to a higher level of structural unemployment in the economy as workers’ skills erode.

Some leftists may think this is propaganda from free-market purists, yet the San Francisco Fed certainly does not have a reputation for libertarian views. Nonetheless, perhaps it would be a good idea to see what some other people have to say. Here’s what one well-known economist wrote in a textbook.

Public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. . . . In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker’s incentive to quickly find a new job. Generous unemployment benefits in some European countries are widely believed to be one of the main causes of “Eurosclerosis,” the persistent high unemployment that affects a number of European countries.

Was this Milton Friedman? Ludwig von Mises? Nope, the author of this mean-spirited right-wing bile is Paul Krugman. And here’s something else written by an economist about the impact of unemployment benefits.

Empirical evidence shows that two causes are welfare payments and unemployment insurance. …unemployment insurance increases the measure of unemployment by inducing people to say that they are job hunting in order to collect benefits. The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a “reservation wage”—the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase that reservation wage, causing an unemployed person to remain unemployed longer. …Unemployment insurance also extends the time a person stays off the job. Clark and I estimated that the existence of unemployment insurance almost doubles the number of unemployment spells lasting more than three months. If unemployment insurance were eliminated, the unemployment rate would drop by more than half a percentage point, which means that the number of unemployed people would fall by about 750,000. This is all the more significant in light of the fact that less than half of the unemployed receive insurance benefits, largely because many have not worked enough to qualify.

Who wrote this? A Tea Party fanatic? A knuckle-dragging GOP Congressman? Hardly, this passage was penned by Larry Summers, the outgoing Chairman of Barack Obama’s National Economic Council.

Given their partisan leanings, you won’t be surprised that Krugman and Summers now semi-disavow their academic writings on this issue, claiming that somehow their analysis does not apply in the current situation. But the bottom line is that incentives matter. If you pay people to remain unemployed, they will have less reason to find a job. The only real issue is the degree to which unemployment benefits increase joblessness.

This doesn’t imply that lawmakers should do nothing about unemployment, but it does suggest that their focus should be on pro-growth policies that will facilitate job creation. Permanently lower tax rates would help, as would reduction in government spending so that more resources would be available for the economy’s productive sector. Trade liberalization and deregulation also would be a good idea.

Unfortunately, all these ideas reduce the power of the political elite, so they are not nearly as popular in Washington as unemployment benefits.

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