Economists Do It With Models

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Even A Stopped Clock Is Right Twice A Day, Comparative Advantage Edition…

August 11th, 2016 · 4 Comments
Econ 101 · Policy · Taxes

You guys, I’m frustrated. Yes, by this:

and by this…

But what I’m referring to is slightly less, well, dramatic, for starters. So allow me to describe one of my (admittedly many) pet peeves: When economists teach the concept of comparative advantage and gains from trade, it goes something like “hey, if you can pay somebody $20 an hour to clean your house and get paid $25 an hour at your regular job, you can specialize in your job and outsource your housecleaning and have $5 an hour left over! Everyone is better off!” Sounds great, right?

Well I tried it, and boy am I disappointed.* First off, I explained to my boss that I hired someone to clean my house and therefore I am able to spend 3 more hours per week at work. He seemed pleased with that, so I then reminded him to adjust my salary accordingly, and, well, that’s where things sort of went off the rails. Luckily, I’m a great negotiator, so he eventually came around to meet my demand. I started envisioning what I would do with that $5 an hour efficiency prize (mmmmm, Starbucks vanilla sweet cream cold brew, here I come), but when I looked at my online banking statement the numbers didn’t play out as I had expected- got paid for 3 extra hours of work, paid for 3 hours house cleaning and a grande cold brew ($4 and change IIRC) and I’m worse off than I was before? How is that possible?

Dammit, I forgot about taxes- in fairness, if my econ textbook has taught me anything, it is to ignore tax considerations when doing comparative advantage analyses. Hopefully by now you’ve identified the two logistical points that insert frictions into this specialization and gains from trade thing:

  • A lot of people don’t actually get paid by the hour (and therefore have either a zero or an unclear marginal wage), and, even when they do, they don’t usually have perfect flexibility over how many hours they work.
  • Income taxes make it such that it only makes sense to specialize if your after-tax wage is higher than what you would pay to get work done.

The first point, well, that’s one’s pretty hard to address (not everyone can have an Uber driver lifestyle I suppose), but it seems like there should be some benefits to thinking about the tax issue here. If my $25 is taxable income, the government collects tax on my $25 but doesn’t collect tax on me cleaning my own house. (Don’t go getting any ideas, government.) If my house cleaner payments were somehow not taxed, the government would lose revenue on my $20 per hour payment but would collect revenue from the person cleaning my house. Granted, this is probably a bit of a loss for the government, since the house cleaner probably pays a lower tax rate then I do, but the government would probably really like that two people are employed rather than one. (If there is slack in the labor market, it need not be the case that I pulled the house cleaner away from some other job.)

Yeah, so this doesn’t happen, and I am stuck cleaning my own house.** You’ve probably gotten out the world’s smallest violin for me at this point, perhaps because many people find there to be something unseemly about hiring people to do stuff that you don’t want to do, like cleaning the house. Economically, I guess the lack of tax abatement isn’t a huge deal, since if people are paid a fixed salary or don’t have flexibility in hours it’s not the tax issue that’s the main impediment to outsourcing one’s house cleaning on the grounds of economic efficiency anyway.

BUT…let’s pretend for a second that I had used childcare rather than cleaning in the above example. Childcare is an importantly different animal, in large part because did you know that kids exist like 24 hours a day? It’s crazy. (Also, if they’re really small you can’t leave them at home by themselves, which is kind of inconvenient.) Because of this, the tradeoff between work and child care is often more binary than in the house cleaning example- in other words, people are generally deciding between working at all and taking care of their kids, or at least deciding between part-time and full-time employment. Because of this feature, it’s a more logistically reasonable candidate for exploiting gains from trade- for example, a potential worker who could pay $10,000 per year for child care (yeah, I know I’m being optimistic compared to many real cases) could leverage trade as long as she could get a job that pays more than $10,000…after taxes. (Yes, I know her taxes as a single person wouldn’t be high, but if she has a partner her marginal tax rate on the $10,000 could be quite high.)

