Saturday, September 27, 2014

How Productive were Mad Men?

Paul Krugman complained this week that executives are paid too much, and that things were better during the golden age of equality, the 1950s and 1960s.  He cites a 1955 Fortune Magazine article describing the diminished economic circumstances of executives compared to the days of far lower income tax rates.  Houses and yachts were smaller, servants fewer, and entertaining less lavish.

Krugman is right that after-tax executive pay has risen relative to worker pay.  His unstated assumption, however, is that executives were just as productive 50 years ago as they are now.  I think that executives worked much less during the 1950s and 1960s than they do now because they were paid less.  High taxes might reduce income inequality as Krugman wants, but talented people would be less productive, and everyone would be poorer as a result.

Below are a few quotations from that same Fortune article, referring to the lifestyles of top executives:
...he paces himself carefully. He plays golf and bridge, but really prefers dominoes noontimes at the Pacific Union Club.
On weekends they retire to a small house set in eighteen acres of orchards and wild land, fifty miles from the city, where the only company they have is their Weimaraner dog.
Cotton brokers, planters, merchants, bankers, drift out of their offices for mid-morning coffee, drive home for lunch, and get home again for dinner well before the sun has disappeared behind the levee. Weekends they play golf, fish for bream and channel cat, or stalk the country’s abundant game birds.
He gets home anywhere between four-thirty and six. “Then I take a coupla knocks,” he says, meaning a couple of highballs, “have dinner and fall into bed.”
No executive, twenty-five years ago, could whisk himself and his golf clubs 1,000 miles away just for a weekend. Today a New York executive can play weekend golf regularly all through the winter in Florida or Bermuda, and follow the season north through Georgia and North Carolina.
...those fellows in New York who have two cocktails before lunch and then can’t do anything the rest of the afternoon.
These do not sound like descriptions of today's executives.  To be fair, the Fortune article also describes some executives taking work home with them, but the overall picture doesn't compare to either the business lifestyle of pre-income tax Scrooge or the 24/7 work schedule enforced by smartphone.  Water is now served for business lunches, not martinis.  Golf courses at 2:00 are full of retirees, not executives.

Academic evidence on the price elasticity of labor supply for high income people often focusses on the effects of relatively small changes in tax rates over the past 20 years.  Researchers find that the effects of tax timing swamp the actual effects of taxes on labor supply, so estimates of labor supply elasticities are imprecise.  But when they compare times or countries with large differences in tax rates it is clear that high income people work more when they are paid more.  For example,
men in the high-skill household actually increase their hours of work after 1970, whereas men in the low-skill household decrease their hours of work.
An important paper by Nobel Prize winning economist Edward Prescott finds that differences in tax rates explain the difference in work hours between Europe and the U.S.  It is obvious to everyone except for left-leaning economists, but when smart people are well paid, they work harder.

Krugman doesn't really seem to care about overall economic well being.  Instead he is consumed with envy at the rich, who he calls vulgar show-offs. His view is just like that of Piketty, who I believe is more interested in taking down the rich than helping the poor.

Taxes are destructive weapons - people like Krugman and Piketty would love to fire them at the rich people they hate, regardless of the collateral damage.

Friday, September 19, 2014

War with ISIL

Last week President Obama, a former adjunct professor of constitutional law who ran for president as an anti-war candidate, declared war on something he called ISIL.

Obama claims that he has the authority to wage war against ISIL for two reasons: First, 13 years ago congress authorized President Bush to go to war against groups responsible for the attacks on 9/11/2001.  But ISIL had nothing to do with 9/11.  His second legal justification is that 12 years ago congress authorized Bush to go to war with Iraq.  But Obama has declared that Iraq war to be over, and has always opposed the original authorization.

Article 1, Section 8 of the US constitution gives congress the power to declare war, not the president.  The War Powers Act of 1973 allows the president to commit forces to a conflict, but he must notify congress within 48 hours, and then must receive congressional approval within 60 days, or he must withdraw within another 30 days.  Obama notified congress about a renewed war on Iraq on August 8, 2014, giving him until October 7 to obtain approval, otherwise he would need to withdraw by November 6.  The senate has apparently decided to wait until after the November 4 elections to begin debate on an authorization of the war.  Left and right agree that the war is illegal - the administration's arguments sound increasingly absurd, but they are getting away with them.

Just a year ago, Obama was ready to start bombing Syria, but he was stopped by a domestic political revolt and Russian diplomatic maneuvering.  It seems reasonable to assume that his administration did not give up, and spent a year waiting and working for a change in the political and diplomatic environment.  Now Russia is distracted by events in Ukraine, and a propaganda campaign has convinced American voters that military action in the region is needed.  As I described at the time, the US strategy is probably to prolong the civil war in Syria for as long as possible.  The Syrian government was winning, but now ISIL has given the US a reason to intervene and prolong the conflict.

