Topic: Tax and Budget Policy

Striking Mortal Blow Against European Anti-Tax Competition Scheme, Luxembourg Rejects Calls to Eliminate Financial Privacy

Europe’s high-tax nations have launched another attack against low-tax jurisdictions. Using the recent German-Liechtenstein imbroglio as an excuse, they are arguing that all so-called tax havens should emasculate privacy laws so that tax collectors from countries such as France and Germany can track - and tax - flight capital. Politicians from uncompetitive welfare states are still bitter that a previous “savings tax directive” resulted in a watered-down scheme that failed to deliver big piles of additional tax revenue. But all their chest-beating may prove equally futile in 2008. Austria already has signalled that it has no interest in weakening its human-rights protections, and now Luxembourg has firmly stated that it rejects any proposals that would weaken its bank secrecy laws. This is a fatal blow since, as the UK-based Guardian explains, an expanded savings tax directive would require support from all 27 EU nations:

Luxembourg will not dilute its bank secrecy rules and is against hasty changes to European Union law that taxes foreign savings, the Grand Duchy’s Treasury Minister Luc Frieden said. …The 2005 rules only tax cash deposits while trusts, stocks and bonds are outside their scope, but Luxembourg won’t be rushed. “I’m amazed that some people want to change this directive even before having had any evaluation about how the current system works,” Frieden told the Reuters Funds Summit. The current directive took years to agree as unanimity among all the bloc’s members is needed in tax matters. …”I think we should not change things again that work well,” Frieden said. The Grand Duchy’s Central Bank Governor, Yves Mersch, said the privacy laws were widely supported in Luxembourg and the EU should focus instead on tackling cross-border abuses. …”Bank secrecy is for me part of our social consensus because confidentiality in a small country is extremely important for the maintenance of democratic rule. …”The Luxembourg government sees no need and will not come up with new proposals in this context and will not change the bank confidentiality rules as they have proven to be in the interest of a good working system in Europe,” Frieden. …Frieden was critical of how the Alpine state [Liechtenstein] has been treated. “I expect all countries to be treated with respect, independent of their size. I feel that is the case with Luxembourg and would like it to be the case vis-a-vis other countries even if they are smaller than Luxembourg,” he said.

Large Health Savings Accounts, Unveiled

This week, the journal Forum for Health Economics & Policy publishes a paper of mine on “large” health savings accounts, a novel proposal to reduce government control over the U.S. health care sector. 

Government exempts employer-sponsored insurance (ESI) from income and payroll taxes, which seems like a tax cut.  But it operates more like a tax increase because it strips workers of control over their earnings.  Oh, and it drives up health insurance premiums too.

Large HSAs would replace the tax exclusion for ESI with an exclusion for money contributed to a Large HSA, which the worker would own.  The same tax exclusion would be available to all workers, regardless of where or whether they purchase health insurance.

Altering the tax exclusion that way would force employers to shift the money they now use to purchase health benefits – on average almost $4,000 for individuals and $9,000 for families – into workers’ cash wages.  Individuals could then contribute, say, up to $8,000 annually to a Large HSA.  Families could contribute up to $16,000. 

Workers could use those funds to purchase medical care and health insurance, from any source, tax-free.  For example, they could hand the money right back to their employer and stay on the company plan.  Anything the worker doesn’t spend grows tax-free.

Large HSAs have a number of advantages over other tax-based health care reform proposals, including Sen. John McCain’s proposal to provide tax credits for health insurance.  Large HSAs would eliminate the tax code’s influence over consumers’ health care decisions to a greater extent, and with fewer economic and political downsides, than Sen. McCain’s tax-credit. 

One downside of McCain’s tax credit proposal, as well as other reform proposals, is that they discriminate against the uninsurable.  A tax break for health insurance is only valuable if you can obtain health insurance.  Tying a tax break to insurance automatically excludes a lot of very sick people.  In contrast, Large HSAs offer the same tax break to the uninsurable, who arguably need it most.

To read more about Large HSAs, click here (free download).

