Illinois SURS Pension Reform: A Review Two Offsetting Critiques

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 20, 2013

Earlier this year, I co-authored a proposal with four colleagues to reform the Illinois State Universities Retirement System. My motivation for doing so was quite simple: the fiscal crisis facing the state of Illinois is very real, “doing nothing” is not an option, the politicians seemed to be making little headway on a solution, and the ideas that were under consideration appeared to be driven far more by ideology than by concern about good retirement policy and good fiscal policy.  Given that I have spent the past 15 years of my life developing academic, policy and practical expertise on issues related to retirement income security, I thought I owed it to Illinois taxpayers to make a serious attempt to bring some balanced, centrist thinking into the discussion.  My four co-authors brought exceptional expertise in areas of university administration, benefits design, state and local public finance, and other highly relevant topics.  Together, we proposed six specific reforms to the SURS system.

Our “Six Simple Steps” proposal was subsequently endorsed by the Presidents and Chancellors of all of the public universities in Illinois.  It has also received favorable feedback from many participants and retirees. Over the summer, our proposal gained serious political traction when the bicameral, bipartisan pension committee of the Illinois General Assembly began to treat it as a leading possibility for breaking through the political logjam that had stifled prior attempts at reform.

Now that our proposal – which is sometimes referred to by others as the “Universities Plan” or the “IGPA Plan” – has gained traction, the political knives are coming out on both sides of the ideological divide.  This is not surprising: under our proposal, faculty are being asked to contribute more, retirees are being asked to receive less, the universities are being asked to take on greater financial responsibility for future costs, and the state is being put on the hook for paying down the enormous unfunded liability.  There is plenty of pain to go around.

We did not cause the pain, of course.  The pain was caused by many generations Illinois General Assembly members who failed to behave with even a modicum of fiscal responsibility.  We are just asking legislators, participants, retirees and taxpayers to be honest about the severity of the problem and to take meaningful steps to stop the fiscal bleeding.  But, in a highly politicized environment, with billions of dollars at stake, I am not at all surprised that ideologues and interest groups are pulling out their knives and trying to cut down our proposal.

So allow me to let you in on a little secret – I don’t love our proposal either.  A few aspects of it leave a bad taste in my mouth, in the same way that some life-saving medicines do.  However, I honestly consider to be the best – by far – of a wide range of distasteful options.

Let’s be honest: If I lived in a state where the state government was not dysfunctional, where we did not have strictly binding constitutional constraints, and where we could draw up our pension system from a relatively clean slate, I would NOT design a system exactly like the one we are proposing.  Rather, I would commit the state to a credible funding path; I would raise the normal retirement age to be in line with Social Security; I would fully index benefits to inflation and, if needed, pay for it through downward adjustments to initial benefits; and I would align incentives by making the entities responsible for hiring decisions (e.g., the universities) also be responsible for paying the full benefit costs associated with those hiring decisions.  While I am dreaming, I would also require the state to use accounting rules that transparently communicated the real economic cost of pensions, rather than hiding the true costs behind intellectually flawed government accounting standards.  Then again, if I lived in such an ideal world, we probably would not be facing the worst pension funding crisis of any state in the nation, and our proposal would have been unnecessary in the first place.

But we, the residents of Illinois, do not live in such a world.  Rather, we live in a state where for many decades our political leaders have failed to make good on the state’s most basic financial obligations.  As a result, the time has come for us to take our fiscal medicine: everyone must make sacrifices.  Unfortunately, the very constitutional protections that were intended to protect retirees now prevent us from enacting the most sensible reforms (such as raising the retirement age, which nearly every serious analyst agrees is a good idea): instead, we are forced to use second-best policy tools (such as reducing COLAs) simply because they have a better chance of passing constitutional challenge.  And we live in a state where after several unproductive years of debate, various powerful politicians have made it crystal clear that certain types of reform are political “must haves” and others are “cannot haves,” a situation that further narrows the realm of politically feasible options.

With these and other painful realities in mind, my colleagues and I set out to design a plan that made the best of a truly terrible situation.  We settled on a plan that:

  1. Has a reasonable chance (although not guaranteed) of being deemed constitutional;
  2. Has a reasonable chance of being politically feasible (as demonstrated by the recent support the plan has received from the bicameral bipartisan pension commission);
  3. Will substantially improve the state’s long-term fiscal situation;
  4. Preserves a smaller defined benefit (DB) element to recognize that many public workers in Illinois are not in Social Security, but also creates a defined contribution (DC) account, in an attempt to balance the various strengths and weaknesses of the two types of plans and create a better system than the Tier II system in place for new employees;
  5. Improves the retirement security of new employees through more favorable vesting rules (that are also more closely aligned with private sector practice);
  6. Provides real – if imperfect – inflation protection by linking increases to the CPI, rather than providing an arbitrary annual nominal increase that leads to enormous fluctuations in retirees’ real standards of living;
  7. Substantially increases the likelihood that the state will begin to pay down the unfunded liability, both by reducing the state’s share of future costs and by providing the stakeholders with a legal right to enforce state funding;
  8. Appropriately aligns incentives so that universities bear the full cost of their hiring decisions;
  9. Suggests many other features that attempt to bring some rationality and transparency to a complex and opaque system (such as reducing the hidden subsidy provided via a financially inappropriately high Effective Rate of Interest);

