President Trump and his advisors are stressing that they want tax cuts for the middle class, not high earners. Trump said, “the rich will not be gaining at all with this plan,” while Treasury Secretary Steve Munchin said, “Our objective is not to create tax cuts for the wealthy. Our objective is about creating middle-income tax cuts.”
The problem is that high earners, not those in the middle, pay the vast bulk of federal income taxes. As the chart below shows, the share of federal income taxes paid by the highest-earning 10 percent has steadily risen—from 49 percent in 1980 to 71 percent by 2014. Meanwhile, the share paid by everyone else has plunged. (Source: TF based on IRS).
The Trump team is painting itself into a corner with its “tax cuts for the middle-class only” rhetoric. I fear that to satisfy that promise in coming weeks, the administration will seek to expand further the most unproductive parts of the tax plan, such as child credits. In turn, that will reduce budget room for tax reforms that would promote growth and simplify the code.
Cutting the most damaging parts of the tax code—such as our high corporate income tax rate—would benefit all Americans by spurring growth and raising wages. That is what Trump and Republicans should be focusing on.
In a note to my last post, I observed that Liberty Street Economics, the blog of Federal Reserve Bank of New York, promised a follow-up to its post addressing the advantages of the Fed's interest payments on required reserves. The follow up would address the benefits of paying interest on banks' excess reserves and of thereby establishing a "reserve-abundant regime."
That follow-up post has since appeared, under the title "Why Pay Interest on Excess Reserve Balances?" As I'd anticipated, it answers the question it poses by outlining some supposed benefits of having banks sit on immense piles of cash, without so much as hinting at the existence of any countervailing costs. As soon as those costs are considered, the supposed benefits turn out to be largely, if not entirely, fictitious.
Real and Pseudo Reserve Economies
According to the post's authors, Laura Lipscomb and Heather Wiggins (Board of Governors) and Antoine Martin (FRBNY), a major advantage of paying interest on excess reserves (IOER) is that, by ensuring that banks possess "a relatively abundant supply of [excess] reserves," it "makes the U.S. payment system more efficient." Besides no longer having to rely "on intraday and overnight credit from the Fed," the authors explain, banks made flush with reserves "are more willing to relinquish reserves early and are therefore engaging in less economizing and hoarding of reserves, making the payment system more efficient."
"Less economizing and [less] hoarding"? Usually, when we speak of someone "economizing" on X, we mean that he or she makes do with less of X. To do less economizing of X is therefore to require more of X. So how can banks do "less economizing and hoarding of reserves"? They can't. They can either economize less and hoard more, or they can economize more and hoard less.
Nor can there be any doubt which of these alternatives IOER encourages. Before that policy was introduced, U.S. banks seldom held more than $2 billion in excess reserves collectively. Today they hold more than $2 trillion. If that isn't less economizing and more hoarding, I can't imagine what would qualify. Certainly to claim, as Lipscomb, Martin, and Wiggins do, that it marks an improvement in the efficiency of the payments system, seems on the face of it quite a stretch.
But let's allow the authors to elaborate:
When reserves are scarce, banks are more reliant on the reserves they receive from other banks to make their own payments than when reserves are more abundant. So reserve scarcity exposes the payment system to a greater risk that a disruption at one bank could spill over and affect the system as a whole. Also, having a larger share of payments settled early reduces the potential consequences of a late day operational disruption.
the amount of intraday credit the Fed needs to extend to banks to cover daylight overdrafts … is much lower when the supply of reserves is high. … A large supply of reserves gives banks a sizable buffer to make payments throughout the day without needing to wait for the receipt of other payments or relying on daylight credit from the Fed or other counterparties.
In addition to needing less daylight credit, banks require less overnight credit in the form of discount window loans when reserves are abundant. The relatively abundant reserve environment means that fewer banks are caught short of balances at the end of the day, or at the end of a reserve maintenance period, which can lead to a scramble for funds, a spike in the federal funds rate, and banks occasionally accessing the discount window.
What's wrong with that? The terminology, for starters. In the absence of IOER, although excess reserves are certainly "scarce" in the sense of being valuable, and therefore unlike salt water to a sailor or sand to a Bedouin, they are not usually "scarce" in the sense of being in short supply. The difference matters because, despite the impression conveyed in the above passages, the "scarcity" of reserves, properly understood, is not a problem with which bankers must cope, like so many farmers coping with a drought. Rather, the degree to which reserves are "scarce" is one normally chosen by the banks themselves. In econ lingo, it is itself the solution to an optimization problem, involving the weighing of private benefits and costs, including the costs of having to rely on occasional intraday and overnight loans.
