Compared to an ideal tax code, it’s awful.
Compared to the pre-existing tax code, it’s a vast improvement.
Compared to my expectations going in, it’s a pleasant surprise. It required some real political courage to pass this thing, and political courage always surprises me. There’s also a lot of good sense in it, which sometimes surprises me even more.
Compared to what I suspect we could have had, if only that same good sense and political courage had been harnessed by a president who was capable of understanding the bill’s content, participating in its formulation, and selling it to the public, it’s something of a disappointment.
Scott Sumner does a superb job of summarizing the good, the bad and the neutral. Instead of quoting him extensively, I’ll (strongly) encourage you to go read the original. A few additional remarks:
1) Many of the things that Scott lists under “the good” are very good relative to the status quo but still very bad relative to the ideal. With an ideal tax code, we would not be applauding reductions in the estate tax or the corporate income tax, because there would be no such taxes. Nor would there be taxes on capital gains, interest, or dividend income, all of which are retained in the new bill.
2) Under “the bad”, Scott is absolutely right to list the retention of health insurance deductibility as a massive disappointment. Here’s one where I am inclined to think that a different president would have made all the difference. It’s hard for me to imagine that a President Bush or a President Cruz would have allowed this to sail through without even a fight.
3) Scott mentions the fact that fewer taxpayers will now be deducting mortgage interest, but omits the retention of the mortgage interest deduction from his lists of the good, the bad and the neutral (perphaps intentionally, perhaps by oversight). I’m of two minds on this one. If you believe, as I do, that interest income should not be taxed, and if you nevertheless feel compelled to tax interest income for the lender, then you should at least offset the damage by making all interest payments deductible for the borrower. The mortgage interest deduction does this for some interest payments (i.e. mortgage interest payments) but not all (i.e. interest on non-mortgage loans). Thus it eliminates one distortion (insofar as every tax on interest is a distortion) but introduces a new one (by making some interest-bearing investments taxfree but not others). Whether that’s on balance a good or a bad thing is unclear to me.
4) Scott calls attention to the fact that we’re going to learn a lot from the response to this bill, in particular with regard to how interstate tax differences affect interstate migration. My first thought on hearing about this bill was that I will now definitely leave New York State sooner than I’d planned to. It remains to be seen whether I, and many thousands of others, will follow through.
Under the bad list, number 7:
“Tax cut will cause the budget deficit to expand sharply—we’ll pay a price for this fiscal irresponsibility down the road.”
Hmm not sure I agree. Interest rates are low. Didn’t you argue in the past that deficits per se are not generally a problem in advanced countries like the USA? I almost feel like I remember you arguing that the national debt was a good deal since it’s so cheap.
Rather, it’s almost always the nature of the underlying spending that matters.
There is one passage in the Guardian coverage that raises questions we have dealt with here before often.
“The bill is also likely to provoke a rush to self-employment. The dramatic cuts in rates for corporations and partnerships will create a huge incentive for workers to set themselves up as small businesses. A two wage-earner couple with an income of $250,000 a year would see little change in their tax bill; a couple with the same income generated through a small business would see an $11,000 annual cut, according to the Tax Policy Center.”
This is people passing earned income as investment income, is it not? This is one reason why capital taxes should not be zero, despite the double taxation.
I agree with Steve 100% on the substance. I wouldn’t lay the imperfection of the bill at Trump’s feet, as even if he had pushed Steve’s perfect bill, it would have been mangled by Congressional Republicans, especially with the narrow majority they have in the Senate, which effectively gives veto power to any tiny group of 2 or 3 Senators. And I’m sure there is virtually no one in Congress who understands the economics of taxation much better than Trump, which is only to say that it’s the blind leading the blind.
Harold, the fact of the matter is that there are a myriad of gray areas people will likely try to exploit. For example, where I work, I’m an employee but I’m not paid hourly. I’m paid to get certain things done every month. They don’t care whether I do this at midnight or come in late. I can work remotely whenever. I could see myself in theory saying “guys, I’m going to be a 1099 contractor. Bill my S-Corp, and send the 1099 to my S-corp. I could probably get away with it, maybe.
