Fund the Washington Area Transit System With A Mandatory Fee on Commuter Parking Spaces

A.  Introduction

The Washington region’s primary transit authority (WMATA, for Washington Metropolitan Area Transit Authority, which operates both the Metrorail system and the primary bus system in the region) desperately needs additional funding.  While there are critical issues with management and governance which also need to be resolved, everyone agrees that additional funding is a necessary, albeit not sufficient, element of any recovery program. This post will address only the funding issue.  While important, I have nothing to contribute here on the management and governance issues.

WMATA has until now been funded, aside from fares, by a complex set of financial contributions from a disparate set of political jurisdictions in the Washington metropolitan region (four counties, three municipalities, plus Washington, DC, the states of Maryland and Virginia, and the federal government, for a total of 11 separate political jurisdictions). Like for governments everywhere, budgets are limited.  Not surprisingly, the decisions on how to share out the costs of WMATA are politically difficult, and especially so as a higher contribution by one jurisdiction, if not matched by others, will lead to a lower share in the costs by those others.  And unlike most large transit systems in the US, WMATA depends entirely (aside from fares) on funding from political jurisdictions.  It has no dedicated source of tax revenues.

This is clearly not working.  Everyone agrees that additional funding is needed, and most agree that a dedicated funding source needs to be created to supplement the funds available to WMATA.  But there is no agreement on what that additional funding source should be.  There have been several proposals, including an increase in the sales tax rate in the region or a special additional tax on properties located near Metro stations, but each has difficulties and there is no consensus.  As I will discuss below, there are indeed issues with each.  They would not provide a good basis for funding transit.

The recommendation developed here is that a fee on commuter parking spaces would provide the best approach to providing the additional funding needed by the Washington region’s transit system.  This alternative has not figured prominently in the recent discussion, and it is not clear why.  It might be because of an unfounded perception that such a fee would be difficult to implement.  As discussed below, this is not the case at all.  It could be easily implemented as part of the property tax system that is used throughout the Washington region.  It should be considered as an approach to raising the funds needed, and would perhaps serve as an alternative that could break the current impasse resulting from a lack of consensus for any of the other alternatives that have been put forward thus far.

Four factors need to be considered in any assessment of possible options to fund the transit systems.  These are:

  • Feasibility:  Would it be possible to implement the option in practical terms?  If it cannot be implemented, there is no point in considering it further.
  • Effectiveness:  Would the option be able to raise the amount of funds needed, with the parameters (such as the tax rates) at reasonable levels that would not be so high as to create problems themselves?
  • Efficiency:  Would the economic incentives created by the option work in the direction one wants, or the opposite?
  • Fairness:  Would the tax or option be fair in terms of who would pay for it?  Would it be disproportionately paid for by the poor, for example?

This blog post will assess to what degree these four tests are met by each of several major options that have been proposed to provide additional funding to WMATA.  A mandatory fee on parking spaces will be considered first, and in most detail.  Many will call this a tax on parking, and that is OK.  It is just a label.  But I would suggest it should be seen as a fee on rush hour drivers, who make use of our roads and fill them up to the point of congestion.  It can be considered similar to the fees we pay on our water bills – one would be paying a fee for using our roads at the times when their capacity is strained.  But one should not get caught up in the polemics:  Whether tax or mandatory fee, they would be a charge on the parking spaces used by those commuters who drive.

Other options then considered are an increase in the bus and rail fares charged, an increase in the sales tax rate on all goods purchased in the region, and enactment of a special or additional property tax on land and development close to the Metrorail stations in the region.

No one disputes that enactment of any of these taxes or fees or higher fares will be politically difficult.  But the Washington region would collapse if its Metrorail system collapsed.  Metrorail was until recently the second busiest rail transit system in the US in terms of ridership (after New York).  However, Metrorail ridership declined in recent years, to the point that it was 17% lower in FY2016 than what it was in FY2010.  The decline is commonly attributed to a combination of relatively high fares, lack of reliability, and the increased safety concerns of recent years, combined most recently with periodic shutdowns on line segments in order to carry out urgent repairs and maintenance. Despite this, Metrorail in 2016 was still the third busiest rail system in the country (just after Chicago).

But the Washington region cannot afford this decline in transit use.  Its traffic congestion, even with Metro operating, is by various measures either the worst in the nation or one of the worst.  Furthermore, the traffic congestion is not just in or near the downtown area.  As offices have migrated to suburban centers over the last several decades, traffic during rush hour is now horrendous not simply close to the city center, but throughout the region. See, for example, this screen shot from a Google Maps image I took at typical weekday afternoon during rush hour (5:30 pm on Tuesday, April 18):

The roads shown in red have traffic backed up.  The congestion is bad not simply around downtown, nor simply on the notoriously congested Capital Beltway as well, but also on roads at the very outer reaches of the suburbs.  The problem is region-wide, and it is in the interest of everyone in the region that it be addressed.

A good and well-run transit system will be a necessary component of what will be needed to fix this, although this is just the minimum.  And for this, it will be fundamental that there be a change in approach from a short-term focus on resolving the immediate crisis by some patch, to a perspective that focuses on how best to utilize, and over time enhance, the overall transportation system assets of the Washington region.  This includes both the Metro system assets (where a value of $40 billion has been commonly cited, presumably based on its historical cost) but also the value of the highways and bridges and parking facilities of the region, with a cost and a value that would add up to far more. These assets are not well utilized now.  A proper funding system for WMATA should take this into account.  If it is not, one can end up with empty seats on transit while the roads are even more congested.

The first question, however, is how much additional funding is required for WMATA.  The next section will examine that.

B.  WMATA’s Additional Funding Needs

How much is needed in additional funding for WMATA?  There is not a simple answer, and any answer will depend not only on the time frame considered but also on what the objective is.

To start, the FY18 budget for WMATA as originally drawn up in the fall of 2016 found there to be a $290 million gap between expenditures it considered to be necessary based on the current plans, and the revenues it forecast it would receive from fares (and other revenue generating activities such as parking fees at the stations and from advertising) and what would be provided under existing formulae from the political jurisdictions.  This gap was broadly similar in magnitude to the gaps found in recent years at a similar stage in the process.  And as in earlier years, this $290 million gap was largely closed by one-off measures that one could not (or at least should not) be used again.  In particular, funds were shifted from planned expenditures to maintain or build up the capital assets of the system, to cover current operating costs instead.

Looking forward, all the estimates of the additional funding needs are far higher.  To start, an analysis by Jeffrey DeWitt, the CFO of Washington, DC, released in October 2016 as part of a Metropolitan Washington Council of Governments (COG) report, estimated that at a minimum, WMATA faced a shortfall over the next ten years averaging $212 million per year on current operations and maintenance, and $330 million per year for capital needs, for a total of $542 million a year.  This estimate was based on an assumption of a capital investment program summing to $12 billion over the ten years.

But the “10-Year Capital Needs” report issued by WMATA a short time later estimated that the 10-year capital needs of WMATA would be $17.4 billion simply to bring Metro assets up to a “state of good repair” and maintain them there.  It estimated an additional $8 billion would be needed for modest new investments – needed in part to address certain safety issues.  But even if one limited the ten-year capital program to the $17.4 billion to get assets to a state of good repair, there would be a need for an additional $540 million a year over the October 2016 DeWitt estimates, i.e. a doubling of the earlier figure to almost $1.1 billion a year.

A more recent, and conservative, figure has been provided by Paul Wiedefeld, the General Manager of WMATA, in a report released on April 19.  He recommended that while Metro has capital needs totaling $25 billion over the next ten years, he would propose that a minimum of $15.5 billion be covered for the system “to remain safe and reliable”.  Even with this reduced capital investment program, he estimated that if funding from the jurisdictions remained at historical levels, there would be a 10-year funding gap of $7.5 billion remaining.  If jurisdictional funding were to rise at 3% a year in nominal terms, then he estimated that $500 million a year would still be necessary from some new funding source.

But this was just for the capital budget, and a highly constrained one at that.  There would, in addition, be a $100 million a year gap in the operating budget, even with the funding from the jurisdictions for operations rising also at 3% a year.  Wiedefeld suggested that it might be possible to reduce operating costs by that amount.  However, this would require cutting primarily labor expenditures, as direct labor costs account for 74% of operating expenditures.  Not surprisingly, the WMATA labor union is strongly opposed.

Even more recently, the Metropolitan Washington Council of Governments issued on April 26 the final report of a panel it convened (hereafter COG Panel or COG Panel Report) that examined Metro funding options.  The panel was made up of senior local administrative and budget officials.  While the focus of the report was an examination of different funding options (and will be discussed further below), it took as a basis of its estimated needs that WMATA would need to cover a ten-year capital investment program of $15.6 billion (to reach and maintain a “state of good repair” standard).  After assuming a 3% annual increase in what the political jurisdictions would provide, it estimated the funding gap for the capital budget would sum to $6.2 billion. Assuming also a 3% annual increase in funding from the political jurisdictions for operations and maintenance (O&M), it estimated a remaining funding gap of $1.3 billion for O&M.  The total gap for both capital and O&M expenses would thus sum to $7.5 billion over the period.

But while these COG estimates were referred to as 10-year funding gaps (thus averaging $750 billion per year), the table in its PowerPoint presentation on the report on page 13 makes clear that these are actually the funding gaps for the eight year period of FY19 to FY26.  FY17 is already almost over, and the FY18 budget has already been settled.  For the eight year period from FY19 going forward, the additional funding needed averages $930 million per year.  The COG Panel recommended, however, a dedicated funding source that would generate less, at $650 million per year to start (which it assumes would be in 2019).  But the reason for this difference is that the COG Panel recommended also that WMATA borrow additional funds in the early years against that new funding stream, so as to cover together the higher figure ($930 million on average per year over FY19-26) for what is in fact needed.  While such borrowing would supplement what could be funded in the early years, the resulting debt service would then subtract from what one could fund later.  While prudent borrowing certainly has a proper role, future funding needs will certainly be higher than what they are right now, and thus this will not provide a long-term solution to the funding issue.  More funding will eventually (and soon) be required.

All these figures reviewed thus far assume capital investment programs only just suffice to bring existing assets up to a “state of good repair”, with nothing done to add to these assets.  It also appears that the estimates were influenced at least to some extent by what the analysts thought might be politically feasible.  Yet additional capacity will be needed if the Washington region is to continue to grow.  While these additional amounts are much more speculative, there is no doubt that they are large, indeed huge.

The most careful recent study of long-term expansion needs is summarized in a series of reports released by WMATA in early 2016.   A number of rail options were examined (mostly extensions of existing rail lines), with the conclusion that the highest priority for a 2040 time horizon was to enhance the capacity at the center of the system.  Portions of these lines are already strained or at full capacity, including in particular the segment for the tunnel under the Potomac from Rosslyn.  Under this plan, there would be a new circular underground loop for the Metro lines around downtown Washington and extending across the Potomac to Rosslyn and the Pentagon.  It is not clear that a good estimate has yet been done on what this would cost, but the Washington Post gave a figure of $26 billion for an earlier variant (along with certain other expenditures).  This would clearly be a multi-decade project, and if anything like it is to be done by 2040, work would need to begin within the current 10-year WMATA planning horizon.  Yet given WMATA’s current difficulties, there has been little focus on these long-term needs.  And nothing has been provided for them.

