Tag Archives: fiscal

Avoiding the word “tax”

I have a new way to balance the budget. When employees are paid, I will require their income to spend one day in an escrow account, where it will be invested in “Liberty Bills”. Liberty Bills are government-issued bonds with a daily return of negative 5%. I am confident that this simple reform will eliminate the deficit.

Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?

Maybe not. In fact, I see similar proposals all the time.

Consider the following: when Dean Baker proposes that we cancel the Treasury debt held by the Fed, he’s essentially saying (aside from the temporary accounting gimmick) that we should undertake a long-term shift in the composition of debt, from bonds to money. Why? Most observers suspect that the Fed will eventually pull back the money created through quantitative easing. To so, however, it needs to sell lots of assets—and if half of its assets disappear, this is no longer a viable option. Under Baker’s proposal, then, the Fed will be forced to leave over $1 trillion in excess reserves in the system, until it recapitalizes through profits (far in the future) or is bailed out by Congress (in which case the proposal is completely circular). Debt that would otherwise be issued by the Treasury will be left in the form of money instead.

What happens then? Quite possibly nothing. With so many reserves in the system, the premium on reserves will linger around zero—no one will sacrifice yield to hold reserves when equivalent riskless assets are available. The rate paid on reserves, the federal funds rate, and the short-term T-bill rate will all be roughly the same. In this environment, issuing debt in the form of money rather than bonds is completely useless: you can borrow at the same rate with T-bills. Monetization changes nothing.

What Baker proposes, however, is to vastly increase the burden of reserve requirements, such that there is no longer an excess supply of reserves. At this point, banks are willing to pay a premium for reserves, the Fed is able to pay interest on reserves at a rate lower than the rate on T-bills. Money becomes a cheaper form of finance than bonds, and we see a fiscal benefit.

But what’s really happening? The Fed saves money in this scenario only because the new reserve requirements force banks to carry a low-yield asset (reserves) in order to accept deposits. In other words, the Fed is taxing bank deposits. In fact, Congress could impose precisely the same tax through legislation: a statutory tax of (federal funds rate – interest on reserves)*(reserve requirement) would be equivalent.

Of course, hardly anyone* wants us to enact an ad-hoc tax on certain types of bank deposits: it’s not a very efficient way to raise money, and it’s quite possibly regressive. I can easily think of a dozen more effective ways to boost revenue. So why does anyone take this proposal seriously? As far as I can tell, it’s because a “reserve requirement” doesn’t sound like a tax. It’s not obvious that this policy is just another distortion-inducing way to gather revenue, and that it should be subject to the same cost-benefit analysis as any tax. As with many proposals for means testing, we’re so eager to escape uncomfortable fiscal tradeoffs that we invent a new, needlessly circuitous way to tax, one that’s even less efficient than the existing tax code.

I’m still fond of Liberty Bills myself.


*As I mentioned in my last post, there are serious proposals for taxing “liquidity creation”, but properly implementing these proposals would produce a policy so different from today’s reserve requirements that it’s a stretch to use the same name.

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Required reserves: much smaller than you think

The blogosphere has already responded in force to Dean Baker’s strange proposal to destroy the $1.6 trillion in Treasuries held by the Fed and use increased reserve requirements to maintain the Fed’s balance sheet once QE is withdrawn. Greg Mankiw poses it as an “exam question”, and rightly observes that the proposal is a mixture of accounting gimmickry and financial repression. (To be fair, the “accounting gimmick” is part of the intent: the idea is to circumvent the statutory debt limit.)

But there’s also a simpler, quantitative problem with Baker’s analysis: he doesn’t seem to have any clue how small required reserves currently are. Let’s take a look:

Currently, banks need to hold only $80 billion in reserves. And that’s in the midst of an ongoing recession, where consumers and businesses have plowed money into liquid assets and, through interest on reserves, the Fed has eliminated the cost of keeping money in accounts with a reserve requirement. Before the spectacular recent increase, the level of required reserves was closer to $40 billion.

The difference between $40 billion and $80 billion, however, is minimal compared to the $1.6 trillion that Baker proposes to capture using a reserve requirement. Currently, the reserve requirement is set at 10% of checking account balances. Even if we increased the reserve requirement to 100%, we’d only be halfway to $1.6 trillion—and that’s under the extraordinarily unrealistic assumption that these balances would stay at their recessionary highs even after a vast expansion in the cost of holding reserves!

How hard is it to get to $1.6 trillion? Let’s say that we broadened the scope of the reserve requirement to cover everything contained in the M2 aggregate: savings deposits, money market deposit accounts, small-denomination time deposits, and retail money market funds. That’s roughly $9 trillion, or $8 trillion after we subtract currency. $1.6 trillion is 20% of $8 trillion. So yes, we can induce a demand for reserves of $1.6 trillion by doubling the reserve ratio and vastly expanding the pool of deposits covered. But even this ignores the fact that depositors would quickly abandon the assets covered by the new requirement, to the point where the total would be far less than $8 trillion.

