The Tax Economics of the Auto Industry

It is estimated that U.S. automakers spend about $1600 per car on so-called legacy costs (health benefits for retirees) and another $800 per car on other union-related added costs, although some of the latter have been cut a bit due to recent negotiations with the UAW. This amounts to an implicit to a $2400-per-car implicit "tax" on American automobile sales that is not levied on the sales of foreign cars.

For the purposes of this essay, I follow the traditional (and likely dubious) assumption in tax economics that retiree benefits cannot be cut. It follows that automaker bankruptcy may free the auto consumer from paying for those retiree benefits, but only by shifting the burden to taxpayers and previous (stock and bond) investors in the U.S. auto industry. In the worst case scenario, taxpayers foot the entire bill, even for the $800-per-car in union related added costs.

Even if taxpayers make up for all of the revenue that would have been obtained by the implicit $2400 per car tax, taxpayers will be better off than they would be if U.S. automakers continue to operate under current union contracts because they are also auto consumers. This is a result known as "Ramsey's Optimal Tax Formula" -- if we must have revenue to pay off a politically favored group, it is better to finance the payoff with a broad-based tax (such as the federal income or payroll tax) than with a narrow tax such as an implicit tax on American auto sales. In this case, the benefits of taxpayer finance (rather than auto consumer finance) are quite large.

In theory, there is a caveat to this result. If the U.S. government had already been following the optimal tax formula, it would have taxed the auto industry more lightly in recognition of the UAW's implicit tax. In this case, changing the UAW's implicit tax into an explicit tax has no effect on the taxpayer-consumer.

Either way, given that the taxpayer is also an auto consumer, he cannot be worse off by letting car companies go bankrupt even though he recognizes that he will foot some or all of the bill for autoworker benefits.

Banks are not the Only Ones Who Can Lend Money

Nonfinancial corporations are lending too. Thanks Professor Paul Emberton for the reference.

UI on Steroids

Suppose that you bought a house in 2005, and took out a mortgage equal to four year's income. Now your house is worth three year's income.

More bad news: you lost your job, and your income is cut in half because unemployment insurance (UI) only replaces that much.

Your best course of action may be to FAIL to find a new job. First of all, you can continue UI as long as Congress extends it and you are still without a job. More important, Citi-group is your mortgage lender, and (hypothetically) they are especially willing to renegotiate mortgages with people who are unemployed. That is, by remaining unemployed you greatly enhance your chances of seeing one year's salary (on your previous job) taken off your mortgage.

I don't know how common is this situation. I do know that at least some mortgage lenders are considering employment status when restructuring a mortgage:

"[Citigroup] recently streamlined its loan modification program to rework delinquent loans. This revamped program uses a simplified formula to figure out an affordable payment as a percentage of the borrower's gross income. It then reduces the monthly payment to that amount by either reducing interest rates on the loan, extending the loan's term or forgiveness of principal." (from Mamundi 2008, emphasis added)

I am not aware of the percentage used by Citigroup, or the frequency over which it measures borrower's gross income for this purpose. For the sake of illustration, suppose that the percentage were 25. An action taken by a borrower to increase his income would increase his payment obligation by 25 percent of the income increment. If an affordable payment were reevaluated monthly, this would amount to a 25 percent marginal tax rate over the life of the loan. If, say, 2009 income were used to calculate an affordable payment for the years 2010-14 and the interest rate were 6 percent per year, then the marginal tax rate would be 108 percent for 2009 (4.3 times the percentage from the formula) and zero thereafter.

It is conceivable that mortgage restructuring could do significant damage to our labor market. Notice that this is an issue of settling past loans, not an issue with making new ones. I explain these results in more detail in a working paper (available from NBER or from www.caseymulligan.net/w14514.pdf). This research is ongoing, so please check back here for updates, corrections, etc.

Also note that I HAVE CHANGED MY MIND about the damage that deflation could do in today's economy -- it could be a lot via this mechanism.

Why Housing Drags down Stocks

The housing crash is one of the fundamentals our economy inherits from the past. This is boom time for the nonresidential sector because, after a long wait, the housing sector no longer absorbs so many resources. If you are young with new business ideas -- good news: you no longer have to compete with the housing sector for funding.

