Inflation has little to do with the Unemployment Rate

Copyright, TheHill.com

The April unemployment rate, released Friday, showed the headline unemployment rate below 4 percent, which has rarely happened in the past 48 years. But a low unemployment rate does not necessarily mean high inflation.

A conventional wisdom, sometimes known as the Phillips curve, holds that low unemployment creates inflation as employers increasingly bid against each other for workers and pass on some of their labor costs to consumers.

One problem with the theory is that low unemployment is not synonymous with high employment. Aside from identifying Americans as either working or being unemployed, federal government statisticians also put adults into a third category: out of the labor force (OLF).

In other words, "unemployed" is just one of two not-working categories, so that both employment and unemployment can fall at the same time if enough people are switching from unemployed to out of the labor force.

The official distinction between unemployed and OLF is whether the not-working person is actively looking for work. This distinction helps to prevent confusing a retiree or a full-time student with a laid-off head of household who is eagerly looking for a new job.

But a number of people are on the margin of looking for work and could be classified either way. During President Obama's first term, the federal government was actively assisting out-of-work people with temporary cash, health and mortgage assistance but only if they said that they were looking for work. That by itself inflated the measured unemployment rate above what it would have been.

When the temporary assistance programs began to expire during 2010 and 2011, that's exactly when the unemployment rate started falling. Some of that drop was a result of additional employment, but an important part of it was just a shift to the OLF form of not working.

To further add to the statistical distortion, the headline unemployment rate is measured as a share of people in the labor force rather than a share of population. When 3.9 percent of the labor force is unemployed, that means that an even lesser percentage of the adult population is unemployed because a great many adults are not in the labor force.

Increases in the number of people classified as OLF can, therefore, reduce the headline unemployment rate without changing the number of people who actually are unemployed.

The chart below shows unemployment (blue) and OLF (red) on the same scale, which is a fraction of the adult population (I have subtracted 28 points from OLF so that the two series come together around 2010).

Around 2010, the two started moving in opposite directions, and this trend continued until about 2016. By that point, unemployment was historically low, in comparison with the population, but employment was not historically high.

What had really changed between 2010 and 2016 was the propensity of people who are out of work to say that they are actively looking.

The most recent year has been different, with unemployment falling yet no real increase in OLF. But that change is fairly small in comparison to the changes from 2010 to 2016.

The other problem with the Phillips curve theory is that it has been backward many times in history; there have been times of rapid economic growth at the same time that inflation was low or even negative.

The takeaway: If you want to understand what is happening with inflation, look somewhere else than the unemployment rate.

UK-US study cited in the Wall Street Journal

Yesterday's WSJ discussed work incentives in the U.S. and the U.K.

The study is here.

A summary is here.

Fiscal Policies and the Prices of Labor: A Comparison of the U.S. and the U.K.

Many countries of the world experienced an unusually deep and long recession after 2007.  Over the same time frame, several facets of fiscal policy were changed, especially policies related to taxation and safety net programs.  The purpose of this paper is to compare changes in fiscal policy parameters as they affected the incentives of middle-class Americans and British to be employed.  The U.K. had a “stimulus programme” followed by an “austerity programme.”  The U.S. federal government also passed what it called a “stimulus package,” followed by a major health reform.

Policy labels acquired during legislative processes are not necessarily indicative of economic fundamentals.  This paper comparably quantifies fiscal policy in terms of one of the fundamentals: the wedge between the supply price of labor and the demand price of labor.  It finds that the two countries have been different in terms of the evolution of employment taxation, on average and across demographic groups.  The American stimulus reduced average incentives to be employed by increasing cash and health benefits for the unemployed and for families with low incomes, whereas the British stimulus did the opposite by temporarily reducing its value-added tax rate and permanently reducing its basic income tax rate.  The British austerity program pushed incentives in the opposite direction as its stimulus by permanently increasing its payroll and value-added tax rates.

            The evolution of employment has also been different in the two countries.  Figure 1 displays an index of each country’s employment rates for prime-aged people.[i]  Employment fell sharply in both countries during the crisis, although less so in the U.K.  The U.K. employment recovery began earlier, and by the end of 2014 the U.K. employment rate had exceeded pre-crisis levels.  Because taxes are one (among many) of the determinants of labor market performance, comparable tax measures are necessary for carefully investigating and comparing labor market outcomes.  This paper provides tax measures, and shows how changes in tax rates are linked to specific legislation.

Taxes potentially affect work decisions in a variety of dimensions, for example: the number of weeks worked per year, the number of hours worked per week, whether to work at all during a year, and the amount of effort to put into work.  Due to the prominence of the business cycle during this period and the sheer size of gross monthly employment flows, this paper focuses on the weeks-per-year margin holding constant weekly hours and the probability of not working at all during a calendar year.  In the 21^st-century U.K., for example, the single largest quarterly employment decline for the non-elderly population has so far been 0.3 million, as compared to at least 2.6 million non-elderly people who join or separate from an employer during the average quarter.[ii]  Adding just one week out of work before joining, or after separating, would therefore create a remarkable net reduction in the number employed at a point in time.  Also, the large majority of unemployment spells last less than 12 months, and some of those lasting 12 months do not blanket an entire tax year.[iii]

I follow the usual steps of public finance analysis and first look at the tax wedge – the gap between supply and demand prices created by a tax or subsidy.  The next step, left for future research, is to draw conclusions about the wedge’s behavioral effects and ultimate incidence.  Thus, with one exception noted below, the estimates in this paper do not require any assumption about the relative incidence of labor taxes on employers and employees.

