1930s Income Taxes

A variety of economists have been debating the role of fiscal policy during the Great Depression. Some of them (also here) seem to suggest that things would have been much different if income tax rates had been lower. Although many things can be blamed on income taxes, the Great Depression is not one of them.

The reason why it's hard to blame much on the income tax is quite simple: most people did not pay any. There was not even withholding in those days. You may have seen some reports about the "lowest income tax bracket" during the 1930s was rising, but that ignores the most prevalent bracket of all -- the zero percent bracket!

I have toyed with the idea of putting some blame on property taxes -- property taxes were hefty, but I don't yet see the mechanism.

Flashback: Inflated Deflation

Citigroup announced today that it would renegotiate home mortgages as part of " sweeping efforts to try to curtail losses from souring mortgages."

I think deflation is unlikely. But if it did occur, its harm would be limited, in part because (unlike the 1930s) mortgages are being widely renegotiated in light of the new economic situation. Renegotiations like that could readily account for deflation-induced reductions in homeowner incomes.

Will the property tax assessors now do their part?

[added Nov 19: I changed by mind. This is bad news, not good. See my post "UI on steroids"]

Housing Wealth and Household Behavior

In order to predict how the housing price crash impacts the economy, we have to understand why the boom and crash occurred in the first place. In an earlier post, I offered a classification of possible models. Now I think there is a better classification:

1. Separable Taste Shocks. Shocks to (current or future) housing tastes that do not affect substitution patterns in the non-residential sector will have no aggregate wealth effect. As Buiter (2008) explains, persons long housing will gain when tastes shift toward housing (and thereby increase housing prices), and persons short housing will lose. [non-technical version: if your taste for housing also affects your willingness to work, then the non-residential sector will be affected, although we would not call the effect a "wealth effect".]


2. Shocks to the Production Set. A larger production set can increase housing prices, and is an aggregate wealth effect by any definition. The wealth effect calculations I made with Luke Threinen are most easily interpreted in such a model, although they can also be interpreted as the result of redistribution created by separable taste shocks.


3. "Distortion" shocks that move the economy closer to the frontier of the production set. Increasing housing subsidies can both increase housing prices and look like an adverse wealth effect from the perspective of household behavior in the non-residential sector. Nonseparable taste shocks may have similar effects.

Changes in the production set or changes in the distance between the market allocation and the production frontier involve wealth effects by any definition. An example: the arrival of information about the technology for producing housing services. People may learn that the technology will advance, which causes a boom in housing prices and a favorable wealth effect. The market may initially believe that banks can streamline the mortgage process and thereby facilitate home-ownership for small home-owners. Or it may believe that the real estate brokerage industry will become more productive. Good news like this boosts housing prices and is an aggregate wealth effect. If the market later learns that ultimately the technological advance will not work (e.g., learn that small homeowners are really more expensive to service than initially thought), housing prices crash and there is an adverse wealth effect.

This conclusion might appear to disagree with Buiter (2008), which argues that changes in housing prices are not wealth effects in the sense that they do not enter the demand for non-housing goods because housing is both an asset and a consumption good. Buiter emphasizes that someone will consume the housing stock – even if it isn’t the current owners – and those prospective consumers gain from a housing price crash even while the current owners lose. I agree that housing prices changes that reflect changes in the current or expected future (separable) preferences for housing are ultimately redistributive.[1] Demand changes are not changes in the production set or changes in the distance between the market allocation and the production frontier. But it is quite possible that the shocks that created the housing boom prior to 2006 and the housing price crash that followed were technological or public policy driven. A technology shock will have aggregate wealth effects, and a public policy shock might too.

[1] Another question is whether the persons short housing are represented in today’s economy (maybe they are unborn, or live abroad, or only exist in the imagination of exuberant housing investors), but my purpose here is not to reclassify a redistributive wealth effect as an aggregate one.

Exception that Proves the Rule: Mayoral Election tied 22-22

This election was odd for a couple of reasons:

http://wcco.com/local/mayors.race.coin.2.858488.html

Gerontocracy Stumbles: The Real Political News This Year?