In recent weeks, once it became clear our plan was gaining political traction, two different analyses came out criticizing our Six Step Plan.  There are two things to note about these criticisms:

First, neither critique provides a truly serious alternative that is politically, legally and fiscally realistic.

Second, the criticisms are striking in the extent to which they are mirror-images, taking precisely opposing views to one another.  The first of these critiques was offered by the Illinois Policy Institute.  They criticize our plan for preserving the DB system, not moving fully to a DC world, not eliminating COLAs, not saving enough money, and taking too long to phase in the changes.  The second of these critiques is by a researcher at University of Illinois at Chicago and the head of Keystone Research Center.  They criticize our plan for not preserving the DB system in its entirety, for suggesting the introduction of a DC element, for partially reducing COLAs, for asking the state to pay down the unfunded liability too quickly and for cutting benefits too much.  And, in an amazing feat of mental gymnastics, they also suggest that by reducing  spending the plan will somehow raise costs to the state.

To the extent we were trying to design a proposal in the “sensible center” of this debate, I will take these completely offsetting criticisms as confirmation that we are on the right track.

Here is a brief table summarizing how the two critiques often negate each other, in their own words (followed by my parenthetic and italicized remarks summarizing their view in my own words).

Our Proposal

Illinois Policy Institute

KeyStone Research

COLA: Switch from 3% automatic annual increase to 50% of CPI “The IGPA plan fails to achieve the savings necessary to reform Illinois’ pension system by only partially reducing cost-of-living adjustments, or COLAs”

(in other words, we should completely eliminate the COLA)

“It would undermine the retirement security of Illinois public‐sector retirees, and especially harm those who live a long retirement”

(in other words, we should make no changes to the COLA)

Hybrid DB/DC system for new employees “The IGPA plan takes reform in the wrong direction by maintaining the defined benefit pension system for current workers”

(in other words, we should totally eliminate the DB and have only a DC)

The plan would “be as bad as or worse than Tier 2 because of the

reduction in the defined benefit portion of the plan from a 2.2% multiplier to 1.5%.”  and “DC plans are less cost effective”

(In other words, we should totally preserve the existing DB and not have any DC)

Force the state to pay down the unfunded liability “this plan allows the pension systems and their members to take legal action to compel the state to make the pension payment. Pension guarantees similar to this plan prioritize pension payments above all other government services, jeopardizing funding for those who rely on it the most.”

(in other words, we should not provide additional tools to force states to pay down the unfunded liability)

“This could be coupled with extending the time

taken to get to 100% funding.”

(In other words, we should not actually reduce benefits, but simply stretch the payments over a longer period of time)

Reduces state’s overall cost as much or more than other proposals “Savings this small not only fail to solve the problem, but will also require lawmakers to revisit Illinois’ pension crisis again in just a few short years.”

(In other words, we simply did not slam workers and retirees enough)

“the Universities proposal could result in higher costs to taxpayers”

(In other words, even though they think we are cutting benefits too much, they falsely claim that somehow this risks increasing costs)

I can understand why those who advocate for the smallest possible government would be disappointed with a plan that does not squeeze out even more savings from the pockets of public sector workers.  I can also understand why some public sector workers and retirees would oppose any benefit reduction.  But such extreme views, while potentially useful for advocacy purposes, do not make for good public policy.  The above comparison make it self-evident that these two critiques are attempts to bolster opposing untenable positions: the Illinois Policy Institute would prefer that we decimate retirement security, and the KeyStone group naively acts as if we can solve this crisis without meaningful changes to benefits.  Supporters of both positions will be disappointed with any realistic proposal that actually solves Illinois’ pension problem while preserving retirement security of public workers.

You may not like our plan.  As I noted earlier, I am not in love with it either.  But I still think it is the best idea out there so far.  Very little in the Illinois Policy Institute or Keystone critiques alters my view with the exception of continuing the existing Self-Managed Plan as a voluntary option for some new employees, as suggested by the Illinois Policy Institute, although I do not think it is the best choice for the median employee.

I am totally open to the possibility that better ideas than ours may still be out there – and if either of these two groups (or any other group or individual) have substantive suggestions that are fiscally responsible AND politically feasible AND constitutional AND not unduly harmful to public employees, I would love to hear them.  So far, however, I continue to believe our Six Step proposal is the most serious proposal on the table.

