Taxes

Last year, I wrote a blog post about how Los Angeles could fix its traffic problems.  Today, the San Diego Union Tribune reported that traffic has decreased between 3.3% and 9.1% during the week and between 5.2% and 11.9% on the weekends.  How has San Diego accomplished this?

Higher gas prices are the reason.  A pleasant byproduct of higher gas prices are that less people will drive.  Of course, when less people drive, traffic decreases.

As mentioned in the earlier post, instead of building more and more freeways, southern California should have implemented a gas tax or implement more toll on freeways.  Higher gas prices are in essence doing the same thing that a gas tax would.  Higher gas prices, however, end up in the pockets of oil companies whereas a gas tax could be used to create better public transportation infrastructure, thus making it easier not to use one’s car and thus further decreasing traffic.

Pierre Dubois of VoxEU has a suggestion to reduce obesity rates: a junk food tax. Dubois claims that a junk food tax of 5% would reduce junk food consumption by 15% and thus reduce obesity.

While junk food is not healthy, it offers the most calories per dollar. Thus, a junk food tax would fall disproportionally on the poor. Dubois states that “poor consumers [affected by the junk food tax] could then find cheap calories in less-dense food items, like starchy foods which are less apt to be overeaten.”

From a philosophical point of view, I generally do not like government officials making rules about what type of food you can eat. If you want to have a banana split every day that is your choice.

Some “experts” argue that in countries with public health care systems, however, the public does end up paying for the additional health costs of obesity. Yet it not been conclusively showed that obesity leads to higher health care costs. While obese individuals generally have higher health care costs each year, those who are extremely overweight also have lower life expectancy. According to a PLoS study, obese individuals actually cost the NHS less money due to their lower life expectancy.

Further, as a practical matter, it is difficult to determine which food are junk foods. Most people would claim that Pringles are junk food. In the UK, food is exempt from their 17.5% sales tax with the exception of potato chips. According to the L.A. Times, a British court has ruled that Pringles are not potato chips and thus are exempt from the tax.

If Pringles don’t count as junk food, then what does?

According to optimal tax theory, taxes should be highest on relatively inelastic activities.  For instance, most men work full-time and and the tax rate does not affect this.  On the other hand, it has been should that the labor supply of women is much more sensitive to wages and income tax rates.  If we follow the conclusions from the optimal taxation literature we should tax men more than women.

This is what Harvard economists Alberto Alesina and Andrea Ichino propose (see Vox EU).  The Free exchange blog as well as Gilles Saint-Paul of the Toulouse School of Economics, however, are more sensible and reject this proposition.  Free exchange concludes on a particularly interesting point:

“…The economist’s idealised utilitarian social planner does not take seriously the costs incurred by the conflicts that will flare up when some are made ‘more equal than others’.  Perhaps liberal constitutions prominently feature equality before the law for a good reason: official non-discrimination works as a truce, a way of keeping the social peace.“

Earlier this month, I wrote about how the flat tax has been gaining popularity in Russia and Eastern Europe.  It seems that businesses like the flat tax as well.

The Cato-at-Liberty blog notes (”…Losing Business to Flat Tax Neighbors…“) that many businesses are leaving ‘high tax-Hungary’ for its flat tax neighbors.  According to a Budapest Times  story,”flat tax is now the preferred system among the post-communist economies of Central and Eastern Europe. Is Hungary – already suffering the lowest rate of economic growth of the new EU member states – in danger of being left behind?…Thousands of Hungarian companies have already relocated their headquarters to Hungarian-speaking southern Slovakia – not only are taxes lower, but accounting has been made child’s play.”

Why do people like the flat tax so much?  The reason is that it is simple, fair, and decreases tax evasion.  The  flat tax is “…a simple, low-rate tax which is easy to collect and difficult to evade is likely to raise more money than a high-rate tax system that is full of loopholes and which nobody fully understands.”

Score one for economists Robert Hall and Alvin Rabushka who have consulted extensively in designing the flat tax systems in Eastern Europe.

According to the Wall Street Journal (”Flat Tax Fred“), Presidential-candidate Fred Thompson has recently proposed instituting a flat tax in the United States “…with two tax rates of 10% and 25%.” One country has already beat Thompson to the punch: Russia.

In 2001, Russia enacted a flat tax rate of 13%.  The reform has been popular and has since been adopted by countries such as Serbia, Ukraine, Georgia, Romania, Slovakia and Macedonia.  But is the flat tax a good thing?

This is the question which Gorodnichenko, Martinez-Vazquex and Sabirianova Peter try to answer in their NBER working paper titled “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia.”  It has generally been found that tax collections drastically increased after the introduction of the flat tax.  This trend, however, may not be due to the flat tax specifically.  Increased GDP from 2001 until the present certainly accounts for much of the increase in collections.  Also, an increase in voluntary tax contributions or stricter enforcement may be the cause of the increase in tax collections.

The authors use data from the Russian Longitudinal Monitoring Survey and measure tax evasion as the difference between  household consumption and reported household income.  Of course, this is not a perfect measure, but as long as the quantity of the measurement error remains constant over time, this methodology will provide researchers with a good understanding of how tax evasion evolved after the institution of the flat tax.

The authors find the tax evasion is more prevalent among younger, unmarried, individuals with fewer years of job tenure.  Individuals working at small companies were more likely to evade taxes, but surprisingly government workers tend to be among those who most frequently evade taxes.  This is likely due to increased non-reported income from accepting bribes.

The authors use a difference in difference technique comparing changes in tax evasion from low and high tax brackets.  The lower tax brackets were not significantly affected by the changing tax laws, but the higher tax brackets did see a substantial change in their marginal tax rates paid.  The authors also employed a regression discontinuity framework.  This methods compares income groups just below and just above discrete changes in marginal tax rates.

The authors found that the flat tax lead to a significant decrease in tax evasion.  This is likely due to the fact that lower marginal tax rates decreases the incentive to avoid reporting income.  Further, if there is a decrease in tax evasion, policy makers can lower the marginal tax rate further while still collecting the same amount of revenue.

Lower marginal tax rates should also lead to an increase in the labor supply.  The authors, however, did not find this to be the case.  The flat tax had minimal or no impact on worker productivity.  This is likely due to the fact that the supply of labor is very inelastic on both the intensive and extensive margins.

