Social Security Could be Saved With the Revenues Lost Under the Trump Tax Plan

As is well known, the Social Security Trust Fund will run out in about 2034 (plus or minus a year) if nothing is done.  “Running out” means that the past accumulated stock of funds paid in through Social Security taxes on wages, plus what is paid in each year, will not suffice to cover what is due to be paid out that year to beneficiaries.  If nothing is done, Social Security payments would then be scaled back by 23% (in 2034, rising to 27% by 2091), to match the amount then being paid in each year.

This would be a disaster.  Social Security does not pay out all that much:  An average of just $15,637 annually per beneficiary for those in retirement and their survivors, and an average of just $12,452 per beneficiary for those on disability (all as of August 2017).  But despite such limited amounts, Social Security accounts for almost two-thirds (63%) of the incomes of beneficiaries age 65 or older, and 90% or more of the incomes of fully one-third of them.  Scaling back such already low payments, when so many Americans depend so much on the program, should be unthinkable.

Yet Congress has been unwilling to act, even though the upcoming crisis (if nothing is done) has been forecast for some time.  Furthermore, the longer we wait, the more severe the measures that will then be necessary to fix the problem.  It should be noted that the crisis is not on account of an aging population (one has pretty much known for 64 years how many Americans would be reaching age 65 now), nor because of a surprising jump in life expectancies (indeed, life expectancies have turned out to be lower than what had been forecast).  Rather, as discussed in an earlier post on this blog, the crisis has arisen primarily because wage income inequality has grown sharply (and unexpectedly) since around 1980, and this has pulled an increasing share of wages into the untaxed range above the ceiling for annual earnings subject to Social Security tax ($127,200 currently).

But Congress could act, and there are many different approaches that could be taken to ensure the Social Security Trust Fund remains adequately funded.  This post will discuss just one.  And that would be not to approve the Trump proposal for what he accurately calls would be a huge cut in taxes, and use the revenues that would be lost under his tax plan instead to shore up the Social Security Trust Fund.  As the chart at the top of this post shows (and as will be discussed below), this would more than suffice to ensure the Trust Fund would remain in surplus for the foreseeable future.  There would then be no need to consider slashing Social Security benefits in 2034.

The Trump tax plan was submitted to Congress on September 27.  It is actually inaccurate to call it simply the Trump tax plan as it was worked out over many months of discussions between Trump and his chief economic aides on one side, and the senior Republican leadership in both the Senate and the Congress on the other side, including the chairs of the tax-writing committees.  This was the so-called “Gang of Six”, who jointly released the plan on September 27, with the full endorsement of all.  But for simplicity, I will continue to call it the Trump tax plan.

The tax plan would sharply reduce government revenues.  The Tax Policy Center (TPC), a respected bipartisan nonprofit, has provided the most careful forecast of the revenue losses yet released.  They estimated that the plan would reduce government revenues by $2.4 trillion between 2018 and 2027, with this rising to a $3.2 trillion loss between 2028 and 2037.  The lost revenue would come to 0.9% of GDP for the 2018 to 2027 period, and 0.8% of GDP for the 2028 to 2037 period (some of the tax losses under the Trump plan are front-loaded), based on the GDP forecasts of the Social Security Trustees 2017 Annual Report (discussed below).  While less than 1% of GDP might not sound like much, such a revenue loss would be significant.  As we will see, it would suffice to ensure the Social Security Trust Fund would remain fully funded.

The chart at the top of this post shows what could be done.  The curve in green is the base case where nothing is done to shore up the Trust Fund.  It shows what the total stock of funds in the Social Security Trust Fund have been (since 1980) and would amount to, as a share of GDP, if full beneficiary payments would continue as per current law.  Note that I have included here the trust funds for both Old-Age and Survivors Insurance (OASI) and for Disability Insurance (DI).  While technically separate, they are often combined (and then referred to as OASDI).

The figures are calculated from the forecasts released in the most recent (July 2017) mandated regular annual report of the Board of Trustees of the Social Security system.  Their current forecast is that the Trust Fund would run out by around 2034, as seen in the chart.

But suppose that instead of enacting the Trump tax plan proposals, Congress decided to dedicate to the Social Security Trust Funds (OASDI) the revenues that would be lost as a consequence of those tax cuts?  The curve in the chart shown in red is a forecast of what those tax revenue losses would be each year, as a share of GDP.  These are the Tax Policy Center estimates, although extrapolated.  The TPC forecasts as published showed the estimated year-by-year losses over the first ten years (2018 to 2027), but then only for the sum of the losses over the next ten years (2028 to 2037).  I assumed a constant rate of growth from the estimate for 2027 sufficient to generate the TPC sum for 2028 to 2037, which worked out to a bit over 6.1%.  I then assumed the revenue losses would continue to grow at this rate for the remainder of the forecast period.