To sum up, how much in additional funding is needed?  While there is no precise number, in part because the focus has been on the immediate crisis and on what might be considered politically feasible, for the purposes of this post we will use the following.  At a minimum, we will look at what would be needed to generate $650 million per year, the same figure arrived at in the COG Panel Report.  But this figure is clearly at the low end of the range of what will be needed.  At best, it will suffice only for a few years.  Our political leaders in the region should recognize that this will need to rise to at least $1 billion per year within a few years if necessary investments are to be made to ensure the system not only reaches a “state of good repair” but also sustains it.  Furthermore, it will need to rise further to perhaps $2.0 billion a year by around 2030 if anything close to the system capacity that will be needed by 2040 is to be achieved.

For the analysis below, we will therefore look at what the rates will need to be to generate $650 million a year at the low end and roughly three times this ($2.0 billion a year in nominal terms, by the year 2030) at the high end.  These figures are of course only illustrative of what might be required.  And for the forecast figures for 2030, I will assume (consistent with what the COG Panel did) that inflation from now to then will rise at 2% a year while real growth in the region will rise, conservatively, at 1% a year.  Note that $2.0 billion in 2030 in nominal terms would be equivalent to $1.55 billion in terms of dollars of today (2017) if inflation rises at 2% a year.

It is important to recognize that providing just the low-end figure of $650 million a year will not suffice for more than a few years.  It does provide a starting point, and while that is important, when considering such a major reform as moving to a dedicated funding source to supplement government funding sources, one should really be thinking longer term.  Not much would be gained by moving to a funding source which would prove insufficient after just a few years, leading to yet another crisis.

C.  A Mandatory Fee on Commuter Parking Spaces

A fee would be assessed (generally through the property tax system) on all parking spaces used by office and other commuting employees.  It would not be assessed on residential parking, nor on customer parking linked to retail or other such commercial space, but would be limited to the all-day parking spots that commuters use.

It would be straightforward to implement.  The owners of the property with the parking spaces would be assessed a fee for each parking space provided.  For example, if the fee is set at $1 per day per space, a fee of $250 per year would be assessed (based on 250 work-days a year, of 52 weeks at 5 days per week less 10 days for holidays).  It would be paid through the regular property tax system, and collected from the owners of that land along with their regular property taxes on the semi-annual (or quarterly or whatever) basis that they pay their property taxes. The owners of the spaces would be encouraged to pass along the costs to those employees who drive and use the spaces (and owners of commercial parking lots will presumably adjust their monthly fees to reflect this), but it would be the owners of the parking spaces themselves who would be immediately liable to pay the fees.

Property records will generally have the number of parking spaces provided on those plots of land.  This will certainly be so in the cases of underground parking provided in modern office buildings and in multi-story commercial parking garages.  And I suspect there will similarly be such a record of the number of spaces in surface parking lots.  But even if not, it would be straightforward to determine their number.  Property owners could be required to declare them, subject to spot-checks and fines if they did not declare them honestly. One can now even use satellite images available on Google Maps to count such spaces. And a few years ago my water bills started to include a monthly fee for the square footage of impermeable space on my land (from roofs and driveways primarily), as drainage from such surfaces feed into stormwater drains and must ultimately be treated before being discharged into the Potomac river.  They determined through the property records system and from satellite images the square footage of such spaces on all individual properties.  If that can be done, one certainly determine the number of parking spaces on open lots.

There are, however, a few special cases where property taxes are not collected and where different arrangements will need to be made.  But this can be done.  Specifically:

  1. Properties owned by federal, state, and local governments will generally not pay property taxes.  But the mandatory fees on parking spaces could still be collected by these government entities and paid into the system just as by private property owners.  Presumably, the governments support the reform as it is supplementing the funds they already provide to WMATA.
  2. Similarly, international organizations located in the Washington region, such as the World Bank, the IMF, the Inter-American Development Bank, and others (mostly much smaller) operate under international treaties which provide that they do not owe property taxes on properties they own.  But as with governments, they could collect such fees on parking spaces made available to their employees who drive to work.  They already charge their employees monthly fees for the spaces, and the new fee could be added on.  And while I am not a lawyer, it might well be the case that such a fee on parking spots could be made mandatory.  The institutions do pay the fees charged for the water they use, and employees do pay sales taxes on the food they purchase in their cafeterias.  Finally, these institutions advise governments to apply good policy.  The same should apply here.
  3. There are also non-profit hospitals, universities, and similar institutions, which are major employers in the region but which may not be charged property taxes. However, the fee on parking spaces, while collected for most through the property tax system, can be seen as separate from regular property taxes.  It is a fee on commuters who make use of our road system and add to its congestion.  The parking fees could still be collected and paid in, even if no regular property taxes are due.
  4. Finally, the Washington region has a large number of embassies and other properties with strict internationally recognized immunities.  It might well be the case that it will not be possible to collect such a mandatory fee on parking spots for their employees (although again, presumably the embassies pay the fees on their water bills).  But the total number employed through such embassies is tiny as a share of total employment in the DC region.  And some embassies might well pay voluntarily, recognizing that they too are members of the local community, making use of the same roads.  Finally, note that embassy employees with diplomatic status also do not pay sales tax on their day-to-day purchases, while the embassy compounds themselves do not pay property taxes.  Proposals to fund WMATA through new or higher property taxes or sales taxes (discussed below) will face similar issues.  But as noted above, the amounts involved are tiny.

How, then, would such a mandatory fee on commuter parking spaces stand up under the four criteria noted above?:

a)  Feasibility:  As just discussed, such a fee on commuter parking spaces, implemented generally through the regular property tax system, would certainly be feasible.  It could be done.  It may well be that a lack of recognition of this which explains why such an option has typically not been much considered when alternatives are reviewed for how to fund a transit system such as WMATA.  It appears that most believe that it would require some system to be set up which would mandate a payment each day as commuters enter their parking lots.  But there is no need for that.  Rather, the fee could be imposed on the owner of the parking space, and collected as part of their property tax payments.  It would be up to the owner of that space to decide whether to pass along that cost to the commuters making use of those spaces (although passing along the cost should certainly be encouraged, so that the commuters face the cost of their decision to drive).

b)  Effectiveness:  The next question is whether such a fee, at reasonable rates, would generate the funds needed.  To determine this, one first needs to know how many such parking spots there are in the Washington region.  While more precise figures can be generated later, all that is needed at this point is a rough estimate.

As of January 2017, the Bureau of Labor Statistics estimated there were 3,217,400 employees in the Washington region’s Metropolitan Statistical Area (MSA).  While this MSA area is slightly larger than the jurisdictions that participate in the WMATA regional compact, the additional counties at the fringes of the region are relatively small in population and employment.  This figure on regional employment can then be coupled with the estimate from the most recent (2016) Metropolitan Washington COG “State of the Commute” survey, which concluded that 61.0% of commuters drive alone to work, while an additional 5.4% drive in either car-pools or van-pools.  Assuming an average of 2.5 riders in car-pools and van-pools (van-pools are relatively minor in number), this would work out to 63.2% as the number of cars (as a share of total employment) that carry commuters to their jobs.  Applying the 63.2% to the 3,217,400 figure for the number employed, an estimated 2,033,400 cars are used to carry commuters.  The total number of parking spaces will be somewhat more, as the parking lots will normally have some degree of excess capacity, but this can be ignored for the estimate here.  Rounding down, there are roughly 2 million parking spaces for these cars in the DC region.  And this number can be expected to grow over time.

With 2 million parking spaces, a daily fee of $1 would generate $500 million per year (based on 250 work-days per year).  A fee of $1.30 per day would generate $650 million. And assuming commuter parking spots grow at 1% a year (along with the rest of the regional economy) to 2030, a $3.50 fee in 2030 would generate $2.0 billion in the prices of that year (equivalent to $2.70 per day in the prices of 2017, assuming 2% annual inflation for the period).

Compared to the cost of driving, fees of $1.30 per day or even $3.50 per day are modest. While many workers do not pay for their parking (or for the full cost of their parking), the actual cost can be estimated by what commercial parking firms charge for their monthly parking contracts.  For the 33 parking garages listed as “downtown DC” on the Parking Panda website, the average monthly fee (showing on April 29, 2017) was a bit over $270. This would come to $13 per work day (based on 250 work days per year).  While the charges will be less in the suburbs, there will still be a cost.  But the full cost to commuters to drive to work is in fact much more.  Assuming the average cost of the cars driven is $36,000, and with simple straight line depreciation over 10 years, the average monthly cost will be $300. To this one should add the cost of car insurance (on the order of $50 to $100 per month), of expected repair costs (probably of similar magnitude), and of gas. The full cost of driving would on average then total over $600 per month, or about $29 per work day.  Even if one ignores the cost of the parking spot itself (as drivers will if their employers provide the spots for free), the cost to the driver would still average about $16 per work day.  An added $1.30 per day to cover the funding needs of the public transit system is minor compared to any of these cost estimates, and would still be modest at $3.50 per day (equal to $2.70 in the prices of today).

Thus at reasonable rates on commuter parking spots, it would be possible to collect the $650 million to $2.0 billion a year needed to help fund WMATA.

c)  Efficiency:  Another consideration when choosing how best to provide additional funds to WMATA is the impact on efficiency of that option.  A fee on parking spaces would be a positive for this.  The Washington region stands out for its severe congestion, including not only in the city center but also in the suburbs (and often even more so in the suburbs).  A fee on parking spots, if passed along to the commuters who drive, would serve as an incentive to take transit, and might have some impact on those at the margin. The impact is likely to be modest, as a $1.30 to $3.50 fee per day would not be much.  As just discussed above, given the current cost of driving (even when commuters who drive are not charged for their parking spots), an additional $1.30 to $3.50 would be only a small additional cost, even when it is passed along.  But at least it would operate in the direction one wants to alleviate traffic congestion.

d)  Fairness:  Finally, the fee would be fair relative to the other options being considered in terms of who would be impacted.  Those who drive to work (over 90% of whom drive alone) are generally of higher income.  They can afford the high cost of driving, which is high (as noted above) even in those cases when they are provided free parking spaces by their employer.

Some would argue that since the drivers are not taking transit, they should not help pay for that transit.  But that is not correct.  First of all, they have a direct interest in reducing road congestion, and only a well-functioning transit system can help with that.  Drivers benefit directly (by reduced congestion) for every would-be driver who decides instead to take transit.  Second, all the other feasible funding options being considered for WMATA will be paid for in large part by drivers as well.  This is true whether a higher sales tax is imposed on the region, higher property taxes, or just higher government funding from their budgets (with this funding coming from the income taxes as well as sales taxes and property taxes these governments receive).  And as discussed below, higher fares on WMATA passengers to raise the amounts needed is simply not a feasible option.