Section I discusses the United Kingdom, demonstrating how many of the tax changes were ultimately offsetting in terms of the employment incentives they created.  The primary exception relates to the subpopulation receiving child tax credits, because the phaseout (sometimes referred to as “taper”) rate of those credits increased with little change in the range of incomes over which the phaseout applies.  Section II shows results for the United States, where employment disincentives have increased over time, especially (but not exclusively) among unmarried workers.  Section III shows the evolution of the employer cost and employee benefit from work – the gap between the two is the employment tax wedge – by country for workers in the middle of the wage distribution.  Section IV concludes.

---

[i] Both series are from the Organization for Economic Co-operation and Development (hereafter, OECD), via the St. Louis Federal Reserve’s FRED database.  In 2007-Q4, the U.K. and U.S. employment rates were 81.5 and 79.8, respectively.

[ii] Average quarterly gross flows are from Gomes (2012, Figure 1), for 1996 through 2010.  Quarterly net employment changes are from the OECD, via the St. Louis Federal Reserve’s FRED database, and, for comparability with Gomes, for the age 16-64 age group. 

[iii] The St. Louis Federal Reserve FRED data series UEMPMED shows that the U.S. median duration of unemployment peaked at 25 weeks in June 2010.  Also note that, for example, an 18-month nonemployment spell lasting from March 2009 to September 2010 nonetheless involves positive weeks worked in both calendar years (tax years in the U.S. coincide with calendar years).

Aging, Taxes, and the State of the Labor Market

Copyright, The New York Times Company

As people age each year, that tends to increase average ages. At the same time elderly people die and babies are born, and that tends to decrease average ages. The combination of these two forces can keep the average population age constant over time.

The baby boom from the late 1940s to early 1960s changed this calculus, because the number of babies born in those years was well above normal. Average ages fell when the baby boomers were born, and have risen thereafter because the baby boomers’ birthdays tended to outweigh the arrival of subsequent birth cohorts.

For decades, people tended to reduce the amount they worked – especially through retirement – as they reached 62 and beyond, because their health declined, they became eligible for Social Security, they wanted to spend time traveling or they looked forward to extra time with grandchildren. Still, retirement behavior need not reduce total workers per capita because people turning 62 can be replaced by young people coming into the work force.

In about 2008, the first baby boomers started to reach normal retirement ages. Their numbers are so large that the people coming out of school are too few to fully replace them. This historically unusual rate of population aging is expected to reduce employment per capita.

You might say that the natural rate of employment has been falling in recent years, for labor supply reasons that have nothing to do with the recession, financial crises and other economic events.

For this reason, in my book and elsewhere I look at labor time series that are adjusted for population aging. The chart of work hours per person below is an example. The chart is on an index scale, with the last month before the recession normalized to 100. An index value of, say, 90, means that hours per person were 90 percent of what they were in December 2007: a drop of 10 percent.

Calculated with data from the Bureau of Labor Statistics, the Census Bureau and the Bureau of Economic Analysis

The red series shows that, without any adjustment, the labor market is still about 6 percent below what it was: less than half recovered from its 10 percent drop. But the recovery is more significant if we adjust for age: the gray series had reached 96.3 by August 2013.

In other words, two of the six percentage points of the current depression of the red series is a consequence of population aging between 2007 and 2013. Because the Federal Reserve and other policy makers cannot stop the aging process and the labor supply shifts that go with it, they should understand that their job of helping recovery will be finished before the red series gets back to 100.

Economists disagree about many things, but they seem to agree with the basic idea that the lack of recovery is partly attributable to population aging, and that policy makers cannot stop the aging process. Paul Krugman, for example, notes that we need to adjust for demographics. He uses a slightly different adjustment, but his measure and mine agree that population aging by itself depresses the usual labor market indicators by 1 or 2 percent.

But aging is not the only change affecting labor supply. Marginal tax rates have increased five percentage points since 2007 and will increase another five percentage points over the next 15 months, a trend attributed especially to expansions in health and other safety net programs. By 2015, a typical worker will keep only half of the value created by employment, compared with 60 percent kept before the recession.

Economists have traditionally recognized that a 17 percent reduction in the reward to working (from keeping 60 to keeping 50) would significantly contract the labor market, and do so at least as much as the 2 percent that the aging of the baby boom does. Yet this time many economists are reluctant to acknowledge marginal tax rate increases, even though marginal tax rates affect labor supply in many of the same ways that aging does.

Perhaps the economists who are silent about marginal tax rate hikes are worried that acknowledging the new rates would overshadow their well-intentioned origins: helping the poor, the unemployed and people without health insurance.

Professor Krugman, for example, says life is too short for him to look closely at my criticism and at the marginal tax rates I’ve measured, and doesn’t indicate that he’s looking at anyone else’s measures either. He’s not the only one: I have visited several Federal Reserve banks since 2009, and hardly any of the economists there seemed to be aware of what’s happening to marginal tax rates.

The Federal Reserve cannot reverse the tax rate increases any more than they can reverse the aging process. Perhaps Congress should ask Janet Yellen, nominated as chairwoman of the Federal Reserve, what she knows about changes in tax and retirement rates, and what they say about the future of the labor market.

