Indexation Perils

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Indexing fiscal policy parameters to consumer price inflation was a nice improvement in the 1970s when both price and wage inflation took off, but the American economy is different now and may require different index approaches.

Economic policy often involves setting benefit amounts or thresholds for program eligibility or for new tax brackets. A few examples are the federal poverty line of $23,550 (for a family of four), the maximum food-stamp benefit of $668 a month and a $113,700 cap on income subject to taxation for Social Security.

Ideally, policy parameters are chosen to balance costs and benefits. The $110,100 threshold might have been pretty sensible for 2012, but we doubt that a $110,100 threshold would be equally sensible in 2017 or 2022. If nothing else, the existence of inflation means that a dollar will not have the same economic value in the future as it does now.

Costs and benefits could be re-evaluated every year, but it is sometimes easier to set a formula for automatic updating — guessing, in effect, how the optimal policy will change over time. Many fiscal policy parameters are now indexed to consumer price inflation, based on the assumption that they should remain in a fairly fixed ratio to consumer prices.

The income tax code was not always indexed, and the rapid inflation of the 1970s awakened many Americans to “bracket creep,” as inflation raised the dollar earnings of the poor and middle class and put them in tax brackets originally meant for higher-income taxpayers, without necessarily giving them any additional purchasing power.

However, many costs and benefits of fiscal policy, especially those related to incomes and jobs, depend on wages rather than consumer prices and arguably fiscal policy parameters should be indexed to wages rather than consumer prices. A few policy parameters are indexed to wages, such as parts of the benefit formulas for Social Security and unemployment insurance, but consumer price indexation is more common.

If wages and consumer prices always moved together, the distinction would be largely academic. But in reality, wages change differently than consumer prices do. There is a tendency for wages to increase more than consumer prices over long periods of time, thanks to labor productivity gains.

Indexing can play a role in political debates, as the parties that believe that a policy parameter is too low might want it indexed to wages rather than consumer prices in order that it increase more over time (for the same reason, they might want it indexed to the average wage rather than the median wage, because average wages have tended to increase more than median wages have). Parties on the other side might push for consumer price indexation, or no indexation at all.

For example, if you think that the poverty line is too high, you are glad that the line is not indexed to wage inflation and might wish that it were not indexed at all, so that more of the population might creep out of the poverty category.

But in these times, we may see political parties switching sides on the indexing question, because a number of forces may cause wages to increase less than consumer prices, if at all.

Rising health insurance costs tend to reduce cash wages or cause them to grow less than consumer prices, as employers cannot compete well when they are paying more in cash wages and more for employee health insurance. I noted in an earlier post that the least-skilled workers are seeing their wages fall over time, largely because they are out of work and failing to acquire the skills that come with working.

Employers are also facing new health care regulations expected to reduce cash wages as many employers of low-skill workers are hit with per-employee fines of about $3,000 per employee per year. Were a federal sales tax, such as the value-added tax used in many European countries, to be created, consumer prices would increase significantly more than wages do.

While we can be thankful we are not now experiencing the high inflation rates of the 1970s that urgently introduced inflation indexing into fiscal policies, we may want to reconsider policy thresholds and how they relate to the labor market fundamentals.

Forgiveness Formulas

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In an ideal world, collecting debts would be as simple as asking debtors to pay their obligations when they are able to. But in reality most businesses have found that they need to obtain other assurances, such as collateral or the option to shut off services to a delinquent payer. Otherwise it is too easy for debtors to claim hardship and walk away without paying.

On the other hand, many families and other debtors do experience genuine hardship. In those cases it can be compassionate and even efficient to at least partly forgive the debts of people who have fallen on hard times. Many economists see loan defaults as (sometimes) an efficiency-enhancing form of risk-sharing.

Even the most hard-hearted lender may choose to partly forgive loans because too much lender effort is required to elicit full payment. Just as you cannot squeeze blood from a stone you cannot get much revenue from someone who does not have it.

One approach would be for lenders to develop and disclose a “forgiveness formula” that would clearly define “hard times” and indicate precisely what kind of forgiveness is possible. The advantage of forgiveness formulas is that distressed borrowers can be certain where they stand with the lender and can readily evaluate whether they were treated “fairly.”

