Rubaiyat Tasnim and the ESG
April 12, 2018

On February 28, 2018, the Graduate Center Public Programs and the Stone Center on Socio-Economic Inequality held a panel on tax reform where experts discussed its implications and how it will impact different constituencies. Panelists were: Larry Kotlikoff, the William Fairfield Warren Professor and Economics Professor at Boston University; Lily Batchelder, the Frederick and Grace Stokes Professor of Law at NYU School of Law and Professor at the NYU’s Wagner School; Leonard Burman, co-founder of the Urban-Brookings Tax Policy Center, the Paul Volcker Professor and Professor of Public Administration and International Affairs at the Maxwell School, and a Senior Research Associate at the Syracuse University; and the Nobel Laureate Paul Krugman, a Distinguished Professor of Economics at the Graduate Center and New York Times columnist. The discussion was moderated by Kathleen Hays, global economics and policy editor at Bloomberg.

Statements by Panelists on the Tax Bill

Paul Krugman started off the discussion by questioning why we are cutting taxes at this point in the business cycle. The US economy is at full employment and the government is in deficit. As the US population is growing older, the burden of maintaining programs such as Medicaid, Medicare, and Social Security is growing as well. The tax cut is only worsening our fiscal condition.

Leonard Burman stated that the tax system needs to be reformed and pointed out the problems of the current system including its inefficiency, complexity, unfairness, and inability to raise enough revenue for the government. The Congressional Budget Office has projected 10 trillion dollars in deficits over the next decade. The US corporate tax rate is high compared to other nations, but the tax bill cut the tax rate for unincorporated business as well which is not very high relative to other countries. The bill succeeded in giving the Republican Party a legislative victory which not only helped them undermine the Affordable Care Act but might also behave the way Reagan’s 1981 tax cut did – it may distort the tax code much more to generate momentum for another tax reform in five years.

Lily Batchelder started her introduction by stating that she has been a fan of tax reform but it is setting out to do the exact opposite of what she was expecting. The tax reform should have addressed the long-term fiscal issues through generating more revenue. The bill is very heavily tilted towards tax cuts for the wealthy. As it is increasing the deficit, it is putting social programs in danger in the future. She highlighted the biggest new loophole in the code: The new pass through deduction cuts taxes for unincorporated businesses and greatly complicates the administration of the tax code to try to ensure that individuals do not form an unincorporated business to avoid the higher individual tax rate.

Laurence Kotlikoff agreed with other panelists about the current condition of US economy, and noted that enormous amounts of off the book debt and contingent liabilities, which when properly accounted for, makes it a 200 trillion dollar debt rather than a 20 trillion dollar debt. He believes the tax reform has positive elements and that there will be a significant increase in capital formation in the country, a 15% increase over time and a 5 and half percent increase in wages, which would offset the increase in debt to GDP ratio. The unfunded liabilities grow by about 6 trillion dollars per year, which compared to the increase in debt of about 1.6 trillion dollars in 10 years is much more substantial. He argued that the tax reform did not increase inequality. As the share of spending of the top 1% within each group will not change at all, he states that the tax reform is fair. The absolute amount of tax benefits for richer will be higher as they pay higher taxes.

Supply side: Will the companies invest more and create more jobs?

L. Kotlikoff argued that as the marginal corporate tax is lowered from 34.6% to 18.8%, a lot of capital from abroad will come in and will be staying in the US. This will impact wages by increasing them by 5.5% over the next ten years. The consumption rate is extremely high, with national saving rate at only 4%, and with a domestic investment rate of 5%, only 1% of national income is being invested from abroad into US. As the country saves too little, the reform will help move capital from abroad.

P. Krugman agreed with L. Kotlikoff that it will attract capital from abroad, but believes it will take a long time. If the bill works, it will still nonetheless produce huge trade deficits for a decade or more. This trade deficit will lead to strong dollars which will deter investments. The corporate profits in US are a return to monopoly power. As taxes are cut on monopolies and new investments are not generated, this will increase wages. As more capital moves from all over the world to the US, it will raise the return on capital all over the world. With more capital from abroad being invested, the returns paid to them will increase and the net benefit to the residents will be only the tax wedge. Foreigners already own a third of equity in US and this tax reform cuts taxes on that. Keeping all these factors in mind, this tax reform will fail to increase income and it will only exacerbate the deficit problem.

