Monday, October 13, 2008

The 95% Tax Cut Myth

Sen. Obama often uses the line that if elected to be President, his plan would cut taxes for 95% of earners. First off, one has to make the assumption that this could even be feasibly done considering our fiscal situation. Estimates of his spending and tax plans state that he would increase the deficit by about $280 billion per year by the end of his first term. And this assumes Iraq spending comes to an end, and includes a very generous estimate of what his health care policies will cost; his campaign vaguely argues it can find unspecified $93 billion per year in "health care savings" within the existing budget programs. To be fair, Sen. McCain's proposals would also increase the deficit by about $230 billion per year according to the same linked study.

But if one can get beyond all this reality, there remains the myth that Obama really would cut taxes for 95 percent of people. The Wall Street Journal has a pretty good article in today's paper explaining how most of these "tax cuts" are really just welfare payments. As the article explains:

For the Obama Democrats, a tax cut is no longer letting you keep more of what you earn. In their lexicon, a tax cut includes tens of billions of dollars in government handouts that are disguised by the phrase "tax credit."

The truth is that most of these "tax cuts" are due to creating a laundry list of "refundable" tax credits. What this means is that if you qualify for a credit worth x amount of money, put you pay less then that amount in taxes, the government refunds you the additional amount in excess of your taxes. The result is that what is described as a tax cut is really just a welfare payment via the tax code. Realizing that the term "welfare" is not a good political starter, his campaign has disguised it as "tax cuts."

According to the the non-partisan Tax Foundation, under his plan, 44 percent of all tax filers would pay no income taxes (up from about 32% currently), with the bulk of these people receiving back more in their annual refund than what they paid in taxes. The result is a $647 billion increase in transfers via these credits over the next ten years to over $1 trillion, or 4 times more then what is currently transferred through "welfare."

Furthermore, these tax proposals have a major problem that conventional welfare programs also have, that being the welfare trap. This is the dynamic that occurs when people who are receiving payments are disincentivized from working more or harder to get off of welfare because doing so would cause the benefits one receives to phase out with more income. The result in that the policy increases the amount of poor and government dependents (or at least reduces income mobility). Similarly, because these tax credits phase out with greater income, the marginal effective rate of taxation on low income workers will become very high under Obama's plan as seen by the chart from the Wall Street Journal (keep in mind this is for only one scenario of tax credits). Why would a low income worker put additional effect in overtime for example, if 35 to 4o percent of that gain would be lost in income taxes and phasing out credits? And that is only the Federal Income Tax. That does not include payroll taxes or state and local taxes. The combined marginal rate would likely be closer to 45 to 55 percent.



Well, EJB, I have to say I'm a little disappointed in the subject of this post. Not because it involves economics (I am slowly learning to love the dismal science) but because you seem to disguise (or are ignorant of) the fact that this is not a WSJ piece. This information and research comes from the AEI, a noted conservative think tank (the authors are AEI "resident scholars"). Thus, I immediately am weary of the validity of its conclusions. However, as a court does when considering a motion for summary judgment, let's presume all facts and allegations to be true and proceed from there.

I will start by linking to these two pages, which I think are fair game, even though they're obviously Obama-campaign-run sites (since you opened the door by bringing in AEI articles). Each page contains various rebuttals and counter-availing considerations to the aforementioned article. Some arguments/considerations stand out, and I'll briefly highlight them below:

1) Let's be REALLY careful when we look at what this chart represents. I know you pointed this out already, but I'd like to reiterate: this involves marginal tax rates (not average tax rates) and it only involves a single, highly specific circumstance, i.e. a household with two wage-earners and two children, one in college and one getting child care. These somewhat drastic marginal rate differences would NOT show up in many other cases. And, as the WSJ article even points out, Obama's tax plan would actually increase the amount of money in pocket for low-income earners.