#4 Josh. There are pros and cons, yes, to being an employee – holiday and sick pay etc. I am pointing out that taxing so called investment income at a lower rate encourages people to class earned income as investment income and avoid tax. If the tax is low enough it encourages even fairly normal employees to try to make the switch, as you point out.
“if you nevertheless feel compelled to tax interest income for the lender, then you should at least offset the damage by making all interest payments deductible for the borrower.”
What is the principle here? Does it extend to payments received by my local pub when I buy a beer, which, because they are taxed as income of the pub, should be dedictible to me?
Steve,
from your posts I understand that you take it as a given that raising the savings rate would raise economic growth, is that correct?
I’m sure that was true historically, but does that still hold?
Raising the savings rate lowers the natural interest rate.
Given that the natural interest rate appears to have dropped – a lot – and is hovering somewhere around zero (in real terms) – why would you want to lower it further?
We have a situation where businesses do not invest despite extremely cheap capital.
Is making capital even cheaper going to cause them to invest?
Has that worked in Japan?
Capital investments are on a diminishing return curve.
If the problem of the developing world is that marginal capital returns are durably close to zero (or negative, as in Japan), then making more capital available isn’t going to help.
In fact, it may make things worse, as pushing down the natural interest rate will render monetary policy powerless (absent helicopter money).
The working age population in Japan has gone into decline in the 1990s. The real natural interest in Japan has been negative ever since (absent constant massive government deficit spending).
The working age population in Europe has gone into decline 10 years ago (the decline is a lot slower than in Japan, thankfully).
In the US, the working age population is still growing, but much more slowly then in the past.
The result appears to be a greatly reduced demand for capital and consequently a greatly decreased natural interest rate. Pushing it down further doesn’t seem like a good idea.
The developed world has seen a secular shift in demographics that has never before happened in history.
This has brought us up against the zero-bound, where conventional economic wisdom is turned upside-down, and thrift is bad
I meant to say “developed world” not “developing world”….
”
If the problem of the developED world is that marginal capital returns are durably close to zero (or negative, as in Japan), then making more capital available isn’t going to help.”
Pat (#6): No, the principle does not extend to beer purchases.
Here is why:
A truly non-distortionary tax system would tax everything equally — including leisure. In principle, it is very difficult (and arguably would be very ill-advised, both politically and on grounds of fairness) to tax leisure. Given that, we must accept a tax system with some distortions. That means we have to accept taxes on things like beer.
The distortions we accept from a beer tax include these: People will drink less beer and they will also work less (because the ability to buy beer is one of the rewards for working, and the beer tax diminishes that rewward).
A tax on interest creates exactly the same distortions: When interest is taxed, people consume less and they also work less (because the ability to earn interest on one’s wages is one of the rewards for working). But the interest tax also piles on a completely new distortion: People will also save less (or, to put this another way, they will reduce their beer consumption by more in the future than in the present and reduce their work by more in the present than in the future). This extra distortion means that in order to raise a dollar in revenue, the government causes more economic damage than necessary — even accounting for the fact that if we’re going to have a practical tax system, we have to accept some damage.
If the government taxed only Michelob but no other beers, there would also be an unnecessary additional distortion — some Michelob lovers would switch to other brands to avoid the tax. In that case, there would be a reasonable argument for either eliminating this tax or (if that’s somehow impossible) making your Michelob tax payments tax-deductible. But in a world with a broad-based sales tax (so that all beer brands, and related beverages, are taxed equally) that argument doesn’t apply.
This is something I’ve blogged about often in the past. When it comes up again, I sometimes waver between re-explaining it to readers who have already seen it twenty times, or taking it for granted and confusing newcomers (or longtime readers who have either skipped, skimmed or forgotten those posts). For those newcomers, etc, I’m glad you asked this question and gave me a chance to (re-)explain.
“The distortions we accept from a beer tax include these: People will drink less beer and they will also work less (because the ability to buy beer is one of the rewards for working, and the beer tax diminishes that reward).”
