Taxing banks does not tame them

During the last financial crisis, it was quite obvious that at least some banks were taking excessive risks. What do economists usually advocate when it comes to discouraging particular behaviors? Taxes. And that is popular as the foolishness of banks has imposed costs on the taxpayers. Thus, some countries such as Germany, the UK and the Netherlands have imposed taxes on banks. Did that work?

Not really, tell us Michael Devereux, Niels Johannesen and John Vella. They look back at the experience in various European countries and conclude that while this taxation on borrowed funds indeed reduced borrowed funds, and therefore loans, it turns out that it also increased the riskiness of the funding. These are two bads. First, loans actually encourage the economy. Second the risk has increased is of course counter-productive. Even worse, it is the safest banks that reduced most borrowing the the unsafest ones that took on additional risk. How could this happen? As there were fewer borrowed funds, and hence relatively more own assets, regulations allowed banks to modify their risk-weighted portfolio. In other words, regulation that was invariant to the introduction of the taxes made things worse.

Consumption taxation is not that regressive

It is a fact of life that governments need revenue. How to get this revenue without hurting the economy too much has been the topic of much research. Quite obviously, you first want to tax activities that are optimally discouraged, such as smoking and polluting. But that is not sufficient. You do not want to depress the labor supply and thus you want to avoid taking labor income. The alternative is taxing consumption, which you indeed want to discourage in favor of investment, but a consumption tax is deemed regressive and unfair: it hurts proportionally more the poor than the rich.

Nico Pestel and Eric Sommer claim that this perception may only hold in the short-term. Indeed, they find the standard result that a revenue-neutral switching from labor income tax to value-added tax is regressive in the short run. This seems to reverse itself in the longer run, though, thanks to a shift in the labor supply. Using a model estimated on German data, they highlight that the ones responding the most to the reduction in the wage taxation are indeed the poorest, and their response overcomes the progressivity of the income tax. The key here is also reducing payroll taxes which seem to be very discouraging for low income workers.

Uncertain times and price setting

Much has been written, including here, about how policy uncertainty is bad for business. Firms do not want to invest much when it is not clear what lies ahead in terms of fiscal policy, for example. This is particularly bad in countries where such uncertainty is chronic. If fiscal authorities or the government cannot get their act together, maybe the central bank can.

Isaac Baley and Julio Blanco show that if firms face uncertainty, monetary policy has less bite. The reason lies in the endogenous price formation (no Calvo fairy here). Specifically, firms are modeled to forecast their nominal costs, but the learning process is obviously imperfect. As the forecast variance increases, for example due to uncertainty about after tax returns, firms become more sensitive to new information and adjust prices more frequently, paying a menu cost. This effect is stronger than their urge to wait-and-see in the face of uncertainty. All this accelerates the transmission of information about the monetary policy, further dampening its impact. In other words, an ineffective government renders the central bank less effective as well.

Is France less distorted than we think?

When you think about market distortions through regulation and taxation in a developed economy, you think first about France. It is the prime example of how excessive government intervention can lead to disincentives for production and to major misallocations of resources across firms and sectors. This all accepted wisdom, except nobody actually measured the misallocation part.

Flora Bellone and Jérémy Mallen-Pisano do this using the Chang-Tai Hsieh and Peter Klenow methodology which consists of using a model of firms heterogeneous in their use of capital, labor and technology. Taking this to data, distortions in the use of factors at the firm or the sector level translate into lower aggregate total factor productivity. Hsieh and Klenow showed that there were massive distortions in China and India relative to the USA. Bellone and Mallen-Pisano show that for France, there are no more distortions that in the United States. Thus, there are no misallocations across firms or sectors, but it remains that there can still be a uniform misallocation across the entire economy, say, because of distortions on the labor market applying equally to all firms.

Marginal tax rates in Sweden

Whenever high marginal tax rates are discussed, the example of Sweden is brought forward. And typically the episode where they where close to 100% on labor income. But this has not always been so high, and it is certainly not the case now. What is the history of tax rates in Sweden?