 Prof. Jeffrey R. Brown, 8/19/2013

 (Author’s note: the opinions expressed here are those of the author – Prof. Jeffrey Brown – alone, and do not necessarily represent the views of any of my co-authors or the University of Illinois.)

Separate Accounts

Filed Under (Finance, U.S. Fiscal Policy) by Charles Kahn on Mar 8, 2013

That a large percentage of individuals in the US do not paying income tax is a matter of concern, and not just to conservatives.  There is an underlying  sense that the paying of taxes is a duty, an act of solidarity with the collective goals of a democratically constituted nation.  While fairness requires that those best able to do so provide more of the financial support for those collective goals, fairness also requires everyone provide a share, even if that share is small.

In fact, this decline in tax-paying is partly connected with one of the programs often argued to be the most effective at reduction of poverty–the earned income credit.  Under this program, recipients’ credits are often greater than the total taxes they would have paid.

Many of the features of the earned income credit are desirable from the point of view of economic theory. The program entails virtually no overhead costs for its running. Its relatively low marginal rates distort decisions less than many alternatives (such as a minimum wage or food stamps). It can be targeted fairly accurately to those it is intended for (the working poor with children).

From the point of view of the economist, there is no difference between having a program in which an individual receives $5,000 from the government and pays $500 in taxes, or a program which just nets it all out and pays the individual $4,500.  From the point of view of the voters, and possibly from the point of view of the recipient, there is a big difference between the two. 

Beside the moral, even quasi-religious, sense to this–that paying taxes imparts a dignity to the payer (like the “widow’s mite”; also compare the rabinnic teaching that the poor are also required to give charity), there is of course also an astute political sense to this: if government coffers are filled by “others,” there is no limit to what we demand of government; if they are filled by “us” then we weigh the costs versus the benefits.

We probably need a name for the psychological quirk that causes us to regard such two-way passage of moneys as different from a one-way passage of a net amount. I recommend the term “budgeting illusion” — the sense that when sums are arbitrarily divided into different accounts, the separate pots take on a reality of their own.

Budgeting illusion also lies behind some of the difficulties we have in dealing sensibly with social security. Ultimately the money goes into the government in whatever form–payroll tax, income tax, gasoline tax–and the money comes out in national defense, social security, highways.  There is no economic sense in which the dollars collected “for” one purpose are separable from the dollars collected “for” another. For social security recipients the fungibility is fortunate, since, in particular, the present value of most people’s social security contributions is not sufficient to pay for their benefits.  Nonetheless,  most taxpayers feel that the social security payments are “their” money and the benefits are “their” compensation for it.

Even if there is no economic distinction between different dollars, there is a political distinction: Having the social security’s trust fund in a separate pot allows the social security administration some political autonomy.  It enables SSA to pay benefits without resort to the Congress even in years when they are not bringing in enough revenue to cover their costs.  The system was intentionally set up this way, of course, to ensure that changes would be close to politically impossible.  But the problem that arises is just the flip side of the earned income credit problem: in each case our awareness of the magnitudes of the payments are altered when we separate or combine the different pots of funding. 


Schoolyard Sanctions

Filed Under (Finance, U.S. Fiscal Policy) by Charles Kahn on Feb 26, 2013

So now Congress is trying to get the European Central Bank to tighten up its restrictions on Euros that go indirectly to Iran through its Target payment system. (See for example this article in the Financial Times). The whole thing begins to sound a little like high school drama: The angry junior refuses to talk to her enemy, and also to anyone disloyal enough to talk to her enemy. Soon that’s not good enough; anyone who talks to someone who talks to her enemy is also on the hit list.  In the end, of course, her standards become so high that she ends up talking to no one but herself.

To be fair, the sanctions against Iran have been much more effective than a skeptical economist would have believed:  trade is much reduced–and what does get through is much more expensive, which, from the point of view of the economist was the real point anyway.  But over time, sanctions are of diminishing effectiveness, as the target learns to devise evasions, and as the countermeasures to the evasions begin to disrupt the lives of more and more third parties.

In their DC bubble, congressmen are likely to believe that the regulatory power of the US is absolute: To their way of thinking the European Central Bank should tighten its requirements because it is the right thing to do, but there is always the implicit threat of restrictions to Europeans’ use of the dollar payments system and resources. The only catch with the logic is that the dollar payment system is not the only one in town.  The Euro is already an important alternative, and the Chinese, while still waiting in the wings, are seriously considering the advantages they can reap from opening their payment and currency systems to the world.  Certainly, there is a way to go before the typical commercial transaction can be carried out as safely, cheaply and reliably through renminbi as through dollars, but American restrictions that hit non-combatants in the economic warfare with Iran can bring that day a lot closer.