Some drivers will likely also argue that they have no choice but to drive.  While they would still gain by any reduction in congestion (and would lose in a big way due to extreme congestion if WMATA service collapses due to inadequate funding), it is no doubt true that at least some commuters have no alternative but to drive.  However, the number is quite modest.  The 2016 survey of commuters undertaken by the Metropolitan Washington COG, referred to also above, asked their sample of commuters whether there was either bus service or train service “near” their homes (“near” as they would themselves consider it), and separately, “near” their place of work.  The response was 89% who said there were such transit services near their homes, and 86% who said there were such transit services near their places of work.  But note also that the 11% and 14%, respectively, who did not respond that there was such nearby transit, included those who responded that they did not know.  Many of those who drive to work might not know, as they never had a need to look into it.

The share of the Washington region’s population who do not have access to transit services is therefore relatively small, probably well less than 10% of commuters.  The transit options might not be convenient, and probably take longer than driving in many if not most cases given the current service provision, but transit alternatives exist for the overwhelming share of the regional population.  The issue is that those who can afford the high cost will drive, while the poorer workers who cannot will have no choice but to take transit.  Setting a fee on parking spaces for commuters in order to support the maintenance of decent transit services in the region is socially as well as economically fair.

D.  Alternative Funding Options That Have Been Proposed

1)   Higher Fares:  The first alternative that many would suggest for raising additional funds for the transit system is to charge higher fares.  While certainly feasible in a mechanical sense, such an alternative would fail the effectiveness test.  The fares are already high.  Any increase in fares will lead to yet more transit users choosing to drive instead (for those for whom this is an option).  The increase in fare revenues collected will be less than in proportion to the increase in fare rates set.  And at some point, so many transit users will switch that total fare revenue would in fact decrease.

In the recently passed FY18 budget for WMATA, the forecast revenues to be collected from fares is $709 million.  This is down from an expected $792 million in FY17 despite a fare increase averaging 4%.  Transit users are leaving as fares have increased and service has deteriorated.  To increase the fares to try to raise an additional $650 million would require an increase of over 90% if no riders then leave.  But more riders would of course leave, and it is not clear if anything additional (much less an extra $650 million) would be raised. And this would of course be even more so if one tried to raise an extra $2.0 billion.

So as all recognize, it will not be possible to resolve the WMATA funding issues by means of higher fares.  Any increase in fares will instead lead to more riders leaving the system for their cars, leading to even greater road congestion.

2)  Increase the Sales Tax Rate:  Mayor Muriel Bowser of Washington has pushed for this alternative, and the recent COG Technical Panel concluded with the recommendation that  “the best revenue solution is an addition to the general sales tax in all localities in the WMATA Compact area in the National Capital Region” (page 4).  This alternative has drawn support from some others in the region as well, but is also opposed by some. There is as yet no consensus.

Sales taxes are already imposed across the region, and it would certainly be feasible to add an extra percentage point to what is now charged.  But each jurisdiction sets the tax in somewhat different ways, in terms of what is covered and at what rates, and it is not clear to what the additional 1% rate would be applied.  For example, Washington, DC, imposes a general rate of 5.75%, but nothing on food or medicines, while liquor and restaurants are charged a sales tax of 10% and hotels a rate of 14.5%.  Would the additional 1% rate apply only to the general rate of 5.75%, or would there also be a 1% point increase in what is charged on liquor, restaurants, and the others?  And would there still be a zero rate on food and medicines?  Virginia, in contrast, has a general sales tax rate (in Northern Virginia) of 6.0%, but it charges a rate on food of 2.5%.  Would the Virginia rate on food rise to 3.5%, or stay at 2.5%?  There is also a higher sales tax rate on restaurant meals in certain of the local jurisdictions in Virginia (such as a 10% rate in Arlington County) but not in others (just the base 6% rate in Fairfax County).  How would these be affected?  And similar to DC, there are also special rates on hotels and certain other categories.  Maryland also has its own set of rules, with a base rate of 6.0%, a rate of 9% on alcohol, and no sales tax on food.

Such specifics could presumably be worked out, but the distribution of the burden across individuals as well as the jurisdictions will depend on the specific choices made.  Would food be subject to the tax in Virginia but not in Maryland or DC, for example?  The COG Technical Panel must have made certain assumptions on this, but what they were was not explained in its report.

But it concluded that an additional 1% point on some base would generate $650 million in FY2019.  This is higher than the estimate made last October as part of the COG Panel work, where it estimated that a 1% point increase in the sales tax rate would raise $500 million annually.  It is not clear what the underlying reasons were for this difference, but the recent estimates might have been more thoroughly done.  Or there might have been differing assumptions on what would be included in the base to be taxed, such as food.

A 1% point rise in the sales tax imposed in the region would, under these estimates, then suffice to raise the minimum $650 million needed now.  But to raise $1.0 billion annually, rising to $2.0 billion a few years later, substantial further increases would soon be needed. The amount would of course depend on the extent to which local sales of taxable goods and services grew over time within the region.  Assuming that sales of items subject to the sales tax were to rise at a 3% annual rate in nominal terms (2% for inflation and 1% for real growth), and that one would need to raise $2.0 billion by 2030 (in terms of the prices of 2030), then the base sales tax rate would need to rise by about 2.2% points.  A 6% rate would need to rise to 8.2%.  A rate that high would likely generate concerns.

Thus while a sales tax increase would be effective in raising the amounts needed to fund WMATA in the immediate future, with a 1% rise in the tax rate sufficing, the sales tax rate would need to rise further to quite high levels for it to raise the amounts needed a few years later.  Whether such high rates would be politically possible is not clear.

Also likely to be a concern, as the COG Panel itself recognized in its report, is that the distribution of the increased tax burden across the local jurisdictions would differ substantially from what these jurisdictions contribute now to fund WMATA, as well as from what it estimates each jurisdiction would be called on to contribute (under the existing sharing rules) to cover the funding gap anticipated for FY17 – FY26:

Funding Shares:

FY17 Actual

FY17-26 Gap

From Sales Tax

DC

37.3%

35.8%

22.8%

Maryland

38.4%

33.5%

26.5%

Virginia

24.3%

30.7%

50.8%

Source:  COG Panel Final Report, pages 9 and 15.

If an extra 1% point were added to the sales tax across the region, 50.8% of the revenues thus generated would come from the Northern Virginian jurisdictions that participate in the WMATA compact.  This is substantially higher than the 24.3% share these jurisdictions contributed in WMATA funding in FY17, or the 30.7% share they would be called on to contribute to cover the anticipated FY17-26 gap (higher than in just FY17 primarily due to the opening of the second phase of the Silver Line).  The mirror image of this is that DC and Maryland would gain, with much lower shares paid in through the sales tax increase than what they are funding now.  Whether this would be politically acceptable remains to be seen.

Use of a higher sales tax to fund WMATA needs would also not lead to efficiency gains for the transportation system.  The sales tax on goods and services sold in the region would not have an impact on incentives, positive or negative, on decisions on whether to drive for your commute or to take transit.  It would be neutral in this regard, rather than beneficial.

Finally, and perhaps most importantly, sales taxes are regressive, costing the poor more as a share of their income than what they cost the well-off.  A sales tax rise would not meet the fairness test.  Even with exemptions granted for foods and medicines, poor households spend a high share of their incomes on items subject to sales taxes, while the well-off spend a lower share.  The well-off are able to devote a higher share of their incomes to items not subject to the general sale tax, such as luxury housing, or vacations elsewhere, or services not subject to sales taxes, or can devote a higher share of their incomes to savings.

Aside from the regressive nature of a sales tax, an increase in the sales tax to fund transit (and through this to reduce road congestion) will be paid by all in the region, including those who do not commute to work.  It would be paid, for example, also by retirees, by students, and by others who may not normally make use of transit or the road system to get to work during rush hour periods.  But they would pay similarly to others, and some may question the fairness of this.

An increase in the sales tax rate would thus be feasible.  And while a 1% point rise in the rate would be effective in raising the amounts needed in the immediate future, there is a question as to whether this approach would be effective in raising the amounts needed a few years later, given constraints (political and otherwise) on how high the sales tax rate could go.  The region would likely then face another crisis and dilemma as to how WMATA can then be adequately funded.  There are also political issues in the distribution of the sales tax burden across the jurisdictions of the region, with Northern Virginia paying a disproportionate share.  This would be even more of a concern when the tax rate would need to be increased further to cover rising WMATA funding needs.  There would also be no efficiency gains through the use of a sales tax.  Finally and importantly, a higher sales tax is regressive and not fair as it taxes a higher share of the income of the poor than of the well-off, as well as of groups who do not use transit or the roads during the rush hour periods of peak congestion.

3)  A Special Property Tax Rate on Properties Near Metro Stations

Some have argued for a special additional property tax to be imposed on properties that are located close to Metro stations.  The largest trade union at WMATA has advocated for this, for example, and the COG Technical Panel looked at this as one option it considered.

The logic is that the value of such properties has been enhanced by their location close to transit, and that therefore the owners of these more valuable properties should pay a higher property tax rate on them.  But while superficially this might look logical, in fact it is not, as we will discuss below.  There are several issues, both practical and in terms of what would be good policy.  I will start with the practical issues.

The special, higher, tax rate would be imposed on properties located “close” to Metro stations, but there is the immediate question of how one defines “close”.  Most commonly, it appears that the proponents would set the higher tax on all properties, residential as well as commercial, that are within a half-mile of a station.  That would mean, of course, that a property near the dividing line would see a sharply higher property tax rate than its neighbor across the street that lies on the other side of the line.

And the difference would be substantial.  The COG Technical Panel estimated that the additional tax rate would need to be 0.43% of the assessed value of all properties within a half mile of the DC area Metro stations to raise the same $650 million that an extra 1% on the sales tax rate would generate.  It was not clear from the COG Panel Report, however, whether the higher tax of 0.43% was determined based on the value of all properties within a half-mile of Metro stations, or only on the base of all such properties which currently pay property tax.  Governmental entities (including international organizations such as the World Bank and IMF) and non-profits (such as hospitals and universities) do not pay this tax (as was discussed above), and such properties account for a substantial share of properties located close to Metro stations in the Washington region.  If the 0.43% rate was estimated based on the value of all such properties, but if (just for the sake of illustration; I do not know what the share actually is) properties not subject to tax make up half of such properties, then the additional tax rate on taxable properties that would be needed to generate the $650 million would be twice as high, or 0.86%.

But even at just the 0.43% rate, the increase in taxes on such properties would be large. For Washington, DC, it would amount to an increase of 50% on the current general residential property tax rate of 0.85%, an increase of 26% on the 1.65% rate for commercial properties valued at less than $3 million, and an increase of 23% on the 1.85% rate for commercial properties valued at more than $3 million.  Property tax rates vary by jurisdiction across the region, but this provides some sense of the magnitudes involved.

The higher tax rate paid would also be the same for properties sitting right on top of the Metro stations and those a half mile away.  But the locational value is highest for those properties that are right at the Metro stations, and then tapers down with distance. One should in principle reflect this in such a tax, but in practice it would be difficult to do. What would the rate of tapering be?  And would one apply the distance based on the direct geographic distance to the Metro station (i.e. “as the crow flies”), or based on the path that one would need to take to walk to the Metro station, which could be significantly different?