Gunnar Du Rietz, Dan Johansson and Mikael Stenkula look back at 150 years and reconstruct marginal tax wedges for top and average earners. Tax wedges are different from tax rates in that they also incorporate other contributions, such as for social security and payroll taxes. I learned from this study that Sweden was in fact a very low tax country at the start of the 20th century, but this all changed with WWII, a succession of crises and the push for the welfare state that culminated in the 1960s. This change of attitude towards taxation and redistribution was relatively quick, and may have lead to excesses that have been built down since the 1990's. The paper also has a very detailed description of the tax system in Sweden over this period.

Tax attractiveness

Tax competition is good and bad. It is good because it forces governments to run lean operations and minimize distortions, but it is also bad because small governments can undercut larger ones and increase their own revenue while reducing aggregate well-being. Some firms and individuals are quite responsive as to where they should set up shop, so it could be useful for them to figure out where the best tax conditions are offered.

The latest attempt at figuring this out comes from Sara Keller and Deborah Schanz. They build a composite index from 16 indicators relevant for company taxation. While one can quibble about the weights but on each indicator, their normalization, and some of the redundancy, there is still useful information in the results. While it should be no surprise that the Caribbean is the most attractive area for business taxes, it is more surprising to see that Europe is significantly more attractive than North America. In fact, the United States are among the least attractive of the 100 countries Keller and Schanz considered (only Argentina, Indonesia, Peru, the Philippines, South Korea and Venezuela are worse, and Zimbabwe is in the sample...). I wonder, though, how much this would change by considering South Dakota and Delaware separately.

The top 1 percent

Much has been written lately about the rise of the top one percent earners in the United States, yet it very little about why this rise has happened. Indeed, this rise in only partially visible elsewhere in the world, which may hint that factors that are not universal may play an important role, and thus there is potential for policy if you want to revert this rise.

Facundo Alvaredo, Anthony B. Atkinson, Thomas Piketty and Emmanuel Saez notice that the rise seems to be most pronounced in English-speaking countries, and they try to identify which factors could lead to such differences in the income share of the top one percent over time and space. They come to the conclusion that there are four factors in play: 1) Tax policy, and especially tax rates for top incomes. There is simply more left after taxes for top earners, but as the other factors show, the impact is larger than that. 2) Lower top tax rates lead to incentives that make it more worthwhile for the top earners to get a larger share of the surplus. This redistribution of the surplus would be consistent with the reduction in the labor income share and the stagnation of wages for large parts of the wage distribution. 3) Capital income is becoming independently more important, especially in Europe where inherited wealth makes a comeback. 4) The correlation between earned income (from labor) and capital income has increased a lot in the United States, widening the distribution of total income. Given all this, I find it difficult to imagine a model of optimal taxation that would not involve an increase in top marginal tax rates.

Uncertainty, slow government and optimal taxes

The optimal taxation literature has come up with incredibly complex and non-linear taxation schemes that have no way of making it into policy. The most complex tax code, the US one, is not complex because that would be socially optimal, it is complex because of special interests. Complex code does not make it past the politicians because they do not understand it, because it appears not to be transparent, or because its mathematical complexity scares everyone.

Marcus Berliant and Shota Fujishima claim rather that the lack of complexity on the tax code has to do with sluggishness. Governments can simply not adapt the tax code as fast as conditions change. Of course, they could also set up contingent rules, but I suppose that this is deemed opaque and subject to interpretation. Anyway, one consequence of this sluggishness is that optimal taxes start looking very different. A typical result of standard theory is that the top earner should have a zero marginal tax rate, so as to encourage this most productive person to work more. But when this person changes from period to period, or if this is the same person but he does not reach the maximum income every period, the result does not carry through. The top marginal tax rate needs to be positive to leave some headroom. But the marginal tax rate is still declining at the top. In a way, this is achieved in many countries by allowing for "loopholes" that makes it possible for the most productive people to pay less taxes.

Biased taxable income elasticities

Anytime you apply a distortionary tax, it bring well-being losses from the distortion (although the revenue can be used for well-being enhancing public goods). In addition, there are social losses that arise from the fact that people try to evade the tax by shift to other goods, go informal, or in the case of income shift compensation to non-taxable benefits or other amenities like more flexible work hours. Traditionally, the literature has evaluated the deadweight loss from taxation by looking at the income elasticity of the tax. That may be too simple a statistic in this case.