Why Retirement Plan Tax Preferences are Not as Expensive as You Might Think

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Dec 13, 2012

Retirement plans such as the 401(k) receive favorable tax treatment under the U.S. income tax system.  Historically, this favorable tax treatment was provided to increase individual saving.  Recent research has called the efficacy of this approach into question, suggesting that individual saving rates may not be all that responsive to marginal tax rates.

Last week, I wrote about the danger of drawing the conclusion that tax incentives do not matter and that we should therefore look to eliminate the tax preference for retirement saving.  My focus was on the role that tax preferences play in providing an incentive for employers to offer plans, and to design them in a way that uses behavioral nudges to increase saving.

This week, I want to focus on a different aspect of this issue, the public discussion of which has been misleading – how much this tax preference costs the U.S. Treasury.  My contention is that the cost figures being bandied about (including my own use of the $100 billion figure in last week’s post) are substantially overstated.  The point of today’s post is to note that the amount of revenue that the government would receive by eliminating the preferential tax treatment for retirement saving would be much less than what it might appear.

To understand this, one must understand (1) how retirement plans are treated under U.S. tax law, (2) how the government actually accounts for the foregone revenue, and (3) how the government ought to account for the foregone revenue.  These are complex topics, but some simple exposition is sufficient for seeing the main point.

(1)   How are retirement plans treated under U.S. tax law?  In a nutshell, the income tax on retirement plan contributions is deferred, not eliminated.  This is an important distinction.  If I receive an additional $1000 in cash salary, and I am in a 35% tax bracket, I owe the government an additional $350 in taxes.  If, however, I receive this additional $1,000 in the form of a contribution to a 401(k) plan, I owe no taxes today.  However, I will owe taxes on the money when I withdraw it during retirement.  Of course, there is financial value to deferring my taxes (what we economists call tax free “inside build-up”), but it is not as if the initial contribution escapes the tax system entirely.

(2)   How does the government account for the foregone revenue?  The U.S. Department of Treasury and the Congressional Joint Committee on Taxation prepare annual estimates of what they label “tax expenditures.”  These tax expenditures are basically just an estimate of how much additional tax would be collected if a particular activity went from being untaxed to being taxed, assuming no behavioral response to the tax.  (As an aside, the fact that they do not account for a behavioral response is why they are careful to always note that “a tax expenditure estimate is not the same as a revenue estimate.”)  In the case of retirement plan contributions, they roughly calculate the amount of money being deferred, apply the relevant marginal tax rates to it, and obtain a rough estimate of how much revenue is not being collected as a result of this tax preference.  However, a key point is that they do not estimate this over the entire life of the account, but rather use an arbitrarily truncated time horizon to estimate the effects.

Going back to my simple example: suppose I contribute an additional $1,000 today to a 401(k) plan.  That saves me $350 in taxes today, and costs the government $350 in foregone revenue in the current tax year (assuming I would save the same amount either way).  So far, so good.  But suppose that I plan to pull the money out in 20 years.  I will pay income taxes on the amount I withdraw.  The present discounted value of the tax that I pay in 20 years will likely be less than $350, but it will be much greater than zero.  For the sake of example, suppose it is worth $150 in present value.  If so, then the net gain to me (and the net cost to government) over my lifetime is $200.  The problem is that the government does not use a present value method.  Instead, it looks at just the front end, and thus overstates the value of the deduction.

(3)   How should the government account for tax expenditures?  Ideally, the government would compute these tax expenditures using the “present value” concept just explained.  A number of experts have made this suggestion.  For example, a paper by the American Society of Pension Professionals and Actuaries (ASPPA) boldly states “tax expenditure estimates for retirement savings provisions should be prepared on a present-value basis” because this “would allow an ‘apples to apples’ comparison” with other tax deductions.

What does all this imply?  A paper written by two Treasury Department officials and published in the December 2011 National Tax Journal found that “the long-run NPV cost can be dramatically different if measured using relatively short time horizons.”  The calculations are a bit tricky because one must make assumptions about rates of return, the appropriate discount rate, current and future marginal tax rates, and so on.  And the extent to which estimates differ depends on the time horizon being examined.

But, these caveats aside, the ASPPA study concludes that “the present-value tax expenditure estimates of contributions made in the first five years are 55 percent lower than the JCT five-year estimates and 75 percent lower than the Treasury five-year estimates.”  That is a huge wedge.

How does all this matter for policy?  The fiscal cliff has DC policymakers scouring the four corners of the earth looking for ways to boost revenue without raising marginal tax rates.  One way to do this is to eliminate tax expenditures.  However, some of those tax expenditures exist for good economic reasons, and the provision of favorable tax treatment for retirement saving is one of them.

As noted last week, the elimination of this provision could have serious unintended consequences for the availability of retirement savings programs through employers.  Now add to that the fact that any revenue implications of such a policy change are substantially overstated and what you get is the potential for good intentions (closing the fiscal gap) to lead to bad policy.

