HBC Testimony

Last week I testified about marginal tax rates at the U.S. House Budget Committee.

The video is here. This video may not be visible on mobile devices. For my testimony, jump ahead to 13:45 and jump again to 51:20.

The written testimony is here.

Flavors of Austerity and Stimulus

Copyright, The New York Times Company Fiscal austerity and fiscal stimulus can have a variety of effects on the economy, depending on the degree to which they redistribute income to high earners from low earners.

As national and state government debt levels have risen, governments are facing the fact that they must soon either default on their obligations, cut their spending, increase their revenue or some combination thereof.

Default is an intriguing option, but it rarely occurs on government debt, even when the alternatives are painful. That is because default sharply increases the cost of future borrowing, and possibly because creditors enjoy a lot of political influence.

That leaves tax increases and government spending cuts, or “fiscal austerity” as it is often called. Austerity seems to be the opposite of fiscal stimulus policies, the tax cuts and spending increases that governments sometimes carry out for the stated purpose of trying to expand the economy.

But economic theory and experience show that the growth effects of both austerity and stimulus depend on the form they take.

For brevity and simplicity, I focus on the employment effects of fiscal policies and partition the public in two groups: high earners and low earners. In this view, a total of four policy options (plus their combinations) might qualify as austerity, depending on whether taxes or spending are adjusted and whether those changes are experienced by the high earners or the low earners.

Both raising taxes on high earners and cutting subsidies — food stamps, for example — for low earners would qualify as austerity, but they have different employment effects.

The typical reason that people work is to have earnings – income from their jobs that they can use to support themselves and their families. This monetary reward is the difference between the resources a person has available if she works and what she has available if she doesn’t work. The better the government treats low earners, the less incentive people have to keep their earnings high.

Thus, both raising taxes on high earners and cutting subsidies for low earners would reduce the government deficit, but the former would reduce employment and the latter increase it. For the same reasons, raising subsidies and cutting taxes for low earners, as the 2009 American Recovery and Reinvestment Act did, would both add to deficit and reduce employment.

From this perspective it might appear that the best way for a government to put austerity into effect is by cutting subsidies and raising taxes for low earners, and the best way to carry out stimulus is by cutting taxes for high earners. But, of course, there is no free lunch. The same policies that increase the incentives to work also redistribute from those with low earnings to those with high earnings.

Thus, while the American Recovery and Reinvestment Act probably reduced employment, it deserves credit for giving resources to those in poverty.

The interplay of the social good of helping the poor and providing them incentives creates tough policy choices for governments looking to reduce their deficits. The more resources available to those living below the poverty line, the less incentive they have to raise their income above that line.

More research is needed to quantify work incentives in various countries, but I suspect that Western European nations have been pursuing exactly such redistributive austerity and will continue to do so, which means that they can expect austerity to depress their economies.

The Largest Marginal Tax Rate Ever?

Copyright, The New York Times Company In 2012, the Treasury Department began a new phase of its Home Affordable Modification Program, or HAMP. In doing so, it may have the distinction of putting into place the largest marginal income tax rate ever in a non-Communist country.

For home mortgage borrowers who appear to be headed for foreclosure, mortgage programs typically recommend a revised mortgage payment amount that is lower than the payment specified in the original mortgage contract. The new payment is set in proportion to the borrower’s income at the time of the modification.

The more the borrower is earning at the time of the modification, the more she will be required to pay her lender over several years. Typically, each additional $100 a borrower is earning (on an annual basis) at the time of the modification adds $31 to the annual amount of the mortgage payment recommended by the Treasury’s mortgage modification guidelines. (This modification is not revisited over time; the income is examined one time and payments set.)

The HAMP program, and its predecessor at the Federal Deposit Insurance Corporation, usually modified the mortgage payments by adjusting the loan interest rate over the subsequent five to seven years.

Thus, assuming a five-year modification time frame, each $100 earned at the time of the modification would add $155 to the borrower’s total mortgage payments, or about $130 in present value.