Thus while it would be feasible to implement the higher property tax as a fixed amount on all properties within a half-mile (at least on those properties which are not exempt from property tax), the half-mile mark is arbitrary and does not in fact reflect the locational advantages properly.

The rate would also have to be substantially higher if the goal is to ensure WMATA is funded adequately by the new revenue source beyond just the next few years.  Assuming, as was done above for the other options, that property values rise at a 3% rate over time going forward (due both to growth and to price inflation), the 0.43% special tax rate would raise $900 million by 2030.  If one needed, however, $2 billion by that year for WMATA funding needs, the rate would need to rise to 0.96%.  This would mean that residential properties within a half mile would be paying more than double the property tax paid by neighbors just beyond the half-mile mark (assuming basic property tax rates are similar in the future to what they are now, and based on the current DC rates), while commercial rates would be over 50% more.  The effectiveness in raising the amounts required is therefore not clear, given the political constraints on how high one could set such a special tax.

But the major drawback would be the impact on efficiency.  With the severe congestion on Washington region roads, one should want to encourage, not discourage, concentrated development near Metro stations.  Indeed, that is a core rationale for investing so much in building and sustaining the Metro system.  To the extent a higher property tax discourages such development, the impact of such a special property tax on real estate near Metro stations would be to discourage precisely what the Metro system was built to encourage.  This is perverse.  One could indeed make the case that properties located close to Metro stations should pay a lower property tax rather than a higher one.  I would not, as it would be complex to implement and difficult to explain.  But technically it would have merit.

Finally, a special additional tax on the current owners of the properties near Metro stations would not meet the fairness test as the current owners, with very few if any exceptions, were not the owners of that land when the Metro system locations were first announced a half century ago.  The owners of the land at that time, in the 1960s, would have enjoyed an increase in the value of their land due to the then newly announced locations of the Metro stations.  And even if the higher values did not immediately materialize when the locations of the new Metro system stations were announced, those higher values certainly would have materialized in the subsequent many decades, as ownership turned over and the properties were sold and resold.  One can be sure the prices they sold for reflected the choice locations.

But those who purchased that land or properties then or subsequently would not have enjoyed the windfall the original owners had.  The current owners would have paid the higher prices following from the locational advantages near the Metro stations, and they are the ones who own those properties now.  While they certainly can charge higher rents for space in properties close to the Metro stations, the prices they paid for the properties themselves would have reflected the fact they could charge such higher rents.  They did not and do not enjoy a windfall from this locational advantage.  Rather, the original owners did, and they have already pocketed those profits and left.

Note that while a special tax imposed now on properties close to Metro stations cannot be justified, this does not mean that such a tax would not have been justified at an earlier stage.  That is, one could justify that or a similar tax that focused on the initial windfall gain on land or properties that would be close to a newly announced Metro line.  When new such rail lines are being built (in the Washington region or elsewhere), part of the cost could be covered by a special tax (time-limited, or perhaps structured as a share of the windfall gain at the first subsequent arms-length sale of the property) that would capture a share of the windfall from the newly announced locations of the stations.

An example of this being done is the special tax assessments on properties close to where the Silver Line stations are being built.  The Silver Line is a new line for the Washington region Metro system, where the first phase opened recently and the second phase is under construction.  A special property tax assessment district was established, with a higher tax rate and with the funds generated used to help construct the line.  One should also consider such a special tax for properties close to the stations on the proposed Purple Line (not part of the WMATA system, but connected to it), should that light rail line be built. The real estate developers with properties along that line have been strong proponents of building that line.  This is understandable; they would enjoy major windfall gains on their properties if the line is built.  But while the windfall gains could easily be in the hundreds of millions of dollars, there has been no discussion of their covering a portion of the cost, which will sum to $5.6 billion in payments to the private contractor to build and then operate the line for 30 years.  Under current plans, the general taxpayer would be obliged to pay this full amount, with only a small share of this (less than one-fourth) recovered in forecast fares.

While setting a special (but temporary) tax for properties close to stations can be justified for new lines, such as the Silver Line or the Purple Line, the issues are quite different for the existing Metro lines.  Such a special, additional, tax on properties close to the Metro stations is not warranted, would be unfair to the current owners, and could indeed have the perverse outcome of discouraging concentrated development near the Metro stations when one should want to do precisely the reverse.

4)  Other Funding Options

There can, of course, be other approaches to raising the funds that WMATA needs.  But there are issues with each, they in general have few advocates, and most agree that one of the options discussed above would be preferable.

The COG Technical Panel reviewed several, but rejected them in favor of its preference for a higher sales tax rate.  For example, the COG Panel estimated that it would be possible to raise their target for WMATA funding of $650 million if all local jurisdictions raised their property tax rates by 0.08% of the assessed values on all properties located in the region. But general property taxes are used as the primary means local jurisdictions raise the funds they need for their local government operations, and it would be best to keep this separate from WMATA funding.  The COG Panel also considered the possibility of creating a new Value-Added Tax (or VAT), a tax that is common elsewhere in the world but has never been instituted in the US.  It is commonly described as similar to a sales tax, but is imposed only on the extra value created at each stage in the production and sale process. But it would be complicated to develop and implement any new tax such as this, and it also has never been imposed (as far as I am aware) on a regional rather than national basis.  A regional VAT might be especially complicated.  The COG Panel also noted the possibility of a “commuter tax”.  Such a tax would have income taxes being imposed on a worker based on where they work rather than where they live.  But since there would be an offset for any such taxes against what the worker would otherwise pay where they are resident, the overall revenues generated at the level of the region as a whole would be essentially nothing.  It would be a wash.  There is also the issue that Congress has by law prohibited Washington, DC, from imposing any such commuter tax.

The COG Panel also looked at the imposition of an additional tax on motor vehicle fuels (gasoline and diesel) sold in the region.  This would in principle be more attractive as a means for funding transit, as it would affect the cost of commuting by car (by raising the cost of fuel) and thus might encourage, at the margin, more to take transit and thus reduce congestion.  Fuel taxes in the US are also extremely low compared to the levels charged in most other developed countries around the world.  And federal fuel taxes have not been changed since 1993, with a consequent fall in real, inflation-adjusted, terms. There is a strong case that the rates should be raised, as has been discussed in an earlier post on this blog.  But such fuel taxes have been earmarked primarily for road construction and maintenance (the Highway Trust Fund at the federal level), and any such funds are desperately needed there.  It would be best to keep such fuel taxes earmarked for that purpose, and separated from the funding needed to support WMATA.

E.  Summary and Conclusion

All agree that there is a need to create a dedicated source of funds to provide additional funds to WMATA.  While there are a number of issues with WMATA, including management and governance issues, no one disagrees that a necessary element in any solution is increased funding.  WMATA has underinvested for decades, with the result that the current system cannot operate reliably or safely.

Estimates for the additional funding required by WMATA vary, but most agree that a minimum of an additional $650 million per annum is required now simply to bring the assets up to a minimum level of reliability and safety.  But estimates of what will in fact be needed once the current most urgent rehabilitation investments are made are substantially higher.  It is likely that the system will need on the order of $2 billion a year more than what would follow under current funding formulae by the end of the next decade, if the system’s capacity is to grow by what will be necessary to support the region’s growth.

A mandatory fee on parking spaces for all commuters in the region would work best to provide such funds.  It would be feasible as it can be implemented largely through the existing property tax system.  It would be effective in raising the amounts needed, as a fee equivalent to $1.30 per day would raise $650 million per year under current conditions, and a fee of $3.50 per day would raise $2 billion per year in the year 2030.  These rates are modest or even low compared to what it costs now to drive.

A mandatory fee on parking spaces would also contribute to a more efficient use of the transportation assets in the region not only by helping to ensure the Metro system can function safely and reliably, but by also encouraging at least some who now drive instead to take transit and hence reduce road congestion.  Finally, such a fee would be fair as it is those of higher income who most commonly drive (in part because driving is expensive), while it is the poor who are most likely to take transit.

An increase in the sales tax rate in the region would not have these advantages.  While an increase in the rate by 1% point was estimated by the COG Panel to generate $650 million a year under current conditions, the rate would need to increase by substantially more to generate the funds that will be needed to support WMATA in the future.  This could be politically difficult.  The revenues generated would also come disproportionately from Northern Virginia, which itself will create political difficulties.  It would also not lead to greater efficiencies in transport use, other than by keeping WMATA operational (as all the options would do).  Most importantly, a sales tax is regressive (even when foods and medicine are not taxed), with the poor bearing a disproportionate share of the costs.

A special property tax on all properties located a half mile (or whatever specified distance) of existing Metro stations could also be imposed, although readily so only on such properties that are currently subject to property tax.  But there would be arbitrariness with such a rigidly specified distance being imposed, with a sharp fall in the tax rate for properties just across that artificial border line.  There is also a question as to whether it would be politically feasible to set the rates to such high rates as would be necessary as to address the WMATA funding needs of beyond just the next few years.

But most important, such a special tax on the current owners would not be a tax on those who gained a windfall when the locations of the Metro stations were announced many decades ago.  Those original owners have already pocketed their windfall gains and have left.  The current owners paid a high price for that land or the developments on them, and are not themselves enjoying a special windfall.  And indeed, a new special property tax on developments near the Metro stations would have the effect of discouraging any such new investment.  But that is the precise opposite of what we should want.  The policy aim has long been to encourage, not discourage, concentrated development around the Metro stations.

This does not mean that some such special tax, if time-constrained, would not be a good choice when a new Metro line (or rail line such as the proposed Purple Line) is to be built. The owners of land near the planned future Metro stops would enjoy a windfall gain, and a special tax on that is warranted.  Such a special tax district has been set for the new Silver Line, and would be warranted also if the Purple Line is to be built.  Those who own that land will of course object, as they wish to keep their windfall in full.

To conclude, no one denies that any new tax or fee will be controversial and politically difficult.  But the Metro system is critical to the Washington region, and cannot be allowed to continue to deteriorate.  Increased funding (as well as other measures) will be necessary to fix this.  Among the possible options, the best approach is to set a mandatory fee that would be collected on all commuter parking spaces in the region.

Tax Cuts Do Not Spur Growth – There Are Income as well as Substitution Effects, and Much More Besides: Econ 101

gdp-growth-and-top-marg-tax-rate-1930-to-2015

A.   Introduction, and a Brief Aside on the Macro Issues

While there is much we do not yet know on what economic policies Donald Trump will pursue (he said many things in his campaign, but they were often contradictory), one thing we can be sure of is that there will be a major tax cut.  Republicans in Congress (led by Paul Ryan) and in the Senator want the same.  And they along with Trump insist that the cuts in tax rates will spur a sharp jump in GDP growth, with the result that net tax revenues in the end will not fall by all that much.

But do tax cuts spur growth?  The chart above suggests not.  Marginal tax rates of those in the top income brackets have come down sharply since the 1950s and early 1960s, when they exceeded 90%.  They reached as low as 28% during the later Reagan years and 35% during the administration of George W. Bush.  But GDP growth did not jump to some higher rate as a result.