Brendan Epstein and Ryan Nunn show that ignoring the endogeneity of the non-taxed benefits and amenities leads to serious biases in the income elasticity and thus deadweight loss, to the point that it provide not good guidance on how to set tax rates. They basically do this by providing examples: build simple models, calibrate them, generate data from them and show that the usual empirical method provide crassly wrong estimates. An econometrician could in principle do better by taking all this in account, unfortunately data will be very hard to come by for this.

The tax payer as a tax enforcer

I am fine with paying my fair share of taxes as long as the others do, too. I do not like it when people hide their income and thus have me pay the taxes for them. The ones gaming the system are the rich (especially where filing taxes is very complex) and the independents, who can skimp on both income and sales tax. And this is why I always insist for a receipt or an otherwise documented transaction.

Marcelo Arbex and Enlinson Mattos consider my behavior like that of an auditor looking out for tax evasion. Except that I would need to be rewarded in some way for my requesting receipts, as I guess not everyone is a crusader like me. SO they come up with a system where I would be rebated part of the sales tax I just paid in return of me filing the receipts. The government then figures out how to best set the sales tax, the tax rebate and the audit expenses. It turns out that you can do without auditing because the tax rebates have a sufficient income effect. Interesting system. Let us call it value-added tax.

(I know, it is not a VAT, but the underlying mechanism is the same as in the VAT, which is not mentioned once in the paper. And still, both the VAT and the system described above require auditing as people could file fake receipts.)

Reduced form welfare

It is not uncommon to find theory papers that assume quadratic utility or loss functions. They are the most tractable functions that allow to find an optimum, yet there is no reason to believe they have anything to do with reality. If you are designing an optimal policy where trade-offs are important, the results hinges quite a bit on the functional forms you choose.

Jasper Lukkezen and Coen Teulings look at optimal fiscal policy and go a step further. They attach a VAR (vector autoregression) to a quadratic welfare function. Not only do they assume an analytically tractable but very likely unrealistic welfare function, they also assume the rest of the economy is entirely linear with relationships that are policy invariant (it is a VAR). For their application, welfare is determined over GDP and the unemployment rate, which may be fine to determine the loss function of a policy maker but has nothing to do with the well-being of economic agents. They care about risk, uncertainty, consumption and time off work, all of which are absent from the model. Hence I do not really understand what the results mean, especially as the optimal policy rules are all over the place. A very confusing paper.

Strict environmental policy through tax competition

Tax competition is a double-edged sword: it keeps government on their toes regarding their expenses, but it also saps their ability to provide public goods. Generally, you would want some level of cooperation across authorities, like in a cartel, as pure tax competition is not believed to reach optimal outcomes. This is particularly true with environmental regulation and taxation.

Cees Withagen and Alex Halsema claim that tax competition may lead to a first best in an environment with cross-border pollution. The important word here is "may" as it still needs to be established that it can happen in practice. The innovation to their approach is to include endogenous capital to the model: capital can flee to other jurisdictions if it is taxed too high. Governments then play against each other. This pushes them to keep capital tax rates low. With more capital and income, demand for environmental quality is higher and emission tax rates are higher. With some luck, the latter may get exactly at the first best. It all depends on the environmental demand parameters, which are hard to estimate, though. A good opportunity to find some better measurements.

How to contain housing bubbles

One cannot deny that housing bubbles can lead to nasty consequences, as shown in Japan, the US and Spain, for example. What can a policy maker do? Foremost, it is difficult to identify bubbles on the spot, and even in hindsight. Also, imagine the backlash when the government intervenes to rein in a booming industry. One thus needs a policy rule that kicks in automatically, or some policy that just reduces the volatility of prices. Natural candidates are transaction taxes and capital gains taxes for houses, and such taxes have been proposed not only for real estate markets, but also for financial markets in general (for instance, the Tobin tax).