Relevant Disclosures:  I serve as a trustee for TIAA, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.


Tax Subsides for 401(k)’s Work, But Not for the Reasons You May Think

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 30, 2012

Earlier this week, the New York Times Economix Blog wrote a piece “Study Questions Tax Breaks’ Effect on Retirement Savings.”  The article summarizes the findings of a fantastic research paper issued by the National Bureau of Economic Research (NBER).  A quick summary of the paper written by the authors themselves can be found here.  The short version is that the researchers used data from Denmark (where much better date is available) to provide evidence that tax subsidies have little effect on overall savings rates.

Their main finding is that “when individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts.  But the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. We estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.”

The policy implications of their finding are extremely important given the current debate about fiscal policy in the U.S.  After all, if tax subsidies for saving do not actually increase saving, then perhaps we should re-think the $100 billion per year that we forego in tax revenue by exempting retirement savings from the income tax base?  Such a conclusion would be quite tempting to politicians who are desperately seeking ways of raising revenue without raising tax rates.

But I say “not so fast.”  Although I do not disagree with the empirical findings of the study, I strongly disagree with the assertions being made by some that this finding justifies the elimination of the tax preference for 401(k) and other retirement vehicles.

The study itself is an outstanding intellectual contribution, and one that will likely (and deservedly) end up being published in a leading scholarly journal.  I can personally vouch for the high intelligence and research integrity of the two U.S. authors.  Raj Chetty was named a MacArthur “Genius” earlier this year, and is widely expected to be awarded the prestigious John Bates Clark medal sometime in the next 6-8 years.  John Friedman of Harvard is also an emerging research star in the economics profession.

So, the researchers are top notch, the study is extremely well done, and the conclusion is that tax subsidies do not generate net much net savings.  So, why not simply eliminate the tax preference for 401(k) plans in the U.S. and raise a trillion dollars of revenue over the next decade?

Because of the important role of plan sponsors, that is why.

For better or for worse, the employer plays a central role in the U.S. retirement system.  Although there are several reasons that employers offer retirement plans and other employee benefits (e.g., to differentially attract certain types of workers, to help manage retirement dates, to motivate workers, etc.), there is little question that the large tax subsidy  looms very large in their decision to use retirement plans – as opposed to other types of benefits – to achieve these outcomes.

To qualify for favorable tax treatment, employer provided retirement plans, including the 401(k), must meet a long list of “plan qualification requirements.”  These requirements are what provide Congress and regulators the ability to influence the design of retirement plans.

An important example is the set of “non-discrimination rules” designed to ensure broad-based participation in an employer’s plan.  These rules provide incentives for plan sponsors to find innovative ways of encouraging saving by their employees.  Indeed, it is not much of a stretch to suggest that these rules are the reason we have seen the widespread adoption over the years of employer matching contributions, automatic enrollment, automatic escalation of contributions, and numerous other innovations in the retirement plan space that have been shown to increase saving.

The authors themselves note that “automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower fiscal cost.”  I agree that behavioral nudges have had an enormous impact.  But in an employer based retirement plan system, the only way to get employers to offer those nudges is to provide them with a compelling financial reason to do so.  In essence, tax subsidies are the nudge for employers to provide the nudge for employees.

Of course, this does not necessarily mean that the existing system should be treated as sacrosanct.  It may be that employers would continue to offer 401(k)’s – along with their numerous savings nudges – if the financial incentive were provided in a less expensive way (e.g., by capping deductibility).  That is a debate we ought to have (hopefully informed by evidence of the same high quality as the NBER study).  My point is simply that any policy discussion should recognize the very important role that employers play as trusted sponsors of the plan, and be careful not to throw out the baby with the bathwater.

Indeed, given that only about half of US workers have opportunities to save through their current employer, we should be looking for ways to encourage more employers to sponsor plans.  If we go after the tax incentives for retirement saving, we must be careful not to inadvertently destroy the plan sponsor infrastructure that is the foundation of retirement security for millions of Americans.


Relevant Disclosures:  I am a Research Associate of the NBER (through which the study above was released) and Associate Director of the NBER Retirement Research Center (through which the authors have received some funding for their study).  I am also a trustee for TIAA CREF, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

The Third “Justification” for a Progressive Income Tax

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Aug 31, 2012

Here is the third in a series of blogs that I started on May 18.  The first was called “Why YOU may LIKE Government ‘Theft’”.  In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor.  The point is to think about whether the top personal marginal tax rate really should be higher or lower than currently, as currently debated these days in the newspapers.

