Andrew Yang’s Proposed $1,000 per Month Grant: Issues Raised in the Democratic Debate

A.  Introduction

This is the second in a series of posts on this blog addressing issues that have come up during the campaign of the candidates for the Democratic nomination for president, and which specifically came up in the October 15 Democratic debate.  As flagged in the previous blog post, one can find a transcript of the debate at the Washington Post website, and a video of the debate at the CNN website.

This post will address Andrew Yang’s proposal of a $1,000 per month grant for every adult American (which I will mostly refer to here as a $12,000 grant per year).  This policy is called a universal basic income (or UBI), and has been explored in a few other countries as well.  It has received increased attention in recent years, in part due to the sharp growth in income inequality in the US of recent decades, that began around 1980.  If properly designed, such a $12,000 grant per adult per year could mark a substantial redistribution of income.  But the degree of redistribution depends directly on how the funding would be raised.  As we will discuss below, Yang’s specific proposals for that are problematic.  There are also other issues with such a program which, even if well designed, calls into question whether it would be the best approach to addressing inequality.  All this will be discussed below.

First, however, it is useful to address two misconceptions that appear to be widespread.  One is that many appear to believe that the $12,000 per adult per year would not need to come from somewhere.  That is, everyone would receive it, but no one would have to provide the funds to pay for it.  That is not possible.  The economy produces so much, whatever is produced accrues as incomes to someone, and if one is to transfer some amount ($12,000 here) to each adult then the amounts so transferred will need to come from somewhere.  That is, this is a redistribution.  There is nothing wrong with a redistribution, if well designed, but it is not a magical creation of something out of nothing.

The other misconception, and asserted by Yang as the primary rationale for such a $12,000 per year grant, is that a “Fourth Industrial Revolution” is now underway which will lead to widespread structural unemployment due to automation.  This issue was addressed in the previous post on this blog, where I noted that the forecast job losses due to automation in the coming years are not out of line with what has been the norm in the US for at least the last 150 years.  There has always been job disruption and turnover, and while assistance should certainly be provided to workers whose jobs will be affected, what is expected in the years going forward is similar to what we have had in the past.

It is also a good thing that workers should not be expected to rely on a $12,000 per year grant to make up for a lost job.  Median earnings of a full-time worker was an estimated $50,653 in 2018, according to the Census Bureau.  A grant of $12,000 would not go far in making up for this.

So the issue is one of redistribution, and to be fair to Yang, I should note that he posts on his campaign website a fair amount of detail on how the program would be paid for.  I make use of that information below.  But the numbers do not really add up, and for a candidate who champions math (something I admire), this is disappointing.

B.  Yang’s Proposal of a $1,000 Monthly Grant to All Americans

First of all, the overall cost.  This is easy to calculate, although not much discussed.  The $12,000 per year grant would go to every adult American, who Yang defines as all those over the age of 18.  There were very close to 250 million Americans over the age of 18 in 2018, so at $12,000 per adult the cost would be $3.0 trillion.

This is far from a small amount.  With GDP of approximately $20 trillion in 2018 ($20.58 trillion to be more precise), such a program would come to 15% of GDP.  That is huge.  Total taxes and revenues received by the federal government (including all income taxes, all taxes for Social Security and Medicare, and everything else) only came to $3.3 trillion in FY2018.  This is only 10% more than the $3.0 trillion that would have been required for Yang’s $12,000 per adult grants.  Or put another way, taxes and other government revenues would need almost to be doubled (raised by 91%) to cover the cost of the program.  As another comparison, the cost of the tax cuts that Trump and the Republican leadership rushed through Congress in December 2017 was forecast to be an estimated $150 billion per year.  That was a big revenue loss.  But the Yang proposal would cost 20 times as much.

With such amounts to be raised, Yang proposes on his campaign website a number of taxes and other measures to fund the program.  One is a value-added tax (VAT), and from his very brief statements during the debates but also in interviews with the media, one gets the impression that all of the program would be funded by a value-added tax.  But that is not the case.  He in fact says on his campaign website that the VAT, at the rate and coverage he would set, would raise only about $800 billion.  This would come only to a bit over a quarter (27%) of the $3.0 trillion needed.  There is a need for much more besides, and to his credit, he presents plans for most (although not all) of this.

So what does he propose specifically?:

a) A New Value-Added Tax:

First, and as much noted, he is proposing that the US institute a VAT at a rate of 10%.  He estimates it would raise approximately $800 billion a year, and for the parameters for the tax that he sets, that is a reasonable estimate.  A VAT is common in most of the rest of the world as it is a tax that is relatively easy to collect, with internal checks that make underreporting difficult.  It is in essence a tax on consumption, similar to a sales tax but levied only on the added value at each stage in the production chain.  Yang notes that a 10% rate would be approximately half of the rates found in Europe (which is more or less correct – the rates in Europe in fact vary by country and are between 17 and 27% in the EU countries, but the rates for most of the larger economies are in the 19 to 22% range).

A VAT is a tax on what households consume, and for that reason a regressive tax.  The poor and middle classes who have to spend all or most of their current incomes to meet their family needs will pay a higher share of their incomes under such a tax than higher-income households will.  For this reason, VAT systems as implemented will often exempt (or tax at a reduced rate) certain basic goods such as foodstuffs and other necessities, as such goods account for a particularly high share of the expenditures of the poor and middle classes.  Yang is proposing this as well.  But even with such exemptions (or lower VAT rates), a VAT tax is still normally regressive, just less so.

Furthermore, households will in the end be paying the tax, as prices will rise to reflect the new tax.  Yang asserts that some of the cost of the VAT will be shifted to businesses, who would not be able, he says, to pass along the full cost of the tax.  But this is not correct.  In the case where the VAT applies equally to all goods, the full 10% will be passed along as all goods are affected equally by the now higher cost, and relative prices will not change.  To the extent that certain goods (such as foodstuffs and other necessities) are exempted, there could be some shift in demand to such goods, but the degree will depend on the extent to which they are substitutable for the goods which are taxed.  If they really are necessities, such substitution is likely to be limited.

A VAT as Yang proposes thus would raise a substantial amount of revenues, and the $800 billion figure is a reasonable estimate.  This total would be on the order of half of all that is now raised by individual income taxes in the US (which was $1,684 billion in FY2018).  But one cannot avoid that such a tax is paid by households, who will face higher prices on what they purchase, and the tax will almost certainly be regressive, impacting the poor and middle classes the most (with the extent dependent on how many and which goods are designated as subject to a reduced VAT rate, or no VAT at all).  But whether regressive or not, everyone will be affected and hence no one will actually see a net increase of $12,000 in purchasing power from the proposed grant  Rather, it will be something less.

b)  A Requirement to Choose Either the $12,000 Grants, or Participation in Existing Government Social Programs

Second, Yang’s proposal would require that households who currently benefit from government social programs, such as for welfare or food stamps, would be required to give up those benefits if they choose to receive the $12,000 per adult per year.  He says this will lead to reduced government spending on such social programs of $500 to $600 billion a year.

There are two big problems with this.  The first is that those programs are not that large.  While it is not fully clear how expansive Yang’s list is of the programs which would then be denied to recipients of the $12,000 grants, even if one included all those included in what the Congressional Budget Office defines as “Income Security” (“unemployment compensation, Supplemental Security Income, the refundable portion of the earned income and child tax credits, the Supplemental Nutrition Assistance Program [food stamps], family support, child nutrition, and foster care”), the total spent in FY2018 was only $285 billion.  You cannot save $500 to $600 billion if you are only spending $285 billion.

Second, such a policy would be regressive in the extreme.  Poor and near-poor households, and only such households, would be forced to choose whether to continue to receive benefits under such existing programs, or receive the $12,000 per adult grant per year.  If they are now receiving $12,000 or more in such programs per adult household member, they would receive no benefit at all from what is being called a “universal” basic income grant.  To the extent they are now receiving less than $12,000 from such programs (per adult), they may gain some benefit, but less than $12,000 worth.  For example, if they are now receiving $10,000 in benefits (per adult) from current programs, their net gain would be just $2,000 (setting aside for the moment the higher prices they would also now need to pay due to the 10% VAT).  Furthermore, only the poor and near-poor who are being supported by such government programs will see such an effective reduction in their $12,000 grants.  The rich and others, who benefit from other government programs, will not see such a cut in the programs or tax subsidies that benefit them.

c)  Savings in Other Government Programs 

Third, Yang argues that with his universal basic income grant, there would be a reduction in government spending of $100 to $200 billion a year from lower expenditures on “health care, incarceration, homelessness services and the like”, as “people would be able to take better care of themselves”.  This is clearly more speculative.  There might be some such benefits, and hopefully would be, but without experience to draw on it is impossible to say how important this would be and whether any such savings would add up to such a figure.  Furthermore, much of those savings, were they to follow, would accrue not to the federal government but rather to state and local governments.  It is at the state and local level where most expenditures on incarceration and homelessness, and to a lesser degree on health care, take place.  They would not accrue to the federal budget.

d)  Increased Tax Revenues From a Larger Economy

Fourth, Yang states that with the $12,000 grants the economy would grow larger – by 12.5% he says (or $2.5 trillion in increased GDP).  He cites a 2017 study produced by scholars at the Roosevelt Institute, a left-leaning non-profit think tank based in New York, which examined the impact on the overall economy, under several scenarios, of precisely such a $12,000 annual grant per adult.

There are, however, several problems:

i)  First, under the specific scenario that is closest to the Yang proposal (where the grants would be funded through a combination of taxes and other actions), the impact on the overall economy forecast in the Roosevelt Institute study would be either zero (when net distribution effects are neutral), or small (up to 2.6%, if funded through a highly progressive set of taxes).

ii)  The reason for this result is that the model used by the Roosevelt Institute researchers assumes that the economy is far from full employment, and that economic output is then entirely driven by aggregate demand.  Thus with a new program such as the $12,000 grants, which is fully paid for by taxes or other measures, there is no impact on aggregate demand (and hence no impact on economic output) when net distributional effects are assumed to be neutral.  If funded in a way that is not distributionally neutral, such as through the use of highly progressive taxes, then there can be some effect, but it would be small.

In the Roosevelt Institute model, there is only a substantial expansion of the economy (of about 12.5%) in a scenario where the new $12,000 grants are not funded at all, but rather purely and entirely added to the fiscal deficit and then borrowed.  And with the current fiscal deficit now about 5% of GDP under Trump (unprecedented even at 5% in a time of full employment, other than during World War II), and the $12,000 grants coming to $3.0 trillion or 15% of GDP, this would bring the overall deficit to 20% of GDP!

Few economists would accept that such a scenario is anywhere close to plausible.  First of all, the current unemployment rate of 3.5% is at a 50 year low.  The economy is at full employment.  The Roosevelt Institute researchers are asserting that this is fictitious, and that the economy could expand by a substantial amount (12.5% in their scenario) if the government simply spent more and did not raise taxes to cover any share of the cost.  They also assume that a fiscal deficit of 20% of GDP would not have any consequences, such as on interest rates.  Note also an implication of their approach is that the government spending could be on anything, including, for example, the military.  They are using a purely demand-led model.

iii)  Finally, even if one assumes the economy will grow to be 12.5% larger as a result of the grants, even the Roosevelt Institute researchers do not assume it will be instantaneous.  Rather, in their model the economy becomes 12.5% larger only after eight years.  Yang is implicitly assuming it will be immediate.

