How far to soak the rich… Optimal top tax rates

You said it. Source: Google images.

A quick read from this morning’s press turned up an interesting article – Determining the optimal U.S. tax rate for high earners.  In brief, the author summarises existing economic literature which empirically estimates the top tax band (NB: the top tax rate in the US is currently 39.6%, compared with 45% in the UK).  He finds the top rate can and should be substantially higher, using 3 elasticity approaches.

Some thoughts:

• Background: tax policy is especially important in the US, relative to other countries, in order to achieve income redistribution.  Americans seem happier to use progressive taxation, rather than cash transfers, to help level the playing field.  Here’s some OECD data, summarised by Greg Mankiw, on the topic of US versus other countries in measuring tax progressiveness.
• The issue: policy makers need to set top tax bands to achieve both needed revenue and a feeling from society that the rich are paying their fair share.  The big concern is the substitution effect, which means the rich will work less as their effective (after-tax) pay is cut.  The measure of this effect is called elasticity, which is measured in 3 ways by the research quoted in the article.
• The result: in all 3 cases, the optimal higher tax rate is far above the existing rate – between 57% and 83%.  For history buffs, the latter is roughly where the top rate was in the 1930s-1950s.
• How can that be true?  From the article, it seems high earners don’t care about their marginal tax rate – again spitting in the face of rational economic theory.  Perhaps they’re working for other reasons than earning a lot, and/or still feel rich with high marginal rates.
• So what?  Part of me reads the article and feels the usual cynicism, e.g. “like that’ll ever happen”.  So worth asking why the US would raise the rates…maybe to squeeze just a bit more out of an already progressive tax system, in order to fund more progressive cash transfer system?  Also worth wondering what the elasticity would be for leaving town – testing the common argument that high earners will quickly leave town if rates are increased (e.g. London hedge fundies moving to Geneva when the top rate was increased to 50%, only to regret it later).  Finally, would hiking top tax rates actually raise additional revenue?  The elasticities in the article would hint at ‘yes’, but other authors suggest otherwise.

In sum: let’s put these findings in the basket of “hollow arguments the rich make to frighten working/middle class voters into voting against their best interests”.  Higher top tax rates may help raise revenue and social equality, with little effect on tax avoidance or decreased effort on behalf of high earners.

Social Security Works (or not?)

You tell ’em, tea-bagger. Source: Google Images.

This morning I read a Huffington Post article by Nancy Altman, which piqued my interest.  It advocates shifting away from privatising Social Security, or indeed advocating 401(k)s or IRAs, and applying additional taxation towards extra funding and benefits from the existing Social Security system.

I see that Ms Altman has a book out, as well as a lobbying group named Social Security Works.  In lieu of buying the book – which I may yet do, given the thesis is far from my understanding of the status quo – I read a few of the lobbying group’s memos.  My thoughts:

• Isn’t Social Security going broke?  Well, yes and no.
  • Social Security’s income comes from (source: the lobbying group)
    • Current taxation: around 85%
    • Investment returns: around 15%.  FYI, ‘investments’ are 100% US Treasury notes and bonds.
  • So what?  Well, lower yields for Treasuries means lower future returns for Social Security.  So that item will need to be supplemented by additional tax, or else benefits will come down.  Also, the large cohort of (working) baby boomers leaving behind a smaller workforce will lower the current taxation component.
  • And… that leads to projected deficits, and loss of benefits, beginning around 2033 under status quo.  Technically, the loss of any benefit would be a default – therefore bankruptcy or ‘going broke’.  The group claims this isn’t the case, as taxation will still be coming in.  If only personal bankruptcy worked that way, right?
  • How to fix this?  The group suggests abolishing the cap on income subject to Social Security tax – right now income over $117k isn’t subject to SS tax.  No mention of removing the cap on SS benefits however – those remain.  The progressive in me thinks this is generally OK: maybe the US can follow the UK National Insurance scheme, and tax the extra income by a lesser rate, like 2%.
• Why not privatise and/or encourage IRAs and 401(k)s?  
  • Cost differential?  Your run of the mill IRA + fund management charge is probably around 1-2% of assets in the retirement account, per year.  Social Security spends about 0.5% of trust fund assets in Administration costs, per year.  So one can plausibly argue that Social Security is a more cost-efficient way to save for retirement – though I wonder what is the administrative cost of collecting SS taxes.
  • Return differential?  I’ve written before about how good a deal Social Security can be for current retirees, particularly against expectations for future generations.  So here’s a thought, keeping in mind where the money for SS payments comes from (see above): given a slowdown in demography (i.e. fewer workers paying in) and investment returns explicitly limited to US Treasury returns, how can there be enough money to go around in future?
    • For example, 30-year Treasury bonds currently yield 2.63% per year.  That means $100 of Bonds purchased today will be worth around $220 in 30 years.  If we assume the Fed can achieve 2% long-term inflation, and SS benefits continue to rise in line with inflation, that’s hardly any real return at all.  And that’s the maximum investment return allowed by Social Security.
• How to fix it?  
  • Sadly, the mathematics just don’t add up unless taxes are raised – hence I absolutely see why the group wants to remove the cap on earnings subject to SS tax.
  • I suppose the amounts sent to ‘auto-enrolled’ 401(k) plans could just be reframed as additional SS tax to help keep up the program, and possibly increase benefits?
  • The only other method I can think of would be to massively increase population through either more lax immigration policy or through discouraging the use of contraception.