Although business capital and GDP will grow (my detailed predictions are here), old capital has to compete with the new projects. That's part of why the stock market falls when we learn that housing investment is lower than expected. The chart below is from my NBER wp "Market Responses to the Panic of 2008" showing how housing investment appears to discourage non-residential investment.

Stocks, Flows, and the Funding of New Projects

The post is to clarify some confusion among blog readers. I wrote in the New York Times:

Although banks perform an essential economic function - bringing together investors and savers - they are not the only institutions that can do this. Pension funds, university endowments, and venture capitalists and corporations all bring money to new investment projects without any essential role played by banks. The average corporation receives about a quarter of its investment funds from the profits it has after paying dividends - and could obtain even more by cutting its dividend, if necessary.

Note that the funds referenced here are flows, and are distinct from the value of institutions that own them. A business needs cash flow -- from its own operations or some other institution -- to pay for investment. The value of the institution is only on paper. For example, a startup company could have tremendous value but no cash flow (or negative cash flow) from its operations and therefore needs outside funds to invest. Conversely, many corporations, pension funds, endowments etc., today have suffered losses in value but nonetheless have significant cash inflows from their investments and operations. Those adverse changes in no way refute or de-emphasize my point. Indeed, Luke Threinen and I predicted both reduced values and increased investment funding. Its poor cash flows that will get my attention.

The importance of flows is why I keep an eye on aggregate capital income in the economy -- the marginal product of capital -- and not the aggregate capitalization of the stock market or some other valuation measure. Aggregate capital income was low during the years prior to the 1930s bank panics; so far those flows are fine today.

Flashback: Rockin' Like a Hurricane

A month ago, I wrote:

"we should be careful not to extrapolate the rate of economic growth measured through September 2008 into the future. We should also be careful to evaluate economic growth measured FROM September 2008 with the understanding that some "rebound" is to be expected as factories clean up after a hurricane or strike."

Today the AP reported:

"Industrial output posted a bigger-than-expected rebound in October after plunging in September by the largest amount in over 60 years. The Federal Reserve said Monday that industrial output rose 1.3 percent last month, reflecting a return to more normal operations following hurricanes and a strike at aircraft manufacturer Boeing Co. the previous month."

Keep this in mind when 2008 Q4 growth comes out.

Hope for Robin Hood Needs A Rapid GM Collapse

Republicans are supposedly the ones who promote "Reverse Robin Hood" policies -- help the rich at the expense of the poor. Robin Hood is supposedly a prototypical member of the Democratic Party. So far neither party has done a whole lot to earn their reputations.

For example, it was Democrats in Congress who pushed against Republican resistance to pass a massive Wall Street bailout. The Democrats' argument was essentially that helping Wall Street would eventually trickle down to regular people. Their only attempt to earn their reputation was to expertly avoid using the phrase "trickle down." How can they sustain their reputation when they make such arguments? How can Republican sustain theirs when they miss such opportunities?

HOPE IS AT RISK

Senator Obama's victory gives hope that the Democratic party will be prevented from promoting any other Reverse Robin Hood policies. Can we sustain that hope through current events in the auto industry?

Workers at GM, Ford, and Chrysler are not among the poor by any definition: those workers' salary and benefits total more than $70 per hour!! Yes, I typed that correctly. Very few American workers earn that much per hour.

GM, Ford, and Chrysler shareholders are not among the poor either: the poor own little if any stocks. So a GM bailout would benefit rich workers and rich shareholders. I guess the argument is that a GM bailout would trickle down to people who really are poor, or at least middle class.

Many of us hope that President-elect Obama will not tolerate trickle down nonsense. The problem in this situation is that the United Autoworkers Union was a strong and visible supporter of Obama, and the auto industry is in deep trouble NOW. Will our hopes be dashed within days of the inauguration?

HOPE CAN SURVIVE

I see three reasons to continue hope.

1. First, President Obama may stand up to the UAW. Maybe he would even insist that we cannot tax the average American to bail out those who are already more fortunate than most Americans!
2. Second, GM is failing so fast that it might not last until inauguration day. Thus it might be Bush who stands up to the UAW -- he has done well on that lately. I admit that Bush's actions on this matter are not consistent with the Republicans' Reverse Robin Hood reputation, but I take solace in the fact that Secretary Paulson initiated the Wall Street bailout, even if many fellow Republicans did oppose it for a few days.
3. Third, a fast failure may result in Bush's living up to the Republican reputation by bailing out automakers before inauguration day -- not exactly Robin Hood's outcome, but at least Obama's record would be untarnished.
   