There are therefore several problems in the interpretation and use of the Roosevelt Institute study.  Their scenario for 12.5% growth is not the one that follows from Yang’s proposals (which is funded, at least to a degree), nor would GDP jump immediately by such an amount.  And the Roosevelt Insitute model of the economy is one that few economists would accept as applicable in the current state of the economy, with its 3.5% unemployment.

But there is also a further problem.  Even assuming GDP rises instantly by 12.5%, leading to an increase in GDP of $2.5 trillion (from a current $20 trillion), Yang then asserts that this higher GDP will generate between $800 and $900 billion in increased federal tax revenue.  That would imply federal taxes of 32 to 36% on the extra output.  But that is implausible.  Total federal tax (and all other) revenues are only 17.5% of GDP.  While in a progressive tax system the marginal tax revenues received on an increase in income will be higher than at the average tax rate, the US system is no longer very progressive.  And the rates are far from what they would need to be twice as high at the margin (32 to 36%) as they are at the average (17.5%).  A more plausible estimate of the increased federal tax revenues from an economy that somehow became 12.5% larger would not be the $800 to $900 billion Yang calculates, but rather about half that.

Might such a universal basic income grant affect the size of the economy through other, more orthodox, channels?  That is certainly possible, although whether it would lead to a higher or to a lower GDP is not clear.  Yang argues that it would lead recipients to manage their health better, to stay in school longer, to less criminality, and to other such social benefits.  Evidence on this is highly limited, but it is in principle conceivable in a program that does properly redistribute income towards those with lower incomes (where, as discussed above, Yang’s specific program has problems).  Over fairly long periods of time (generations really) this could lead to a larger and stronger economy.

But one will also likely see effects working in the other direction.  There might be an increase in spouses (wives usually) who choose to stay home longer to raise their children, or an increase in those who decide to retire earlier than they would have before, or an increase in the average time between jobs by those who lose or quit from one job before they take another, and other such impacts.  Such impacts are not negative in themselves, if they reflect choices voluntarily made and now possible due to a $12,000 annual grant.  But they all would have the effect of reducing GDP, and hence the tax revenues that follow from some level of GDP.

There might therefore be both positive and negative impacts on GDP.  However, the impact of each is likely to be small, will mostly only develop over time, and will to some extent cancel each other out.  What is likely is that there will be little measurable change in GDP in whichever direction.

e)  Other Taxes

Fifth, Yang would institute other taxes to raise further amounts.  He does not specify precisely how much would be raised or what these would be, but provides a possible list and says they would focus on top earners and on pollution.  The list includes a financial transactions tax, ending the favorable tax treatment now given to capital gains and carried interest, removing the ceiling on wages subject to the Social Security tax, and a tax on carbon emissions (with a portion of such a tax allocated to the $12,000 grants).

What would be raised by such new or increased taxes would depend on precisely what the rates would be and what they would cover.  But the total that would be required, under the assumption that the amounts that would be raised (or saved, when existing government programs are cut) from all the measures listed above are as Yang assumes, would then be between $500 and $800 billion (as the revenues or savings from the programs listed above sum to $2.2 to $2.5 trillion).  That is, one might need from these “other taxes” as much as would be raised by the proposed new VAT.

But as noted in the discussion above, the amounts that would be raised by those measures are often likely to be well short of what Yang says will be the case.  One cannot save $500 to $600 billion in government programs for the poor and near-poor if government is spending only $285 billion on such programs, for example.  A more plausible figure for what might be raised by those proposals would be on the order of $1 trillion, mostly from the VAT, and not the $2.2 to $2.5 trillion Yang says will be the case.

C.  An Assessment

Yang provides a fair amount of detail on how he would implement a universal basic income grant of $12,000 per adult per year, and for a political campaign it is an admirable amount of detail.  But there are still, as discussed above, numerous gaps that prevent anything like a complete assessment of the program.  But a number of points are evident.

To start, the figures provided are not always plausible.  The math just does not add up, and for someone who extolls the need for good math (and rightly so), this is disappointing.  One cannot save $500 to $600 billion in programs for the poor and near-poor when only $285 billion is being spent now.  One cannot assume that the economy will jump immediately by 12.5% (which even the Roosevelt Institute model forecasts would only happen in eight years, and under a scenario that is the opposite of that of the Yang program, and in a model that few economists would take as credible in any case).  Even if the economy did jump by so much immediately, one would not see an increase of $800 to $900 billion in federal tax revenues from this but rather more like half that.  And other such issues.

But while the proposal is still not fully spelled out (in particular on which other taxes would be imposed to fill out the program), we can draw a few conclusions.  One is that the one group in society who will clearly not gain from the $12,000 grants is the poor and near-poor, who currently make use of food stamp and other such programs and decide to stay with those programs.  They would then not be eligible for the $12,000 grants.  And keep in mind that $12,000 per adult grants are not much, if you have nothing else.  One would still be below the federal poverty line if single (where the poverty line in 2019 is $12,490) or in a household with two adults and two or more children (where the poverty line, with two children, is $25,750).  On top of this, such households (like all households) will pay higher prices for at least some of what they purchase due to the new VAT.  So such households will clearly lose.

Furthermore, those poor or near-poor households who do decide to switch, thus giving up their eligibility for food stamps and other such programs, will see a net gain that is substantially less than $12,000 per adult.  The extent will depend on how much they receive now from those social programs.  Those who receive the most (up to $12,000 per adult), who are presumably also most likely to be the poorest among them, will lose the most.  This is not a structure that makes sense for a program that is purportedly designed to be of most benefit to the poorest.

For middle and higher-income households the net gain (or loss) from the program will depend on the full set of taxes that would be needed to fund the program.  One cannot say who will gain and who will lose until the structure of that full set of taxes is made clear.  This is of course not surprising, as one needs to keep in mind that this is a program of redistribution:  Funds will be raised (by taxes) that disproportionately affect certain groups, to be distributed then in the $12,000 grants.  Some will gain and some will lose, but overall the balance has to be zero.

One can also conclude that such a program, providing for a universal basic income with grants of $12,000 per adult, will necessarily be hugely expensive.  It would cost $3 trillion a year, which is 15% of GDP.  Funding it would require raising all federal tax and other revenue by 91% (excluding any offset by cuts in government social programs, which are however unlikely to amount to anything close to what Yang assumes).  Raising funds of such magnitude is completely unrealistic.  And yet despite such costs, the grants provided of $12,000 per adult would be poverty level incomes for those who do not have a job or other source of support.

One could address this by scaling back the grant, from $12,000 to something substantially less, but then it becomes less meaningful to an individual.  The fundamental problem is the design as a universal grant, to all adults.  While this might be thought to be politically attractive, any such program then ends up being hugely expensive.

The alternative is to design a program that is specifically targeted to those who need such support.  Rather than attempting to hide the distributional consequences in a program that claims to be universal (but where certain groups will gain and certain groups will lose, once one takes fully into account how it will be funded), make explicit the redistribution that is being sought.  With this clear, one can then design a focussed program that addresses that redistribution aim.

Finally, one should recognize that there are other policies as well that might achieve those aims that may not require explicit government-intermediated redistribution.  For example, Senator Cory Booker in the October 15 debate noted that a $15 per hour minimum wage would provide more to those now at the minimum wage than a $12,000 annual grant.  This remark was not much noted, but what Senator Booker said was true.  The federal minimum wage is currently $7.25 per hour.  This is low – indeed, it is less (in real terms) than what it was when Harry Truman was president.  If the minimum wage were raised to $15 per hour, a worker now at the $7.25 rate would see an increase in income of $15.00 – $7.25 = $7.75 per hour, and over a year of 40 hour weeks would see an increase in income of $7.75 x 40 x 52 = $16,120.00.  This is well more than a $12,000 annual grant would provide.

Republican politicians have argued that raising the minimum wage by such a magnitude will lead to widespread unemployment.  But there is no evidence that changes in the minimum wage that we have periodically had in the past (whether federal or state level minimum wages) have had such an adverse effect.  There is of course certainly some limit to how much it can be raised, but one should recognize that the minimum wage would now be over $24 per hour if it had been allowed to grow at the same pace as labor productivity since the late 1960s.

Income inequality is a real problem in the US, and needs to be addressed.  But there are problems with Yang’s specific version of a universal basic income.  While one may be able to fix at least some of those problems and come up with something more reasonable, it would still be massively disruptive given the amounts to be raised.  And politically impossible.  A focus on more targeted programs, as well as on issues such as the minimum wage, are likely to prove far more productive.

The Fed is Not to Blame for the Falling Stock Market

Just a quick note on this Christmas Eve.  The US stock markets are falling.  The bull market that had started in March 2009, two months after Obama took office, and which then continued through to the end of Obama’s two terms, may be close to an end.  A bear market is commonly defined as one where the S&P500 index (a broad stock market index that most professionals use) has fallen by 20% or more from its previous peak.  As of the close of the markets this December 24, the S&P500 index is 19.8% below the peak it had reached on September 20.  The NASDAQ index is already in bear market territory, as it is 23.6% lower than its previous peak.  And the Dow Jones Industrial average is also close, at a fall of 18.8% from its previous peak.

Trump is blaming the Fed for this.  The Fed has indeed been raising interest rates, since 2015.  The Fed had kept interest rates at close to zero since the financial collapse in 2008 at the end of the Bush administration in order to spur a recovery.  And it had to keep interest rates low for an especially long time as fiscal policy turned from expansionary, in 2009/10, to contractionary, as the Republican Congress elected in 2010 forced through cuts in government spending even though employment had not yet then fully recovered.

Employment did eventually recover, so the Fed could start to bring interest rates back to more normal levels.  This began in late 2015 with an increase in the Fed’s target for the federal funds rate from the previous range of 0% to 0.25%, to a target range of 0.25% to 0.50%.  The federal funds rate is the rate at which banks borrow or lend federal funds (funds on deposit at the Fed) to each other, so that the banks can meet their deposit reserve requirements.  And the funds are borrowed and lent for literally just one night (even though the rates are quoted on an annualized basis).  The Fed manages this by buying and selling US Treasury bills on the open market (thus loosening or tightening liquidity), to keep the federal funds rate within the targeted range.

Since the 2015 increase, the Fed has steadily raised its target for the federal funds rate to the current range of 2.25% to 2.50%.  It raised the target range once in 2016, three times in 2017, and four times in 2018, always in increments of 0.25% points.  The market has never been surprised.  With unemployment having fallen to 5.0% in late 2015, and to just 3.7% now, this is exactly one would expect the Fed to do.

The path is shown in blue in the chart at the top of this post.  The path is for the top end of the target range for the rate, which is the figure most analysts focus on.  And the bottom end will always be 0.25% points below it.  The chart then shows in red the path for the S&P500 index.  For ease of comparison to the path for the federal funds rate, I have rescaled the S&P500 index to 1.0 for March 16, 2017 (the day the Fed raised the target federal funds rate to a ceiling of 1.0%), and then rescaled around that March 16, 2017, value to roughly follow the path of the federal funds rate.  (The underlying data were all drawn from FRED, the economic database maintained by the Federal Reserve Bank of St. Louis.  The data points are daily, for each day the markets were open, and the S&P 500 is as of the daily market close.)