This Econ 101 post will discuss the economics on why this is actually what one should expect.  It will focus on the microeconomics behind this, as the case for income tax cuts is normally presented by the so-called “supply siders” as a micro story of incentives.  The macro case for tax cuts is different.  Briefly, in times of high unemployment when the economy is suffering from insufficient demand in the aggregate to purchase all that could be produced if more labor were employed, a cut in income taxes might spur demand by households, as they would then have higher post-tax incomes to spend on consumption items.  This increase in demand could then spur production and hence GDP.

Critically, this macro story depends on allowing the fiscal deficit to rise by there not being simultaneously a cut in government expenditures along with the tax cuts.  If there is such a cut in government expenditures, demand may be reduced by as much as or even more than demand would be increased by households.  But the economic plans of both Trump and Congressman (and Speaker) Paul Ryan do also call for large cuts in government expenditures.  While both Trump and Ryan have called for government expenditures to increase on certain items, such as for defense, they still want a net overall reduction.

The net impact on demand will then depend on how large the government expenditure cuts would be relative to the tax cuts, and on the design of the income tax cuts.  As was discussed in an earlier post on this blog on the size of the fiscal multiplier, If most of the income tax cuts go to those who are relatively well off, who will then save most or perhaps all of their tax windfall, there will be little or no macro stimulus from the tax cuts.  Any government expenditure cuts on top of this would then lead not to a spur in growth, but rather to output growing more slowly or contracting.  And the tax plan offered by Donald Trump in his campaign would indeed direct the bulk of the tax cuts to the extremely well off.  A careful analysis by the non-partisan Tax Policy Center found that 71% of the tax cuts (in dollar value) from the overall plan (which includes cuts in corporate and other taxes as well) would go to the richest 5% of households (those earning $299,500 or more), 51% would go to the top 1% (those earning $774,300 or more), and fully 25% would go to the richest 0.1% (those earning $4.8 million or more).

[A side note:  To give some perspective on how large these tax cuts for the rich would be, the 25% going to the richest 0.1% under Trump’s plan would total $1.5 trillion over the next ten years, under the Tax Policy Center estimates.  By comparison, the total that the Congressional Budget Office projects would be spent on the food stamp program (now officially called SNAP) for the poor over this period would come to a bit below $700 billion (see the August 2016 CBO 10-year budget projections).  That is, the tax breaks to be given under Trump’s tax plan to the top 0.1% (who have earnings of $4.8 million or more in a year) would be more than twice as large as would be spent on the entire food stamp program over the period.  Yet the Republican position is that we have to cut the food stamp program because we do not have sufficient government revenues to support it.]

The macro consequences of tax cuts that mostly go to the already well off, accompanied by government expenditure cuts to try to offset the deficit impact, are likely therefore to lead not to a spur in growth but to the opposite.

The microeconomic story is separate, and the rest of this blog post will focus on the arguments there.  Those who argue that cuts in income taxes will act as a spur to growth base their argument on what they see as the incentive effects.  Income taxes are a tax on working, they argue, and if you tax income less, people will work longer hours.  More will be produced, the economy will grow faster, and people will have higher incomes.

This micro argument is mistaken in numerous ways, however.  This Econ 101 post will discuss why.  There is the textbook economics, where it appears these “supply siders” forgot some of the basic economics they were taught in their introductory micro courses. But we should also recognize that the decision on how many hours to work each week goes beyond simply the economics.  There are important common social practices (which can vary by the nature of the job, i.e. what is a normal work day, and what do you do to get promoted) and institutional structures (the 40 hour work week) which play an important and I suspect dominant role. This blog post will review some of them.

But first, what do we know from the data, and what does standard textbook economics say?

B.  Start with the Data

It is always good first to look at what the data is telling us.  There have been many sharp cuts in income tax rates over the last several decades, and also some increases.  Did the economy grow faster after the tax cuts, and slower following the tax increases?

The chart at the top of this post indicates not.  The chart shows what GDP growth was year by year since 1930 along with the top marginal income tax rate of each year.  The top marginal income tax rate is the rate of tax that would be paid on an additional dollar of income by those in the highest income tax bracket.  The top marginal income tax rate is taken by those favoring tax cuts as the most important tax rate to focus on.  It is paid by the richest, and these individuals are seen as the “job creators” and hence play an especially important role under this point of view.  But changes in the top rates also mark the times when there were normally more general tax cuts for the rest of the population as well, as cuts (or increases) in the top marginal rates were generally accompanied by cuts (or increases) in the other rates also.  It can thus be taken as a good indicator of when tax rates changed and in what direction.  Note also that the chart combines on one scale the annual GDP percentage growth rates and the marginal tax rate as a percentage of an extra dollar of income, which are two different percentage concepts.  But the point is to compare the two.

As the chart shows, the top marginal income tax rate exceeded 90% in the 1950s and early 1960s.  The top rate then came down sharply, to generally 70% until the Reagan tax cuts of the early 1980s, when they fell to 50% and ultimately to just 28%.  They then rose under Clinton to almost 40%, fell under the Bush II tax cuts to 35%, and then returned under Obama to the rate of almost 40%.

Were GDP growth rates faster in the periods when the marginal tax rates were lower, and slower when the tax rates were higher?  One cannot see any indication of it in the chart. Indeed, even though the highest marginal tax rates are now far below what they were in the 1950s and early 1960s, GDP growth over the last decade and a half has been less than it what was when tax rates were not just a little bit, but much much higher.  If cuts in the marginal tax rates are supposed to spur growth, one would have expected to see a significant increase in growth between when the top rate exceeded 90% and where it is now at about 40%.

Indeed, while I would not argue that higher tax rates necessarily lead to faster growth, the data do in fact show higher tax rates being positively correlated with faster growth.  That is, the economy grew faster in years when the tax rates were higher, not lower.  A simple statistical regression of the GDP growth rate on the top marginal income tax rate of the year found that if the top marginal tax rate were 10% points higher, GDP growth was 0.57% points higher.  Furthermore, the t-statistic (of 2.48) indicates that the correlation was statistically significant.

Again, I would not argue that higher tax rates lead to faster GDP growth.  Rather, much more was going on with the economy over this period which likely explains the correlation. But the data do indicate that very high top marginal income tax rates, even over 90%, were not a hindrance to growth.  And there is clearly no support in the evidence that lower tax rates lead to faster growth.

The chart above focuses on the long-term impacts, and does not find any indication that tax cuts have led to faster growth.  An earlier post on this blog looked at the more immediate impacts of such tax rates cuts or increases, focussing on the impacts over the next several years following major tax rate changes.  It compared what happened to output and employment (as well as what happened to tax revenues and to the fiscal deficit) in the immediate years following the Reagan and Bush II tax cuts, and following the Clinton and Obama tax increases.  What it found was that growth in output and employment, and in fiscal revenues, were faster following the Clinton and Obama tax increases than following the Reagan and Bush II tax cuts.  And not surprisingly given this, the fiscal deficit got worse under Reagan and Bush II following their tax cuts, and improved following the Clinton and Obama tax increases.

C.  The Economics of the Impact of Tax Rates on Work Effort

The “supply siders” who argue that cuts in income taxes will lead to faster growth base their case on what might seem (at least to them) simple common sense.  They say that if you tax something, you will produce less of it.  Tax it less, and you will produce more of it. And they say this applies to work effort.  Income taxes are a tax on work.  Lower income tax rates will then lead to greater work effort, they argue, and hence to more production and hence to more growth.  GDP growth rates will rise.

But this is wrong, at several levels.  One can start with some simple math.  The argument confuses what would be (by their argument) a one-time step-up in production, with an increase in growth rates.  Suppose that tax rates are cut and that as a result, everyone decides that at the new tax rates they will choose to work 42 hours a week rather than 40 hours a week before.  Assuming productivity is unchanged (actually it would likely fall a bit), this would lead to a 5% increase in production.  But this would be a one time increase. GDP would jump 5% in the first year, but would then grow at the same rate as it had before.  There would be no permanent increase in the rate of growth, as the supply siders assert.  This is just simple high school math.  A one time increase is not the same as a permanent increase in the rate of growth.

But even leaving this aside, the supply sider argument ignores some basic economics taught in introductory microeconomics classes.  Focussing just on the economics, what would be expected to happen if marginal income tax rates are cut?  It is true that there will be what economists call “substitution effects”, where workers may well wish to work longer hours if their after-tax income from work rises due to a cut in marginal tax rates. But the changes will also be accompanied by what economists call “income effects”.  Worker after-tax incomes will change both because of the tax rate changes and because of any differences in the hours they work.  And these income effects will lead workers to want to work fewer hours.  The income and substitution effects will work in opposite directions, and the net impact of the two is not clear.  They could cancel each other out.

What are the income effects, and why would they lead to less of an incentive to work greater hours if the tax rate falls?:

a)  First, one must keep in mind that the aim of working is to earn an income, and that hours spent working has a cost:  One will have fewer hours at home each day to enjoy with your wife and kids, or for whatever other purposes you spend your non-working time. Economists lump this all under what they call “leisure”.  Leisure is something desirable, and with all else equal, one would prefer more of it.  Economists call this a “normal good”.  With a higher income, you would want to buy more of it. And the way you buy more of it is by working fewer hours each day (at the cost of giving up the wages you would earn in those hours).

Hence, if taxes on income go down, so that your after-tax income at the original number of hours you work each day goes up, you will want to use at least some portion of this extra income to buy more time to spend at home.  This is an income effect, and will go in the opposite direction of the substitution effect of higher after-tax wages leading to an incentive to work longer hours.  We cannot say, a priori, whether the income effect or the substitution effect will dominate.  It will vary by individual, based on their individual preferences, what their incomes are, and how many hours they were already working.  It could go either way, and can only be addressed by looking at the data.

b)  One should also recognize that one works to earn income for a reason, and one reason among many is to earn and save enough so that one can enjoy a comfortable retirement. But in standard economic theory, there is no reason to work obsessively before retirement so that one will then have such a large retirement “nest egg” as to enjoy a luxurious life style when one retires.  Rather, the aim is to smooth out your consumption profile over both periods in your life.

Hence if income tax rates are cut, so that your after-tax incomes are higher, one will be able to save whatever one is aiming for for retirement, sooner.  Hence it would be rational to reduce by some amount the hours one seeks to work each day, and enjoy them with your wife and kids at home, as your savings goals for retirement can still be met with those fewer hours of work.  This is an income effect, and acts in the direction of reducing, rather than increasing, the number of hours one will choose to work if there is a general tax cut.

c)  More generally, one should recognize that incomes are earned to achieve various aims. Some of these might be to cover fixed obligations, such as to pay on a mortgage or for student debt, and some might be quasi-fixed, such as to provide for a “comfortable” living standard for one’s family.  If those aims are being met, then time spent at leisure (time spent at home with the family) may be especially attractive.  In such circumstances, the income effect from tax cuts might be especially large, and sufficient to more than offset the substitution effects resulting from the change in the after-tax wage.