Twelve years ago, as the US was preparing to invade Iraq, I thought it was a good idea.  The US, still fresh from its Cold War victory and having just easily overthrown the government of Afghanistan, seemed capable of anything.  After the previous great victory, in World War II, the US had remade Germany and Japan in its own image - why couldn't it do the same with Iraq? 

But as a guy in a barber chair next to me sometime in 2003 said, "We'll invade them no problem, but then the trouble will start."  Many of my friends who are smarter than I am turned against the war early.  75% of the country supported the war at its start, but by late 2005 more than 50% opposed the war, and now the country believes the war was a mistake 71% to 22%.  Some of the remaining supporters of the war simply hate to give in to the political party they oppose, while others believe the war was a noble venture regardless of the outcome. 

The past 12 years should have taught us that a Middle Eastern war will not end in victory, and will be very expensive in lives and money.  It will also probably be illegal under US and international law.  But I still wonder whether the apparent debacles of the post-WWII years; Korea, Vietnam, Afghanistan, Iraq, and Libya, might have a deeper logic to them.  The primary goal of US foreign policy is the security of the US, and the only other goal is the prosperity of the US.  It could be argued that the US is secure and prosperous, so someone must be doing something right, an argument I have made in more detail before.

But regardless of whether the war makes sense, it is clear that short of a popular revolution, we are stuck with militaristic US foreign policy.  If six years into the presidency of an anti-war candidate, with a large majority recognizing the folly of the last war, we are still stumbling from one war to another, it must be the case that making war is an inherent feature of the United States and that there is nothing that conventional politics can do about it.

Saturday, September 13, 2014

Scottish Independence

People in Scotland will vote on independence from the UK this week.  A referendum like this is supposed to express the "will of the people" on important issues, but it is good to remember that Kenneth Arrow proved more than 60 years ago that no voting system can coherently express the preferences of voters.  On Thursday there will be a result that everyone will have to live with, but we still won't know what "the people" really want.

The English political and social elite want to keep Scotland in the UK, because the bigger their country, the more prestige they will have in elite circles of the world.  Scottish elites are torn, because they wonder about whether being at the top of the Scottish pyramid might be more fun than being part of the second tier of UK society.  It is similar to the dilemma of American politicians - run for governor of a state, or for a seat in the US senate?  Politicians with different personalities and preferences make different choices.

Businesspeople always worry about change and risk, so business owners in both England and Scotland tend to oppose breaking up the UK.

Ordinary people who do not own businesses and have no political or social ambitions beyond their local communities derive pleasure from team membership.  In both England and Scotland, many of them have emotional ties to the flag of the UK, and would be genuinely sad to see it change.  A large number of ordinary Scots, however, feel a greater emotional connection to the Scottish flag than to the UK flag.  The extent of these feelings will determine the result of the referendum much more than the arguments of economists and political scientists.

In Scotland last year, my driver from Tongue was convinced that the vote would be yes, since he had never met a true Scotsman who didn't want independence.  A stuffier museum guide with an English accent was equally convinced that the vote would be no.  He told me that there was no chance of independence, and implied that Americans who asked the question had no idea of how silly the idea really was.

What would be the economic effects of Scottish independence?  It isn't clear whether an independent Scotland would be able to join the EU, but there are prosperous small countries outside the EU, such as Iceland, Norway, and Switzerland, and prosperous small counties inside the EU, such as Ireland, so it isn't obvious that EU membership matters a great deal.  Another important question is whether Scotland would share a currency with the UK or start their own currency.  It seems to me that Scotland could adopt the pound whether or not the UK approved, just as Ecuador, Panama and other countries use the US dollar as their currency, without ever receiving permission from the US.  Scotland might be better off with its own currency, but it wouldn't want to say so until it created it, so as not to create panic and flows of pounds out of the country.

The most important effects of independence might be political.  Scotland is poorer than England, and so tends to be more liberal politically.  If Scotland left the UK, the UK might move to the right and toward freer markets.  Scotland might experiment with higher taxes and a larger social welfare state, but any economic weakness that resulted might eventually lead them into free market experiments.  As part of the UK, Scotland tends to support a welfare state leading to more benefits paid in Scotland, but as an independent country it might have a different view.

Without Scotland, it might be difficult for the remaining UK to pretend to be a world power.  The nuclear deterrent, participation in foreign wars, the permanent seat on the Security Council, and worldwide diplomatic activity might all be abandoned.  This would save UK taxpayers a lot of money.