There is the competition between the income effect and the substitution effect. Tax makes people poorer, so they have to work harder to maintain their income. Leisure is a normal good and you consume less of it when you are poorer (income effect).
However, as SL said above, tax also makes you work less because of the substitution effect
Whether we work more or less depends on which of these forces is greater.
However, Govt spending only works in one direction – to make us work less. If the govt gives you some sort of payment or subsidy out of tax you feel wealthier, so you work less. However the substitution effect still applies, making work look more expensive and leisure less expensive, so you work less.
If the government builds roads and teaches people to read, that makes them work less?
Are you sure that logic really applies outside of a purely mathematical model?
#11. No I am not sure. Direct payments or subsidies will presumably work that way, but infrastructure development will possibly work the other way. Anything that increases the options for people to do a wider variety of jobs that they find satisfying will presumably encourage people to work more.
If you teach someone to read they will certainly be more productive, but they might well work fewer hours.
“It required some real political courage to pass this thing, and political courage always surprises me.”
In the UK comedy Yes Minister it was described thus:
“[How to guide ministers to making the right decisions]
Sir Humphrey: If you want to be really sure that the Minister doesn’t accept it, you must say the decision is “courageous”.
Bernard: And that’s worse than “controversial”?
Sir Humphrey: Oh, yes! “Controversial” only means “this will lose you votes”. “Courageous” means “this will lose you the election”!
Steve #9 The interest income of the lender is taxed the same as the beer sales income of the pub (assuming they are both companies the lender is taxed on interest income less borrowing and other costs and the pub on beer sales revenue less costs – both at the company tax rate). So if there is a distortion imposed by the company tax it applies to both.
If the deduction for interest payments offsets a distortion, so should a deduction for beer purchases.
If we think about it in terms of commodity taxation, alcoholic beverages tend to be taxed more heavily than financial services, so to neutralise a distortion in relative taxation more favourable treatment might, on your principle, be given to the beer consumer. On the other hand it could be argued that because leisure is not taxed, we should tax beer more heavily because it is a complement to leisure. If this is accepted then the way to tax beer more heavily is to apply a higher rate of consumption tax or excise, not to deny a deduction for beer purchases as this would mot distinguish beer purchases from many other purchases that are also not deductible.
Pat (#14): Taking it as given that we can’t tax leisure, and taking it as given that the govt has to raise some revenue, an ideal tax system would tax beer but would not tax interest. A deduction for interest payments moves us closer to (the equivalent of) that system; a deduction for beer purchases moves us farther away.
Harold (#10): Be careful about invoking the income effect in tax efficiency discussions. Unlike the substitution effect, the income effect is not a distortion. Yes, wasteful govt spending will make me feel poorer and therefore make me want to work harder — but if I’m poorer, it’s *optimal* for me to work harder, so this is not something we’d want to offset with a countervailing policy.
By contrast, the substitution effect pushes me off my optimal work and consumption paths, so we’d like to use policy to minimize it if we can. And the substitution effect of an interest tax is more distortionary than the substitution effect of a consumption tax, so it’s the interest taxes you’d want to start with.
Steve #15: I think a better principle to apply here is that, if we are going to have an income tax, we have to measure income accurately, as mismeasurement creates its own distortions.
We want to measure net income, so we net off costs against revenues. The lender deducts borrowing costs and the publican deducts beer purchases in order to properly count their net income.
On the other hand, when I visit the pub and buy a beer, that shouldn’t be a deduction because the beer is not an input into an income earning activity.
In the case of mortgage interest, if I am earning rent from a geared property and that income is taxed, then clearly I should deduct the interest costs. If I am living in the property my imputed income is not taxed so the interest costs should not be deducted.
In any case whether I should be able to deduct the interest costs/beer is independent of whether the lender/pub is taxed on the payment received. It depends only on whether the deduction is necessary in order to accurately measure my net income subject to tax.
This is off topic but, how many times has Steve told us that a your vote will never be decisive?
https://www.nbcnews.com/politics/politics-news/tied-virginia-house-race-be-decided-drawing-name-out-bowl-n831856
Pat (#17):
In any case whether I should be able to deduct the interest costs/beer is independent of whether the lender/pub is taxed on the payment received.