It seems that the flat tax is not only attractive according to economic theory, but may also work well in reality–at least in terms of reducing tax evasion.

•  Yuriy Gorodnichenko, Jorge Martinez-Vazquez, Klara Sabirianova Peter (2008) “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia“, NBER WP #13719.

“Medicare adopted its [Medicare as a Secondary Payer] MSP policy in 1982, effective January 1, 1983. This legislation states that for individuals working at firms with 20 or more employees, and otherwise eligible for Medicare benefits, Medicare serves as a secondary payer for health care expenses. The employer’s health insurance is the first payer. Because employer-sponsored health plans tend to be more comprehensive than Medicare, these workers are effectively foregoing their Medicare benefits by working. If these same individuals were not working, they would receive Medicare as their primary health insurance.”

A recent NBER working paper (”A Tax on Work for the Elderly: Medicare as a Secondary Payer“) claims that the MSP policy creates an implicit tax for elderly workers and thus creates disincentives to work. The authors calculate that the implicit tax is 15-20 percent at age 65 and increases to 45-70 percent by age 80. Making the Medicare the primary payer (MPP) will have two fiscal impacts. First, the cost of Medicare will increase. Since Medicare will be the primary payer, it will then be paying for more treatments. Secondly, enacting an MPP policy will decrease the implicit tax, increase the income and hours worked of elderly individuals and thus increase income tax receipts. The authors claim that since the second fiscal impact will dominate the first and thus recommend that an MPP system be implemented.

• Gopi Shah Goda, John B. Shoven, Sita Nataraj Slavov (2007) “A Tax on Work for the Elderly: Medicare as a Secondary Payer” NBER WP #13383.

Jason’s Furman’s blog post on The Economist’s Free Exchange blog not only has a clever title, but makes a clear argument against an estate tax and in favor of a inheritance tax. Philosophically, this amounts to taxing those who inherit wealth (Paris), but not those who general the wealth (Britney). He cites a paper by Lily Batchelder which states “inheritances should also be included in the heir’s income… because they are just as much income for the heir as are wages or lottery winnings.â€? The reason for an estate or an inheritance tax is to decrease income inequality. Furman writes “the correlation between tax rates under [Ms. Batchelder's] proposed inheritance tax and the current estate tax are 0.23 – suggesting the current system is not doing a very good job of applying higher tax rates to people with greater ability to pay.” Finally, if bequests are accidental–which is unlikely–then the tax will create no economic distortions.

Economists throughout recent history have created models in search of answering the following question: what is the optimal income tax structure? Optimal is generally defined by some social welfare function. While liberals generally favor progressive taxes over proportional or regressive taxes for ideological reasons, this paper makes an argument for progressive taxes by employing economic theory. Although they may distort labor supply decisions for individuals at the high end of the income spectrum, progressive taxes not only increase equality in society but also act as a from of insurance from idiosyncratic wage shocks.

The authors overlapping generations (OLG) model has individuals with two types of ability levels (α_L, α_H). Each year the individual receives an idiosyncratic, serially correlated shock to their wage (η_t). Thus, individual’s wage depends on their 1) age (ε_j), 2) ability level, 3) the idiosyncratic shock, and 4) overall wage rate in the economy. The individual can save money in a risk free asset, but is not allowed to borrow; thus, having a progressive tax code will act as insurance policy for their after tax income. The authors assume that sales taxes are determined exogenously and Social Security taxes are set at a balance budget level each year. The utility function is assumed to be time separable and each individual has significant levels of risk aversion.

The authors find that a tax structure with a constant marginal tax rate of 17.2% with a fixed $9,400 deduction would be optimal. The taxes implied under this system would be as follows:

The authors claim that compared to the current U.S. system, their optimal system would have both the poor and the rich paying less taxes with the middle class paying more. An ex-ante expected utility calculation finds that 62% of individuals will have increased utility from this plan over their lifetime.

This paper, however, does have some serious shortcomings. First, sales taxes and Social Security taxes are taken to be exogenous. Second, government spending is taken to be completely exogenous as well. Third, the paper does not allow poor individuals with no income to receive a grant from the government (i.e..: EITC). Also, transfer payments, such as welfare (a.k.a. TANF) are a de facto tax which redistributes income from rich to poor, but these calculations are not taken into account in the paper. Finally, many poor people with incomes near the Medicaid eligibility limit face implicit tax rates of over 100%; the paper ignores government considerations regarding these in-kind transfer programs.

I think this paper is only really important in that it shows that a simplified tax structure is superior to a complicated one, and that some progressivity is desirable even for those with no altruistic leanings in that it acts as insurance against adverse income shocks.

• Conesa and Kreuger (2005) “On the Optimal Progressivity of the Income Tax Code” NBER working paper #11044.

If taxation reduces the amount of hours worked, why does Scandinavia—which has some of the world’s highest tax rates—have labor force participation (LFP) rates similar to the U.S? This is the question addressed by Richard Rogerson in the NBER working paper “Taxation and market work: Is Scandinavia an outlier?â€?

The study looks at three groups of countries: the U.S., the EU (Belgium, France, Germany and Italy), and Scandinavia (Denmark, Finland, Norway, and Sweden). Europeans and Scandinavians work approximately 1500 hours per employed person per year compared to the American figure of about 1850. In the year 2000, the employment to population ratio in Scandinavia is approximately 0.70, which is the same as in the U.S. Europe has an employment to population ratio of only 0.60 in 2000. We can see Scandinavia’s similarity to the U.S. workforce occurs mostly on the extensive margin. Yet, Scandinavia has the highest tax rates while the United States has the lowest. How can this be explained if taxes provide a disincentive to work?

Rogerson uses OECD and GGDC (Gronigen Growth and Development Center) data and claims that where the government revenue is spent can explain the differential. Government spending is divided into four categories as shown below.

Rogerson contends that the EU has more government spending in the ’subsidy to leisure’ category while Scandinavia spends more on ’subsidy to work’ programs. The paper states that Scandinavia spends 8% of government spending on child and elderly care compared to only 2% in Europe. Further, government employment is highest in Scandinavia (i.e.: 15% in the U.S., 18% in Europe, and 28% in Scandinavia). Of course, government spending on employing individuals will increase the labor participation rates. Increased taxes decrease the incentive to work, but increased spending on programs which decrease the cost of going to work will increase labor force participation.