The Wall Street Journal, the Dollar and the Fed

Today’s Wall Street Journal editorial, “The Buck Stops Where?” is the latest in a long series of editorials and articles suggesting the Federal Reserve has been “reckless” to cut interest rates on bank reserves. This story relies heavily on some questionable arguments about the dollar’s exchange rate.

Here are some quotes from the editorial followed by my comments:

  1. “The flight from the dollar has made U.S.-based investments less attractive at a time when the U.S. financial system urgently needs to raise capital.”

    That is almost backwards. It now costs fewer Euros or yen to buy U.S. shares or build U.S. plants than it did a few months ago, which makes U.S. investments more attractive to foreigners, not less attractive. It is true, however, that if the dollar were expected to fall sharply in the future, then risk of exchange rate losses might discourage foreigners from buying dollar-denominated assets and also encourage U.S. investors to buy foreign securities.

  2. “If the dollar had merely retained its value against the euro, oil would be in the neighborhood of $70 a barrel. Dollar weakness explains a large part of the oil price surge.”

    The reason a lower dollar makes oil prices rise is that it makes oil cheaper than it would otherwise be in euro, so Europeans buy more oil than they otherwise would – bidding-up the price (at least in dollars). We can’t be sure what would have happened to oil prices if the Fed had kept interest rates on bank reserves high enough to maintain the dollar’s value against the euro, because higher U.S. interest rates would have had some adverse effects on the world economy (and therefore on industrial demand for energy). If the euro had been stabilized by cutting ECB interest rates, by contrast, the effect on oil prices would have been much different. The oil price is a ratio of barrels to dollars, which means it is partly real and partly monetary.

  3. “Exports in goods are being more than offset by the rising cost of oil imports.”

    Actually, the U.S. current account deficit in fourth quarter was down 12.7% from a year before. Incidentally, purchases of U.S. government securities by foreign central banks were reduced by $148.8 billion last year, while private foreign investments in Treasuries rose by $202.1 billion.

  4. “Import prices have surged nearly 14% in the last year.”

    Import prices were up by 13.6% in the 12 months ending in February only because the price of petroleum imports was up by 60.9%. The price of all other imports was up 4.5%. While it makes some sense to blame rising import prices on dollar weakness, it does not make sense to suggest that petroleum prices are uniquely affected by the dollar, unlike most other imports.

    There is also some reverse causality–with rising oil prices contributing to a lower dollar and not just the other way around. Rising commodity prices lift the exchange rates of commodity-exporting countries like Canada and Australia, which shows up as a drop in the trade-weighted U.S. dollar.

David Malpass of Bear Stearns is an excellent economist who has supported a strong dollar in several Journal op eds. But Malpass does not argue, as the editorial page does, that a weaker exchange rate is necessarily inflationary. Indeed, one of the graphs in David’s December 6 forecast was aptly titled, “Trade-weighted dollar not well-connected to CPI inflation.” Even using 3-year trends, there’s virtually no connection.

On March 14, the Journal’s “Ahead of the Tape” column argued that the Fed is wrong to focus on core inflation, because “inflation is on the rise and energy and food have a lot to do with it.”

Should the Fed raise interest rates when world oil prices go up and lower interest rates when oil prices fall?

That is, after all, what it means to say the Fed should base policy on “headline” inflation, including energy prices (and the impact of ethanol subsidies on food prices).

While he was an academic researcher, Ben Bernanke showed that central bank reactions to oil prices have caused or aggravated virtually every postwar recession.

Recessions eventually cause oil prices to fall and central banks to ease aggressively – years after the recession is over (as in 2003-2004), as I noted in “Interest Rates and Dollar Fundamentals” (WSJ Nov. 15, 2007)

What is different this time is mainly a matter of timing – the Fed easing before recession rather than long after. What also appears different, so far, is that the Fed is acting alone, which largely explains the euro’s recent strength. Yet the ECB has always followed the Fed, after many months, and probably will again.

The Fed may be at risk of overdoing it, but making that case requires looking at some historical variables (or a model, like John Taylor’s) that have a decent track record for predicting inflation.

The trade-weighted dollar has been falling since February 2002, and the price of gold has risen nearly as long. If exchange rates or gold prices could generate reliable forecasts of inflation, then we should have seen escalating inflation for the past six years.

