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Greatest Research Hits of 2017
From tax reform to minimum wage laws to the optimal taxation of pot, our look back on the year that was in tax and fiscal policy research. Plus, our inaugural “Fiscal Raspberry Award” recognizing jaw-dropping awfulness in the study of fiscal policy.
As 2018 approaches, we offer our year-end review of interesting tax and fiscal policy research we have come across in 2017. Our review is hardly exhaustive (essentially stuff that conveniently comes across our computers and desks), but we try to flag items that are pertinent to policy topics of ongoing interest in Minnesota and relevant to state policy making. As usual, the year offered some interesting insights and occasionally provocative conclusions. As a bonus, we are pleased to announce our first ever “Fiscal Raspberry Award” honoring exceptional awfulness in the study of fiscal policy.
Tax Reform: What Might Have Been and What Could Lie in the Future
There’s tax reform and then there’s TAX REFORM – the latter being a fundamental reconceptualization and redesign of tax systems. As an alternative to the corporate income tax, the “Destination-Based Cash-Flow Tax” floated as part of the House GOP’s tax reform earlier this year is an example of the latter. Even though the “DBCFT” crashed and burned politically, a simulation of its adoption in the U.S. helps explain why tax experts and economists across the political spectrum were rather intrigued by this reform idea.[1]
Researchers simulated the adoption of the House DBCFT (a.k.a. “Better Way” plan) with a model that explored both the macroeconomic and distributional impacts here and in the global economy by incorporating responses from other countries around the world to this reform. Researchers concluded in the short run U.S. capital stock would rise by 25%, pre-tax wage rates would rise by 8% and GDP by would rise by 9%. Over time capital stock and wage rates remained significantly above their baseline values. Moreover, this reform produced enough additional revenues to permit a reduction in personal income tax rates while maintaining the economy’s initial debt-to-GDP ratio. When incorporating responses and matching tax rate cuts around the world, the effects are much smaller but the benefits to labor, capital, and the U.S. economy are still positive because the absolute marginal tax rate in the U.S. would fall by a larger amount than elsewhere.
The DCBFT reflects an interest in moving more towards consumption-based (VAT and VAT-like) taxation which some believe is only a matter of time as the problems and dissatisfaction with our existing system become more manifest. An interesting “what if” investigation explored what the impact on state and local government budgets would be of an add-on federal VAT to specifically to reduce the federal deficit.[2]
Researchers concluded a federal VAT would affect state and local budgets both by changes in state and local tax bases and changes in the cost of government services due to changing prices of compensation and purchased goods. Interestingly, the effect of a VAT on state income and property tax bases can be larger than the effect on sales tax bases. The impact of a VAT depends on both how big the VAT base is and how big consumer price level changes are. In Minnesota, research found the impact on combined state and local budget balances ranged from a 0.6% increase to a 1.4% decrease.
On the Business Front
Approximately 95% of all businesses in the U.S are pass-through entities, a share that has grown steadily over decades. One reason for this growth is the potential tax advantaged nature of the pass-through organizational form in which firms are only taxed at the individual level unlike corporations, which are taxed at both the entity and individual levels. How big is this differential? Researchers have now estimated the aggregate effective business income tax rate for corporations at the state level is 30% higher than that for pass through entities (6.1% vs. 4.7%).[3] It’s an important consideration for states in developing equitable business tax treatment, balancing budgets, and identifying appropriate conformity responses to any federal tax reform.
How does Minnesota “get away” with having one of the highest state corporate income tax rates in the nation? Many would immediately answer, “we don’t,” but it’s generally recognized that state corporate income tax features like single sales apportionment, absence of throwback rules, and the R&D credit are necessary to take some of the sting out of our high statutory rates. Research offers new insights into the relative influence of “bases vs. rates” in explaining the variation in corporate tax revenues across states.[4] Studying 30 years of state corporate tax collections, researchers found tax base components account for more than 75% of the explained variation in tax revenues during that period and play a more important role in explaining revenue-to-GDP ratio patterns across states than rate changes do. Interestingly, over time apportionment rules and carryback provisions are waning in importance while depreciation rules and interactions with federal tax policies are explaining more of the variance. Researchers concluded given the large effects the structure of the tax base has on corporate revenue, “policymakers should be careful to use these policies to accomplish specific goals.”
