Thursday, July 23, 2009

Some Musings on Taxation

Question: What is Hauser's Law? Answer: The Most Simple, Important Economic Concept You've Never Heard Of

In 1993, an economist named Kurt Hauser discovered an amazing fact: the federal government, no matter how much it raised or lowered the top income tax rate, always collects about 19.5% of GDP in tax receipts:

This is almost unbelievable. Look at the 1950s, when marginal rates were 90%. The government collected about 19.5% of GDP. Look at the 1980s, when the highest rate got down to 28%. The government collected about 19.5% of GDP.

Some critics say this is misleading because it measures total tax revenue (including corporate revenue, etc.), and not simply revenue from individuals. Fair enough. Take out everything else and here’s what it looks like:

Case closed, I’d say. Note the amazing constancy even during the huge cuts in the 80s. (I remember a former economics advisor of mine, James Tobin, testifying before Congress that the tax cuts would lead to huge drops in revenue and result in recession. This, from a Nobel Prize winner.)

My colleague, Simina Farcasiu, points out that the data above probably understate the case since GDP is likely understated during high tax regimes, i.e. when tax rates are high, the underground economy is larger, so tax receipts during high tax periods are even lower as a percentage of "total" GDP (legit + underground).

The conclusion is clear enough: marginal rates should be lower since this will stimulate economic activity and the government will collect more actual dollars as GDP expands. Not that it’s always desirable to give politicians more to spend, but the point is the economy will be healthier, and therefore society at large.

What's interesting to me is that when people are asked what they consider to be a fair rate of taxation, the most common reply is 20%. It seems that this is also what society, collectively, has decided to pay, regardless of the tax rate.

But wait, you say, willingness has nothing to do with it. The law is the law! True, and not true. First, high income earners are quite dexterous at finding legal ways to avoid taxes. One way is to live more of your life on pre-tax income. Say you run a small or medium size business. Right now you're thinking quite creatively about what sort of expenses can be run through your company. Don't have a dental plan? You will soon. Not expensing at least part of your car lease? You will soon. These are things most business owners won't obsess about in a low tax environment, but they are obsessing about it now, and the taxes haven't even hit yet. Oh, and these same folks are pondering just not working as hard, which is another legal way to avoid taxes. And, of course, there will be those who have no compunction about crossing legal lines.

All this, of course, should remind you of the Laffer Curve:

Hauser's Law can be taken as empirical proof of the Laffer Curve's efficacy. And really, no one can argue with Laffer's basic logic. At a 0% tax rate, the government collects nothing. At a 100% marginal rate, presumably no one will work, or more likely all labor will be off the books, so again, the government collects nothing.

What is difficult to tell is how the curve is shaped, and where the peak of the curve is. I used to live in Hong Kong where there was a 15% flat tax, and tax collection was quite robust. Indeed, the Hong Kong government would run a huge surplus every year.

Some interesting experiments were conducted by three Canadian economists to understand whether there was any psychological underpinnings to the Laffer Curve. It turns out there are very strong ones:

"The fact that tax responsiveness of work is substantially greater when the tax rates are set by another subject in flesh and blood than by nature is taken as evidence that workers respond strongly and emotionally to unfair taxation, which is consistent with the history of tax revolts. To be more specific, taxpayers want to punish the tax setters who intentionally violated the social norm of fair taxation."*

In other words, when tax payers feel like they are getting shafted, they take it personally, and they react. "I'll show them," is the attitude, which is a sentiment I am hearing over and over, and, for the most part, which is amazing because most of the coming tax hikes haven’t even taken effect. This sentiment is most prevalent among the well off, which makes some sense, since the top 5% of taxpayers already pay 60% of federal taxes (source: IRS). Now our president says almost daily that everything he wants to do can be financed by these very same people. He even seems pleased at the prospect.

{*A Micro-foundation for the Laffer Curve In a Real Effort Experiment (Levy-Garboua, Masclet, and Montmarquette, 2006)}

It will never happen. He may try, but the revenue won't materialize, because those 5% are already enraged, and they also happen to be the best equipped to avoid taxes if they want to. As I suggested, many are small business owners who can live more of their lives pre-tax, and many have the resources to say, "Screw you, I'm retiring." They'll move to Florida (no state income tax) and buy munis.