Note this 6.1% growth is a nominal rate of growth, reflecting both inflation and real growth.  The long-run forecasts in the Social Security Trustees report were for real GDP to grow at a rate of 2.1 or 2.2%, and inflation (in terms of the GDP price index) to grow at also 2.2%, leading to growth in nominal GDP of 4.3 or 4.4%.  Thus the forecast tax revenue losses under the Trump plan would slowly climb over time as a share of GDP, reaching 2% of GDP by about 2090.  This is as one would expect for this tax plan, as the proposals would reduce progressivity in the tax system.  As I noted before on this blog and will discuss further below, most of the benefits under the Trump tax plan would accrue to those with higher incomes.  However, one should also note that the very long-term forecasts for the outer years should not be taken too seriously.  While the trends are of interest, the specifics will almost certainly be different.

If the tax revenues that would be lost under the Trump tax plan were instead used to shore up the Social Security Trust Fund, one would get the curve shown in blue (which includes the interest earned on the balance in the Fund, at the interest rates forecast in the Trustees report).  The balance in the fund would remain positive, never dipping below 12% of GDP, and then start to rise as a share of GDP.  Even if the TPC forecasts of the revenues that would be lost under the Trump plan are somewhat off (or if Congress makes changes which will reduce somewhat the tax losses), there is some margin here.  The forecast is robust.

The alternative is to follow the Trump tax plan, and cut taxes sharply.  As I noted in my earlier post on this blog on the Trump tax plan, the proposals are heavily weighted to provisions which would especially benefit the rich.  The TPC analysis (which I did not yet have when preparing my earlier blog post) has specific estimates of this.  The chart below shows who would get the tax cuts for the forecast year of 2027:

The estimate is that 87% of the tax revenues lost under the Trump plan would go to the richest 20% of the population (those households with an income of $154,900 or more in 2027, in prices of 2017).  And indeed, almost all of this (80% of the overall total) would accrue just to the top 1%.  The top 1% are already pretty well off, and it is not clear why tax cuts focused on them would spur greater effort on their part or greater growth.  The top 1% are those households who would have an annual income of at least $912,100 in 2027, in prices of 2017.  Most of them would be making more than a million annually.

The Trump people, not surprisingly, do not accept this.  They assert that the tax cuts will spur such a rapid acceleration in growth that tax revenues will not in fact be lost.  Most economists do not agree.  As discussed in earlier posts on this blog, the historical evidence does not support the Trumpian view (the tax cuts under Reagan and Bush II did not lead to any such acceleration in growth; what they did do is reduce tax revenues); the argument that tax cuts will lead to more rapid growth is also conceptually confused and reveals a misunderstanding of basic economics; and with the economy having already reached full employment during the Obama years, there is little basis for the assertion that the economy will now be able to grow at even 3% a year on average (over a mulit-year period) much less something significantly faster.  Tax cuts have in the past led to cuts in tax revenues collected, not to increases, and there is no reason to believe this time will be different.

Thus Congress faces a choice.  It can approve the Trump tax plan (already endorsed by the Republican leadership in both chambers), with 80% of the cuts going to the richest 1%.  Or it could use those revenues to shore up the Social Security Trust Fund.  If the latter is done, the Trust Fund would not run out in 2034, and Social Security would be able to continue to pay amounts owed to retired senior citizens and their survivors, as well as to the disabled, in accordance with the commitments it has made.

I would favor the latter.  If you agree, please call or write your Senator and Member of Congress, and encourage others to do so as well.

————————————————————————

Update, October 22, 2017

The US Senate passed on October 19 a budget framework for the FY2018-27 period which would allow for $1.5 trillion in lost tax revenues over this period, and a corresponding increase in the deficit, as a consequence of new tax legislation.  It was almost fully a party line vote (all Democrats voted against it, while all Republicans other than Senator Rand Paul voted in favor).  Importantly, this vote cleared the way (under Senate rules) for it to pass a new tax law with losses of up to $1.5 trillion over the decade, and pass this with only Republican votes.  Only 50 votes in favor will be required (with Vice President Pence providing a tie-breaking vote if needed).  Democrats can be ignored.

The loss in tax revenues in this budget framework is somewhat less than the $2.4 trillion that the Tax Policy Center estimates would follow in the first decade under the Trump tax plan.  But it is still sizeable, and it is of interest to see what this lesser amount would achieve if redirected to the Social Security Trust Fund instead of being used for tax cuts.

The chart above shows what would follow.  It still turns out that the Social Security Trust Fund would be saved from insolvency, although just barely this time.