Much of the world has lived under gerontocracy since the 1970s. That is, countries throughout the world -- democracies and nondemocracies alike -- have awarded much of their tax dollars to programs for the elderly. Social Security -- which writes checks to the elderly -- is the largest federal program in the U.S. The second largest is Medicare -- a publicly-funded first-class medical insurance program for persons aged 65 and older. Medicare is on its way to becoming the largest federal program, and not because Social Security is shrinking.

Outside of the U.S., many governments spend even more of the national income on programs for the elderly. In some Western European countries the elderly receive from the government (not to mention their receipts from private sources) a fraction of national income that exceeds their fraction of the population. In those places, the elderly had already proven that their share of need placed no limit on what they could obtain from the public treasury.

Only three years ago, the march toward gerontocracy seemed unstoppable. Elderly programs had been growing for decades, and seemed destined to grow further as the baby boom retired. President Bush -- the leader of a Republican party that supposedly believed in "public spending control" -- signed the expensive Medicare Prescription Drug Act with much fanfare.

The political landscape couldn't have been better for the elderly. They were healthier than ever, selling their homes to young people at high prices, and cashing dividend checks from sizable stock portfolios. Most important -- and thanks to the above -- the elderly enjoyed long retirement periods that permitted them to devote time and attention to important political issues. As they prepared to welcome the baby boomers to the retirement class, they could expect to add numbers to their politically robust ranks.

To add to the euphoria, Senator McCain helped pass campaign finance reform , which put financially-funded political groups at a further disadvantage relative to grass-roots organizations. It's no accident that the AARP enthusiastically endorsed that reform, because the elderly don't lobby with money -- they influence political change with time and attention.

2008 did not stop the aging process for the baby boom, or for anybody else. However, the stock market and housing crash delayed many retirements. With many of the baby boomers remaining in the workforce with the young, it is less likely that they will identify with retirees. Even if they do, work will keep them busy -- maybe too busy to pay much attention to political matters.

This year also witnessed significant innovations in political fund raising, with much of the credit going to the Obama campaign. The previous campaign finance reform ultimately did not stop the collection and disbursement of hundreds of millions of political dollars.

The young survive to fight another political day, and to do so with more numbers and dollars than we previously expected.

The Marketplace for Indoctrination

Did you see "Professors’ Liberalism Contagious? Maybe Not" in the New York Times?

The article confirms that Professors tend to be "lefty" (liberal, identify much more with the Democratic party, or however you want to say it). It also confirms that college-age is the part of the life cycle when people become especially lefty in their politics. But it questions the conclusion that college-age people are adopting their Professors' lefty views.

I agree that it is easy to exaggerate the effect of Professors' political views on those of the students. Like almost any market, the marketplace for college education is competitive and thereby serves the interests of its customers. That is, marketplace for college education has outcomes that reflect the interaction of supply and demand!

If the college students, their parents, and their employers all did not want the students to be exposed to a parade of lefty Professors, then an entrepreneurial college would stand to make millions in tuition revenue by putting some not-so-lefty Professors out there. The schools that stuck by their lefty-ness would see dwindling enrollments.

Even if there were not as much as one among the thousands of colleges that was so entrepreneurial, there could still be a department that might dare to house a Professor or three who were not-so-lefty (in order to protect the innocent by refusing to name names, I will amorphously refer to that department as the "Economics Department"). If supply and demand had any predictive power, then we could be sure that the Economics Department would attract students -- and recruiters from the world of employment -- at the expense of departments that refused to recognize their consumers' situations (again, to protect the innocent, I will refer to the latter departments as "Humanities Departments").

By these kinds of mechanisms, Professors' political views reflect the situations of their students, and not the other way around. Humanities Departments are in really big trouble if many elderly ever enroll in college (that is, Humanities Departments should not expect to be acquired by business schools)!