The economics of the problem in question are actually pretty simple — so simple that, over the course of three decades, I taught them to several thousand undergraduates. As it happens, I still have a copy of my class notes. Here is the relevant page:
For "prudential" read "excess," and never mind the typos. The point is that the mere fact that banks can avoid having to borrow if they hold more reserves hardly suffices to establish that getting them to do so makes either the banks themselves or the public better off.
An Inefficient Reserve Market?
Am I then claiming that, without IOER, the market for bank reserves would be perfectly efficient, with banks holding just the right amount of excess reserves? Not at all. Without IOER, the market for excess reserves might be inefficient for several reasons. It might be so because the Fed doesn't charge banks the right price for daylight overdrafts or overnight loans. And it might be so because the Fed doesn't reward them sufficiently for holding excess reserves.
Setting aside the problem of routinely mispriced Fed credit, which was once very serious but has since been somewhat rectified, many economists, myself included, have long understood that there's a case for reducing banks' opportunity cost of reserve holding by paying a positive return on reserves. But that hardly means that banks can't be overcompensated for their reserve holdings, or that they can't thereby be encouraged to hold inefficiently large quantities of excess reserves.
The well-known arguments for paying interest on bank reserves are in fact arguments for paying a rate of interest reflecting the true opportunity cost of reserve holding. That means a "Friedman rule" rate not lower but also no higher than market rates on other liquid and risk-free assets.
Furthermore, because the Friedman rule applies to a hypothetical economy free of nominal rigidities and other frictions, even that rate is likely to be too high in practice. In their recently published study devoted to determining an optimal IOER rate in light of real-world frictions, Matthew Conzoneri, Robert Cumby, and Behzad Diba arrive at an optimal steady state tax on excess reserves of 20 to 40 basis points, implying an optimal IOER rate equal to the Friedman rate minus that optimal tax. Allowing for what the authors' refer to as a "bank lending externality" pushes the optimal IOER rate down even more, and can even make it negative.
Yet almost since IOER was first introduced, in October 2008, the Fed's practice has been to set its IOER rate above, if not substantially above, corresponding market rates, and to thereby encourage banks, not merely to fine-tune their reserve holdings to equate marginal (social) benefits and costs, but to pile-up as many reserves as the Fed sends their way.
In short, slice and dice it however you like, there is no way to make sense of Liberty Street Economics' claim that the Fed's interest payments on excess reserves serve to achieve an optimal quantity of bank reserves, or to otherwise make our payments system more efficient.
There's No Such Thing as a Free (Liquid) Lunch
But hold on: can't the Fed produce reserves costlessly? And doesn't that mean that, even if there are more than enough of them, their presence can't possibly be wasteful?
No, and no. Even if it didn't cost a thing for the Fed to increase the nominal quantity of reserves, it costs plenty to get banks to increase their excess reserve holdings, which is what the Fed does by paying interest on excess reserves. Every dollar that banks keep in the form of excess reserves is a dollar they might instead have traded (along with some others) for a security, or lent. (And if you think that banks don't lend reserves, you need to read this Nick Rowe post.)
As the chart below shows, in the good-old, pre-IOER days, when U.S. commercial banks hardly held any excess reserves, their total loans and leases amounted to about 100 percent of their deposits. Today, in contrast, banks hold excess reserves equal to about 20 percent of their deposits, and loans and leases equal to about 80 percent of their deposits. That change is a truer index of the cost of IOER.
None of this would matter if the Fed acted as an efficient savings-investment intermediary, as commercial banks are able to do, at least in principle. But the Fed isn't a commercial bank, and it doesn't employ funds at its disposal the way commercial banks do. It makes loans to other banks, but not to businesses or consumers. And its investments are typically confined to Treasury and some agency securities.
High-Tech Financial Repression
When central banks of less-developed countries impose high reserve requirements on their nations' banks, for the sake of steering more of their citizens' savings onto their own balance sheets, and thence to their governments' coffers, economists call it "financial repression." And they condemn it.
How come? Because ever since Adam Smith wrote his eloquent chapter (No. 2 of Book 2) on the subject, they've understood the crucial role bank lending plays in boosting economic productivity and otherwise spurring growth. In recent decades that understanding has been reinforced by a vast crop of writings on the topic, both theoretical and empirical.
When, on the other hand, the Federal Reserve gets banks to accumulate trillions of dollars in excess reserves, and to thereby fund its acquisition of an equivalent amount of government and mortgage-backed securities (where by "vast" I again refer not just to nominal but to real quantities), Federal Reserve economists call it "making the payments system more efficient"!