One has to make an assumption as to what would happen to tax revenues after 2027, as well as for what the time pattern would be for the $1.5 trillion in losses over the ten years from FY2018 to 27.  With nothing else available, I assumed that the losses would grow over time at the same rate as what is implied in the Tax Policy Center estimates for the losses in the second decade of the Trump tax plan as compared to the losses in the final year of the first decade.  As discussed above, these estimates implied a nominal rate of growth of 6.1% a year.  I assumed the same rate of growth here, including for the year to year growth in the first decade (summing over that decade to $1.5 trillion).

The result again is that the Social Security Trust Fund would remain solvent for the foreseeable future, although now just marginally.  The Trust Fund (as a share of GDP) would just touch zero in the years around 2080, but would then start to rise.

We therefore have a choice.  The Republican-passed budget framework has that an increase in the fiscal deficit of $1.5 trillion over the next decade is acceptable.  It could be used for tax cuts that would accrue primarily to the rich.  Or it could be used to ensure the Social Security system will be able, for the foreseeable future, to keep to its commitments to senior citizens, to their survivors, and to the disabled.

 

Lower Corporate Taxes Have Not Led to Higher Real Wages

A recently released report from the president’s Council of Economic Advisers (CEA) claims that cutting the headline corporate income tax rate from the current 35% to 20% would lead to a jump in the real incomes of American households by a minimum of $4,000 a year and possibly by as much as $9,000.  Others have criticized those forecasts for a variety of reasons, and Larry Summers has called the estimates “absurd”.

Indeed, they are absurd.  One way to see this is by looking at the historical evidence.  This is not the first time the US would cut its corporate tax rates.  Did such cuts in the past then lead to a jump in real wages?  As the chart above suggests, the answer is no.  This blog post will discuss that evidence, as well as other issues with the CEA analysis prepared under (and it appears largely by) its new chair Kevin Hassett.  But first some background on the CEA and its new chair, and what this recent incident portends for the Council and its previous reputation for professionalism.

The Council of Economic Advisers has, until now, been a highly respected office in the White House, set up to provide the president with objective and professional economic advice on the key economic issues of the day.  The Council was established in 1946 during the Truman administration, and has had as its chair and its members many illustrious and well-respected economists.  A number later received the Nobel Prize in Economics and similar awards.  While the CEA can be and has been political at times (it is located in the Office of the President, after all), it has had an able staff who were expected to provide professional assessments of the issues as a service to the president.  Many came on leave from academic posts.  As an example of the type of staff they could draw, both Larry Summers and Paul Krugman, then young and rising economists, were on the Council staff in the early 1980s during the Reagan administration.

The current chair is Kevin Hassett.  Trump did not nominate someone to the position until April, and Hassett took up his post (following Senate approval) only on September 13.  Prior to this post, Hassett was perhaps best known for co-authoring (with James K. Glassman) the 1999 book titled “Dow 36,000”, in which he forecast the Dow Jones Industrial Average would reach 36,000 by 2002 and certainly no later than by 2004.  In the event, the Dow never exceeded 11,750 (in January 2000) and dropped to 7,200 in October 2002, as the Bush administration’s first recession took hold.

Hassett has now, as one of his first official acts, released a formal CEA study that claims that if the Trump Tax Plan were enacted, with the headline corporate income tax cut from 35% to 20%, household incomes in the US would rise by a minimum of $4,000 per year, and possibly by as much as $9,000.  Larry Summers has termed it “dishonest, incompetent, and absurd”, and other economists have been similarly scathing.

The study really is pretty bad, and must be an embarrassment to the CEA staff. The report starts (Figure 1) with a chart that shows average real wage growth over the last several years (2013 to 2016) among the 10 OECD member countries with the highest statutory corporate income tax rates, as compared to that for the 10 OECD members with the lowest rates.  Between 2013 and 2016 (but essentially just in 2015) the wage growth was higher by a few percentage points in the set of OECD countries with the lower tax rates.  But the 10 OECD member countries with the lowest corporate tax rates were mostly countries from Central and Eastern Europe (Estonia, Latvia, and so on to Slovenia).  They were starting from lower wage rates than in the richer countries, and benefited as they opened up to globalization and in particular to the EU markets.  It is difficult to see how this simplistic correlation tells us much about what would happen if the US cut its corporate income tax rate.

Hassett then quantifies his estimate of the dollar gains per household by citing a number of obscure articles (several of which were never published in a peer-reviewed journal) to come up with estimates of possible elasticities (explained below) that relate how much household incomes would rise if corporate taxes were cut.  He concludes this review by asserting that an elasticity in the range of -0.16 to -0.33 would be reasonable, in his view.  The -0.16 figure came from a study from 2009 published in the “Federal Reserve Bank of Kansas City Economic Review”.  That is not exactly a prestigious journal.  And the -0.33 figure came from a 2007 paper that was presented at a conference, and does not appear to have ever been published.