It’s My Way or No Highway

Congressional earmarks have received a lot of media attention lately, despite the fact that they make up only a small percentage of the overall budget.

Even advocates of limited government sometimes bemoan the disproportionate focus on earmarks and the relative lack of attention paid to larger spending items, like entitlement programs.

But the full story on earmarks isn’t simply their direct impact on the budget. Earmarks are also used by Congressional leadership to raise the public profile of incumbents in tough reelection fights, entice members to vote for controversial bills, and enforce party discipline.

The latter was on display yesterday when, as The Hill notes, the chairman of the House Appropriations Committee, Rep. David Obey (D-WI), “canceled meetings with a New Orleans delegation because a Louisiana lawmaker had defied party leadership on a procedural vote the night before.”

In canceling the meeting, Obey was “punishing” Rep. Charlie Melancon (D-La.) by refusing to allow his constituents to make a pitch for their earmark wish list to the House’s chief appropriator. More broadly, Obey sent a clear message to other lawmakers: recalcitrance will jeopardize your earmarks.

Using taxpayer funds to enforce party discipline is a blatant misuse of taxpayer dollars. Further, this practice undercuts a chief argument of earmark defenders who claim that the process is an essential means to fast-track funds to critical local projects, like roads and infrastructure. Unless, of course, truly critical projects exist only in the districts of loyal partisans.

In other earmark news, yesterday the Senate overwhelmingly rejected a one-year moratorium on earmarks. Hardly a surprise.

Airbus, Alabama, Boeing, and McCain

Press reports on the tanker saga have left two points unappreciated. The first is the hidden cost of creating a new aircraft assembly facility in Alabama. The second is how John McCain’s demands for competition in this deal helped Airbus and Northrop – not because McCain is crooked but because competition in defense contracting is phony.

To review: The Air Force needs refueling tankers because we fight far-off wars and don’t want to ask permission for overseas basing rights. B-52 bombers couldn’t fly from Missouri to Afghanistan to bomb the Taliban without tankers. Fighters and cargo aircraft need them too. The Air Force’s tanker fleet of 520 KC-135s and 59 larger KC-10s is old. In 2004, the Air Force tried to begin replacing them by leasing tankers from Boeing, as private airlines do. The deal unraveled when it emerged that leasing the tankers would add $6 billion to the taxpayers’ bill, that the deal was partially intended to prop up Boeing, and that Boeing had bought influence with Pentagon officials. McCain led the opposition. Two Boeing executives and one Air Force official went to prison. The Secretary of the Air Force and the head of Boeing lost their jobs.

Still looking for new tankers, the Air Force solicited another set of proposals for the new tanker, now dubbed the KC-45A. A few weeks ago, Airbus, a subsidiary of EADS, the European Aeronautic Defence and Space Company, won, along with its partner, American defense contractor Northrop-Grumman. The deal would eliminate jobs in Kansas and Washington where Boeing has production facilities. Congressmen and Senators from those states erupted into patriotic indignation and vowed hearings. Politicians from Alabama, where Airbus will place a new production facility, vowed to fight for the deal. Boeing protested, which forces a GAO review – delaying the start of production by at least 100 days. Now allegations have emerged that McCain aided the victors while taking their money and their lobbyists for his Presidential campaign. Got it?

The Air Force says EADS’s tanker is better than Boeing’s. I believe them. It would be reckless to choose an inferior product given the likely protest from the loser and what happened in 2004. But while getting the best plane for the least money is essential, when it awards contracts, the Pentagon should be able to consider their effect on the political landscape, because that landscape drives future contracts. You can’t get the politics out of defense contracting, so you need to get the politics right.

The political problem with the Airbus deal is that it opens a production facility in Alabama to make conventional aircraft assembled elsewhere into tankers, but will not close Boeing’s similar plant in Wichita, Kansas. This means taxpayers have a new mouth to feed. Because they create concentrated interests, US military production facilities are nearly impossible to close. In the private sector, sellers make money by cutting costs and delivering products more efficiently. In defense contracting, companies succeed by keeping production lines open and relying on local Congressman, workers and lobbyists to get them work. That’s why the US has twice the number of shipyards it needs despite consolidation in the shipbuilding industry. It would have been better to keep all the production in Europe, preventing new domestic lobbies from forming, or more realistically, accomplish the same thing by making Airbus lease Boeing’s plant.