Those paths were roughly similar up to September 2018, and only then did they diverge.  That is, the Fed has been raising interest rates for several years now, and the stock market was also steadily rising.  Increases in the federal funds rate by the Fed in those years did not cause the stock market to fall.  It is disingenuous to claim that it has now.

Why is the stock market now falling then?  While only fools claim to know with certainty what the stock market will do, or why it has moved as it has, Trump’s claim that it is all the Fed’s fault has no basis.  The Fed has been raising interest rates since 2015.  Rather, Trump should be looking at his own administration, capped over the last few days with the stunning incompetence of his Treasury Secretary, Steven Mnuchin.  With a perceived need to “do something” (probably at Trump’s instigation), Mnuchin made a big show of calling on Sunday the heads of the six largest US banks asking if they were fine (they were, at least until they got such calls, and might then have been left wondering whether the Treasury Secretary knew something that they didn’t), and then organizing a meeting of the “Plunge Protection Team” on Monday, Christmas Eve. This all created the sense of an administration in panic.

This comes on top of the reports over the weekend that Trump wants to fire the Chairman of the Fed, Jerome Powell.  Trump had appointed Powell just last year.  Nor would it be legal to fire him (and no president ever has), although some may dispute that.  Finally, and adding to the sense of chaos, a major part of the federal government is on shutdown starting from last Friday night, as Trump refused to approve a budget extension unless he could also get funding to build a border wall.  As of today, it does not appear this will end until some time after January 1.

But it is not just these recent events which may have affected the markets.  After all, the S&P500 index peaked on September 20.  Rather, one must look at the overall mismanagement of economic policy under Trump, perhaps most importantly with the massive tax cut to corporations and the wealthy of last December.  While a corporate tax cut will lead to higher after-tax corporate profits, all else being equal, all else will not be equal.  The cuts have also contributed to a large and growing fiscal deficit, to a size that is unprecedented (even as a share of GDP) during a time of full employment (other than during World War II).  A federal deficit which is already high when times are good will be massive when the next downturn comes.  This will then constrain our ability to address that downturn.

Plus there are other issues, such as the trade wars that Trump appears to take personal pride in, and the reversal of the regulatory reforms put in place after the 2008 economic and financial collapse in order not to repeat the mistakes that led to that crisis.

What will happen to the stock market now?  I really do not know.  Perhaps it will recover from these levels.  But with the mismanagement of economic policy seen in this administration, and a president who acts on whim and is unwilling to listen, it would not be a surprise to see a further fall.  Just don’t try to shift the blame to the Fed.

The Revenue and Distributional Impacts of the Senate Republican Tax Plan

A.  Introduction

To truly understand the Republican tax plans now winding their way through Congress, one must look at the specifics of what is being proposed.  And the more closely one looks, the more appalling these plans are seen to be.  The blatant greed is breathtaking.  Despite repeatedly asserting that the plans would provide tax cuts for the middle class, the specific proposals now before Congress would in fact do the opposite.  Figures will be provided below.  And while the Secretary of the Treasury has repeatedly stated that only millionaires will pay more in taxes, the specific proposals now before Congress would in fact give millionaires huge cuts in the taxes they owe.

While provisions in the plans are changing daily, with certain differences between the versions being considered in the House and in the Senate as well as between these and what the White House set out in late September, the overall framework has remained the same (as the proponents themselves are emphasizing).  And this really is a Republican plan.  The House version was passed on a largely party-line vote with no Democrats in favor and only a small number of Republicans opposed, and the Senate version will require (assuming all Democrats vote against as they have been shut out of the process) 50 of the 52 Republican Senators (96%) to vote in favor.  The Republican leadership could have chosen to work with Democrats to develop a proposal that could receive at least some Democratic support, but decided not to.  Indeed, while their plans have been developed by a small group since Trump assumed the presidency in January, the specifics were kept secret as long as possible.  This made it impossible (deliberately) for there to be any independent analysis.  They are now trying to rush this through the House and the Senate, with votes taken as quickly as possible before the public (and the legislators themselves) can assess what is being voted upon.  The committees responsible for the legislation have not even held any hearings with independent experts.  And the Congressional Budget Office has said it will be unable to produce the analysis of the impacts normally required for such legislation, due to the compression of the schedule.

Fortunately, the staff of the Joint Committee on Taxation (JCT, a joint committee of both the House and the Senate) have been able to provide limited assessments of the legislation, focused on the budgetary and distributional impacts, as they are minimally required to do.  This blog post will use their most recent analysis (as I write this) of the current version of the Senate bill to look at who would be gaining and who would be losing, if this plan is approved.

As a first step, however, it would be good to address the claim that these Republican tax plans will spur such a jump in economic growth that they will pay for themselves.  This will not happen.  First, as earlier posts on this blog have discussed, there is no evidence from the historical data to support this.  Taxes, both on individuals and at the corporate level, have been cut sharply in the US since Reagan was president, and they have not led to higher growth.   All they did was add to the deficit.  Nor does one see this in the long-term data.  The highest individual income tax rates were at 91 or 92% (at just the federal level) between 1951 and 1963, and at 70% or more up until 1980.  The highest corporate income tax rate was 52% between 1952 and 1963, and then 46% or more up until 1986.  Yet the economy performed better in these decades than it has since.  The White House is also claiming that the proposed cut in corporate income taxes will lead to a rise in real wages of $4,000 to $9,000.  But there is no evidence in the historical data to support such a claim, which many economists have rejected as just absurd.  Corporate income tax rates were cut sharply in 1986, under Reagan, but real wages did not then rise – they in fact fell.

Finally, the assertion that tax cuts will lead to a large jump in growth ignores that the economy is already at full employment.  Were there to be an incipient rise in growth, leading to employment gains, the Federal Reserve Board would have to raise interest rates to keep the economy from over-heating.  The higher interest rates would deter investment, and one would instead have a shift in shares of GDP away from investment and towards consumption and/or government spending.

Any impact on growth would thus be modest at best.  The Tax Policy Center, using generous assumptions, estimated the tax plan might increase GDP by a total of 0.3% in 2027 and by 0.2% in 2037 over what it would otherwise then be.  An increase of 0.2% over 20 years means an increase in the rate of growth of an average of just 0.01% a year.  GDP figures are not even measured to that precision.

There would, however, be large distributional effects, with some groups gaining and some losing simply from the tax changes alone (and ignoring, for the purposes here, the further effects from a higher government debt plus increased pressures to cut back on government programs).  This blog post will discuss these, from calculations that draw on the JCT estimates of the revenue and distributional impacts.

B.  Revenue Impacts by Separate Tax Programs

The distributional consequences of the proposed changes in tax law depend on which separate taxes are to be cut or increased, what changes are made to arrive at what is considered “taxable income” (deductions, exemptions, etc.), and how those various taxes impact different individuals differently.  Thus one should first look at the changes proposed for the various taxes, and what impacts they will have on revenues collected.

The JCT provides such estimates, at a rather detailed level as well as year by year to FY2027.  The JCT estimates for the tax plan being considered in the Senate as of November 16 is available here.  Estimates are provided of the impacts of over 144 individual changes, for both income taxes on individuals and on various types of business (corporate and other).  A verbal description from the JCT of the Senate chair’s initial proposal is available here, and a description of the most recent changes in the proposal (as of November 14) is available here.  I would encourage everyone to look at the JCT estimates to get a sense of what is being proposed.  It is far more than what one commonly sees in the press, with many changes (individually often small in terms of revenue impact) that can only be viewed as catering to various special interests.

I then aggregated the JCT individual line estimates of the revenue impacts over FY18-27 to a limited set of broad categories to arrive at the figures shown in the chart at the top of this post, and (in a bit more detail) in the following table,:

Revenue Impact of Tax Plan ($billions)

FY18-27

A)  Individual excl. Estate, AMT, & Pass-Through:

  1)  Cuts

-$2,497

  2)  Increases 

 $2,688

     Net, excl. Estate, AMT, & Pass-Through  

    $191

B)  Primarily Applicable to the Rich:

  1)  Increase Estate Tax Exemption

     -$83

  2)  End Alternative Minimum Tax

   -$769

  3)  Tax Pass-Through Income at Lower Rates

   -$225

     Total for Provisions Primarily for Rich

-$1,077

C)  Business – Domestic Income:

  1)  Cut Tax Rate 35% to 20%, and End AMT 

-$1,370

  2)  Other Tax Cuts

   -$139

  3)  Tax Increases

    $826

     Net for Domestic Business

   -$682

D)  Business – Overseas Income:

  1)  End Taxation of Overseas Profit

  -$314

  2)  Other Tax Cuts

    -$21

  3)  Tax Increases (except below)

     $32

     Net for Overseas, excl. amnesty & anti-abuse 

  -$303

  4)  Partial Amnesty on Overseas Profit

    $185

  5)  Anti-abuse, incl. in Tax Havens

    $273

     Overall Totals

-$1,414

Source:  Calculated from estimated tax revenue effects made by the staff of the Joint Committee on Taxation, publication JCX-59-17, November 17, 2017, of the November 16 version of the Republican Chairman’s proposed tax legislation.

a)  Individual Income Taxes

As the chart and table show, while overall tax revenues would fall by an estimated $1.4 trillion over FY18-27 (excluding interest on the resulting higher public debt), not everyone would be getting a cut.  Proposed changes that would primarily benefit rich individuals (doubling the Estate Tax exemption amount to $22 million for a married couple, repealing the Alternative Minimum Tax in full, and taxing pass-through business income at lower rates than other income) would reduce the taxes the rich owe under these provisions by close to $1.1 trillion.  But individual income taxes excluding these three categories would in fact increase, by an estimated $191 billion over the ten years.

This increase of $191 billion in income taxes that most affect the middle and lower income classes, is not a consequence of an explicit proposal to raise their taxes.  That would be too embarrassing.  Rather, it is the net result of numerous individual measures, some of which would reduce tax liability (and which the politicians then emphasize) while others would increase tax liabilities (and are less discussed).  Cuts totaling $2.5 trillion would come primarily from reducing tax rates, from what they refer to as a “doubling” of the standard deduction (in fact it would be an increase of 89% over the 2017 level), and from increased child credits.  But there would also be increases totaling close to $2.7 trillion, primarily from eliminating the personal exemption, from the repeal of or limitation on a number of deductions one can itemize, and from changes that would effectively reduce enrollment in the health insurance market.

Part of the reason for this net tax increase over the full ten years is the decision to try to hide the full cost of the tax plan by making most of the individual income tax provisions (although not the key changes proposed for corporate taxes) formally temporary.  Most would expire at the end of 2025.  The Republican leadership advocating this say that they expect Congress later to make these permanent.  But if so, then the true cost of the plan would be well more than the $1.5 trillion ceiling they have set under the long-term budget plan they pushed through Congress in September.  Furthermore, it makes only a small difference if one calculates the impact over the first five years of the plan (FY18-22).  There would then be a small net reduction in these individual income taxes (excluding Estate Tax, AMT, and Pass-Through) of just $57 billion.  This is not large over a five year period – just 0.6% of individual income taxes expected to be generated over that period.  Over this same period, the cuts in the Estate Tax, the AMT, and for Pass-Through income would total $535 billion, or well over nine times as much.