However, perhaps we should also remember what is wrong with government using high marginal tax rates to take from the rich in order to help the poor.  The problem is that a higher personal marginal tax rate distorts individual behavior, particularly labor supply and savings behavior, by discouraging work effort and investment.  Since those are good for the economy, high marginal tax rates are bad for the economy!  In fact, economic theory suggests that the “deadweight loss” from taxation may increase roughly with the square of the tax rate.  In other words, doubling a tax rate (e.g. from 20% to 40%) would quadruple the excess burden of taxes – the extent to which the burden on taxpayers exceeds the revenue collected.

The point is just that we face tradeoffs.  Yes, we have four possible reasons that we as a society may want higher tax rates on the rich in order to provide a social safety net, but we also have significant costs of doing so.  Probably somewhere in the middle might help trade off those costs against the benefits, but it’s really a matter of personal choice when you vote: how much do you value a safety net for those less fortunate that yourself?  And how much do you value a more efficient tax system and economy?

In the first blog on May 18, I listed all four justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, then perhaps a different justification is more appealing.  In that blog, I put off the last three justifications and mostly just discussed the first one, namely, the arguments of “moral philosophy” for extra help to the poor.   As a matter of ethics, you might think it morally just or fair to help the poor starving masses.  That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).

In the second blog on July 13, I discussed the second justification.  Aside from that moral theorizing, suppose the poor are not deemed special at all: every individual receives the exact same weight, so we want to maximize the un-weighted sum of all individuals’ “utility”, as suggested by Jeremy Bentham, the “founding figure of modern utilitarianism.”  His philosophy is “the greatest happiness of the greatest number”.   Also suppose utility is not proportional to income, but is instead a curved function, with “declining marginal utility”.  If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person.  In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich to help the poor.

The point of THIS blog is a third justification, quite different in the sense that it does NOT require making anybody worse off (the rich) in order to make someone else better off (the poor).  It is a case where we might all have nearly the same income and same preferences, and yet we might all be better off with a tax system that has higher marginal tax rates on those with more income, and transfers to those with little or no income.  How?  Suppose we’re all roughly equally well off in the long run, or in terms of expectations, but that we all face a random element in our annual income.  Some fraction of us will have a small business that experiences a bad year once in a while, or become unemployed once in a while, or have a bad health event that requires us to stop work once in a while.  To protect ourselves against those kinds of bad outcomes, we might like to buy insurance, but private insurance companies might not be able to offer such insurance because of two important market failures:

  1. Because of “adverse selection”, the insurance company might get only the bad risks to sign up, those who are inherently more likely to become unemployed or to have a bad year.
  2. Because of “moral hazard”, insurance buyers might change their behavior and become unemployed on purpose, or work less and earn less.

With those kinds of market failure, the private market might fail altogether, and nobody is able to buy such insurance.  Yet, having such insurance can make us all better off, by protecting us from actual risk!

Potentially, if done properly, the government can help fix this market failure.  Unemployment insurance is one such attempt.  But the point here is just that a progressive income tax can also act implicitly and partially as just that kind of insurance:

In each “good” year, you are made to pay a “premium” in the form of higher marginal tax rates and tax burden.  Then, anytime you have a “bad” year such as losing your job or facing a difficult market for the product you sell, you get to receive from this implicit insurance plan by facing lower tax rates or even getting payments from the government (unemployment compensation, income tax credits, or even welfare payments).

I don’t mean that the entire U.S. tax system works that way; I only mean that it has some element of that kind of plan, and it might help make some people happier knowing they will be helped when times are tough.  But you can decide the importance of that argument for yourself.

Next week, the final of my four possible justifications for progressive taxation.

Paul Ryan’s Budget is Not Nearly as Radical as the Status Quo

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on Aug 15, 2012

I find myself bemused by the sheer number of commentators that have labeled vice presidential candidate Paul Ryan a “radical” because of his views on the federal budget.  His core view – that we ought to keep federal spending as a share of GDP at a level approximately equal to where it has been for the entire lifetimes of most Americans – strikes me as far less radical than the current policy status quo.

Let’s start with some basic facts.  In the post-war period in the U.S., federal spending has averaged just under 20 percent of GDP.  (You can confirm this for yourself by going to the White House OMB site and downloading Table 1.2).  There have clearly been some ups and downs over this period for a variety of reasons, but it has never exceeded a quarter of GDP except for 2009 – the depths of the Great Recession – when outlays reached 25.2% of GDP.

In other words, for 60 years – through military conflicts great and small, through booms and busts, through the creation and demise of countless government programs, and through tectonic shifts in the global economic landscape, the U.S. has found it possible to keep government at about 20% of GDP.  And throughout this period, the economic engine of the U.S. remained the envy of the world, even now in the aftermath of the Great Recession.

Absent substantial changes to our public policies, however, U.S. government spending as a share of GDP is projected to rise at an unprecedented rate.  According to the CBO’s “extended alternative fiscal scenario,” which they describe roughly as a continuation of current policies, spending as a share of GDP is projected rise to 35.7% of GDP in just the next 25 years.  This seems to me to be prima facie evidence that our future fiscal problems are being driven by rising spending, rather than a lack of revenue.

