An Interview with Joel Slemrod on Tax Policy

Aaron Steelman of the Richmond Federal Reserve interviews Joel Slemrod of the University of Michigan, mainly on tax policy issues. Here are some thoughts from Slemrod:

On current taxation of employer-provided health insurance: \”Well, it certainly reduces the after-tax price of health insurance for people. The problem is that it reduces the price below the true social cost, so that people acting in their own family\’s interest, are, at the margin, buying insurance where the value to them is actually less than the true cost. In a word, we are subsidizing high-deductible, low copay insurance policies and, given the upward trend we are seeing in the fraction of our gross national product that goes to health care, I think we ought to be moving toward reducing or eliminating such subsidies. Not only that, it\’s a very unattractive sort of subsidy, because the subsidy rate is dependent on the household\’s marginal tax rate, so the subsidy rate is highest for the highest-income people. And I just don\’t think that even people who would argue for a subsidy would favor such regressivity if they were designing a subsidy scheme from scratch. The reason to be wary about abandoning the subsidy is that it supports the system of employer-provided health insurance, which spreads risks across employees and offsets the problem of adverse selection that can plague health insurance markets; before we eliminate the subsidy entirely, we need to have other policies in place to prevent a collapse of efficient markets for health insurance.\”

On how high-income people react to high tax rates: \”My own view … is that certainly high-income people notice taxes, and they react to taxes in ways that lower their exposure to taxes. The evidence for taxes substantially affecting what one might call \”real\” behavior, such as labor supply or savings, is not as strong as the evidence regarding another class of behaviors we might label \”avoidance.\”\”

On how saving is affected by fear of nuclear war: \”I have three articles that try to estimate whether, when people seriously think there\’s a chance of a nuclear conflagration, this belief affects their saving behavior. In short, do people believe we ought \”to eat, drink, and be merry, for tomorrow we die?\” To test this hypothesis I looked at aggregate saving over time in the United States, across countries, and micro data within the United States, and in all three cases found that when people think, or profess to think, there\’s a chance of a nuclear war, their saving rate goes down, just as economic theory would predict.\”

On how people time their deaths to reduce estate taxes: \”We looked at estate tax return data from the history of the U.S. estate tax and found that when the estate tax was going to change — go up or down — in an anticipated way, then the distribution of deaths around that date was not symmetric. When the tax rate was going to increase, more people died before the rate rose, and when the tax rate was going to be lowered, people held on and more people died after the decrease. Since we wrote the paper, the general \”death elasticity\” finding has been replicated using data from episodes in Australia and Sweden when they ended their estate taxes. Those studies found evidence that people delayed their death to save their heirs\’ money, in some cases, millions and millions of dollars.\”

Caballero #3: The Pretense of Knowledge Syndrome in Macroeconomics

This is the third of three posts based on an interview that Ricardo Caballero of  MIT did with Douglas Clement of the Minneapolis Fed.

Caballero on the pretense-of-knowledge syndrome in macroeconomics:

\”[T]he economy is so complex that there is little hope of understanding much without models. I just don’t want these models to acquire a life that is independent from the purpose they are ultimately designed to serve, which is to understand the functioning of real economies…. [T]he current core of macroeconomics has become so mesmerized with its own internal logic that it begins to confuse the precision it has achieved about its own world with the precision it has about the real one.

\”There is absolutely nothing wrong with building stylized structures as just one more tool to understand a piece of the complex problem. My problems with this start when these structures take on a life on their own, and researchers choose to “take the model seriously”—a statement that signals the time to leave a seminar, for it is always followed by a sequence of naïve and surreal claims….

\”My point is that by some strange herding process, the core of macroeconomics seems to transform things that may have been useful modeling short-cuts into a part of a new and artificial “reality.” And now suddenly everyone uses the same language, which in the next iteration gets confused with, and eventually replaces, reality. Along the way, this process of make-believe substitution raises our presumption of knowledge about the workings of a complex economy and increases the risks of a “pretense of knowledge” about which Hayek warned us in his Nobel Prize acceptance speech.\”

The interview questions here are focused on a paper by Caballero called \”Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome.\” that was published in the Fall 2010 issue of my own journal, where Caballero spells out these arguments in greater detail.

Caballero #2: Moral Hazard and Policy During a Crisis

This is  the second of three posts based on an interview that Ricardo Caballero of MIT did  with Douglas Clement of the Minneapolis Fed.