One obvious potential solution to alleviate inefficiency in this situation would be to make child care tax deductible- as noted above, the impact to the government’s bottom line is likely small due to those who wouldn’t have paid for child care without the deduction. On the down side, the government *would* lose revenue from households who were purchasing child care even though it wasn’t tax deductible. Also, there’s that pesky thing we talked about a couple of days ago where tax deductions don’t help lower income households in the ways that we might expect (not to mention that households only get the money back at tax time, which doesn’t help households with short-term cash flow concerns).

Now, I never thought I would say this, but Trump’s team of Steves (now with more female non-economists!) is kind of onto something:

We now know more about Trump’s proposal to subsidize child care
by Josh Barro

Donald Trump’s proposal to make child-care expenses deductible from tax became a little less vague on Thursday — and significantly more expensive.

Source: Business Insider

The relevant points are as follows:

1. The deduction would be “above the line.” That means it would appear before Line 37 on the Form 1040, and therefore the deduction would come out of your income before calculating adjusted gross income. Here’s why it matters where on the form the deduction goes: You can take “above the line” deductions on top of the standard deduction, without itemizing your other deductions. As a result, more taxpayers could take advantage of this deduction, including taxpayers who don’t make enough money to itemize. (Itemizing is generally for people who pay a significant amount of mortgage interest and/or state and local tax.)

2. The deduction would apply against one-half of payroll tax, not just income tax. Clinton and others have pointed out that a new income-tax deduction would be of no value to low-income parents who don’t make enough money to pay income tax. Making the deduction also applicable against the employee-paid half of payroll tax would provide some savings to anybody with labor income. The benefit wouldn’t be huge — it would equal 7.65% of the amount deducted — but that’s not nothing.

The article itself still criticizes the plan on the grounds that higher-income households get a larger discount, which is true, but you guys, this could actually get pretty close to a situation where comparative advantage and gains from trade work in the way that the textbook tells me that they do. Now we just need to have clear objectives and dig into the nerdy details of every other policy in order to satisfy…..HAHAHAHAHAHAHAHA, yeah, I know. I’ll instead direct you to the part where Trump confuses his employees with his hotel guests.

* I’m kidding- I’m not, it’s great (though I have an atypical work situation), but just go with me here.
** Still nope.

→ 4 CommentsTags: Econ 101 · Policy · Taxes

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Getting To The Disposition Effect…

August 10th, 2016 · No Comments
Behavioral Econ · Videos

Know what the disposition effect is? Well you do now…

Next time we’ll look at one of the seminal disposition effect papers and learn how we can test for it in a sample of data.

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On How It Feels To Try To Focus On Economic Issues This Election Season…

August 9th, 2016 · No Comments
Just For Fun · Politics

That is all.

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Let’s Back Up A Second And Give Marginal Tax Rates Their Moment…

August 9th, 2016 · 3 Comments

I got a few comments of note on my last post regarding tax deductions versus tax credits. First, from Tumblr:

and from Facebook:

Technically speaking, neither of them are wrong I suppose (though I didn’t confirm the average tax rate calculation in the first comment), but the second guy is right that some additional review and clarification is probably helpful for some people.

So allow me to start with a story that, if my household is at all representative, a number of you will be able to relate to. When I was younger (let’s say like ten or so), my grandfather explained that he needed to find some tax deductions because otherwise he’d end up in a higher tax bracket (his words, not mine). The implication from his complaint was that staying in a lower tax bracket would make him better off on net, and this seemed strange. (He later clarified, still but somewhat less incorrectly, that he just didn’t want the government taking 80% of his marginal dollar, so his main error was in not realizing that it wasn’t 1962.) Now I know that tax codes are a little silly sometimes, but even 10-year-old me was suspicious that they were so stupid as to create incentives to throw money away.