One should also keep in mind that these figures are for overall amounts collected, and that the impact on individuals will vary widely.  This is especially so when the net effect (an increase of close to $200 billion in the individual income taxes generated) is equal to the relatively small difference between the tax increases ($2.7 trillion in total) and tax cuts ($2.5 trillion).  Depending on their individual circumstances, many individuals will be paying far more, and others far less.  For example, much stress has been put on the “doubling” of the standard deduction.  However, personal exemptions would also be eliminated, and in a household of just three, the loss of the personal exemptions ($4,050 per person in 2017) would more than offset the increase in the standard deduction (from $12,700 to a new level of $24,000).  The change in what is allowed for the separate child credits will also matter, but many households will not qualify for the special child credits.  And if one is in a household which itemizes their deductions, both before and after the changes and for whatever reason (such as for high medical expenses), the “doubling” of the standard deduction is not even relevant, while the elimination of the personal exemptions is.

Taxes relevant to the rich would be slashed, however.  Only estates valued at almost $22 million or more in 2017 (for a married couple after some standard legal measures have been taken, and half that for a single person) are currently subject to the Estate Tax, and these account for less than 0.2% of all estates.  The poorer 99.8% do not need to worry about this tax.  But the Senate Republican plan would narrow the estates subject to tax even further, by doubling the exemption amount.  The Alternative Minimum Tax (AMT) is also a tax that only applies to relatively well-off households.  It would be eliminated altogether.

And pass-through income going to individuals is currently taxed at the same rates as ordinary income (such as on wages), at a rate of up to 39.6%.  The current proposal (as of November 16) is to provide a special deduction for such income equal to 17.4%.  This would in effect reduce the tax rate applicable to such income from, for example, 35% if it were regular income such as wages (the bracket when earnings are between $400,000 and $1.0 million in the current version of the plan) to just 28.9%.  Pass-through income is income distributed from sole proprietorships, partnerships, and certain corporations (known as sub-chapter S corporations, by the section in the tax code).  Entities may choose to organize themselves in this way in order to avoid corporate income tax.  Those receiving such income are generally rich:  It is estimated that 70% of such pass-through income in the US goes to the top 1% of earners.  Such individuals may include, for example, the partners in many financial investment firms, lawyers and accountants, other professionals, as well as real estate entities. There are many revealing examples.  According to a letter from Trump’s own tax lawyers, Trump receives most of his income from more than 500 such entities.  And Jeff Bezos, now the richest person in the world, owns the Washington Post through such an entity (although here the question might be whether there is any income to be passed through).

The JCT estimates are that $83 billion in revenue would be lost if the Estate Tax exemption is doubled, $769 billion would be lost due to a repeal of the AMT, and $225 billion would be lost as a result of the special 17.4% deduction for pass-through income.  This sums to $1,077 billion over the ten years.

Rich individuals thus will benefit greatly from the proposed changes.  Taxes relevant just to them will be cut sharply.  These taxes are of no relevance to the vast majority of Americans.  With the proposal as it now stands, most Americans would instead end up paying more over the ten year period.  And even if all the provisions with expiration dates (mostly in 2025) were instead extended for the full period, the difference would be small, with at best a minor cut on average.  It would not come close to approaching the huge cuts the rich would enjoy.

b)  Taxes on Income of Corporations and Other Businesses

The proposed changes in taxes on business incomes are more numerous.  They would also in general be made permanent (with some exceptions), rather than expire early as would be the case for most of the individual income tax provisions.  There are also numerous special provisions, with no obvious explanation, which appear to be there purely to benefit certain special interests.

To start, the net impact on domestic business activities would be a cut of an estimated $682 billion over the ten year period.  The lower tax revenues result from cutting the tax rate on corporate profits from 35% to 20%, plus from the repeal of the corporate AMT.  The cuts would total $1,370 billion.  This would be partially offset by reducing or eliminating various deductions and other measures companies can take to reduce their taxable income (generating an estimated $826 billion over the period).

However, there would also be measures that would cut business taxes even further (by an estimated $139 billion) on top of the impact from the lower tax rates (and elimination of the AMT).  Most, although not all, of these would be a consequence of allowing full expensing, or accelerated depreciation in some cases, of investments being made (with such full expensing expiring, in most cases, in 2022).  The objective would be to promote investment further.  This is reasonable, but with full expensing of investments many question whether anything further is gained, in terms of investment expenses, from cutting the corporate rate to 20%.

Special provisions include measures for the craft beer industry, which would reduce tax revenues by $4.2 billion.  The rationale behind this is not fully clear, and it would expire in just two years, at the end of 2019.  The measures should be made permanent if they are in fact warranted, but their early expiration suggests that they are not.  Also odd is a provision to allow the film, TV, and theater industries to fully expense certain of their expenses.  But this provision would expire in 2022.  If warranted, it should be permanent.  If not, it should probably not be there at all.

There are a large number of such special provisions.  Individually, their tax impact is small.  Even together the impact is not large compared to the other measures being proposed.  They mostly look like gifts to well-connected interests.

Others lose out.  These include provisions that allow companies to include as a cost certain employee benefits, such as for transportation, for certain employee meals (probably those provided in remote locations), and for some retirement savings provisions.  Workers would likely lose from this.  The proposal would also introduce new taxes on universities and other non-profits, including taxes on certain endowment income and on salaries of certain senior university officials (beyond what they already pay individually).  The revenues raised would be tiny, and this looks more like a punitive measure aimed at universities than something justified as a “reform”.

There would also be major changes in the taxes due on corporate profits earned abroad.  Most importantly, US taxes would no longer be due on such activities.  While this would cost in taxes a not small $314 billion (or $303 billion after a number of more minor cuts and increases are accounted for) over the ten years, also significant is the incentive this would create to relocate plants and other corporate activities to some foreign location where local taxes are low.  There would be a strong incentive, for example, to relocate a plant to Mexico, say, if Mexico offered only a low tax on profits generated by that plant.  The same plant in the US would pay corporate income taxes at the (proposed) 20% rate.  How this incentive to relocate plant abroad could possibly be seen as a positive by politicians who say they favor domestic jobs is beyond me.  It appears to be purely a response to special interests.

The corporate tax cuts are then in part offset by a proposal to provide a partial amnesty on the accumulated profits now held overseas by US companies.  Certain assets held overseas as retained earnings would be taxed at 5% and certain others at 10%.  Under current US law, corporate profits earned overseas are only subject to US taxes (at the 35% rate currently, net of taxes already paid abroad in the countries where they operate) when those profits are repatriated to the US.  As long as they are held overseas, they are not taxed by the US.  An earlier partial amnesty on such profits, in 2004 during the Bush administration, led to the not unreasonable expectation that there would again be a partial amnesty on such taxes otherwise due when Republicans once again controlled congress and the presidency.  This created a strong incentive to hold accumulated retained earnings overseas for as long as possible, and that is exactly what happened.  Profits repatriated following the 2004 law were taxed at a rate of just 5.25%.

The result is that US companies now hold abroad at least $2.6 trillion in earnings.  And this $2.6 trillion estimate, commonly cited, is certainly an underestimate.  It was calculated based on a review of the corporate financial disclosures of 322 of the Fortune 500 companies, for the 322 such companies where disclosures permitted an estimate to be made.  Based also on the deductible foreign taxes that had been paid on such overseas retained earnings, the authors conservatively estimate that $767 billion in corporate income taxes would be due on the retained earnings held overseas by the 322 companies.  But clearly it would be far higher, as the 322 companies, while among the larger US companies, are only a sub-set of all US companies with earnings held abroad.

Thus to count the $185 billion (line D.4. in the table above) as a revenue-raising measure is a bit misleading.  It is true that compared to doing nothing, where one would leave in place current US tax law which allows taxes on overseas profits to be avoided until repatriated, revenues would be raised under the partial amnesty if those accumulated overseas earnings are now taxed at 5 or 10%.  But the partial amnesty also means that one will give up forever the taxes that would otherwise be due on the more than $2.6 trillion in earnings held overseas.  Relative to that scenario, the amnesty would lead to a $582 billion loss in revenues (equal to an estimated $767 billion loss minus a gain of $185 billion from the 5 and 10% special rates of the amnesty; in fact the losses would be far greater as the $767 billion figure is just for the 322 companies which publish data on what they are holding abroad).  This is, of course, a hypothetical, as it would require a change in law from what it is now.  But it does give a sense of what is being potentially lost in revenues by providing such a partial amnesty.

But even aside from this, one must also recognize that the estimated $185 billion gain in revenues over the next few years would be a one time gain.  Once the amnesty is given, one has agreed to forego the tax revenues that would otherwise be due.  It would help in reducing the cost of this tax plan over the next several years, but it would then lead to losses in taxes later.

Finally, as is common among such tax plans, there is a promise to crack down on abuses, including in this case the use of tax havens to avoid corporate taxes.  The estimate is that such actions and changes in law would raise $273 billion over the next ten years.  But based on past experience, one must look at such estimates skeptically.  The actual amounts raised have normally been far less.  And one should expect that in particular now, given the underfunding of the IRS enforcement budget of recent years.

C.  Distributional Impacts

The above examined what is being proposed for separate portions of the US tax system.  These then translate into impacts on individuals by income level depending on how important those separate portions of the tax system are to those in each income group.  While such estimates are based on highly detailed data drawn from millions of tax returns, there is still a good deal of modeling work that needs to be done, for example, to translate impacts on corporate taxes into what this means for individuals who receive income (dividends and capital gains) from their corporate ownership.

The Tax Policy Center, an independent non-profit, provides such estimates, and their estimate of the impacts of the Republican tax plans (in this case the November 3 House version) has been discussed previously on this blog.  The JCT also provides such estimates, using a fundamentally similar model in structure (but different in the particulars).

Based on the November 15 version of the Senate Republican plan, the JCT estimated that the impacts on households (taxpayer units) would be as follows:

Overall Change in Taxes Due per Taxpayer Unit

Income Category

2019

2021

2023

2025

2027

Less than $10,000

-$21

-$5

$9

$11

$18

$10 to $20,000

-$49

$136

$180

$180

$307

$20 to $30,000

-$87

$138

$144

$170

$355

$30 to $40,000

-$288

-$97

-$16

-$10

$284

$40 to $50,000

-$496

-$275

-$197

-$187

$283

$50 to $75,000

-$818

-$713

-$607

-$610

$139

$75 to 100,000

-$1,204

-$1,150

-$962

-$994

-$38

$100 to $200,000

-$2,091

-$2,027

-$1,622

-$1,657

-$118

$200 to $500,000

-$6,488

-$6,319

-$5,176

-$5,510

-$462

$500 to $1,000,000

-$21,581

-$20,241

-$15,611

-$16,417

-$1,495

Over $1,000,000

-$58,864

-$48,175

-$21,448

-$25,111

-$8,871

Total – All Taxpayers

-$1,357

-$1,200

-$901

-$950

$57

Source:  Calculated from estimates of tax revenue distribution effects made by the staff of the Joint Committee on Taxation, publication JCX-58-17, November 16, 2017, of the November 15 version of the Republican Chairman’s proposed tax legislation.