Here\’s Caballero on why it\’s misguided, once a financial is actually underway, to worry that financial bailouts will create moral hazard incentives for high-risk behavior.

\”I still recall politicians and economists calling for the need to teach lessons (in a punitive sense) to the financial system in the middle of the crisis. In fact, I think Lehman happened to a large extent due to the political pressures stemming from this view. What timing! …

\”I draw an analogy between panics and sudden cardiac arrest. We all understand that it’s very important to have a good diet and good exercise in order to prevent cardiac arrest. But once you’re in a seizure, that’s a totally secondary issue. You’re not going to solve the crisis by improving the diet of the patient. You don’t have time for that. You need a financial defibrillator, not a lecture. …

The main dogma behind the great resistance in the policy world to institutionalize a public insurance provision is the idea that if the financial defibrillator were to be implanted in an economy, banks and their creditors would abandon all forms of a healthy financial lifestyle and would thus dramatically increase the chances of a sudden financial arrest episode.

\”This moral hazard perspective is the equivalent of discouraging the placement of defibrillators in public places out of concern that, upon seeing them, people would have a sudden urge to consume cheeseburgers because they would realize that their chances of surviving sudden cardiac arrest had risen as a result of the ready access to defibrillators.

\”But actual behavior is less forward-looking and rational than is implied by that logic. People indeed consume more cheeseburgers than they should, but this is more or less independent of whether or not defibrillators are visible. Surely there is a need for advocating healthy habits, but no one in their right mind would propose doing so by making all available defibrillators inaccessible. Such a policy would be both ineffective as an incentive mechanism and a human tragedy when an episode of sudden cardiac arrest occurs.

\”I think this is one of the many instances when economists and politicians choose to solve a second-order problem they understand rather than focusing on what actually happens in real life.\”

Caballero #1: Demand for Safe Assets in the Financial Crisis

The Minneapolis Fed publishes a magazine called the Region that has consistently excellent interviews with leading economists. The June 2011 issue has an interview with Ricardo Caballero, who is chairman of the MIT economics department. To avoid making this post of encyclopedic length, I\’m going to break it into three parts: Caballero on the demand for safe assets in the financial crisis, on moral hazard concerns during a financial crisis, and on how to do macroeconomics these days. But the excerpts in these three posts just scratch the surface of the interview, and the whole thing is worth reading.

Here\’s Caballero on what he sees as the underlying root of the financial crisis: a global shortage of financial assets, and especially highly-rated fixed income assets. In describing the financial crises, he says:

\”It’s a story in two steps. The first, present at least since the Asian crisis, is that the world has experienced a shortage of assets to store value. Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets. I believe this global asset shortage is one of the main forces behind the so-called global imbalances, the low equilibrium real interest rates that preceded the crisis, and the recurrent emergence of bubbles. Contrary to the conventional wisdom, I think these phenomena are not the result of loose monetary policy, but rather the other way around: Monetary policy is loose because an asset shortage environment would otherwise trigger strong deflationary forces. …

\”This is the second step, which began in earnest after the Nasdaq crash, when foreign demand for U.S. assets went back to its historical pattern of being heavily concentrated on fixed income … and especially on highly rated instruments. …The enormous demand for U.S. assets, with a heavy bias toward “AAA” instruments, could not be satisfied by U.S. Treasuries and single-name corporate bonds, and that imbalance generated huge incentives for the U.S. financial system to produce more “AAA” assets. As a result, we saw both the good and the bad sides of the most dynamic financial system in the world, in full force. Subprime loans became inputs into financial vehicles, which by the law of large numbers and by the principles of tranching were able to create \”AAA\” instruments from those that were not. …

\”Unfortunately, by construction, AAA tranches generated from lower-quality assets are fragile with respect to macroeconomic and systemic shocks, when the law of large numbers doesn’t work. That is, this way of creating safe assets may be able to create micro-AAA assets but not macro-AAA assets. In other words, these assets were not very resilient to macroeconomic shocks, even though they might have technically met AAA risk standards. …

\”In principle, this was not a big issue, but it became a huge one when highly leveraged systemically important institutions began to keep these macro-fragile instruments in their balance sheets (directly, or indirectly through special-purpose vehicles, or SPVs This was an accident waiting to happen; AIG and the investment banks should have known better, but the low capital charges were too hard to resist.\”

Switching from a fuel tax to a vehicle-miles tax to finance highways?

