The Incidental Economist

I took a break from house cleaning (really!) and saw the following by Ezra Klein:

A number of you have written to ask what I think of Paul Krugman’s column attacking Paul Ryan’s budget. As far as Krugman’s policy critique goes, I agree. I’d refer people back to my post “Paul Ryan’s budget proposal does not balance the budget,” which uses the same Tax Policy Center data that Krugman does. The question comes down to whether Ryan is serious about increasing the revenues in his plan from 16 percent of GDP to 19 percent of GDP. He says he is, but as far as I know, he has not modified his proposal to reflect that.

That’s when I recalled a graph from Joe Newhouse’s recent Health Affairs paper of a time series of federal tax revenue relative to GDP. Here it is:

What’s the point? The point is 19% is high. The norm seems to be in the 16-18% range. It should come as no surprise that it will take historically high tax revenue to balance the budget.

Robert Pear’s article in the NY Times this weekend missed a key point about the Administration’s legal defense of the individual mandate, which hinges on the government’s power to collect taxes. Jim Hufford breaks it down:

[Even if] the commerce clause argument gives the mandate’s challengers a leg to stand on, the taxing and spending clause does not. Congress’s power of taxation is limited only by the requirement that any tax laid be conducive to the general welfare; and Congress decides whether a tax is conducive the general welfare. Pear’s article is fine up to this point. But then we get this:

Opponents contend that the ‘minimum coverage provision’ is unconstitutional because it exceeds Congress’s power to regulate commerce.

And that’s followed by Orrin Hatch and various other conservative politicians’ statements about mandates exceeding the commerce power, followed by the administration’s response to the commerce clause arguments. But not another word about the taxing power.

And that’s the problem. The article makes it sound like the administration has the upper hand on the taxing clause (a.k.a., the “general welfare clause”) argument, but the challengers are still in the fight and coming out swinging with their commerce clause argument. But it’s not really like that. Because you can’t answer a general welfare clause argument with a commerce clause argument. And if the government wins on either issue, the fight is over.

What’s more, not only does the article fail to alert readers on that decisive point, it also glides right by this essential observation: that the challengers have no legal argument at all to dispute the validity of the mandate as an exercise of the taxing power.

It’s as if the administration is arguing that Congress can get 2 by adding 1 + 1 or 3 + -1, and the challengers are responding that negative numbers don’t count.

Now that’s good blogging by Jim and very unfair of me to quote almost his whole post. In my defense, I couldn’t find a good place to break it up (mea culpa, Jim).

Somebody asked about how the new health reform law (ACA, the Affordable Care Act) affects small business. This stuff isn’t hard to find, if you know where to look. Here’s a summary and citations to good sources.

First of all, businesses with fewer than 50 employees are exempt from the employer mandate. Most of the small business action is on tax credits. What follows is my own simplified paraphrase of the tax credit provisions as described in the Kaiser summary:

Provide a tax credit of up to 35% in 2010-2013, 50% in 2014-2016, nothing after 2016 of the employer’s contribution toward the employee’s health insurance premium if the employer contributes at least 50% of the total premium cost. The full credit will be available to employers with 10 or fewer employees and average annual wages of less than $25,000. The credit phases-out as firm size and average wage increases. Tax-exempt small businesses meeting these requirements are eligible for tax credits of up to 25% (2010-2013) and later 35% (2014-2016)  of the employer’s contribution toward the employee’s health insurance premium.

If you want more details, read the short report from the Congressional Research Service (two pages of text, followed by a few handy tables).

This post has been cited in the 29 April 2010 edition of Health Wonk Review.

Greg Mankiw wrote on Saturday, “[O]ne of the prime motives for healthcare reform had nothing to do with health per se but rather was a desire by those on the left for greater redistribution of income.” As rationale for this claim Mankiw cites his November 2007 post.

To judge whether my conjecture is correct, ask your favorite pundit of the left the following: What health reform would you favor if the reform were required to be distribution-neutral? That is, you can change the rules of the health system but you cannot change the distribution of economic resources between rich and poor. My guess is that your favorite pundit would either object to the question or answer by retreating to more modest reforms. If so, this suggests that calls for sweeping reform are mainly motivated by the desire for increased redistribution.

One thing I noticed in following health reform closely is that few pundits–on the left or right–understand health economics. However, the lefty pundits in Mankiw’s hypothetical would be correct that the provisions of the Affordable Care Act (ACA) could not be implemented without increased redistribution. A motivation for increased redistribution as an end in itself is not required to hold that point of view.