In sum: I was absolutely intrigued by the idea that, instead of thinking of Social Security as a slowly fading institution of old-time, New Deal America, we should consider the program as a better option for our future pensions.  The cold mathematics, however, means pretty unpalatable choices to make this happen.  But, as I’ve written before, the millennial generation faces stark mathematics regardless of how pensions are handled – there just isn’t enough money to go around.

Financial literacy and UK pension changes

The money is mine!! Source: Google images

A quick one today, versus yesterday’s rant.

There was another Dispatches episode recently discussing April 2015 changes to UK pensions policy.  For those unaware, until now UK pensioners were forced to purchase annuities with their savings (aside from a 25% lump sum, which could be taken as cash). As of April, this is no longer required: folks can use their funds as they like.

On the face of it, there seems to be no issue here.  I mean, we’re all about freedom, particularly when it comes to hard-earned savings, right?  Well… my concern here is about timing: it’s like the government just said “we know you had saved in expectation of this happening, but instead it will be that…now go!”  There was little prep time for folks to learn how to manage their own pension savings.

I may be making a mountain out of a mole hill, but the stories in the Dispatches episode, in conjunction with surveys of financial literacy such as this one give me reason for pause.  There will inevitably be several folks (such as those interviewed in the show) who decide to blow a significant portion of their now-liquid savings on new cars and such; their financial future will need to be picked up by additional state pension benefits, paid for by younger generations.  I’ve written at length about my feelings of the latter.

So what’s the solution?  To be honest, I’m torn: my libertarian side says the government had no business forcing the purchase of annuities, so this is an unambiguously good thing; my paternalist (and perhaps more realist and cynical) side thinks this will almost certainly increase the need for state pension benefits, and associated taxation.  Hum.

In sum: if you know of someone benefitting from the rule changes, please encourage him/her to seek financial advice.  Thankfully the UK government has set up the Money Advice Service…I really hope it gets used.

Tough going for Millennials in the US: census data

Thanks to Derek Thompson of The Atlantic for this article on the latest US Census data.  The focus is how Millennials are doing relative to their parents’ generation, now that the former has reached solid working years.  Some thoughts:

• I was surprised to hear that Detroit was one of the highest-earning cities in 1980, with huge income losses for this generation.  In my head, the wonder years of auto factory workers’ pay were earlier than that.
• Lots of averages and medians to make headlines – the median Millennial is $2,000/year worse off than his/her parents, taking inflation into account.  So far my dad is right: this is the first generation where parents are better off than kids.
• The continued prosperity along the coasts makes a lot of sense, given our society seems to be diverging into professional classes earning more and a shrinking middle class.  Those folks with college degrees, looking for entry-level white collar work, are almost certainly worse off than the previous generation.
• Along the geographic split, there seems to be an obvious political takeaway: Republican interior states will most likely want to hear how they can resurrect the middle class, and/or save their kids from economic doom (example policies: blame immigrants, implement austerity, cut taxes).  Democrat coastal states will more likely be sanguine for more tax/spend (e.g. improve infrastructure, increase immigration, etc.).  In sum, the economic data support the central tenets of the main voting blocs in the various areas.

In sum: initial data support my dad’s thesis over mine (I’m optimistic Millennials will still do better than parents).  The separation among states makes this an interesting political issue – particularly if the main parties can get Millennials to vote.

Mo’ money, mo’ problems: too much capital

Too many with too much spare: 10 year government bond yields as of 31 Jan 2015. Source: Pension Partners via Twitter.

I’m confused, and a bit frustrated.  In bullet points:

• We’re barely recovering from recession, right? I mean, the press are going nuts over slow but steady progress in the US, and worse news for Europe, Japan, and the rest of the world.
• Keynes says buy and build.  Perhaps my economic view is coloured by my alma mater’s famous mathematician-turned-bursar-turned-economist, but a sure-fire method to help along a country in recession is for the government to start spending like a rap star.  Hire folks to do anything, but maybe something relatively useful in the long-term like repair infrastructure.  The ASCE helpfully puts a $3.6 trillion price tag on getting the US infrastructure up to scratch by 2020… that’s about 20% of US GDP.
• Record low interest rates = BORROW NOW.  Look, I hate the national debt as much as anyone – it does indeed steal from later generations to pay for things today.  But particularly in the case of infrastructure, you’re already screwing later generations through depreciation (with crumbling roads and such, it’s literal depreciation, rather than a book entry).  So today’s record low interest rates (see chart above – the same message goes for the US as many other governments), the message is clear: BORROW.
• Why are rates so low?  Too much capital lying around.  Though it seems to disagree with the first point, there seems to be a huge surplus of investable capital around.  It’s like investors have become so risk-averse, or have such a lack of ideas, that they’d rather lock up cash for 10 years, being paid nothing (or less than nothing, in real terms) than try for ‘risky’ propositions.  The triumph of return of capital over return on capital continues to reek.
• Investors: you are committing self-harm buying bonds at these rates.  Yes, bonds have made amazing returns for decades.  Rates could still go lower – indeed, now that the zero-bound has been shattered by the likes of Switzerland (see above), they could in theory go wherever.  But remember why you are saving/investing in the first place: to generate a return on your savings.  Otherwise you might as well store your currency behind a tile.  Stop being fearful.