The U.S. government imposes a tax of 18.4 cents/gallon on gasoline as a main source of financing for the Highway Trust Fund. However, the tax rate hasn\’t been raised since 1993, so inflation has eaten away at its real value. In addition, as fuel economy improves, miles travelled are rising faster than fuel consumption. Thus, the Highway Trust fund has been spending roughly $10 billion more per year since 2008 on highway projects than the fuel tax takes in. Thus, there have been proposals to switch from a fuel tax to a vehicle-miles tax as a way of funding highways. Here are a some thoughts about this policy: 
1) Both a fuel tax and a vehicle-miles tax can be viewed as user fees–that is, those who use the roads are paying for their maintenance and upkeep.
2) A vehicle-miles tax would probably raise more money than fuel tax over time, because vehicle-miles are rising more than fuel consumption. In the Winter 2010-2011 issue of the Rand Review, Paul Sorenson, Liisa Ecola, and Martin Wachs illustrate this point with a figure.
 3) The administrative apparatus for collecting the fuel tax is in place, and there are severe issues with how a vehicle-miles tax would be implemented. Sorenson, Ecola, and Wachs write:  “Mileage-based road use fees could be implemented in various ways, but three options appear to offer the greatest promise: (1) estimating mileage based on a vehicle’s fuel economy and fuel consumption, (2) metering mileage based on a device that combines cellular service with a connection to the onboard diagnostics port, and (3) metering mileage based on a device that contains a global positioning system (GPS) receiver.\” The first method seems a little rough-and-ready, and might need to be collected once a year, perhaps when auto registration is renewed. It would be much more visible to the public than the existing fuel tax. The other two methods raise legitimate privacy concerns: should the government really have the power to track where all cars have gone? One way or another, collection costs are likely to be higher for a new vehicle-miles tax.  

4) A vehicle-miles tax does not reward driving a fuel-efficient automobile–which may help the poor.             The Congressional Budget Office published in March 2011 a comparison of a vehicle-miles tax vs. the existing fuel tax in “Alternative Approaches to Funding Highways.”VMT taxes are qualitatively similar to fuel taxes in their implications for equity. Like fuel taxes, they satisfy the user-pays principle, but they impose larger burdens relative to income on people in low-income or rural households. However, to the extent that members of such households tend to drive vehicles that are less fuel efficient, such as pickup trucks or older automobiles, those highway users would pay a smaller share of VMT taxes than of fuel taxes.” 
5) Trying to sort out the relevant externalities is tricky. The CBO suggests that costs imposed by highway users can be divided up into costs more related to miles travelled and costs more related to fuel use. \”Mileage-related costs, which include the costs associated with pavement damage, congestion,
accidents, noise, and emissions of local air pollutants by passenger vehicles, in fact account for the majority
of total costs. (The costs associated with local air pollution from passenger vehicles are considered mileage
related because those emissions, unlike emissions from trucks, are regulated on a per-mile basis.) Fuel-related costs include the costs of local air pollution from trucks, climate change, and dependence on foreign oil.\” I\’m not sure that a single policy can sensibly address costs of road maintenance and construction, environmental costs of fossil fuels, and costs of congestion. Trucks are much harder on pavement than cars. Contributions to congestion depend on when and where you drive. Pollution is affected by the type of car you drive, not just by miles traveled.
Here\’s a useful CBP table summarizing arguments about taxes on fuel versus taxes on vehicle miles traveled. 

Report of the Global Commission on Drug Policy

The Global Commission on Drug Policy seems to be a more-or-less self-appointed group of \”world leaders,\” including former Presidents of Brazil , Colombia, Mexico and Switzerland, along with Kofi Annan, Richard Branson, George Shultz, Paul Volcker, and others. Its Report is a call to \”end the criminalization, marginalization and stigmatization of people who use drugs but who do no harm to others.\”

The report has facts, comparison studies, and citations that should make it of interest to those on all sides of this issue. For example, you can get a quick overview of areas that have decriminalized or legalized use and possession of various drugs, including Portugal, which in 2001 \”became the first European country to decriminalize the use and possession of all illicit drugs.\”

One figure that interested me showed the rise in consumption in certain well-known illegal drugs in the last decade or so.

Another figure shows a ranking of psychoactive drugs according the actual and potential harms they could cause to society, as defined by a team of scientists publishing in The Lancet a few years ago. The color classifications, on the other hand, represent the seriousness with which each of these drugs are treated in international treaties. Thus, heroin and cocaine are ranked as highly risky, and international law treats them that way. But the items ranked fourth, fifth, and eighth on the list by the experts–alcohol, ketamine, and tobacco–are not subject to international control. Like many aspects of drug policy, it\’s one of those things that makes you go hmmmm.