There is a perfectly good reason why the ACA must be redistributive. By now we know how avoidance of adverse selection requires that a mandate accompany outlawing pre-existing condition exclusions. And low-income subsidies must accompany a mandate (if necessary, see Krugman for a review of the logic). If an individual can’t afford health insurance without a subsidy, it’s not helpful to provide one and to adjust the tax system to make the overall package distribution neutral. That’s like saying, “Can’t afford insurance? Let me help with the cost. Now pay me back.”

If a distribution-neutral reform exists it doesn’t do much and/or isn’t politically viable. That may be what Mankiw prefers, but admitting as much isn’t evidence that increased redistribution is the motivation for reform. It’s just being honest.

The first romp was a post on estate tax economics that reviewed an NBER paper by Wojciech Kopczuk. In this post I review one by Louis Kaplow, which begins with the familiar idea that every type of tax imposes some distortion: tax discourages the thing upon which it is levied. With different modes of taxation available–income tax, estate tax, value-added tax, etc.–a goal is to achieve a redistributional end with minimal distortion.

The notion of externalities plays a role in tax theory, as it does in many areas of economics. The overproduction (underproduction) of things with negative (positive) externalities is a welfare loss. Hence Pigovian taxes and subsidies can be welfare improving and the distributive consequences can be remedied through the income tax. The combination is a pure correction of the externality. The welfare gains of the correction can be distributed to make everyone better off. Notice that this combination of tax changes is revenue (and distribution) neutral. From this perspective, the revenue effects of transfer taxation–the very aspect Kopczuk thought most important–are irrelevant. (All this assumes changes to the income tax don’t impose a different set of undesirable externalities and disincentives, which probably isn’t fair to ignore.)

<Press the pause button.> In two short paragraphs I’ve summarized six pages (roughly 25%) of Kaplow’s paper. At this point I thought, “Oh, come on! Such rarefied tinkering with the tax system isn’t really possible is it?!?” Well, to Kaplow’s credit he read my mind (anti-causally!) and writes, “The foregoing discussion is obviously Panglossian, naive, or . . . choose your preferred adjective. No suggestion is made that reality operates so predictably or efficiently.” (I had to look up Panglossian. Plus, note Kaplow’s humor! Also, all quotes © 2010 by Louis Kaplow.) Nevertheless, Kaplow points to the 1986 and 1993 U.S. tax reforms that implemented changes in the spirit of what he sketched out. We’re talking theory here so let’s give Kaplow some slack. <Press play.>

Next Kaplow turns to transfer taxation. As did Kopczuk, he considers the externalities of transfers. He claims that there are positive externalities in the form of donee benefits. That is, the donor is not compensated for the benefits experienced by the donee. This argues for gift subsidization. (I did get a vague sense of double counting and Kaplow points to a paper by Peter Diamond in which that claim is made.)

On the other hand, to the extent that the donee, now wealthier by the amount of the gift, substitutes leisure for work there is a negative externality on the treasury: lost tax revenue. (I guess we are to ignore the fact that the donor will or did substitute leisure for work in order to save the sum that is gifted. So didn’t the treasury “get theirs” already? Hmm…) Kaplow goes on to describe a few other sources of negative externalities that I covered in my review of Kopczuk’s paper.

Given all the above, and particularly since tax changes can be made revenue and distribution neutral, the essential question is how to tax most efficiently (i.e. how to maximally internalize externalities), making use of all available taxation modes. In the specific case of transfers, it is possible that externalities exist at all levels of wealth (e.g. the positive externality on donees and the negative one on the treasury). Should transfers be taxed (or subsidized) at all levels?

In the final part of his paper, Kaplow discusses a few other considerations such as: transfer motives (covered in my review of Kopczuk’s paper); the fact that the most inter-generational transfers are in the form of human capital (how ought that be folded into the analysis?); the inequality of starting points brought about in large part by differences in human capital inheritance; the effect of transfer taxation on savings incentives (which can be augmented by adjusting taxation of capital gains); and charitable contributions (transfers from individuals to charitable entities outside the family are also significant).

As in my reading of Kopczuk’s paper, at the end of Kaplow’s I was left feeling like I’d missed the forest for the trees. There are clearly a lot of important considerations in transfer (or any) taxation. But they can’t be fully understood in isolation. For revenue and distributional neutrality to hold, increasing tax via mode A requires decreasing it via mode B and vice versa (more complicated still, the multiplicity of taxation modes is potentially unlimited). Given this, the absolute value and sign of externalities that arise via tax mode A don’t matter except relative to those that arise via mode B. Neither Kopczuk nor Kaplow provided in their papers a comprehensive theory within which to make a full analysis across all externalities of all modes. (This is not a critique of the papers as that’s not what they were about. I just yearn for more and will keep reading as I find relevant material.)