Two posts on the sales tax and work incentives

If you want to measure the incentive for working, the sales tax needs special consideration.

(A)  Arithmetic.  Think of it this way:

(Disposable income) = (Total income) - (income taxes) - (sales taxes)

Sales taxes are levied as a percentage s of one's disposable income: namely, when you buy a dollar's worth of items at the store you get an extra sales tax charge of s dollars. Income taxes are, for simplicity, a fraction t of income. We have:

(Disposable income) = (Total income) - t*(Total income) - s*(Disposable income)

Equivalently:

(Disposable income) = [(1-t)/(1+s)]*(Total income)

(B) Labor supply behavior.  In order to understand how labor supply behavior changes in response to tax rate changes, to a first approximation all we need to know is the percentage change in [(1-t)/(1+s)]. Over the past 10 years, U.S. sales taxes (levied at the state and local levels) have hardly changed, which means that the time series for t, which is what I showed in my WSJ article, is all we need to calculate the percentage change in [(1-t)/(1+s)].

John Cochrane explains this further on his blog. Today I gave an example, from the U.K., where sales tax rates were NOT constant.

The U.K. example also reminds us how the sales tax is included in the CPI so that, if you do have a marginal tax rate measure inclusive of the sales tax, you should NOT multiply it by a real wage deflated by the CPI because that would double-count the sales taxes. The MTR series that I showed in my WSJ article (and available here in excel format) does not include sales taxes, and therefore can be multiplied by wages deflated by the CPI.

Indeed, economists researching wages should make this multiplication more often than they do (which is hardly ever), because taxes are part of the functioning of prices in the labor market.

(C) Welfare analysis.  If you want to calculate the new deadweight losses from new income taxes, you have to consider the sales tax and any other other wedge between total income and disposable income, even if the sales tax were constant over time, because the behavioral changes avoiding the new income taxes have the side effect of reducing sales tax revenues.  That's what I do in the small section of my book (Appendix 4.3) that quantifies labor market deadweight losses.

Taxing Employers and Employees

Copyright, The New York Times Company

The delay of the Affordable Care Act’s employer mandate is a favorable development for the labor market, but the employer mandate is only the tip of the iceberg in terms of the labor-market distortions that the law has scheduled to come on line next year.

The Affordable Care Act’s employer mandate will eventually levy a penalty on large employers that do not offer affordable health insurance to their full-time employees. The penalty is based on the number of full-time employees and adds about $3,000 to the annual cost of employing each person.

Employers have been complaining about the penalty, saying it will reduce the number of people they hire and cause them to reduce employee hours. Even economists and commentators supporting the law acknowledge that per-employee penalties reduce hiring by raising the cost of employment.

Economists have traditionally recognized that it hardly matters whether a tax is levied on employers or on employees, especially in the long run. In the employee-tax case, the employee pays the tax directly. In the employer-tax case, the employee pays the tax indirectly through reduced pay, because employer penalties reduce the willingness of employers to compete for people (Jonathan Gruber of the Massachusetts Institute of Technology has provided some good evidence in support of this widely accepted economic proposition).

Among other things, employment, employer costs and employee take-home pay would be essentially the same if the government levied a $3,000 fine on workers for having a full-time job with a large employer that does not offer health benefits, rather than levying the fine on employers on the basis of their full-time personnel, as the Affordable Care Act does.

But the political optics of the two policies are dramatically different. Large businesses can supposedly afford $3,000 per employee, while many employees could not afford another $3,000 bite out of their paychecks. Like it or not, economics’ equivalence results tells us employees will have to afford what amounts to a tax on them beginning in 2015, pursuant to the Treasury Department’s decision to begin collecting the employer penalty in that year.

For the purposes of understanding the state of the labor market, it doesn’t really matter whether individuals would be paying a tax for having a full-time job or receiving a subsidy for not having a full-time job. Either policy would reduce the gap between the income of full-time employees and everybody else. The ultimate result will be less full-time employment, in an amount commensurate with the size of the tax or subsidy.

The Affordable Care Act offers subsidies for people without work or in part-time positions that far exceed $3,000 per employee per year, which makes the employer mandate only a small piece of the law’s employment effects.

The law’s other new work-disincentive provisions, still on schedule for next year, include (i) a sliding income scale that sets premiums for people who buy health insurance on the new marketplaces, (ii) a plan for premium assistance that essentially resurrects the Recovery Act’s subsidy for what are known as Cobra benefits, allowing employees who have left a job to continue to participate, for a limited time, in their former employer’s health plan, in a more comprehensive form and (iii) hardship relief from the individual mandate.

As an example of these provisions, I explained last week how, even without the employer penalties, the premium assistance plan sharply penalizes full-time employment in favor of part-time employment. In combination, the provisions going into effect next year are two or three times larger than the employer mandate by itself, depending on the type of worker and the industry of employment.

Proponents of the Affordable Care Act, including a number of economists, have yet to acknowledge that so many provisions of the act have, from a labor economics perspective, so much in common with the employer mandate. But labor-market distortions are a common feature of several significant parts of the act and are an important part of what has happened in our labor market.

Whatever labor market benefits accrue from delaying the employer mandate could be had many times over by delaying the entire Affordable Care Act.