And then there will be the resurgence of the grey market economy. I heard about a contractor on Long Island the other day who now will quote two prices for jobs: one cash under the table, the other above board. He had never done this before. What set him off after all these years? Was it...

35% Personal Federal Tax
8.8% Personal State Tax (NY)
6.2% Social Security Payroll Tax
2.4% Medicare Payroll Tax

No, it was none of these things. It was a new 3% payroll tax to pay for the hugely inefficient Metropolitan Transit Authority in New York City. Even though his business is 100 miles from the city, he has to pay the tax because the Long Island Railroad (part of the MTA) has a single branch that services his town, something that he never uses. For this guy, it was the tipping point, which jibes with the Canadian study. (Interestingly, this guy's employees are also highly incentivized to go along with the scheme since they, too, will avoid taxes by being paid off the books.) If taxpayers feel they are getting jerked around, they will sometimes radically alter their behavior, and may have little compunction about crossing legal lines.

Any and every tax proposal that has ever come out of Washington uses something called “static scoring,” which assumes that people never vary their behavior. This is wildly unrealistic. I can tell you that conversations about tax-minimization are being had everywhere right now, from little shops to big corporations. Look for corporate perks like a car and driver to make a big comeback.

Next month we will ponder the question: are we a socialist country?

Wednesday, July 1, 2009

People Are Irrational - More Evidence

Can you find the rational agents?

There are many problems with the theory, of course, but the one that has always stuck out for me is the whole idea of a rational agent because, frankly, people are nuts. We are not programmed to be purely rational. Although this seems obvious to most, an associate professor expressing this view anytime between 1970 and 2000 would have been smacked upside the head by his tenure review committee. Enjoy the rest of your career at East Nowhere Community College. It's still a dangerous viewpoint, but so much contrary evidence has rolled in that there are cracks in the monolith.

Which brings me to an interesting study of professional golfers by two professors at U. Penn. They analyzed golfers to see if they sank putts of equal length with differing rates of success depending on whether the putts were for birdies or pars. In theory, it shouldn't matter. A stroke is a stroke. "Par" and "birdie" are arbitrary assignations - they merely describe how you do on a hole.

1.6 million Tour putts were analyzed, and it turns out that pro golfers are 3% better at making par putts for par than for birdie. This adds up to about three strokes per tournament and some serious money. Interestingly, when confronted, few pro golfers doubted the findings. More interestingly, some said there was nothing they could do about it. The bias seems hardwired.
"You can't fool yourself," said Stuart Cink.

“Bogie aversion" has direct analogs in the investment world. For instance, it's a proven fact that people hate losing a dollar more than they like making a dollar. I myself feel this way, even though it makes no sense. Here's another one: lying on the street you find a pair of third row Springsteen tickets that are going on Ebay for $5000 apiece. Assuming you are a Springsteen fan, do you go to the concert or sell the tickets? Most would go to the concert. Would those same people pay $10,000 for the tickets? Not likely. This is also irrational behavior.

Then there’s the fact that two different people, given the exact same set of facts, will often do two totally different things. That means at least one isn’t a rational agent.

There are many, many such examples. As a result, markets will never be efficient. My own view is that they are mostly efficient most of the time, and terribly inefficient some of the time (e.g. lately).

Why does EMT persist? For one thing, it’s beautiful. When you follow it through its development from Markowitz to Sharpe to Tobin, with each economist adding new levels of elegance, you can’t help but admire the intellectual force behind the theory, and how neatly it seems to wrap the messy world of investing up into simple concepts. If this had been the fruits of my own intellectual efforts, I too would be reluctant to give up the ghost. The Nobel sitting in my study wouldn’t make it any easier, either. But the fact is, EMT is dead, as is a host of other market theories loosely banded together as Modern Portfolio Theory.

Nobels await those with better ideas, but they won’t be as beautiful, because they will need to explain the messiness of the human psyche.