By these estimates, each income group would, on average, enjoy at least some cut in taxes in 2019.  A number of the proposed tax measures are front-loaded, and it is likely that this structure is seen as beneficial by those seeking re-election in 2020.  But the cuts in 2019 vary from tiny ($21 for those earning $10,000 or less, and $49 for those earning $10,000 to $20,000), to huge ($21,581 for those earning $500,000 to $1,000,000, and $58,864 for those earning over $1,000,000).  However, from 2021 onwards, taxes due would actually rise for most of those earning $40,000 or less (or be cut by minor amounts).  And this is already true well before the assumed termination of many of the individual income tax measures in 2025.  With the plan as it now stands, in 2027 all those earning less than $75,000 would end up paying more in taxes (on average) under this supposed “middle-class tax cut” than they would if the law were left unchanged.

The benefits to those earning over $500,000 would, however, remain large, although also declining over time.

D.  Conclusion

The tax plan now going through Congress would provide very large cuts for the rich.  One can see this in the specific tax measures being proposed (with huge cuts in the portions of the tax system of most importance to the rich) and also in the direct estimates of the impacts by income group.  There are in addition numerous measures in the tax plan of interest to narrow groups, that are difficult to rationalize other than that they reflect what politically influential groups want.

The program, if adopted, would lead to a significantly less progressive tax system, and to a more complex one.  There would be a new category of income (pass-through income) receiving a special low tax rate, and hence new incentives for those who are well off to re-organize their compensation system when they can so that the incomes they receive would count as pass-through incomes.  While the law might try to set limits on these, past experience suggests that clever lawyers will soon find ways around such limits.

There are also results one would think most politicians would not advocate, such as the incentive to relocate corporate factories and activities to overseas.  They clearly do not understand the implications of what they have been and will be voting on.  This is not surprising, given the decision to try to rush this through before a full analysis and debate will be possible.  There have even been no hearings with independent experts at any of the committees.  And there is the blatant misrepresentation, such as that this is a “middle-class tax cut”, and that “taxes on millionaires will not be cut”.

If this is passed by Congress, in this way, there will hopefully be political consequences for those who chose nonetheless to vote for it.

Productivity: Do Low Real Wages Explain the Slowdown?

GDP per Worker, 1947Q1 to 2016Q2,rev

A.  Introduction, and the Record on Productivity Growth

There is nothing more important to long term economic growth than the growth in productivity.  And as shown in the chart above, productivity (measured here by real GDP in 2009 dollars per worker employed) is now over $115,000.  This is 2.6 times what it was in 1947 (when it was $44,400 per worker), and largely explains why living standards are higher now than then.  But productivity growth in recent decades has not matched what was achieved between 1947 and the mid-1960s, and there has been an especially sharp slowdown since late 2010.  The question is why?

Productivity is not the whole story; distribution also matters.  And as this blog has discussed before, while all income groups enjoyed similar improvements in their incomes between 1947 and 1980 (with those improvements also similar to the growth in productivity over that period), since then the fruits of economic growth have gone only to the higher income groups, while the real incomes of the bottom 90% have stagnated.  The importance of this will be discussed further below.  But for the moment, we will concentrate on overall productivity, and what has happened to it especially in recent years.

As noted, the overall growth in productivity since 1947 has been huge.  The chart above is calculated from data reported by the BEA (for GDP) and the BLS (for employment).  It is productivity at its most basic:  Output per person employed.  Note that there are other, more elaborate, measures of productivity one might often see, which seek to control, for example, for the level of capital or for the education structure of the labor force.  But for this post, we will focus simply on output per person employed.

(Technical Note on the Data: The most reliable data on employment comes from the CES survey of employers of the BLS, but this survey excludes farm employment.  However, this exclusion is small and will not have a significant impact on the growth rates.  Total employment in agriculture, forestry, fishing, and hunting, which is broader than farm employment only, accounts for only 1.4% of total employment, and this sector is 1.2% of GDP.)

While the overall rise in productivity since 1947 has been huge, the pace of productivity growth was not always the same.  There have been year-to-year fluctuations, not surprisingly, but these even out over time and are not significant. There are also somewhat longer term fluctuations tied to the business cycle, and these can be significant on time scales of a decade or so.  Productivity growth slows in the later phases of a business expansion, and may well fall as an economic downturn starts to develop.  But once well into a downturn, with businesses laying off workers rapidly (with the least productive workers the most likely to be laid off first), one will often see productivity (of those still employed) rise.  And it will then rise further in the early stages of an expansion as output grows while new hiring lags.

Setting aside these shorter-term patterns, one can break down productivity growth over the close to 70 year period here into three major sub-periods.  Between the first quarter of 1947 and the first quarter of 1966, productivity rose at a 2.2% annual pace.  There was then a slowdown, for reasons that are not fully clear and which economists still debate, to just a 0.4% pace between the first quarter of 1966 and the first quarter of 1982.  The pace of productivity growth then rose again, to 1.4% a year between the first quarter of 1982 and the second quarter of 2016.  But this was well less than the 2.2% pace the US enjoyed before.

An important question is why did productivity growth slow from a 2.2% pace between the late 1940s and mid-1960s, to a 1.4% pace since 1982.  Such a slowdown, if sustained, might not appear like much, but the impact would in fact be significant.  Over a 50 year period, for example, real output per worker would be 50% higher with growth at a 2.2% than it would be with growth at a 1.4% pace.

There is also an important question of whether productivity growth has slowed even further in recent years.  This might well still be a business cycle effect, as the economy has recovered from the 2008/09 downturn but only slowly (due to the fiscal drag from cuts in government spending).  The pace of productivity growth has been especially slow since late 2010, as is clear by blowing up the chart from above to focus on the period since 2000:

GDP per Worker, 2000Q1 to 2016Q2,rev

Productivity has increased at a rate of just 0.13% a year since late 2010.  This is slow, and a real problem if it continues.  I would hasten to add that the period here (5 1/2 years) is still too short to say with any certainty whether this will remain an issue.  There have been similar multi-year periods since 1947 when the pace of productivity growth appeared to slow, and then bounced back.  Indeed, as seen in the chart above, one would have found a similar pattern had one looked back in early 2009, with a slow pace of productivity growth observed from about 2005.

There has been a good deal of work done by excellent economists on why productivity growth has been what it was, and what it might be in the future.  But there is no consensus.  Robert J. Gordon of Northwestern University, considered by many to be the “dean in the field”, takes a pessimistic view on the prospects in his recently published magnum opus “The Rise and Fall of American Growth”.  Erik Brynjolfsson and Andrew McAfee of MIT, in contrast, argue for a more optimistic view in their recent work “The Second Machine Age” (although “optimistic” might not be the right word because of their concern for the implication of this for jobs).  They see productivity growth progressing rapidly, if not accelerating.

But such explanations are focused on possible productivity growth as dictated by what is possible technologically.  A separate factor, I would argue, is whether investment in fact takes place that makes use of the technology that is available.  And this may well be a dominant consideration when examining the change in productivity over the short and medium terms.  A technology is irrelevant if it is not incorporated into the actual production process.  And it is only incorporated into the production process via investment.

To understand productivity growth, and why it has fallen in recent decades and perhaps especially so in recent years, one must therefore also look at the investment taking place, and why it is what it is.  The rest of this blog post will do that.

B.  The Slowdown in the Pace of Investment

The first point to note is that net investment (i.e. after depreciation) has been falling in recent decades when expressed as a share of GDP, with this true for both private and public investment:

Domestic Fixed Investment, Total, Public, and Private, Net, percentage of GDP, 1951 to 2015, updated Aug 16, 2016

Total net investment has been on a clear downward trend since the mid-1960s.  Private net investment has been volatile, falling sharply with the onset of an economic downturn and then recovering.  But since the late 1970s its trend has also clearly been downward. Net private investment has been less than 3 1/2% of GDP in recent years, or less than half what it averaged between 1951 and 1980 (of over 7% of GDP).  And net public investment, while less volatile, has plummeted over time.  It averaged 3.1% of GDP between 1951 and 1968, but is only 0.5% of GDP now (as of 2015), or less than one-sixth of what it was before.

With falling net investment, the rates of growth of public and private capital stocks (fixed assets) have fallen (where 2014 is the most recent year for which the BEA has released such data):

Rate of Growth In Per Capita Net Stock of Private and Government Fixed Assets, edited, 1951 to 2014

Indeed, expressed in per capita terms, the stock of public capital is now falling.  The decrepit state of our highways, bridges, and other public infrastructure should not be a surprise.  And the stock of private capital fell each year between 2009 and 2011, with some recovery since but still at almost record low growth.

Even setting aside the recent low (or even negative) figures, the trend in the pace of growth for both public and private capital has declined since the mid-1960s.  Why might this be?

C.  Why Has Investment Slowed?

The answer is simple and clear for pubic capital.  Conservative politicians, in both the US Congress and in many states, have forced cuts in public investment over the years to the current low levels.  For whatever reasons, whether ideological or something else, conservative politicians have insisted on cutting or even blocking much of what the United States used to invest in publicly.

Yet public, like private, investment is important to productivity.  It is not only commuters trying to get to work who spend time in traffic jams from inadequate roads, and hence face work days of not 8 1/2 hours, but rather 10 or 11 or even 12 hours (with consequent adverse impacts on their productivity).  It affects also truck drivers and repairmen, who can accomplish less on their jobs due to time spent in jams.  Or, as a consequence of inadequate public investment in computer technology, a greater number of public sector workers are required than otherwise, in jobs ranging from issuing driver’s licenses to enrolling people in Medicare.  Inadequate public investment can hold back economic productivity in many ways.

The reasons behind the fall in private investment are less obvious, but more interesting. An obvious possible cause to check is whether private profitability has fallen.  If it has, then a reduction in private investment relative to output would not be a surprise.  But this has in fact not been the case:

Rate of Return on Produced Assets, 1951 to 2015, updated

The nominal rate of return on private investment has not only been high, but also surprisingly steady over the years.  Profits are defined here as the net operating surplus of all private entities, and is taken from the national account figures of the BEA.  They are then taken as a ratio to the stock of private produced assets (fixed assets plus inventories) as of the beginning of the year.  This rate of return has varied only between 8 and 13% over the period since at least 1951, and over the last several years has been around 11%.

Many might be surprised by both this high level of profitability and its lack of volatility.  I was.  But it should be noted that the measure of profitability here, net operating surplus, is a broad measure of all the returns to capital.  It includes not only corporate profitability, but also profits of unincorporated businesses, payments of interest (on borrowed capital), and payments of rents (as on buildings). That is, this is the return on all forms of private productive capital in the economy.

The real rates of return have been more volatile, and were especially low between 1974 and 1983, when inflation was high.  They are measured here by adjusting the nominal returns for inflation, using the GDP deflator as the measure for inflation.  But this real rate of return was a good 9.6% in 2015.  That is high for a real rate of return.  It was higher than that only for one year late in the Clinton administration, and for several years between the early 1950s and the mid-1960s.  But it was never higher than 11%.  The current real rate of return on private capital is far from low.