Of course, if you cast a wide enough net, it’s quite possible to reach $1.6 trillion: US households have almost $50 trillion in financial assets. But you have to ask why this would be a remotely desirable way to raise money. Reserve requirements are effectively a tax on deposits: at the very least, banks are forced to sacrifice the spread between perfectly safe assets (like T-Bills) and reserves (which have traditionally paid zero). Why does Baker think this is a efficient tax? It seems awfully bizarre to me: not only are you taxing savings, which is already inefficient, but you’re restricting the tax to a certain form of savings, which is all the more arbitrary and inefficient. (Not to mention regressive—Grandma’s savings account is taxed while hedge funds are not.)

To be fair, there are serious proposals to use reserve requirements as a regulatory tool, taxing risky liquidity creation to bring it down to the socially optimal level. But to do this properly, you’d need to completely redefine the requirements’ scope: the real risk to the financial system comes from “shadow banking” like repo and commercial paper, not traditional retail deposits. Is this what Baker is proposing? If so, that’s fine—but he certainly doesn’t give any hint of it.

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The optimal taxation of Manhattanites

Matthew Yglesias dismisses the argument that $250,000 isn’t “really rich” in Manhattan:

Allison Schrager offers what is I think my least-favorite economic argument, the regional variant of the old people who buy expensive houses aren’t rich because their houses cost so much switcheroo…

“Perhaps fairness also requires that the tax code account for the higher cost of living in some areas. The income cut-off for tax increases floated by President Obama is $250,000. That sum buys you a lot more in Fargo than it does in Manhattan. Most high earners live in expensive areas. They command such high salaries, in part, to offset their high cost of living.”

But that’s not to say that $250,000 buys “more housing” in Fargo than it does in Manhattan, it’s to say that it buys worse housing. The people in those expensive Manhattan apartments are paying for the positive amenity value. They could move to the Bronx, but they don’t want to. Similarly, Manhattan is full of restaurants that don’t exist in Fargo. There are law firms in Manhattan and law firms in Fargo, but the Manhattan law firms are better. Service professionals move to New York to peddle their services because the city features a critical mass of well-heeled clients who can pay top dollar for the best hairstylists or dentists or architects in the world. Fargo’s not like that…

I’m with Yglesias about the $250,000: that income officially makes you rich everywhere. As a practical matter, I also agree that the tax code shouldn’t account for the “cost of living”. But from a theoretical perspective, there is some basis for the idea that Manhattan should have higher federal tax brackets than the rest of the country.

Let’s go back to a fundamental result in the theory of optimal taxation: the Atkinson-Stiglitz Theorem. This result demonstrates that if consumption and leisure are “separable in the utility function”, the optimal tax system should rely only on income taxation. Translated into English, this means that unless someone’s consumption decisions provide extra information about her underlying earning ability—information beyond what’s signaled by the level of income itself—it’s best to avoid taxing different goods at different rates.

As I pointed out in a earlier post, this result shows why some seemingly sensible propositions are wrong: the fact that demand for gasoline is highly inelastic doesn’t singlehandedly justify a higher gas tax. But Atkinson-Stiglitz is also useful in how it fails: it tells us when differential taxation might be reasonable after all.

In particular, if a certain type of consumption makes it easier to earn a high income (conditional on particular level of a ability), then the tax code should favor that type of consumption over others. The obvious candidate here is place of residence: it’s easier to earn a high income in Manhattan than Fargo. This doesn’t quite mean that we should set taxes based on the “cost of living”—a city might be more expensive because it has better amenities, not because it offers better income opportunities. (In practice, it’s usually a little of both.) But to the extent that cost of living is a proxy for income opportunities, it can play a useful role in the tax system.

Think about it this way: discouraging productive (but expensive) urban agglomeration is one of the efficiency costs of taxation. Normally, we think about the losses from income taxation along the labor/leisure margin: if the marginal tax rate on your labor income is too high, you’ll substitute away from labor and spend more time at home. (Perhaps you’ll retire sooner, or leave the labor force if you’re a secondary earner.) But the effect on decisions about where to live is also a source of inefficiency. Maybe after moving from Fargo to Manhattan, it’ll cost $50,000 more every year to maintain the same standard of living, and you’ll earn an extra $100,000. This should be a great tradeoff, but you’ll stay in Fargo if your marginal tax rate is higher than 50%.

In fact, if we change a few labels, we can think about this problem using another famous result in public economics: Diamond and Mirrlees’s demonstration that intermediate goods should not be taxed. Living in a high-powered city, after all, is just an “intermediate good” that makes labor more productive.

Now, in the real world I don’t think the tax code should discriminate according to place of residence. First of all, we don’t have any accurate measure for the extent to which cities improve productivity; we only have cost of living, which is an incredibly indirect proxy. Second, changing the tax code along these lines invites endless political manipulation—how long before the “cost of living” is mysteriously estimated to be highest in swing states? Finally, and most importantly, the high cost of living in the most expensive urban areas owes more to regulation-induced scarcity than economic fundamentals. Given the artificial supply constraint, lower taxes for Manhattan residents would be mainly a giveaway to incumbent property owners, not a way to encourage efficient concentration of labor.