It is done this way with the intention of creating a monthly payment that is “affordable” (defined as 31 percent of income). But there’s a flip side to the argument: the disadvantage of higher earnings in calculating the resulting payment. To an economist looking at it that way, it’s the equivalent of a 130 percent marginal tax rate: a $130 payment differential solely as a consequence of earning an extra $100.

This year the Treasury decided to encourage changes in this procedure. In particular, it will now subsidize lenders for modifying mortgage principal balances rather than interest payments. Because the principal balance determines payments for the life of the loan, in effect Treasury is asking lenders to modify payments for the life of the loan and not just five to seven years.

Take a 30-year mortgage originated in 2006: it has 24 years left. Under the new rules, an extra $100 earned by the borrower at the time of modification costs her $31 a year for 24 years, which amounts to a total of about $390 in present value. That’s a 390 percent marginal tax rate that applies to borrowers who are having, or expect to have, their mortgage modified.

Economists agree that marginal income tax rates of 100 percent or more are destructive to the labor market and strongly encourage corruption. The best we can hope for is that people subject to such confiscatory marginal tax rates are and remain oblivious of the incentives that Treasury is presenting them.

Marginal tax rates in excess of 100 percent are also present in antipoverty programs, especially in what is known as the Medicaid notch, where an additional $1 of income can mean the complete loss of coverage. In a sense, the Medicaid notch is a marginal tax rate in the thousands of percent, because beneficiaries lose benefits valued in thousands of dollars as a consequence of earning an additional $1.

But while a few thousands of dollars are at stake with one family’s Medicaid coverage, tens of thousands, sometimes hundreds of thousands, are at stake in each mortgage modification transaction.

For this reason, I think Treasury officials have earned the award for largest marginal income tax rate ever. Let’s hope they are not in training to yet again break their record.

Income and Living Standards

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Perhaps the most important indicator in economics is the standard of living, often identified with “consumption”: the amount of consumer goods and services that people acquire. Despite a wealth of data on other economic subjects, our measurement of consumption is still rather primitive.

A recent study by my University of Chicago colleague Erik Hurst and Profs. Orazio Attanasio and Luigi Pistaferri attempts some repairs on the little consumption data we have, in order to get a better understanding of how living standards relate to income.

Economists believe that maintaining and enhancing one’s standard of living are among the most important motivators of economic behavior. A few people work purely for the sake of working, but many others work with the primary intention of providing for themselves and their families. A few people save purely for the joy of saving, but many others save so that they can maintain their living standard in the future, when they might be unemployed or retired. One criticism of the Soviet Union’s economic approach was that while it could create a vast military infrastructure it generated relatively little for consumers.

For these reasons, consumption may be a more important economic indicator than even gross domestic product, which is the total production in the economy.

Although much attention is accorded to the various monthly reports of United States consumer-spending statistics, we economists have surprisingly little information about the amount and nature of consumer spending. A large number of household surveys carefully measure family incomes and their various sources but offer little or no indication of how much those households spend.

One reflection of the lack of consumer spending data is that we know a lot more about the income situation of the poor than we know about what they are spending and what their standards of living are.

We also know a lot about how incomes have evolved over time, especially how less-skilled workers saw little growth in their earning power over the last several decades while skilled workers saw sharp increases in their incomes. These trends are sometimes described as growing wage or income “inequality” – that is, say, a growing gap between the wages of people above average and the wages of those below average.

Less is known about the equality or inequality of living standards, because there is less data on consumer spending by households. To make matters worse, some of the relatively little household spending data we have appears to be ill suited for measuring the amount of inequality in living standards and how it has changed over time.

Among other things, higher-income households appear to underreport their consumer spending relative to low-income households and to an increasing degree over time.

The study by Professors Hurst, Attanasio and Pistaferri tried to correct for these measurement challenges by looking at, among other things, the gaps between high- and low-income households in terms of their spending on entertainment and on food and in terms of the number of vehicles they own.