Why then has private investment slowed, in relation to output, if profitability is as high now as it has ever been since the 1950s?  One could conceive of several possible reasons. They include:

a)  Along the lines of what Robert Gordon has argued, perhaps the underlying pace of technological progress has slowed, and thus there is less of an incentive to undertake new investments (since the returns to replacing old capital with new capital will be less).  The rate of growth of capital then slows, and this keeps up profitability (as the capital becomes more scarce relative to output) even as the attractiveness of new investment diminishes.

b)  Conservatives might argue that the reduced pace of investment could be due to increased governmental regulations, which makes investment more difficult and raises its cost.  This might be difficult to reconcile with the rate of return on capital nonetheless remaining high, but in principle could be if one argues that the slower pace of new investment keeps up profitability as capital then becomes more scarce relative to output. But note that this argument would require that the increased burden of regulation began during the Reagan years in the early 1980s (when the share of private investment in GDP first started to slow – see the chart above), and built up steadily since then through both Republican and Democratic administrations.  It would not be something that started only recently under Obama.

c)  One could also argue that the reduced investment might be a consequence of “Baumol’s Cost Disease”.  This was discussed in earlier posts on this blog, both for overall government spending and for government investment in infrastructure specifically.  As discussed in those posts, Baumol’s Cost Disease explains why activities where productivity growth may be relatively more difficult to achieve than in other activities, will see their relative costs increase over time.  Construction is an example, where productivity growth has been historically more difficult to achieve than has been the case in manufacturing.  Thus the cost of investing, both public and private, relative to the cost of other items will increase over time.  This can then also be a possible explanation of slowing new investment, with that slower investment then keeping profitability up due to increasing scarcity of capital.

One problem with each of the possible explanations described above is that they all depend on capital investments becoming less attractive than before, either due to higher costs or due to reduced prospective return.  If such factors were indeed critical, one would need to take into account also the effect of taxes on investment returns.  And such taxes have been cut sharply over this same period.  As discussed in an earlier blog post, taxes on corporate profits, for example, are taxed now at an effective rate of less than 20%, based on what is actually paid after all the legal deductions and credits are included.  And this tax rate has fallen steadily over time.  The current 20% rate is less than half the effective rate that applied in the 1950s and 1960s, when the effective rate averaged almost 45%.  And the tax rate on long-term capital gains, as would apply to returns on capital to individuals, fell from a peak of just below 40% in the mid-1970s to just 15% following the Bush II tax cuts and to 20% since 2013.

Such sharp cuts in taxes on profits implies that the after-tax rate of return on assets has risen sharply (the before-tax rate of return, shown on the chart above, has been flat).  Yet despite this, private investment has fallen steadily since the early 1980s as a share of GDP.

Such explanations for the reason behind the fall in private investment since the early 1980s are therefore questionable.  However, the purpose of this blog post is not to debate this. Economists are good at coming up with models, possibly convoluted, which can explain things ex post.  Several could apply here.

Rather, I would suggest that there might be an alternative explanation for why private investment has been declining.  While consistent with basic economics, I have not seen it before.  This explanation focuses on the stagnant real wages seen since the early 1980s, and the impact this would have on whether or not to invest.

D.  The Impact of Low Real Wages

Real wages have stagnated in the US since the early 1980s, as has been discussed in earlier posts on this blog (see in particular this post).  The chart below, updated to the most recent figures available, compares the real median wage since 1979 (the earliest year available for this data series) to real GDP per worker employed:

Real GDP per Worker versus Real Median Wage, 1979Q1 to 2016Q2, rev

Real median wages have been flat overall:  Just 3% higher in 2016 than what they were 37 years before.  But real GDP per worker is almost 60% higher over this same period.  This has critically important implications for both private investment and for productivity growth. To sum up in one line the discussion that will follow below, there is less and less reason to invest in new, productivity enhancing, capital, if labor is available at a stagnant real wage that has changed little in 37 years.

Traditional economics, as commonly taught, would find it difficult to explain the observed stagnation in real wages while productivity has risen (even if at a slower pace than before). A core result taught in microeconomics is that in “perfectly competitive” markets, labor will be paid the value of its marginal product.  One would not then see a divergence such as that seen in this chart between growth in productivity and a lack of growth in the real wage.

(The more careful observers among the readers of this post might note that the productivity curve shown here is for average productivity, and not the marginal productivity of an extra worker.  This is true.  Marginal productivity for the economy as a whole cannot be easily observed, nor indeed even be well defined.  However, one should note that the average productivity curve, as shown here, is rising over time.  This can only happen if marginal productivity on new investments are above average productivity at any point in time.  For other reasons, the real average wage would not rise permanently above average productivity (there would be an “adding-up” problem otherwise), but the theory would still predict a rise in the real wage with the increase in observed productivity.)

There are, however, clear reasons why workers might not be paid the value of their marginal product in the real world.  As noted, the theory applies in markets that are assumed to be perfectly competitive, and there are many reasons why this is not the case in the world we live in.  Perfect competition assumes that both parties to the transaction (the workers and employers) have complete information on not only the opportunities available in the market and on the abilities of the individual worker, but also that there are no costs to switching to an alternative worker or employer.  If there is a job on the other side of the country that would pay the individual worker a bit more, then the theory assumes the worker will switch to it.  But there are, of course, significant costs to moving to the other side of the country.  Furthermore, there will be uncertainty on what the abilities of any individual worker will be, so employers will normally seek to keep the workers they already have to fill their needs (as they know what these workers can do), than take a risk on a largely unknown new worker who might be willing to work for a lower wage.

For these and other reasons, labor markets are not perfectly competitive, and one should not then be surprised to find workers are not being paid the value of their marginal product.  But there is also an important factor coming from the macroeconomy. Microeconomics assumes that all resources, including labor resources, are being fully employed.  But unemployment exists and is often substantial.  Additional workers can then be hired at the current wage, without a need for the firm to raise that wage.  And that will hold whether or not the productivity of those workers has risen.

In such an environment, when unemployment is substantial one should not be surprised to find a divergence between growth in productivity and growth in the real wage.  And while there have of course been sharp fluctuations arising from the business cycle in the rate of unemployment from year to year, the simple average in the rate since 1979 has been 6.4%.  This is well in excess of what is normally considered the full employment rate of unemployment (of 5% or less).  Macro policy (both fiscal and monetary) has not done a very good job in most of the years since 1979 in ensuring there is sufficient demand in the aggregate in the economy to allow all workers who want to be employed in fact to be employed.

In such an environment, of workers being available for hire at a stagnant real wage which over time diverges more and more from their productivity, consider the investment decision a private firm faces.  Suppose they see a market opportunity and can sell more. To produce more, they have two options.  They can hire more labor to work with their existing plant and equipment to produce more, or they can invest in new plant and equipment.  If they choose the latter, they can produce more with fewer workers than they would otherwise need at the new level of production.  There will be more output per unit of labor input, or put another way, productivity will rise if the latter option is chosen.

But in an economy where labor is available at a flat real wage that has not changed in decades, the best choice will often simply be to hire more labor.  The labor is cheap.  New investment has a cost, and if the cost of the alternative (hire more labor) is low enough, then it is more profitable for the firm simply to hire more labor.  Productivity in such a case will then not go up, and may indeed even go down.  But this could be the economically wise choice, if labor is cheap enough.

Viewed in this way, one can see that the interpretation of many conservatives on the relationship between productivity growth and the real wage has it backwards.  Real wages have not been stagnant because productivity growth has been slow.  Labor productivity since 1979 has grown by a cumulative 60%, while real median wages have been basically flat.

Rather, the causation may well be going the other way.  Stagnant and low real wages have led to less and less of an incentive for private firms to invest.  And such a cut-back is precisely what we saw in the chart above on private (as well as public) investment as a share of GDP.  With less investment, the pace of productivity growth has then slowed.

As a reflection of this confusion, conservatives have denounced any effort to raise wages, asserting that if this is done, jobs will be lost as firms choose instead to invest and automate.  They assert that raising the minimum wage, which is currently lower in real terms than what it was when Harry Truman was president, would lead to minimum wage workers losing their jobs.  As a former CEO of McDonalds put it in a widely cited news report from last May, a $15 minimum wage would lead to “a job loss like you can’t believe.”   Fast food outlets like McDonalds would then find it better to invest in robotic arms to bag the french fries, he said, rather than hire workers to do this.

This is true.  The confusion comes from the widespread presumption that this is necessarily bad.  Outlets like McDonalds would then require fewer workers, but they would still need workers (including to operate the robotic arms), and those workers would be more productive.  They could be paid more, and would be if the minimum wage is raised.

The error in the argument comes from the presumption that the workers being employed at the current minimum wage of $7.25 an hour do not and can not possess the skills needed to be employed in some other job.  There is no reason to believe this to be the case.  There was no problem with ensuring workers could be fully employed at a minimum wage which in real terms was higher in 1950, when Harry Truman was president, than what it is now.  And average worker productivity is 2.4 times higher now than what it was then.

Ensuring full employment in the economy as a whole is not a responsibility of private business.  Rather, it is a government responsibility.  Fiscal and monetary policy need to be managed so that labor markets are tight enough to ensure all workers who want a job can get a job, while not so tight at to lead to inflation.

Following the economic collapse at the end of the Bush administration in 2008, monetary policy did all it could to try to ensure sufficient aggregate demand in the economy (interest rates were held at or close to zero).  But monetary policy alone will not be enough when the economy collapsed as far as it did in 2008.  It needs to be complemented by supportive fiscal policy.  While there was the initial stimulus package of Obama which was critical to stabilizing the economy, it did not go far enough and was allowed to run out. And government spending from 2010 was then cut, acting as a drag which kept the pace of recovery slow.  The economy has only in the past year returned to close to full employment.  It is not a coincidence that real wages are finally starting to rise (as seen in the chart above).

E.  Conclusion

Productivity growth is key in any economy.  Over the long run, living standards can only improve if productivity does.  Hence there is reason to be concerned with the slower pace of productivity growth seen since the early 1980s, and especially in recent years.

Investment, both public and private, is what leads to productivity growth, but the pace of investment has slowed since the levels seen in the 1950s and 60s.  The cause of the decline in public investment is clear:  Conservative politicians have slowed or even blocked public investment.  The result is obvious in our public infrastructure:  It is overused, under-maintained, and often an embarrassment.

The cause of the slowdown in private investment is less obvious, but equally important. First, one cannot blame a decline in private investment on a fall in profitability:  Profitability is higher now than it has been in all but one year since the mid-1960s.

Rather, one needs to recognize that the incentive to invest in productivity enhancing tools will not be there (or not there to the same extent) if labor can be hired at a wage that has stagnated for decades, and which over time became lower and lower relative to existing productivity.  It then makes more sense for firms to hire more workers with their existing stock of capital and other equipment, rather than invest in new, productivity enhancing, capital.  And this is what we have observed:  Workers are being hired, but productivity is not growing.

An argument is often made that if firms did indeed invest in capital and equipment that would raise productivity, that workers would then lose their jobs.  This is actually true by definition:  If productivity is higher, then the firm needs fewer workers per unit of output than they would otherwise.  But whether more workers would be employed in the economy as a whole does not depend on the actions of any individual firm, but rather on whether fiscal and monetary policy is managed to ensure full employment.

That is, it is the investment decisions of private firms which determine whether productivity will grow or not.  It is the macro management decisions of government which determine whether workers will be fully employed or not.

To put this bluntly, and in simplistic “bumper sticker” type terms, one could say that private businesses are not job creators, but rather job destroyers.  And that is fine.  Higher productivity means that a firm needs fewer workers to produce what they make than would otherwise have been needed, and this is important for ensuring efficiency.  As a necessary complement to this, however, it is the actions of government, through its fiscal and monetary policies, which “creates” jobs by managing aggregate demand to ensure all workers who want to be employed, are employed.