But it isn’t ridiculous to think that a properly designed tax system might want to incorporate the fundamental differences between cities. In fact, in the lens of Atkinson-Stiglitz, it’s a lot more reasonable than most of the other breaks in the tax code.

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Insurance against oil shocks: the best idea Bill Frist ever had

Back in 2006, there was a brief stir over the Republican majority’s plan to offer $100 rebates to offset higher prices from gasoline. It quickly became the object of almost universal derision, earning scorn from politicians and bloggers of both the left and right.

Kevin Drum, for instance:

A hundred dollar rebate! It’s bad economics, bad policy, bad optics, and the palpable stink of election-year desperation all rolled into one fetid package. But at least it’s means tested!

On the conservative side, Power Line asked “Wasn’t there a time when Republicans knew something about economics?” and proceeded to demonstrate its own ignorance of economics:

Taxes are a large part of the cost of gasoline. How about if we cut them?

Ironically, the rare proposal that managed to draw bipartisan condemnation was one of the best ideas Congress ever had.

First, why is one of the main alternative proposals—a cut in gas taxes—such a ridiculous idea? Since the US accounts for more than 20% of world oil consumption and the short-term supply of oil is highly inelastic (except when it’s in contango and oil is being hoarded), elementary tax incidence theory tells us that a substantial chunk of the gains from a short-term cut in taxes will go to producers, not consumers. In fact, a very short-term cut in the summer is even worse, since most of the supply is completely fixed, as refineries are already planning to produce as much as they can (which is what made Hillary Clinton’s 2008 proposal so absurd). On top of all this, gas taxes are presumably there to serve some purpose—in particular, to internalize some of the harm from congestion, accident, and pollution externalities—and that purpose doesn’t go away when the price of oil increases.

In short, cutting gas taxes in response to high prices is very bad policy. But that doesn’t mean there shouldn’t be any response from the government.

Of course, the US can’t repeal the laws of supply and demand: there’s no way to suddenly turn on the spigot and make oil cheaper in a world market where American producers will never provide more than a few percent of supply. An increase in oil prices will make Americans poorer.

But the problem isn’t just that an increase in prices makes consumers poorer. It’s that they have short-term liquidity problems: most consumers lack any cheap line of credit for when gas suddenly becomes more expensive. Instead, they have to cut other spending, even when the increase in prices isn’t expected to last forever—and that’s a very real inefficiency.

In an ideal, frictionless economic world, consumers would either buy insurance against high gas prices ahead of time or have easy access to credit, to make a sudden price change more palatable. In the real world, this doesn’t happen: the administrative costs of insurance are too high, and there are innumerable agency failures making it difficult to provide credit. When consumers are operating under these constraints, government intervention can be beneficial.

Frist’s $100 rebate proposal, though tiny, was a way to slightly ease the liquidity constraints facing consumers hit by price increases—in a sense, he wanted the government to provide insurance when the private sector could not. Of course, it wasn’t targeted to consumers who used the most oil, but that was unavoidable. Without any preexisting arrangement, the only way to provide targeted relief would be to cut the gas tax, which for all the reasons I’ve already covered would be a horrible idea.

Such relief could be made much more effective, however, if we made it part of a formal insurance system. Imagine the following: every year, taxpayers filling out their 1040s are given the option to purchase a limited amount of insurance against a surprise increase in oil prices. (The insurance is priced by government economists based on data from futures markets—in fact, the government can even take an offsetting position to negate its risk.) Naturally, anyone who is especially susceptible to an increase in prices will want to buy the most insurance—for instance, a commuter from the exurbs, or a New Englander whose house requires heating oil. This way, the government delivers targeted relief without the perverse incidence of a tax cut.

Whenever government intervenes in a market, of course, the natural question is to ask what advantage government has in providing the service. In this case, I think the answer is obvious: since the government already administers taxes, the overhead from offering oil price insurance consists of little more than an extra line on tax returns, some wire transfers (when the insurance is paid out), and maybe some checks in the mail. The government’s scale is so enormous that its cost of conducting trades to hedge the risk is minimal (and next to the size of its budget, the risk is minimal anyway). There are no regulatory barriers to navigate, and no costs to advertise the new program.

I can’t see why this has never been proposed.

In the absence of a more systematic program, however, ad-hoc insurance like Frist’s doomed “gas rebate” is a completely reasonable idea. It’s revealing that the proposal was so roundly mocked as bad policy—lawmakers and pundits relied more on the vague sense that a rebate sounded gimmicky than on any serious economic analysis. Republicans immediately pivoted to the their “real solution” (pretending that domestic supply can change world prices), while Democrats did the same (using CAFE to force consumers to buy efficient cars). And a perfectly valid proposal skidded to failure.

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Is there a macroeconomic rationale for higher gas taxes?