A rapid and decisive GM collapse would allow us to continue to hope that President-elect Obama represents genuine change: leading politicians of the Democratic party will no longer tax the average American to bail out the rich, regardless of whether those rich do business in Detroit or in New York City.

[added Nov 18: The $70 per hour includes wages and benefits, but you might say some of the benefits "belong" to the retired workers, and that current workers cannot expect such a generous retirment (Mark Perry reports that in 2006, each retiree received an average of $48,793 of pension and benefits from their former employer; this does not include social security). An alternative indicator of how much auto workers make (wages and benefits) is to look at U.S. workers in Toyota plants (where the retiree legacy is not such a problem): almost $50 per hour. Whether you call it $50/hr, $60/hr, or $70/hr, these people earn much more than the average American worker.]

I Paid My Income Tax Today

This is supposed to be a serious blog, but I will permit some levity on the occasional Friday.

Thanks to Angela for recommending this song.

Surprisingly Quick Confirmation of Ricardian Equivalence

A month ago the Treasury floated the idea of its purchasing equity stakes in banks, and I first explained how Treasury investment would crowd out private investment. Academics had ignored this point, and largely still ignore it.

Suppose the Treasury bought bank shares in the open market. That is, they traded cash-for-shares with existing shareholders. Why would those shareholders take their newfound cash straight to bank they had previously owned and ask for a new share issue? Professor Barro says that the shareholders would save their cash for future taxes they'll owe, but at the very least might we expect that they'd spend the cash on a variety of other things? In that case, the bank in question would have little or no increase in shareholder equity.

The actual Treasury transactions were not with shareholders, but with the banks themselves -- a trade of cash for new share issues. But why should it matter whether the Treasury deals with the banks or with the bank's shareholders? If it doesn't matter, then we are back to the conclusion that Treasury transactions do not boost shareholder equity.

I was fascinated to observe how quickly the world would learn that it really doesn't matter:

1. First, the Washington Post and two Harvard Professors noticed that banks were not cutting dividends despite their massive losses. Dividend payments are one way to neutralize the Treasury purchases.


2. Second, reporters noticed that PNC financial took its Treasury cash and immediately bought National City Bank.


3. Third, reporters heard that JP Morgan Chase CEO told his employees that Treasury cash would help them acquire competitors.

All of this in only a few weeks! And I had worried that it would take years of careful academic study to prove my point.

Read all about this in my new Economists' Voice article "Is the Treasury Impotent?" Despite (or because of?!) the evidence that Treasury investments are not helping capitalize banks, Professor Mankiw still thinks they are a good idea.

Would the Treasury be Equally Impotent in the Auto Industry?

Some members of Congress are encouraging the Treasury to include automakers in the banking sector bailout plan. I don't yet know the details. But let's work through the effects of (so far, hypothetical) Treasury purchases of newly issued GM stock.

GM suspended its dividend earlier this year. But it could reinstate it, which would push some of the Treasury dollars out the door, at the rate of about $0.5 billion per year.

GM could use the cash to buy another automaker. That would put more Treasury dollars in the pockets of shareholders (of the other automaker).

GM could spin off GMAC to its shareholders. That's not cash in shareholder pockets, but some valuable shares.

Do not take for granted that (hypothetical) Treasury purchases of newly issued GM stock would significantly change the organization of the industry by reducing the probability of bankruptcy. Absent Treasury action, GM would likely end up joining with another automaker. All the Treasury action might do is let GM be the acquirer rather than the acquired.

There are fraudulent conveyance laws: GM cannot sell its valuable assets and then declare bankruptcy. Thus, Treasury cash would enable GM to spin off GMAC only if GM kept enough of the Treasury cash to avoid going bankrupt too soon after the spin off.

If bankruptcy were the only way shareholders could free themselves from obligations to unions and retirees, then bankruptcy may happen regardless of whether the Treasury gives cash.

Obviously, more analysis is needed here, but this time let's be quicker to admit that Treasury cash will not stick where it lands.