Rogerson then creates a model where households gain utility from consumption, leisure, and family services (e.g.: child care). In the model, taxes due decrease work incentives, but programs which decrease the price of child care increase the labor supply curve. The paper then argues that the differential in service employment explains the overall employment differential because the service sector is a proxy for the amount of child care. More and less expensive child care services make it easier for parents to enter the labor force.

This argument is very interesting and believable, but the evidence given is weak. The fact that Scandinavia has a higher service sector LFP rate does not necessarily mean that more child care is being given since the service sector includes everyone from economists, lawyers, technology consultants, fast food workers as well as child care specialists. More convincing evidence would include empirical data which showed that after a government increased child and elderly care spending, labor force participation also rose. Still, it seems obvious to Public Economists that Ricardian Equivalence will not hold in reality; where the government spends its money has significant effects on all markets.

Yesterday, President Bush gave the State of the Union Address. In this post, I 1) analyze Bush’s new health care plan, 2) review some commentary from various blogs on the net, and 3) give a excerpt from the speech which directly relates to health care.

Healthcare Economist’s Analysis
The heart of the Bush proposal is as follows:

• Families With Health Insurance Will Not Pay Income Or Payroll Taxes On The First $15,000 In Compensation And Singles Will Not Pay Income Or Payroll Taxes On The First $7,500.

On the positive side, since this is a fixed deduction regardless of the generosity of the health insurance, there is less incentive for individuals to purchase “too much” insurance. In the case where each dollar worth of health insurance decreases one’s tax liability, insurance only costs (1-Ï„)*A dollars per year with the tax deduction when the true cost to society is A. The proposal is also good in that it the tax break does not discriminate between employer-provided and individual-based insurance. This will help (somewhat) to reduce the phenomenon that individuals often choose their job based on the type of insurance offered rather than actual job characterisitcs or the wage offered. According to the President, the health insurance deduction will decrease the taxes for most available which will free up more disposal income for them to spend on other items.

On the negative side, the plan is very inequitable. Since this is a tax deduction, if you are poor and do not owe any taxes, you will not receive any financial help with the deduction. Since tax rates are progressive, the deduction is most valuable to individuals in the high tax bracket, the rich. Look at the example below for a single individual.

We can see that the value of the health insurance tax deduction is worth more than 2x the value for the individual making $10,000,000 as for the person making $10,000.

Other problems with the proposal is the possibility of ‘fake’ health insurance. It seems that the government does not establish a minimum level of health insurance. Thus, someone who wants the tax deduction, but does not want to buy health insurance could buy a policy for $1 which pays for all medical expenses over $1 trillion. Of course, the person will never be able to use this policy but since they technically have insurance, they will receive the deduction. If the person gets sick, however, they can still go to the emergency room and get free care, paid for by the American taxpayers. Thus, some level of minimum insurance should be established in order to qualify for the deduction.

Also, while treating the employer-provider and individual-based insurance groups equivalently may be more fair, it may exacerbate the problem of adverse selection in the individual markets. People with pre-existing conditions may find it even more difficult to afford insurance in the individual market under this reform.

Overall, I think the plan does little to help those who need insurance most. The dollars saved from eliminating the deductibility of employer-provided health insurance could be used in a much more productive fashion to provide health care to more Americans.

Around The Blog-o-sphere
Below I have tried to give a diverse review of some early feedback about the SOTU plan from around the blog-o-sphere:

• SameFacts.com “Maybe I’m missing something here, but this just seems laughable. The idea of a deduction for the uninsured is silly: the value of deductions increases with tax rate, and most of the uninsured either don’t pay income taxes or at the lowest bracket.”
• Cato-at-Liberty: “the president’s proposal mirrors the proposal for “large HSAsâ€? that I introduced.”
• Managed Care Matters: “But it won’t do anything to fix the underlying problem - people who need insurance can’t get it, and if they can, many can’t afford it, leaving the rest of us to pay for their health care.”
• Paul Krugman at Economist’s View: “…the actual plan is to penalize workers with relatively generous insurance coverage…”
• The Heritage Foundation: “It would treat all Americans equally by ending the tax discrimination against families who buy their own health insurance, either because they do not have insurance offered by employers or because they prefer other coverage.“

Transcript
Below is a transcript of the section of Bush’s State of the Union speech which refers to health care. The full transcript is available at the White House website and there is a section on the Bush health care policy initiative as well.

A future of hope and opportunity requires that all our citizens have affordable and available health care. (Applause.) When it comes to health care, government has an obligation to care for the elderly, the disabled, and poor children. And we will meet those responsibilities. For all other Americans, private health insurance is the best way to meet their needs. (Applause.) But many Americans cannot afford a health insurance policy.

And so tonight, I propose two new initiatives to help more Americans afford their own insurance. First, I propose a standard tax deduction for health insurance that will be like the standard tax deduction for dependents. Families with health insurance will pay no income on payroll tax — or payroll taxes on $15,000 of their income. Single Americans with health insurance will pay no income or payroll taxes on $7,500 of their income. With this reform, more than 100 million men, women, and children who are now covered by employer-provided insurance will benefit from lower tax bills. At the same time, this reform will level the playing field for those who do not get health insurance through their job. For Americans who now purchase health insurance on their own, this proposal would mean a substantial tax savings — $4,500 for a family of four making $60,000 a year. And for the millions of other Americans who have no health insurance at all, this deduction would help put a basic private health insurance plan within their reach. Changing the tax code is a vital and necessary step to making health care affordable for more Americans. (Applause.)

My second proposal is to help the states that are coming up with innovative ways to cover the uninsured. States that make basic private health insurance available to all their citizens should receive federal funds to help them provide this coverage to the poor and the sick. I have asked the Secretary of Health and Human Services to work with Congress to take existing federal funds and use them to create “Affordable Choices” grants. These grants would give our nation’s governors more money and more flexibility to get private health insurance to those most in need.

There are many other ways that Congress can help. We need to expand Health Savings Accounts. (Applause.) We need to help small businesses through Association Health Plans. (Applause.) We need to reduce costs and medical errors with better information technology. (Applause.) We will encourage price transparency. And to protect good doctors from junk lawsuits, we passing medical liability reform. (Applause.) In all we do, we must remember that the best health care decisions are made not by government and insurance companies, but by patients and their doctors. (Applause.)