Fiscal Policy without Incentives: IMF version

The IMF had a recent conference on rethinking macroeconomics. I was not invited and did not attend, but watched the video. Conspicuously absent from the fiscal policy presentations is any acknowledgement that transfer spending in practice reduces the reward to work and as a result is "destabilizing." Nobody raises this issue, let alone explain why marginal tax rates and related incentives should be ignored. It is just common knowledge in this part of the macro community that marginal tax rates are so far down on the list of factors to be considered that they are not even worth one tenth of one percent of the presentation time.

The closest any presenter gets to this issue is that Professor Perotti takes 5 seconds to note that ALL of the econometric evidence on "government spending multipliers" are really estimates of government purchase multipliers and tell us nothing about the effect of transfers on GDP (see page 15 of the pdf containing his slides). Professor Roubini mentions "moral hazard" (approx the 60 minute mark of the video), but he is referring to incentives for government behavior, not inventives faced by households and nonfinancial businesses.

Professor Gordon talks about determinants of hours per capita (75 min mark), but fails to mention marginal tax rates or anything like a substitution effect! In his reply to Gordon, Professor Roubini takes 20 seconds to mention that "In France ... unemployment benefits are ridiculously high" (79:25), leaving open (but unsaid) that high unemployment benefits in other countries may be a factor.

The Wealthy Keep the Tax Man Guessing

Copyright, The New York Times Company

Although wealthy people are a small fraction of the population, their behavior is of great practical interest to Treasury officials.

Every year, the United States Treasury receives extraordinary amounts of personal income tax revenue in April as individuals file their returns and reconcile the taxes they owe with the taxes that were withheld from their paychecks during the previous calendar year. Most people do not owe much, if anything, when they file their return but a small group of taxpayers has large balances to settle.

The chart below shows the inflation-adjusted amount of individual income tax receipts by the Treasury in April of each year since 1998, as reported by in the Daily Treasury Statement. The amount has fluctuated wildly, from a low of $122 billion to a high of $235 billion. The standard deviation of these April receipts is $36 billion.

United States Treasury

The general state of the economy in the calendar year helps to predict the amount the Treasury receives in following April. At the same time, additional fluctuations in April receipts derive from the situations and behaviors of a small segment of the population not well represented in the unemployment rate and other measures of the business cycle: the wealthy.

First of all, taxes are withheld less often from asset income like dividends and capital gains than they are withheld from wages. The wealthy receive a larger share of their income from assets than from wages, not to mention that by definition the wealthy have more of both types of income. Second, much of the population does not owe any income tax – let alone owe extra in April – and the wealthy pay a disproportionate share of income taxes.

The wealthy have become an even more important driver of tax revenues in recent history, as an increasing share of the nation’s income has accrued to them. Thomas Piketty and Emmanuel Saez have compiled decades of data for the United States (and other countries). They find, for example, that the very wealthiest of America’s households — the top one-tenth of 1 percent — recently received about one-thirteenth of the nation’s income, while they received only one-fiftieth in the 1960s and 1970s.

The wealthy are sometimes idolized and other times envied, and for these reasons alone their behavior is of interest. But Treasury officials have another reason to stay abreast of the wealthy: their activities are an important determinant of the amount of revenue received by the Treasury, and when it is received.

If you have special insights into how the wealthy behave, consider applying for a job at the Treasury.

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.

The Health Care Law and Retirement Savings

Copyright, The New York Times Company

Because of its definition of affordability, beginning next year the Affordable Care Act may affect retirement savings.

Employer contributions to employee pension plans are exempt from payroll and personal income taxes at the time that they are made, because the employer contributions are not officially considered part of the employee’s wages or salary (employer health insurance contributions are treated much the same way). The contributions are taxed when withdrawn (typically when the worker has retired), at a rate determined by the retiree’s personal income tax situation.

Employees are sometimes advised to save for retirement in this way in part because the interest, dividends and capital gains accrue without repeated taxation. In addition, people sometimes expect their tax brackets to be lower when retired than they are when they are working.

These well-understood tax benefits of pension plans will change a year from now if the act is implemented as planned. Under the act, wages and salaries of people receiving health insurance in the law’s new “insurance exchanges” will be subject to an additional implicit tax, because wages and salaries will determine how much a person has to pay for health insurance.

While much about the Affordable Care Act is still being digested by economists, they have long recognized that high marginal tax rates lead to fringe benefit creation. And the Congressional Budget Office has concluded that the act will raise marginal tax rates.

Were an employer to reduce wages and salaries (or fail to increase them) and compensate employees by introducing an employer-matching pension plan, the employee is likely to benefit by receiving additional government assistance with his health-insurance costs. The pension contributions will add to the worker’s income during retirement, except that the income of elderly people does not determine health-insurance eligibility to the same degree, because the elderly participate in Medicare, most of which is not means-tested.

Take, for example, a person whose four-member household would earn $95,000 a year if his employer were not making contributions to a pension plan or did not offer one. He would be ineligible for any premium assistance under the Affordable Care Act because his family income would be considered to be about 400 percent of the poverty line.

If instead the employer made a $4,000 contribution to a pension plan and reduced the employee’s salary so that household income was $91,000, the employee would save the personal income and payroll tax on the $4,000 and would become eligible for about $2,600 worth of health-insurance premium assistance under the act. (The employer would come out ahead here, too, by reducing its payroll tax obligations).