2) The idea in economics of bounded rationality. Bounded rationality theory simply notes that while most economic theories presume that humans are "hyperrational," there are all sorts of other concerns that make choosing the "rational" outcome infeasible. Bounded rationality's effects become even more noticeable and relevant in discussions of low-income earners. It's all well and good to argue that phasing out tax credits will increase marginal tax rates. Hypothetically, this will create a disincentive. But to then make the leap and claim that this disincentive will actually cause someone making less than $25k to reject a higher paying job is pure conjecture - and, I might add, blatantly counter-intuitive. There are absolutely no empirical studies to back up this theory. Plus, even if it were true, then the effect is ONLY important/magnified at the margins!

3) I won't go into much depth here, but there are plenty of philosophical problems with the "welfare trap" theory - to ground an entire argument on that idea is to build a house of cards. There are also proposed solutions to the "welfare trap" that Obama could then implement - for instance, a guaranteed minimum income or a negative income tax.

4) A public policy argument. Obviously, any tax cut for the middle or lower class will increase marginal tax rates (because they'll be phased out when you move up in tax brackets). So, if we're going to argue that tax cuts for the poor are bad, because it disincentivizes climbing the wealth ladder, is it then necessary to argue the contrary position (namely, that we must INCREASE the incentives for income mobility?) I'm not saying that this necessarily follows, but it seems like it could. This result would be highly problematic because it would involve one of two things, either: a) only cutting taxes for the extremely wealthy (may be a good way to incentivize people to earn more, as if they needed more incentive; but not a good way to increase government revenue); or b) increase taxes on the poor! Taxing poor people at a higher rate means they'll have all the incentive they'll need to get out there and work! In fact, let's just cut welfare altogether...the resulting increase in deaths and decay among the poverty-stricken will surely incentivize income mobility! No longer will anyone bask in the glory of being welfare-dependent. Which brings me to...

5) Lost in all this economic talk is the simple fact that Obama's plan would leave people at a given low level of income significantly better off.

And finally:
6) Marginal rate incentives are stressed entirely too much, especially when compared to effective rates, which have plenty of efficiency implications (considering that they describe what the private sector spends compared with the public sector). The chart itself, I believe, is rather meaningless.

EJB, I don't expect you to respond to each and every point and I don't actually disagree with the thesis of the original post. I have simply found and compiled any and all counter-arguments that I could find and submit them for your disapproval. Once again, I am playing out of my league, and I fully expect corrections that help me to see the errors of my post.


First off, the article linked IS from the Wall Street Journal; however, the chart that I posted (also from the WSJ) used data from AEI. But in this line of attack JSK comes very close to responding in ad hominem. He is attacking the messenger (AEI), not the message. But then after placing that out there for the readers, he covers himself by saying essentially that we should assume it is factual. It is true that AEI is a think tank with ideological leanings, but so are all of them; it still produces academic work where methods are disclosed and information is sourced. This is far different from most campaign sites that JSK suggests are similar. The link regarding the deficit estimates for example borrows heavily from work from the Brookings Institute and the Urban Institute, both left leaning think tanks, though I did not discriminate there. Furthermore, as JSK points out (and he makes note that I also mentioned it), the chart is for one scenario. However, if you read the linked article, one can easily put together a whole host of likely combinations of proposed credits that a "normal" family would qualify for, and the results will all be similar even if they vary by degree.

But now lets actually address some argument. My post basically had two parts following the discussion of the effect to the annual deficit. The first (and what the WSJ article focused on), was not an argument that these proposals would not have the direct effect of putting more money into lower income workers pockets. In fact, I think it is quite clear that I am saying it will do just that in that I am calling these proposals to be similar to welfare. The point of that discussion was not that it would or would not directly harm or benefit a poorer household, but that a huge growth in welfare programs is being disguised as "tax cuts." It would seem that JSK is making a counter to an argument that was not being made.