On Friday I attended a job market talk by recent Harvad PhD graduate Filipe Campante. Mr. Campante’s job market paper discussed how the equilibrium level of redistribution changes as inequality in a society increases.

The author sensibly assumes wealth is distributed in a according to a Pareto distribution. Individuals choose a tax level in order to maximize disposable wealth:

• w^d_i=(1-Ï„)w_i+T
• T=Ï„W-φ(Ï„)

The variable w_i represents pre-tax wealth and w^d_i is after-tax wealth. The constant marginal tax rate is Ï„ and the lump sum redistribution amount is T. The convex function φ(Ï„) represents economic or administrative costs to redistribution. Since the distribution of wealth is pareto, all individuals whose pre-tax wealth is above the mean wealth level, (W), will desire no redistribution (Ï„=0). Those with wealth below the mean will prefer taxes to be (1-w_i/W). In equilibrium, the tax rate will be equal to the desired tax rate of the median voter. Since the wealth distribution is pareto, the median individual’s wealth level is below the mean wealth and thus some redistribution will take place.

Adding campaign contributions to the model

The central proposition Campante makes is that inequality will alter the traditional median voter predictions if we take into account campaign contributions. Consumers are assumed to vote or donate to political campaign because they gain utility from this action. This direct utility from civic participation is needed since a rational individual would realize that their vote has a measure 0 likelihood of changing the election’s outcome. Campante also gives evidence that any one individual’s contributions also will not change the outcome of the election. Some empirical findings are:

1. Contributions are typically very small and unable to change an election outcomes (the median contribution is around $500)
2. Contributions are strongly related to personal income
3. Contributions are strongly related to other forms of political participation, such as turnout
4. Parties largely use contributions to increase the turnout of potential supporters

The author assumes contributions are proportional to income. Also, there are two parties: one for the rich (R) and one for the destitute (D). Party R favors less redistribution and party D favors more redistribution. A clever theoretical model is developed which finds that as inequality increases from complete equality, the society will favor more redistribution at first. This is due to the fact that when inequality increases, the median voter is relatively poorer and thus favors more redistribution (i.e.: an increase in τ). However, as inequality increases past a critical value, σ*, more and more wealth will fall into the hands of the supporters of party R. Party R will receive significantly more campaign contributions than Party D and thus the voter turnout for the supporters of Party R will be higher than the turnout for Party D. Thus, income redistribution, τ, will decrease as income inequality increases past the critical value σ*.

To summarize, when inequality increases there are two effects: 1) the median voter will prefer more and more redistribution and 2) Party R will receive a higher and higher percentage of the political contributions. Effect 1 dominates when inequality is relatively low and effect 2 dominates when inequality is relatively high.

Empirical Work

While the theoretical section of this paper is interesting, the empirical section is less significant. The author does not test whether redistribution increases with inequality—which is what the model proposes—but only whether campaign contributions increase with inequality. Campante finds that the amount, but not the number, of campaign contributions increases with inequality. This evidence is predicted by the theoretical model developed, but does not prove the theory since the regressions are based on campaign contributions and not redistribution levels.

• Campante, Filipe “Redistribution in a Model of Voting and Campaign Contributions,” Working Paper, Nov. 2006.

The current tax system is complex.  If a researcher would want to correctly model the current tax system, they would have to take into account the myriad of deductions in the federal tax code (e.g.: Earned Income Tax Credit, Child Tax Credit, mortgage interest deduction, etc.) as calculate these deductions for each type of household.  One would also have to take into account: the FICA payroll tax (for Social Security, Medicare and Unemployment Insurance), the effect of extra current earnings on future Social Security benefits, the corporate income tax, and any implicit tax from loss of transfer programs such as TANF, Medicaid and Medicare. 

Many economists have proposed a simpler solution.  Milton Friedman proposed a Negative Income Tax, the Europeans rely heavily on the Value Added Tax, and a recent NBER working paper by Laurence Kotlikoff and David Rapson (”Comparing average and marginal tax rates under the FairTax and the current system of federal taxation“) proposes a flat 23% federal retail sales tax which they decide to name the ‘FairTax’. 

The ‘FairTax’ proposal is elegant and does not favor any specific group.  Below I review my opinions of the pros and cons of the proposal.

Pros

1. Simple - This proposal is simple and theoretically elegant.  It eliminates the loopholes many wealthy individuals use to drastically reduce their tax liability.
2. Progressive during the Transition phase - Since a sales taxes current and future earnings at the time of consumption in addition to taxing current wealth as it is spent on goods and services, this tax is somewhat progressive.  During the implementation phase of the tax, those who saved money and paid income taxes on their earnings will now also have to pay a large retail sales tax on these savings.  The income tax only taxes current and future earnings, but does not tax existing wealth.  As you can see below, (Y=current assets, L=labor income, w=wage, c=compution, τ=tax rate), the income tax and the retail sales tax are mathematically equivalent except for the fact that the retail sales tax also is a tax on existing assets.
• Y+wL=c*(1-Ï„)
• 1/(1+Ï„)*[Y+wL]=
3. Incentive to save - Since only spending is taxed, the ‘FairTax’ will give individuals an incentive to save more.  If an income tax rate is 25%, currently an individual can only save 75% of their earnings (excluding 401(k) and IRA options).  Under the ‘FairTax’, an individual saves 100% of their earnings and one is only taxed when the money is spent in retirement.
4. Decreases the marginal tax rate of most workers - Kotlikoff and Rapson show that a married couple with $35,000 of earnings with two children faces a marginal income tax rate of 47.6% (mostly due to EITC takeback rates).  In their paper, Kotlikoff and Rapson show that marginal tax rates will be reduced for nearly all individuals.  Lower marginal tax rates gives workers an incentive to work more hours as well.