An elasticity of -0.16 means that if the corporate tax rate were cut by 1% (not 1 percentage point, but rather by actually 1%, e.g. from 35% to 34.65%), then real wages would rise by 0.16%.  A 10% cut in the corporate tax rates (e.g. 35% to 31.5%) would lead, according to this assumption, to real wages rising by 1.6%.  And a cut in the corporate income tax rate from 35% to 20% (a 43% fall), as proposed in the Trump tax plan, would raise real wages by 6.9% under this assumption.  Hassett then applies this to the wage portion of household incomes to arrive at his calculated gain of $4,000 per household.  And the $9,000 gain is based on assuming an elasticity of -0.33.

There are numerous problems with this analysis, starting with the assumption that correlations are the same as causation.  There is also a question of what correlations are relevant.  The study that came up with the -0.33 elasticity, for example, looked at correlations across a panel of 50 countries.  It is not clear that such correlations would be of much relevance to judging the impact on real wages of a change in the US on corporate tax rates, as real wages across such a range of countries are driven by many factors (including, not least, the level of development).  And the -0.16 elasticity came from a study that examined correlations between real wages and corporate tax rates across the different states of the US.  But labor is mobile across US states, as is capital, plus the range of variation (state to state) in corporate tax rates is relatively modest as state taxes are relatively modest in size.  And indeed, it is not even clear how many companies actually pay the headline corporate income tax rates on the books, as states routinely grant them special tax holidays and other favors in order to try to get them to move to their states.

One would have thought that the most interesting investigation as to whether changes in corporate income taxes would matter in the US to real wages, would have been to see what actually happened in the US when such rates were cut in the past.  The fact that Hassett ignored this obvious question in the new CEA report is telling.  And there have indeed been earlier changes in the corporate tax rate, most notably (in recent decades) in 1987/88, following from the Tax Reform Act of 1986 during the Reagan administration.

The impact (or rather the lack of it) can be seen in the chart at the top of this post.  As had been discussed in earlier posts on this blog, real wages have been stagnant in the US (for the median wage earner) since around 1980.  The chart at the top of this post is an update of one prepared for a post from February 2015 that looked at the proximate causes of stagnant wages over this period, despite growth of real GDP per capita of more than 80% over the period.  While real GDP per capita is now 82% above what it was at the start of 1979, real wages (as measured by real median weekly earnings of full-time workers) are just 5.7% above where they were at the start of 1979.  Furthermore, the current “peak” of 5.7% growth can all be attributed to growth in the period since mid-2014, as the economy finally approached full employment levels in the later years of the Obama administration (having been held back by government spending cuts from 2010), with this carrying over into 2017.

The top corporate tax rate on profits was cut from 46% in the years up through 1986, to 40% in 1987 and then to just 34% in 1988 and thereafter to 1993 (when it was raised to the current level of 35%).  Did the cuts in 1987/88 lead to a sharp jump in real wages?  There is no indication of that at all in the chart.  Indeed, real wages fell by close to 6% between late 1986 and 1990, and then stayed at close to that low level until they started to rise some in the mid to late 1990s.  And there is no indication that the small increase in the corporate tax rate in 1993 to 35% led to wages then declining – indeed, they started to rise a few years later.

Based on this, one might come to the conclusion that a cut in corporate tax rates will lead to a fall (not an increase) in real wages, as seen following the 1987/88 cuts.  And also that a modest rise in the tax rate (such as in 1993) would lead to a gain in real wages a few years later.  But I would not claim this.  Rather, I would say that real wages and corporate tax rates are simply not closely linked to one another.  But for Hassett and others to claim that cuts in corporate taxes will lead to a significant jump in real wages, the exact opposite outcome following the 1987/88 cuts needs to be explained.

The CEA report was badly done, and must be an embarrassment to the professional staff there who certainly know better.  And as Larry Summers remarked in his blog post:  “Considering all this, if a Ph.D student submitted the CEA analysis as a term paper in public finance, I would be hard pressed to give it a passing grade.”

An Analysis of the Trump Tax Plan: Not a Tax Reform, But Rather a Massive Tax Cut for the Rich

A.  Introduction

The Trump administration released on September 27 its proposed tax plan.  It was exceedingly skimpy (only nine pages long, including the title page, and with all the white space could have been presented on half that number of pages).  Importantly, it was explicitly vague on many of the measures, such as what tax loopholes would be closed to partially pay for the tax cuts (simply saying they would do this somehow).  One can, however, examine measures that were explicitly presented, and from these it is clear that this is primarily a plan for massive tax cuts for the rich.