Flashback: Do Not Read This Until Nov 5

[Flashback from Oct 20:]

If your candidate lost yesterday, I'm sorry. If you lament because you assumed that your candidate would have implemented superior public policies, then you can feel better already because your sorrow is based on a false assumption.

Democrats and Republicans clearly have different rhetoric. But rhetoric is not policy. Republicans talk a great game when it comes to cutting government spending, but President Clinton's administration had one of the lowest ratios of government spending to GDP. President Bush added immensely to Medicare spending with the Prescription Drug Act. Democrats talk a great game about helping the poor, but they pushed through a bill to tax America in order to bail out Wall Street fat cats. FDR started Social Security, but Nixon did the most to increase its spending. Democrats talk about limiting the power of the state when in comes to the death penalty, but a Republican Governor (Ryan in IL) put a moratorium on the death penalty.

Do you remember when Democrats were devasted because Roe-v-Wade would be overturned once President Reagan made his Supreme Court appointments? Well, those appointments happened and Roe-v-Wade still stands. I could go on and on with examples.

Economic theory suggests that political party might not affect policy, but instead merely reflect public policy preferences of the citizens. With some exceptions (see below), political parties compete with each other. Obama was one of the most liberal U.S. Senators because he faced little contest in Illinois, but became quite middle-of-the-road when it came to the Presidential race. Politicians are politicians first and (at best) ideologues second. A public opinion shift may give one party or another a small advantage and thus create a correlation between public policy and party-in-power, but this does not mean that political party itself has a significant impact on policy. Indeed, it would be inefficient if it did.

A number of economic studies have failed to find a correlation between party-in-power and public policy. Others have found a correlation (Professors Besley and Case have a nice survey in the JEL), but even there the implied impact is quite small. For example, Besley and Case look at state governments (where spending is about 1000 1982-dollars per capita per year) and find that governor's party is not correlated with spending and that a 10 percentage point increase in the Democratic party's share of the state legislature is associated with additional state government spending in the amount of $10 per capita per year. $10 per capita per year could be less than the cost of voting itself! Furthermore, effects at the state level may be larger than they would be at the national level because state-legislature elections are often uncontested and the whole economic logic cited above presumes competition.

Professors Snowberg, Wolfers, and Zitzewitz tried to look at situations in which party-in-power was significantly different even when citizen preferences were not. They found some effects, but they were also quite small. Eg., a Bush administration (rather than Kerry or Gore) was expected to increase stock prices by 2-3%. That is pretty trivial, given that the stock market fluctuated that much in the 20 minutes it took me to type this entry.

The Federal government currently spends about $9000 per capita per year. Even if I applied the estimates from the states (which I think are too big because national elections are more competitive), that means a victory for Obama (McCain) AND the Congressmen of his party will increase (decrease) federal spending by $90 per capita per year. Regardless of whether you like or dislike public spending, $90 is not worth much worry.

I am aware that I wrote an article showing how women's relative wages increased over the years, but essentially did so only during years of Republican presidents. But I don't know (yet) whether or how that progress can be attributed to public policy (more on the women's wage issue here).

P.S. How much would did (would have) an Obama victory cost? The $90 upper bound pertains to both executive and legislative victories by Democrats. Obviously, Obama is only part of that. Furthermore, some of the $90 would be a pure transfer. On the other had, deadweight costs may be created both from the taxation and the spending of the $90. I would say less than $50.

Voting: I Enjoyed the Experience

For those who are voting tomorrow (or, like me, voted already), I hope you enjoy(ed) the experience. The election outcomes will be the same regardless of whether you vote or not.

If you vote, your favorite candidates will have one more vote than they would have had if you had not voted. But your candidate won't need just one more vote, except in the highly unlikely case that your candidate ends up tied or losing by just one vote.

A U.S. Presidential election has never come down to one vote. The Bush-Gore election was pretty close, and some say that Gore really won, but all admit that the Bush and Gore votes in the pivotal state of Florida differed by hundreds. That is, even if you are a Floridian and had voted differently that day, Bush would still be the President.

A U.S. Senate election has never come down to one vote.