On the other hand, such a theory seems like it would be almost hopelessly … well … theoretical. There are practical limitations of knowledge and tax collection, not to mention an explosion of heterogeneity, that would seem to reduce the applicability of much of the theory, if it exists. To his credit, Kaplow acknowledges what I yearn for, both on the theoretical and empirical fronts.

In all, a more complete analysis of optimal taxation as a whole (that is, both income taxation and transfer taxation) would be a daunting task—one that, with regard to many of the factors highlighted here, has not really been attempted.

… There is much empirical work to be done if the many open questions are to be resolved. Moreover, the present analysis suggests that the pertinent list of empirical questions is rather different from those that have received the most attention to date.

OK then. Good start. I eagerly await the sequel.

Addendum: I confess to not having read the very long footnotes that accompany the body of Kaplow’s paper. However, I did notice that he references his book on taxation theory. See his website for details.

I’m not the least bit surprised that there are economic theories that specifically address estate taxation. But I was not the least bit aware of them until I read the recent NBER paper by Wojciech Kopczuk that “provides a non-technical overview of the economic arguments related to the desirability of transfer taxation and a summary of empirical evidence surrounding these issues.” (All quotations © 2010 by Wojciech Kopczuk.)

Kopczuk begins with a review and commentary of the literature on the bequest motive. He notes that altruism cannot fully explain inter-generational transfers as tests of that hypothesis are generally rejected.

It should also be pointed out that from the point of view of the optimal policy, altruistic preferences introduce a reason to subsidize rather than tax transfers and hence do not provide an argument for estate taxation that is observed in practice.

Continuing, Kopczuk finds that strategic or exchange-based motivations are also not compelling. Moreover, they do not suggest whether taxation or subsidization is, in general, appropriate. Is the child under-compensated or is the parent over-paying for whatever services are offered in the exchange?

The joy-of-giving perspective in which the donor does not internalize the benefits to the donee has been a “useful way of describing behavior and is often used in practice as a positive model of bequests,” Kopczuk writes. But it argues for subsidizing, not taxing, bequests in order to internalize their positive externality. He concludes that “while it may be a useful way of describing behavior, paradoxical implications of this theory highlight that it is not an appealing approach for thinking about welfare.”

Kopczuk also reviews theories based on the notions of accidental bequests (that the donor over-saved for other purposes, like retirement), wealth accumulation (that the building of family wealth is desirable for its own sake), and that bequests are a function of psychological biases or mistakes. His review of bequest motive theories concludes with the idea that likely more than one motive exists. This heterogeneity makes for difficult ground upon which to obtain a rational policy stance.

The paper pivots on a passage in which Kopczuk rejects a welfare-based approach to estate taxation. Instead, he finds the revenue implications to be paramount.

Yet, as discussed above, interpersonal externalities …  call for subsidizing rather than taxing gifts. … Subsidizing gifts may well make sense for much of the public but this kind of externality should go away when we get to the top of the distribution: the marginal utility of income (or wealth) of both parents and children is low and hence the relevance of correcting bequest externalities is negligible. … [T]he precise nature of a bequest motive is relevant only in so far as its welfare implications are relevant and at the top of the distribution they are not. What is relevant are revenue implications of taxing bequests, but this is an empirical question rather than theoretical one.

Kopczuk then argues that estate taxation has different effects than income taxation because individuals may differ with respect to wealth and income for different reasons. That is, differences in income largely reflect differences in ability to earn wages. Differences in wealth, on the other hand, may reflect heterogeneity in other dimensions, like entrepreneurial skill or even luck. Thus an estate tax exerts different distortionary pressures than income tax. It is not a redundant mode of taxation.

What, then, justifies estate (or, for that matter, income) taxation? Kopczuk attempts to address this question by suggesting there are negative externalities of wealth concentration. He points to three negative externality candidates: (1) Some of the worst governed countries are also home to the highest concentrations of wealth; (2) Excess wealth can permit some individuals to dominate the state, potentially threatening democracy; (3) Retaining family control of a business prevents others possibly better equipped to run it from doing so. However, he admits that, “[d]etermining whether such externalities exist is an ongoing research issue.”

Finally, Kopczuk discusses what is known about the effects of estate taxation.

[I]t appears likely that both wealth accumulation and avoidance are responsive to tax considerations with neither of these effects being very large, but the bulk of response working along avoidance margin. … If indeed wealth accumulation is not too responsive to tax incentives, then arguments related to undesirability of capital taxation do not apply in this context.