Forgiveness formulas are also consistent with the idea that agreements should be clearly specified in writing, so the parties to the agreement fully understand each other and never have to argue about what the agreement really meant. Carefully specified written agreements are sometimes found in employment relationships, tenant-landlord relationships and even marriages.

This is the approach that the Federal Deposit Insurance Corporation took during the George W. Bush administration to restructure home mortgages that had fallen under water (that is, when home prices had fallen so much that selling the home would no longer provide enough proceeds to pay the mortgage in full). Borrowers were told what new mortgage terms would be affordable and under what net-present-value conditions those terms should be considered acceptable to lenders.

The clarity of forgiveness formulas is also their weakness, because they make it easier for debtors to “game the calculation” and can ultimately make loans more costly for borrowers who pay in full. The Internal Revenue Service has long been secretive about its procedures for auditing returns and restructuring delinquent tax payments, and the Treasury maintained that approach when it became involved with restructuring home mortgages (the Congressional Oversight Panel discusses this matter on Page 41 of this report).

Hospitals are also known to partly forgive medical debts incurred by the uninsured, while they make no accommodation for many others. Some states require hospitals to explain in writing how they go about discounting charges for hardship patients (as we can see in New York’s policy), but you might guess that hospitals worry that patients will game those calculations in order to pay less.

One advantage of health reforms that get more people on health insurance is that by getting people to pay for their health care before they get sick, the reforms reduce the number of cases in which clear forgiveness has to be traded off with formula gamesmanship.

ACA Forecasts Have Not Yet Been Grounded in Microeconomics

The Congressional Budget Office, Jonathan Gruber and others attempting to forecast the effect of the Affordable Care Act (ACA) on the propensity of employers to offer health insurance have gotten the microeconomics wrong.

Background: Beginning in 2014, employers who offer affordable health insurance will thereby render their employees ineligible for health insurance tax credits that can be large as $15,000 per family per year. All analysts agree that there are SOME employers who will react to this situation by dropping their coverage, and that their employees will benefit by obtaining the subsidies. The debate is about the size of this effect and whether it would large enough to offset other factors that might be encouraging employers to offer coverage.

In one way or another, the answer to the question is ultimately found through empirical analysis. One could wait until say, 2015, and measure what happened. For those of us who want a forecast before then, we must somehow relate historical episodes to what the ACA will do in 2014.

The approach of CBO, Professor Gruber (see 27:02 in this video), and others has been to (a) think of a "demand" for employer-sponsored insurance (hereafter, ESI) and (b) look at the historical sensitivity of that demand to the price of ESI, especially variation associated with the ESI subsidy implicit in the exclusion of ESI premiums from payroll taxes and employee income taxes. Item (b) is acceptable enough -- I agree that subsidies impact prices -- but item (a) is fundamentally flawed because the wrong demand curve has been identified.

Historically, there has not been a viable non-group insurance market, so that employers dropping their coverage are in effect asking a significant fraction of their employees to go uninsured or to apply for Medicaid. The demand curves traced out by such episodes are telling us about the distribution of employee preferences for being uninsured (or on Medicaid) and the distribution of ESI administration costs (broadly defined to include insurance loadings and other factors). Economic theory does not tell us the precise shape of these distributions, so it's nice to have examined the historical episodes, which suggest that the elasticity of the propensity to offer ESI with respect to the price of ESI is roughly -0.5. In other words, historical increases in ESI prices in the amount of 10% have caused roughly 5% of employers to drop coverage.

But, under the ACA, dropping ESI does not mean leaving the employees uninsured. The propensity of employers to drop ESI under the ACA therefore has little to do with the distribution of employee preferences for being uninsured or for participating in Medicaid. Thus, to a first approximation, the -0.5 elasticity cited above is irrelevant. (More precisely, the magnitude of the historical elasticity is probably a conservative lower bound on the magnitude of the elasticity relevant for ACA forecasts, because going uninsured is a feasible but unlikely choice for employees who lose ESI).

What we really need to know is the distribution of employee preferences to participate in the ACA's "exchange" plans, and the distribution of ESI administration costs as compared to exchange administration costs (again, broadly interpreted to include insurance loadings, etc.). Health economists have not studied that yet.

