Interpreting the Fed

My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:

I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dicates.

In my estimation, the pre-crisis TR is something like the following for the real interest rate r:

r = 2.0 - (1.5)(u-u*) + (0.5)(pi-2.0).

Let’s say u* is still 5.0. Then if u=6.5 and pi=2.5, the TR says r = 0, which implies the nominal interest rate is i = 2.5. Yet the Fed says that i will still be zero!

Some argue that u* has risen above 5.0. That would raise the i implied by the TR, strengthening the conclusion that the Fed’s new rule is more dovish than the TR.

Some argue that r* [the constant term in the TR] has fallen from 2.0 to 1.0. I doubt it, but even with that change, the TR still implies i = 1.5. My conclusion about dovishness is robust.

This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. I believe the numbers for 2003 are roughly u=6.0, u*=5.0, and pi=1.0. For the TR shown above, the 2003 numbers imply r =0 and i=1.0, which is about the same as the actual i.

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

Option C

In the negotiations over the fiscal cliff, many people think the House Republicans are in a tough spot.  The logic is that they have little leverage, because they face only two choices:

A. Concede to most of the president's demands.
B. Take the economy over the cliff, and get blamed for it.

As a result, the logic goes, they will end up doing A, because B is so much worse.

Keith Hennessey points out that there is also option C: Extend the tax cuts, except at the top, for one year. Apparently (and I was not aware of this), Senate Democrats passed a bill doing exactly this back in July.  If the House passes it now, it goes to the President's desk, and he would have a hard time vetoing it.

This is not great policy, as it sets up another fiscal cliff one year from now, and it does not address all the spending cuts that are part of the fiscal cliff.  But from the Republicans' point of view, it may be better than either A or B.  Keith argues that the ability of Speaker Boehner to fall back on this option should give him more bargaining power as he negotiates with the president.  That is, because the president won't like option C either, the possibility that it could occur may make him more willing to compromise.  From the president's perspective, it is better to make concessions today than having to do this whole fiscal-cliff thing again a year from now.

The Poverty Trap in France

From Forbes:

Let’s take an unemployed mother living alone with two children between six and 10 years old. In 2010, there were 284,445 French families in this situation that were on welfare.

This mother will be given the “Active Solidarity Income.” Since she has two children, the amount will be $1,100. If she is renting an apartment with a $650 rent, she will be given the “Housing Customized Aid,” amounting to $620. Then she will receive “Family Allowances,” which amounts to another $160. Finally, let’s add the payment known as “Allowance for the start of the school year,” which is $750 once a year, or $62.50 per month. (She might even benefit from other aids, but these are the most common.) She will be given a total of $1,942.50 per month.

Now imagine that this mother has found work and will be paid the “legal minimum wage,” which amounts to $1,820 gross—or $1,430 after taxes. Since she would be earning $1,430, she will no longer receive the “Active Solidarity income.” Her “Housing Customized Aid” will be lowered to $460, but she will still be given “Family Allowances” and the “Allowance for the start of the school year.” Therefore, her total income will amount to $2,112.50....

For this mother of two, working again will bring her family an additional income of only $170. Moreover, this $170 is likely to be lost in the cost of transportation to work, since the cost of gas in France is $7 per gallon. In any case, such a small amount of money is not an incentive to go back to work. Between staying home and working, the choice is simple: welfare is a better deal.

Make Your Own Deficit-Reduction Plan

The Wall Street Journal's interactive graphic lets you choose from a menu of options.

She's German. He's Greek. It's Christmas.

Click here for the previous installment.

Fiscal Cliff Fact of the Day

As reported in the NY Times:

Even if Republicans were to agree to Mr. Obama’s core demand — that the top marginal income rates return to the Clinton-era levels of 36 percent and 39.6 percent after Dec. 31, rather than stay at the Bush-era rates of 33 percent and 35 percent — the additional revenue would be only about a quarter of the $1.6 trillion that Mr. Obama wants to collect over 10 years.

This Debuted at the Harvard Holiday Party

Deck the Halls

Not quite fair to Keynesianism, but fun nonetheless:

An Unfortunate Broken Promise

Back in 2008, when President Obama was running for his first term, he promised to be a post-partisan leader.  While a Democrat, he said he would accept good ideas when they came from Republicans.  At the time, I believed him, at least to some degree.  And I wrote about it in this NY Times column.

Sadly, I was wrong.  The short version of the story is this: As a candidate, President Obama campaigned on a platform of raising taxes on the rich.  Yet he and his economic advisers also said they wanted to raise dividend taxes only slightly, from 15 to 20 percent.  For reasons I explained in the Times article, keeping dividend taxes low was a position bolstered by good economics. Now, however, the president wants to raise dividend taxes to ordinary income tax rates (plus, for high-income taxpayers, the new tax of 3.8 percent that is part of the Obamacare legislation).

To put it another way, he campaigned as a moderate, willing to concede that the other party had some good ideas on tax policy.  Once in office, he gave up on those ideas.

A similar thing happened with Bowles-Simpson.  During his first term, he appointed a bipartisan panel, which concluded we could address our long-term fiscal problem with lower tax rates and a broader tax base.  Now, the President goes around the country lambasting that approach.

Reasonable people can disagree about whether President Obama is a good or bad president.  But the claim that he has tried to transcend partisanship and find a middle ground is just impossible to square with the facts.

