Sunday, December 4, 2016

If I Had Trump's Ear...

If I were Trump's economic advisor, my advice to him would be that his legacy hinges on fulfilling the most basic spirit of his campaign promises, which is to improve the quality of the average, middle-class, 'normal' American's way of life.  And within this context (and the context of the recent election), that would seem to hinge on two, overwhelming concerns --

1) curtailing immigration
2) improving wages, especially of blue-collar type workers

And obviously these are related.  Trying not to delve into too much of the contentious political aspects of pursuing these things (especially number 2), let me just suggest a couple of things that have occurred to me.  

I see a lot of discussion in various whereabouts which seems to suggest that people have either forgotten or just to have relatively bad models in their head of the basics of how wages are determined, at least in my opinion.  Very basic economic theory says that wages (or really, the 'return' to anything, wages being the return to labor) are determined by what is called Marginal Value Product (MVP).  Not 'number of immigrants', not 'women entering the workforce', not 'supply of labor,' etc, though of course those are all relevant.  What it seems has happened is people have made rather radical theoretical simplifications -- even some very smart people -- and ignored that the process of production is intrinsically an interplay.

To make a slightly smaller simplification that gives a much more accurate picture (in my opinion, at least) wages are (mostly) determined by the ratio of capital to labor.  The higher the ratio of capital to labor, the higher wages will be, because labor has become relatively more dear (i.e., in lower supply compared to the amount of capital available for production.)  When capital is in short supply, labor must compete hard and prices of labor fall.  Conversely, when capital is abundant, capitalists must compete hard and wages increase.

Reducing the ratio of capital to labor, for example, through high immigration, hurts wages.  But not merely by 'increasing the supply of labor.'  If the supply of capital increases proportionately, there might be no change.  Real wages might even increase, due to efficiencies discovered in a larger system. But typically, immigrants don't bring much capital with them, and often strain the system when they arrive in sufficient numbers (have you seen Houston traffic lately?) precisely because there isn't enough capital to accommodate them.

With that in mind, it appears that the two things Trump should focus on are keeping his promises to overhaul -- and ultimately curtail -- immigration, and simultaneously attract more capital to the US. Not 'raise the minimum wage.'  Not engage in crony capitalism and special tax-break type arrangements to attract or retain businesses.  Even a cut in personal income taxes, while obviously something desirable and frequently the object of much political attention, is probably not the best focus of his efforts.  I don't think much of any tax cut he could arrange would help most people anywhere near as much as a raise would.  At least to me, the most crystal clear and obvious way -- perhaps very nearly the only real way -- to address low wages is more capital.

But how do you do it?

My second thought -- as weird as this sounds, probably the best way to do this would be to impose a small-ish, uniform, across-the-board import tariff, and simultaneously cut corporate tax rates back a bit.  This kind of suggestion has of course attracted both enthusiasm and criticism -- most of the criticism on free-trade, free-market grounds -- but I think a little bit of thought could put it into a context that might make it easier to digest.

First, it is obvious that a lower corporate tax rate would attract capital, for obvious reasons.  This is not an uncommon opinion.  But it is not obvious that a tariff would -- how exactly would imposing a tax attract capital?  Free-traders would protest 'protectionism!'  And beyond a certain point, I have no doubt they are correct.  Yet I have started to think these two are actually very closely related, and one actually implies the other -- so that to have the one and not the other could actually be something like the inverse of protectionism.  'Domestic vampirism,' or something.  To discontinue doing it might be helpful.

I will argue by analogy from a perspective I am more familiar with, and maybe other people are, too -- the housing market.  

According to at least some economic theory, different sorts of taxes are in fact interchangeable, and this is obviously the case (at least to me) in the housing market between property taxes and income taxes.  I will try to make a brief, hopefully-intuitive explanation for those who don't already know this.  Most people accept that the value of an asset is a function of the income derived from the asset, which can be expressed as an NPV (net present value).  This relationship of asset prices to income is what makes metrics like PE ratios and bond rates 'work' and why making comparisons between them is meaningful (take the reciprocal of a bond rate and multiply by 100, and you have something comparable to a PE on a stock.  I usually think of this as an 'asset multiplier' -- the multiple of income that the asset price commands, which is also used in business valuations, appraisals, etc., by the people who do these sorts of things.  The inverse is the discount rate, but I'm not going to go into that...)

