Monday, May 26, 2014

Misc.

Yes, I am on vacation, but I couldn't resist a few comments on some recent events.

Piketty

Last week I expressed doubt about Thomas Piketty's policy suggestions, but now it appears that there are far more serious problems with his book.  What I think is interesting is that I was convinced before I read it that wealth inequality had increased over the past few decades, but now I am not sure after reading responses to the book.  The results of good intellectual debate are unpredictable, and Piketty's book might end up backfiring against the left.

Ukraine

Yesterday's elections in Ukraine look like a victory for team USA.  It turns out that a large majority of Ukrainians want to align with the West instead of with Russia. From an economic point of view this is meaningless, since Ukraine is very poor and offers few benefits for the West.  But from a security point of view it is important as I argued a couple of months ago.

Some are arguing that this is a defeat for the West because it has driven Russia and China into a closer alliance.  But that alliance was inevitable either way.  The fracking revolution is pushing Russia to look for new energy customers, not events in Ukraine.  Europe and the U.S. are recovering from their economic difficulties of the past 6 years, and their security situation is improving.  Obama's pledge to defend Japan and the outcome in Ukraine might someday be seen as turning points in early 21st century geopolitical history.

New York Times

Saturday's lead editorial was a good illustration of my theory about the New York Times posted last month.  "Tax laws are too lax!! (and here is exactly what people do to get around them)."   It is like the warnings on concentrated grape juice during prohibition:  "add water, but whatever you do, do not add yeast or sugar or leave it in a dark place or let it sit too long, because “it might ferment and become wine.”"

Or the warning on hops flavored malt syrup:  "Do not stop the bottle with this cork containing this patented red rubber siphon hose, because that is necessary only when fermentation is going on."

Friday, May 23, 2014

Summer

As usual, I will take a break from blogging over the summer.  I expect to return in the fall.  Thanks for visiting!

Sunday, May 18, 2014

Piketty

In the book everyone is talking about, Thomas Piketty advocates an 80% tax on incomes, a one-time tax of up to 20% on wealth, and an ongoing annual wealth tax of up to 10%.  He is a bit vague on the exact tax structure he advocates, but pulling a few sections of the book together, it appears that he wants the following:

Income Tax:

80%   on income above $500,000
60%   on income between $200,000 and $500,000
I assume he supports current U.S. tax rates for income below $200,000.

One-Time Wealth Tax  (The French call it a "National Solidarity Tax")

20%   On wealth over $7 million
10%    On wealth between $1.4  and $7 million

Annual Wealth Tax

10%    On wealth above $1.4 billion
  5%     On wealth between $140 million and $1.4 billion
  2%     On wealth between $7 million and $140 million
  1%      On wealth between $1.4 million and $7 million
0.5%    On wealth between $275,000 and $1.4 million
0.1%    On wealth below $275,000

Imagine a person with a $20 million nest egg invested in assets with expected returns of 5%, which is approximately the annual return on the U.S. stock market from 2000 through 2013.  If this person consumes 50% of his after income tax income (only $97,000 the first year, then declining), I calculate that he will be down to $16 million after 10 years.

Bill Gates would be down from $76 billion to $25 billion in 10 years.

My primary criticism of Piketty's work is that he seems to have no appreciation of the fact that taxes like these would dramatically change behavior.  I have always thought that his empirical work took a naive view of the tax code.  Martin Feldstein explains in a recent article.  The tax code has changed dramatically over the past several decades, which has caused people to change how they report income, and these changes happen to make it appear as if income inequality has changed far more than it really has.

Another example of Piketty's failure to understand the effects of tax rates is his discussion of the structure of a one-time tax on wealth to pay down national debts.  He first suggests rates that would yield revenues equal to 2% of GDP, but to raise more money, he says (p. 543):
To obtain one-time receipts of 20 percent of GDP, it would therefore suffice to apply a special levy with rates 10 times as high. 
In other words, if you multiply the tax rate by 10, you will obtain 10 times as much revenue.  Even a one-time tax will come with some warning, since it will take time for the tax to make its way through the legislative process.  Does Piketty really believe that the wealthy will sit still during this time, not figuring out ways to hide wealth or exploit loopholes?