A Governor's election has never come down to one vote.

Chip Hunter and I used a computer file with vote tallies from over 70,000 general elections to the U.S. House, state Houses, and state Senates (read more in the June 2003 issue of Public Choice). Most notable are the large number of uncontested elections (that is, elections for which only one candidate is on the ballot). I can guarantee you that an uncontested election will not end up tied!

Are there any readers who voted in the 1910 election in the 36th Congressional district of New York? Those are the only persons having the privilege of voting in a U.S. House election that came down to one vote. 6 state House and 3 state Senate elections came down to one vote; the other 40,000+ did not. One of every 89,000 votes cast in U.S. Congressional elections, and one of 15,000 in state legislator elections, "mattered" in the sense that they were cast for a candidate that tied or won by one vote.

Inflated Deflation

The prospect of a damaging deflation has been highly exaggerated. Deflation is unlikely today. Even if it did occur, our economy today is better positioned to adjust to it.

Deflation occurs when the prices of most goods and services fall – that is, most things cost less now than they used to cost. Deflation is the opposite of inflation, which is when the prices of most goods and services rise. A large and sustained deflation occurred during the Great Depression, and some economists blame much of the Great Depression’s poor economic performance on that deflation.

DEFLATION IS A GENERAL PRICE DECLINE

For most of our lifetimes, there have been some prices that have fallen, even while many prices rose. For example, the Bureau of Labor Statistics reports $20 buys more toys today than it did 30 years ago. Although some toy manufacturers may be worse off because toys sell so cheaply now, most of us are happier that we can either buy more toys or spend our incomes on other things.

Some prices have fallen during the last month or two, such as the prices of oil and raw materials. Because most of us do not obtain much (if any) income from the ownership of oil wells, aluminum mines, and the like, we should be glad – not concerned – that these prices are falling. Remember that we have been reading since 2005 how the American consumer – and the American economy in general – has suffered from high oil prices. Finally now some of that suffering eases.

Housing prices fallen a lot over the last two years, and will continue to fall. Most of us do own houses, and falling housing prices have created a number of problems. But falling housing prices is different from a general deflation; it takes a lot more than falling housing prices to create deflation, even over a short period of time.

Indeed, it was less than six months ago – when we were all quite aware of the housing price reductions – that the Federal Reserve and other commentators expressed concerns about inflation. The inflation concerns were present because housing is only one of many goods and services that we consume and those other prices seemed to be on the rise. The deflator for personal consumption expenditures rose at 3.3% per year from 2006 Q3 through 2008 Q3 – that’s inflation of 3.3% per year.

Energy was part of this increase – it increased 16% per year over that period. However, energy goods are only 4% of consumption expenditures, so this accounts for less than one percentage point of the 3.3; even if energy prices had fallen 16% per year over those two years, there would still have been inflation. My purpose here is to assess the likelihood and consequences of general deflation.

DEFLATION CAN BE FUELED BY FINANCIAL TURMOIL, BUT IS NONETHELESS UNLIKELY
Although I do not believe that the recent financial turmoil has a significant impact on the wider economy’s employment and real growth rates, I do believe that financial turmoil can affect consumer prices and therefore the rate of inflation or deflation. Financial turmoil can cause investors to seek liquid assets like insured bank deposits, Treasury Bills, and perhaps currency. If banks, the Federal Reserve, and the Treasury fail to supply the safe assets demanded by the market, then consumer prices will have to fall in order to make the existing liquid assets more valuable in real terms. Milton Friedman and Anna Schwartz were right when they blamed some of the 1930s deflation on the Federal Reserve’s failure to accommodate investors’ demands for liquid assets (see Chapter 7 of their A Monetary History of the United States).