In sum: these low yields are a joke.  It is implicit transfer from savers to borrowers.  But instead of just being mad at the situation, I encourage the governments of the world to take advantage of savers/investors with a surplus of capital and fear, and a dearth of decent ideas.  Borrow loads at these low rates, and use the proceeds to bring forward decades of investment.

End soapbox.

Closing a capital gains tax loophole: Piketty-lite for the US

One of the policies President Obama outlined in his State of the Union speech was eliminating (to an extent) a pretty sweet tax loophole: the tax-free cost-rebase of assets passed following the owner’s death.

For example, consider hypothetical farmer Joe’s (age 85) farmland he bought decades ago for $100/acre: suppose the fair value of the land is now $5,000/acre (probably an understatement).  If Joe sells his farmland, he owes capital gains tax on $4,900/acre.  Suppose instead, Joe dies this year and the farm passes to his only child: the farm passes to the child tax-free, and the child’s ‘cost’ for the land is now $5,000/acre.  No capital gains tax to the government.

The above situation seems OK-ish in the family farm arena: as a society we shouldn’t force poor Joe’s child to sell the farm to pay tax, should we?? Well, consider that this same process/economic policy applies to HUGE farms, buildings, houses, stocks, bonds, etc. etc.  For example, the same story would occur if Joe was a very wealthy ex-CEO with a shareholding of $100 million.  Estate tax would be owed, though wealthy Joe would probably have found some ways of mitigating that.

Anyway, this policy proposal sounds a bit like the rant I wrote a while ago, about making a serious effort to equalise opportunity; to me, the most justifiable/fair redistribution would happen at death of the elder generation, to improve opportunity for the younger generation.  As a side benefit, having punitive death taxes would probably encourage consumption, which is generally helpful for redistribution (i.e. the rich save more than poor, so getting them to save less is likely a good thing overall).

As was written in the Economist, this policy idea will likely go nowhere fast.  However, their chart of where these long-term capital gains end up hopefully helps illustrate the point that indeed, these gains would be an effective source for redistributive taxation.  Hold off the pitchforks!!

Who gets the gains? They do! Source: Economist.com

More evidence of millennials’ economic headwinds

I’ve written before about the intergenerational issues associated with Social Security in the US.  Now I read more evidence of the millennial generation having lower real wages, thus leading to negative savings rates.  Not altogether surprising, with the higher level of student debt.

Where does this leave us?  A lot of software development jobs are required for all those indebted millennials…

Happy Friday!

Inter-generational and intra-country economic inequality: a couple articles

I’ve already talked about how US Social Security (and likely other western public pensions) are currently paying out unsustainable benefits, leaving the younger generation with a not-yet-discussed financial burden.  Another example of inter-generational inequality results from the higher education bubble (Wiki link in my Finance 101: Saving post). What’s now necessary for a decent job, or at least a job with relatively stable (not falling) wages, is a college degree.  The cost of this has ticked along at higher than inflation for a while.

Anyway, Bloomberg has a good article this morning about the effect these college bills have had on Generation X relative to their parents’ generation.  A prime example of why my dad might be right in saying this generation may be the first in the US which is poorer than the generation before.

The solution?  Maybe greater public acceptance of online courses, which are frequently free.  Take edX: same courses as those paying $10,000s in tuition, free online.  OK, no PhD teaching assistant to help with coursework, but the material is the same.  And you’ll likely remember just as much, and use the material just as much, as if you attended campus.  The Economist wrote a good piece on how this may, indeed, be the future.

On intra-country economic inequality: the Fed’s Survey of Consumer Finances came out recently, so much analysis has been done on how (once again, it seems) the rich are getting richer and the not-rich are getting poorer.  The New York Times has a good summary of the data.  The bit about stock ownership is intriguing – those who have owned stocks since 2008 have made back every penny of their losses in the financial crisis, plus some interest (e.g. The S&P 500 is up 36% from Jan 1, 2008 as of yesterday). Those who didn’t own stocks, but lost their jobs in 2008?  Well, their wages aren’t increasing very much, if they’ve found similar jobs…