Thanks to Larry Willmore\’s \”Thought du Jour\” blog for the pointer.

Mark Bils on price measurement

Brent Meyer of the Federal Reserve Bank of Cleveland has a nice interview with Mark Bils of the University of Rochester, focusing on the subject of price measurement. Here are some comments from Bils:

On why price measurement matters: \”My interest in price measurement really came out of discussions I had with [Stanford economist] Pete Klenow. Our interest was always less in thinking about inflation and prices. It was rather on the fact that whatever you mismeasure on prices affects how you measure real incomes and economic growth. … Because if you overestimate inflation by 1 percent, then instead of being, say, 1 percent per year real growth, it is really 2 percent per year. Well, that means the growth rate is doubled!\”

On inflation and quality change in health care prices: \”If I compare healthcare costs today versus in the year 1800, well, I could go out and buy a bunch of leeches today for almost nothing. And I could have the healthcare I had in 1800. If you had a certain condition and you had $10,000 to get treated at today’s health prices, or $10,000 to get treated at 1960s prices with 1960s technology, I don’t think it’s so obvious that people would want to go back in time to get their important health conditions dealt with. In that sense, you say, I don’t know if there’s inflation. It’s pretty hard to say that there’s been a lot of inflation over the long haul in healthcare.\”

On quality improvements and car prices: \”My first car was a 1983 Accord, which cost $9,600. It was a great car, but it didn’t have any of the safety equipment that you have today. It didn’t have power windows. It didn’t have air conditioning. It didn’t have many features. If you took that same car—it did get good gas mileage, actually—and you tried to sell it as a new car today, I don’t think you would get $9,600 for it, if you had to compete with what’s out there.\”

On why some changes in consumer prices affect macroeconomic national income more than others: \”A consumer price index isn’t an ideal measure of what’s happening to real income. That’s partly why I think that gasoline is a problem—because it’s so much an imported good. When its price goes up, that’s really a big loss in real income. Whereas when it’s a good that’s produced here, the loss in real income is that it takes more resources to produce it. If our efficiency drops in producing food, and then the food prices go up, that’s a real loss in income. If there’s an upward shock in prices, then the farmers—the people selling the food—do at least get some benefit from the price increases.\”

On the imprecision of hedonic adjustments to price measurements: \”There’s a classic example for vehicles. If you look at gas efficiency, miles per gallon, everything else equal, people would rather get better gas mileage. There’s not much question about that. But if you’re using a hedonic equation, and you say everything else that I observe, how much more are people willing to pay for better fuel efficiency? You actually get a negative number. If I take two vehicles, the characteristics I enter for them, plus miles per gallon/fuel efficiency, I’ll see the one that gets better miles per gallon tends to go for a lower price. … [T]here are very limited characteristics that we’re entering about the vehicle. So all these unmeasured characteristics that people like in their cars tend to be in a luxury car, and we’re not recording all those. They may not care so much about the fuel efficiency; they want performance of the engine. So when I, as a price measurer, look just at this, I’ll price fuel efficiency negatively. That means that if all the cars in the country got more fuel efficient, and we employed the hedonics literally, we would say inflation went up. Even with computers there are problems like this. These hedonic coefficients jump around a lot.\”

The Case Against Price Gouging Laws

Michael Giberson of Texas Tech University has written a nice readable essay on \”The Problem with Price Gouging Laws.\” Part of the essay rehearses standard economic arguments over such laws, but with a nice variety of examples and discussion from both economists and philosophers. The case for price gouging laws, of course, is that raising the price for selling necessary goods during an emergency is morally offensive. But economists are congenitally open to the possibility that, upon deeper reflection, people\’s first quick reactions about what is \”right\” or \”wrong\” may be misleading.  Price gouging laws have the following predictable consequences:

Discourage bringing supplies into certain areas. As one example, there is a chain of convenience stores in Tennessee called Weigle\’s. It sells gasoline, and it buys that gasoline on the spot market–not under long-term contracts. In 2008, when Hurricanes Gustav and then Ike tore through the Gulf of Mexico and shut down oil drilling, Weigle\’s ran out of gas. They trucked gas in from other cities, but the extra costs meant that they raised the price of gas by about $1/gallon. This let to an investigation by the state attorney general, which was eventually settle without an admission of wrongdoing, but with a mixture of payments  to the state and consumer refunds. The next time a similar  situation arises, one wonders whether Weigle\’s  will choose to pay the higher costs of trucking in gasoline from other cities. In South Carolina during the same episode, a number gas stations apparently just closed their doors, rather than risk facing charges of price gouging. More generally, if you want people from the cities surrounding a disaster area to bring in ice and food and batteries and other supplies for sale, then you need to be concerned that price gouging laws will discourage them from doing so.

