Goolsbee on Supply-Side and Subprime.

I just saw links to two older pieces by Austan Goolsbee that are relevant now. The first I found from James Pethokoukis’ 7 things you need to know about Austan Goolsbee as CEA chair, and that is his New York Times editorial: Is the New Supply Side Better Than the Old? He takes on Martin Feldstein directly in the editorial, and points out three arguments that the new Supply Siders use and why they are wrong (my bold):

All the major Republican candidates have called for extending the Bush tax cuts indefinitely, and several advocate several hundred billion dollars in additional high-income cuts — on the grounds that this would help the economy grow.

The Republicans have not been shy about claiming the old mantle of supply-side economics, proclaiming that tax cuts will pay for themselves by getting people to work harder or to start their own companies…

Professor Feldstein, head of the National Bureau of Economic Research, is perhaps the godfather of modern public-sector economics and is often cited as a potential Nobel laureate…As he put it in a 2006 interview published in a magazine of the Federal Reserve Bank of Minneapolis, when you raise top marginal rates, “it shows up as lower taxable income.” He added: “A reduction in taxable income, whether it occurs because I work less or because I take my compensation in this other form, creates the same kind of inefficiency.”

But for all the renewed interest in supply-side ideas, the politicians espousing these views have missed three important points that have come out of the continuing academic debate.

First, the impact of high-income tax cuts depends on how much additional income a person can keep. When President John F. Kennedy cut top marginal rates to 70 percent from 91 percent, take-home pay more than tripled for these taxpayers, to 30 percent from 9 percent. That is a big difference. By contrast, letting the Bush tax cuts expire so top rates rise to 39.6 percent in 2011 from 35 percent, cutting the take-home share to 60.4 percent from 65 percent, hardly seems the stuff of tax revolution.

Second, other research has shown that the new supply-side movement missed a fundamental shift over the last 30 years — the dramatic, disproportionate rise in the compensation of high-income people. The new supply-siders have confused this shift with the impact of tax cuts….

But the data also show that incomes at the top have been growing rapidly regardless of what happened to tax rates. In the four years after the increase in top marginal rates in 1993, average salaries grew 18.7 percent among the top 1 percent of earners and less than 0.1 percent for the bottom 90 percent.

Seeing the same pattern when taxes rose as when they fell indicates that tax cuts weren’t responsible. It suggests that cuts for high-income taxpayers likely gave windfalls to those whose incomes were already rising sharply because of broader market forces.

Third, recent research has documented that much of what the new supply-side economics attributed to tax cuts was really just the relabeling of income. Sometimes the increase in personal income was matched by an equal and opposite decrease in corporate income. At other times, increases in personal income turned out to be a result of corporate executives shifting the timing of their year-end compensation from a high-tax year to a low-tax year.

Shifts like these have nothing to do with supply-side economics. The academic debate continues, but thus far, the new Laffer curve has looked more like a fleeting figment of economic imagination.

If anyone can hold the line on not extending the Bush tax cuts for the richest 3% of Americans it’s someone whose academic work and popular writing has found that “the new Laffer curve has looked more like a fleeting figment of economic imagination.”

He also wrote an editorial, very typical of the time, that risky, explosive subprime loans were great for the economy because people were obviously income smoothing. How can you tell people were income smoothing? Because they were taking out risky, explosive subprime loans!

‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

This was very typical of elite economic thinking, and I hope Goolsbee, like many, feel a bit of egg on their face for this kind of exaggerated talk about how “perfect” the subprime market was chugging along. Here he is defending the Consumer Financial Protection Agency:

He’s using language that I think 2007 Goolsbee would be comfortable with if he was aware of the amount of fraud (on both ends) and off-selling of risk that was going on in the subprime securitization market.

As a side note, reading that editorial reminded me of my long-time interest in consumption smoothing as a theoretical tool: is it performative or normative? When Milton Freidman introduced the idea in 1957 he wrote: “The permanent income component is not to be regarded as expected lifetime earnings… It is to be interpreted as the mean income at any age regarded as permanent by the consumer unit in question, which in turn depends on its horizon and foresightedness.” It was a sneak attack on Keynesian thought, not a guide to assume that people are always thinking 10 years out on their mortgages versus their earnings. But should people be income smoothing as a normative issue? If they take on excessive debt should we de facto assume it is because of income smoothing?

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2 Responses to Goolsbee on Supply-Side and Subprime.

  1. Milton Recht says:

    The rise in executive and high-income compensation mentioned in 2 and 3 is in large part due to the sharp rise in the stock market as pay shifted from salary to stock incentives and stock options, starting around 1980 as more income was generated from stock investments than salaries. An effect of a tax law change itself.

    To make statements about effects of marginal tax cuts on high-income earners, studies have to separate the effects of taxes on stock compensation (options, etc.) and wages.

    They studies do not. For example, the timing switch mentioned in three is in part a decision about when to recognize the wealth gain in stock option compensation. The proper question is not when an executive converts the investment and pays taxes on it. Of course, a rational executive will pick a lower tax year. The studies fail to recognize that the wealth, the appreciation in the stock price, has already occurred and exists independent of its conversion into a taxable event.

    The more relevant questions is to what extent did tax policy aid or hinder that stock’s appreciation and do corporations adjust their incentive compensation policies to offset expected tax effects. If corporations adjust future realized compensation for expected tax changes, then of course, corporate income also changes in an opposite direction to gross income to keep after tax income level.

    Over the period from Kennedy to Bush, the tax laws increased relating to exceeding a maximum executive compensation level. The consequence was that the amount of executive compensation paid as stock options, etc. increased tremendously.

    To make a positive, negative or neutral statement about marginal tax rates on high-income taxpayers, the studies have to distinguish tax effects on wages versus wealth creation (which can occur without recognized taxable income) versus stock market effects.

    High wealth and high-income effects are not synonymous and different taxes have different effects on these two components.

    There is still a lot of research needed to answer the questions about the effect of marginal tax rates. Yes, a lower marginal tax rate speeds up income recognition. The more relevant, important and difficult question is did the decrease in marginal tax rates contribute to the increased wealth that was recognized in the earlier period?

    A paper than definitively answered positively or negatively the supply side effect of marginal tax cuts would have to look both at income and wealth increases (decreases) due to marginal tax cuts.

    Looking at either wealth or income creation separately cannot answer the question about marginal tax effects. Both components need to be considered at the same time.

  2. jest says:

    Re: consumption smoothing

    For a population that can’t even properly identify the religion of their own president, or are capable of this we shouldn’t be using terms like “consumption smoothing,” or for that matter “performative” or “normative.”

    This is like using 6 dimensional chess to describe the actions of a chimp.

    The motivations behind consumption are more akin to motivations of nailing the hot blonde walking down the street: we want stuff & we want it now.

    Sorry to be so terse (it’s early & I haven’t had any coffee), but the reason we’re in this mess is because economists come up with the craziest, cock-eyed, silly, Rube Goldberg explanations for extremely simple things. This is how we get otherwise reasonable people writing papers entitled “‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded” as if it were a good thing.

    It’s hard to think of another class of smart dumb people who are more dangerous than economists.

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