Several of my favorite bloggers like to argue that the macroeconomic effects of oil shocks justify higher taxes on oil, to bring down overall consumption and the harm from future shocks. While I agree that oil should be taxed at a higher level, I’m not sure that this provides a convincing rationale.

First of all, we need to be clear about why oil shocks have an effect on the economy. To my knowledge, there are three main possibilities:

  1. As consumers spend more on oil, they spend less on other forms of consumption, thus lowering output.
  2. Higher oil prices make the production of certain goods uneconomical, and there is an optimizing shift away from these goods, possibly lowering overall output.
  3. An increase in oil prices raises inflation fears and pressures the Fed into adopting a tighter policy.

Though #2 is certainly a possibility, it doesn’t offer any clear reason why we should raise the gas tax. After all, the entire point of the price mechanism is to encourage consumption when costs are low and discourage it when costs are high. Someone investing in a factory that requires oil inputs does so in full awareness that future oil increases might render her investment unprofitable. To justify adding an additional disincentive to using oil, we need to identify some kind of externality from this decision, or interaction with a market imperfection. And while there are certainly externalities from pollution and congestion, a purely macroeconomic externality seems hard to identify.

Possibility #3 is more plausible. But as Charles Evans, president of the Chicago Fed (and a monetary economist of some repute), points out in a a recent article, it is quite difficult in the post-Volcker era to identify either a substantial response in monetary policy or an response in inflation to an oil shock. The increase in prices shows up as a one-time uptick in the headline CPI, of course, but does very little to influence future inflation. As Evans observes:

The modest dependence of policy on energy and other commodity prices implied by our analysis is not surprising. The shares of firm costs accounted for by energy and commodities are not large and, in fact, have fallen over time. Moreover, at least in the case of oil, price increases tend to slow the economy even without any policy rate increases. Of course, if commodity and energy prices were to lead to a general expectation of a broader increase in inflation, more substantial policy rate increases would be justified. But assuming there is a generally high degree of central bank credibility, there is no reason for such expectations to develop—in fact, in the post-Volcker period, there have been no signs that they typically do.

Ultimately, the need for the Fed to offset the rise in inflation following a surge in oil prices is very small—because there isn’t much of a rise at all.

Of course, this doesn’t prevent crazy people from using commodity prices as a justification for tight policy, and to the extent that Fed decisions are influenced by such individuals it’s possible that oil shocks are macroeconomically corrosive in practice (even if they shouldn’t be in theory). But then the macroeconomic justification for gas taxes rests mainly on the idea that monetary policymaking is poorly implemented—and if we’re talking about an idea as politically difficult as increasing the gas tax, we probably want to consider the more direct step of making monetary policy more effective. Regardless, given the relatively small influence of commodity prices on monetary policy in the last few decades, the case here for a significantly higher gas tax appears limited.

Finally there is possibility #1, which is the most common intuition for how higher oil prices impact the economy: when consumers are spending more money on gasoline, they have less money to spend on everything else, and output declines.

It’s important to realize that this story is not as straightforward as it seems. When consumers spend more on imported oil, there are two possibilities: either (1) exports increase and the current account deficit stays the same, or (2) the current account deficit increases. In case (1), the rise in exports means that there isn’t a direct hit to output. With (2), meanwhile, we have to remember that the inevitable correlate of a current account deficit is a capital account surplus. To exactly the extent that a oil shock causes imports to rise above exports, there is a rise in the flow of capital into the United States. Since the financial system isn’t perfectly frictionless, this capital inflow won’t necessarily be directed to the consumers forced to cut back by higher oil prices—but it will ultimately end up with someone, and there is only a macroeconomic effect to the extent that the “someone” is less likely to spend than the consumers and businesses paying more for oil. While this is completely plausible (after all, credit constraints are everywhere), it’s not clear that the magnitude is large enough to justify much of a tax.

It’s even harder to see the externality here. A consumer who buys an SUV is probably aware of the fact that higher gas prices will cause him trouble in the future—you don’t need to be hyperrational Economic Man to say “hey, the last time gas was at $4 a gallon, I had to cut back on some other spending, and it wasn’t much fun”. To the extent that government adds a tax on top of this, it’s making the incentive to avoid spending on oil even larger than it should be.

Perhaps in a liquidity trap there’s some macroeconomic spillover. But that brings us to a key point: commodity prices are highly procyclical. Though they fluctuate for many reasons, they tend to decline tremendously during a severe recession, which arguably makes them a stabilizing force during times of economic distress. It’s easy to imagine this effect overwhelming all the other macroeconomic consequences of oil—after all, a recession is precisely the time when credit constraints (which are the mechanism through which short-term commodity price changes have an influence on other types of consumption) are most binding.

In the end, therefore, it’s not clear that oil price movements are destabilizing at all, much less destabilizing in a way that justifies a preventative tax. There are many reasons to tax gasoline, but macroeconomics isn’t one of them.