The business workforce got its usual share of attention, and unsurprisingly the academic canon on the impact of minimum wage laws grew yet larger this year. Two particular investigations received a fair amount of news coverage and social media attention because their contrarian findings highlighted potential downsides of minimum wage increases. One investigation looked at the labor effects of Seattle’s move toward a $15 minimum wage with the caveat that the findings cannot be generalized to predict the effects of changes in minimum wage laws at the federal level, the state level, or in any other locality. Researchers concluded the step-up in the minimum wage from $11 to $13 per hour resulted in a reduction in hours worked in low wage jobs of around 9% – resulting in a loss of 3.5 million hours worked per calendar quarter.[5] Alternative estimates showed the number of low-wage jobs declined by 6.8%, which represents a loss of more than 5,000 jobs. Noting the contrast between these findings and previous literature, researchers argued the results could be explained largely, if not entirely, by data limitations in earlier studies that they were able to circumvent.
Another study, based on 35 years of Current Population Survey data, found increasing the minimum wage significantly decreases the share of automatable employment held by low-skilled workers, and increases the likelihood that low-skilled workers in automatable jobs become unemployed.[6] According to the researchers, the effects differ considerably across industries and demographic groups with older workers the most likely to be impacted. They conclude groups often ignored in the minimum wage literature are in fact quite vulnerable to employment changes and job loss because of automation following a minimum wage increase.
Noting that the debate about minimum wage impacts remains “intense and unsettled,” with abundant conflicting evidence, another analysis provided some perspective on what we don’t know in hopes of charting a research agenda to better reconcile the disparate findings.[7] Highlighting several relationships and economic factors that remain underanalyzed despite over a century of study, the researcher concluded absolutism on the issue is probably neither fruitful nor accurate. Instead, it would be wiser and more productive to “recognize that there is not one minimum wage effect,” and instead try “to better understand why the employment effects of minimum wages vary across workers, labor markets, time, and the policy environment.” That’s probably sage advice to the academic community but woefully unsatisfying to policymakers.
Our favorite workforce study, however, comes from an attempt to explain why younger men (aged 21-30) have exhibited a larger decline in work hours since the turn of the century compared to older men or women.[8] One contributing factor: video games. Researchers concluded that innovations in gaming since 2004 explains about half the increase in leisure pursuits for younger men, predicting a decline in labor hours of 1.5% to 3% which is 38 to 79 percent of the differential in the decline between this group and older men. Moral: good pay and benefits are important, but a few X-Boxes in the lunchroom wouldn’t hurt either.
“Will You Still Feed Me When I’m 64?”
We obtained some interesting new insights into the biggest tax relief beneficiaries of Minnesota’s on/off /on again 2017 tax bill – senior citizens. A Census Bureau investigation concluded that incomes of the elderly are actually higher than those reported in official income and poverty statistics.[9] Using administrative income records linked to survey participants, researchers found median household income of persons 65 and over 30% higher ($44,400 vs. $33,800) and poverty rates 24% lower (6.9% vs. 9.1%) than what official statistics reported. The discrepancy was mainly attributable to underreporting of retirement income from defined benefit pension plans and retirement account withdrawals. The large difference between survey and administrative records were present within most demographic subgroups. Researchers noted such findings suggest the possibility that surveys of retirement consumption may also be biased by income underreporting.
Such findings were further supported by an examination of income trends prior to and immediately after retirement. Employing data from the IRS Statistics of Income Division, researchers concluded most individuals do not experience a reduction in inflation adjusted spendable income after claiming Social Security.[10] Changes in spendable income after claiming Social Security are the result of changes in both income and taxes, as researchers found that declines in work-related income were largely offset by a reduction in taxes. The study also affirmed that what we think we know about the economic condition of seniors and retiring baby boomers is likely incorrect. Citing, among other evidence, a study that found pension income was underreported by nearly 60% on Census surveys, researchers noted the data on which official household income and poverty statistics are based “suffers from misclassification of income, underreporting of income, and underreporting of enrollment in means-tested government programs.”