In conclusion, Kopczuk has certainly provided an accessible review of estate tax economics, though I cannot judge its accuracy or thoroughness. In general, he is either not impressed with the literature (e.g., he finds welfare economics and the bequest motive irrelevant) or finds it insufficient (e.g., not enough is known about externalities).

It seems to me one cannot reason about estate taxation without simultaneously reasoning about income taxation, or other forms (like value added taxation). As Kopczuk pointed out, the taxation modes are different. For a constant level of desired government revenue, if one advocates more or less of one mode of taxation, it necessarily means commensurately less or more of another. Therefore, an argument about one can’t be sustained without knowing a considerable amount about the other, which I do not. (Educated readers, feel free to suggest papers.)

I’m a believer in do-it-yourself tax prep for situations that are fairly simple, as is mine (even with my wife’s small business to contend with). Following my own advice, I just did our taxes in about three hours. Consequently, I am now experiencing my annual post-tax-prep irritation at the complexity of our tax system and the amount of work required to comply. This year, for the first time, I’ll vent it on a blog, any blog. Oh, OK, this one will do.

Actually, with modern software (TurboTax, and the like) it is far easier than ever to prepare tax returns, but still not as easy as it should be. Because I use tax prep software the focus of my ire has shifted from the tax code to the software implementation (the existence of which facilitates tax code complexity, but that’s a different post). I’m rarely 100% satisfied with my software tax prep experience. There always seems to be little things that aren’t explained or don’t feel quite right.

This year, TurboTax nearly tripped me up by not offering to import my mutual fund data until after I had entered it by hand (which wasn’t hard). But when it finally got around to offering importation, which I accepted, I found my taxable events had been doubled, one set hand entered and another imported. Oops! Easy to fix, but sheesh! How many folks are going to catch that one?

I had a few other minor irritations in my encounter with TurboTax this year, but nothing easy to describe in words. So, let’s move on to my second source of annual tax frustration: the IRS withholding calculator and the use of allowances to index withholding.

Look, I have a very simple request to the IRS or Congress: give me the freedom to do withholding my way and in return you’ll get what I owe you with far less error. I know with better accuracy than anyone else in the world what my taxable income will be in the next tax year. I can look at my 1040 from the prior year, make a few adjustments for things I can predict, and voila, out pops a reasonable estimate of my taxable income. Next, I can look up the tax rates and, presto, I know fairly well what my tax will be next year. Call it X. Now, all I want to do is tell my employer how much to withhold from each of my 26 paychecks. This isn’t hard. It’s X/26.

But wait! I can’t just give that number to my employer. I have to convert it into some integer called “allowances.” The method of converting to allowances is complicated and, um, STUPID!!! To make it easier one can use the IRS withholding calculator. Except, that’s stupid too because it is not based on the entries in my prior year’s 1040. It seems as if it is, but it isn’t. For example, they ask you for your expected wages and your 401(k) contributions. That’s, must I say it again, STUPID. It takes far more work to figure that out than to just look up your taxable wages on your prior year’s 1040 (and then inflate that a little if you really want to).

Also, the withholding calculator has no way of handling self-employment income and the sundry deductions one gets for a small business. Guess where all that information is? ON MY LAST YEAR’S 1040!!! So, thank you very much IRS, but you’ve found a way to make a very simple thing–something I can do in my head–nearly impossible to do half as well and for no good reason.

I know I’m going to get a lot of advice on how to do this in a less frustrating way. Good, give it to me. I want it. And Uncle Sam should want me to have it because the biggest source of error in my tax withholding is due to the cockamamie ways the IRS offers to help me calculate it. And somebody please tell me why withholding allowances make sense. Can’t do it? How about just tell me the formula that converts allowances to dollars. Now that would be helpful!

Today NBER released a paper by Jon Gruber on the tax exclusion (a.k.a tax subsidy) for employer-sponsored health insurance (ESI). Since its content relates to that of many of my prior posts I will draw out a few points I haven’t already raised or that answer some questions I’ve had.

Gruber claims, without citation, that about 80% of those with ESI have access to Section 125 (cafeteria) plans. I wondered about something like this before. Because employee contributions to non-cafeteria plans are taxed the tax exclusion does not apply to every dollar of ESI premiums. Note that the word “access,” in bold above, is his. He is not saying that 80% are enrolled in a Section 125 plan. So this doesn’t exactly answer my question about what proportion of workers are in such plans. A citation would have been helpful.

Gruber correctly points out that a significant benefit of the ESI tax exclusion: it supports the risk-pooling benefits of the employer-based system. One concern is that employers will cease offers of insurance if the tax subsidy were to vanish. Based on his own work (the extensive margin is relatively low) Gruber writes that if the tax exclusion were repealed “there is no reason to think that there will be a wholesale exit of medium and large firms from ESI.” Perhaps a gradual erosion is more likely.