Discourage conserving on key resources. If prices rise during an emergency, people have an incentive to buy only what they need, and not to stock up. As a result, supplies will run out more slowly and remain available for more people. Imagine a situation in which prices of hotel rooms are not allowed to rise, at a time when many evacuated families are looking for a room. A large family might reserve two rooms at the capped rate, but decide to crowd into one room at a higher rate–thus leaving a room available for another family.

Concentrate economic losses on certain economic actors. Price gouging laws often impose costs on merchants, whose costs rise in times of emergencies. They impose larger costs on smaller firms, who have a harder time getting resupplied, than they do on large national chains that have a built-in ability to shift supplies from elsewhere.

Concentrate economic losses on the disaster area. One study sought to analyze what would have happened in the aftermath of Hurricanes Katrina and Rita, if price-gouging laws had been in place. It found that such a law would have caused greater losses in the disaster areas, because if would have discouraged suppliers in neighboring areas from bringing in supplies. However, the neighboring areas would have moderated any costs to the neighboring areas, because supplies from those areas weren\’t being shipped to the disaster area. A web of economic transactions acts as a mechanism for spreading costs of shortages over a wider geographic area.

Before reading this article, I hadn\’t realized that the creation and spread of price-gouging laws is a relatively recent development. Giberson writes: \”The first state law explicitly directed at price gouging was enacted in New York in 1979, in response to increases in home heating oil prices during the winter of 1978–1979. …
Just three states passed similar laws in the 1980s: Hawaii in 1983, and Connecticut and Mississippi in 1986. Then, 11 more states added anti-price gouging laws or regulations in the 1990s and 16 states followed in the 2000s. When price gouging laws are revised, the tendency is for the scope of the law to be broadened, the penalties to become more punitive, and the conditions under which the laws are applied to become less restrictive.\”

Africa\’s economic development

In the 2010 Annual Report of the Globalization and Monetary Policy Institute at the Dallas Fed, Janet Koech has an essay on Africa–Missing Globalization\’s Rewards? Compared with growth stories like China and India, economic growth in Africa remains anemic. Yet I\’ve been wondering for a few years, based on little hints here and there, whether economic growth in Africa countries might be picking up. The modest upturn in Africa\’s exports and foreign direct investment since about 2000 as a share of world totals are one such hint:

Long-Term Unemployment in the U.S.

Andreas Hornstein and Thomas A. Lubik of the Richmond Fed write about \”The Rise in Long-Term Unemployment: Potential Causes and Implications.\” They define long-term unemployment as lasting more than 26 weeks. They write: “The share of long-term unemployment [as a proportion of total unemployment]  peaked at 46 percent in the second quarter of 2010, and averaged a bit more than 43 percent for all of 2010. This peak value for the share of long-term unemployment is significantly higher than the previous peak of 26 percent that was attained following the 1981–82 recession. Finally, mean duration of unemployment had increased to about 35 weeks by the middle of 2010, again a substantial increase over the previous peak for mean unemployment duration of 21 weeks after the 1981–82 recession. Never before in the postwar period have unemployed workers been unemployed for such a long time.”

Here\’s an illustrative figure. The left axis measures the unemployment rate. The right axis measures what share of the unemployed are long-term unemployed–more than 26 weeks.

Much of the rise in overall unemployment is due more people entering long-term unemployment than in the past, and to those who have been long-term unemployed having a harder time finding jobs than in the past. This is a potentially major change for the U.S. economy. This figure shows that over the 1968 to 2006 period, U.S. workers were employed in any given month had one of the highest chances compared to other countries of losing that job in that month, but at the same time, a U.S. worker who was unemployed in any given month also had the highest chance of finding a job that month compared to other countries.

The very high rates of long-term unemployment, and the difficulties that the long-term unemployed are having in finding jobs, suggests that the true unemployment picture may be even more grim than the headline statistics suggest.