He dismisses the idea that high income taxes would affect the incentives of executives to work hard (p.513)
The idea that all US executives would immediately flee to Canada and Mexico and no one with the competence or motivation to run the economy would remain is not only contradicted by historical experience and by all the firm-level data at our disposal; it is also devoid of common sense.
If instead of $1 million I only receive $200,000 in return for taking on some additional responsibility, does Piketty really believe that I will be just as eager to do so?

Piketty doesn't consider the possibility that his taxes would be avoided and evaded.  He seems to think that governments around the world will adopt strict reporting requirements and implement the loophole-free tax code with complete efficiency.  He acknowledges today's tax evasion, but appears to believe that imposing a wealth tax on the entire world will eliminate it.  How might Piketty's tax be avoided and evaded?

When calculating net wealth, tax collectors will need to take account of the depreciation of physical assets.  Wealthy people will find assets with depreciation schedules for tax purposes that differ from reality and purchase them as stores of wealth that are protected from taxes.  For example, airplanes can currently be depreciated over 5 years, while actual planes tend to last longer.  Wealthy people might load up on planes and store them in hangars.  Valued for tax purposes at zero (because they have been depreciated) they would be far better stores of wealth than cash in the bank, stocks, bonds, or productive businesses.  Piketty might think his plan is immune to such things, because depreciation schedules will correspond to reality, but to do so he will have to repeal the laws of politics.

Another tactic might involve borrowing money from non-profit institutions (presumably exempt from the wealth tax) at very high rates of interest, say 25%, with interest and principal payable in the distant future.  In 10 years, a $1 million loan would become a $9.3 million debt which could be deducted from wealth for tax purposes.  But if the loan contained a provision that it would forgiven on the death of the borrower (except for the original principal and some interest), the borrower might receive tax benefits far greater than the interest costs.  Of course, the tax authorities might see through this scheme and enact new regulations, but the ingenuity of lawyers and accountants would, as they have throughout human history, always stay one step ahead of the tax collectors.

Companies now go to great lengths to hide the amount of debt that they have, either to mislead investors or to work around regulations.  With a wealth tax, individuals will do the reverse.  The IRS will have its hands full valuing things like convertible debt, ground rent, preferred equity, forward purchase agreements, swaps, and various tranches of debt.

In addition to legal tax avoidance strategies, many wealthy people would resort to illegal tax evasion.  Gold is probably the easiest asset to hide.  Wealth would be laundered by means of false consumption; paying low-wealth individuals for goods that are not delivered, with most of the money secretly returned.  This laundered wealth could be used to purchase gold, which could be buried or hidden abroad.  Increased demand for gold might raise gold prices, increasing the wealth of gold owners, but even if gold prices did not rise, holding unreported gold would be a better investment than assets that would be gradually taxed away.

Progressive wealth taxes would create incentives to spread wealth to multiple "holders" with secret agreements to return assets to the real owners on demand.  It is possible that this could be done legally through option contracts that would be difficult for tax authorities to value properly.  For example, if our $20 million petite rentier (Piketty's term) "sold" $1 million in assets to 15 different holders for $100,000 each, and "bought" them back after 10 years, his net saving would be nearly $6 million.  The holders would pay no additional wealth tax, since they would be paying $100,000 for assets declared to be worth $100,000.  The holders would also receive income from the assets during their holding period.  Even if the holders were taxed at the true value of the assets, their tax would be lower than the taxes of the wealthy investor would have been, and their taxes could be subtracted from the final return of capital to the wealthy investor.

Piketty believes that estimating wealth would be easy.  All we need is something like the current property tax system to estimate other asset values. He says (p. 520):
Taxpayers can of course challenge these valuations with appropriate evidence.  In practice, corrections are rare, because data on real estate transactions are readily available and hard to contest.
Piketty clearly has never invested in commercial real estate.  Disputes over property values are common, and estimating the values of complicated financial instruments or operating businesses would be far, far more difficult.