Income effects are real, and it is mistake to ignore them.  They act in the opposite direction of the substitution effect, and will act to offset them.  The offset might be partial, full, or even more than full.  We cannot say simply by looking at the theory.  Rather, one needs to look at the data.  And as noted above, the data provdes no support to the suppostion that lower tax rates will lead to higher growth.  Once one recognizes that there will be income effects as well as substitution effects, one can see that this should not be a surprise.  It is fully consistent with the theory.

One can also show how the income and substitution effects work via some standard diagrams, involving indifference curves and budget constraints.  These are used in most standard economics textbooks.  However, I suspect that most readers will find such diagrams to be more confusing than enlightening.  A verbal description, such as that above, will likely be more easy to follow.  But for those who prefer such diagrams, the standard ones can be found at this web posting.  Note, however, that there is a mistake (a typo I assume) in the key Figures 2A and 2B.  The horizontal arrows (along the “leisure” axis) are pointed in the opposite direction of what they should (left instead of right in 2A and right instead of left in 2B).  These errors indeed serve to emphasize how even the experts with such diagrams can get confused and miss simple typos.

D.  But There is More to the Hours of Work Decision than Textbook Economics

The analysis above shows that the supply-siders, who stress microeconomic incentives as key, have forgotten half of the basic analysis taught in their introductory microeconomics classes.  There are substitution effects resulting from a change in income tax rates, as the supply-siders argue, but there are also income effects which act in the opposite direction. The net effect is then not clear.

However, there is more to the working hours decision than the simple economics of income and substitution effects.  There are social as well as institutional factors.  It the real world, these other factors matter.  And I suspect they matter a good deal more than the standard economics in explaining the observation that we do not see growth rates jumping upwards after the several rounds of major tax cuts of the last half century.

Such factors include the following:

a)  For most jobs, a 40 hour work week is, at least formally, standard.  For those earning hourly wages, any overtime above 40 hours is, by law, supposed to be compensated at 50% above their normal hourly wage.  For workers in such jobs, one cannot generally go to your boss and tell him, in the event of an income tax increase say, that you now want to work only 39 1/2 hours each week.  The hours are pretty much set for such workers.

b)  There are of course other workers compensated by the hour who might work a variable number of hours each week at a job.  These normally total well less than 40 hours a week.  These would include many low wage occupations such as at fast food places, coffee shops, retail outlets, and similarly.  But for many such workers, the number of hours they work each week is constrained not by the number of hours they want to work, but by the number of hours their employer will call them in for.  A lower income tax rate might lead them to want to work even more hours, but when they are constrained already by the number of hours their employer will call them in for, there will be no change.

c)  For salaried workers and professionals such as doctors, the number of hours they work each week is defined primarily by custom for their particular profession.  They work the hours that others in that profession work, with this evolving over time for the profession as a whole.  The hours worked are in general not determined by some individual negotiation between the professional and his or her supervisor, with this changing when income tax rates are changed.  And many professionals indeed already work long hours (including medical doctors, where I worry whether they suffer from sleep deprivation given their often incredibly long hours).

d)  The reason why one sees many professionals, including managers and others in office jobs, working such long hours probably has little to do with marginal income tax rates.  Rather, they try to work longer than their co-workers, or at least not less, in order to get promoted.  Promotion is a competition, where the individual seen as the best is the one who gets promoted.  And the one seen as the best is often the one who works the longest each day.  With the workers competing against each other, possibly only implicitly and not overtly recognized as such, there will be an upward spiral in the hours worked as each tries to out-do the other.  This is ultimately constrained by social norms.  Higher or lower income tax rates are not central here.

e)  Finally, and not least, most of us do take pride in our work.  We want to do it well, and this requires a certain amount of work effort.  Taxes are not the central determinant in this.

E.  Summary and Conclusion

I fully expect there to be a push to cut income tax rates early in the Trump presidency.  The tax plan Trump set out during his campaign was similar to that proposed by House Speaker Paul Ryan, and both would cut rates sharply, especially for those who are already well off. They will argue that the cuts in tax rates will spur growth in GDP, and that as a consequence, the fiscal deficit will not increase much if at all.

There is, however, no evidence in the historical data that this will be the case.  Income tax rates have been cut sharply since the Eisenhower years, when the top marginal income tax rate topped 90%, but growth rates did not jump higher following the successive rounds of cuts.

Tax cuts, if they are focused on those of lower to middle income, might serve as a macro stimulus if unemployment is significant.  Such households would be likely to spend their extra income on consumption items rather than save it, and this extra household consumption demand can serve to spur production.  But tax cuts that go primarily to the rich (as the tax cuts that have been proposed by Trump and Ryan would do), that are also accompanied by significant government expenditure cuts, will likely have a depressive rather than stimulative effect.

The supply-siders base their argument, however, for why tax cuts should lead to an increase in the growth rate of GDP, not on the macro effects but rather on what they believe will be the impact on microeconomic incentives.  They argue that income taxes are a tax on work, and a reduction in the tax on work will lead to greater work effort.

They are, however, confused.  What they describe is what economists call the substitution effect.  That may well exist.  But there are also income effects resulting from the changes in the tax rates, and these income effects will work in the opposite direction.  The net impact is not clear, even if one keeps just to standard microeconomics.  The net impact could be a wash.  Indeed, the net impact could even be negative, leading to fewer hours worked when there is a cut in income taxes.  One does not know a priori, and you need to look at the data.  And there is no indication in the data that the sharp cuts in marginal tax rates over the last half century have led to higher rates of growth.

There is also more to the working hours decision than just textbook microeconomics. There are important social and institutional factors, which I suspect will dominate.  And they do not depend on the marginal rates of income taxes.

But if you are making an economic argument, you should at least get the economics right.

Taxes to Pay for Highways: A Switch from the Tax on Gallons of Fuel Burned to a Tax on Miles Driven Would Be Stupid

Impact of Switching from Fuel Tax on Gallons Burned to Tax on Miles Driven

A.  Introduction

According to a recent report in the Washington Post, a significant and increasing number of state public officials and politicians are advocating for a change in the tax system the US uses to support highway building and maintenance.  The current system is based on a tax on gallons of fuel burned, and the proposed new system would be based on the number of miles a car is driven.  At least four East Coast states are proposing pilots on how this might be done, some West Coast states have already launched pilots, and states are applying for federal grants to consider the change.  There is indeed even a lobbying group based in Washington now advocating it:  The Mileage-Based User Fee Alliance.

There is no question that the current federal gas tax of 18.4 cents per gallon of gasoline is woefully inadequate.  It was last changed in 1993, 23 years ago, and has been kept constant in nominal terms ever since.  With general prices (based on the CPI) now 65% higher, 18.4 cents now will only buy 11.2 cents at the prices of 1993, a decline of close to 40%.  As a result, the Highway Trust Fund is terribly underfunded, and with all the politics involved in trying to find other sources of funding, our highways are in terrible shape. Basic maintenance is simply not being done.

An obvious solution would be simply to raise the gas tax back at least to where it was before in real terms.  Based on where the tax was when last set in 1993 and on the CPI for inflation since then, this would be 30.3 cents per gallon now, an increase of 11.9 cents from the current 18.4 cents per gallon.  Going back even further, the gasoline tax was set at 4 cents per gallon in 1959, to fund the construction of the then new Interstate Highway system (as well as for general highway maintenance).  Adjusting for inflation, that tax would be 32.7 cents per gallon now.  Also, looking at what the tax would need to be to fund adequately the Highway Trust Fund, a Congressional Budget Office report issued in 2014 estimated that a 10 to 15 cent increase (hence 28.4 cents to 33.4 cents per gallon) would be needed (based on projections through 2024).

These fuel tax figures are all similar.  Note also that while some are arguing that the Highway Trust Fund is underfunded because cars are now more fuel efficient than before, this is not the case.  Simply bringing the tax rate back in real terms to where it was before (30.3 cents based on the 1993 level or 32.7 cents based on the 1959 level) would bring the rate to within the 28.4 to 33.4 cents range that the CBO estimates is needed to fully fund the Highway Trust Fund.  The problem is not fuel efficiency, but rather the refusal to adjust the per gallon tax rate for inflation.

But Congress has refused to approve any such increase.  Anti-tax hardliners simply refuse to consider what they view as an increase in taxes, even though the measure would simply bring them back in real terms to where they were before.  And it is not even true that the general population is against an increase in the gas tax.  According to a poll sponsored by the Mineta Transportation Institute (a transportation think tank based at San Jose State University in California), 75% of those polled would support an immediate increase in the gas tax of 10 cents a gallon if the funds are dedicated to maintenance of our streets, roads, and highways (see the video clip embedded in the Washington Post article, starting at minute 3:00).

In the face of this refusal by Congress, some officials are advocating for a change in the tax, from a tax per gallon of fuel burned to a new tax per mile each car is driven.  While I do not see how this would address the opposition of the anti-tax politicians (this would indeed be a totally new tax, not an adjustment in the old tax to keep it from falling in real terms), there appears to be a belief among some that this would be accepted.

But even if such a new tax were viewed as politically possible, it would be an incredibly bad public policy move to replace the current tax on fuel burned with such a tax on miles driven.  It would in essence be a tax on fuel efficiency, with major distributional (as well as other) consequences, favoring those who buy gas guzzlers.  And as it would encourage the purchase of heavy gas guzzlers (relative to the policy now in place), it would also lead to more than proportional damage to our roads, meaning that road conditions would deteriorate further rather than improve.

This blog post will discuss why such consequences would follow.  To keep things simple, it will focus on the tax on gasoline (which I will sometimes simply referred to as gas, or as fuel).  There are similar, but separate taxes, on diesel and other fuels, and their levels should be adjusted proportionally with any adjustment for gasoline.  There is also the issue of the appropriate taxes to be paid by trucks and other heavy commercial vehicles.  That is an important, but separate, issue, and is not addressed here.

B.  The Proposed Switch Would Penalize Fuel Efficient Vehicles

The reports indicate that the policy being considered would impose a tax of perhaps 1.5 cents per mile driven in substitution for the current federal tax of 18.4 cents per gallon of gas burned (states have their own fuel taxes in addition, with these varying across states). For the calculations here I will take the 1.5 cent figure as the basis for the comparisons, even though no specific figure is as yet set.

First of all, it should be noted that at the current miles driven in the country and the average fuel economy of the stock of cars being driven, a tax of 1.5 cents per mile would raise substantially more in taxes than the current 18.4 cents per gallon of gas.  That is, at these rates, there would be a substantial tax increase.

Using figures for 2014, the average fuel efficiency (in miles per gallon) of the light duty fleet of motor vehicles in the US was 21.4 miles per gallon, and the average miles driven per driver was 13,476 miles.  At a tax of 1.5 cents per mile driven, the average driver would pay $202.14 (= $.015 x 13,476) in such taxes per year.  With an average fuel economy of 21.4 mpg, such a driver would burn 629.7 gallons per year, and at the current fuel tax of 18.4 cents per gallon, is now paying $115.87 (= $.184 x 629.7) in gas taxes per year. Hence the tax would rise by almost 75% ($202.14 / $115.87).  A 75% increase would be equivalent to raising the fuel tax from the current 18.4 cents to a rate of 32.1 cents per gallon.  While higher tax revenues are indeed needed, why a tax on miles driven would be acceptable to tax opponents while an increase in the tax per gallon of fuel burned is not, is not clear.