So if this calls into at least some question the wisdom of having targeted scarce state tax relief dollars to this selected demographic, it doesn’t explain why Uncle Frank, who’s probably in decent economic shape in his retirement years, is so argumentative at the holiday dinner table. An investigation into the role the internet and social media plays in the growth of political polarization offers some understanding.[11]
Testing the hypothesis that the internet is a major force in the dramatic growth of U.S. political polarization because it allows citizens to self-select news and information through social media, researchers analyzed the relationship between changes in measures of political polarization with trends in internet and social media usage. Perhaps surprisingly, researchers found the increase in polarization is largest in the demographic least likely to use the internet and social media – a.k.a. seniors. Although less than 20% of people aged 75 years and older used social media, growth in political polarization index points in this demographic was 111% above the average population from 1996-2012 and 660%(!) above adults under 40 (whose internet and social media usage is above 80%). Researchers could only speculate on an alternative explanation but noted one possibility was “endogenous positioning of traditional media” otherwise known as the cable TV news channel running 24/7 in the living room.
“Dude, This Tax Incidence is Totally Awesome”
Minnesota’s adoption of medical marijuana legislation may have some unintended fiscal consequences – namely increased reliance on costly social insurance programs by working age adults. In a study of how passage of state medical marijuana laws affect Social Security Disability Insurance (SSDI) and workers compensation claims, researchers found adoption of such laws increased the propensity to claim SSDI by 9.9% and increased SSDI benefits by 2.6%.[12] No statistically significant effects were found relative to workman’s comp although the relationship was positive. Interestingly, age mattered. Passage of medical marijuana legislation increases SSDI and workers comp claiming among younger adults (23 to 40 years), but not older ones (41 to 62 years).
Meanwhile, with state budgets under stress and support for recreational marijuana legalization growing, states are becoming policy laboratories for its taxation and regulation. A study examined the impact of the State of Washington’s decision to switch from a 25% gross receipts tax collected at every step of the supply chain to a 37% excise tax at retail.[13] The study concluded that, true to gross receipts tax theory, pot tax pyramiding led to inefficient forms of vertical integration within the state’s marijuana growing industry. Consumers bore 44% of the additional retail tax burden. Perhaps most significantly, the researchers found consumer demand for marijuana to be price inelastic in the short run but price elastic within a few weeks of the price increase. Based on this, researchers concluded both that the new excise tax was pushing the inflection point and “considerable state revenue may be left on the table” in other states featuring much lower levels of taxation.
And if Minnesota does want to eventually participate in the money grab, research based on nearly 40 years of data from high school seniors suggests liberalization laws have minimal impacts.[14] Researchers examined 132 outcomes ranging from other substance abuse to traffic accidents and found legalization statistically significantly improved twenty outcomes and worsened four outcomes although the effects themselves were generally very small. One likely hypothesis explaining these results, according to the researchers, is “removal of these laws merely ratifies de jure what is already de facto.” Translation: legal or not, people have been toking for 40 years.
Additional Color on Growing Inequality
It’s safe to say that growing income inequality is one of the most influential issues shaping both tax and fiscal policy debates in government. There is abundant evidence of rising income inequality in official statistics but several studies this year examined how the issue is a much more nuanced and complex one than conventional wisdom might suggest.
Much of the nuance arises out of studying consumption data, which many economists argue is a preferable indicator or measure of “real” well-being than income. One study found the rise of income inequality over the last 50 years (measured by comparing the 90th to the 10th percentiles) was over 4 times greater than the rise in consumption inequality (29% versus 7%).[15] Another study found modest growth in real wages and in median household incomes over the last 40 years when using the federal Bureau of Economic Analysis’ Personal Consumption Expenditure index as the deflator instead of the CPI.[16] Yet another study offered perspective on the inequality issue by comparing IRS total income data (labor plus capital) with Social Security Administration data on labor income (wages plus self-employment).[17] This analysis found that diverging patterns in top income shares are 1) a function of the increasing importance of income accruing to pass-through entities; and 2) extremely concentrated in pass-through income at the very farthest tail of the distribution – above the 99.99th percentile.