Deflation today is unlikely because banks, the Treasury, and the Federal Reserve have accommodated at least some of these demands. Large commercial banks increased their deposits by $157 billion during the last week of September 2008 (at the height of today's banking crisis), and maintain those higher levels throughout October. An increase of $157 billion would normally have taken about 6 months. Treasury debt held by the public increased almost $800 billion from September 15 through October 30. Much of that increase was available to the non-bank public, because bank holdings of Treasury and Agency securities were pretty constant until the second half of October, at which time they increased about $100 billion. With the Treasury, the Fed, and the banking sector accomodating the increased demand for liquid assets, the bigger risk is that high inflation next year will result from failures by the Treasury and the Fed to accommodate reductions in liquid asset demand that will accompany a return to financial normalcy.

Deflation today is also unlikely because it is much better detected and understood than in was in the 1930s. Today, the Federal Reserve and the public have access to consumer price indices within a few weeks of those prices’ actually being experienced by consumers. Thanks in large part to the history written by Milton Friedman and Anna Scwartz, Federal Reserve officials are also well aware that they have the power to avoid a sustained deflation.

MORTGAGE AND PROPERTY TAX DAMAGE HAS ALREADY BEEN EXPERIENCED
Even if our economy were to experience a sustained deflation, it would survive it better than we did in the 1930s. The 1930s sustained deflation was damaging because, among other things, it dramatically redistributed wealth from persons owing mortgages to those who had underwritten them – in a way that was not anticipated when those mortgages were signed. The deflation also amounted to a un-legislated increase in property taxes, because their dollar value stayed fixed while taxpayers’ dollar incomes fell, as did the public sector’s dollar expenses.

Farmers in the 1930s found their crops were selling for half the dollar amount that they were in the 1920s, yet had no easy mechanism to cut the dollar amounts of their mortgage and property tax obligations. Today, because home prices are way down (50 percent by some estimates) regardless of whether we see inflation or deflation, homeowners have little equity to lose to banks as a consequence of deflation. Home mortgages already need to be renegotiated to better reflect home values and homeowner incomes. Homeowners also have a tremendous incentive to have their homes re-assessed by the property tax authorities -- even a 10 percent deflation would be only a minor change in the overall mortgage and property tax landscape today.

DEFLATION = CORPORATE TAX CUT

Corporate taxes are more important today than they were in the 1930s, in part because corporate taxes were unconstitutional until 1913. I have calculated that corporate taxes in recent times have been more than 12 percent of all capital income in the economy, as compared to about 3 percent in the 1930s. Harvard's Professor Feldstein has explained over the years how inflation amounts to an un-legislated corporate tax hike because corporate depreciation allowances are not indexed for inflation. That is, corporations make deductions for historical investments, but during times of inflation those dollars of deductions are few compared with the dollars of current revenues; an inflation-neutral tax code would recognize that the investments made in the past are worth more (to the degree that there has been inflation) than their dollar amount would suggest.


It follows that deflation amounts to an un-legislated corporate tax cut. Is there a better time than now to cut corporate taxes?!

[Added Nov 19: I changed my mind about the mortgage and property tax damage from deflation -- it could be bad if not handled propery by the Fed and the Treasury. See my post "UI on Steroids"]

Still Alone

Most economists have a bleak outlook for next year. Their expectations are very different from mine.

They forecast less consumption. I forecast consumption to be below trend, so we more or less agree on that. Where we disagree is on business investment. They make a big deal about banks' (supposed) not lending. I emphasize that investment resources have been freed up from the housing and consumption sectors and are now available for business investment.

They claim that employment will fall markedly. I emphasize that baby boomers will delay their retirements -- which has the opposite effect.

I emphasize that forecasts like theirs are logically inconsistent with the commentary given about the housing boom -- commentary given by many of the same economists.

Many economists have much more experience with forecasting than I do. IMO, their forecasting models are not appropriate for today's very unusual situation, even though those models may have worked in the past. Today's situation is when an academic economist's opinion is needed -- that's me.

My short track record is pretty good. Without much company, I correctly predicted that the Treasury stock purchases would be neutralized by bank financial transactions. Also without much company, I correctly predicted that non-residential structures investment would actually grow even while residential structures investment plummeted. I also predicted that housing prices would continue to fall, although others also predicted this.