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The practical irrelevance of the Friedman rule

In his recent Economist debate with Brad DeLong on whether the inflation target should be raised, eminent monetary economist Bennett McCallum emphasizes the Friedman rule as an important determinant of the optimal long-term rate of inflation:

First, in the absence of the ZLB, the optimal steady-state inflation rate—according to standard new Keynesian reasoning—lies somewhere between the Friedman-rule value of deflation at the steady-state real rate of interest (therefore something like –2% to 4%) and the Calvo-model value of zero, with careful calibration indicating that the weight on the latter may be considerably larger. Second, a theoretically attractive modification of the Calvo model would imply that the weight on the second of these values should be zero, so that the Friedman-rule prescription itself would be optimal (in the absence of the ZLB).

Third, even when the effects of the ZLB are added to the analysis, the optimal inflation rate is (according to this line of analysis) probably negative—closer to –2 % than to 4 %…

The Friedman rule follows naturally from a basic model of monetary policy. “Money” is a good that is costless to provide, yet valuable to consumers and businesses; for the sake of efficiency, it should be priced at cost, which means that the risk-free nominal interest rate should be zero (so that you don’t lose anything from holding wealth in the form of cash rather than Treasury bills). Since real interest rates are usually positive, this means that we need long-term deflation.

This is all valid in theory. But does it have practically meaningful welfare consequences? Brad DeLong does a little arithmetic and comes out skeptical:

Say that if cash in my pocket earned the same real rate of return as bonds in my portfolio, I would carry more cash and find myself having to stop at the ATM only once a quarter rather than once a week. Say it takes me six minutes to go the ATM. Say my time is worth $30 per hour at the margin. Say that other portfolio swaps I would no longer have to do are of equal value. Then I would gain $6 per week or $300 per year from a deflation rate of 3% per year. Say I am representative of 200m American adults.

That is a net welfare gain of $60 billion a year for America from this “reduced shoe leather wear” effect of having an inflation target of –3% per year.

The lost production from the recession that began in 2008 has so far amounted to $2.6 trillion. The meter is still running at a current rate of $1.04 trillion per year. It will be at least $4 trillion before we are through.

This is easy to see in other ways as well. Suppose that we’re considering whether to raise the long-term inflation target from 2% to 4%, and that this implies an increase in the typical yield on T-Bills from 4% to 6%. Currently, the amount of currency in circulation plus required reserves is a little above $1 trillion. (Keep in mind that due to zero interest rates, this is slightly higher than it otherwise would be.) What is a plausible estimate of the welfare loss from a change in inflation target from 2% to 4%?

Let’s be extreme and say that the resulting change in steady-state nominal interest rates causes real base money demand to fall in half, from $1 trillion to $500 billion. At worst, this implies a ($500 billion)*6% = $30 billion welfare loss due to deviation from the Friedman rule.* (This would happen if, say, all $500 billion was held by individuals who valued real money balances at exactly 5.999% a year; an increase in the nominal interest rate to 6% would be just enough to inefficiently cause them to forgo this benefit.) That is 0.2% of US GDP—already a pretty small effect, but not completely trivial.

But of course, we wouldn’t expect the demand for base money to fall in half. Laurence Ball, for instance, finds that the semi-elasticity of money demand with respect to interest rates is -0.05, so that a 2% increase in interest rates would lead to a 10% decline in M1. Let’s allow for the maximum possible welfare impact and suppose that the entire decline in M1 takes place in non interest-paying currency, which accounts for about half of the aggregate. Then we’ll see roughly a 20% decline in currency demand, for an absolute decline of $200 billion—which gives a maximum welfare hit of ($200 billion)*6% = $12 billion. Now we’re at less than one-thousandth of GDP!

It doesn’t end there. First of all, seignorage is a way for the government to collect revenue—revenue that would otherwise be raised using some other distortionary tax. Some economists think that higher interest rates can’t be justified on revenue-raising grounds alone: if you were designing the optimal mix of taxes (and nothing else), seignorage wouldn’t be one of them. But if you’re interested in maintaining positive interest rates for some other reason, the fact that seignorage income allows you to bring down some other tax means that the true welfare cost is even lower than you’d initially estimate.

And then there’s the elephant in the room: who holds currency, anyway? There is roughly a trillion dollars of paper currency in circulation; that’s over $3000 for every man, woman, and child in America. Most of the value is held in the form of $100 bills. Clearly most of it isn’t being used for the purpose of ordinary transactions. Estimates suggest that half or more is held outside the US, and undoubtedly an enormous percentage is used by organized crime. As Schmitt-Grohe and Uribe calculate in their survey on the optimal rate of inflation, accounting for the value of currency held abroad can easily push the “optimal inflation rate” (looking only at the tradeoff between revenue and the distortion imposed by departure from the Friedman rule) much higher, up to 2-10%. And that’s not even accounting for the fact that it would be beneficial to extract money from the tax evaders and drug cartels who presumably hold most of the cash circulating domestically.

In short: even if we are generous and assume that currency is being held domestically for legitimate purposes—and wave aside the revenue benefits—the economic impact of departure from the Friedman rule is a very tiny fraction of GDP. In a more realistic world, the costs are smaller still, and quite possibly even negative. They are minor relative to some of the other costs of inflation, and they pale in comparison to the macroeconomic costs of hitting the zero lower bound.

