Tuesday, June 28, 2022

How Incumbents Capture Price Controls: Example from the U.S. Senate

U.S. Senators are proposing to put both retail and business-to-business price controls on insulin.  The (intended?) result will that be that consumers will pay more, diabetes complications will get worse, and incumbent manufacturers will make more money.

Drugs generally follow a life cycle.  Unique new drugs often command a high price that soon falls sharply as the incumbent faces competition from alternative therapies and/or generics.  Insulin has the same kind of life cycle.  Two biosimilars (essentially a generic version of a biologic, which is a more complicated type of drug) were quickly approved under one of the new approval pathways created by the Trump Administration that helped bring prices down (explained further in my forthcoming Journal of Law and Economics paper).  Seven more biosimilars are in the approval pipeline and will soon be competing with the incumbents.

The incumbents would like to freeze time before those competitors arrive, and Senators Shaheen and Collins are obliging.  While they advertise freezing the retail price at $35 plus inflation, they will also impose price controls on the business-to-business transactions that new entrants use to break into the market (read more about them in Chapter 10 of http://yourehiredtrump.com, or in Chapter 13 of my favorite textbook, or in the analysis by OACT and CBO).  By hindering the entry and diffusion of the new biosimilars, the price of insulin will not fall as it would have, and usually does over the drug life cycle.

Suppressing competition is exactly what I'd expect Big PhRMA to order up on the Congressional menu (again, see Chapter 10 of http://yourehiredtrump.com).  I am less surprised than anyone to again see PhRMA deploy Karl Marx's rhetorical device (he always decried the "middlemen" of capitalism), "This legislation rightly recognizes the role of insurers and middlemen" as they see a PhRMA-protection bill come together.

Consumers will have less choice and pay more as a result of this bill.  Adherence to diabetes treatments will be worse than it would have been if this bill were not getting in the way of competition.  Low adherence is not just a health problem, but a financial problem too as private and public health plans are saddled with additional hospitalization expenses for treating diabetes complications.

Monday, June 27, 2022

The Hidden Increase in Capital Taxation

The taxation of business income is now increasing significantly, without any action from Congress.  The increase can be understood as two forces acting through one simple formula.

For tax purposes, depreciation is a statutory time path of deductions from a business' taxable income for each dollar invested in a real asset.  The path is called "depreciation" because the undiscounted present value of that time path is equal to one.  That is, 100 percent of every dollar invested will someday be available as a deduction.

One simple formula representing two shocks: D/(D+R)

An important reason that business-income taxation distorts investment is that business owners  evaluate time paths at a discount rate R > 0.  Therefore, in present value, only a fraction (z, in the usual notation) of investment is deductible from taxable income.

With constant depreciation (D) and discount (R) rates, z = D/(D+R) <= 1.  This simple formula captures two things going on right now in the U.S.: the sunsetting of TCJA's bonus depreciation and inflation.  (The former is specific to the U.S. but the latter is relevant for those nations that also tax business income while allowing depreciation deductions).

TCJA allowed the expensing of some investment, which makes z = 1 (think of expensing either as R = 0 or infinite D).  Expiration of expensing pushes z below one.

The depreciation schedule is a nominal time path; depreciation allowances are not indexed for inflation.  Therefore the appropriate discount rate R is a nominal interest rate.  Clearly nominal interest rates have increased over the past year and a half (inflation!), which reduces z in all but the expensing case.  Indeed we can ignore the expensing case if we take the sunsetting first and then add in inflation.

Quantitative results

In order to translate reductions in z into increases in the effective real price of investment, I use a special case of the Hall-Jorgenson formula, where the pre-tax real price is inflated by the tax factor (1-tz)/(1-t) <= 1, were t is the statutory rate of taxation of business income (Cohen, Hassett, and Hubbard consider the more realistic, but also more complicated, cases).  The equality holds only when z = 1 (i.e., expensing).

The chart below shows the relation between the nominal interest rate R and the tax factor.  We start close to the origin with low inflation and bonus depreciation.  Sunsetting by itself moves off the origin to (pre-inflation) R of, say, 2-3%/yr.  That is about a 7 percent increase in the real price of investment.

Next inflation increases R.  So far annualized R appears to have increased about 2 percentage points although there are concerns that it could increase more (presumably it would increase close to 1-for-1 with inflation if inflation were expected to be permanent).  That increases the real price of investment another 4 percent or so.

Inflation further increases the real price of investment due to personal income taxation, especially to the extent that personal income is taxed at higher personal rates than business income is.  On the other hand, the sunsetting of expensing is not relevant for structures because they did not get bonus depreciation.  So perhaps all three effects combined increase the price of investment 15 percent, with about half specific to TCJA.

Oil and gas

Oil and gas extraction is particularly capital intensive.  Using a capital share of 71 percent, that suggests an 11 percent shift (upward) in the marginal cost for that industry, with about half due to TCJA subset and therefore not shared by foreign producers of oil and gas.

Comparing the period of the Biden presidency (Feb 2021 - Feb 2022, which is latest available) to 2018-19, inflation-adjusted world oil prices have increased 20-25 percent while US O&G industry marginal cost has shifted up 11 percent.  That by itself would blunt much of the supply response.  Then add:

  • new threats of federal energy and banking regulation,
  • threats to increase the statutory rate on business income, and
  • the effects of ESG investing that increasingly stigmatizes investment in fossil fuels,
and it should be no surprise that U.S. supply hardly responded in 2021 to high oil prices while suppliers in Canada, Russia, China, Norway, and even OPEC did.