Cons

1. Tax Evasion - With only 1 type of tax, tax evasion may become a significant problem.  Small and medium sized business may decide not to record transactions in order to reduce the retail sales tax they must pay.  The tax literature suggests that many small taxes through a variety of channel (i.e.: income tax, sales tax and a corporate tax) may be empirically superior to one single tax, since using a portfolio of taxes reduces the incentive for individuals to evade the tax.
2. Politically Difficult to pass- most politicians like to target favored groups with tax cuts.  The child tax credit appeals to families and the mortgage interest tax deduction appeals to homeowners.  It will be difficult for these strong constituencies to agree to have their tax deductions taken away.
3. Elderly - Since it is the retired elderly who have wealth but no earnings, this tax will hit them the hardest.  The authors propose increasing Social Security benefits by 23% to compensate for the tax, but do we really want to be increasing public pension benefits as the Baby Boomers retire?  This may be a fiscally destabilizing proposal.
4. Eliminates sound policies - The EITC has brought many people into the work force.  The elimination of tax deductions for charitable giving may reduce the amount of funds NGOs receive and the federal government may have to provide more welfare programs to cover the shortfall.  Do we want a completely impartial system which may not be Pareto optimal or do we want a less ‘fair’ system than could improve economic efficiency for all.
5. Medicaid - There will still be high implicit tax rates for some individuals.  Since benefits such as Medicaid are ‘lumpy’, those who are at the margin for Medicaid eligibility will still face a high implicit tax rate (likely greater than 100%). 

 

On Thursday I mentioned the Treasury Department’s plan to turn over some of the collection of delinquent taxes to private companies.  In most modern societies of the Western world, tax collectors are salaried employees of the state.  This was not always the case.  A 2006 paper by Cosgel and Miceli aims to create a model as to why governments choose the tax collection systems they do.  They also examine the tax collection methods of the Ottoman empire to help support their thesis.  The authors claim that the agency relationship between the government and the tax collectors is the determining factor as to which system is chosen.  The three competing systems are 1) share contract, 2) rent contract and 3) wage contract.  I will discuss each in detail below.

Share Contract

The share contract occurs when the government grants the agent a fixed percentage of all tax revenue received.  This is the system which is currently proposed by the U.S. government.  Share contracts were also used in pre-revolutionary France, India, China and Medieval Egypt.  The model Cosgel and Miceli employ is one of a tax collector attempting to maximize utility by choosing an effort level ‘e‘:

• U=E[f(e)B-T(f(e)B)]-e

The tax base is represented by ‘B‘ and ‘f(e)‘ is a stochastic function.  The compensation to the tax collector ‘T()‘ is a function of the total revenue collected.  The first order condition for this model is:

• f’(e)E[B(1-T')]=1

Once the collector chooses the optimal e*, the value of the tax collection to the government is:

• f(e*)E[B]-e*-k-u

where ‘u‘ is the reservation utility and ‘k‘ is the fixed cost to measuring the tax.

Rent Contract

In a rent contract the collector would pay the government a fixed amount and in turn would receive the right to all taxes of the specified area in return.  Republican Rome, the Abbasid Empire and the Ottomans all heavily used rent contracts.  Sometimes these contracts were given to military officers in lieu of wage payments for their services.  The objective function and first order conditions for the tax collector are below:

• U=f(e)B-e-T(B)
• f’(e)B=1

The rent contract is the only one in which effort is state contingent [e* is a function of the stochastic variable 'B'], because the tax collector’s payment to the government is determined ex ante but the actual revenue ‘R‘ is determined ex post. 

The return for the government is:

• V=E[f(e*(B))B-e*(B)]-m-u

Here, effort is a function of the tax base since more effort will be put forth when the tax base is larger.  The cost of the government verifying the tax base is ‘m’, however if there is competitive bidding for the contract, then m=0.

Wage Contract

Wage or salaried workers are the most common form of compensation for tax collectors today.  Eighteenth century Sweden and Russia used salaried agents to collect taxes.  After tax collection cartels in England (The Great Farm) and France (Ferme Générale) reduced the percentage of tax revenue the governments were receiving, both countries switched to a salaried system in the mid to late 18th century.  The objective function and FOC for this model are below:

• U=f(e)E[B]-se-w(e),    s.t.: w(e)-e>u
• f’(e)E[B]=1+s

Here ‘s‘ is the cost of monitoring.  In this model, the government receives:

• V=f(e*(s))E[B]-e*(s)(1+s)-u

Analysis

The main determinant of which method to choose is to see whether it is more costly 1) to verify tax revenue, 2) to verify the tax base, or 3) to verify worker effort.  The three options correspond to a high level of 1) k 2) m  and 3) s.  Share contracts are not very common since it is often very difficult to determine how much tax revenue has been received.  The tax collectors could hide the revenue.  Verifying the tax base is often difficult in rural areas where farmers produce agricultural products.  Valuing crops for tax purposes is often difficult. 

The authors claim that the Ottoman empire used rent contracts for longer than did England or France because the tax base was easily calculated prior to the 19th century.  Surveys were conducted every twenty to thirty years and would remain relatively accurate.  At the beginning of the 20th century, the authors claim that the tax base became more variable due to “demographic and socio-economic transformations” yet the authors do not specify which transformations these are.  Nevertheless, when the Ottomans moved to a salaried system of bureaucrats in the late 19th century, the authors claim that these “transformations” (which increased the variability of the tax base) were the cause of this institutional change.

One point which is not emphasized in the paper is that in a competitive bidding process the rent contract should be the most efficient.  If there is competitive bidding, the government will not have to value the tax base, but can simply auction off the contract and bidders will increase the price until the contract price reaches the estimated tax receipts less labor costs for collecting the taxes.  It is possible that this is theoretically true, but has not been shown empirically throughout history (for instance due to cartels); yet the authors do not make this point and simply assume that the government must incur a cost to verify the tax base.  Overall, the paper provides a nice unifying principal-agent framework to the systems of tax collection which could be chosen by a government, but only provide weak empirical evidence that the reason a tax collection system was chosen in the past came from the incentives derived from their models.  The authors also skip over the problem of who monitors the monitors within the government. 

Cosgel, Metin; Miseli, Thomas; (2006) “Tax collection in history: Public institutions and institutional change in the Ottoman Empire“, Presentation at the International Economic History Congress, Helsinki, Finland; August 22, 2006. 

The New York Times reports (”IRS Enlists Help…“) that the Internal Revenue Service will begin to subcontract collection of delinquent tax payments to private firms.  The article states:

“…the I.R.S. will turn over data on 12,500 taxpayers — each of whom owes $25,000 or less in back taxes — to three collection agencies. Larger debtors will continue to be pursued by I.R.S. officers.

