Monday, July 2, 2012

The Investment Tax Increase in the Affordable Care Act

On Thursday,the Supreme Court upheld the Affordable Care Act. One component of the Act is a 3.8% increase in the investment tax, starting on January 1, 2013. For filers with joint income above $250,000, or single filers with income above $200,000, the tax rates on long-term capital gains and dividends will increase from 15% to 18.8%. At first glance, this sounds like a horrible idea in an economy trying to recover from a recession. (In fact, my first reaction upon hearing about it was to exclaim, "That's a horrible idea in an economy trying to recover from a recession!")

If I have learned one thing in economics so far, though, it's that first glances never suffice. So here are a few ideas I'm considering on my subsequent glances.

Everyone learns in their first economics class, if not sooner, that fiscal policy is distortionary. Government spending and taxes distort the efficiency-inducing incentives of the free markets. Most people also learn that not all free markets are efficient; in cases of market failure, the government can and should improve upon market outcomes. And at least some people learn that efficiency isn't the sole priority of a society. We also need some notion of equity, and here too, the government probably can and maybe should improve upon market outcomes.

All this tells us so far is that some amount of taxes are needed. Where should they come from? Macroeconomists have been studying this question for years. The basic framework for analysis, called a Ramsey model, supposes that a government can choose tax rates on capital and labor so as to maximize welfare of a representative private citizen, while financing a given level of government spending. The model's canonical result (the Chamley-Judd result) is that the optimal capital tax rate is zero. The full tax burden should fall on labor income. 

The reason an investment tax sounds like such a bad idea at first glance corresponds to the intuition behind this result. Taxes on labor and on capital are both distortionary, but taxes on capital are worse because of the intertemporal nature of investment. Investment decisions at any point in time affect the capital stock at all future points in time.

The Chamley-Judd result is based on a very simplified model of the economy, but is nonetheless a useful starting point from which to depart. One simplification in the model is the assumption of a representative agent, basically meaning that we can act as if there is a single "typical" household (or lots of households whose aggregate preferences "behave" like a single household). This is one of the most common, and often one of the most useful, assumptions in economics. However there are some situations where it is not a useful assumption-- situations in which distribution matters for aggregate outcomes. Some of the literature on the recent financial crisis and recession is recognizing the essential role of heterogeneity of indebtedness. In other words, we can't hope to understand the recession unless we have at least two representative households in the model, creditors and debtors. Aggregating over household types in this dimension gives qualitatively different results about the outcomes of economic policies. (I promise I'll get to the investment tax soon...)

A primary example is the work of Atif Mian and Amir Sufi, summarized here. They find that the recession is largely attributable to household debt constraints. 

The basic argument, laid out in a series of studies, is this: When highly indebted households experience a shock to their credit availability that necessitates deleveraging, their decline in consumption and efforts to pay back debt push interest rates down. In a well-functioning flexible-price economy, interest rates would decline to the point where households with healthy balance sheets would be induced to increase their consumption, thereby making up for the reduced purchases of the over-levered households.
But what happens if real interest rates need to fall dramatically -- even go negative -- to boost the economy? The existence of currency prevents the nominal interest rate from going below zero, which effectively limits real interest rates from getting low enough unless the economy experiences substantial inflation. So even though interest rates for financially healthy individuals are historically low, they need to get even lower to induce those consumers to buy a car or remodel their kitchen. In such an environment, the economy will be stuck in an equilibrium where household demand for goods and services is depressed by a real interest rate that isn't sufficiently low.
Many economists use this framework to justify fiscal stimulus, but they may be missing the point. In both the data and the theory, the critical problem is the high level of debt in the household sector. So why doesn’t macroeconomic policy directly combat this problem?...[The practical problem is that] a successful principal writedown program must be targeted at  households whose consumption behavior would be materially changed. Unfortunately, such a program is difficult to design. What is more likely to happen is that all underwater homeowners would line up for relief

Heterogeneity of agent balance sheets severely limits the efficacy of standard fiscal and monetary policy solutions. Mian argued before the Senate subcommittee on Financial Institutions and Consumer Protection that transfers from creditors to debtors (e.g. principal writedown programs), and the eventual replacement of non-contingent with contingent debt, is the only policy that can be truly effective in such a situation. If we can overcome the practical (and political) problem of transferring some money from creditor households to debtor households, we can escape this low equilibrium. (This, at first glance seems radical and crazy. Probably did to the Senators too. But it is not historically unprecedented, and after carefully reading and replicating Professor Mian's papers for a class, I became more and more convinced that it might not be crazy. It is radical, and it's about time, too.)

Finally, back to the investment tax. Who will pay that extra tax? High income households who are earning dividends and capital gains, i.e. creditors. Who are the major beneficiaries? Recipients of the expanded Medicaid system. People not previously covered, who will now be added to the rolls, are highly likely to be debt constrained. First, they have low income: less than $29,328 for a family of four. Second, their lack of coverage can be both a cause and a symptom of problematic balance sheets. A household that is struggling to make its mortgage payments may forego health insurance. Healthcare costs are a leading contributor to problematic household debt. So an increase in the investment tax that funds Medicaid expansion may be precisely what Mian and Sufi prescribe.

I am not saying that this guarantees that the tax will be a good thing. There are a lot of other factors to consider (possibilities of gaming the system, uncertainty for investors, etc.), and without empirical evidence it is impossible to weigh them. I am merely saying that my first reaction to the tax, one of unambiguous dismay, was unjustified.

I am unqualified to say much about the Affordable Care Act as a whole, other than this: Efficiency is more complicated than it seems, and that's why we need economists. Equity and social justice are more complicated still, and that's why we need diverse economists, informed citizens, religious activists, civil rights activists, philosophers, theologians, wise leaders, open minds, and prayers.