A Reading for the Pigou Club

From The New Yorker.  One disappointing quotation:

"We would never propose a carbon tax, and have no intention of proposing one," [White House spokesman Jay] Carney told reporters.

Some Advice on Tax Planning

I don't normally give advice on personal finances, but in light of the fiscal situation we are facing, I will pass along one tidbit.  Consider converting some of your retirement savings into a Roth IRA. Over the past few years, I have converted all that I can, which is about half of my retirement savings. 

To make the best of a Roth conversion, you need liquid assets outside of retirement accounts to pay the resulting tax liability.  But if you can do this, you will shelter more of your savings from capital taxation, and you will avoid required minimum distributions when you turn 70 1/2, which means tax-free accumulation for a longer period of time.

To read more about this option, click here.

Why the President is Not So Keen on Just Limiting Deductions

From the White House blog.  Bottom line: If you apply a $25,000 deduction cap only to households with income above $250K, phase in the cap gradually as income rises above $250K, and exclude charitible giving from the cap, you increase revenue by only $450 billion over ten years.

The Gray Lady's Misleading Headline

Over my coffee this morning, I read the following headline on the front page of The New York Times: "Complaints Aside, Most Face Lower Tax Burden Than in the Reagan ’80s."  Below it was a graphic comparing average tax rates for various income groups in 1980 and 2010.

The problem is that Reagan did not become president until January 1981, and his tax policy was not fully implemented until a couple of years later (and arguably not until his second term, when we got very significant tax reform).  So the headline should have read, "Complaints Aside, Most Face Lower Tax Burden Than in Carter's 1980."  That makes the story very different, as 1980 was the year the incumbent Carter was defeated by the challenger Reagan, who was proposing significant tax reduction as a key part of his campaign.

By the way, the online version of The Times omits the mention of Reagan in the headline.  There, the headline is the more accurate "Complaints Aside, Most Face Lower Tax Burden Than in 1980."

Addendum: Using the Times online interactive graphic, you can compare the average tax rates between any two years.  Here, by income level, is how the average tax rate changed from 1988, Reagan's last year in office, to 2010, the most recent year available.

0 to 25K, fell by 4 percentage points
25 to 50K, fell by 3 percentage points
50 to 75K, fell by 2 percentage points
75 to 100K, fell by 2 percentage point
100 to 125K, fell by 1 percentage point
125 to 150K, fell by 1 percentage point
150 to 200K, unchanged
200 to 350K, rose by 2 percentage point
350K+, rose by 1 percentage point

That is, according to the Times numbers, since Reagan left office, tax rates have risen at the top and fallen for the middle class and especially the poor.

Quick Movie Reviews

Over the last week, I saw two of the movies that critics have been raving about: Lincoln and Argo.  Lincoln was okay but a bit disappointing compared to expectations.  It is too hagiographic for my taste.  Argo was great.

The Coming Tax Hikes

Donald Marron of the Urban-Brookings Tax Policy Center explains the tax increases that are part of the upcoming fiscal cliff.

Dividing Household Chores

Advice from economist Emily Oster.  A good reading to assign when teaching the theory of comparative advantage.

Michael Sandel and His Critics

My Harvard colleague Michael Sandel has been getting a lot of attention lately with his book What Money Can't Buy: The Moral Limits of Markets. To get a flavor of the debate, read

1. A short essay by Michael Sandel.
2. A review of his book by economic historian Deirdre McCloskey.
3. A commentary from erstwhile ec 10 sectionleader Jodi Beggs.
4. A review by Chicago's Raghu Rajan.

A Master of Tax Avoidance

Warren Buffett has an op-ed in today's NY Times on one of his most popular themes: The rich should pay more in taxes.  At first blush, his position seems noble: A rich guy says that people like him should pay more to support the commonweal.  But on closer examination, one realizes that Mr Buffett never mentions doing anything to eliminate the tax-avoidance strategies that he uses most aggressively.  In particular:

1. His company Berkshire Hathaway never pays a dividend but instead retains all earnings.  So the return on this investment is entirely in the form of capital gains.  By not paying dividends, he saves his investors (including himself) from having to immediately pay income tax on this income.

2. Mr Buffett is a long-term investor, so he rarely sells and realizes a capital gain.  His unrealized capital gains are untaxed.

3. He is giving away much of his wealth to charity.  He gets a deduction at the full market value of the stock he donates, most of which is unrealized (and therefore untaxed) capital gains.

4. When he dies, his heirs will get a stepped-up basis.  The income tax will never collect any revenue from the substantial unrealized capital gains he has been accumulating.

To be sure, there are pros and cons of changing the provisions of the tax code of which Mr Buffett takes advantage. Tax policy always involves difficult tradeoffs.  But it seems odd to me that whenever Mr Buffett talks about taxing the rich more, the "loopholes" that he uses never seem to enter into the conversation.

Solow on Hayek and Friedman

From The New Republic.

Slugging It Out, Inside Obama’s Mind

Click here to read my column in Sunday's NY Times.

Response to Diamond and Saez

In a widely discussed recent paper, Peter Diamond and Emmanuel Saez have suggested that the top tax rate should be very high--about 73 percent.  Tax Notes has a new commentary on their conclusion.