Given this, what sounds more radical?  Suggesting that we make cut the growth rate of spending to keep the ratio of government-to-GDP near historical levels, as Paul Ryan has suggested?  Or allowing government to grow from 20% to over 35% of GDP?

Google’s definition of radical is “affecting the fundamental nature of something.”  A failure to change policy course would affect the fundamental nature of the U.S. economy.  Now that is radical.

If we want to avoid this, then we need to re-think the role of government.  Most of the future projected growth of government is due to a rising health care costs and an aging population.  One cannot slow rising health care costs and population aging simply by cutting spending, as any serious student of the budget – of which I consider Paul Ryan to be one – already knows.  Nor is it obvious we really want to stop all those trends – at least some of the rise in health spending brings new health benefits, and most of us are quite happy to live longer.

What we can do is recognize that our programs need to change with the times.  Remaining life expectancy today, conditional on reaching age 62, is about 50% longer than it was in the 1960s.  Yet we continue to encourage people to exit the labor force early.  Even worse, we have created a mentality where most Americans seem to believe that they have a God-given right to have their retirement income and health care expenses paid for by taxpayers after they reach age 62 or 65.  At a minimum, we should recognize that if people are living both longer and healthier lives than they were in decades past, we ought to make them wait longer to start receiving benefits.

There are good reasons to have Social Security and Medicare.  But we need to recognize that the fiscal burden they are placing on taxpayers is going to grow rapidly in the years to come, and that the best way forward is to reform them to make them sustainable for future generations.  Paying for these rapid cost increases through an inefficient tax system that depresses investment, discourages entrepreneurship, penalizes work, and retards economic growth is the real “radical” solution – and the one that should work hard to avoid.

Energy and Environmental Policies are All Interrelated

Filed Under (Environmental Policy, Finance, U.S. Fiscal Policy) by Don Fullerton on Aug 3, 2012

Recent debate at the state and national level has focused on whether to enact a climate policy to control greenhouse gas emissions such as carbon dioxide.  The fact is, however, that we already have policies that affect such emissions, whether we like it or not.  Such policies can be coordinated and rational, or they can be piecemeal, inconsistent, and counter-productive.  Almost any policy designed to improve energy security, for example, would likely affect oil prices and energy efficiency, just as any policy to encourage alternative fuels would also affect energy security, electricity prices, consumer welfare, and health!  Here is a guide for thinking about how some of these policies work, and which combinations might work better than others.

The most obvious existing policy that affects carbon dioxide emissions is the gasoline tax that applies both at state and federal levels.  If that tax encourages less driving and more fuel-efficient cars, then it also impacts urban smog and global warming as well as protecting us from the whims of oil-rich nations with unstable governments.   In fact, with respect to the price at the pump, a tax on emissions would look a lot like a tax on gasoline, and vice versa.  Averaged over all state and federal taxes, the U.S. gasoline tax is about $0.39 per gallon, far less than around the rest of the world.  Most countries in the OECD have a tax over $2/gallon.

For the most part, the U.S. has chosen to avoid tax approaches to energy and environmental policy and instead uses various mandates, standards, and subsidies.   Cars sold in the U.S. are required to meet emission-per-mile standards for most local and regional pollutants like fine particles, sulfur dioxide (SO2), nitrous oxides (NOX), and volatile organic compounds (VOC) that contribute to ozone smog.  Those rules make cars more expensive but have successfully cleaned the air in major cities and around the country.  They also have the side effect of reducing greenhouse gases.  Another mandate is the “Corporate Average Fuel Economy” (CAFE) standards that require each auto manufacturing company to meet a minimum for the average miles-per-gallon of their fleet of cars sold each year.  For each big gas-guzzler they sell, the company needs to sell more small fuel-efficient cars to bring the average back down.  To meet this standard, every car company must raise the price of their gas guzzlers (to sell fewer of them) and reduce the price of their small fuel-efficient cars (to sell more of them).  The effect is the same as having a tax on big cars and subsidy on small cars.

These energy and environmental policies are also intricately related to other tax policies, as well as government spending!  For any chosen size of government and overall tax bite, any dollar not collected in gasoline tax is another dollar that must instead be collected from payroll taxes, income taxes, corporate profits tax, or state and local sales tax.  When looked at through that lens, gasoline taxes may not be that bad – or at least not as bad as some of those other taxes we must pay instead. 

Every state and local government is also worried about the pricing of electricity by huge electric companies that might naturally have monopoly power over their customers.  Production efficiency requires a large plant, so a small remote town might be served only by one power company (with no competition from neighbors far away, since too much power is lost during transmission).  So the public utility wants to regulate electricity prices, perhaps with block pricing that helps ensure adequate provision to low-income families.   Yet the pricing of electricity inevitably affects electricity use, which affects coal use, urban smog, and greenhouse gas emissions.  These policies are intricately related.