Finally, Piketty's tax system might have important effects on levels of consumption.  I calculate that the cost of consumption in terms of future wealth would decline by roughly 15% for a person with a net worth of $20 million.  Given unit price elasticity of consumption for the wealthy, their consumption would decline by around 15%.  There would be an offsetting wealth effect, since each year our 20 millionaire would be losing around 2% of his wealth, which would tend to reduce his consumption.  Many estimates of the wealth elasticity of consumption are around 5%, meaning that a 2% loss of wealth would lead to a 0.1% drop in consumption the following year.  So my guess is that the initial reaction of the wealthy to the Piketty taxes would be a large increase in consumption and a corresponding reduction in investment.  Over time, as more wealth is taxed away, consumption would drop, but probably never back to current levels.

The effect of increased consumption by the wealthy would be diversion of resources from productive use, such as research, development, and new capital equipment, into non-productive uses, such as jets for personal use, big houses, vacation travel, designer clothes, etc.  This diversion would reduce the rate of growth of the economy, and make everyone poorer in the long run.  Piketty thinks that the wealth tax would increase productive investment as wealthy people tried to earn more than the wealth tax, but his 80% income tax would make this very difficult to do.  If he countered by exempting investment income from the income tax he would open up a gigantic loophole that would undermine his entire project.

It is striking that Piketty seems far more interested in taking down the rich than helping the poor.  About his proposed income tax he says (p. 513):
A rate of 80% applied to incomes above $500,000 or $1 million a year would not bring the government much in the way of revenue, because it would quickly fulfill its objective: to drastically reduce renumeration at this level but without reducing the productivity of the US economy.
The objective is not revenue, but cutting executive pay.  Piketty does believe that his one-time wealth tax will raise significant revenue, but that revenue is to be used to pay down public debt.  Revenues from the ongoing wealth tax will clearly decline over time as private fortunes are whittled away, and because of more and more sophisticated tax avoidance schemes.  It is hard to see how anyone benefits, except for envious second-percenters like Piketty who will have their vengeance against the one percent.

I thought the most interesting idea in Piketty's book was differential investment returns for wealthy and less wealthy investors.  Universities with large endowments, for example, have been earning higher returns than those with smaller endowments.  Famous billionaires seem to increase their wealth faster than ordinary investors.  Piketty has an interesting hypothesis, but I suspect that he is wrong about wealthy investors in general.  Smart investors with a lot of money might be able to earn high returns, but eventually their wealth will be inherited by heirs with less ability or interest in making money.  These heirs will fall victim to high-fee advisers and their wealth will melt away.  Large endowment universities happen to have a lot of smart people around to watch over them, so they might be able to do better for longer periods of time.  Eventually, however, my guess is that hubris will get the better of institutions like Harvard and Yale.  For example, they might decide that they are so smart that they can invest their consciences and still earn high returns with little risk.

Piketty is right that the top families tend to stay on top for a long time, but I think he is wrong about why.  As I discussed last week, recent research suggests that even under the most redistributionist regimes imaginable, such as China under the cultural revolution, the same families manage to stay in charge.  Piketty thinks this is explained by ownership of capital that earns rent regardless of the ability or effort of the owners - he believes that trust funds are forever.  I think that money comes and goes, but genetic endowments last for many generations.  Piketty's tax plan would wreak havoc with the economy, but talented families would learn how to manipulate the new system and stay in control.  Everyone else will still be out of power, and they will also be a lot poorer.


Saturday, May 10, 2014

Trouble

What if humans are still evolving, in different ways in different places?  According to Nicholas Wade, a long-time science writer for the New York Times and Science magazine and a former editor of the prestigious Nature magazine, scientific studies now point in this direction.  His book, A Troublesome Inheritance, Genes, Race and Human History, just came out this week.