The Friedman rule is the ultimate example of an idea that is qualitatively true yet quantitatively irrelevant.


*For the sake of completeness, I should note that in a formal sense this isn’t quite right. If holding money is complementary to other economic activities, then it’s possible that we would obtain a general equilibrium “tax interaction effect” where the wedge in incentives from a positive nominal interest rate adds to (larger) preexisting distortions from other taxes. But even though a basic theoretical model might say that money is used due to a “cash-in-advance” constraint on consumption, a little introspection suggests that this can’t possibly be responsible for most demand for American currency: only a very, very tiny fraction of consumption is paid for with $100 bills. Most of this cash is held for other reasons (quite possibly illegitimate ones) that aren’t related to some clearly identifiable economic activity like consumption or work already distorted by a tax. In fact, to the extent that cash usage is motivated by tax evasion or crime, we actually see an additional benefit from taxing cash, by the same logic. And regardless, since seignorage revenue allows us to bring down existing taxes, we’d see an offsetting benefit of roughly the same magnitude—the net cost from these more subtle fiscal considerations is very, very unlikely to be much greater than zero.

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Means testing and implicit taxes

Often I see proposals for means testing entitlement programs. For instance, Richard Posner writes:

Perhaps some politician will be bold enough to advocate that all entitlements programs, including social security as well as Medicare, be means-tested, as Medicaid is. There is no reason why people who can afford to provide for their retirement should be subsidized by the government, which is to say by the taxpayer. But such a reform does not appear to be politically feasible.

This is a very common sentiment: in an era of impending fiscal crisis, why should the government be paying Social Security benefits to Bill Gates? Economically, however, its logic is questionable.

Means testing is an implicit tax, with all the distortionary effects of ordinary taxes. If $1000 in additional income causes you to lose $100 in government benefits, your effective marginal tax rate is 10% higher than it otherwise would be. It’s strange to see people who would cringe at higher-bracket tax increases suddenly turn around and extol the virtues of means testing Social Security—and it’s hard to attribute this to anything other than a superficial understanding of what “taxes” really are.

But in fairness, the fact that means testing is an implicit tax doesn’t mean that it’s necessarily a bad idea. Two circumstances come to mind.

First, maybe the program in question is highly inefficient. Tyler Cowen, for instance, argues that since Medicare is an in-kind benefit while Social Security is a cash transfer, we should always cut Medicare first. If you believe that Medicare is extremely wasteful, you can make the argument that the benefits from a cutback outweigh the drawbacks of what Greg Mankiw once called “an income tax surchage levied only on old, sick people”. Of course, it’s hard to see how this argument could possibly apply to Social Security, which is as close to a pure transfer program as you can come.

Second, maybe the implicit tax is a relatively efficient one. Under many proposals for Social Security means testing, this is clearly not the case: cutting back benefits on the basis of current ability to pay is a terribly inefficient proposal, wrapping an income tax and a severe capital tax into one. As Scott Sumner once pointed out, this proposal would place the burden of fiscal adjustment entirely on responsible savers like himself, offering continued benefit checks to the former NFL star who blew his savings by his 40th birthday but not to the far lower-income nurse who steadily contributed to her 401(k).

Still, it’s conceivable that we could design a means testing scheme that worked more effectively. For instance, we could means test on the basis of lifetime income. This would mean an effective hike in income taxes—which makes you wonder why we shouldn’t just enact a direct increase instead—but at least there’s a glimmer of an argument as to why it would be efficient. After all, a progressive tax on lifetime income is more distributionally accurate than a progressive tax schedule on year-to-year income: your earnings across several decades are a better indicator of your ability to pay than your earnings in any single year, and there’s no reason to let a millionaire pay at a low rate because he happened to have a bad year.

Moreover, given the current system for calculating benefits, at the margin means testing would be easy to implement. Right now, the Primary Insurance Amount formula for Social Security offers benefits at a rate of 15% for average indexed monthly earnings over $4,517 (and a higher rate for earnings below that). We could easily lower this percentage to 0%, or even a negative rate at sufficiently high levels. Making the PIA formula more progressive is, in fact, one of the recommendations of the much-maligned deficit commission:

The Commission recommends gradually transitioning to a four-bracket formula by breaking the middle bracket in two at the median income level ($38,000 in 2010, $63,000 in 2050), and then gradually changing the replacement rates from 90 percent, 32 percent, and 15 percent to 90 percent, 30 percent, 10 percent, and 5 percent.

But regardless of the specific proposal, there’s one fact we can’t escape: means testing is a marginal tax increase. As such, it ought to be given the same consideration as any other tax increase, and we shouldn’t let a highly distortionary change in incentives slip by just because we’re not officially calling it a “tax”.

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Is it better to tax goods with inelastic demand? (Atkinson-Stiglitz redux)

Not necessarily.

