Archive for the 'Taxes' Category

Greg Mankiw explains:

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail.  The bailouts of the past will surely lead people to expect bailouts in the future.  Bailouts are a specific type of subsidy–a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency.  In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.

You may recall that I made precisely this argument regarding Fannie Mae and Freddie Mac some years ago when I was CEA Chair.  (No, I was not a prescient genius.  The potential problem was apparent to anyone who cared to look.)  But now the problem of implicit subsidies is far more widespread.  We have in effect turned much of the financial system into government-sponsored enterprises.

What to do?  We could promise never to bail out financial institutions again.  Yet nobody would ever believe us.  And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax.  If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

Will the tax law in fact be so well written?   It certainly won’t be perfect.  But it is possible that it will be better than doing nothing at all, watching the finance industry expand excessively, and waiting for the next financial crisis and taxpayer bailout.

The full post can be found here.

Update: University of Chicago economists Douglas W. Diamond and Anil K Kashyapagree agree and explain why here.

Alvin Rabushka, an expert in taxation in the United States, alluded to it in discussing the recently passed “fiscal stimulus” bill:

There is danger lurking in this measure. The vast majority of federal income taxes is being paid by fewer and fewer households. The share of federal income taxes paid by the top 20% of all households has increased from 64.9% in 1979 to 86.3% in 2005. (That of the top 1% rose from 25.8% to 39.4% during 1986-2005, the top 5% from 43.9% to 59.7%, and the top 10% from 55.7% to 70.3%.) The share paid by the bottom 40% fell from 4.1% to -3.8% (negative tax) during 1979-2005. Negative tax means that the government is topping up household incomes with an earned income tax credit, cash, payable to low-income households….

On these numbers, a refundable tax credit against employee social insurance earnings would remove more than another 8 million tax units (5.8%) from federal tax liabilities, putting the share of non-taxpaying units around 49%.

If the “Making Work Pay” credit were to become permanent, and if Congress were to raise the offset to a higher percentage of the payroll tax, the 49% of households without any federal tax liability will quickly surpass 50%. When that happens, a non-taxpaying political majority will find itself in the enviable position of being able to vote tax increases on a minority of taxpayers (thereby financing benefits for themselves) without having to pay any of the increase. The models used by economists to estimate the economic gains of making the “Making Work Pay” tax credit permanent do not include this political outcome and its implications for U.S. democracy.

This was repeated by Michael Boskin, professor of economics at Stanford University, in a recent Wall Street Journal article:

New and expanded refundable tax credits would raise the fraction of taxpayers paying no income taxes to almost 50% from 38%. This is potentially the most pernicious feature of the president’s budget, because it would cement a permanent voting majority with no stake in controlling the cost of general government.

A very dangerous tipping point.