Finally, an independent Scotland would encourage separatist movements around the world, including, eventually, the (currently) United States of America.  This might be a good thing.   Wars appear to be random events that happen from time to time between states that interact with each other.  With more countries there will be more wars, but they will be small and geographically contained.  It was the large empires that developed during the 19th and 20th centuries that led to the gigantic wars of the 20th century.  Breakup of these empires has been taking place for the last 70 years, and it might take another 70 years for the process to be complete.  Scottish independence would be another step in that direction.

Overall, I think the effects of independence would be positive, although some people will be worse off and there will  be transition difficulties.  Even if independence narrowly fails, however, Scotland will be given additional autonomy, and will probably try another referendum sometime in the next decade. 

Sunday, September 7, 2014

Krugman Has a Point

Between political rants, Paul Krugman occasionally writes about economics.  When he does, he is obviously worth taking seriously.

His latest crusade is against what he calls "The Deflation Caucus."  Krugman believes in monetary expansion by the Federal Reserve, and attacks the
Pundits, politicians and plutocrats [who] have accused them [the Fed], over and over again, of “debasing” the dollar, and warned that soaring inflation is just around the corner.
Monetary expansion means electronically creating money to buy things, usually bonds.  The pundits, politicians and plutocrats Krugman attacks are now calling on the Fed to reverse course, sell what they have bought, and extinguish the new money.  Doing so would lower the price of bonds, raising interest rates.  They think this will head off future inflation, while Krugman believes it would initiate a deflationary spiral, resulting in an economic depression.

I disagree with Krugman about the effects of deflation itself and any virtues of inflation, but I agree with him that this is the wrong time for monetary contraction.  He is right that there is no evidence of accelerating wage and price inflation, and no evidence that financial market participants expect high inflation in the future.

Just this week I received a one page argument against monetary expansion from a salesman promoting an investment advisor that I think does a good job illustrating Krugman's criticisms.  The key sentence in the piece is:
If printing money actually created wealth, then we should allow every citizen to counterfeit their own money.
Suppose there is an optimal quantity of money in an economy in the same sense that there is an optimal quantity of hair ribbons, given the cost of production and demand.  Of course, if prices could be costlessly denominated in any multiple, then any "quantity" of money would suffice, since a single dollar could be distributed to everyone in trillionths, with prices adjusted accordingly.  But given the value of having prices quoted in familiar, stable units, it makes sense to say that too little or too much money in the economy can cause problems.  As the monopoly provider of money, government determines supply.  At the moment, it seems more likely that there is too little instead of too much money, so government can improve the economy (in other words, create wealth) by creating more of it.  Allowing a few people to counterfeit U.S. dollars would accomplish the same thing, but once started, that process would be hard to control, resulting in too much money.

The anti-expansionist also said this:
No monetary policy expert has argued that the US experienced the crisis of 2008 because the Fed was too tight.  And no one, with credentials, argues now that the US economy is growing too slowly because money is scarce.
The crash of '08 had many causes, but I don't think it is crazy to think that Fed tightness had something to do with it.  Here is a chart of the Federal Funds Rate from 2002 to 2014:

From the summer of '04 to the summer of '06 the Fed went from 1% to 5.3%.  This was the steepest hike since the late 1970s when the Fed deliberately triggered the recession of the early 1980s in order to reduce inflation.
My old boss at the Federal Reserve, Arturo Estrella, once wrote a paper showing that inverted yield curves are good predictors of recessions.  What causes inverted yield curves?  Fed tightening at the short end of the curve!
Moving to the second sentence of the previous quote, is it possible that the economy is now growing so slowly because money is scarce?  I think so - I meet a lot of people who have a much harder time borrowing now than they did 10 years ago.  According to Larry Summers, the reason for the slowdown is that the intersection of supply and demand for loans is at a negative interest rate.  Since rates must be positive (otherwise people would hold cash instead of lending it) the economy is stuck.  I don't quite agree with this argument, but it is an example of a "credentialed" economist claiming that scarce money is holding back growth.
So I agree with Krugman that the sky-is-falling inflation hawk crowd is wrong, and that Fed tightening now would likely cause an unnecessary recession.  I also think his discussion of the motivations of tight money advocates is interesting.   
I think that my major disagreement with Krugman is over "austerity" in government spending.  If the federal government cut spending and cut taxes by the same amount, I think there would be a positive economic effect, because I think that distortions caused by taxation are much larger than Krugman  seems to think they are.  I also worry more about the unsustainability of federal government debt than Krugman does.  I think there is a fairly low ceiling on potential federal tax revenue, for both economic and political reasons.  Krugman might agree, but would put the blame on Republicans who won't raise taxes.  But if Republicans are here to stay, piling up debt that won't be repaid is a big mistake. 

Monday, May 26, 2014


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


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.


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


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


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.