The Impact of Increased Inequality on the Social Security Trust Fund, and What To Do Now

Social Security Trust Fund to GDP, with benefit changes, 90% of Wages from 1984 or 2016, 1970 to 2090, revised

A.  Introduction

It is well known that with current Social Security tax and benefit rates, the Social Security Trust Fund is projected to run out by the 2030s.  The most recent projection is that this will happen in 2034.  And it is commonly believed that this is a consequence of lengthening life spans.  However, that is not really true.  Later in this century (in the period after the 2030s), life spans that are now forecast to be longer than had been anticipated before will eventually lead, if nothing is done, to depletion of the trust funds.  But the primary cause of the trust funds running out by the currently projected 2034 stems not from longer life spans, but rather from the sharp growth in US income inequality since Ronald Reagan was president.  Had inequality not grown as it has since the early 1980s, and with all else as currently projected, the Social Security Trust Fund would last to about 2056.

This particular (and important) consequence of the growing inequality in American society over the last several decades does not appear to have been recognized before.  Rather, the problems being faced by the Social Security Trust Fund are commonly said to be a consequence of lengthening life expectancies of Americans (where it is the life expectancy of those at around age 65, the traditional retirement age, that is relevant).  I have myself stated this in earlier posts on this blog.

But this assertion that longer life spans are to blame has bothered me.  Social Security tax rates and benefit formulae have been set based on what were thought at the time to be levels that would allow all scheduled benefits to be paid for the (then) foreseeable future, based on the forecasts of the time (of life expectancies and many other factors). Thus it is not correct to state that it is longer life spans per se that can be to blame for the Social Security Trust Fund running out.  Rather, it would be necessary for life spans to be lengthening by more than had been expected before for this to be the case.

This blog post will look first at these projections of life expectancy – what path was previously forecast in comparison to what in fact happened (up to now) and what is forecast (now) for the future.  We will find that the projections used to set the current Social Security tax and benefit rates (last changed in the early 1980s) had in fact forecast life spans which would be longer than what transpired in the 1980s, 1990s, and 2000s.  That is, actual life expectancies have turned out to be shorter than what had been forecast for those three decades.  However, life spans going forward are currently forecast to be longer than what had been projected earlier.  On average, it turns out that the earlier forecasts were not far off from what happened or is now expected through to 2034.  Unexpectedly longer life spans do not account for the current forecast that the Social Security Trust Fund will run out by 2034.

Rather, the problem is due to the sharp increase in wage income inequality since the early 1980s.  Only wages up to a ceiling (of $118,500 in 2016) are subject to Social Security tax.  Wages earned above that ceiling amount are exempt from the tax.  In 1982 and also in 1983, the ceiling then in effect was such that Social Security taxes were paid on 90% of all wages earned.  But as will be discussed below, increasing wage inequality since then has led to an increasing share of wages above the ceiling, and hence exempt from tax.  It is this increasing wage income inequality which is leading the Social Security Trust Fund to an expected depletion by 2034, if nothing is done.

This blog post will look at what path the Social Security Trust Fund would have taken had wage inequality not increased since 1983.  Had that been the case, 90% of wages would have been covered by Social Security tax since 1984, in the past and going forward.  But since it is now 2016 and we cannot change history, we will also look at what the path would be if the ceiling were now returned, from 2016 going forward, to a level covering 90% of wages.  The final section of the post will then look at what would happen if the wage ceiling were lifted altogether so that the rich would pay at the same rate of tax as the poor.

One final point for this introduction:  In addition to longer life spans, many commentators assert that it is the retiring baby boom generation which is depleting the Social Security Trust Fund.  But this is also not true.  The Social Security tax and benefit rates were set in full knowledge of how old the baby boomers were, and when they would be reaching retirement age.  Demographic projections are straightforward, and they had a pretty good estimate 64 years ago of how many of us would be reaching age 65 today.

B.  Projections of Increasing Life Spans for Those in Retirement

Life expectancies have been growing.  But this has been true for over two centuries, and longer expected life spans have always been built into the Social Security calculations of what the Social Security tax rates would need to be in order to provide for the covered benefits.  The issue, rather, is whether the path followed for life expectancies (actual up to now and as now expected for the future) is higher or lower than the path that had been expected earlier.

What we have seen in recent decades is that while life spans for those of higher income have continued to grow, they have increased only modestly for the bottom half of income earners.  Part of the reason for this stagnation of life expectancy for the bottom half of the income distribution is undoubtedly a consequence of stagnant real incomes for lower income earners.  As discussed in an earlier post on this blog, median real wages have hardly risen at all since 1980.  And indeed, average real household incomes of the bottom 90% of US households were lower in 2014 than they were in 1980.

Thus it is an open question whether life spans are turning out to be longer than what had been projected before, when Social Security tax and benefit rates were last adjusted.  The most recent such major adjustment was undertaken in 1983, following the report of the Greenspan Commission (formally titled the National Commission on Social Security Reform).  President Reagan appointed Alan Greenspan to be the chair (and later appointed him to be the head of the Federal Reserve Board), with the other members appointed either by Reagan or by Congress (with a mix from both parties).

The Greenspan Commission made recommendations on a set of measures (which formed the basis for legislation enacted by Congress in 1983) which together would ensure, based on the then current projections, that the Social Security Trust Fund would remain adequate through at least 2060.  They included a mix of increased tax rates (with the Social Security tax rate raised from 10.8% to 12.4%, phased in over 7 years, with this for both the old-age pensions and disability insurance funds and covering both the employer and employee contributions) and reduced benefits (with, among other changes, the “normal” retirement age increased over time).

It is now forecast, however, that the Trust Funds will run out by 2034.  What changed? The common assertion is that longer life spans account for this.  However, this is not true. The life spans used by the Greenspan Commission (see Appendix K of their report, Table 12) were in fact too high, averaging male and female together, up to about 2010, but are now forecast to be too low going forward.  More precisely, comparing those forecasts to those in the most recent 2015 Social Security Trustees Report:

Projected Life Expectancies at Age 65 - As of 1982 vs 2015, Up to 2090

 

The chart shows the forecasts (in blue) used by the Greenspan Commission (which were in turn taken from the 1982 Social Security Trustees Report) overlaid on the current (2015, in red) history and projections.  The life span forecasts used by the Greenspan Commission turned out actually to be substantially higher than what were the case or are forecast now to be the case for females to some point past 2060, higher up to the year 2000 for males, and based on the simple male/female average, higher up to about 2010 for all, than what were estimated in the 2015 report.  For the full period from 1983 to 2034 (using interpolated figures for the periods when the 1982 forecasts were only available for every 5 and then every 10 years), it turns out that the average over time of the differences in the male/female life expectancy at age 65 between the 1982 forecasts and those from 2015, balances almost exactly. The difference is only 0.01 years (one-hundreth of a year).

For the overall period up to 2034, the projections of life expectancies used by the Greenspan Commission are on average almost exactly the same as what has been seen up to now or is currently forecast going forward (cumulatively to 2034).  And it is the cumulative path which matters for the Trust Fund.  Unexpectedly longer life expectancies do not explain why the Social Security Trust Fund is now forecast to run out by 2034.  Nor, as noted above, is it due to the pending retirement of more and more of the baby boom generation.  It has long been known when they would be reaching age 65.

C.  The Ceiling on Wages Subject to Social Security Tax

Why then, is the Social Security Trust Fund now expected to run out by 2034, whereas the Greenspan Commission projected that it would be fine through 2060?  While there are many factors that go into the projections, including not just life spans but also real GDP growth rates, interest rates, real wage growth, and so on, one assumption stands out. Social Security taxes (currently at the rate of 12.4%, for employee and employer combined) only applies to wages up to a certain ceiling.  That ceiling is $118,500 in 2016. Since legislation passed in 1972, this ceiling has been indexed in most years (1979 to 1981 were exceptions) to the increase in average wages for all employees covered by Social Security.

The Greenspan Commission did not change this.  Based on the ceiling in effect in 1982 and again in 1983, wages subject to Social Security tax would have covered 90.0% of all wages in the sectors covered by Social Security.  That is, Social Security taxes would have been paid on 90% of all wages in the covered sectors in those years.  If wages for the poor, middle, and rich had then changed similarly over time (in terms of their percentage increases), with the relative distribution thus the same, an increase in the ceiling in accordance with changes in the overall average wage index would have kept 90% of wages subject to the Social Security tax.

However, wages did not change in this balanced way.  Rather, the changes were terribly skewed, with wages for the rich rising sharply since the early 1980s while wages for the middle classes and the poor stagnated.  When this happens, with wages for the rich (those earning more than the Social Security ceiling) rising by more (and indeed far more) than the wages for others, indexing the ceiling to the average wage will not suffice to keep 90% of wages subject to tax.  Rather, the share of wages paying Social Security taxes will fall.  And that is precisely what has happened:

Social Security Taxable Wages as Share of Total Wages, 1982 to 2090

Due to the increase in wage income inequality since the early 1980s, wages paying Social Security taxes fell from 90.0% of total wages in 1982 and again in 1983, to just 82.7% in 2013 (the most recent year with data, see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  While the trend is clearly downward, note how there were upward movements in 1989/90/91, in 2001/02, and in 2008/09.  These coincided with the economic downturns at the start of the Bush I administration, the start of the Bush II administration, and the end of the Bush II administration.  During economic downturns in the US, wages of those at the very top of the income distribution (Wall Street financiers, high-end lawyers, and similar) will decline especially sharply relative to where they had been during economic booms, which will result in a higher share of all wages paid in such years falling under the ceiling.

Why did the Greenspan Commission leave the rule for the determination of the ceiling on wages subject to Social Security tax unchanged?  Based on the experience in the decades leading up to 1980, this was not unreasonable.  In the post-World War II decades up to 1980, the distribution of incomes did not change much.  As discussed in an earlier post on this blog, incomes of the rich, middle, and poor all grew at similar rates over that period, leaving the relative distribution largely unchanged.  It was not unreasonable then to assume this would continue.  And indeed, there is a footnote in a table in the annex to the Greenspan Commission report (Appendix K, Table 15, footnote c) which states:  [Referring to the column showing the historical share in total wages of wages below the ceiling, and hence subject to Social Security tax] “The percent taxable for future years [1983 and later] should remain relatively stable as the taxable earnings base rises automatically based on increases in average wage levels.”

Experience turned out to be quite different.  Income inequality has risen sharply since Reagan was president.  This reduced the share of wages subject to Social Security tax, and undermined the forecasts made by the Greenspan Commission that with the changes introduced, the Social Security Trust Fund would remain adequate until well past 2034.

Going forward, the current forecasts for the path of the share of wages falling under the ceiling and hence subject to Social Security tax are shown as the blue curve in the chart. The forecasts (starting from 2013, the year with the most recent data when the Social Security Administration prepared these projections) are that the share would continue to decline until 2016.  However, they assume the share subject to tax will then start a modest recovery, reaching a share of 82.5% 2024 at which it will then remain for the remainder of the projection period (to 2090).  (The figures are from the Social Security Technical Panel Report, September 2015, see page 64 and following.  The annual Social Security Trustees Report does not provide the figures explicitly, even though they are implicit in their projections.)