You might think that the distribution of ESI administration costs would be relevant for the ESI-exchange margin, but the exchanges will have administrative costs too. The application for exchange plans is 21 pages long: employers who drop ESI may well replace it by helping their employees with application and other administrative tasks, much like employers help employees with immigration paperwork. From this perspective, ESI and exchange participation look like very close substitutes and the 0.5 price elasticity magnitude looks like a wild underestimate.

Although the exchange plans will not be called "Medicaid," you might think that the distribution of preferences for Medicaid participation could be important because people will attach some of the same stigma to exchange participation as they do to Medicaid. I would agree with you if the purpose was to quantify the effect of Massachusetts' health reform on ESI coverage, because premium support was made available in Massachusetts primarily through its "Commonwealth Care" program which was a collection of 4 Medicaid managed plans (one plan has been added since). In contrast, recipients of federal ACA subsidies will be receiving cash they can spend on a plan of their choice, one or two of which will be the plans in which their state's U.S. Senators are enrolled: that’s a lot closer substitute for ESI than Medicaid is.

Because they have helped uncover distributions of administration costs and preferences for being uninsured, the historical studies are better suited to predict the number of people who will change from uninsured to insured as a consequence of the ACA, as RAND has done. But that's very different from predicting how many people move from ESI to non-group policies. Even without considering labor-market equilibrium effects or general equilibrium effects of the ACA on ESI coverage, we can already see that demand analysis has been misapplied in ACA forecasting and that the propensity of the ACA to reduce ESI coverage has been underestimated.

Why a $2,000 Employer Penalty is Really $3,046

Under the ACA, employers not offering health insurance will owe a $2,000 per employee "shared responsibility" penalty (unless the employer has fewer than 50 FTEs). This penalty is not deductible from business taxes, and thereby is equivalent from an employer's point of view to a $3,046 wage cut.

When an employer cuts wages by $3,046, he reduces his payroll expenses by $3,279, which includes the payroll tax he would have owed on the $3,046.

Payroll expenses are deductible, so by cutting his payroll expenses by $3,279, he increases his corporate tax by 39 percent of that = $1,279. So net of corporate tax this wage cut saves him $2,000, which is just enough to pay the $2,000 penalty.

Unless an employee (or employees like him) has opportunities to take a job at an employer who does not pay a penalty, he can expect the $2,000 penalty to ultimately depress his wages by $3,046.

Hidden Costs of the Minimum Wage

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The current federal minimum wage of $7.25 an hour is increasingly creating economic damage that needs to be considered with the benefits it might offer the poor.

Democrats are now proposing to increase the federal minimum wage to $9 an hour. News organizations have repeatedly noted that economists do not agree on the employment effects of historical minimum-wage changes (the more recent federal changes in 2007, 2008 and 2009 have not yet been studied enough for us to agree or disagree on results specific to those episodes) and do not agree on whether minimum wage increases confer benefits on the poor.

That doesn’t mean that we economists disagree on every aspect of the minimum wage. We agree that minimum wages do some economic damage, although reasonable economists sometimes believe that the damage can be offset and even outweighed by benefits.

More important, we agree that the extent of that damage increases with the gap between the minimum wage and the market wage that would prevail without the minimum. A $10 minimum wage does less damage in an economy in which market wages would have been $9 than it would in an economy in which market wages would have been $2.

Moreover, elevating the wage $2 above the market does more than twice the damage of elevating the wage $1 above the market. (Employers can more easily adjust to the first dollar by asking employees to take more responsibility or taking steps to reduce turnover, steps that get progressively harder.) That’s why economists who favor small minimum wage increases do not call for, say, a $100 minimum wage, because at that point the damage would far outweigh the benefits.

Market wages normally tend to increase over time with inflation and as workers become more productive. As long as the minimum wage is a fixed dollar amount, the tendency for market wages to increase over time means that economic damage from the minimum wage is shrinking. That’s one reason that economists who see benefits of minimum wages would like to see minimum wages indexed to inflation, allowing the minimum wage to increase automatically as the economic damages fell.