It is also clear that this is not a tax reform.  A tax reform would be revenue neutral.  The measures proposed would not be.  And a reform would focus on changes in the structure of the tax system.  There is little of that here, but rather proposals to cut various tax rates (including in several cases to zero), primarily for the benefit of those who are well off.

One can see this in the way the tax plan was approached.  In a true tax reform, one would start by examining the system, and whether certain deductions and tax exemptions are not warranted by good policy (but rather serve only certain vested interests).  Closing such loopholes would lead to higher revenues being collected.  One would then determine what the new tax rates could be (i.e. by how much they could be cut) to leave the overall level of tax collection the same.

But that was not done here.  Rather, they start with specific proposals on what the new tax rates “should” be (12%, 25%, and 35% for individuals, and 20% for corporations), and then make only vague references to certain, unspecified, deductions and tax exemptions being eliminated or reduced, in order not to lose too much in revenues (they assert).  They have the process backward.

And it is clear that these tax cuts, should they be enacted by Congress, would massively increase the fiscal deficit.  While it is impossible to come up with a precise estimate of how much the tax plan would cost in lost revenues, due to the vagueness on the parameters and on a number of the proposals, Republicans have already factored into the long-term budget a reduction in tax revenues of $1.5 trillion over ten years.  And estimates of the net cost of the Trump plan range from a low of $2.2 trillion over ten years ($2.7 trillion when additional interest is counted, as it should be), to as high as $5 trillion over ten years.  No one can really say as yet, given the deliberate lack of detail.

But any of these figures on the cost are not small.  The total federal debt held by the public as of the end of September, 2017, was $14.7 trillion.  The cost in lost revenue could equal more than a third of this.  Yet Republicans in Congress blocked the fiscal expenditures we desperately needed in the years from 2010 onwards during the Obama years, when unemployment was still high, there was excess capacity in our underutilized factories, and the country needed to rebuild its infrastructure (as we still do).  The argument then was that we could not add to our national debt.  But now the same politicians see no problem with adding massively to that debt to cover tax cuts that will primarily benefit the rich.  The sheer hypocrisy is breath-taking.

Not surprisingly, Trump officials are saying that there will be no such cost due to a resulting spur to our economic growth.  Trump himself asserted that his tax plan would lead the economy to grow at a 6% pace.  No economist sees this as remotely plausible.  Even Trump’s economic aides, such as Gary Cohn who was principally responsible for the plan, are far more cautious and say only that the plan will lead to growth of “substantially over 3 percent”.  But even this has no basis in what has been observed historically after the Reagan and Bush tax cuts, nor what one would expect from elementary economic analysis.

The lack of specificity in many of the proposals in the tax plan issued on September 27 makes it impossible to assess it in full, as major elements are simply only alluded to.  For example, it says that a number of tax deductions (both personal and corporate) will be eliminated or reduced, but does not say which (other than that they propose to keep the deductions for home mortgage interest and for charity).  As another example, the plan says the number of personal income tax brackets would be reduced from seven currently to just three broad ones (at 12%, 25%, and 35%), but does not say at what income levels each would apply.  Specifics were simply left out.

For a tax plan where work has been intensively underway for already the eight months of this administration (and indeed from before, as campaign proposals were developed), such vagueness must be deliberate.  The possible reasons include:  1) That the specifics would be embarrassing, as they would make clear the political interests that would gain or lose under the plan; 2) That revealing the specifics would spark immediate opposition from those who would lose (or not gain as others would); 3) That revealing the specifics would make clear that they would not in fact suffice to achieve what the Trump administration is asserting (e.g. that ending certain tax deductions will make the plan progressive, or generate revenues sufficient to offset the tax rate cuts); and/or 4) That they really do not know what to do or what could be done to fix the issue.

One can, however, look at what is there, even if the overall plan is incomplete.  This blog post will do that.

B.  Personal Income Taxes

The proposals are (starting with those which are most clear):

a)  Elimination of the Estate Tax:  Only the rich pay this.  It only applies to estates given to heirs of $10.98 million or more (for a married couple).  This only affects the top 0.2%, most wealthy, households in the US.

b)  Elimination of the Alternative Minimum Tax:  This also only applies to those who are rich enough for it to apply and who benefit from a range of tax deductions and other benefits, who would otherwise pay little in tax.  It would be better to end such tax deductions and other special tax benefits that primarily help this group, thus making the Alternative Minimum Tax irrelevant, than to end it even though it had remained relevant.

c)  A reduction in the top income tax rate from 39.6% to 35%:  This is a clear gain to those whose income is so high that they would, under the current tax brackets, owe tax at a marginal rate of 39.6%.  But this bracket only kicks in for households with an adjusted gross income of $470,700 or more (in 2017).  This is very close to the minimum income of those in the top 1% of the income distribution ($465,626 in 2014), and the average household income of those in that very well-off group was $1,260,508 in 2014.  Thus this would be a benefit only to the top 1%, who on average earn over $1 million a year.