The results suggest that consumer-spending inequality has increased over the last 30 years, much like the well-known increases in wage and income inequality.

Has the 1996 Welfare Reform Been Reversed?

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Changes in food stamps and unemployment insurance have helped reverse the economic effects of the much-debated welfare reform law of 1996.

In previous posts I have showed how women who are heads of households and spouses have had different labor market experiences since 2007 depending on their marital status. Employment rates fell more for unmarried women, largely because they returned to work more slowly after layoffs than married women did.

I suggested that safety-net program expansions were an important reason for the different experiences of unmarried women, because they reduce the reward for working, especially among unmarried women.

The chart below puts these changes in a broad historical perspective. I used annual tables from the Bureau of Labor Statistics on employment among women by marital status for all women 16 and over (the tables are not separated for heads of households and spouses, as I did for my 2007-10 analysis).

Source: Bureau of Labor StatisticsEmployment rate of unmarried women relative to rate among married women, with percentage difference expressed in decimals. In 2010, for example, 49 percent of unmarried women were employed, compared with 57 percent of married women.

From 1980 through the mid-1990s, the fraction of unmarried women who worked increased less than the fraction of married women working, which is why the series shown in the chart declines over that time frame. Then, coincident with 1996 federal legislation reforming welfare, the trend sharply reversed itself.

Some main components of the 1996 welfare reform were to require that a significant fraction of welfare recipients be working and to limit the amount of time that households could receive welfare. (Welfare was called Aid for Dependent Children before the law, and Temporary Assistance for Needy Families since its enactment.) One intention of the reform was to give welfare participants more incentives to work and maintain their own living standards.

Economists expected that the reforms would increase work among unmarried women, who had been disproportionately represented among the welfare caseloads.

But as Rebecca M. Blank, now the deputy secretary of commerce, wrote in a review of welfare studies published in 2002 about the “stunning changes in behavior” she found: “Nobody of any political persuasion predicted or would have believed possible the magnitude of change that occurred in the behavior of low-income single-parent families” in the 1990s. Some of those changes were clearly consequences of the welfare rule changes.

Although the welfare program per se has not changed much since 2007, a number of safety-net programs have changed, and changed in the direction of significantly reducing the reward for working among unmarried women who are heads of households.

In this sense, the 1996 welfare reform was reversed over the last couple of years; while the 1996 law increased the reward for working, the recent expansions have reduced it.

The farm bill of 2002 began a gentle push in the direction of more help for the poor – and a lesser reward for work – as it provided for state-level expansions of the food stamp program, a program less affected than welfare was by the 1996 work requirements.

The more drastic changes occurred in 2008 and 2009 when the food stamp program was expanded again (twice), and unemployment insurance was expanded in several dimensions. It was at these times that unmarried women began again to lose ground to married women in terms of their propensities to be employed.

Policy experts still debate whether the 1996 welfare reforms were a good idea. For those who prefer an approach that offers more help to the poor even if it provides fewer incentives to work, the good news is that several pieces of legislation since 2007 have expanded the social safety net and effectively reversed the 1996 law.

Marital Status, the Safety Net and the Recession

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The expanding social safety net is part of the reason that unmarried women who are heads of household have gone back to work more slowly than married women have.

Last week I showed how employment rates fell significantly more during the recession for unmarried (and nonelderly) women who are heads of households than they did for married women.

The first chart below shows how this result is probably not attributable to sharply different layoff rates by marital status, because the number of unmarried women who were in their first month of unemployment, expressed as a ratio to the number of unmarried employed women, changed essentially in parallel with the number of married women in their first month of unemployment.

United States Census Bureau

What seems to be especially different between married and unmarried women is their propensity to be unemployed for long periods. The second chart shows the number of women in their seventh month of unemployment (that is, weeks 27-30). Unemployment this long increases much more among unmarried women.

United States Census Bureau

A similar chart could be drawn for the eighth month, the ninth month and so on. The point is that married and unmarried women enter unemployment at about the same rate, but unmarried women leave it more slowly.