Call it what they will, the Fed's policy is also financially repressive. By diverting savings to the government and its agencies and to whatever endeavors they favor, it denies that much funding to other prospective borrowers, many of whom — and small business owners especially — would employ the funds in question more productively.
According to a recent working paper by Brian Chen, Samuel Hanson, and Jeremy Stein, all of Harvard, overall bank lending to small businesses has yet to fully recover the ground it lost in 2008, and has hardly recovered at all at the top 4 banks. The evidence suggests, furthermore, that this sustained decline, which may have played a part in "the weak productivity growth in the decade since the crises," reflects "a systematic and sustained supply-side shift." Although Chen, Hanson, and Stein don't investigate the cause of the shift, and don't mention IOER as a possible culprit, it is certainly a likely suspect. Among other things it's well-known that the biggest banks have also been among the chief accumulators of excess reserves.
But surely, you may be thinking, there's a difference between forcing banks to hold more reserves, as some less-enlightened central banks have done, and rewarding them for doing so. There is, but it doesn't make the Fed's policy much less financially repressive. The difference is that, instead of imposing a "reserve tax" on banks and their depositors, the Fed's above-market IOER rate grants them a subsidy proportional to the difference between the actual IOER rate and its optimal counterpart. Although the subsidy serves to somewhat enhance rather than to reduce the attractiveness of bank deposits, that slight gain is more than offset by the diversion of deposited savings to less productive uses.
Who, then, foots the bill for the subsidy? Taxpayers do. That becomes evident once one considers that the Fed, being a relatively inefficient intermediary, can afford to pay above-market rates on banks' reserves only by either (1) sacrificing some of the revenue it would ordinarily remit to the Treasury or (2) taking extraordinary risks in order to earn more revenue than usual. As Deborah Lucas explained at a recent Shadow Open Market Committee meeting, the Fed has taken the latter course by using bank reserves, which are short-term assets, to fund longer-term Treasuries and MBS. "There is," she adds, "no free lunch from that transaction." Instead, the Fed's extra earnings reflect increased risk, which
ultimately falls on taxpayers, who serve as (conscripted) equity holders for any risky government investment. When the budget treats cash flows generated from a market risk premium as revenues but does not recognize an offsetting cost, it is arguably equivalent to levying a hidden tax that confiscates the risk premium to pay for additional spending.
In fairness to the authors of the Liberty Street Economics post, they never actually claim to be offering an objective assessment of the the Fed's practice of paying interest on banks' excess reserves. Instead, they state their intent is to review some "potential benefits" of that practice. So perhaps it is unfair of me to suggest that their review is misleading.
But I don't think so. First of all, when economists refer to a policy's "benefits," they often mean its net benefits. So when that's not what they mean, they should be clear about it, by at least noting that the policy also has costs that they have chosen not to consider. They should also make it clear that, because they are considering only the benefit side of a full cost-beneft reckoning, their assessment should not be understood as implying that the policy is a good idea. Instead of taking such precautions, Lipscomb, Martin, and Wiggens make it all too easy for readers of their article to assume that the "benefits" it describes do in fact suffice to justify the Fed's IOER policy.
Yet all is not lost, for our authors can easily make up for any misunderstanding their post may have caused. To do so, they need only publish a companion piece, which they could call "Why Not Pay Interest on Excess Reserve Balances?," addressing all the disadvantages of paying interest on banks' excess reserves, and especially of paying it at above-market rates. The piece should of course address the drag on productive investments that comes from stuffing banks with reserves they don't need. But it needn't stop there. It could also point out how above-market IOER undermines monetary control, and how (by severing balance-sheet management from monetary control) it makes it all too easy for the Fed to play the part of a fiscal fairy godmother. Needless to say, the essay should studiously avoid even a whisper concerning any potential benefits to be expected from the policy.
I should think that a month would be more than enough time for three experts to prepare the essay in question. So let's give them a deadline: November 1st. If they come through, we can all celebrate the general gain in understanding to which their two-part assessment is bound to contribute. And if not, we will still have learned something, to wit: that the Fed's own assessments of the merits of its policies are best taken with a grain of salt.
[Cross-posted from Alt-M.org]
As the rankings in the recently-released Economic Freedom of the World: 2017 Annual Report make clear, the United States and China find themselves in very different places on the matter of trade policy. Occupying the somewhat middling overall position of number 63 (of the 159 jurisdictions ranked) in the "Freedom to Trade Internationally" category, the U.S. is nonetheless significantly ahead of China at number 108.