L. Batchelder pointed out how there could have been a way to do business tax reform that could help the economy in the long run. This bill loses a huge amount of revenue and may not have been a good time to act on an economic stimulus. The positive growth effects of the tax reform disappear and potentially reverse. Raising taxes in the future or cutting spending programs may be necessary to pay for the tax reform and will likely put a drag on growth.

L. Burman added to these points by stating how the models developed by the Joint Committee on Taxation do not produce the big macro effects advocated by the supporters of the tax reform. The bill allows firms to immediately deduct the cost of new investments, called expensing. Theoretically, this will encourage them to invest more, make workers more productive and could raise wages. Empirically, there has not been a huge response to tax reforms in many countries or even within the United States. The tax rate cut to foreign holders of US equities will only benefit the foreign equity holders. He gave the example of 1986 corporate tax rate cut which led to other US trading partners to cut their tax rates in response, eventually reducing the effectiveness of tax rate cuts.

What Is the Tax Reform’s Impact on the Economy and Will It Benefit All?

P. Krugman stated that the tax reform will lead to more spending. But it would have been better to have done that when the unemployment rate was 9.5% rather than now. The fast economic growth will also see a hike in interest rates by Jay Powell, the new chairman of the Federal Reserve, which will limit the effect of the tax reform. So, the increase in consumer confidence will not initiate much growth. The deficit spending in a full employment economy will react differently than deficit spending in a depressed economy. Orders for new capital equipment, which is the first early indicator of an investment surge has not gone up yet.

L. Burman, addressing the stock market rise, stressed the point that the increase in profitability is from the companies making decisions assuming a tax rate of 35%. The value of the profitable companies go up when the income is taxed at 21%, which is a one-time shift and unlikely to continue. The observation that a lot of the companies are paying bonuses and wages are going up are not anomalies at this stage of economic cycle. As the labor market is getting tighter, the companies are competing to keep their workers through bonuses.

L. Batchelder distinguished between the direct and indirect effects of tax bill. She terms this bill as an “incredibly regressive bill” when considering the direct effects on employee compensation or wages. As an example, the average tax cut for a household with $40-50,000 is about $400, while a household with a million dollars’ income gets a tax cut of $27,000. Adding on the indirect effects, as calculated by JCT, 25% of all corporate tax cuts benefits labor. Incorporating all these effects, the tax cuts for the wealthy is three times larger than they are for the middle class. As the individual provisions expire, every income group earning less than $75,000 on average loses out.

L. Kotlikoff disagreed arguing that the tax reform is not regressive. He explained that the same tax rate cut for rich means a bigger absolute tax break, as they earn more to begin with. Looking at the inequality in spending, the share of spending in the top 1% in any age-cohort remain unchanged and so does the share of taxes they pay. He terms the tax reform as a “second-rate reform,” because it failed to raise revenue and will undermine public education and Obama Care, leading to another 10 million people being uninsured. He emphasizes comparing people within their age group when comparing taxes paid.

P. Krugman focused on the lost revenue that has to be offset by spending less on social programs. So, the effects on the after-tax-and-transfer distribution of income makes the tax reform regressive, impoverishing the government even further.

L. Kotlikoff stated that despite some simplifications in the tax code, the pass-through still remains complicated.

Batchelder stated that the pass through deduction opens up huge gaming opportunities. She added that the pass-through deduction is providing the largest benefits to the wealthy, with the top 1% earning 50% of the pass-through business income. A pass-through business refers to certain ways to organize a business in which profits are immediately passed through to owners and are subject to the individual-level tax but not a corporate –level tax. These business forms include sole proprietorships, partnerships, and S-corporations. The pass-though deduction allows these businesses to write off 20% of business income to try to make up for the higher individual tax rate that pass-throughs are subject to but also limits the deduction. The limitations are complex and this creates more complication than simplification.

Branko Milanovic
March 05, 2018

It has become a truism to say that the welfare state is under stress from the effects of globalization and migration and thus may not be able to provide the same level of income support that it had provided in the past. In my previous post that looked at policies to reduce inequality in the 21^st century, I mentioned that I would follow up with a discussion of the welfare state. In this post I want to go back to the origins of the welfare state to understand the origin of the current stress.