Nicole Aregger, Martin Brown and Enzo Rossi exploits differences in such taxes across Swiss administrative divisions, as well as corresponding house price indices, to identify whether such taxes work. They do not. The capital gain taxes, especially those that apply to short-term gains, amplify prices movements. Why? Likely because house owners are reluctant to put their house on the market if such penalties apply, which drives prices even higher. As for transaction taxes, they have no impact whatsoever on price fluctuations. Thus such tax policies do not work, unlike you are willing to subsidize capital gains...

Why Americans spend so much on health: they work themselves sick

If you compare Americans to Europeans, you can come up with a few differences: they are richer, work more, pay less in taxes, spend a lot more on health, but are less healthy. Could all these facts somehow be related?

Yes, according to Hui He and Kevin Huang, who use a dynamic general equilibrium model to study the impact of labor income taxes on the labor supply and health outcomes. The resulting story they can tell follows essentially these lines: First, to be more likely to be healthy, you need a good amount of leisure, or not be overworked (which may explain why I have been sick the last few days). But if labor income tax is low, you tend to want to work more. This diminishes your health, which you compensate by buying more health services, which you can afford thanks to higher income. Due to high demand for these services, they also become more expensive. In the end, Americans end up with an outcome where they have more stuff to consume which they trade off with paying more for health services, enjoying lower health and less leisure. All this because of the labor income taxes. Whether they are better off is a matter of individual taste. I could certainly need a bit more leisure about now.

Greening the tax system works

It has been some time that I have not mentioned the virtues of greening the tax system. By that I mean levying taxes on activities that exert negative externalities on others, such as pollution or congestion, while reducing standard taxes such as the income tax and even subsidizing activities that have a positive externality, such as getting educated. Yet, despite that great virtues of greening the tax system, it happens only moderately. Maybe it is because it bears some short-term costs before yielding longer term benefits.

Walid Oueslati confirms this using an endogenous growth model. In the long run, growth and welfare are indeed enhanced by environmental taxes if the proceeds are used to reduce wages taxes (but not capital taxes, a surprise given the optimal capital tax literature). In the short run, however, the impact on both can be negative due to the reallocation of factors during the transition to the new steady state. These disruption are similar to the sort-term costs of freeing up international trade. If you add it some temporary transfers to those who suffer in the transition, all is good and current opponents trying to protect some rents should be willing to go along. So, what are we waiting for?

PS: This must be the worst-looking working paper cover I have seen so far. The abstract is unreadable. Why this choice of colors?

On the causality between the labor income share and the size of governments

One puzzling feature of national account data in recent years has been a decline in the labor income share across most economies. This is not limited to the last recession but has been happening by and large since the 1970s. Why this is occurring is an important research question, and what the consequences are as well.

François Facchini, Mickael Melki and Andrew Pickering claim that this decrease has lead to a reduction in the size of the government. For this, they build a small two-sector model from which they obtain this positive relationship. Then they run some linear regressions to confirm this. But have they really? With the same model, I can obtain a reverse causation or even both variables being jointly function of others. It all depends on what I am assuming to be exogenous. Invert the regression equation, and you cannot reject the reverse causality either (I suppose, I have not done it). So all they have shown is that there is a correlation, nothing more. Claiming causation here is misleading. And if anything, I would have assumed that the causality runs from government size (which is set by political processes and policy) to the labor income share (which responds to market forces and policy).

Small countries are more right wing

Over the past decade or so, there has been a trend for European countries to drift toward the right on the political spectrum. Even nominally leftist governments have positive views of lean governments and austerity talk. Why this? I doubt this is because suddenly the United States has become a shining example. There is something more fundamental at work.

Franto Ricka thinks it has all to do with increased tax competition. This became more prominent with the expansion from EU-15 to EU-25 around 2004, where a series of relatively small countries joined the union. Smaller countries have an interest of playing tough in tax competition, especially for capital tax rates, as they can increase revenue by lowering taxes. And this puts pressure on the larger ones. Thus, even though political preferences have not changed, political outcomes have become more right wing as Europe expanded, and voters elected as well more politicians from the right.

How costly is it to issue equity when capital gains are taxed?