The Trump plan document does include a rather odd statement that the congressional tax-writing committees could consider adding an additional, higher, tax bracket, for the very rich, but it is not at all clear what this might be.  They do not say.  And since the tax legislation will be written by the congressional committees, who are free to include whatever they choose, this gratuitous comment is meaningless, and was presumably added purely for political reasons.

d)  A consolidation in the number of tax brackets from seven currently to just three, of 12%, 25%, and 35%:  Aside from the clear benefit to those now in the 39.6% bracket, noted above, one cannot say precisely what the impact the new tax brackets would have for the other groups since the income levels at which each would kick in was left unspecified.  It might have been embarrassing, or contentious, to do so.  But one can say that any such consolidation would lead to less progressivity in the tax system, as each of the new brackets would apply to a broader range of incomes.  Instead of the rates rising as incomes move up from one bracket to the next, there would now be a broader range at which they would be kept flat.  For example, suppose the Trump plan would be for the new 25% rate to span what is now taxed at 25% or 28%.  That range would then apply to household incomes (for married couples filing jointly, and in 2017) from $75,900 on the low end to $233,350 at the high end.  The low-end figure is just above the household income figure of $74,869 (in 2016) for those reaching the 60th percentile of the income distribution (see Table A-2 of this Census Bureau report), while the top-end is just above the $225,251 income figure for those reaching the 95th percentile.  A system is not terribly progressive when those in the middle class (at the 60th percentile) pay at the same rate as those who are quite well off (in the 95th percentile).

e)  A ceiling on the tax rate paid on personal income received through “pass-through” business entities of just 25%:  This would be one of the more regressive of the measures proposed in the Trump tax plan (as well as one especially beneficial to Trump himself).  Under current tax law, most US businesses (95% of them) are incorporated as business entities that do not pay taxes at the corporate level, but rather pass through their incomes to their owners or partners, who then pay tax on that income at their normal, personal, rates.  These so-called “pass-through” business entities include sole proprietorships, partnerships, Limited Liability Companies (LLCs), and sub-chapter S corporations (from the section in the tax code).  And they are important, not only in number but also in incomes generated:  In the aggregate, such pass-through business entities generate more in income than the traditional large corporations (formally C corporations) that most people refer to when saying corporation.  C corporations must pay a corporate income tax (to be discussed below), while pass-through entities avoid such taxes at the company level.

The Trump tax plan would cap the tax rate on such pass-through income at 25%.  This would not only create a new level of complexity (a new category of income on which a different tax is due), but would also only be of benefit to those who would otherwise owe taxes at a higher rate (the 35% bracket in the Trump plan).  If one were already in the 25% bracket, or a lower one, that ceiling would make no difference at all and would be of no benefit.  But for those rich enough to be in the higher bracket, the benefit would be huge.

Who would gain from this?  Anyone who could organize themselves as a pass-through entity (or could do so in agreement with their employer).  This would include independent consultants; other professionals such as lawyers, lobbyists, accountants, and financial advisors; financial entities and the partners investing in private-equity, venture-capital, and hedge funds; and real estate developers.  Trump would personally benefit as he owns or controls over 500 LLCs, according to Federal Election Commission filings.  And others could reorganize into such an entity when they have a tax incentive to do so.  For example, the basketball coach at the University of Kansas did this when Kansas created such a loophole for what would otherwise be due under its state income taxes.

f)  The tax cuts for middle-income groups would be small or non-existent:  While the Trump tax proposal, as published, repeatedly asserts that they would reduce taxes due by the middle class, there is little to suggest in the plan that that would be the case.  The primary benefit, they tout (and lead off with) is a proposal to almost double the standard deduction to $24,000 (for a married couple filing jointly).  That standard deduction is currently $12,700.  But the Trump plan would also eliminate the personal exemption, which is $4,050 per person in 2017.  Combining the standard deduction and personal exemptions, a family of four would have $28,900 of exempt income in 2017 under current law ($12,700 for the standard deduction, and personal exemptions of four times $4,050), but only $24,000 under the Trump plan.  They would not be better off, and indeed could be worse off.  The Trump plan is also proposing that the child tax credit (currently a maximum of $1,000 per child, and phased out at higher incomes) should be raised (both in amount, and at the incomes at which it is phased out), but no specifics are given so one cannot say whether this would be significant.

g)  Deduction for state and local taxes paid:  While not stated explicitly, the plan does imply that the deduction for state and local taxes paid would be eliminated.  It also has been much discussed publicly, so leaving out explicit mention was not an oversight.  What the Trump plan does say is the “most itemized deductions” would be eliminated, other than the deductions for home mortgage interest and for charity.