If this relationship holds, then it is intuitive that a government taxing a portion of income is equivalent to taxing a portion of its present value, because the present value just is a function of income and is interchangeable with it using relatively simple conversion factors. Theoretically, anyway. So, on a house -- suppose that a house 'yields' an income of $6000 per year (after all expenses, etc., except property tax).  Further suppose that the government claims $2000 of this income in tax.  If the discount rate in this market is 6% (i.e., the 'multiplier' is 16.67), the implied value of the house is $100,000 -- but this value is discounted by 1/3 on the market, because the government claims 1/3 of the income it generates ($2000/$6000 = 1/3) -- asset buyers will not pay for income that they do not expect to receive. So, the house will have a market price of about $67,000 with a property tax of about 3% (3% of $67,000 = $2000, approximately).  

Therefore -- a 3% property tax and a 33% income tax on the property are (approximately) equivalent.  (Yes, I'm rounding a bit.)  It doesn't matter which way you charge it, the two taxes amount to the same thing.  Guessing home valuations is a bit easier, I suppose, so that is the way it tends to be done.  But to do it the other way would be equivalent.

I would like to argue that, I think, tariffs and business income taxes may likewise actually be interchangeable -- and by setting a lot of tariffs at zero and corporate taxes at 40%, our policies may have induced a really harmful disequilibrium.  It might help a great deal to (try to) put them back into equilibrium.

Unfortunately, I do not know how to calculate the right values for this example, but the argument is basically as follows -- given that taxes are to be imposed, a domestic business pays income taxes in order to access American markets.  Presumably, the taxes go to 'uphold the common good' -- to pay for roads, basic law and order, etc.  (Or some such; I don't want to get into a debate about that -- call it pay-to-play, if you prefer.)  Under a regime of no tariffs foreign companies get access to the American 'common good' for free -- so they are being subsidized by domestic companies and taxpayers.  The foreign companies have no equivalent tax imposed for access to the American market, which constitutes a strong incentive to locate overseas.  I don't really know what to call this, but it reminds me of the 'moral hazard' people used to talk about during the financial crisis -- privatization of profit, socialization of costs.

I will grant a few things -- first, that they do not have as much 'access' to the American 'common good' as domestic companies, since much of their operations are overseas.  But it is absolutely inarguable that they derive value from it (else they wouldn't do business with us), and aren't required to support it as domestic companies do. A second thing I will grant -- just as a 3% property tax was equivalent to a 33% income tax, yet 3% and 33% are very different numbers, there is no doubt that a tariff equivalent to a 40% income tax would also be a very much smaller number.  Income deducts expenses, but revenue does not.

But I'm not sure how to calculate it -- it seems like a sales or revenue tax, and so you would need to know how much profit was derived per unit to calculate what was equivalent to a 40% income tax.  But obviously, most profit margins are in the less-than-10% range, especially for the kinds of things America tends to import, so likely an equivalent tariff would be something like 4%.  Anyway, I think that's a reasonable estimate, and getting fairly close is at least a lot better than completely blowing it.  Hopefully Trump would know someone smarter than me who could do the math.  And hopefully if this was done, 40% would not be the target since one would want to reduce the corporate rate at the same time.

By making the two equivalent, the goal would be something like tax indifference -- it would not matter which side of a border a company was on, the impact of the American-imposed tax regime would be the same.  And since America is a relatively great place to do business, more businesses would be induced to move here if they'd like to sell here.  And with increasing levels of domestic production, capital would accumulate and wages would rise.

But even if companies didn't choose to relocate here, they could at least defray a little of the price it takes to keep this place running...

A rather massive caveat -- I'm not 100% sure that this is all actually true.  If I think about it in terms of Arnold Kling's null hypothesis (that, basically, pretty much no matter what you do, nothing matters, assuming I understand him right), it could be that all this stuff is already 'priced in' and all material adjustments already made.  So that a change in policy would simply result in a very large (and possibly painful) shifting and re-coordination of prices, with nothing materially changing as a result.

I don't really have an answer for that.  I would like to say that it couldn't hurt to try, but I don't really think that's true.  It probably could.

Also -- I'm hardly an expert on this stuff.  I have no idea what fraction of our imports even have a tariff of less than 4%.  The whole thing may not even be meaningful if it doesn't apply to very much trade volume.

Another idea I have seen floated -- create what are essentially uncapped IRA funds, so that any arbitrarily large amount of money could be invested with no tax consequences until the funds are withdrawn for other use.  That would also, no doubt, lead to a massive accumulation of capital; however, I suspect that the capital would not lead to actual investment in the US.  Most likely it would simply inflate asset bubbles in Asia, or some other place, as Americans used their 'IRA' funds to buy assets wherever the expected yield was highest, i.e., not here.

If Trump wants people to capitalize the US, he has to make it more profitable to do so.  Maybe try some of both?  As much as I like the idea of revamping the income tax code, though, I don't think it would help nearly as much, and I don't think he should use up too much political capital on it -- unless, of course, it was quite popular anyway.

Just an idea...

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