!!! This, of course, can’t be correct. If, subject to whatever constraints we’ve decided we’re bound by, we’ve decided that the optimal tax on beer is 6%, and if you tax the seller 5%, then you want to tax the buyer 1% — but if you tax the seller 3%, then you want to tax the buyer 3%. So the correct statement is that “the amount I should be able to deduct $X$ varies one-for-one (but in the opposite direction) with the amount the seller is taxed on the payment received”.
(Edited to add: The key point is that discouraging sales of beer and discouraging purchases of beer amount to the same thing. Every sale that doesn’t take place corresponds to a purchase that doesn’t take place and vice versa — so it doesn’t make a bit of difference which you discourage. Therefore a penny tax on the seller and a penny tax on the buyer are interchangeable. If you want to tax beer, and you can’t tax the seller, you can tax the buyer. If you don’t want to tax beer but somehow must tax the seller, you can erase the effect of the tax by subsidizing the buyer. Et cetera.)
Ken B: I think what I’ve said is that your vote is extremely unlikely to be decisive and that therefore the time you spend voting is better spent otherwise. I’ve also said that lottery tickets are extremely unlikely to pay off and therefore you’re better off choosing some other investment. Are you tempted to post a comment observing that somebody recently won the lottery? :)
Steve
This is the SECOND time this has happened in Virginia, according to the article! You have to admit that long odds or not it’s pretty amusing.
And did you see this? https://www.clickondetroit.com/news/michigan-lottery-monroe-county-man-wins-4m-on-scratch-off-ticket
That’s just up the road from me! And I see a story like that every month.
Steve #19: A “deduction” is an income tax concept. Say we are in a world with no commodity taxation (ie no taxes on beer or financial services), but we still have an income tax. If I buy a beer I won’t get a deduction because my beer purchase is not part of an income earning activity. But the pub should be taxed on the payment it receives from me (net of costs, including its wholesale beer purchases).
If I borrowed the money to buy the beer, again I won’t get a deduction for the interest costs, but the lender will be taxed on the interest it receives from me.
But if I borrow money as part of an income earning activity, I should get a deduction (so that I measure my net income from that avtivity accurately).
The tax treatment of a lender is independent of the question of whether or not I should get a deduction for my interest expenses; this depends solely on whether my expenses need to be offset against income that is subject to tax.
Pat: I’ve already explained why you’re wrong. Repeating yourself won’t make you right.
Steve: we seem to have quite different frameworks for thinking about taxes.
Merry Christmas. I enjoy your blog.
Call it a feature/call it a bug, 500+ independent agents are never going to come up with an ideal bill, so you take what you can get. (That is the beauty of the benevolent dictator that is proffered The Armchair Economist.)
KenB (#18): I suspect that Steve is not telling us the whole voting story. I, too, find politics fascinating; I, too, acknowledge the futility of my vote; I, too, always participate in the process.
SL: ” If … we’ve decided that the optimal tax on beer is 6%, and if you
tax the seller 5%, then you want to tax the buyer 1% — but if you tax the
seller 3%, then you want to tax the buyer 3%.”
So, the principle is, from a macro viewpoint, a sale is a sale, or a dead
loss is a dead loss, and it doesn’t matter who pays how much.
Is that right think?
“The key point is that discouraging sales of beer and discouraging purchases of beer amount to the same thing. Every sale that doesn’t take place corresponds to a purchase that doesn’t take place and vice versa”
hmmmm… I see a problem here.
If the producer manufactures a bottle, unpurchased by the marginal buyer (due to
a tax), the bottle goes into the trash, expensively. Whereas, if the marginal
producer decides not to manufacture (due to tax), he saves a lot, and so
does society, considering use of resources.
Does economics account for this?
Josh #1 – I agree, what’s the big “price to be paid”? Seems clear “starving the beast” is the only way to restrain spending, the upside of the public perception of a deficit bogeyman. Worst case if tax cuts don’t generate anticipated growth, we have by definition the capacity to raise them again; we do it all the time. On the other hand deficits caused by “too much” spending consume real resources…at least I read that somewhere
Important not to confuse balanced budgets with “fiscal responsibility”.