What is the impact of capital gains tax on share prices? It should be rather high, as stock shares main point is to appreciate. But assessing this is difficult because people find all sorts of ways to avoid this tax, such as taking offsetting losses or exemptions. In addition, capital gains are only taxed when realized.

Harry Huizinga, Johannes Voget and Wolf Wagner find a trick to disentangle this. When there is a cross-border merger or acquisition, any assets subject to capital gains suddenly fall under a different tax jurisdiction as shareholders are located in different countries. As long as the M&A was operated with cash, a change in asset value should reflect the impact of the difference in capital gains taxes. From their database, the authors find that a one percentage point difference in taxes results in a 0.225% reduction in the share price at takeover, and calculating backwards this indicates that the effective tax rate is 31% of the statutory one. This means that the average capital gains tax in the OECD increases equity costs by 5.3%. It is then evident to find that where taxes are higher, takeovers are more likely to be financed by equity, as it does not imply a transfer of tax liability.

Sin taxes and liberty

I have discussed quite a few times sin taxes that are instituted to redress some individual behavior. Indeed, people make choices that harm others or themselves directly or indirectly. They create congestion and pollution by driving a care, they increase tax- or insurance-financed health care cost by smoking or becoming obese, they also become public hazards by being drunk. This is one reason why we often tax automotive fuels, unhealthy foods, tobacco and alcohol more than other goods.

But some people object to such sin taxes because they infringe on personal liberties. One of them is Gilles Saint-Paul, whose work I have several times discussed here in a positive light (I, II, III), but this time I have to disagree. His view is that the state is too paternalistic when it intervenes in otherwise free markets with sin taxes, and this has become worse since behavioral economics has highlighted choice patterns that deviate from standard utilitarianism. Well, this is exactly the point. Behavioral economics has brought forward that there are situations were people take actions that they later regret. This is precisely when they would appreciate (at least later) some paternalism in the sense that the state can provide them with a commitment device.

So why does Saint-Paul object to this? His argument is that one should not object to personal choices, and that people should only blame themselves for poor choices. But what if one can help them? Should this not happen only because it is the state? He complains that economists have abandoned utilitarism, which maximizes the sum of individual utilities. I do not think that is correct, but he seems to completely ignore that there are externalities out there, that there is regret, that there are temptations, and that there is lack of commitment. and all this should not be myopically ignored when computing utilities. He is going as far as comparing this supposed abandonment of utilitarianism to eugenics. In other words, he sees excessive government intervention. I agree that there is potential for this, but I see no demonstration that this is happening, and the mere fact that there is intervention is not sufficient, as Saint-Paul seems to imply in a rather puzzling paper.

PS: Robert Wiblin at Overcoming Bias has recently made a similar argument to libertarians in favor of paternalism and also finds it "incredibly obvious." Yet, it needs to be made.

The short-run impact of taxing saturated fats

Saturated fats are bad, and we should avoid them. But they are cheaper than non-saturated fats, and if they are that bad, the obvious solution is to impose a tax on the bad ones so that they become more expensive than the good ones. Or you could inform users so that they make the best choice, but you still need to tax if the consumption of bad fats has an impacts on others, as in increased demand for health care that is paid at least in part by public funds. One way or the other, you need to tax saturated fats. The question is how much do you need to tax, and before answering that question you need to know how responsive people are to such taxes.

Jørgen Dejgård Jensen and Sinne Smed study this last question for Denmark, where a tax was introduced in October 2011. That was very recently, so they can only figure out the short-term elasticity. They find that for the products containing the most saturated fats, such as butter and oils, quantities sold decreased by 10-20% for an increase of tax in the order of 8 to 22% (it varies because the nutrient is taxed, not the food class). That looks a significant elasticity for foods that are quite essential to cooking. But as I mentioned in the introduction, another way of reduction consumption of "bad" foods is to inform the public. I suspect this what also happened with the introduction of this tax, as the media must have written about it and made many people aware of the adversarial effects of saturated fats. With the current empirical strategy, there is no way the authors can identify the impact of the tax from the impact of information, and that is likely why the elasticity is so high.