The second component is what JSK spends most of him time discussing. This is the notion of the "welfare trap" and the associated chart. Essentially the argument against this effect happening is that it ignores total income and that it is crazy to think that one would turn down a job advancement because of a large marginal rate. His argument that total income or total tax burden matters more then marginal rates with regards to behavior is a common one; however, it bucks the entire theory behind behavioral decision making. People make decisions on the margin; when the marginal benefit (or at least the perceived benifit) of performing an act exceeds the marginal cost (once again, the perceived) of performing it, one will engage in that act. This profound understanding came along in the 1870's in what would become called the Marginal Revolution . If you are interested in reading about the basic economics of this beyond what I put here, fell free to read the link (side note: I wonder if Marx, who like Smith based his thinking under the Labor Theory of Value would have had different reasoning had he lived 30 years later).

This marginal benefit/ marginal cost mechanism answers the classic Water/Diamond Paradox. That is why is water, which is essential to existence cost virtually nothing, but diamonds, which have virtually no practical purpose valued at such a high price?:

Human beings cannot even survive without water, whereas diamonds were in Smith's day mere ornamentation or engraving bits. Yet water had a very low price, and diamonds a very high price, by any normal measure. Marginalists explained that it is the marginal usefulness of any given quantity that determines its price, rather than the usefulness of a class or of a totality. For most people, water was sufficiently abundant that the loss or gain of a gallon would withdraw or add only some very minor use if any; whereas diamonds were in much more restricted supply, so that the lost or gained use would be much greater.

Similarly, when one is making the decision to work an additional amount, pursue a higher paying job, and so on, people base their decision not on the total income (price) that is received for their total labor, but rather the marginal benefit relative to the marginal cost of that additional action. It is true, as JSK states via Bounded Rationality, that people are not always making a calculated decision, but over time peoples actions through experience drift into this equilibrium. Think for a moment your decision to purchase a second hamburger after eating the first. You are not doing a detailed analysis of the marginal benefit to you in buying another, but through past experience, you know how fulfilling that second burger will likely be, and you make the marginal decision to stuff your self or not when you compare it in your mind to the cost of doing so.

I will give a historical example of the "welfare trap" due to the reduction of marginal benefits of working to support my case as well as a personal anecdotal example. The welfare reform of 1996 was explicitly enacted because the total amount of people on welfare, particularly people who didn't work at all, had been steadily increasing. This is because the program was completely based on meas testing where a family would receive cash and other benefits solely on their condition. So if an unemployed individual started working, then these benefits would phase out, and therefore the marginal benefit of working was greatly reduced. The 1996 reform in general, restricted access to welfare programs to able-boddied individuals who were not pursuing work or further education or training. The relative marginal benefit of working further increased with these reforms. As a paper by a fellow at the left leaning Brookings Institute stated (in case you still don't trust "right leaning" think tanks).

The 1996 reforms have been followed by a major decline in the welfare caseload, big increases in employment and earnings of single mothers, substantial increases in total income of families headed by mothers, and the biggest declines in child poverty since the 1960s.

Now as he points out, some of this improvement can be chalked up to strong economic growth in these years; however, there had been strong economic growth in the mid to late 80's as well and no such effect occurred, so it is pretty safe to say that at the very least a good portion of the improvement was due to these reforms.

Lastly, I bring attention to a personal example. During my last year of high school, i worked a considerable amount. When applying for federal student aide for college I learned that the way the formula worked was once a student surpassed a certain threshold in annual income (somewhere around $4000 thousand at the time if I remember correctly), each additional dollar earned translated into a 50 cent reduction in student aide for the year. Just like the phasing out tax credits that Obama proposes, I had a benefit phase out, which had the effect of raising my marginal "tax rate" to about 72 percent when all taxes were included. So what I did was quit my job two months early and I sat on my butt for the summer. It didn't matter that my total average tax rate for the year was much lower, because I had already made those decisions and it was the marginal rate that effected me at that point. I essentially was effected by the "welfare trap" where a social program benefit (student aide) disincentivized me from working further to benefit myself and in turn society. Marginal rates are important, and I didn't even understand anything about economics at that time in my life. :)