I was right to be suspicious, of course- that’s not how tax brackets work. But one thing I’ve noticed is that a lot of people have similar mistaken beliefs about how taxes are calculated. So let’s do a quick refresher- if this isn’t new to you, just forward to that friend you know we all have instead…

First, let’s take a look at some marginal tax rates (assuming you’re single, but you can see the complete set of numbers here):

  • 10% for income $0 to $9,275
  • 15% for income $9,275 to $37,650
  • 25% for income $37,650 to $91,150
  • 28% for income $91,150 to $190,150
  • 33% for income $190,150 to $413,350
  • 35% for income $413,350 to $415,050
  • 39.6% for income $415,050+

Let’s say you make $50,000 per year (or, if you want to be super picky, have $50,000 in adjusted gross income or whatever, since this is the amount that you actually pay taxes on). To find out how much you will pay in federal taxes, what you DON’T do is look up $50,000 in the table above, get a 25% tax rate, and multiply 25% by $50,000. If this were how things worked, then yeah, a guy making $38,000 would in fact want to burn $351 of income, for example. (If you don’t believe me, you can calculate and confirm that taking away 15% from $37,649 results in a bigger number than taking 25% away from $38,000.)

What you *do* do, instead, is more sensical but more arithmetically complicated. Again, let’s say you make $50,000 per year. Your federal tax calculation would look like this:

  • Well, I max out the $0 to $9,275 bracket, so I pay 10% * $9,275 = $927.50 for that bracket.
  • I also max out the $9,275 to $37,650 bracket, so I pay 15% on, let’s see, $37,650 – $9,275 = $28,375 of income, which comes out to $4,256.25 for that bracket.
  • I go…hm, $50,000 – $37,650 = $12,350 into the $37,650 to $91,150 bracket, so I pay 25% * $12,350 = $3,087.50 for that bracket.
  • Adding this all together gives me $8,271.25 in taxes owed.

I’ll be honest with you, I didn’t particularly like working though that, but it is what it is, and we have calculators and Excel (and tax prep software) and such to help. Besides, no one has to do this very often, at least not for decision-making purposes. For example, let’s say I offer you $1,000 to do some research for me. You can look at the tax table and immediately know that your tax rate on this incremental income will be 25% (since you were already earning $50,000, remember), leaving you with $750 in compensation after federal income taxes. Note that it didn’t matter that your average tax rate on the original $50,000 of income was $8,271.25 / $50,000 = 16.5%, since it’s only the marginal (i.e. applied to the last dollar) tax rate of 25% that is relevant to an extra dollar of income. (This would of course get more complicated if the incremental income spanned different tax brackets, but the logic is still the same.)

The same principle holds in reverse for tax deductions- if you make $50,000 and have a $100 tax-deductible expenditure (ignore the standard deduction for now), your taxable income decreases by $100 and your taxes owed decrease by $25, in effect giving you a discount on your expenditure equal to your marginal tax rate. Note again that it was only this last tax bracket, or your marginal tax rate, that was relevant in calculating the effect of the tax deduction.

So yeah…with a progressive tax system- i.e. one with larger tax rates for higher income brackets- your marginal tax rate will be higher than your average tax rate, as you can see from the example above. (They will be the same, however, for individuals with income in the lowest tax bracket only.) So, while you mainly want to keep your marginal tax rate in mind for decision-making purposes, I guess it could make you feel better to calculate your average tax rate and be reminded that the federal government isn’t taking all of your money in income taxes. That’s FICA’s job, after all…

→ 3 CommentsTags: Taxes

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In Case It Isn’t Obvious, A Primer On Tax Deductions Versus Tax Credits…

August 8th, 2016 · 4 Comments
Income Distribution · Policy · Taxes

I’ve been doing my taxes myself for a while now, and, thankfully, I am not old enough to have had to file any complicated returns before the advent of online tax preparation systems. That said, tax calculations are complicated enough that there were a number of things that caught me by surprise. For example, I remember my inner monologue that first time…

H&R Block: Would you like to take the standard deduction, itemize your deductions, or calculate both to see which is better?
Me: Why wouldn’t I want to figure out what is optimal? Duh…
H&R Block: *asks for tax deduction info*
Me: *enters tax deduction info*
H&R Block: Based on what you’ve entered, you should take the standard deduction?
Me: WTF is the standard deduction and why did it make all of my charitable giving (like, all $100 of it, people) irrelevant?