This stabilization of the share of wages subject to Social Security tax at 82.5% is critically important.  Should the wage income distribution continue to deteriorate, as it has since the early 1980s, the Social Security Trust Fund will be in even greater difficulty than is now forecast.  And it is not clear why one should assume this turnaround should now occur.

Finally, it should be noted for completeness that the share of wages subject to tax varied substantially over time in the period prior to 1982.  Typically, it was well below 90%.  When Social Security began in 1937, the ceiling then set meant that 92% of wages (in covered sectors) were subject to tax (see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  But the ceiling was set in nominal terms (initially at $3,000), which meant that it fell in real terms over time due to steady, even if low, inflation.  Congress responded by periodically adjusting the annual ceiling upward in the 1950s, 1960s, and 1970s, but always simply setting it at a new figure in nominal terms which was then eroded once again by inflation.  Only when the new system was established in the 1970s of adjusting the ceiling annually to reflect changes in average nominal wages did the inflation issue get resolved.  But this failed to address the problem of changes in the distribution of wages, where an increasing share of wages accruing to the rich in recent decades (since Reagan was president) has led to the fall since 1983 in the share subject to tax.

Thus an increasing share of wages has been escaping Social Security taxes.  The rest of this blog post will show that this explains why the Social Security Trust Fund is now projected to run out by 2034, and what could be achieved by returning the ceiling to where it would cover 90% of wages, or by lifting it entirely.

D.  The Impact of Keeping the Ceiling at 90% of Total Wages

The chart at the top of this post shows what the consequences would be if the ceiling on wages subject to Social Security taxes had been kept at levels sufficient to cover 90% of total wages (in sectors covered by Social Security), with this either from 1984 going forward, or starting from 2016.  While the specific figures for the distant future (the numbers go out to 2090) should not be taken too seriously, the trends are of interest.

The figures are calculated from data and projections provided in the 2015 Social Security Trustees Annual Report, with most of the specific data coming from their supplemental single-year tables (and where the share of wages subject to tax used in the Social Security projections are provided in the 2015 Social Security Technical Panel Report).  Note that throughout this blog post I am combining the taxes and trust funds for Old-Age Security (OASI, for old age and survivor benefits) and for Disability Insurance (DI).  While technically separate funds, these trust funds are often combined for analysis, in part because in the past they have traditionally been able to borrow from each other (although Republicans in Congress are now trying to block this flexibility).

The Base Case line (in black) shows the path of the Social Security Trust Fund to GDP ratio based on the most recent intermediate case assumptions of Social Security, as presented in the 2015 Social Security Trustees Annual Report.  The ratio recovered from near zero in the early 1980s to reach a high of 18% of GDP in 2009, following the changes in tax and benefit rates enacted by Congress after the Greenspan Commission report.  But it then started to decline, and is expected to hit zero in 2034 based on the most recent official projections.  After that if would grow increasingly negative if benefits were to continue to be paid out according to the scheduled formulae (and taxes were to continue at the current 12.4% rate), although Social Security does not have the legal authority to continue to pay out full benefits under such circumstances.  The projections therefore show what would happen under the stated assumptions, not what would in fact take place.

But as noted above, an important assumption made by the Greenspan Commission that in fact did not hold true was that adjustments (based on changes in the average wage) of the ceiling on wages subject to Social Security tax, would leave 90% of wages in covered sectors subject to the tax.  This has not happened due to the growth in wage income inequality in the last 35 years.  With the rich (and especially the extreme rich) taking in a higher share of wages, the wages below a ceiling that was adjusted according to average wage growth has led to a lower and lower share of overall wages paying the Social Security tax.  The rich are seeing a higher share of the high wages they enjoy escaping such taxation.

The blue curves in the chart show what the path of the Social Security Trust Fund to GDP ratio would have been (and would be projected going forward, based on the same other assumptions of the base case) had the share of wages subject to Social Security taxes remained at 90% from 1984.  The dark blue curve shows what path the Trust Fund would have taken had Social Security benefits remained the same.  But since benefits are tied to Social Security taxes paid, the true path will be a bit below (shown as the light blue curve). This takes into account the resulting higher benefits (and income taxes that will be paid on these benefits) that will accrue to those paying the higher Social Security taxes.  This was fairly complicated, as one needs to work out the figures year by year for each age cohort, but can be done.  It turns out that the two curves end up being quite close to each other, but one did not know this would be the case until the calculations were done.

Had the wage income distribution not deteriorated after 1983, and with all else as in the base case path of the Social Security Trustees Report (actual for historical, or as projected going forward), the Trust Fund would have grown to a peak of 26% of GDP in 2012, before starting on a downward path.  It would eventually still have turned negative, but only in 2056.  Over the long term, the forecast increase in life expectancies (beyond what the Greenspan Commission had assumed) would have meant that further changes beyond what were enacted following the Greenspan Commission report would eventually have become necessary to keep the Trust Fund solvent.  But it would have occurred more than two decades beyond what is now forecast.

At this point in time, however, we cannot go back in time to 1984 to keep the ceiling sufficient to cover 90% of wages.  What we can do now is raise the ceiling today so that, going forward, 90% of wages would be subject to the tax.  Based on 2014 wage distribution statistics (available from Social Security), one can calculate that the ceiling in 2014 would have had to been raised from the $117,000 in effect that year, to $185,000 to once again cover 90% of wages (about $187,000 in 2016 prices). 

The red curves on the chart above show the impact of starting to do this in 2016.  The Trust Fund to GDP ratio would still fall, but now reach zero only in 2044, a decade later than currently forecast.  Although there would be an extra decade cushion as a result of the reform, there would still be a need for a longer term solution.   

E.  The Impact of Removing the Wage Ceiling Altogether

The financial impact of removing the wage ceiling altogether will be examined below.  But before doing this, it is worthwhile to consider whether, if one were designing a fair and efficient tax structure now, would a wage ceiling be included at all?  The answer is no. First, it is adds a complication, and hence it is not simple.  But more importantly, it is not fair.  A general principle for tax systems is that the rich should pay at a rate at least as high as the poor.  Indeed, if anything they should pay at a higher rate.  Yet Social Security taxes are paid at a flat rate (of 12.4% currently) for wages up to an annual ceiling, and at a zero rate for earnings above that ceiling.

While it is true that this wage ceiling has been a feature of the Social Security system since its start, this does not make this right.  I do not know the history of the debate and political compromises necessary to get the Social Security Act passed through Congress in 1935, but could well believe that such a ceiling may have been necessary to get congressional approval.  Some have argued that it helped to provide the appearance of Social Security being a self-funded (albeit mandatory) social insurance program rather than a government entitlement program.  But for whatever the original reason, there has been a ceiling.

But the Social Security tax is a tax.  It is mandatory, like any other tax.  And it should follow the basic principles of taxation.  For fairness as well as simplicity, there should be no ceiling.  The extremely rich should pay at least at the same rate as the poor.

One could go further and argue that the rates should be progressive, with marginal rates rising for those at higher incomes.  There are of course many options, and I will not go into them here, but just note that Social Security does introduce a degree of progressivity through how retirement benefits are calculated.  The poor receive back in pensions a higher amount in relation to the amounts they have paid in than the rich do.  One could play with the specific parameters to make this more or less progressive, but it is a reasonable approach.  Thus applying a flat rate of tax to all income levels is not inconsistent with progressivity for the system as a whole.

Leaving the Social Security tax rate at the current 12.4% (for employer and employee combined), but applying it to all wages from 2016 going forward and not only wages up to an annual ceiling, would lead to the following path for the Trust Fund to GDP ratio:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised

The Trust Fund would now be projected to last until 2090.  Again, the projections for the distant future should not be taken too seriously, but they indicate that on present assumptions, eliminating the ceiling on wages subject to tax would basically resolve Trust Fund concerns for the foreseeable future.  A downward trend would eventually re-assert itself, due to the steadily growing life expectancies now forecast (see the chart in the text above for the projections from the 2015 Social Security Trustees Annual Report). Eventually there will be a need to pay in at a higher rate of tax if taxes on earnings over a given working life are to support a longer and longer expected retirement period, but this does not dominate until late in the forecast period.

As a final exercise, how high would that tax rate need to be, assuming all else (including future life expectancies) are as now forecast?  The chart below shows what the impact would be of raising the tax rate to 13.0% from 2050:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised #2

The Social Security Trust Fund to GDP ratio would then be safely positive for at least the rest of the century, assuming the different variables are all as now forecast.  This would be a surprisingly modest increase in the tax rate from the current 12.4%.  If separated into equal employer and employee shares, as is traditionally done, the increase would be from a 6.2% tax paid by each to a 6.5% tax paid by each.  Such a separation is economically questionable, however.  Most economists would say that, under competitive conditions, the worker will pay the full tax.  Whether labor markets can be considered always to be competitive is a big question, but beyond the scope of this blog post.

F.  Summary and Conclusion

To summarize:

1)  The Social Security Trust Fund is projected to be depleted under current tax and benefit rates by the year 2034.  But this is not because retirees are living longer.  Increasing life spans have long been expected, and were factored into the estimates (the last time the rates were changed) of what the tax and benefit rates would need to be for the Trust Fund not to run out.  Nor is it because of aging baby boomers reaching retirement.  This has long been anticipated.

2)  Rather, the Social Security Trust Fund is now forecast to run out by the 2030s because of the sharp increase in wage income inequality since the early 1980s, when the Greenspan Commission did its work.  The Greenspan Commission assumed that the distribution of wage incomes would remain stable, as it had in the previous decades since World War II.  But that turned out not to be the case.

3)  If relative inequality had not grown, then raising the ceiling on wages subject to Social Security tax in line with the increase in average wages (a formula adopted in legislation of 1972, and left unchanged following the Greenspan Commission) would have kept 90% of wages subject to Social Security tax, the ratio it covered in 1982 and again in 1983.

4)  But wage income inequality has grown sharply since the early 1980s.  With the distribution increasingly skewed distribution, favoring the rich, an increasing share of wages is escaping Social Security tax.  By 2013, the tax only covered 82.7% of wages, with the rest above the ceiling and hence paying no tax.

5)  Had the ceiling remained since 1984 at levels sufficient to cover 90% of wages, and with all other variables and parameters as experienced historically or as now forecast going forward, the Social Security Trust Fund would be forecast to last until 2056.  While life expectancies (at age 65) in fact turned out on average to be lower than forecast by the Greenspan Commission until 2010 (which would have led to a higher Trust Fund balance, since less was paid out in retirement than anticipated), life expectancies going forward are now forecast to be higher than what the Greenspan Commission assumed.  This will eventually dominate.

6)  If the wage ceiling were now adjusted in 2016 to a level sufficient to cover once again 90% of wages ($187,000 in 2016), the Trust Fund would turn negative in 2044, rather than 2034 as forecast if nothing is done.

7)  As a matter of equity and following basic taxation principles, there should not be any wage ceiling at all.  The rich should pay Social Security tax at least at the same rate as the poor.  Under the current system, they pay zero on wage incomes above the ceiling.

8)  If the ceiling on wages subject to Social Security tax were eliminated altogether, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last until 2090.

9)  If the ceiling on wages subject to Social Security tax were eliminated altogether and the tax rate were raised from the current 12.4% to a new rate of 13.0% starting in 2050, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last to well beyond the current century.