But the real reason to be opposed to a switch in the tax to miles driven is the impact it would have on incentives.  Taxes matter, and affect how people behave.  And a tax on miles driven would act, in comparison to the current tax on gallons of fuel burned, as a tax on fuel efficiency.

The chart at the top of this post shows how the tax paid would vary across cars of different fuel efficiencies.  It would be a simple linear relationship.  Assuming a switch from the current 18.4 cents per gallon of fuel burned to a new tax of 1.5 cents per mile driven, a driver of a highly fuel efficient car that gets 50 miles per gallon would see their tax increase by over 300%!  A driver of a car getting the average nation-wide fuel efficiency of 21.4 miles per gallon would see their tax increase by 75%, as noted above (and as reflected in the chart).  In contrast, someone driving a gas guzzler getting only 12 miles per gallon or less, would see their taxes in fact fall!  They would end up paying less under such a new system based on miles driven than they do now based on gallons of fuel burned.  Drivers of luxury sports cars or giant SUVs could well end up paying less than before, even with rates set such that taxes on average would rise by 75%.

Changing the tax structure in this way would, with all else equal, encourage drivers to switch from buying fuel efficient cars to cars that burn more gas.  There are, of course, many reasons why someone buys the car that they do, and fuel efficiency is only one.  But at the margin, changing the basis for the tax to support highway building and maintenance from a tax per gallon to a tax on miles driven would be an incentive to buy less fuel efficient cars.

C.  Other Problems

The change to a tax on miles driven from the tax on gallons of fuel burned would have a number of adverse effects:

a)  A Tax on Fuel Efficiency:  As noted above, this would become basically a tax on fuel efficiency.  More fuel efficient cars would pay higher taxes relative to what they do now, and there will be less of an incentive to buy more fuel efficient cars.  There would then be less of an incentive for car manufacturers to develop the technology to improve fuel efficiency.  This is what economists call a technological externality, and we all would suffer.

b)  Heavier Vehicles Cause Far More Damage to the Roads:  Heavier cars not only get poorer gas mileage, but also tear up the roads much more, leading to greater maintenance needs and expense.  Heavier vehicles also burn more fuel, but there is a critical difference.  As a general rule, vehicles burn fuel in proportion with their weight: A vehicle that weighs twice as much will burn approximately twice as much fuel.  Hence such a vehicle will pay twice as much in fuel taxes (when such taxes are in cents per gallon) per mile driven.

However, the heavier vehicle also cause more damage to the road over time, leading to greater maintenance needs.  And it will not simply be twice as much damage.  A careful early study found that the amount of damage from a heavier vehicle increases not in direct proportion to its weight, but rather approximately according to the fourth power of the ratio of the weights.  That is, a vehicle that weighs twice as much (for the same number of axles distributing the weight) will cause damage equal to 2 to the fourth power (=16) times as much as the lighter vehicle.  Hence if they were to pay taxes proportionate to the damage they do, a vehicle that is twice as heavy should pay 16 times more in taxes, not simply twice as much.

(Note that some now argue that the 2 to the fourth power figure found before might be an over-estimate, and that the relationship might be more like 2 to the third power.  But this would still imply that a vehicle that weighs twice as much does 8 times the damage (2 to the third power = 8).  The heavier vehicle still accounts for a grossly disproportionate share of damage to the roads.)

A tax that is set based on miles driven would tax heavy and light vehicles the same.  This is the opposite of what should be done:  Heavy vehicles cause far more damage to the roads than light vehicles do.  Encouraging heavy, fuel-thirsty, vehicles by switching from a tax per gallon of fuel burned to a tax per mile driven will lead to more road damage, and proportionately far more cost than what would be collected in highway taxes to pay for repair of that damage.

c)  Impact on Greenhouse Gases:  One also wants to promote fuel efficiency because of the impact on greenhouse gases, and hence global warming, from the burning of fuels. By basic chemistry, carbon dioxide (CO2) is a direct product of fuel that is burned.  The more fuel that is burned, the more CO2 will go up into the air and then trap heat. Economists have long argued that the most efficient way to address the issue of greenhouse gases being emitted would be to tax them in proportion to the damage they do.  A tax on gallons of fuel that are burned will do this, while a tax on miles driven (and hence independent of the fuel efficiency of the vehicle) will not.

An interesting question is what level of gasoline tax would do this.  That is, what would the level of fuel tax need to be, for that tax to match the damage being done through the associated emission of CO2.  The EPA has come up with estimates of what the social cost of such carbon emissions are (and see here for a somewhat more technical discussion of its estimates).  Unfortunately, given the uncertainties in any such calculations, as well as uncertainty on what the social discount rate should be (needed to discount costs arising in the future that follow from emitting greenhouse gases today), the cost range is quite broad. Hence the EPA presents figures for the social cost of emitting CO2 using expected values at alternative social discount rates of 2.5%, 3%, and 5%, as well as from a measure of the statistical distribution of one of them (the 95th percentile for the 3% discount rate, meaning there is only an estimated 5% chance that the cost will be higher than this).  The resulting costs per metric ton of CO2 emitted then range from a low of $11 for the expected value (the 50th percentile) at the 5% discount rate, $36 at the expected value for the 3% discount rate, and $56 for the expected value for the 2.5% discount rate, to $105 for the 95th percentile at a 3% discount rate (all for 2015).

With such range in social costs, one should be cautious in the interpretation of any one. But it may still be of interest to calculate how this would translate into a tax on gasoline burned by automobiles, to see if the resulting tax is “in the ballpark” of what our fuel taxes are or should be.  Every gallon of gasoline burned emits 19.64 pounds of CO2.  There are 2,204.62 pounds in a metric ton, so one gallon of gas burned emits 0.00891 metric tons of CO2.  At the middle social cost of $36 per metric ton of CO2 emitted (the expected value for the 3% social discount rate scenario), this implies that a fuel tax of 32.1 cents per gallon should be imposed.  This is surprisingly almost precisely the fuel tax figure that all the other calculations suggest is warranted.

d)  One Could Impose a Similar Tax on Electric Cars:  One of the arguments of the advocates of a switch from taxes on fuel burned to miles driven is that as cars have become more fuel efficient, they pay less (per mile driven) in fuel taxes.  This is true.  But as generally lighter vehicles (one of the main ways to improve fuel economy) they also cause proportionately far less road damage, as discussed above.

There is also an increasing share of electric, battery-powered, cars, which burn no fossil fuel at all.  At least they do not burn fossil fuels directly, as the electricity they need to recharge their batteries come from the power grid, where fossil fuels dominate.  But this is still close to a non-issue, as the share of electric cars among the vehicles on US roads is still tiny.  However, the share will grow over time (at least one hopes).  If the share does become significant, how will the cost of building and maintaining roads be covered and fairly shared?

The issue could then be addressed quite simply.  And one would want to do this in a way that rewards efficiency (as different electric cars have different efficiencies in the mileage they get for a given charge of electricity) rather than penalize it.  One could do this by installing on all electric cars a simple meter that keeps track of how much it receives in power charges (in kilowatt-hours) over say a year.  At an annual safety inspection or license renewal, one would then pay a tax based on that measure of power used over the year.  Such a meter would likely have a trivial cost, of perhaps a few dollars.

Note that the amounts involved to be collected would not be large.  According to the 2016 EPA Automobile Fuel Economy Guide (see page 5), all-electric cars being sold in the US have fuel efficiencies (in miles per gallon equivalent) of over 100 mpg, and as high as 124 mpg.  These are on the order of five times the 21.4 average mpg of the US auto stock, for which we calculated that the average tax to be paid would be $202.  Even ignoring that the electric cars will likely be driven for fewer miles per year than the average car (due to their shorter range), the tax per year commensurate with their fuel economy would be roughly $40.  This is not much.  It is also not unreasonable as electric cars are kept quite light (given the limits of battery technology) and hence do little road damage.

e)  There Are Even Worse Policies That Have Been Proposed:  As discussed above, there are many reasons why a switch from a tax on fuel burned to miles driven would be a bad policy change.  But it should be acknowledged that some have proposed even worse. One example is the idea that there should be a fixed annual tax per registered car that would fund what is needed for highway building and maintenance.  Some states in fact do this now.

The amounts involved are not huge.  As was calculated above, at the current federal gasoline tax of 18.4 cents per gallon, the driver of a car that gets the average mileage (of 21.4 mpg) for the average distance a year (of 13,476 miles) will pay $115.87 a year.  If the fuel tax were raised to 32.1 cents per gallon (or equivalently, if there were a tax of 1.5 cents per mile driven), the average tax paid would be still just $202.14 per year.  These are not huge amounts.  One could pay them as part of an annual license renewal.

But the tax structured in this way would then be the same for a driver who drives a fuel efficient car or a gas guzzler.  And it would be the same for a driver who drives only a few miles each year, or who drives far more than the average each year.  The driver of a heavy gas guzzler, or one who drives more miles each year than others, does more damage to the roads and should pay more to the fund that repairs such damage and develops new road capacity.  The tax should reflect the costs they are imposing on society, and a fixed annual fee does not.

f)  The Cost of Tax Collection Needs to be Recognized:  Finally, one needs to recognize that it will cost something to collect the taxes.  This cost will be especially high for a tax on miles driven.

The current system, of a tax on fuel burned, is efficient and costs next to nothing to collect.  It can be charged at the point where the gasoline and other fuels leaves in bulk from the refinery, as all of it will eventually be burned.  While the consumer ultimately pays for the tax when they pump their gas, the price being charged at the pump simply reflects the tax that had been charged at an earlier stage.

In contrast, a tax on miles driven would need to be worked out at the level of each individual car.  And if the tax is to include shares that are allocating to different states, the equipment will need to keep track of which states the car is being driven in.  As the Washington Post article on a possible tax on miles driven describes, experiments are underway on different ways this might be done.  All would require special equipment to be installed, with a GPS-based system commonly considered.

Such special equipment would have a cost, both up-front for the initial equipment and then recurrent if there is some regular reporting to the center (perhaps monthly) of miles driven.  No one knows right now what such a system might cost if it were in mass use, but one could easily imagine that a GPS tracking and reporting system might cost on the order of $100 up front, and then several dollars a month for reporting.  This would be a significant share of a tax collection that would generate an average of just $202 per driver each year.

There is also the concern that any type of GPS system would allow the overseers to spy on where the car was driven.  While this might well be too alarmist, and there would certainly be promises that this would not be done, some might not be comforted by such promises.

D.  Conclusion

While one should always consider whether given policies can be changed for the better, one needs also to recognize that often the changes proposed would make things worse rather than better.  Switching the primary source of funding for highway building and maintenance from a tax on fuel burned to a tax on miles driven is one example.  It would be a stupid move.

There is no doubt that the current federal tax on gasoline of 18.4 cents per gallon is too low.  The result is insufficient revenues for the Highway Trust Fund, and we end up with insufficient road capacity and roads that are terribly maintained.