By now, my older and wiser self knows what the deal is…most basically, I now get that the tax system offers a “standard deduction” that you can take so that you don’t have to bother with the hassle of entering all of the tax deductible stuff you did over the course of the year. (Similarly, the standard deduction makes things easier for the IRS since there’s no verification to be done.) That sounds fine on the surface, but wait- isn’t there the unintended consequence that the first $X of my tax deductible stuff doesn’t actually help me in terms of lowering tax liability, where X is the amount of the standard deduction? Yup, since the actual choice isn’t between “itemized deductions” and “no deductions” but instead “itemized deductions” and “standard deduction.”

Obviously my next step was to look up how large the standard deduction is in order to determine how annoyed to be. It was a bit lower at the time, but the standard deduction is currently $6,300 for single filers or married couples filing separately, $9,250 for head-of-household filers, and $12,600 for married couples filing jointly. Wait what? What sort of mythical creature has more than $6,300 in tax deductible stuff? (said my 21-year-old self) More importantly, why wasn’t I aware of this when I gladly signed up for a recurring donation to the Human Rights Campaign on the grounds that the tax deduction would basically make it a wash in terms of disposable income? (yeah, I now know that’s incorrect on multiple levels) Or, perhaps more significantly, why wasn’t I bludgeoned over the head with this information when I signed up for a student loan? (For the record, no one told me about the income limits for student loan interest to be tax deductible either, but that’s for another post.)

The point that I’m trying to make here is twofold. First, making expenditures tax deductible is one of those things that sounds nice in theory (since it sounds like a subsidy or discount of some sort) but that likely doesn’t actually impact the bottom line of many households because of the standard deduction situation. Furthermore, even when they do matter- my mortgage interest, for example (since I’m totally a grownup now)- it’s only the amount above and beyond the standard deduction that affects a household’s bottom line. Second, tax deductions are kind of insidious because people don’t seem to fully think through the standard deduction issue when deciding whether to undertake their tax deductible activities. For example, I remember being presented with some sort of “rent vs. buy” real estate calculator a number of years ago, and it definitely didn’t take the standard deduction consideration into account. As a result, many households are likely underestimating the real cost of the “tax deductible” opportunities they are presented with, which leads to distortions in consumption of these opportunities.

But wait, I’m not done ranting about tax deductions…to see why, let’s take a quick tax deduction quiz:

Q: You just donated $100 to the Human Rights Campaign. This contribution is tax deductible. What is the effective cost to you of this contribution?

A: This is a trick question on multiple levels. First, as noted above, your effective cost is $100 if the contribution doesn’t put the total of your tax deductible expenditures above the standard deduction. So let’s assume for the sake of argument that there is no standard deduction and, for simplicity, that this $100 is your only tax deductible expenditure (you scrooge). You still can’t answer this question without looking at how much money you make! This is because tax deductions reduce the amount of income that is taxable, so your discount is equal the amount of taxes that you would have paid on the $100 you contributed. With a progressive tax system, the amount of taxes you would have paid on the $100 depends on how much money you make overall. So let’s take a look at some marginal tax rates (assuming you’re single, but you can see the complete set of numbers here):

  • 10% for income $0 to $9,275
  • 15% for income $9,275 to $37,650
  • 25% for income $37,650 to $91,150
  • 28% for income $91,150 to $190,150
  • 33% for income $190,150 to $413,350
  • 35% for income $413,350 to $415,050
  • 39.6% for income $415,050+

If you make $50,000 per year, you’re paying a 25% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $49,900 and you avoid $25 of taxes. In this case, your $100 contribution effectively cost you $75.