The move, an initiative of the Bush administration, represents the first step in a broader plan to outsource the collection of smaller tax debts to private companies over time. Although I.R.S. officials acknowledge that this will be much more expensive than doing it internally, they say that Congress has forced their hand by refusing to let them hire more revenue officers, who could pull in a lot of easy-to-collect money.”

As an economist, I would like to briefly compare the incentives of private tax collectors and the government tax collection.  Privately owned debt collection firms likely want to collect as much money as quickly as possible in order to maximize profits.  This is a good thing if compels more citizens to pay their taxes on time. 

Since government employees do not have a profit motive, it is likely that government collections rate would be lower.  The statement in the NYT that using private debt collection is more expensive is due to the fact that 22% to 24% of all cash received by the firms will be used as their commission.  One benefit to using government tax collectors is that without the profit motive, the IRS agents have an incentive to be more “fair” in the case that the ruling of delinquent payment was incorrect. 

The Economist’s View blog relates some of the arguments of Paul Krugman.  Krugman believes that the trend of privatizing administrative and military government functions could make this country one ruled by tax farmers and mercenaries.  Another issue to consider is how secure a taxpayer’s private financial information will be in the hands of a private firm.

For most individuals, dividend taxation is higher than capital gains taxation.  In theory, one would believe that corporations would thus elect to hold all their profits as retained earnings (or repurchase outstanding shares) in order to increase the price of the stock as opposed to paying out the profits as dividends, since the tax treatment of capital gains is more favorable for investors.  If there were no problems of asymmetric information, the stock price would rise more than the the value of the dividend because of the tax rules.

In the data, however, most firms do pay dividends, despite the tax disadvantage.  This is the ‘Dividend Puzzle.’

In their 2006 NBER paper (”Dividends and Taxes“), Roger Gordon and Martin Dietz offer three traditional theories to explain this phenomenon.  I will briefly review each model.

• “New View”: The new view assumes that share repurchases are not allowed.  This is not a very reasonable assumption, but share repurchases are outlawed in the UK, and in the US periodic share repurchases are treated as dividends for tax purposes.  The theory says that if an individual has potential projects whose rate of return is high, then Tobin’s q will be greater than 1.  The firm should then sell new shares to finance these high-return projects until q=1. If future projects have a lower return, then the firm should pay out profits as dividends.
• Agency Model: Shareholders face a tradeoff.  If they choose to keep profits within the firm in the form of retained earnings, managers may be tempted to use the money on projects with a sub-optimal rate of return.  It is assumed that managers (like bureaucrats) are empire builders and wish to increase the portion of the company over which they have control.  Investors are assumed to have less than full knowledge of the profitability of a project and thus must to some degree rely on the manager’s judgement.  In order to limit the capital available to the managers so they will only be able to finance high return projects, investors elect to have a constant stream of dividend payouts.  The drawback to this is that managers who find high-return projects are capital constrained and must go to the capital markets for more funds, which are generally more costly than procuring funds from within.  The tradeoff where dividends limit the capital available to empire-building managers but also increase the cost of financing future investment is the essence of this model.
• Signaling: In the signaling model, the manager cares about the share price of the firm as well as its true value.  We are no longer in an empire-building set-up.  Investors are not certain whether or not a firm is a high or low value firm, but managers do know the true value of the company.  Dividends are costly, so highly profitable firms will be able to finance paying a constant stream of dividends.  The dividend stream is a signal to the market that this firm is profitable one.

This theories aim to explain some stylized facts that we see in the data.  Let’s see how they do:

• Dividends are often positive, and stable over time.  The new view would not predict this.  Dividends should vary according to changes in profitability.  The Agency and Signalling models would both display this phenomenon as described above.
• New Share offerings are seen concurrently with dividend payouts: The New View and the Signaling models make it seem non-sensical to raise capital by increasing the number of shares, but decrease capital through dividend payouts.  The agency theory would support this since a steady stream of dividends over time would limit capital, but occasional needs for the financing of lucrative projects would lead occasional share offerings.
• Dividend Tax rate changes: The new view would hold that there is no change in efficiency.  The firm pays out its profits through dividends if possible, so an increase in the dividend tax lowers firm value, but does not change efficiency.  In the agency cost model, an increase in the dividend tax lowers efficiency.  Lowering the dividend tax will lead to decreased dividend payments and more retained earnings; but this leaves more cash in the hands of empire-building managers.  The signaling model would predict an efficiency improvement.  Since dividends payouts are more expensive, a lower level signal would be needed to communicate to investors that the firm is high quality.

Gordon and Dietz conclude that the Agency model best fits the data, but more investigation is required.  The do not support this conclusion with econometric proof, but simply that the Agency model best fits the stylized facts of the market.  Their paper is very theoretical and they make some assumptions of which I am uncomfortable.  They assume that firms can acquire other firms as a more efficient way to increase the share price than paying dividends which are tax disadvantaged.  But merging with another firm involves many transaction costs (lawyers, integration costs, etc.), and is likely less efficient for investors unless a smooth match is made.  I am curious on how dividend payments of firms in the same sector affect the decision of an single firm to pay dividends. More interesting papers regarding taxation are available at Roger Gordon’s homepage.

Arnold Kling is a respected libertarian economist who has worked at the Cato Institute.  In a post for TCS Daily titled Bleeding-Heart Libertarianism, Kling makes an argument for a negative consumption tax for all individuals.  The thesis is simple and elegent, but does have some problems.  I highlight five major ones that come to mind.

• Fraud: If everyone poor people received a very large lump sum transfer (on the order of $20,000) for some individuals, there would be large incentives to lie about the amount of consumption that occurred.  Would people invent fake Social Security numbers to get 2 rebates?
• Healthcare: Kling would eliminate Medicaid and Medicare. While I do not believe these are ridiculous ideas, he does not create a system which all individuals would be compelled to buy some form of insurance.  Kling simply assumes that hospitals will turn away individuals who cannot pay, yet American society has not reached the point where it will allow its hospitals to turn away patients in need. 
• Black markets: If taxes are based on large consumption taxes, would this lead to the creation of large black markets?
• Immigration:  Would immigrants also receive a very large tax rebate?  If this is true, then immigrants from poorer countries would move to the U.S. to receive the generous tax benefits available here.  If immigrants are not eligible for the tax deduction, when would they become eligible?  Currently, immigrants are eligible for some tax deductions (eg: the standard deduction for each child, business expenses, etc.) but not others (eg: the EITC).   
• Inefficient Taxation: Optimal tax theory generally says that the government should tax goods with inelastic demand more than goods with elastic demand.  For instance, one should tax cigarettes because of its inelastic demand.  While a general taxation may be wise to reduce government market interference, deadweight loss could be reduced by targeting taxes.