And these policies are related to government spending, since they affect car and gasoline purchases and therefore required spending on roads and highways as well as train tracks and mass transit in cities.  These environmental and energy policies affect human health, and therefore health spending by government – as necessary to pay for additional illness caused by emissions from cars, power plants, and heat from burning fossil fuel. 

We have no way to avoid these inter-connections.  You are a consumer who wants lower gas taxes and electricity prices, but you also own part of the power company and auto manufacturers through your mutual fund or pension plan.  You pay other taxes on income and purchases, and you breathe the air, so you are affected by emissions and need health care.  We might as well think holistically and act for the good of everybody, because we are everybody!

Tour de LIBOR

Filed Under (Finance, U.S. Fiscal Policy) by Morton Lane on Jul 17, 2012

Anyone struggling to understand the LIBOR scandal could do worse than observe the way the Peloton behaves in this year’s Tour de France. All riders in the Peloton receive the same time at the end of the race. It’s like everyone getting the average rate in LIBOR rate benchmark setting. Furthermore it leads to the similar collusive behavior.

Sometimes the collusion is used to good, or at least gentlemanly, effect, such as waiting for Mark Cavendish and others who were victimized by the “tack” attack. At other times it negates the race by turning it into a rest period – a parade.

But presumably the Tour officials instituted the “same time” rule to avoid worse behavioral consequences – a scramble to the finish with attendant increased probability of crash and injury among bunched riders. Possibly it was originally also because of the difficulty of measuring individual times.

Analogous difficulties, rationales and discussions were present when the Chicago Mercantile Exchange introduced the Eurodollar futures contract in 1981. It was the first contract cash-settled to an index, LIBOR, rather than a deliverable deposit. The Exchange conducted its own standardized survey of banks for LIBOR settlement. The seemingly superior alternative, a deliverable instrument, was exposed to have its own problems when the failure of Continental Bank and the delivery of its certificate of deposit caused the failure of the domestic CD futures contract in 1984.

The BBA formalized its LIBOR calculation in 1985 in part because of the success of the Eurodollar contract itself. The exchange switched from CME calculated LIBOR to the BBA LIBOR for settlement purposes after 1997.

No doubt it is time to improve BBA the calculation. It has been gamed and gamers should suffer the consequences – that includes the calculation agent.

However, when there is an illiquid market, or when a market becomes illiquid, there are pluses and minuses to index settlement or transactional delivery. There are almost certainly better ways to provide a benchmark, but it remains the case that there is no perfect way. When changes are made or suggested lets game them in advance to anticipate behaviors. Radical changes may precipitate even worse practices.

No doubt the Tour de France officials feel the same way about the Peloton time calculation.

The Second “Justification” for a Progressive Income Tax

Filed Under (Other Topics, U.S. Fiscal Policy) by Don Fullerton on Jul 13, 2012

Way back on May 18, I wrote a blog called “Why YOU may LIKE Government ‘Theft’”.  In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor.  This combination of economics and philosophy is meant to help each of us think about what really should be the top personal marginal tax rate: should it be higher or lower than currently?  This topic is hotly debated these days in the newspapers!

In that blog, I listed all four justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, then perhaps a different justification is more appealing.  I put off the last three justifications to later blogs and mostly just discussed the first one, namely, that some “ethicists” in the field of “moral philosophy” have found ethical justifications for extra help to the poor.  The moral justification may be the most common or usual one; you might think it morally just or fair to help the poor starving masses.  That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).

But that’s not the only reason to have some degree of progressivity in our income tax system (taking higher percentages of income from those with more income).  The second justification basically says okay, let’s skip the moral theorizing.  Instead, suppose the poor are not deemed special at all.  Suppose that ALL individuals receive the exact same weight.  Suppose the objective is to maximize the un-weighted sum of all individuals’ wellbeing (or what we call “utility”).  Actually, this is perhaps the view of Jeremy Bentham, who came to be considered the “founding figure of modern utilitarianism.”  His philosophy is “the greatest happiness of the greatest number”.  That is, just add up all individual utilities, without weights, and maximize that sum.

So far, that might sound like no justification for taking from the rich to give to the poor.  However, we did not say just add up their incomes, or to maximize total GNP.   Instead, one might also believe that utility is not proportional to income, but is instead a curved function, as in the diagram below.  In other words, “declining marginal utility”.  If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person.  In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor.

The only remaining question is the degree of curvature, or the rate at which marginal utility declines.  If it is a nearly straight line, then we might not want much redistribution.  But if it has a lot of curvature, then the sum of utilities could be maximized by taking more from the rich than we do currently.

So, what do you think?  I invite your comments.