I thought it was pretty well accepted that the mortgage deduction does not benefit homeowner borrowers, since it will just translate into higher housing prices. It benefits realtors and developers, which explains why the realtor lobby fought so hard against its reduction.
HH 28
People are charmed or strange. Everyone buys tops. The charmed receive a subsidy to defray part of their purchase of tops.
This looks to me like a transfer from the strange to the charmed. Everyone pays taxes, everyone buys tops.
You say, what about the top makers? I respond it must be sweet to be a top maker, but sweeter still to be a charmed top maker. Then I ask you if curing cancer would benefit only drug makers, or if patients might benefit too?
Ken B #29,
I am not sure what the abstraction adds. Who are the Strange in your example? Almost everyone with a home loan is able and willing to take the mortgage deduction. So it seems more like a transfer from non-Tops buyers to Tops-buyers. In the real, above-quantum world, not everyone buys homes.
Say I want to buy a house. My budget is $50k down with a $150 loan. I expect the rate to be 5% and pay about $800 a month. Interest is $625/month. Then Uncle Sam comes and says they will subsidize $125 towards my interest payments. Now I can borrow $173k on my budget, so the max I can pay goes from $200k to $223k. The same, relatively speaking, is true for all other buyers. You are better at math than me, so feel free to correct my assumption, but if given the same makeup in down-payment and loans across all buyers, my positional value would be the same. Given the constraints in the housing market, supply will not change in the short term. So I will pay $223k for the same house I was going to pay $200k for before the subsidy. That’s great for the seller and it’s great for the real estate agent, but I don’t see what difference it makes for me.
SL. “Be careful about invoking the income effect in tax efficiency discussions. Unlike the substitution effect, the income effect is not a distortion. Yes, wasteful govt spending will make me feel poorer and therefore make me want to work harder — but if I’m poorer, it’s *optimal* for me to work harder, so this is not something we’d want to offset with a countervailing policy.”
I have been pondering this. I don’t doubt you are right in the economic definition, but it seems wrong in one sense at least.
In the absence of tax, I consume X amount of leisure. In the presence of tax I consume less than X amount of leisure. How is that not a distortion?
It is said that a head tax is essentially non distortionary. Then I see that if we accept the tax as non-distortionary, we must say that decreased leisure is not a distortion. But does this stem from us excluding leisure from “goods”? It is outside the “economy”, so to speak, as we do not pay for it directly.
However, if we say leisure is a normal good for the purposes of discussing the income effect, then by this definition the head tax becomes distortionary.
So the clause “if leisure is a normal good” is perhaps key to this distinction. The income effect does not distort the money economy by shifting spending from one thing to another, but in the “time economy” (if there is such a thing) it does introduce a distortion.
So if we are considering the money economy, which is quite normal for economics, it is not a distortion. Is this a reasonable assessment, or am I barking up a wrong tree?
Harold:
By your definition, a bad harvest is distortionary, because it changes people’s diets.
But that’s not how we use the word. *Given* the bad harvest, there is an optimal combination of responses (presumably some decrease in consumption coupled with some increase in labor). A *distortion* refers to moving people away from this optimal combination of responses.
The government’s decision to take money from you so they can give money to me (or so they can finance an army or a park) is, from your point of view, no different from a bad harvest on your farm. There is an optimal set of responses. A *distortion* is anything that moves you away from that optimum. For a tax increase, optimally you would respond to the income effect but not the substitution effect. So the substitution effect counts as a distortion; the income effect doesn’t.
#32. Thanks for the reply and the bad harvest example is illuminating. There is a distinction between “distortion” and “bad”. We might wish to avoid tax (or a bad harvest) but that does make it distortionary (in the way we use the term).
@Henri Hein:
Only in a supply-constrained market, right?
In a state without much zoning and unlimited flat land (and unlimited sprawl), some/much/most of the subsidy from the deduction would accrue to homebuyers/people who build their own home.