Worth noting, however, are incipient signs that the two countries may be trending in different directions. Traditionally a relatively closed and protectionist economy, China through its words and even some of its actions has shown encouraging signs of moving towards greater openness (a topic I explore in a new policy analysis). In depressing contrast, trade policy under the Trump administration may be headed for a different track. A number of developments this year serve to illustrate this nascent divergence:
Rhetoric: Chinese President Xi Jinping offered a surprising but sorely-needed defense of free trade at the World Economic Forum in January. Likening the pursuit of protectionism to "locking oneself in a dark room" in his keynote address, Xi added that "While wind and rain may be kept outside, that dark room will also block light and air." Similar sentiment has also been voiced in subsequent speeches by other senior leaders including Premier Li Keqiang and Vice Premier Zhang Gaoli.
President Donald Trump, meanwhile, said in his February speech to Congress that "I believe strongly in free trade but it also has to be fair trade"—language suggesting a less than full-throated embrace of the concept (Notably, in Premier's Li's own speech he reversed this formulation, stating that "In fact, free trade...is the prerequisite for fair trade."). Privately, the President is reported to have told his chief of staff, "I want tariffs...bring me some tariffs."
New trade agreements: China continues to play a leading role in efforts to conclude the 16-member Regional Comprehensive Economic Partnership, a trade deal with a potential payoff estimated to be at least $260 billion over ten years. The country also has several other free trade agreements (FTAs) under negotiation, including a trilateral agreement with Japan and South Korea, and this year began exploring the possibility of a bilateral deal with Canada.
President Trump, in contrast, used his first week in office to withdraw from the 12-member Trans-Pacific Partnership, an agreement whose income gains were calculated at $131 billion through 2030 for the U.S. alone. While talk has been floated of a free trade agreement (FTA) with the United Kingdom, no formal efforts to begin negotiations have been undertaken with the U.K. or any other country.
Existing trade agreements: President Trump earlier this year expressed his desire to renegotiate the bilateral FTA with South Korea and more recently has threatened to withdraw from the agreement altogether. Negotiations have also begun on revising NAFTA—the subject of similar withdrawal threats by Trump—with early indications suggesting the Trump administration's desire to take the deal in a more protectionist direction.
China and New Zealand, meanwhile, announced in March their intention to further expand an existing FTA between the two countries.
The odds of China becoming a free trade paragon in the near future are admittedly remote. Even marginal progress in that direction, however, would be most welcome, delivering benefits to China such as greater economic efficiency and access by Chinese consumers to higher-quality imports. Gains would accrue outside of China as well, with its resulting growth contributing to higher living standards among its trading partners.
On the other side of the Pacific, the Trump administration's flirtations with protectionism are an ongoing concern. Although thus far mostly constrained to rhetorical flourishes, the White House's decision to withdraw from the TPP has inflicted a real opportunity cost on the US economy, and further protectionist backsliding must be avoided. As President Trump seeks to Make America Great Again, he should remember that openness to trade has been a key ingredient in making the country the superpower it is today.
Ike Brannon's recent post on the Jones Act is excellent, and those who have not done so already should give it a read. He notes some of the many economic hardships imposed by the law, which are shielded from proper scrutiny because its large costs are spread across the population and benefits concentrated among a relatively limited number of entities such as shipbuilders.
Brannon's concluding sentences, however, may be too kind to the political process:
[P]laces like Puerto Rico, Hawaii and Alaska would benefit most of all [from getting rid of the Jones Act], since they are overly dependent upon shipping prices.
However, as those are only two low population states and a territory with no voting representation, their inconveniences won’t resonate much with Congress.
Such language implies that the elected representatives of Alaska and Hawaii are fully cognizant of the burdens imposed by the Jones Act, but are prevented from making headway toward its removal due to insufficient political sway. The truth is far worse. As I noted yesterday at USAToday.com, all four members of Hawaii's congressional delegation—Sen. Brian Schatz, Sen. Mazie Hirono, Rep. Colleen Hanabusa, and Rep. Tulsi Gabbard—stand foursquare in support of the law. Among the three members of Alaska's delegation, both Sen. Lisa Murkowski and Rep. Don Young have touted their backing of the Jones Act (I have been unable to determine the position of Sen. Dan Sullivan, who has only held his current position since 2015).
Why is this? While the definitive motivations of these politicians are known only to themselves, a reasonable guess can nonetheless be hazarded.