Wade believes that people in different parts of the world have evolved differently, and that the resulting genetic differences explain why some countries are rich and free while others are poor and oppressed.  The old debate about IQ and race is only a sideshow - other characteristics like trust, inquisitiveness, patience, and aggression explain far more, and are largely inherited.  From page 177:
If running a productive, Western-style economy were simply a matter of culture, it should be possible for African and Middle Eastern countries to import Western institutions and business methods...Tribal behavior is more deeply ingrained than are mere cultural prescriptions.  Its longevity and stability point strongly to a genetic basis.
What are the policy implications of Wade's conclusions?  Wade doesn't delve deeply into policy questions, but if his theory is right, some troubling ideas would seem to follow, such as:

  1. Foreign aid and "democracy promotion" are wastes of money and time.**
  2. Mass immigration is dangerous, because immigrants from vastly different cultures cannot assimilate unless given generations to evolve.
  3. Efforts to create "color-blind" societies are doomed.

If Wade is correct, only policies that effect the evolutionary process have any hope of success if "success" means less violence, more freedom, and more wealth.  For example, roughly 2.5% of men ages 18-39 in the U.S. are incarcerated.  Isolating the most criminal and aggressive men during their prime reproductive ages, if continued for 100 years or so, could have a profoundly positive effect on the level of social capital.  Low-cost abortions might have the same effect, assuming that women who have abortions tend to be less responsible than other women, and that the same is true for their male partners.  Availability of drugs such as heroin that interfere with sex drives and tend to be taken by people prone to irresponsible behavior could also increase social capital in the long run.

Wade spends pages and pages trying to convince readers that he is not a right-wing nut and that acceptance of his ideas will not lead to rejection of liberal dogma.  I am not so sure.


**Unless the goal of these programs is to pay off foreign dictators for trade or security reasons, not to actually promote economic development or democracy.


Saturday, May 3, 2014

Krugman Cringes

Yesterday, Paul Krugman wrote:
When John Boehner, then the House minority leader, declared in early 2009 that since American families were having to tighten their belts, the government should tighten its belt, too, people like me cringed; his remarks betrayed his economic ignorance.  We need more government spending, not less, to fill the hole left by inadequate private demand.
But Boehner's view is not "economic ignorance;" it represents a different view of fairness than Krugman's. Struggling Republican taxpayers don't think it is fair for government workers to live better than they do by taking their money. They are not as upset at rich people, because they believe that rich people earn their money instead of taking it from taxpayers.

Cutting payroll taxes would be just as stimulative as raising spending, but it would be less conducive to the long-run growth of government than spending programs would be.  In other words, Krugman is trying to bully his opponents by labeling legitimate political differences as ignorance.

I spent part of the week in Washington, D.C., where I toured some high-end apartment buildings.  They were designed for young, wealthy renters, and there are a lot of them in D.C.  Since D.C. is a federal government company town, nearly all of these kids' incomes are ultimately taken from taxpayers.  I don't think it is crazy for a $17 per hour worker in flyover country paying more than 25% of his earnings in federal taxes (income tax plus employee and employer portions of FICA), barely able to afford an $800 per month apartment to resent young people living off of the federal government living in $3100 per month apartments.

Krugman thinks that this worker should resent rich people instead, and many do, but those who resent government do not do so out of ignorance.  It is Krugman's condescension and narrow-mindedness that makes people like me cringe.

Saturday, April 26, 2014

Moral Equivalence In Ukraine

Americans argued about "moral equivalence" during the Cold War.  Conservatives believed that the Soviet Union was an evil empire, and that God was on the side of the United States.  Liberals argued that the two were simply great powers battling for world domination,and that we should be cautious about accepting the premises of U.S. propaganda.

Today American liberals are taking the conservatives' place, and conservatives are flipping over to the Russian side.  Very few take the old liberal position of moral equivalence.

My view is that conservatives were right during the Cold War, because communism really was evil.  Now I am more ambivalent and lean toward moral equivalence between Russia and the United States.