A few readers who commented on last week’s post suggested that unmarried women experience more discrimination than married women do, and that’s why they are slower to return to work.

It would be nice to have more direct evidence on that hypothesis; for now, I note that this is the opposite kind of discrimination than what prevailed during the Great Depression, when married women were often prohibited from working while unmarried women were permitted to work.

Part of the difference in labor-market experiences has to do with the safety net. Many safety-net programs, like the Supplemental Nutrition Assistance Program, which provides food stamps, and Medicaid, base eligibility on family income.

A married woman (and her family) with a husband earning above the poverty line – the vast majority of husbands do so – is ineligible for a number of safety-net programs regardless of whether she’s employed, because her family’s income is above the poverty line regardless of her employment status.

Unmarried household heads, on the other hand, are usually the sole breadwinner for the family, and when their income falls to zero, the household income essentially does, too. For this reason, more unmarried women who are heads of households can expect anti-poverty programs to help them when they are out of work than married women can.

In other words, anti-poverty programs provide significantly more cushion for unmarried women than they do for married women.

An unintended but unavoidable consequence of providing someone a cushion when they are without work is that they are provided with less incentive to get back to work.

By definition, married women have husbands and unmarried women do not, and husbands can many times be a source of support. But husbands can provide more flexible support than government programs do. After all, husbands know their wives better than the government does and thereby do less to discourage women from getting back to work than government benefit rules do.

Note, too, that the safety net expanded during 2008 and 2009 in ways that were more accessible to unmarried women. The Supplemental Nutrition Assistance Program became more generous in a number of ways, and, as noted, it provides less cushion for the average married woman than it does for the average unmarried woman head of household.

For a time, the 2009 American Recovery and Reinvestment Act paid for 65 percent of the health insurance costs for unemployed people, but only if those people could not join a spouse’s health insurance plan. Thus, as the law’s health insurance subsidy appeared and then was phased out, it had different effects on the incentives to get back to work among unmarried people than it did among married people.

A great many unmarried women have been unable to find work through no fault of their own. At the same time, we know that the safety net affects the propensity of people to work.

Unless incentives suddenly stopped mattering during this recession, it appears that the expanding social safety net explains some of the excess nonemployment among unmarried women who are heads of households.

Marital Status and the Recession

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Job losses among women during the recent recession exhibit a curious pattern by marital status that is revealing about the importance of labor demand and supply factors.

During the 2008-9 recession, job losses were not equitably shared; employment rates fell more for some groups than others. Not surprisingly, employment changes varied by industry, with the greatest percentage job losses in residential construction and large job losses in manufacturing.

It is also well known that job losses were greater among men than among women – the so-called mancession – largely because men had been more likely to work in the residential construction and manufacturing industries that were hit hardest.

In this way, changes in the patterns of demand help explain why employment changes were different for men than for women. People stopped buying new houses, cars and other items that were disproportionately produced by men, and many times continued buying health care and education that were disproportionately produced by women.

The chart below displays quarterly employment rates separately for married women and unmarried women who were heads of households, both under age 65. Not surprisingly, the latter are somewhat more likely to work because they have no spouse to help provide for the family.

United States Census Bureau

More surprising is that employment rates fell so much more for these unmarried women who were heads of household. Employment per capita fell 4.7 percentage points among them, compared with 1.6 percentage points among married women. The job-loss gap associated with marital status turns out to be as large as the more widely recognized job loss gap associated with gender.

Neither group of women had many members working in construction, so the decline of construction cannot explain these differences. In fact, married women in 2007 were a bit more likely to be working in an industry that would decline thereafter.

An “added-worker effect” has been observed during a number of recessions: more married women worked during a recession than during an expansion because wives sometimes begin work to help replace the income lost by their unemployed husbands.

At first glance, this added-worker effect might seem to explain what is shown in the chart: perhaps married women were laid off at essentially the same rate as unmarried women, but offsetting those layoffs were the wives who started working when their husbands were laid off.