What I was surprised by in the research for this blog post was finding that a wide range of signals all pointed to a similar figure for what the gasoline tax should be. Specifically:

  1. The 1959 gas tax of 4 cents per gallon in terms of current prices would be 32.7 cents per gallon;
  2. The 1993 gas tax of 18.4 cents per gallon in terms of current prices would be 30.3 cents per gallon;
  3. The proposal of a 1.5 cent tax per mile driven would be equivalent (given current average car mileage and the average miles driven per year) to 32.1 cents per gallon;
  4. The tax to offset the social cost of greenhouse gas emissions from burning fuel would be (at a 3% social discount rate) 32.1 cents per gallon.
  5. The Congressional Budget Office projected that the gasoline tax needed to fully fund the Highway Trust Fund would be in the range of 28.4 to 33.4 cents per gallon.

All these point in the same direction.  The tax on gasoline should be adjusted to between 30 and 33 cents per gallon, and then indexed for inflation.

The Impact of the Reagan and Bush Tax Cuts: Not a Boost to Employment, nor to Growth, nor to the Fiscal Accounts

Private Employment Following Tax Law Changes

A.  Introduction

The belief that tax cuts will spur growth and new jobs, and indeed even lead to an improvement in the fiscal accounts, remains a firm part of Republican dogma.  The tax plans released by the main Republican presidential candidates this year all presume, for example, that a spectacular jump in growth will keep fiscal deficits from increasing, despite sharp cuts in tax rates.  And conversely, Republican dogma also holds that tax increases will kill growth and thus then lead to a worsening in the fiscal accounts.  The “evidence” cited for these beliefs is the supposed strong recovery of the economy in the 1980s under Reagan.

But the facts do not back this up.  There have been four major rounds of changes in the tax code since Reagan, and one can look at what happened after each.  While it is overly simplistic to assign all of what followed solely to the changes in tax rates, looking at what actually happened will at least allow us to examine the assertion underlying these claims that the Reagan tax cuts led to spectacular growth.

The four major changes in the tax code were the following.  While each of the laws made numerous changes in the tax code, I will focus here on the changes made in the highest marginal rate of tax on income.  The so-called “supply-siders” treat the highest marginal rate to be of fundamental importance since, under their view, this will determine whether individuals will make the effort to work or not, and by how much.  The four episodes were:

a)  The Reagan tax cuts signed into law in August 1981, which took effect starting in 1982. The highest marginal income tax rate was reduced from 70% before to 50% from 1982 onwards.  There was an additional round of tax cuts under a separate law passed in 1986, which brought this rate down further to 38.5% in 1987 and to 28% from 1988 onwards. While this could have been treated as a separate tax change episode, I have left this here as part of the Reagan legacy.  Under the Republican dogma, this should have led to an additional stimulant to growth.  We will see if that was the case.  There was also a more minor change under George H.W. Bush as part of a 1990 budget compromise, which brought the top rate partially back from 28.0% to 31.0% effective in 1991.  While famous as it went against Bush’s “read my lips” pledge, the change was relatively small.

b)  The tax rate increases in the first year of the Clinton presidency.  This was signed into law in August 1993, with the tax rate increases applying in that year.  The top marginal income tax rate was raised to 39.6%.

c)  The tax cuts in the George W. Bush presidency that brought the top rate down from 39.6% to 38.6% in 2002 and to 35.0% in 2003.  The initial law was signed in June 2001, and then an additional act passed in 2003 made further tax cuts and brought forward in time tax cuts being phased in under the 2001 law.

d)  The tax rate increases for those with very high incomes signed into law in December 2012, just after Obama was re-elected, that brought the marginal rate for the highest income earners back to 39.6%.

We therefore have four episodes to look at:  two of tax cuts and two of tax increases.  For each, I will trace what happened from when the tax law changes were signed up to the end of the administration responsible (treating Reagan and Bush I as one).  The questions to address are whether the tax cut episodes led to exceptionally good job growth and GDP growth, while the the tax increases led to exceptionally poor job and GDP growth. We will then look at what happened to the fiscal accounts.

B.  Jobs and GDP Growth Following the Changes in Tax Law

The chart at the top of this post shows what happened to private employment, by calendar quarter relative to a base = 100 for the quarter when the new law was signed. The data is from the Bureau of Labor Statistics (downloaded, for convenience, from FRED).  A chart using total employment would look almost exactly the same (but one could argue that government employment should be excluded as it is driven by other factors).

As the chart shows, private job growth was best following the Clinton and Obama tax increases, was worse under Reagan-Bush I, and abysmal under Bush II.  There is absolutely no indication that big tax cuts, such as those under Reagan and then Bush II, are good for job growth.  I would emphasize that one should not then jump to the conclusion that tax increases are therefore good for job growth.  That would be overly simplistic.  But what the chart does show is that the oft-stated claim by Republican pundits that the Reagan tax cuts were wonderful for job growth simply has no basis in fact.

How about the possible impact on GDP growth?  A similar chart shows (based on BEA data on the GDP accounts):

Real GDP Following Tax Law Changes

Once again, growth was best following the Clinton tax increases.  Under Reagan, GDP growth first fell following the tax cuts being signed into law (as the economy moved down into a recession, which by NBER dating began almost exactly as the Reagan tax cut law was being signed), and then recovered.  But the path never catches up with that followed during the Clinton years.  Indeed after a partial catch-up over the initial three years (12 calendar quarters), the GDP path began to fall steadily behind the pace enjoyed under Clinton.  Higher taxes under Clinton were clearly not a hindrance to growth.

The Bush II and Obama paths are quite similar, even though growth during these Obama years has had to go up against the strong headwinds of fiscal drag from government spending cuts.  Federal government spending on goods and services (from the GDP accounts, with the figures in real, inflation-adjusted, terms) rose at a 4.4% per annum pace during the eight years of the Bush II administration, and rose at a 5.6% rate during Bush’s first term.  Federal government spending since the late 2012 tax increases were signed under Obama have fallen, in contrast, at a 2.8% per annum rate.

There is therefore also no evidence here that tax cuts are especially good for growth and tax increases especially bad for growth.  If anything, the data points the other way.

C.  The Impact on the Fiscal Accounts

The argument of those favoring tax cuts goes beyond the assertion that they will be good for growth in jobs and in GDP.  Some indeed go so far as to assert that the resulting stimulus to growth will be so strong that tax revenues will actually rise as a result, since while the tax rates will be lower, they will be applied against resulting higher incomes and hence “pay for themselves”.  This would be nice, if true.  Something for nothing. Unfortunately, it is a fairy tale.

What happened to federal income taxes following the changes in the tax rates?  Using CBO data on the historical fiscal accounts:

Real Federal Income Tax Revenues Following Tax Law Changes

Federal income tax revenues (in real terms) either fell or at best stagnated following the Reagan and then the Bush II tax cuts.  The revenues rose following the Clinton and Obama tax increases.  The impact is clear.

While one would think this should be obvious, the supply-siders who continue to dominate Republican thinking on these issues assert the opposite has been the case (and would be, going forward).  Indeed, in what must be one of the worst economic forecasts ever made in recent decades by economists (and there have been many bad forecasts), analysts at the Center for Data Analysis at the conservative Heritage Foundation concluded in 2001 that the Bush II tax cuts would lead government to “effectively pay off the publicly held federal debt by FY 2010”.  Publicly held federal debt would fall below 5% of GDP by FY2011 they said, and could not go any lower as some federal debt is needed for purposes such as monetary operations.  But actual publicly held federal debt reached 66% of GDP that year.  That is not a small difference.

Higher tax revenues help then make it possible to bring down the fiscal deficit.  While the deficit will also depend on public spending, a higher revenue base, all else being equal, will lead to a lower deficit.

So what happened to the fiscal deficit following these four episodes of major tax rate changes?  (Note to reader:  A reduction in the fiscal deficit is shown as a positive change in the figure.)

Change in Fiscal Deficit Relative to Base Year Following Tax Law Changes

The deficit as a share of GDP was sharply reduced under Clinton and even more so under Obama.  Indeed, under Clinton the fiscal accounts moved from a deficit of 4.5% of GDP in FY1992 to a surplus of 2.3% of GDP in FY2000, an improvement of close to 7% points of GDP.  And in the period since the tax increases under Obama, the deficit has been reduced by over 4% points of GDP, in just three years.  This has been a very rapid base, faster than that seen even during the Clinton years.  Indeed, the pace of fiscal deficit reduction has been too fast, a consequence of the federal government spending cuts discussed above.  This fiscal drag held back the pace of recovery from the downturn Obama inherited in 2009, but at least the economy has recovered.

In contrast, the fiscal deficit deteriorated sharply following the Reagan tax cuts, and got especially worse following the Bush II tax cuts.  The federal fiscal deficit was 2.5% of GDP in FY1981, when Reagan took office, went as high as 5.9% of GDP in FY1983, and was 4.5% of GDP in FY1992, the last year of Bush I (it was 2.5% of GDP in FY2015 under Obama).  Bush II inherited the Clinton surplus when he took office, but brought this down quickly (on a path initially similar to that seen under Reagan).  The deficit was then 3.1% of GDP in FY2008, the last full year when Bush II was in office, and hit 9.8% of GDP in FY2009 due largely to the collapsing economy (with Bush II in office for the first third of this fiscal year).

Republicans continue to complain of high fiscal deficits under the Democrats.  But the deficits were cut sharply under the Democrats, moving all the way to a substantial surplus under Clinton.  And the FY2015 deficit of 2.5% of GDP under Obama is not only far below the 9.8% deficit of FY2009, the year he took office, but is indeed lower than the deficit was in any year under Reagan and Bush I.  The tax increases signed into law by Clinton and Obama certainly helped this to be achieved.

D.  Conclusion

The still widespread belief among Republicans that tax cuts will spur growth in jobs and in GDP is simply not borne out be the facts.  Growth was better following the tax increases of recent decades than it was following the tax cuts.

I would not conclude from this, however, that tax increases are therefore necessarily good for growth.  The truth is that tax changes such as those examined here simply will not have much of an impact in one direction or the other on jobs and output, especially when a period of several years is considered.  Job and output growth largely depends on other factors.  Changes in marginal income tax rates simply will not matter much if at all. Economic performance was much better under the Clinton and Obama administrations not because they raised income taxes (even though they did), but because these administrations managed better a whole host of factors affecting the economy than was done under Reagan, Bush I, or Bush II.

Where the income tax rates do matter is in how much is collected in income taxes.  When tax rates are raised, more is collected, and when tax rates are cut, less is collected.  This, along with the management of other factors, then led to sharp reductions in the fiscal deficit under Clinton and Obama (and indeed to a significant surplus by the end of the Clinton administration), while fiscal deficits increased under Reagan, Bush I, and Bush II.

Higher tax collections when tax rates go up and lower collections when they go down should not be a surprising finding.  Indeed, it should be obvious.  Yet one still sees, for example in the tax plans issued by the Republican presidential candidates this year, reliance on the belief that a miraculous jump in growth will keep deficits from growing.

There is no evidence that such miracles happen.

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.