Senator McCain has mud on his face because after he blocked the Boeing lease deal and pushed to reopen the bidding, he got around $14,000 in contributions from EADS employees, more than any other politician. Then he hired some of their lobbyists for his presidential campaign. Did that affect his behavior on the current round of proposals? McCain says no. “All I asked for in this situation was a fair competition,” he says.

But keep in mind what fair competition here means. As my friend Owen Cote, a researcher at MIT, points out, with only two viable competitors, this is a not a real market. Ensuring competition among two sellers means giving both leverage over the buyer, because if one exits the process, competition is lost. What the press has not pointed out is that McCain’s insistence on competition gave Airbus the power to force changes in the Air Force’s criteria.

There were two disputes about the Pentagon’s request for proposals that McCain got involved in to the benefit of Northrop-Airbus. First, in September and December 2006, just before the Pentagon was to release its RFP, McCain wrote to top Pentagon officials, asking them to eliminate language in the RFP forcing consideration of how penalties due to a WTO dispute over subsidies might affect the tanker’s production cost. That provision, championed by Boeing booster Norman Dicks (D-WA), would have hurt Northrop-Airbus more than Boeing. McCain got his wish.

Second, in the December letter, McCain asked the Pentagon to give the proposals credit for having more cargo space, instead of equal points for having in excess of a certain amount of space. Meanwhile, the Northrop-Airbus team, which was proposing a bigger aircraft, threatened to withdraw their bid if the Air Force did not change its criteria on this issue. This double whammy put the Air Force up a creek. If Northrop and Airbus weren’t bluffing, leaving the criteria be would hand the deal to Boeing, and enrage McCain, who could then accuse the Air Force in public hearings of giving Boeing another sweetheart deal. The Air Force complied, giving another advantage to Northrop-Airbus.

It therefore appears that John McCain was necessary to EADS getting this deal, even as he was taking in their campaign contributions and lobbyists. That doesn’t mean there’s anything nefarious here. McCain had good reason to help block the deal in the first round. The changes he asked for in the second round were arguably wise. The subsidy issue could actually be seen as an ace in the hole for Boeing that should not have been there in the first place. Plus $14,000 is cheap if he were going to sell out.

But it sure doesn’t look good. Who was it that said that “questions of honor are raised as much by appearances as by reality in politics”?

Obama Finds Juche ‘Intriguing’

Another (fictitious) dispatch from my anonymous correspondent on the campaign trail:

LANCASTER, Pa. — Sen. Barack Obama told a crowd of enthusiastic supporters here that the North Korean concept of “Juche,” its stated policy of complete economic and social independence and isolation, is “intriguing” and worthy of further study as a possible antidote to the economic malaise of the state in recent years.

The comment on Juche (pronounced “joo-CHEH”) came as a response to a question from a voter who expressed doubt that a repeal of NAFTA would help the region’s economy. Obama’s remark took the campaign’s message of economic nationalism and support for the weakened manufacturing sectors of the upper Midwest well beyond the rhetoric espoused by his Democratic primary opponent, Sen. Hillary Clinton.

“Trade is not helping the Pennsylvania economy get back its jobs,” Obama told the questioner. “And it may be time to quit tinkering with a system that stopped working a long time ago and get back to the basics.”

“Now we’re talking!” enthused Dean Baker, co-director of the Center for Economic and Policy Research, a D.C. think tank. “Someone finally had the guts to go all the way. Hallelujah!”

A spokesperson for the Obama campaign stressed that the senator was not articulating an official policy position but merely discussing aloud an idea that the campaign’s economic advisers have been contemplating for some time.

Obama said that his one reservation with such an economic system is that North Korea’s economy has struggled a bit in recent years. He attributed those struggles more to execution than policy, along with a rash of bad weather. Autarkic economic self-reliance, he averred, would provide a needed tonic to the U.S. economy and work especially well in the recession-plagued Midwest.