Other Notable Findings
Tax filing is costly and getting more so. A study found compliance costs have been increasing since the 1980s and has reached 1.2% of GDP in the most recent years. In examining taxpayers’ choices between itemizing and claiming the standard deduction, the study also concluded taxpayers will forgo tax savings to avoid compliance costs.[18]
More evidence of the beneficial effects of work supports comes from a study examining the relationship between state earned income tax credits and the health benefits to mothers and newborns. For key infant health outcomes like birthweight and gestation weeks, the greatest positive effects were seen among states like Minnesota with the most generous EITCs.[19]
What does the likely shift of redistributive policy financing obligations from the federal government to the state level mean for state budgets in recessionary times? Potentially a lot. A study examining the implications of Medicaid financing reform for state government budgets concluded that had an “acyclical” block grant structure unresponsive to economic conditions been in place during the Great Recession it would have increased states’ shortfall by 2% to 3.5% of own source revenues compared to the current matching system.[20] As a frame of reference, 3.5% of Minnesota’s 2009 state own source income was about $735 million.
2017 Fiscal Raspberry Award
It was probably only a matter of time. For years many public pension plan advocates have argued 80% funding is the standard by which to determine whether a plan is healthy – an idea officially labeled a “myth” by the American Academy of Actuaries and a level other public pension experts argue should only ever be breached under the very worst economic circumstances. As pension plans across the country struggle to regain even this lowball level of fiscal health, it appears the white flag has been raised and a new argument is being advanced rationalizing pension underfunding as good public policy. Our winner of the 2017 Fiscal Raspberry award is the policy brief, “Funding Public Pensions: Is Full Pension Funding a Misguided Goal?” from the Haas Institute at University of California Berkeley.
Retitled by one professional actuary wit, “Funding Public Pensions: Is Actually Paying the Promised Benefits a Misguided Goal?” the policy brief is primarily an argument against recently promulgated public pension accounting standards and their influence in setting contribution requirements. But the brief argues the pursuit of full funding under these accounting rules is not only unnecessary, it’s wasteful.
The analysis essentially boils down to this – state governments don’t go away and pension plans don’t need to be fully funded to keep benefit checks from bouncing. Therefore striving for full funding and obsessing over pension debt is wasteful by diverting money away from essential public services. The paper argues, “many if not most defined benefit pension systems can operate forever at far less than full funding.” How?
“If the contributions to the fund (employer and employee contributions, as well as investment income) are adequate to offset the normal cost (the present value of additional benefits accrued by all employees in that year – ed.), then the unfunded liability of a plan will not change from one year to the next. If the unfunded liability does not change one year to the next, the fund can operate indefinitely with the same unfunded liability."
There are a lot of “ifs” in that perpetual motion finance machine, to which we would add a few others:
- What if plan cash flow net of investment returns is chronically negative (as in Minnesota and the rest of the country) to the tune of billions of dollars per year due to ever-increasing benefit payments to an ever-increasing supply of retirees putting evermore pressure on investment returns and higher contributions just to offset normal cost growth, let alone amortize billions in unfunded obligations?
- What if investment returns from risk asset classes are negative or below expectations for a period of years with their inherent compounding effects?
- What if future taxpayers under this morphing “pay as you go” concept decide they don’t want to be saddled with the retirement expense of both their own workforce and those that retired long before them?
- What if the opportunity cost to future taxpayers “to keep those pension checks from bouncing” means drastic cuts in education, human services and other essential government programs for those taxpayers?
- What if pension beneficiaries want and expect full funding assurances and don't want to be surprised by large, unexpected benefit cuts when essential demands of the present supersede promises of the past?
And more to the point – the whole reason pension plans have unfunded liabilities in the first place is because past contributions and investment returns failed to cover the normal cost of benefits. If they had been, these plans would be in fine shape. What exactly has changed since 2000 to guarantee “adequate” funding for each year’s crop of new benefits?
We have been watching like a hawk to see if any hint of this analysis would seep into the debate surrounding Minnesota public pensions. Fortunately, we have seen no sign of it here even though it has now become fodder for pension advocates at the national level and in other states. So kudos to Minnesota’s plan managers and policy leaders for continuing to understand the importance of adequately funding pension plans, even if their response to our problems to date has been several dollars late and even more dollars short.
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