Bloggers across the political spectrum, from Noah Millman to Ryan Avent, have recently argued that because the demand for oil is inelastic with respect to price, a gas tax is a relatively efficient way to raise revenue. Though I support a higher gas tax, I don’t think this argument is quite right.

It’s true that the deadweight loss from a tax (a standard measure of inefficiency) is intimately connected to the supply and demand of the good being taxed. If either supply or demand is inelastic with respect to price, the deadweight loss will be low. But when designing a tax system, the deadweight loss isn’t the only relevant consideration.

To see why, let’s consider a silly example. Imagine a tax with the lowest deadweight loss imaginable: a tax on breathing, levied at a rate of $10 every day that you take a breath. The demand elasticity here is exactly zero—no one (I hope) is going to stop breathing for an entire day just to avoid paying the tax. This is a wonderfully efficient tax: it has zero deadweight loss.

In fact, this is effectively a lump-sum tax, a tax demanded equally of every individual. Since lump-sum taxes are a perfectly efficient way to collect money, anyone thinking about how to minimize deadweight loss will always raise revenue exclusively through lump-sum taxes. But this is a cheat: obviously we don’t observe lump-sum taxes in practice, even though at the margin it would be possible to implement them. (If the government demanded that everyone coughed up an additional $50, almost everyone could manage to do it.)

The reason why the government doesn’t do this, of course, is distributional: we care about the poor, and it wouldn’t be fair to ask them to pay exactly the same dollar amount as the rich. This is important for even the most conservative fiscal policy proposals—many of them suggest flat taxes, but never a regressive lump sum. And one we realize that this is a key issue, it’s critical for our understanding of optimal taxation, far beyond the observation that lump sum taxes are a bad idea.

A famous result in public finance, the Atkinson-Stiglitz theorem on the optimality of direct taxation, captures this intuition in a striking way. Atkinson and Stiglitz show that if the utility function is weakly separable between consumption of various goods and labor (intuitively, the amount you work has nothing to do with your consumption choices, except insofar as working more gives you more money to spend), then no consumption taxes are needed to attain the optimum. You don’t levy higher taxes on gas than soy milk because soy milk has a higher elasticity; you just determine the optimal tax schedule on income and then stay away.

Why is this? Well, the reason we don’t levy lump-sum taxes is that we’re concerned about distribution. But it’s also a story about information: if we knew exactly what each person was capable of making, we could assign everyone personalized lump-sum taxes, and achieve our distributional goals without distorting any incentives. (“Matt, the government has calculated that you are easily capable of making $1 million a year over the next 10 years; therefore you must pay $300,000 in tax every year, regardless of your actual income.”) Of course, we don’t have this information, and we’re forced to use income as a proxy for ability to pay instead. But then we reach the Atkinson-Stiglitz result: if your exact consumption decisions don’t add any information about this ability, they shouldn’t be part of the tax. Unless gasoline consumption indicates that you have high hidden earnings potential, it shouldn’t be subject to any special charges.

Mapping this result onto the real world is tough, since “income taxes” in practice include taxes on saving (i.e. capital income), rather than the original income itself. Unless propensity to save or access to savings vehicles offer additional information about underlying earning ability, the Atkinson-Stiglitz results suggest that taxes on capital income should be zero, and that our current regime is inefficient. In this context, it might be efficient to raise gas taxes if they’re replacing taxes on capital gains. But it would be even more efficient to replace capital gains taxes with taxes on regular income*, or implement a progressive consumption tax. It’s tough to imagine a world where hiking gas taxes is the fiscally optimal thing to do, or even the second best.

Of course, this isn’t to say that gas taxes aren’t a good idea. If they’re correcting an externality, gas taxes are absolutely appropriate. They’re just hard to justify on fiscal grounds alone.


*Since people with lots of capital tend to be rich, and they acquired that capital under the assumption that it would be taxed, in practice a sudden implementation of this change would represent a windfall gain for the rich. But this could be counteracted either through an explicit one-time expropriation of capital or an implicit expropriation through an increase in consumption taxes.

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Taxes, hidden and explicit

When I say that monetary policy is fiscally irrelevant, I don’t mean that it’s conceptually impossible to raise a lot of money through seignorage. Under the current institutional setup, the demand for money is too small—if not for interest on reserves, base money would consist entirely of cash and a very small component of bank reserves—but you can imagine policies that would change this.

For instance, right now the only reserve requirement that banks face is the 10% requirement on checking accounts. We could expand this to, say, 50% on every kind of liquid financial balance, and demand for reserve deposits would increase enormously. Seignorage still wouldn’t balance the budget, but at least it would be a respectable contributor to annual revenue.

At a fundamental level, though, this is really just another kind of tax: the government requires that people who want to hold liquidity in the form of bank deposits also hold a government-issued asset that pays zero interest. And it’s a deeply inefficient tax at that: everyone would eventually find a way around it (so that it didn’t raise any revenue), but the accompanying process of financial innovation would be costly and disruptive. Even if the tax had no loopholes, it would be a questionable idea. When we can tax income or consumption, why tax a certain way of holding financial assets? (Some smart people have an answer to that question, though it probably wouldn’t involve the kind of massive tax I posit here.)