The popular press has been decrying the existence of large numbers of Americans without medical insurance. From Indiana to Wisconsin to California, politicians are looking for a means–such as government provided health insurance–to give more residents medical insurance. Economists, however, generally speak out against the provision of private goods by the government.

An interesting solution was proposed by Pauly Herring and Song (2002) in which individuals would receive a $1000 refundable tax credit if they (or their employers) purchased health insurance. The study focuses on single individuals using the 1996-97 Community Tracking Survey (CTS). Using the eHealthInsurance.com website, they were able to calculate the premiums each individual in the CTS survey would pay if they were currently applying for insurance. The authors assumed participants would choose the lower priced options and thus calculated the premiums owed at the 10th and 25th quartiles for a variety of deductible amounts.

Results

• They found that using this credit, approximately 20% of all individuals who had previously purchased individual insurance would pay zero net premiums after applying the credit.
• Assuming an Arrow-Pratt absolute risk aversion coefficient of 0.00095, Pauly, et al. are able to calculate a reservation price for each person, using an expected utility framework. They find that of all the currently uninsured individuals in the sample, 77%-85% would take up the insurance.
• The 85% number, may be overly optimistic. The calculated reservation price is actually greater than the absolute premium for 23% of the sample, and thus the authors settle on 60%-65% as a more conservative estimate. The lower take-up rate may be due to the fact that most poor individuals are able to receive charity care at no cost, and thus have less of an incentive to purchase insurance at some non-zero cost.
• According to Health Affairs, maintaining the tax-exempt status of employer-provided group insurance cost taxpayers $188.5 billion in foregone revenue in 2004. If we implemented the voucher system where single households received a $1000 credit and family households received a $2000 credit, the cost to taxpayers would be only $142.9 billion assuming all individuals received the credit (calculations made using US Census population projections p. 18). This does not even take into account the cost reductions from decreased Medicaid and/or Medicare usage.
• One issue to worry about with this proposal is fraud. Will people falsely report that they have insurance in order to receive the credit? I would assume this wold occur, but the prevalence can not be predicted.

Pauly, Herring, and Song (2002) “Tax Credits, the Distribution of Subsidized Health Insurance Premiums and the Uninsured” Forum for Health Economics and Policy, Vol 5(5).

Of course they should! Non-profit hospitals treat the poorest patients in the most underserved communities using a bare bones administrative budget…right?

According to the New York Times (”Nonprofit Hospitals Face Scrutiny Over Practices“), the traditional view of non-profit hospitals as altruistic institutions may be flawed. The commissioner of internal revenue, Mark W. Everson, said tax officials often found little difference between nonprofit and for-profit hospitals “in their operations, their attention to the benefit of the community or their levels of charity care.” In fact, uninsured patients may pay more for services than the uninsured. For instance, HMOs often negotiate price discounts for their customers who receive services at non-profit hospitals; the uninsured have no one to negotiate on their behalf.

Some excerpts from the article:

• Some nonprofit hospitals have hired debt collection agencies that “harass the poor.”
• Some nonprofit hospitals and health systems in Minnesota have provided “lavish gifts” and “grossly excessive” compensation to top executives while providing “paltry levels” of charity care. For instance, the president of NewYork-Presbyterian Hospital, Dr. Herbert Pardes, received more than $4.3 million in compensation in 2004, plus $1.2 million in contributions to his employee benefit plan.

Do you want your tax dollars to help arbitrarily subsidize some hospitals over others? If we want to assist the uninsured, policy should help the poor to afford health insurance, either through easier access to Medicaid or (preferably) monetary transfers to these individuals.

H&R Block, one of the largest tax services businesses in the United States, has incorrectly filed its taxes in 2003 and 2004.  The tax error understated H&R Block’s tax liability by $32 million.   Oh the irony!!! 

Check out the complete article in BusinessWeek (”H&R Block falls on 3Q results, tax issue“).

Passed in 1978, Proposition 13 was a ballot initiative to amend the state constitution to limit property taxes to a 1% of a homes value. The amendment also capped the annual growth rate in property value assessment at 2% per year until the house is resold.

 

William Fischel (1989) argues in “Did Serrano Cause Proposition 13? â€? that an earlier court case was the true motivation for the reform. Serrano v. Preist (1971) was brought about because of concerns that rich areas had more funds to devote to their neighborhood’s schools. California was not a land of equal opportunity for all youngsters in the eyes of the court. The judges declared property tax finance of local schools to be unconstitutional and thus education funding was provided almost exclusively from the California general revenues.

 

While many economists would argue that taxes are distortionary and Proposition 13 was a positive development, the Tiebout model would beg to differ. Charles Tiebout recognized that when public goods are excludable and provided by a variety of jurisdictions, those with high preferences for the public good will live near others with the same preferences (and vice versa). Education is a perfect example of this. Those with kids tend to live in higher property taxed neighborhoods with better schools, while senior citizens prefer to live in areas with low property taxes and poor schools.

 

Since Serrano severed the tie between school spending and property taxes, rich families were in essence subsidizing the schools of the poor. Further, affluent neighborhoods could not increase taxes to pay for their own schools since Serrano made this action unconstitutional. Anecdotes exist of thousand dollar bake sales that parents used to get around Serrano but the prevalence of this phenomenon is unknown.

 

Nevertheless, Fischel claims that parents became frustrated that the link between taxes paid and their children’s school’s expenditure level was broken. This lead to the passage of Proposition 13 which significantly decreased the property tax levels for homeowners and landlords. Since the Tiebout model uses property taxes as the price for education and individuals can choose their desired educational consumption by selecting their neighborhood of residence, there existed a near competitive market before the Serrano passage. Fischel argues convincingly the Serrano decision lead to a Pareto inferior outcome in California.