On the other hand, the tax exclusion also promotes purchase of too much insurance (the intensive margin is relatively high). Gruber briefly surveys some of the literature on this point. He also notes the well-known labor market distortions due to an employer-based system that include “limited job to job mobility and distorted retirement decisions.”

Gruber then turns to a brief summary of his microsimulation model that he uses to estimate the effects of changes to the ESI tax exclusion. The model is based on data from the Current Population Survey and the Medical Expenditure Panel Survey and relies on parameters available in the literature. That is, estimates are incorporated from empirical research on employer and individual responses to variations in degree of tax exclusion.

Based on empirical evidence, Gruber makes some assumptions about the insurance-wage trade-off (how saved premium dollars translate into increased wages).

Any firm-wide reaction, such as dropping insurance or lowering employee contributions, is directly reflected in wages. Yet any individual’s decision, such as switching from group to non-group insurance, is not reflected in that individual’s wages; rather, the savings to the firm (or the cost to the firm) is passed along on average to all workers in the firm. (© 2010 by Jonathan Gruber.)

Before turning to the implications of reform options, Gruber notes the limitations of his approach. One is worth highlighting:

If [the] tax subsidy is removed (or mitigated), then healthy workers may find better prices in a more closely experience-rated non-group market, and to some extent abandon the cross-subsidized employer pools. This will raise the price of ESI, which could exert further pressure on healthy workers to exit. This potentially important spiral of rising premiums is not included in the analysis. This effect could be reinforced through the reduced influence of non-discrimination rules that are enforced indirectly through the tax exclusion.

The concluding section of the paper summarizes simulation results for a variety of changes to tax exclusion policy. Included among them are exclusion cap policies, akin to though not equal to the proposed Cadillac tax.  I won’t review the results much here as there are too many and they are summarized well in tables at the end of the paper, one of which is excerpted below.

A reader was confused as to why the special tax treatment of employer based health insurance premiums is considered a “tax subsidy.” I appreciate the question. It isn’t obvious that this is the right terminology. But it is standard, as is “tax expenditure.”

The confusion may stem from the fact that the subsidy isn’t explicit. It’s not as if Uncle Sam sends you a check for purchasing employer based insurance. Instead, what Uncle Sam does is cut you a tax break. If you declined employer based coverage and took the premium as wage it would be taxed. Then if you were to use those dollars to buy non-group coverage you would not get a break on your taxes.

So, relative to taking the compensation as wage and relative buying coverage in the non-group market, employer based coverage is treated differently. All other things equal, it is cheaper thanks to the tax rules. The difference in what it would cost without those favorable rules and what it does cost is the tax subsidy.

Some may object to the terminology on the grounds that it has a bias toward taxation. That is, if one is inclined to think that employer health insurance is “getting a break” then one is led to wonder how that can be justified. On the other hand, if one views the lack of taxation of compensation in the form of health insurance as appropriate government restraint from meddling, then the notion that lack of taxation is a subsidy might be offensive.

I contend that if one thinks government should not tax health insurance then one should think it ought to exempt non-group coverage too. It’s not necessarily a crazy idea. But to put it on sound intellectual footing one ought to tell a good story as to how encouraging compensation in the form of insurance as opposed to wage is welfare improving. That’s a hard story to tell, as I’ll illustrate next week.

I’ve been trying to find a way to convert into an annual dollar amount the 26% figure calculated in my prior post, the amount of employer based health spending due to the tax subsidy. To do so I’d need to know total health spending by employer-insured individuals who are beneficiaries of the tax subsidy. I haven’t found that yet. Anybody know it?

The closest I’ve found is the NHE figure for annual private health spending. It’s in the $700-$800 billion range. Even the low end of that is probably high because there is some private health spending outside the employer-based system. Also, not every dollar of employer-based insurance premiums avoids taxation. Employee contributions to non-Section 125 (non-cafeteria) plans are taxed. (Good luck trying to find a figure for what proportion of employees are in or out of Section 125 plans and what proportion of the premiums they pay. Some colleagues and I have been looking for the former for a while. I recall seeing figures that half of firms offer Section 125 plans. They’re probably the bigger firms so the majority of workers are probably in such plans.)

So, it’s 26% of X where X is probably in the ~$400 billion range, but that’s a bit of a WAG. If right, that would make the additional spending due to the tax subsidy ~$100 billion per year or ~$1 trillion over 10 years. And that’s the price tag of health reform.

I think someone can only believe the tax subsidy is not a big deal if they don’t understand it.