Eliminating the deduction for state and local taxes appears to be purely political.  It would adversely affect mostly those who live in states that vote for Democrats.  And it is odd to consider this tax deduction as a loophole.  One has to pay your taxes (including state and local taxes), or you go to jail.  It is not something you do voluntarily, in part to benefit from a tax deduction.  In contrast, a deduction such as for home mortgage interest is voluntary, one benefits directly from buying and owning a nice house, and such a deduction benefits more those who are able to buy a big and expensive home and who qualify for taking out a large mortgage.

h)  Importantly, there was much that was not mentioned:  One must also keep in mind what was not mentioned and hence would not be changed under the Trump proposals.  For example, no mention was made of the highly favorable tax rates on long-term capital gains (for assets held one year or more) of just 20%.  Those with a high level of wealth, i.e. the wealthy, gain greatly from this.  Nor was there any mention of such widely discussed loopholes as the “carried interest” exception (where certain investment fund managers are able to count their gains from the investment deals they work on as if it were capital gains, rather than a return on their work, as it would be for the lawyers and accountants on such deals), or the ability to be paid in stock options at the favorable capital gains rates.

C.  Corporate Income Taxes

More than the tax cuts enacted under Presidents Reagan and Bush, the Trump tax plan focuses on cuts to corporate income (profit) taxes.  Proposals include:

a)  A cut in the corporate income tax rate from the current 35% to just 20%:  This is a massive cut.  But it should also be recognized that the actual corporate income tax paid is far lower than the headline rate.  As noted in an earlier post on this blog, the actual average rate paid has been coming down for decades, and is now around 20%.  There are many, perfectly legal, ways to circumvent this tax.  But setting the rate now at 20% will not mean that taxes equal to 20% of corporate profits will be collected.  Rather, unless the mechanisms used to reduce corporate tax liability from the headline rate of 35% are addressed, those mechanisms will be used to reduce the new collections from the new 20% headline rate to something far less again.

b)  Allow 100% of investment expenses to be deducted from profits in the first year, while limiting “partially” interest expense on borrowing:  This provision, commonly referred to as full “expensing” of investment expenditures, would reduce taxable profits by whatever is spent on investment.  Investments are expected to last for a number of years, and under normal accounting the expense counted is not the full investment expenditure but rather only the estimated depreciation of that investment in the current year.  However, in recent decades an acceleration in what is allowed for depreciation has been allowed in the tax code in order to provide an additional incentive to invest.  The new proposal would bring that acceleration all the way to 100%, which as far as it can go.

This would provide an incentive to invest more, which is not a bad thing, although it still would also have the effect of reducing what would be collected in corporate income taxes.  It would have to be paid for somehow.  The Trump proposal would partially offset the cost of full expensing of investments by limiting “partially” the interest costs on borrowing that can be deducted as a cost when calculating taxable profits.  The interest cost of borrowing (on loans, or bonds, or whatever) is currently counted in full as an expense, just like any other expense of running the business.  How partial that limitation on interest expenses would be is not said.

But even if interest expenses were excluded in full from allowable business expenses, it is unlikely that this would come close to offsetting the reduction in tax revenues from allowing investment expenditures to be fully expensed.  As a simple example, suppose a firm would make an investment of $100, in an asset that would last 10 years (and with depreciation of 10% of the original cost each year).  For this investment, the firm would borrow $100, on which it pays interest at 5%.  Under the current tax system, the firm in the first year would deduct from its profits the depreciation expense of $10 (10% of $100) plus the interest cost of $5, for a total of $15.  Under the Trump plan, the firm would be able to count as an expense in the first year the full $100, but not the $5 of interest.  That is far better for the firm.  Of course, the situation would then be different in the second and subsequent years, as depreciation would no longer be counted (the investment was fully expensed in the first year), but it is always better to bring expenses forward.  And there likely will be further investments in subsequent years as well, keeping what counts as taxable profits low.

c)  Tax amnesty for profits held abroad:  US corporations hold an estimated $2.6 trillion in assets overseas, in part because overseas earnings are not subject to the corporate income tax until they are repatriated to the US.  Such a provision might have made sense decades ago, when information systems were more primitive, but does not anymore.  This provision in the US tax code creates the incentive to avoid current taxes by keeping such earnings overseas.  These earnings could come from regular operations such as to sell and service equipment for foreign customers, or from overseas production operations.  Or such earnings could be generated through aggressive tax schemes, such as from transferring patent and trademark rights to overseas jurisdictions in low-tax or no-tax jurisdictions such as the Cayman Islands.  But whichever way such profits are generated, the US tax system creates the incentive to hold them abroad by not taxing them until they are repatriated to the US.