The overwhelming majority of Crimeans wanted to join Russia, and the U.S. is on record as supporting the right of regions to declare independence under international law. (although not under U.S. law)  In Ukraine, a legally elected government was violently overthrown - if it happened in Canada, and the new government wanted association with Russia, the U.S. would also be calling it a junta or worse and would consider invading.  Russian statements that they plan to keep the option of military force "on the table" sounds a lot like John Kerry and Colin Powell.

But skepticism about the logical consistency of the American position doesn't affect which side I am on.  I root for my tribe, because I would rather have Americans bossing Russians around than the other way around.  As a kid on the school bus put it to me in Boone, Iowa in 1968, "If they win, they'll come here and say 'cook me some eggs,' and we'll have to do it."

I also think that, in the long run, the U.S. is on the winning side.  Americans are experts at trickery, deceit, and passive aggression.  They are a lot richer than Russians, and have a freer, stronger economic system.  They are also more popular than Russians, both because they are richer, and because their culture and institutions are more universal.  The U.S. and the West are in a stronger long term position, as is convincingly argued here and here.  Technical legal points will not overcome these advantages.

The U.S. might have temporarily overreached by trying to pull Ukraine too quickly to the West, and it might see some short term setbacks, but in this conflict my money is on red, white, and blue - the stars and stripes, not the horizontal tricolor.

Saturday, April 19, 2014

Tensions in Asia

The biggest news story in the world today might be the growing tension between China and Japan.  Chinese military spending is second only to that of the U.S., and is just less than double that of number 3, which is Russia.  Japan is number 5, but growing.  Today Japan began its first military expansion in 40 years with a radar station on a disputed island.

China and Japan both spend fairly small percentages of their GDP on defense.  Japan, at 1%, spends less as a fraction of GDP than any other country in the top 15.  China, at 2%, has a defense/GDP ratio less than half that of the United States.  Both have extra economic capacity, so continued tensions could easily  lead to increased defense spending, and defense spending spirals can end in conflict.

Journalists sometimes wonder why the U.S. doesn't do more to ease tensions.  After all, President Theodore Roosevelt won a Nobel Peace Prize for negotiating the end of a war in eastern Asia, so maybe President Obama could win a second prize by facilitating agreement between China and Japan over disputed islands and other issues.

But the U.S. has bigger concerns than winning gold medals.  The primary strategic imperative for the U.S. is to prevent any Eurasian country from attaining a level of security that would allow it to concentrate on building a navy that could challenge U.S. Navy.  Whenever a Eurasian country appears to be ascendant, the U.S. will support its rivals.  If any of these rivals gain the upper hand, the U.S. will switch sides.  The best possible situation is constant Eurasian tension and conflict.  As George Friedman of Stratfor put it last week:
U.S. national strategy must be founded on the control of the sea. The oceans protect the United States from everything but terrorism and nuclear missiles. The greatest challenge to U.S. control of the sea is hostile fleets. The best way to defeat hostile fleets is to prevent them from being built. The best way to do that is to maintain the balance of power in Eurasia. The ideal path for this is to ensure continued tensions within Eurasia so that resources are spent defending against land threats rather than building fleets. Given the inherent tensions in Eurasia, the United States needs to do nothing in most cases. In some cases it must send military or economic aid to one side or both. In other cases, it advises.
Establishment media refuse to think about such possibilities.  A Washington Post writer recently dismissed the idea, thinking that it was so absurd that producing evidence to the contrary was not necessary:
there is an assumption in China that the black hand of America benefits from bad blood between the two neighbors. That is not the case, but if a conflict erupts in the East China Sea, truth will be the first casualty.
France became the most powerful country in Europe by strategically encouraging Germany to destroy itself in the Thirty Years' War.  The strategy was managed by Father Joseph, perhaps the most pious statesman Europe has ever known.  Britain survived for centuries in a bad neighborhood by playing the same game.

It is hard to argue with the strategy.  The last Asian power with hegemonic ambitions and a free hand attacked the U.S.  With modern weaponry China could make Peal Harbor look like a production of the Barley Townswomen's Guild.  Better that they fight over there than attack us here.