We can first dispense with partisan explanations, as Hawaii's congressional delegation is comprised entirely of Democrats while Murkowski and Young are both Republicans. More relevant is the fact that according to the American Maritime Partnership, Alaska is ranked #3 among the 50 states for maritime jobs per capita. Hawaii, being the lone U.S. state comprised of an island chain which imports as much as 90% of its food, presumably has a significant maritime sector as well. Those engaged in such employment, and who profit most from the Jones Act's concentrated benefits, are much more invested in its future than the consumers forced to bear its significant but relatively small individual costs. Commensurate pressures from constituents then win out over economic sense when politicians set their positions.
Further food for thought is to be found in the fact that the Senate's most committed Jones Act critic, Sen. John McCain, hails from the landlocked state of Arizona. McCain's legislation to grant Puerto Rico a permanent exemption from the Jones Act enjoys co-sponsorships from Sen. Mike Lee of Utah and Sen. James Lankford of Oklahoma, also of landlocked states. As a result, these Senators are more likely attuned to the Jones Act's net economic drag than benefits to maritime special interests. This may all be coincidence, but it fits perfectly with the public choice model of special interests.
When it comes to protectionist U.S. policy, bitter experience has shown that the truth is often worse than we think.
As Republicans unveiled their tax reform plan last week, President Trump said, “We will cut taxes tremendously for the middle class.” Trump advisor Gary Cohn said, “We are giving tax cuts to middle- and lower-income Americans.” And House Speaker Paul Ryan said, “The entire purpose of this is to lower middle-class taxes.”
The problem is that “middle-class” Americans pay little in federal income taxes, while “lower-income” Americans pay virtually nothing. So Republican leaders are making promises that will be difficult to keep, and they are distracting themselves from the better message of growth and prosperity for all.
The chart below, based on CBO data for 2013, shows average federal income tax rates by income quintile. The highest-earning fifth of households paid 15.5 percent of their income to taxes, on average. The bottom two groups paid less than nothing, on average, because the refundable EITC and child credit wiped out their liabilities and gave them a subsidy. And the middle-income group that Trump, Cohn, and Ryan are talking about paid just 2.6 percent, on average.
The CBO uses a broad definition of “income” in these calculations, which inflates the denominators here and reduces the measured tax rates. Nonetheless, the data indicate who needs income-tax relief, and it is not the bottom three groups.
More important, dividing Americans into “classes” is the wrong way to go. Instead, Republicans should focus their tax reform talking points on economic expansion, business investment, entrepreneurship, job opportunities, wage growth, simplification, and international competitiveness. The Republican tax framework would advance all those goals, and thus benefit every American.
GOP leaders should leave the class struggle to the other party, and focus on how tax reform would support durable economic growth for the nation and broad-based prosperity.
Round 3 of the NAFTA renegotiation wrapped up last Wednesday. Round 4 is scheduled for October 11-15 in the Washington, DC area. How have things been going so far? Here's one assessment:
The United States, Canada and Mexico said at the end of a five-day session in Ottawa there had been progress made in the talks but acknowledged that much work remained to conclude the negotiations by the end of the year.
The next round might be a big one. Inside US Trade notes that "controversial ideas for investor-state dispute settlement and a sunset clause tied to the trade deficit" will be "finalized and proposed at the fourth round."
The original plan was to do the renegotiation over 7 rounds in total, concluding this year. However, the idea of the three NAFTA countries reaching an agreement by the end of the year was always a bit unrealistic and now seems even more so. If all goes perfectly, perhaps they could do it by the spring or summer of next year, but it won't be easy.
On October 26, we will have a full day conference here at Cato talking about a wide range of issues in the negotiations. You can register here. The full details are at the link, but here's a brief rundown.
We'll start with a panel made up of some of the original negotiators to explain why we had a NAFTA in the first place. What was the pre-NAFTA situation, and how did NAFTA improve things? We'll then have a discussion panel that delves into the various criticisms of NAFTA over the years. Next, we'll talk a bit of politics, focusing on the United States and Mexico, which are the places where the political process could present a hurdle to domestic ratification of a new NAFTA. We'll then have a session on how to "modernize" NAFTA, that is, how to incorporate provisions that have been developed in other trade agreements over the 20+ years since NAFTA was signed (such as on e-commerce and trade in services). Finally, we'll have two breakout sessions, one on dispute settlement (a particularly contentious issue in the NAFTA renegotiation) and one on various product-specific issues that are being fought outside of NAFTA but could have an impact on the negotiations (trade in lumber, dairy, and aircraft).
We hope you can join us!