Even though the Affordable Care Act is known as a health-insurance law, in effect it could be paying for a large portion of employer contributions to pension plans. This has the potential of changing retirement savings and the relative living standards of older and working-age people.

Research-free Policy Analysis

A widely held belief: "[The poor and unemployed] will spend a large fraction of any aid, and therefore transfers to that group will have a much bigger multiplier effect than, say, tax cuts for the rich." The exact words are from Professor Krugman, but many others believe it.

Where is the research that supports the claim that transfers to the poor and unemployed have a multiplier effect on GDP?

Where is the research that supports the claim that transfers to the poor and unemployed have a multiplier effect on aggregate employment?

Empirical research would be best. A theory would be interesting too, as long as the theory were complete in terms of recognizing that the funds have to come from somewhere.

Commenters please let me know. To get you warmed up, let me note some irrelevant replies:

• Irrelevant Reply #1. Theoretical research by Woodford, Rebelo, Werning, Krugman, Eggertsson, and others on what they call the "government spending multiplier". Those authors really mean government purchases, which are quite different from the transfers I'm asking about. If nothing else, GDP by definition includes government purchases but does not include transfers.
• Irrelevant Reply #2. Empirical estimates of the "government spending" multiplier. As far as I know those studies measure government purchases (esp Department of Defense purchases), not transfers, and purchases are quite different from the transfers I'm asking about.
• Irrelevant Reply #3. Empirical estimates of the consumption behavior of the unemployed (this one is a classic). I am not asking whether the poor and unemployed spending their money differently than everyone else does -- they do. I am not asking whether aid to the poor and unemployed expands the markets for the things the poor and unemployed tend to buy. I am asking about the effects on aggregate GDP and employment, including all of the sectors -- even the sectors that do not disproportionately serve the poor and unemployed.

Interesting Reply. This new Keynesian model addresses the question I am asking. Not surprisingly, it finds that the "Keynesian aggregate demand effect" is trivial. The model also features a wealth effect of transfers by assuming, without explanation, that the poor and unemployed's labor supply is less sensitive to transfers than everyone else's labor supply.

Tax Exclusions for Health Insurance: Let Me Count the Ways

Copyright, The New York Times Company

The magnitude and distributional effects of the tax exclusion for health insurance look quite different when viewed from the perspective of the entire safety net.

Expenditures on health services, especially those made through employer-sponsored health-insurance plans, are largely excluded from a host of taxes. The tax exclusions affect both the size of the health-services sector and society’s distribution of disposable income.

By excluding health services from tax, governments in effect redirect money toward health care and away from other activities that might be subsidized or prevent government from reducing overall tax rates, or both. The tax exclusions therefore have a lot in common with direct government spending on health, and for this reason are often described as “tax expenditures.”

A typical approach to estimating the size of the health subsidy implicit in the tax exclusions is to estimate the amount of federal personal income tax revenue that is lost because of the income that escapes tax. It’s important to know the amount of the implicit subsidy, because it is directly related to the amount by which the health sector is enlarged by public policy.

However, the income-tax approach underestimates the amount of the exclusion, because health services are often excluded from many other taxes. The payroll tax is an important instance: employer-provided health-insurance premiums are exempt from payroll and state personal income taxes, too, regardless of whether the employer or employee pays them.

Health-insurance premiums paid by employers on behalf of their employees will escape pretty much anything that taxes an employee’s wages and salaries, because those premiums are not officially considered part of employee wages or salaries. For example, the food-stamp program and Section 8 housing subsidy programs implicitly tax wages and salaries by withholding benefits according to how much a person earns, but for that purpose they ignore employee fringe benefits like health insurance.

Health goods and services often escape state sales taxes, depending on the type of good or service delivered or the type of organization delivering it. Many health services are delivered by nonprofit institutions that escape corporate income and property taxes, too. Just as with the housing industry, we vastly underestimate the government’s effect on the health industry if we focus only on the income tax.

A good summary statistic for the overall effect of tax exclusions on the health industry would be a measure of the marginal tax rate on earned income that included all the relevant taxes. When an employee accepts a $1 pay cut so that his employer can add that dollar to his health insurance contribution, that overall marginal tax rate would tell us how much of that dollar comes back to the employee in the form of the various tax reductions.

I am not aware of a marginal tax-rate measure comprehensive enough for this purpose (it would also need to pay special attention to the Medicaid program and its different treatment of adults and children), but previous studies have taken some useful steps in this direction. The studies find marginal tax rates greater than 50 percent for families above but near the poverty line, which means most of the money they might devote to employer-provided health insurance would come back to them in terms of reduced taxes and enhanced benefits.

More study is needed to quantify accurately the government’s effect on the health market. But we can be sure that public policy has served to enlarge the health industry at the expense of others and that previous estimates do not fully appreciate the magnitude of the distortion.

Penalizing Success

"I leave because [French leaders] consider that success, creation, talent, difference, in fact, should be sanctioned" says Gérard Depardieu.

Click here to rent/buy one of his films.

Sales Taxes: Incidence and Incentives

It is commonly said that the sales tax affects workers and non-workers alike, as opposed to payroll and income taxes which tend to fall on wage earners, because everybody buys things but not everyone workers.  The elderly, for example, are harmed more by a sales tax than by a wage tax.