This is an issue, and could be addressed directly by changing the law to make overseas earnings subject to tax in the year the earnings are generated.  The tax on what has been accumulated in the past could perhaps be spread out equally over some time period, to reduce the shock, such as say over five years.  The Trump plan would in fact start to do this, but only partially as the tax on such accumulated earnings would be set at some special (and unannounced) low rates.  All it says is that while both rates would be low, there would be a lower rate applied if the foreign earnings are held in “illiquid” assets than in liquid ones.  Precisely how this distinction would be defined and enforced is not stated.

This would in essence be a partial amnesty for capital earnings held abroad.  Companies that have held their profits abroad (to avoid US taxes) would be rewarded with a huge windfall from that special low tax rate (or rates), totalling in the hundreds of billions of dollars, with the precise gain on that $2.6 trillion held overseas dependant on how low the Trump plan would set the tax rates on those earnings.

It is not surprising that US corporations have acted this way.  There was an earlier partial amnesty, and it was reasonable for them to assume there would be future ones (as the Trump tax plan is indeed now proposing).  In one of the worst pieces of tax policy implemented in the George W. Bush administration, an amnesty approved in 2004 allowed US corporations with accumulated earnings abroad to repatriate that capital at a special, low, tax rate of just 5.25%.  It was not surprising that the corporations would assume this would happen again, and hence they had every incentive to keep earnings abroad whenever possible, leading directly to the $2.6 trillion now held abroad.

Furthermore, the argument was made that the 2004 amnesty would lead the firms to undertake additional investment in the US, with additional employment, using the repatriated funds.  But analyses undertaken later found no evidence that that happened.  Indeed, subsequent employment fell at the firms that repatriated accumulated overseas earnings.  Rather, the funds repatriated largely went to share repurchases and increased dividends.  This should not, however, have been surprising.  Firms will invest if they have what they see to be a profitable opportunity.  If they need funds, they can borrow, and such multinational corporations generally have no problem in doing so.  Indeed, they can use their accumulated overseas earnings as collateral on such loans (as Apple has done) to get especially low rates on such loans.  Yet the Trump administration asserts, with no evidence and indeed in contradiction to the earlier experience, that their proposed amnesty on earnings held abroad will this time lead to more investment and jobs by these firms in the US.

d)  Cut to zero corporate taxes on future overseas earnings:  The amnesty discussed above would apply to the current stock of accumulated earnings held by US corporations abroad.  Going forward, the Trump administration proposes that earnings of overseas subsidiaries (with ownership of as little as 10% in those firms) would be fully exempt from US taxes.  While it is true that there then would be no incentive to accumulate earnings abroad, the same would be the case if those earnings would simply be made subject to the same current year corporate income taxes as the US parent is liable for, and not taxable only when those earnings are repatriated.

It is also not at all clear to me how exempting these overseas earnings from any US taxes would lead to more investment and more jobs in the US.  Indeed, the incentive would appear to me to be the opposite.  If a plant is sited in the US and used to sell product in the US market or to export it to Europe or Asia, say, earnings from those operations would be subject to the regular US corporate income taxes (at a 20% rate in the Trump proposals).  However, if the plant is sited in Mexico, with the production then sold in the US market or exported from there to Europe or Asia, earnings from those operations would not be subject to any US tax.  Mexico might charge some tax, but if the firm can negotiate a good deal (much as firms from overseas have negotiated such deals with various states in the US to site their plants in those states), the Trump proposal would create an incentive to move investment and jobs to foreign locations.

D.  Conclusion

The Trump administration’s tax plan is extremely skimpy on the specifics.  As one commentator (Allan Sloan) noted, it looks like it was “written in a bar one evening over a batch of beers for a Tax 101 class rather than by serious people who spent weeks working with tax issues”.

It is, of course, still just a proposal.  The congressional committees will be the ones who will draft the specific law, and who will then of necessity fill in the details.  The final product could look quite different from what has been presented here.  But the Trump administration proposal has been worked out during many months of discussions with the key Republican leaders in the House and the Senate who will be involved.  Indeed, the plan has been presented in the media not always as the Trump administration plan, but rather the plan of the “Big Six”, where the Big Six is made up of House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Committee Chairman Kevin Brady, Senate Finance Committee Chairman Orrin Hatch, plus National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin of the Trump administration.  If this group is indeed fully behind it, then one can expect the final version to be voted on will be very similar to what was outlined here.

But skimpy as it is, one can say with some certainty that the tax plan:

a)  Will be expensive, with a ten-year cost in the trillions of dollars;

b)  Is not in fact a tax reform, but rather a set of very large tax cuts;

and c)  Overwhelmingly benefits the rich.

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.