Now let’s see what happens if you were to make $300,000 per year. (Lucky you! Also, Why didn’t you donate more than $100?) In this scenario, you’re paying a 33% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $299,900 and you avoid $33 of taxes. In this case, your $100 contribution effectively cost you $67.

This simple illustration shows how making expenditures tax deductible provides bigger subsidies to higher-income households than to lower-income households. (Not surprisingly, some expenditures are only tax deductible for households making below a certain amount, which puts the bias in the other direction.) Put this together with the observation that lower-income households are less likely to even clear the standard deduction in the first place and it becomes clear that making expenditures tax deductible disproportionately helps higher-income households. I guess what I’m saying is that I want you to come back and read this every time you hear a politician suggesting making an expenditure tax deductible in order to provide relief to income-strapped households.

So…is there a better way? If by “better” we mean “impacts all households equally,” then yeah, probably, and it’s called a tax credit. Tax credits are importantly different from tax deductions in that they operate to lower taxes directly rather than lowering the amount of taxable income. For example, if a 25% tax credit were given for donations to the Human Rights Campaign, then the $100 donation in the example above would result in a $25 reduction in taxes owed for every household that makes such a contribution.

I get that the details of taxes are boring- I mean, this is basically the stuff that accountant jokes are made of. But it’s so important to get right- tax deductions and tax credits are used not only to provide income relief but also to change incentives, and it’s really hard to respond optimally to incentives when you don’t fully get how the incentives offered affect you and your financial situation. In a more general sense, you want to understand how the policies that politicians propose actually affect households so that you know what you’re voting for.

In related news, for example, here are two proposals for easing the burden of child-care costs. You now have the tools you need to think about where the benefits of the policies go, which is good since I sure don’t trust politicians to provide this information themselves in an unbiased fashion.

→ 4 CommentsTags: Income Distribution · Policy · Taxes

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Some Economic Insight For Donald Trump From an Individual Not Named Steve…

August 5th, 2016 · 4 Comments
Econ 101 · Economic History · Macroeconomics

Dear Mr. Trump,

You didn’t approach me to be part of your econsquad, but that’s fine- while I do have more of an economics background than 12/13ths of your team, my name isn’t Steve, so I’m not sure I’d be a good fit. Hypothetically, I’d like to think I’d take you up on your offer were it to be extended, since my commitment to education is fairly universal, and the over/under bets on how long it would take me to get fired would be pretty entertaining. Anyway, you know how you get those security briefings so that you can prepare before you actually get the job? Turns out I did a bit of a similar thing in anticipation of getting your call. I figured it shouldn’t go to waste, so here you go.

As is true with almost all first Fridays of the month, the Bureau of Labor Statistics released its “jobs report” today- i.e. its numbers for July employment and unemployment. The bare minimum information you need to know is that the economy added 255,000 jobs and the unemployment rate remained at 4.9%. The general consensus among economists is that this is a very good report. Now, I know you don’t like this number, so allow me to explain a bit and, perhaps more helpfully, provide you with a few alternatives.

First, how could jobs get added and the unemployment rate not change? I was hoping this was no longer an esoteric issue, but to refresh- the unemployment rate is the percentage of unemployed people in relation to the universe of people who either have or are actively looking for a job- i.e. the labor force. People can enter or exit the labor force depending on their personal circumstances- for example, people who quit their jobs to volunteer for your campaign have exited the labor force for the time being. An unemployment rate of 4.9% means that 95.1% of people who are looking for jobs have them, so if 95.1% of the new people in the labor force found jobs, the unemployment rate wouldn’t budge.