There is some truth to this conventional wisdom, but it has been exaggerated because many income streams are automatically indexed to inflation (specifically, the CPI), and CPI inflation reflects sales taxes.  For example, UK unemployment benefits are indexed to the CPI.  When the UK increased its VAT, inflation was created and the unemployed automatically got a raise while workers did not.

Another example, US social security benefits are indexed to the CPI via the Cost of Living Adjustment.  Thus, if the U.S. were to implement a VAT, the CPI would go up and the elderly would automatically get a raise.  Workers would not.

On the other hand, newly retired people have their social security benefit indexed to wages, which would not automatically increase after a VAT.  So new retirees would, in effect, pay the VAT throughout their retirement.  Elderly people also have non-social-security income sources, which are sometimes not indexed to inflation.  To the extend that elderly relied on non-indexed income, they would pay part of the VAT too.

In terms of incentives, the VAT discourages work because people work in order to buy more.  But, as noted above, there is an addition work-discouraging effect of sales taxes: through CPI-indexation it reduces the income gap between workers and non-workers.

The Microeconomics of Poverty since 2007

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Government safety net programs were put on steroids by the 2009 stimulus law, erasing incentives for a significant fraction of the unemployed.

Last week I noted that poverty, when measured to include taxes and government benefits, did not rise from 2007 to 2011. That result, I contended, indicated that people in the neighborhood of the poverty line faced marginal tax rates of about 100 percent. I also noted that 100 percent marginal tax rates were excessive.

These three statements generated many angry comments, so it’s worth examining them in more detail.

One possibility is that the poverty rate did rise significantly, even when adjusted to reflect taxes and government benefits. That possibility would contradict Jared Bernstein’s work in this area, because he concluded that America had “the deepest recession since the Great Depression and poverty didn’t go up.” It would also contradict Arloc Sherman’s findings that the poverty rate was essentially unchanged (thanks to generous new subsidies).

The measurement of poverty and its trends is an important and continuing research area, and future research could suggest that the poverty rate had increased. However, future research could also point in the other direction.

In 1995, a panel established by the National Research Council to evaluate poverty measurement concluded that it might make sense to recognize not only the monetary resources available to families, but also the amount of free time they had. After 2007, many people found themselves with less pretax income and more free time because they had lost their jobs. Because the official poverty measures consider only the pretax income, adjusting poverty measures to reflect free time would cause the poverty rate to fall more, or increase less, after 2007.

Assuming for the moment that Mr. Bernstein and Mr. Sherman are right about the poverty changes, a second possibility is that poverty failed to rise even while marginal tax rates were significantly less than 100 percent. As one blogger put it, “Just because poverty rates didn’t rise doesn’t mean that the government imposed a 100 percent implicit tax rate.”

One might wonder exactly how, in theory, poverty rates remained fixed when millions of people lost their jobs, and when the government did not essentially replace all the disposable income lost because of layoffs. The magnitude of marginal tax rates imposed by the government is ultimately an empirical question, though. As far as I know, none of my detractors have offered any estimates.

I have been examining marginal tax rates under the American Recovery and Reinvestment Act of 2009, especially as experienced by families near the poverty line. The chart below shows some of my results pertinent to Mr. Bernstein’s poverty measures.

The chart examines households that in 2007 had household income of less than 175 percent of the poverty line and were therefore at risk of falling into poverty if they were later laid off from their job. The chart organizes unemployed heads and spouses in terms of their marginal tax or “job acceptance penalty” rate. With that rate, I mean the fraction of a person’s employee compensation that goes to federal, state and local government treasuries or to expenses associated with commuting to work (I assume that is $5 for each one-way trip) as a consequence of working full time at the same wage as before layoff rather than remaining unemployed. (The remainder of the worker’s compensation, if any, is left to enhance the disposable income of the worker and the worker’s family.)

The chart also organizes unemployed people in terms of what they earned weekly before layoff, with special attention to the group in the $250 to $349 range, which is near the weekly earnings of a full-time minimum-wage job.

Among the unemployed who had earned near minimum wage (shown in red in the chart), a majority had a job-acceptance penalty rate of at least 100 percent, meaning that accepting a job with the same pretax pay as they had before layoff would not increase their disposable income. If they were to accept such a job, all the compensation would go to the Treasury in additional personal income taxes, additional payroll taxes and reduced unemployment insurance benefits (under the stimulus, unemployment insurance benefits alone were more than half of the pretax pay from the previous job), and in some cases reduced benefits from the Supplemental Nutrition Assistance Program, known as SNAP, and Medicaid.

Only 18 percent of those earning near minimum wage had a job-acceptance penalty rate of less than 80 percent.

My results consider the unemployment insurance program and its federal additional compensation and subsidies for Cobra, which gives workers who have lost their jobs the right to purchase group health insurance for a limited period of time; SNAP; Medicaid; the regular personal income tax (both federal and state); the earned-income tax credit, the child tax credit, the additional child tax credit and the “making work pay” tax credit.

Job-acceptance penalty rates of 100 percent or more are probably more prevalent than shown in the chart because I did not include child care costs among employment expenses and did not include programs like disability insurance, Temporary Assistance for Needy Families and Supplemental Security Income, means-tested housing subsidies, means-tested tuition assistance, means-tested energy-assistance programs and other programs that impose positive implicit marginal tax rates.