In this way, the added-worker hypothesis is a supply theory, one made possible by the changes in the composition of industry demand that created job losses for men.

But the added-worker effect is much too small to explain the sharply different job-loss rates by marital status. The employment rate among nonelderly married men fell 4 percentage points, to 83 percent from 87 percent. While that is a large decline by historical standards, it still means that roughly 95 percent of wives whose husbands were employed in 2007 had husbands who continued their employment during the recession.

Among the 5 percent of wives who were not so fortunate, roughly two-thirds of them had already been working before the recession and therefore could not react to their husband’s unemployment by starting work.

Estimates of the impact of the added-worker effect are that two or fewer wives who start working for every 100 husbands who become unemployed — and, by definition, none for every 100 husbands who continue to be employed.

The added-worker effect alone might explain why employment rates would fall a tenth of a percentage point more for unmarried women, but not the 3.1 percentage point gap that actually occurred.

Industry factors do not explain why the job market was different for married and unmarried women. Nor do age and schooling. Yet I think the relationship between marital status and job losses is revealing about other demand and supply factors, to which I will turn in next week’s post.

How Is the Payroll Tax Cut Doing?

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The payroll tax cut is having the expected labor market effects, but those effects will reverse themselves when the cuts inevitably expire.

Beginning in January 2011, the payroll tax withheld from employee paychecks was temporarily reduced to 4.2 percentage points from 6.2 percentage points. The cut was scheduled to expire at the end of 2011, but Congress has continued it through the end of 2012.

My calculations last year, based on the proposed cut of 3.1 percentage points, suggested that the payroll tax cut “could raise employment by at least a million, albeit the duration of job creation is related to how long the tax cut lasts.”

On a seasonally adjusted basis, payroll employment was 130.2 million at the end of 2010, just before the payroll tax cuts took effect. As of last month, payroll employment was up 2 percent, or 2.5 million, to 132.7 million. The household employment survey tells a similar story. Aggregate hours worked — the product of employment and the length of an average employee’s work — increased almost 3 percent.

Of course, the payroll tax cut was not the only factor affecting the economy since 2010. If nothing else, population growth would have increased employment by about 1.2 million over that time frame. In addition to the increase expected from population growth, payroll employment therefore increased by another 1.3 million since the time that the payroll tax cut went into effect.

During the same period, various parts of the federal government’s 2009 stimulus package expired and state and local governments were, on average, laying off employees. Housing prices also fell somewhat — more than 4 percent according to the Case-Shiller index. One point of view is that government and housing contraction tends to reduce total employment, which makes it even more remarkable that the net result of the payroll tax cut and these contractionary events was an employment increase beyond population growth.

Regardless of the source of the two and a half million new jobs, employment is still millions below where it would have been if employment had grown with population since 2007. But nobody promised that a mere two-percentage-point payroll tax cut would bring the economy back all by itself.

This minirecovery may not last, because the payroll tax cut will eventually expire. When that happens, the payroll tax rate increase by itself will tend to reduce employment by about a million, so that employment can increase further only if population or other sources of economic growth are enough to offset tax-cut expiration.

Career Concerns in Chicago

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Chicago has been in the news twice recently, once for being ranked as the most corrupt American city and this week for losing its opportunity to hold the Group of 8 economic summit meeting in May. The economics of the two events are related.

A study at the University of Illinois at Chicago and the University of Illinois Institute of Government and Public Affairs found that Chicago city officials, especially aldermen, were convicted by the federal government for corrupt activities while in office more often than officials in other cities.

It’s been decades since a Chicago mayor has been convicted of a crime while in office. But something has seemed different in that office too, because its holder had been named Richard Daley for 42 of the 56 years from 1955 to 2011 (first Richard J. Daley, then his son Richard M. Daley). It’s also been at least decades since a Chicago mayor sought a higher office.