But these are not normal times. The least-skilled workers are seeing their wages fall over time, largely because they are out of work and failing to acquire the skills that come with working. Moreover, the new health care regulations going into effect in January are expected to reduce cash wages, as many employers of low-skill workers are hit with per-employee fines of about $3,000 per employee per year, as the law mandates new fringe benefits for other employers and low-skill workers have to compete with others for the part-time jobs that are a popular loophole in the new legislation. (The minimum wage law restricts flexibility on cash wages, by establishing a floor, but makes no rule on fringe benefits.)

To keep constant the damage from the federal minimum wage, the federal minimum wage needs not an increase but an automatic reduction over the next couple of years in order for it to stay in parallel with market wages.

Possible Obamacare Tweaks

Supposing that the Affordable Care Act is implemented in essentially the same form as it was written, what minor modifications would be most likely?  Here's my list.  These are NOT my preferred changes, just my guesses of what labor market related minor changes are most likely.  The economics and politics of the tweaks are fascinating!

1. Implementation date.  Push every provision dated January 2014 back to January 2015.  Another version would be to keep the 2014 date in law, but grant lots of one-year waivers.  The difference between these two approaches is who would be paying the Administration to go along.  In the first case, House Republicans might pay in terms of agreeing to a tax increase or raising the debt ceiling, etc.  In the second case, individual businesses might pay for their waiver, perhaps by supporting 2014 Democratic candidates for Congress.  A clever administration would remind the House Republicans that failure to pay concede enough would lead it to fall back on the waiver approach, which might cost Republican members seats in the next Congress.
2. Form of the Employer Penalty.  The employer penalty, equivalent to more than $3,000 per employee not offered affordable insurance by his employer, is a particularly large burden on employment relationships with low-income employees.  It will reduce wages and create unemployment, especially among low-income people, and may end up indirectly costing the government more than the fees collect.  The per-employee penalty could be converted into a proportional payroll tax, which would make it much less of a burden on on employment relationships with low-income employees.  It could apply to all employees -- even those with health insurance from their employer -- but employer health insurance contributions could count as payments of the tax, as Massachusetts had once proposed before it settled on its per-employee penalty (see the "Competing Visions" chapter of this book).  If capped like the UI tax, it could be made to appear like an insurance payment.  Perhaps, relative to the status quo, Republicans could embrace this approach if the cap coincided with the existing penalty amount and Democrats could accept it once they realize that this penalty puts our government on the wrong side of the laffer curve for tax collections among low-income households.
3. Limit Enrollment in the Exchange Subsidies.  Massachusetts is thought to have had a de facto enrollment limit on enrollment in their CommCare plans, but the limits were not reached.  Federal enrollments have already been limited in some of the plans created by the ACA [need cite for this].  There is a good chance that the exchange subsidies cost the federal government astonishingly more than anticipated, and stopping enrollment seems like the natural next step at that point.
4. A Penalty for Employers that Drop Insurance.  This is different than a penalty for employers that do not offer insurance, because the drop penalty would not apply to employers who were previously not offering insurance (and thereby had nothing to drop).  Equivalently, employers who add insurance could be given a subsidy: employers who had already been offering it need not apply.  I am not aware of precedents of exactly this form, but there is a long history of subsidies with the same basic political appeal and economic characteristics.

The economic effects of these modifications are interesting.  Changing the form of the employer penalty to a proportional payroll tax would cause more low-income people to drop out of employer insurance (if they have it) and take coverage in the exchanges.  Perhaps that means that the payroll tweak would have to come after the enrollment limit.

An enrollment limit could reduce the long run substitution from employer coverage to exchange coverage.  But anticipation of that limit would accelerate the process: an employer who was too slow to make his employees eligible for exchange subsidies could ultimately cost his employees a lifetime of exchange subsidies.  Households who were too slow to reduce their incomes below 400% of the poverty line (households above that cannot get exchange subsidies even with unlimited enrollment) would also cost themselves a lifetime of exchange subsidies.  The economics of enrollment limits also depend on what criteria are used to admit applicants into the program as existing participants exit.