As Avner Offer has recently reminded us in his excellent book (co-authored with Daniel Söderberg), the origin of social democracy and the welfare state is in the realization (and financial ability to deal with it) that all people in their lives go through periods where they are not earning anything, but have to consume: this applies to the young (hence children’s benefits), to the sick (health care and sick pay), to those who had a misfortune to get injured at work (worker’s accident insurance), to mothers when they give birth (parental leave), to people who lose jobs (unemployment benefits), and to the elderly (pensions). The welfare state was created to provide these benefits, delivered in the form of insurance, for either unavoidable or very common conditions. It was built on the assumed commonality of behavior or, differently put, cultural and often ethnic homogeneity. It is no accident that the prototypical welfare state born in Sweden in the 1930s, had many elements of (not used here in a pejorative sense) national socialism.

In addition to commonality of behavior and experiences, the welfare state, in order to be sustainable, required mass participation. Social insurance cannot work on small parts of the workforce because it then naturally leads to adverse selection, a point well illustrated by the endless wrangles over US health care. The rich, or those who are unlikely to be unemployed, or the healthy ones, do not want to subsidize the “others” and opt out. The system that would rely only on the “others” is unsustainable because of huge premiums it would require. Thus the welfare state can work only when it covers all, or almost all, of the labor force, i.e. when it is (1) massive and (2) includes people with similar conditions.

Globalization erodes both requirements. Trade globalization has led to the well-documented decline in the share of the middle class in most western countries and the polarization of income. With income polarization the rich realize that they are better off creating their own private systems because sharing the systems with those who are substantially poorer implies sizeable income transfers. This leads to “social separatism” of the rich, reflected in the growing importance of private health plans, private pensions, and private education. The bottom line is that a very unequal, or polarized, society cannot maintain an extensive welfare state.

Economic migration, to which most of the rich societies have been newly exposed in the past fifty years (especially so in Europe), also undercuts the support for the welfare state. This happens through the inclusion of people with actual or perceived differences in social norms or lifecycle experiences. It is the same phenomenon as dubbed by Peter Lindert as a lack of “affinity” between the white majority and African Americans in the US which rendered the US welfare state historically smaller than its European counterparts. The same process is now taking place in Europe where large pockets of immigrants have not been assimilated and where the native population believes that the migrants are getting an unfair share of the benefits. Lack of affinity need not be construed as some sinister discrimination. Sometimes it could be indeed that, but more often it may be grounded in correct thinking that one is unlikely to experience the lifecycle events of the same nature or frequency as the others, and is hence unwilling to contribute to such an insurance. In the US, the underlying fact that African Americans are more likely to be unemployed probably led to less generous unemployment benefits; similarly, the underlying fact that migrants are likely to have more children than the natives might lead to the curtailment of children’s benefits. In any case, the difference in expected lifetime experiences undermines the homogeneity necessary for a sustainable welfare state.

In addition, in the era of globalization more developed welfare states might experience a perverse effect of attracting less skilled or less ambitious migrants. Under “everything being the same” conditions, a decision of a migrant where to emigrate will depend on the expected income in one country vs. another. In principle, that would favor richer countries. But we have also to include a migrant’s expectation regarding where in the income distribution of the recipient country she expects to end up. If she expects to be in the low income deciles, then a more egalitarian country with a larger welfare state will be more attractive. An opposite calculation will be made by the migrants who expect to end up in the higher deciles of the recipient countries’ income distributions. If the former migrants are either less skilled or less ambitious than the latter, then the less skilled will tend to choose countries with more developed welfare states. Hence the adverse selection.

In very abstract terms, the countries that would be exposed to the sharpest adverse selection will be those with large welfare states and low income mobility. Migrants going to such countries cannot expect, even in the next generation, to have children who would climb up the income ladder. In a destructive feedback, such countries will attract the least skilled or the least ambitious migrants and, once they create an underclass, the upward mobility of their children will be limited. The system then works like a self-fulfilling prophecy: it attracts ever more unskilled migrants who fail to assimilate. The natives tend to see migrants as generally lacking in skills and ambition (which may be true because these are the kinds of people their country attracts) and hence as “different”. At the same time, failure to be accepted will be seen by the migrants as confirmation of natives’ anti-migrant prejudices, or, even worse, as religious or ethnic discrimination.

There is no easy solution to the vicious circle faced by developed welfare states in the era of globalization. This is why I argued in my previous blog for (1) policies that would lead toward equalization of endowments so that eventually taxation of current income can be reduced and the size of the welfare state be brought down, and (2) that the nature of migration be changed so that it be much more akin to temporary labor without automatic access to citizenship and the entire gamut of welfare benefits. This last point is discussed in Chapter 3 of my “Global inequality” as well as here.

The original post can be found at GlobalInequality.