CNN broadcaster Lou Dobbs, a noted critic of U.S. trade policy in recent years, extended cautious praise for Obama’s words. “American economic woes are far more severe than North Korea’s, and we need a stronger dose of Juche than what Pyongyang employs. Pennsylvania would benefit little from a system that merely closes off imports from other countries. To truly help, we need to allow the state to ban imports from other states as well. Obama’s comments were a little timorous for me and revealed how out of touch he and the rest of the D.C. elites really are.”

Obama’s audience seemed quite receptive to the idea. “I’ve never heard of Juche before, but when he explained it a bit I thought it made perfect sense,” said Thaddeus Verhoff, an unemployed sheet welder from nearby Mt. Joy.

Other analysts hailed the proposal as a deft political move. “Rather than continuing to take baby steps around each other, Obama has jumped ahead to the inevitable end point of the debate without giving Senator Clinton any room to get to his left,” said John Cavanaugh, a columnist at Roll Call. “All she can do now is criticize him for being too protectionist, which doesn’t fly in Democratic circles.”

The Clinton team has yet to formally respond to Obama’s comments. A campaign spokesperson did indicate to reporters that Clinton would “stoop to no one” in her defense of state economic sovereignty.

Obama’s Reckless Tax Increase to ‘Save’ Social Security

A column in the Wall Street Journal discusses Senator Obama’s plan to boost the top tax rate on entrepreneurs and investors from less than 38 percent to more than 50 percent. This huge tax increase will significantly undermine incentives to both earn and report income. As a result, the author, formerly with the Social Security Administration, explains that behavioral responses will result in far less money than projected by “static” revenue estimates:

Mr. Obama has recently veered sharply left. He now proposes to solve the looming Social Security shortfall exclusively with higher taxes. …Currently, all wages below about $100,000 are subject to a 12.4% Social Security payroll tax. But all wages above that amount are not subject to the tax. Mr. Obama wants to eliminate the cap, but, in a concession to taxpayers, exempt wages between $100,000 and $200,000. …Mr. Obama’s plan would keep Social Security in the black for only three additional years. Under his proposal, annual deficits would hit in 2020, instead of 2017. By the 2030s the system would still run an annual deficit exceeding $150 billion. Mr. Obama’s modest improvements to Social Security’s financing come at a steep cost. …The top marginal federal tax rates would effectively increase to 50.3% from 37.9%, equivalent to repealing the Bush income tax cuts almost three times over. If one accounts for behavioral responses, even the modest budgetary improvements from Mr. Obama’s plan are likely to be overstated. If employers reduce wages to cover their increased payroll-tax liabilities, these wages would no longer be subject to state or federal income taxes, or Medicare taxes. A 2006 study by Harvard economist and Obama adviser Jeffrey Liebman concluded that roughly 20% of revenue increases from raising the tax cap would be offset by declining non-Social Security taxes. Assuming modest negative behavioral responses, Mr. Liebman projected an additional 30% reduction in net revenues, leaving barely half the intended revenue intact. Mr. Obama’s plan would also dramatically raise incentives for tax evasion, further degrading revenue gains. Many high-earning individuals evade the Medicare payroll tax by setting up “S Corporations,” paying themselves in untaxed dividends rather than taxable wages. John Edwards avoided $590,000 in Medicare taxes this way in the 1990s. …The U.S. already collects far more Social Security taxes from high earners than other countries do. Social Security taxes here are currently capped at about three times the national average wage – far above other developed countries. In Canada and France payroll taxes are levied only up to the average wage. In the United Kingdom, taxes stop at 1.15 times the average wage; in Germany and Japan at 1.5 times.

Obama also wants to let the Bush tax cuts expire, which means the top tax rate would rise even farther - to more than 55 percent. But the bad news may get even worse. It is unclear how Obama will “fix” the alternative minimum tax. If his Social Security plan is any indication, he may propose to raise the top rate even further. What would all this mean? Simply stated, European-style tax rates will mean European-style stagnation.