One key parameter of interest to policymakers is the firms elasticity of offering health insurance with respect to price. This is an important question because the current tax exemption of employee compensation in the form health insurance in essence changes the price of health insurance. A large—in absolute value—elasticity would imply that the tax subsidy would compel a significant amount of firms to offer insurance to there employees. A small elasticity means that firms are not price sensitive and thus the tax subsidy may be ineffective in decreasing uninsurance.

Below is a brief review of the empirical findings from recent studies. The estimates are from Gruber and Lettau (2000). In the upcoming weeks, I will be analyzing some of these studies in more detail.

 

Conventional Wisdom holds that financial aid helps poor students afford higher education.  This is certainly true.  However, does financial aid truly help the entire distribution of poor families in the United States.   A study by Hansen and Weisbrod in their 1969 book Benefits, Costs and Finance of Public Higher Education seeks to analyze how financial aid is distributed among different segments of society.  They focus on the California.  In 1965, the average income of families with children enrolled in the University of California system was $12,000.  In the California State College system the average was $10,000 and the average for families without children in either system was $7,900.  The average amount of state taxes paid by each group was $350, $260 and $182 respectively. 

When Hansen and Weisbrod calculated the net taxes paid, discounting the benefits received from higher education financial aid, families in the UC system receive a net subsidy of (+$1,350), families in the Cal State system received a subsidy of (+$1,140) and those without children in either system still owed the tax (- $182).  This does not seem to be distributionally fair.

When we look at medical school admission today, 50.8% of entrants in private schools and 44.0% of public school entrants come from families which earn over $100,000.  Medical School financial aid is thus targeted almost exclusively towards the rich.  While financial helps the few poor students who wish to become doctors, in general the financial aid is a subsidy to the rich.

If one really wants to help young Americans get an education, a grant to people who are 18 years old would be an improvement.  This could either 1) help them afford an education, 2) give them some start-up capital to being a business, or 3) save some money for the future (including going back to college later).  This would be a more efficient way to allocate aid for college since it would not distort college tuition prices and would allow individuals to decide how to best maximize their welfare. 

Much of the background for my analysis was found in Health Care Economics by Paul J. Feldstein, 6th edition; Thompson Delmar Learning, 2005.

In the United States today, many employees receive compensation in the form of health insurance in addition to pecuniary remuneration. Health insurance, however, is tax deductible when it is received from an individual’s employer while wages are not. A Health Affairs report shows that this tax expenditure from excluding health insurance from the federal income tax cost the government over $100 billion in 2004.

Is this tax expenditure worth the cost? My “Health Care Tax Policy” paper examines the pros and cons of this policy. On one hand, the tax may encourage over-insurance; on the other the tax subsidy may eliminate some problems of adverse select. The conclusion of the paper is that the tax subsidy is efficient only if adverse selection is a significant problem, and if the cost savings from group policies outweigh any fixed costs firms incur from administering health care plans.

Please, feel free to take the time to read the paper and give me some feedback.

Massachusetts has proposed a health care bill which four major components:

1. Mandatory insurance for all Massachusetts residents

2. Firms who do not offer insurance to their employees are subject to a payroll tax of: 5% for firms having between 11 and 100 employees and 7% for firms having over 100 employees. Firms employing 10 employees or less are exempt from this measure.

3. Repeal of the surcharge employers who provide insurance pay for the “Free Care Pool”, a fund which helps finance health insurance for the poor.

4. Employers with 50 or fewer employees could purchase insurance through Connector, a Massachusetts health insurance plan for small businesses.

5. Increase funding for Medicaid and increase reimbursements to physicians and hospitals.

Let’s look at the Pros and Cons…

Pros:

This bill will certainly increase health coverage. The first reason is of course because health coverage will be mandatory. This will force the uninsured, who are generally younger, into the insurance pool. This will reduce the problem of adverse selection where only the sick want insurance. Old sick people will certainly benefit, but young healthy people may or may not benefit from mandatory insurance.

While the payroll tax at first seems onerous on business, according to a Families USA Report currently only 5% of businesses with 25 or more employees do not offer health insurance and 16.3% of employers with 10-24 employee do not offer insurance. The repeal of the surcharge for the “Free Care Pool” will reduce the cost to firms that provide health insurance for their employees, and after the implementation of the payroll tax, we would expect few firms to not offer group insurance. Connector fund should be of great assistance to help small businesses to reduce their insurance cost. When risks are pooled over many small businesses, insurance costs per employee are lower due to reduced administrative costs and a reduced risk for adverse selection.

Cons:

Mandatory health insurance may be efficient in the sense that it eliminates adverse selection, however, libertarians would object to the government compelling an individual to purchase thousands of dollars worth of insurance. Does the government know better than you that spending money on food, electricity or your children’s school is less worthwhile then health insurance? Libertarians believe individuals should be able to make that decision for themselves.

In a closed economy, we would expect firms to adopt health insurance to avoid the payroll tax; however firms may also take other actions to avoid the tax. The Massachusetts Taxpayer Foundation perceptively notes that with the increased cost of labor in Massachusetts, many business would set up shop in adjoining states with lower labor costs. In the short run firms would likely simply reduce the cash wages employees earn so that their total compensation (wages + health insurance) is at the same equilibrium amount as before the legislation. If wages were sticky and did not decrease, this could lead to increased unemployment to levels that we see in European countries. Further, firms could substitute capital for labor leading to inefficient production.

Conclusion

Overall, I think this is a good bill, provided that the revenues raised from the payroll tax are used to reduce taxes in other areas. Many of the provisions of the bill address the problems of adverse selection inherent in the health insurance market. Allowing small firms to pool their insurance pools through the Connector fund is a great idea, where no one loses. One question that has not been addressed in any of the reports I saw was ‘how much insurance are employers required to provide in order to be exempt from the payroll tax?’ Forcing employers to provide comprehensive insurance will lead to ‘over-insurance’ for many individuals. On the other hand, allowing employers to only offer ‘catastrophic’ insurance with the option for the purchase of more insurance by employees will give rise to adverse selection again. In the short run, I would expect to see unemployment jump as firms reduce employment since wages are sticky. In the long run, I would expect to see real wages drop slightly in order to compensate for the additional compensation workers receive in the form of health insurance.