Thursday, September 19, 2019

Analysis: The Implicatons of a Wealth Tax in the U.S.

Public Finance, Inequality, Cash Flow

Empirically, broad wealth inequality has a potentially negative effect on economic growth. Countries where gaps between income and wealth narrow have much greater overall economic growth than countries with widening income gaps. The OECD finds that the large disparities in income can be associated with 10% reduced growth in Mexico and New Zealand, and up to 9% in the U.S. This is generally caused by the reduced educational outcome from the bottom 40% of earners, which we already knew.

Calls to address inequality have created discourse surrounding the economic implications of a wealth tax. Proponents of a wealth tax concede that it's not a pro-growth policy. Instead, they contend that reducing inequality and redistributing the benefits will be better for growth in the long run. While this may be somewhat true when factoring in other policy decisions, many arguments for a wealth tax are inconsistent with tax and public finance literature. In fact, it would be better and more attractive to abandon a wealth tax and favor taxing capital income and/or consumption. 

In the paper linked below, "a tax of t on wealth is revenue-equivalent to a tax of τ = (1+r )t/r imposed on capital income rW." (With a two percent rate of return, a 2 percent wealth tax is a 102 percent tax on capital income) If we want to analyze the analytical implications of a wealth tax, we can break down the rate of return and see what the literature suggests each tax on said return will do. 
r = normal rate of return + risk + rents

When most people think about inequality and power imbalances in society, they think about rents. They think about corporations deriving supernormal profits/extraordinary returns from extensive market power, rent-seeking, government protection of an industry, or a misrepresentation of income which one could view as unethical. The literature suggests that "a uniform capital income tax collects revenue at a high rate, (1+r)/r times higher than a wealth tax, from all these components." A wealth tax can produce the same amount of revenue, but it would be done so through taxing the principal. What does this mean? Choosing to use wealth relieves rents which are exactly what we're trying to tax, extraordinary returns. If you want to be less distortionary and focus on supernormal profits, you should favor a 20 percent capital income tax over a 2 percent wealth tax.

There are many ways we can utilize the current tax code to expose us to supernormal profits, but still be consistent with sound tax literature. For instance, you can deduct the investment from capital gains(thus reducing the burden on "savings") and then tax the return. This gives the IRS some exposure to supernormal returns while maintaining that the code is conducive towards investment, placing weight on the correct tax element, correcting the base, and not relieving pressure on rents. 

Does this tax logic sound attractive? It should! And you can apply this to the tax base in general. On the intensive margin, the tax base reduces normal returns. Lower after-tax returns reduce investment, productivity, wages, and economic growth. To address this, we want to exempt the normal return and focus on taxing cash flows and consumption. On the extensive margin, we focus on entrepreneurship, long-run dynamism, and tax competition.  What we want to do is minimize marginal tax rates on capital and limit average effective rates(tax burden) from rising above international norms and factor in incentives such as relations to the labor supply.

Thursday, September 5, 2019

Cost & Benefit Analysis: Inflation Targets

For the past two decades, monetary regimes have implicitly and explicitly targeted a low rate of inflation of ~2-4%. Targeting depreciation has led to criticisms as to why the monetary authorities are devaluing a nation's currency. However, people often fail to take into consideration to costs and benefits of different inflation targets.

Low Negative Inflation

Friedman was someone who actually argued that the optimal rate of inflation was negative. Spending cash has welfare benefits and, in theory, monetary policy should be used to maximize those benefits, i.e. reduce the cost of cash. In this case, the cost of cash in the nominal interest rate, which represents the risk-free rate of return. The real interest rate is determined by our advancements in technology, productivity, supply-side policies(which effect the previous two examples) and culture, and is positive in the long run. If real interest rates are positive, and nominal interest rates are zero, then the optimal inflation rate must be negative(to have a stable monetary policy/no tightness) since the real interest rate equals the nominal interest rate minus the inflation rate.  

Another POV: For every dollar, you have in cash or some account, you are foregoing buying a risk-free bond and earning interest on that bond that can be used to boost consumption and investment in the long run. That foregone interest is one cost of holding cash.

Assume that a bond earns a real return, r. The optimal rate of inflation that removes the difference between bond returns and cash returns sets inflation = -r. That is, the optimal rate of inflation is actually deflation at the rate of r% per year. At the deflation rate, you are no worse off holding cash than holding bonds. So, the central bank should aim for stable and gradual deflation, otherwise known as "The Friedman Rule".

Zero Inflation

In the news, you'll see a lot of people in the business/finance industry advocate for lower rates of inflation. The low cost of borrowing is one factor, but a concept is known as 'menu costs' is another. Firms face costs in changing their prices. When a firm changes the price it charges for its products, it just updates its online catalog, replaces the stickier prices on its shelves, etc. These costs are known as 'menu costs', the idea that you have to create a new 'menu' when you change the price of a good(in this case due to inflation changing prices annually). Menu costs are empirically quite large which can be a hassle for many firms. An ideal monetary regime would be one that targets an inflation rate of 0% to reduce menu costs. They would still change their prices relative to demand and shocks, but they won't have to worry about the constant and rapid change of price due to inflation. Targeting a non-zero rate of inflation also serves as a hassle due to the tax code. Inflation serves as a distortion on the real after-tax return on investment; minimizing these distortions guides us towards an optimal rate of 0%.  

Low Positive Inflation


It's not possible to reduce nominal interest significantly below zero(you can go a little), so in times of an economic downturn, if your rates are at zero you've given yourself less room to navigate during a recession. Now, the Fed doesn't actually run out of ammunition as it could simple, in theory, just buy as many assets as it wants, implement QE or invoke hefty measure by using 13.3(13.3 pertains to the U.S. in specific), but the political feasibility of doing these things may not be possible or they could be illegal -> see Japan. This is a phenomenon known as the Zero Lower Bound(ZLB). Suppose the normal inflation rate is 4% and the normal nominal interest rate is 6%. If we enter a recession, the central bank can cut interest rates by 600 basis points before approaching the ZLB. If the normal inflation rate is 2% and the normal nominal interest rate is 4%, then the central bank only 400 basis points worth of cuts before it hits the ZLB. If the normal inflation rate is 0% and the normal nominal interest rate is 2%, then the central bank can only cut interest rates by 200 basis points before hitting the ZLB. Given this information, a higher inflation target gives the central bank more room to stimulate during a recession given political feasibility as a factor as to why it wouldn't be able to stimulate by more 'extreme' means.

There's also something called the grease effect. Wages are very sticky downwards, if your boss cuts your salary despite you having done nothing "wrong", you would probably go into a frenzy. However, firms face business disruptions in both directions, so if a firm is underperforming in on year, it has no way to reduce costs short of firing people, which is bad for the firm, the employee, and the entire economy. Consequently, having some inflation gives all firms some flexibly, which creates some level of efficiency. 


Conclusion

Since it's nearly impossible for a central bank to do "whatever it wants" during a recession and since deflation, especially unexpected deflation, is dangerous and responsible for the worse economic downturns in history, such as the Great Depression, modern central banks have weighed all considerations and tend to target a slightly positive interest rate of 2-3%. Some people want it to be pushed up to 4% and others, like myself, would prefer a nominal GDP targeting schematic which would also have an implicit positive inflation target.

The key reasoning from a nominal GDP Target are due to 3 things main things

Countery-cyclical policy
Financial Market Efficiencey
and a stronger Phillips Curve