I agree with Mr. Bernstein that government policy, especially the 2009 stimulus law, is responsible for preventing a rise in the poverty rate. But it achieved that end by erasing incentives for a significant fraction of the unemployed.

Poverty Should Have Risen

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When measured to include taxes and government benefits, poverty did not rise between 2007 and 2011, and that shows why government policy is seriously off track.

When somebody earns, say, $10,000 by working, he should keep some of it for himself and his family rather than handing it all over to the government. By the same reasoning, when someone loses $10,000 by not working, he should get some help from the government or from others in the forms of reduced taxes and enhanced benefits but still should bear a portion of that loss himself.

Economists debate the fraction of wages that workers should keep for themselves, because the optimal fraction is a trade-off between incentives, insurance, support of public goods, freedom and other factors. Libertarians and other believers in small governments might set the fraction at 80 percent or more. Other economists think that incentives have an effect on behavior, but incentive effects are small, so we can safely set the fraction at 30 percent, or even a bit less.

But I thought economists agreed that the fraction should not be zero, so that people losing money by not working would bear a portion of the loss. If people with declining incomes found them entirely replaced by government help, that amounts to 100 percent taxation (providing more benefits as income falls is sometimes called “implicit taxation”).

As James Tobin, a John F. Kennedy adviser, Nobel laureate and leading Keynesian economist of his day, said in a 1965 article, a 100 percent tax rate causes “needless waste and demoralization,” adding:

This application of the means test is bad economics as well as bad sociology. It is almost as if our present programs of public assistance had been consciously contrived to perpetuate the conditions they are supposed to alleviate.

Professor Tobin called the 100 percent tax situation demoralizing because the affected people find that all of the benefits of their hard work and success go to the government in the form of more tax receipts and fewer benefit payments. The unintended result would be less work and more families earning less than the poverty line, which is why Professor Tobin described such policies as perpetuating poverty.

If, as economists recommend, everybody’s tax rate is effectively less than 100 percent, then someone with disposable income of, say, 110 percent of the poverty line should find himself falling into poverty when he loses his job. His living standards would not fall to zero because he should be getting some help in terms of reduced taxes and increased benefits. But optimally his disposable income would fall to 80 percent of the poverty line, and perhaps below, until he found a new job.

Under the Obama administration, workers with disposable income in the neighborhood of the poverty line did not, on average, see their job losses during the recession translate into significant reductions in their disposable income.

As Jared Bernstein put it, America had “the deepest recession since the Great Depression and poverty didn’t go up.” He shows that the percentage of people in households with disposable income less than the poverty line was 15 percent in 2011, just as it was in 2007 before the recession began. In fact, the percentage fell a bit after 2008 when the stimulus law went into effect.

The results suggest that the government was helping too much. If they had been following the advice of Professor Tobin and all other economists who say they believe that tax rates should be less than 100 percent, the fraction of households with disposable income below the poverty line would have risen as a consequence of millions of lost jobs, just less than it would have without any government help.

Mr. Bernstein, one of the Obama administration advisers who designed the stimulus law and said it would quickly push the unemployment rate below 8 percent, appears to be unaware that it is possible for the government to help too much by creating the kind of situation Professor Tobin described and depress the economy in the process. Mr. Bernstein fails to mention incentives in any way and instead describes the poverty results as “a real accomplishment and a sign of a far more civilized society.”

Erasing incentives is not the way to a civilized society but rather to an impoverished one.

Why Doesn't Poverty Rise During a Deep Recession?

Because government benefits replace almost every dollar that people (in the neighborhood of the poverty line, at least) lost in the labor market. That's a 100 percent tax -- for every dollar a person earns (loses) he loses (gains) a dollar in government benefits, respectively.

Jared Bernstein presents the facts, especially this chart.

The official measure is cash income, and the alternative measure adjusts the official measure for all of the government taxes and benefits people pay or receive.

Bernstein thinks that the government has done well here, when it fact this reveals how excessive the benefits are.

The Fiscal Cliff: a non-Keynesian Analysis

Much of the discussion and analysis of the fiscal cliff is purely Keynesian: incentives are ignored and it is assumed that moving money around has a multiplier effect (negative in this case, because it involves moving money "from the consumer" to the Treasury).

Here's a back of the envelope on incentives:

• Emergency unemployment benefits are ended "prematurely".  Keynesians say that end depresses the economy, but it really expands it because it reduces the pay people can receive by not working.  In terms of marginal tax rates for middle income people, this provision will lower them about 2.2 percentage points (see Chapter 5 of The Redistibution Recession, this is expressed as a percentage of total  compensation).
• "Bush rates" for individual income tax expire:  rates rise about 3 percentage points (using the same compensation units as above -- not the usually units you see cited).
• The payroll tax cut expires: raises rates 1.8 percent points (same units as above).
• AMT hits a lot more people.  If the Bush tax cuts had not expired, that would probably rate rates about one point.  But the cliff  expires the Bush rates, so it is possible that adding on the AMT lowers rates.  So let's call it zero.
• TOTAL: marginal tax rates for middle income people go up 2.7 points.  Their after tax share falls by 0.049 log points (that is, about 5 percent).