From what I’ve read, your contention is that this is not the “real” unemployment rate, which is actually a fair point to some degree. What is much less fair, however, is the assertion that the BLS is somehow hiding this from the American people. So check this out:

If by “hiding” you really mean “placing at the bottom of a boring wall of text,” then yeah, I can’t argue with that. In any case, there is a wealth of data there that is the stuff that numbers geeks like me live for. In addition, I’d like to direct your attention to Table A-15, since this is, in a way, where your “real” unemployment rates are hiding:

Worried about the people who give up looking for work because they think things are hopeless? They’re called discouraged workers, and they are included in U-4: 5.2%

Also worried about people who aren’t actively looking for work but would take a job if it presented itself? They’re called marginally attached workers, and they are included in U-5: 6.0%

Also worried about people who are working part time because they can’t find a full-time job? They’re included in U-6: 9.7%

Update: Here’s even some historical numbers for you in handy Twitter form- I hope you don’t find it presumptuous that I inferred Twitter to be your preferred communication method.

You may have noticed that I reported the “seasonally adjusted” numbers here- like the BLS, I am not trying to pull anything shady, and you can see an explanation of why seasonally-adjusted numbers are better for looking at trends over time here:

Now, even U-6 is pretty far from the 40-something percent unemployment you’ve mentioned a few times, so I spent some time reverse engineering what it is you might be referring to. This is what I came up with, and please do let me know if I’m off base…for this, let’s take a look at Table A:

Here, we can see that the employment-population ratio- i.e. the percentage of working-age adults capable of civilian employment (with a few very minor caveats)- is 59.7%, so if you consider literally every working-age adult who doesn’t have a job as unemployed, you do in fact get somewhere in the neighborhood of 40% as an unemployment rate. While I do acknowledge that economists view (mainly non-population-demographic-based) decreases in the employment-population ratio as problematic (mainly on the grounds that fewer workers means less stuff produced, but also social Security funding and such), I would strongly advise against making it a policy objective to get this figure anywhere near 100%. Why? Go tell Melania that she needs to go get a job for the sake of unemployment numbers and report back how that works out for you. 🙂

(Update) I do realize that this information puts you in a difficult spot with your supporters- I mean, we can’t always choose our audiences, except in this case where that is exactly what you are doing. It also likely puts you in an awkward place with Melania, since she probably feels less special after you implied that some 35 percent of the population is just like her, and I doubt that “they are, but only in a non-discouraged non-marginally-attached not in the labor force sense” goes over well in a romantic context. Please remind her that this is not the case- much of that 35-ish percent is comprised of full-time students (advanced high school and college), retirees, the disabled, people for whom childcare would cost more than their income (yikes) and so on. (You could have your Steves dig into the Census data and find out how many of each type of these people there are- I’m nice, but I’m not going to do all of their homework for them.) Here, you could even print out the Wikipedia page for “civilian noninstitutional population” for her and put a solid gold bow around it or whatever it is you do to stay on her good side. In related news, my 87-year-old grandfather would like you let you know that he will punch you in the face if you don’t stop referring to him as “unemployed.”

In case you’re curious (you’re probably not, let’s be honest), conspiracy theories regarding the unemployment rate have been around for a while (no really, that article is great), and there have been significant shifts over time in the nature and direction of the theories. Can you imagine that in the 1960’s people believed that the official unemployment number was INFLATED (by erroneously adding in discouraged workers, no less, which seems to be what you advocate) as part of a Communist plot. So I guess what I’m suggesting is that you’re a Communist. Just kidding, but think through the logic for a second- higher unemployment rates are usually used to make arguments for more social assistance, which is the opposite of what your adopted party stands for. Is that really where you want to go with this? Especially when people seem to be taking your statements literally in a way that is not particularly productive:

Now, go back to your private-sector Steves, but keep this unexpectedly insightful observation from an actual economist in mind…


→ 4 CommentsTags: Econ 101 · Economic History · Macroeconomics