A promotion tournament is one way that labor economists have suggested that people can be provided incentives to behave well in their jobs, be they in the private or public sector. The idea is that people have an extra reason to do their job well when they expect to be closely evaluated on the occasion of a promotion decision.

Promotions are sometimes a factor in political careers, too. Aldermen sometimes become mayors and mayors governors. Both George W. Bush and Bill Clinton were governors before being elected president. Officials are sometimes criticized for looking toward higher offices, but those aspirations might give them an extra reason to stay away from corruption, lest credible accusations of corruption mar their campaigns.

Many Chicago mayors have not been expected to pursue higher office. Richard J. Daley and Harold Washington died in office. Richard M. Daley retired, and Chicagoans do not expect him to run for governor, senator or president.

The current mayor, Rahm Emanuel, could be different. He is a prominent figure in the national Democratic Party. If, hypothetically, he were building a résumé for governor or another office, that could be good for Chicago. The better Chicago performs while he is mayor, the better his résumé will look.

Indeed, Mayor Emanuel has already involved himself in statewide, national and international interests. He was eager to play host to the G-8; although that was moved to Camp David, Chicago will be the site of a NATO meeting this year.

Mayors often concern themselves with the city’s public school system through high school. Mayor Emanuel has looked a bit presidential in tackling higher education, too.

Thus, while Chicagoans have wondered why their city should endure the hassle of G-8 and NATO meetings, perhaps they should appreciate having a mayor who might have “career concerns.”

The Safety Net Isn't Free

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Benefit payments by government safety net programs, like unemployment insurance, help the people who receive those payments. But government officials, politicians and journalists sometimes go another step and assert that everyone benefits when the poor and unemployed receive payments from the government, because that “puts money in the hands of consumers,” and consumer spending is said to stimulate employers to hire.

I explained last week that the “hands of the consumer” theory ignores the hands of the people who pay for safety net benefits. For example, because of the extra taxes needed to help pay for the unemployment insurance program, a taxpayer may no longer be able to afford to make an addition to his house.

Thus, while jobs will be needed to serve the unemployed people as they spend their benefit payment, there will be no need for the construction workers and others who would have helped with the taxpayer’s home project.

Dean Baker of the Center for Economic Policy and Research disagreed, in a post on the center’s Beat the Press blog, saying that, for now, unemployment insurance benefits do not cost us anything because they are not financed with current taxes:

At the point in a business cycle where large numbers of people are receiving benefits (like now) the U.I. system will be running a deficit. This allows unemployed workers to receive benefits, which they will overwhelmingly spend, without an offsetting current payment from other workers.

I agree that unemployment benefits and other safety net benefit payments are many times financed with taxes in the future or taxes in the past. But that “financing channel” still does not make the payments free from the perspective of today’s economy.

Suppose the government has been borrowing the money to pay for unemployment benefits. It borrows money by selling bonds. The purchasers of those bonds have less to spend on something else.

As I explained last week, government borrowing to pay for safety net benefits may increase consumer spending and reduce investment spending, because it does put money in the hands of consumers.

But that could either increase or reduce employers’ need to hire, depending on, among other things, whether the consumer goods purchased are more or less labor-intensive than investment goods not purchased (see last week’s discussion of liquidity considerations).

Last week I noted that I was holding constant the amount that safety net beneficiaries (“the poor”) work and earn, so that more safety net income for the poor means more total income for them, which permits them to spend more. But the safety net causes some beneficiaries, or their spouses, to work less.

Unless the safety net replaces all of the income lost from reduced work time – it typically does not – then the families who reduce their labor in response to the safety net expansion will spend less as a result of the safety net, and the amount less could be many times more than the amount that the safety net expanded.

Now the “hands of consumers” theory is turned on its head: at the same time that the poor spend most of whatever income they have on consumer items, the safety net’s redistribution reduces their total spending because it reduces their total family income.

Benefit payments by government safety net programs help the families who receive those payments. But it is inaccurate to ignore that fact that those payments hurt the rest of us.