IF all of this happened (it won't), my model predicts that the labor market shrinks 1.8-3.7 percent relative to the constant marginal tax rate baseline. At the baseline, the labor market grows at something like population growth (+1 percent over one year).  So maybe the labor market shrinks 0.8 - 2.7 percentage points in absolute terms.  That's a noticeable recession, but much smaller than what happened 2008-9.

I doubt that the Bush rates expire on the middle class (the rich don't count much in the employment statistics), so that entry can be forecast as zero.  So then marginal tax rates actually go down (the emergency UI expiration more than offsets the payroll tax cut expiration -- see my book on this point), and the labor market grows a bit faster than one percent in absolute terms.

If the Bush tax rates were maintained (at least on the non-rich), and just part of the unemployment benefits were to expire, then marginal tax rates might edge up a bit.

In my view, the tax rates on the rich matter little for what happens to employment in the short run, because the rich don't count much in the employment statistics.  They count much more in the spending and productivity statistics, which would be depressed by returning to the Bush rates for them. 

What could be interesting is if we go over the fiscal cliff, have a mild recession, but the entry into that mild recession opens the spigots for still more help for the poor and unemployed (think ARRA), and turns a mild recession into a deep one (sound familiar?).

The bigger issue for the labor market in the medium term is what happens with the ACA.  If that goes in as planned, it should be a lot more depressing than the fiscal cliff (although I am still preparing my estimates here -- not a simple law).

Romer's Case is Fundamentally Flawed

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A fundamental flaw in much of the advocacy for government spending to “jump-start the economy” has been a failure to adequately distinguish government transfers to individuals from government spending on goods and services.

When the Obama administration designed the American Reinvestment and Recovery Act in early 2009, its chief economic adviser and one of the act’s enthusiastic advocates was Prof. Christina Romer of the University of California, Berkeley. Ever since, Professor Romer has insisted that opposition to the act’s purported stimulus value is largely motivated by ideology, contrary to empirical evidence, and is getting in the way of the even bigger stimulus that is needed.

The recovery act had three basic components: government purchases, transfers to the poor and unemployed, and so-called tax cuts. (Parts of the act gave resources to state and local governments, which they could devote to the same three components.)

I agree with Professor Romer that plenty of historical episodes featured surges in government purchases of goods and services, especially but not exclusively purchases by the Defense Department. Moreover, I agree with her that historical episodes can be informative about the modern-day effects of government purchases.

The fatal flaw in Professor Romer’s evaluation of recovery act’s effects occurs when she assumes that transfers to the poor and unemployed have the same employment and output effects as government spending on goods and services.

Economic theory and common sense tell us that paying someone to build a tank or pave a highway – as government purchases often do – has a very different effect than paying them for not working or paying them for earning less rather than more – as the law’s transfers did.

Professor Romer calls herself “an empirical economist” and might therefore eschew economic theory and common sense until it is supported by empirical evidence. But she fails to mention that dozens, if not hundreds, of empirical studies have found that safety-net programs discourage people from working and discourage employers from hiring (there are so many studies that there are now studies of studies, summaries of meta-analyses and so on).

That literature offers a range of estimates, and sometimes passionate arguments among its authors, but certainly does not support the idea that incentives are negligible, especially when the government obtains the large majority of the proceeds of a person’s work.

Understandably the law was put together hastily in early 2009 as people feared that the recession was getting out of control, and some bases were momentarily left uncovered. But almost four years later, an empirical economist should have noticed that the legislation eroded incentives to work and eroded incentives for employers to hire or avoid layoffs, and that these parts of the act by themselves are likely to have reduced employment and certainly did not expand it as much as government purchases would.

An empirical economist would also notice that the demographic groups whose work incentives were eroded the most by the law, like unmarried people, were remarkably the same groups whose employment and work hours fell the most. By further expanding safety-net programs, a bigger stimulus would only have created more groups with labor-market outcomes like the unmarried and enlarged the ranks of people for whom government help permitted them to spend more by working less.

Professor Romer might point to a study the President’s Council of Economic Advisers released shortly after she left in 2010, contending that extending the duration of unemployment insurance increased national employment. But that study suffers from the same flaw, because its estimates are based on the backward assumption that the historical “multipliers” for government purchases apply to transfer-program spending too.

In my new book, I explain how the American Reinvestment and Recovery Act did not erode work incentives by extending unemployment benefits (those extensions, examined in the White House study, were put in place by other legislation), but rather by giving unemployed people bonuses, paying for most of an unemployed person’s health insurance and expanding the food stamp program, to name just a few provisions.

Throughout the time Professor Romer has been trying to convince us that the law expanded our economy, she has failed to mention that it eroded work incentives, and she has not explained how its transfers could possibly have the expansionary effects of historical military buildups and the like.

One might expect that the tax credits part of the law would have enhanced incentives and thereby help offset the incentives that were eroded by its transfers. However, many of the tax credits were withheld from people from high incomes. Regardless of whether redistribution is achieved by collecting more taxes from families with high incomes, providing more subsidies to families with low incomes, or both, an essential consequence is the same: a reduction in the reward to activities and efforts that raise incomes.

Studies suggest that the American Reinvestment and Recovery Act helped keep living standards out of poverty, a great benefit that may be worth depressing the labor market. But empirical evidence, economic theory and common sense all contradict Professor Romer’s assumption that transfers to the poor and the unemployed raise employment about as much as the same amount of government spending on goods and services.