To the extent that it is reasonable to expect that employers will someday receive a subsidy for adding insurance, employers should hurry up and drop their health insurance so that they can qualify for this future credit.

Health Reform, the Reward to Work and Massachusetts

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The United States labor market is in for a shock when health reform is fully carried out, regardless of what employers decide about health insurance or how smoothly reform might have unfolded in Massachusetts.

Beginning next year, millions of Americans will be eligible for generous subsidies in the form of cash assistance to pay for their health insurance premiums and out-of-pocket health expenses pursuant to the Affordable Care Act. The subsidies will sharply reduce the financial reward to working because they will be phased out with household income.

As the Princeton economists Alan B. Krueger, who has held positions in the Obama administration, and Uwe E. Reinhardt, my Economix colleague, explain, health insurance premium assistance “would present millions of low-income American families with total marginal tax rates in excess of 75 percent.” They add, “Such high marginal tax rates may well make unemployment and welfare an attractive alternative to working.”

It would appear that, together with per-employee penalties levied on employers, the new law’s health insurance subsidies could significantly affect the labor market.

Most workers are offered affordable health insurance by their employers, and the new law will consider them ineligible for subsidies and will not ask their employers to pay any penalty. You might guess that the aggregate labor-market impact of the law could be small, because the penalties and subsidies would not apply to the majority of the work force “covered” by employer health insurance.

But it is wrong to assume that the law will have little effect on the reward to working among covered workers. Their employers could drop coverage, or the employee could switch to a job without coverage. More important, the subsidies are available to the unemployed and others who do not work, even if their previous jobs had provided coverage. If and when they go back to work in a covered job, federal law will welcome their return by taking their subsidy away.

Yet another reason that covered workers will experience high marginal tax rates like those noted by Professors Krueger and Reinhardt is that the subsidies will be available to family members on the basis of the employee’s income, in combination with his or her spouse’s income, if any.

The Department of Health and Human Services says there is no reason for alarm because the experience in Massachusetts since 2006 shows “that the health care law will improve the affordability and accessibility of health care without significantly affecting the labor market,” as I noted last week, referring to a Washington Examiner report.

For those worried about dire labor market consequences of the federal law, Jonathan Gruber of the Massachusetts Institute of Technology replies (at 27:32 in this video): “We’ve actually run this experiment, folks, we ran it in Massachusetts. O.K. In Massachusetts, we put in a system with more generous subsidies than the federal government is doing.”

When it comes to quantifying the new federal law’s penalty on employment, Professor Gruber and Health and Human Services are incorrect to take comfort in the Massachusetts experience since 2006. As I explained last week, the federal law’s employer penalty is more than tenfold the Massachusetts penalty. In other words, if the Massachusetts penalties pushed down workers’ wages by 16 cents an hour, the federal penalties would push them down $1.67.

Professor Gruber is also incorrect that the federal law is introducing less generous subsidies than the Massachusetts law did. Federal subsidies will be available for people laid off from their jobs, but the new Commonwealth Care subsidies in Massachusetts are not, because Commonwealth Care excludes people eligible for the Medical Security Program (a longstanding program providing health benefits to Massachusetts people receiving cash unemployment benefits).

Moreover, people leaving a job with health insurance have to wait six months before they can enter Commonwealth Care.

Commonwealth Care also excludes children: if a Massachusetts resident wants health insurance subsidies for his or her children, Medicaid is the primary option. The federal law has no such restriction: it allows Americans to receive subsidies while enrolling their entire families in the same health plan as, say, the United States senators representing their states.

Indeed, many consumers may perceive Commonwealth Care to be an extension of Medicaid. When it began, Commonwealth Care consisted of four plans offered by the state’s Medicaid Managed Care Organizations (a fifth plan has recently been added). Perhaps that’s why only 158,000 people were enrolled in Commonwealth Care as of 2011, which is less than 10 percent of the people in Massachusetts whose family income fell in the interval required by the program.

In contrast, recipients of federal subsidies will be receiving cash they can spend on a plan of their choice: that’s a lot more generous than helping people join Medicaid.

For all these reasons, economic reasoning points to a contraction of the United States labor market as the full Affordable Care Act is carried out, regardless of what may have happened in Massachusetts.