But regardless of the merits of such a measure, you can’t escape the fact that it’s just another name for a tax—and as such, there’s no need for it work through monetary policy at all. We could levy an explicit tax on banks and be done. Put that way, of course, the feds’ ability to raise money through monetary policy sounds less exciting: it’s just a disguised, relatively ineffective way of exercising the authority to tax. No special fixes here.

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The fallacies of MMT

Recently there’s been some spread in the influence of “Modern Monetary Theory”, a set of beliefs about monetary and fiscal policy championed by figures like Jamie Galbraith and Randall Wray. It’s been given (unfavorable) attention by Paul Krugman, lengthy blog posts by Steve Waldman and Nick Rowe, ample article space at new deal 2.0 and even a platform at the New York Times. Though MMT is certainly nonsense, I’m hesitant to spend much time refuting it—since it has roughly the same stature among economists that creationism commands among biologists, there’s a sense that I’m just tilting at windmills. Nevertheless, beliefs that are ridiculed by specialists can become powerful (and dangerous) outside the mainstream, and I think it’s best to confront them head-on.

MMT starts with lengthy historical musing about the origins of money. The claim is that we can’t think about “money” independent of the special status granted to a particular form of currency by the government. Specifically, the power to levy taxes in dollars is what gives dollars value in the first place.

All this may be true. But it’s also mostly irrelevant for the conduct of monetary policy. Perhaps government, using its power of taxation, nudged us into the equilibrium where green pieces of paper are used both as a medium of exchange and a unit of account. But that doesn’t mean that taxes, at the margin, have anything to do with the demand for currency.

In fact, this is easy to refute. Until the advent of QE, the vast majority of base money was held in the form of paper currency. The role of electronic bank reserves was incredibly marginal, fluctuating around $10 billion out of a monetary base of over $900 billion. Yet these electronic bank reserves were used to conduct the vast bulk of transactions in our economy. As James Hamilton points out, circa 2008 each dollar of electronic reserves was whizzing around on Fedwire an average of 350 times every day. Before the advent of interest on reserves, excess reserves were virtually nonexistent: banks were profit-maximizers, and there was no need to hold even a cent more than the 10% reserve requirement on checking accounts. The only question was whether to hold reserves in the form of “vault cash” (mainly in ATMs) or electronic accounts at the Fed.

In short: pre-2008 demand for base money—the asset that the government creates—consisted overwhelmingly of demand for cash.

But certainly no more than a trivial fraction of taxes are paid in cash. Employers don’t FedEx their withholdings to the IRS in envelopes filled with $100 bills; corporations don’t send a fleet of armored trucks when their bill comes due. Even Grandma probably sends a check. (In fact, if you’ll forgive my ignorance, I’m not positive that we’re even allowed to pay the feds in cash.)

Yet there has to be some reason why individuals are holding cash: it pays zero interest, which in normal times is well below even the safest alternative assets. And certainly there’s a demand for cash to conduct petty transactions: it’s how I pay at food trucks and Chinese restaurants too stingy to accept Visa. But this isn’t enough to justify the vast amount of cash in circulation, which at nearly $1 trillion amounts to over $3000 for every man, woman, and child in America. (That’s a lot of food trucks!)

In reality, of course, much of this cash is held abroad—estimates derived from formal cash shipments hover around 50%, but given the vast sums smuggled out of the country under questionable circumstances, the actual fraction is probably far higher. Cash is useful for tax evasion, illegal transactions, and storing value in a country without a reliable banking system. You’ll notice, however, that none of these explanations have anything to do with the MMT theory of money, in which the government creates demand for money by levying taxes (except insofar as taxes create demand for tax evasion!).

And even if (against all evidence) you accept the MMT view of money, it doesn’t become fiscally relevant. Suppose that you’re trying to patch a $20 trillion hole in the long-term federal budget. You raise taxes by $300 billion (in real terms) a year. At a real interest rate of 2%, this works out to $15 trillion. You’re most of the way there! Now consider the effect of your tax increase on demand for base money. As I’ve stressed, it’s abundantly clear that there is no significant effect, but let’s indulge MMT and make the ludicrous assumption that money demand will increase one-for-one with the rise in annual tax revenue. At a nominal interest rate of 4%, your annual seignorage income increases by $12 billion; the present value of the long-term increase is $600 billion. Not much compared to $15 trillion you raised from taxes, or the $20 trillion you owe—you’re still deep in the hole.

In fact, $600 billion is exactly 4% of $15 trillion. Even in the utterly implausible case where annual tax increases lead to a commensurate rise in the demand for money, the extra revenue from seignorage is just a fraction of the revenue you raised from taxes in the first place—this fraction being the nominal interest rate.

To sum up: MMT is wrong about money. Even supposing that it’s right, its impact is fiscally marginal. The government does have a budget constraint.

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