Thursday, June 16, 2022

Recession Time? Don’t Act Surprised

Treasury Secretary Yellen does not see any indicator of an imminent recession.  She isn’t looking.  The normal economic tailwinds have calmed and, as predicted, Biden's economic policies are a significant headwind.

A recession is sometimes defined as a reduction in the number employed nationally for a couple of months.  Other times it is defined as a reduction in real GDP for two quarters or more.

When it comes to predicting events like this, my recursive approach is to first understand where the general trends are heading.  In technical terms, is the economy’s “steady state” above or below where we are now, and how much?  If the trends are strong up, small perturbations around that trend will not make a recession.  If the trends are flat, then even a small negative shock will create a recession by one or more of the definitions.  Which definition will be triggered can be assessed by contrasting employment trends with productivity trends.

Four important trends are worth considering: organic productivity growth, organic population growth, recovery from the pandemic recession, and new public policies affecting productivity,  population, or employment.

Organic trends

Given that recessions are defined in absolute rather than per capita terms, population growth is normally an economic tailwind.  However, annual adult population has fallen from a bit above one percent 1980-2018 to about 0.4 percent.  Illegal immigration is a wild card here because we do not know how many are immigrating, what fraction are adults, and whether and how those adults will be economically engaged.  With that caveat, we now are in a situation where even a small negative shock that would not have caused a recession in the one-percent population growth era will now.

Recovery from the pandemic was also a tailwind.  It someday will continue to lift employment, but at the moment it looks like employment has recovered as much as it can given the serious health problems encountered during the pandemic, including but not limited to self-destructive substance abuse habits that are not complementary with productive employment.  Some of these people will show up on payrolls but how reliably they show up for work is another question.  Diabetes, liver disease and heart disease have gotten out of control since 2020.

Workers lost skills and capital laid idle during the pandemic.  These are recovering, although their recovery will not be fully recognized in the growth data.  GDP and productivity levels were exaggerated during the pandemic as many goods were unavailable or low quality in ways not captured by the national accountants.  For example, public school teachers stayed home from school but the national accountants assumed that they were as productive as ever merely because they continued to get paid.  As they get back to traditional teaching, this will not be officially recognized as economic progress for the same reason the pandemic regress was never acknowledged. 

Crime has gotten bad, especially in big cities where productivity is normally the highest.  Consumers and businesses are avoiding big cities, which is a cost (“excess burden”) beyond the crime statistics because the whole point of the avoidance behaviors is to keep from being one of those statistics.

Fitzgerald, Hassett, and I predicted in 2020 that Biden’s economic agenda would reduce the levels of full-time equivalent employment per capita by 3.1 percent and real gdp per capita by 8.5 percent.  If that level effect were spread over five years, that would be 0.6 percent per year and 1.7 percent per year, respectively, as shown in the Table as an addendum panel.  That by itself makes a recession likely in one of those five years.

Regulatory Policy

Our analysis of Biden’s agenda distinguished regulation from capital taxation from labor taxation.  His regulatory agenda seems to be going ahead as we expected.  The good news is that Biden’s nomination of David Weil to the Department of Labor was rejected by the Senate and Biden was slow to fully mismanage the National Labor Relations Board.  But we did not anticipate that Biden’s DOL would disrupt labor markets as much as it did with its mask mandates.  Sticking with our original estimate, it looks that Biden’s regulatory agenda is reducing employment by 0.2 percent per year (of five years) and real GDP by 0.7 percent per year below the organic trends.  See the Table’s top panel.

Of particular concern over the next few months is the reliability of the electric grid and air travel.  Snafus of this type are already built into our regulatory analysis but these examples put more texture on the economic reasoning that links the marginal regulations with poor economic performance.

Capital Taxation: Inflation Sneaks In

Biden’s Build Back Better bill would implement much of the capital taxation we envisioned in 2020.  The good news is that the bill has not yet passed, and passage of its capital tax elements are not imminent in some other form.  The bad news is that inflation is taxing businesses without any Congressional action (recall Feldstein and more recently Hassett on the effect of inflation on the cost of capital), while it appears that Biden will let temporary provisions in the 2017 TCJA expire.  With capital taxation during the Biden administration increasing about half of what we expected, it would reduce real GDP by about 0.4 percent per year over five years.

Speaking of inflation, higher Fed Funds rates are already showing up in mortgage rates.  In effect, the Federal Reserve is introducing a tax (or cutting a subsidy) on structures investment, which is likely to send at least that sector into a recession.  Socially responsible (a.k.a., woke) investing is also skewing the allocation of capital.

Combining capital taxation and regulation, the headwinds in the Biden economy are 0.25 percent per year for employment and 1.1 percent per year for real GDP.

Labor Taxation: Direction Unclear

Labor taxation is an interesting wild card here.  Marginal tax rates on work were cut sharply when the $300 weekly unemployment bonus expired last summer.  That effect has played out already.  But I expect that Congressional Democrats, and even some Republicans, will expand unemployment benefits if anything resembling a recession were occurring.  That could easily and quickly reduce employment by one percent, if not more.  On the other hand, various federal health insurance subsidies are about to expire.  If they do (without resurrection), that will encourage work.

Bottom Line

Overall, a recession is highly likely with so many headwinds and so few tailwinds.  A recession is more likely by the GDP definition than the employment definition.  The depth of the recession depends on how much Congress destabilizes things by further adding to the already large federal portfolio of programs for the unemployed and poor and further adding to tax burdens.