Tuesday, September 30, 2008

Reader Mailbag: Capital Gains Taxes Under Obama

A reader writes in the following:

Hello, just wanted to see what an economist's take on Obama's tax plans, concerning capital gains rates.

I'm reading message board postings from people who say they're small business owners who claim that Obama's tax plans would ruin them, that raisingthe CG rate would cause them to have to lay off their staff, etc. They otherwise seem to be GOP partisans who I wouldn't expect to vote for Obama whether or not they owned small businesses. I don't really think Obama wants to ruin businesses the way it's being made out to be by some (including Steve Forbes), so what would you say the real effects would be?

I'm an independent voter undecided but having whittled my choices down to Obama or a third-party candidate. Thank you for your feedback.

The premise--that Obama proposes to raise capital gains taxes on small business owners--is false. Here are various excerpts from his advisors' description of his proposal in the Wall Street Journal:
Sen. Obama also recognizes that small businesses are the engine of job growth in the economy. That is why he is proposing additional tax cuts, including a tax credit for small businesses that provide health care, and the elimination of capital gains taxes for small businesses and start-ups. The vast majority of small businesses would face lower taxes under the Obama plan than under the McCain plan.
Regarding capital gains taxes more generally, there's this from the same article:
- The top capital-gains rate for families making more than $250,000 would return to 20% -- the lowest rate that existed in the 1990s and the rate President Bush proposed in his 2001 tax cut. A 20% rate is almost a third lower than the rate President Reagan set in 1986.
And the crucial overall point:
His plan would not raise any taxes on couples making less than $250,000 a year, nor on any single person with income under $200,000 -- not income taxes, capital gains taxes, dividend or payroll taxes.

Overall, tax rates on capital gains would be lower than they were during the economic growth glory days of the 1990s. The country's economic performance has been far worse during the Bush years, when lower capital gains rates were introduced. More sophisticated analyses of the effects of capital gains rates on economic growth have not found any relationship and estimates from the Congressional Budget Office suggest that even a substantial change in the capital gains tax would have an imperceptible effect on GDP, on the order of a couple hundredths of one percentage point after ten years.

My op-ed in today's Arizona Daily Star

Here's an op-ed I wrote that was published in today's Arizona Daily Star (Tucson's newspaper). Note that I didn't choose the title (my suggestion was something like "We Need a Bailout Bill"). Also note that I had a 550-word budget and a lot of ground to cover. I'll try to expand on the points in the op-ed later today if I can.

McCain Again Mistakenly Refers to a "Fiscal" Crisis!


As Felix Salmon of Portfolio.com noted after the debate, McCain for some bizarre reason kept referring to the current credit crunch as a "fiscal" crisis. Salmon writes:

"But from a technocratic standpoint, the fact that McCain twice referred to the financial crisis as a "fiscal crisis" is telling. It means (a) that he doesn't really understand it, and (b) that insofar as he does, he thinks that government is at least as much part of the problem as it is part of the solution."

Its clear now that this is a deliberate choice of words as he repeated it again this morning on Fox News (via TPM). See the video below.

(Comes at about 1:06)

UPDATE: This is more than just a simple gaffe. McCain spent a large part of the debate talking about cutting spending and earmarks (which are trivial)...and many in the House GOP are proposing spending cuts as well --which is precisely not what you want to do in the midst of a recession. Justin Wolfers an economist at Penn and a regular at freakonomics called some of these proposals "truly bizarre" yesterday in his appearance on Bloomberg.

Monday, September 29, 2008

Fallows' Bell Tolls for Holtz-Eakin

James Fallows asks who will be most harmed for having associated with McCain 2008. His choice is Sarah Palin (and that part of the post is well worth reading, if only for the summarizing "No, they're not.") You really should read the whole post, but here are the nut graphs (professional journos: can you have nut graphs, plural?):
But closing fast on her is the once-estimable Douglas Holtz-Eakin, former head of the Congressional Budget Office (ie, Voice of Responsibility) and member of the Council of Economic Advisors. Just now, he appeared on MSNBC to discuss the market crash and failure of the bailout bill, and in the subtlety and fairness of his remarks he was indistinguishable from Tom DeLay in his prime. 

"Once again we see the failure of Barack Obama's Democrats to address the nation's true needs," was (approximately) the first thing out of his mouth, when discussing a bill that two-thirds of the members of his own (and the president's) party voted against. He led not what this means for the real economy; not what the possible solutions were; not the need to work something out fast; but pure spin-room flackery. 

This kind of bluster is what flacks are for, on both sides. Their reputations go up when they can say such things with a straight face! Even better, with a face contorted in partisan outrage. It is not the right role for the main economic advisor to a campaign. Somebody from the campaign may need to say this, DH-E. Not you.
As bad as Holtz-Eakin's economic blabbering has been this year, It's this stuff that has really wrecked him among people who still work as economists.

Watch Out Tomorrow...

UPDATE: Its not entirely clear to me that even if a flood of orders for redemptions come tomorrow (for the end of the year) that it will necessarily lead to a big selloff tomorrow --this may just occur over the 4th quarter. Of additional concern however, is that end of quarter reporting or "window dressing" may force the unwinding of positions tomorrow.

We may have even more chaos to look forward to in financial markets tomorrow as hedge fund redemptions cascade in for the end of the quarter as the NYT reports:

Even as Washington reached a tentative agreement [ed. note ...ha ha] on Sunday over what may become the largest financial bailout in American history, new worries were building inside the nearly $2 trillion world of hedge funds. After years of explosive growth, losses are mounting — and so are concerns that some investors will head for the exits.

No one expects a wholesale flight from hedge funds. But even a modest outflow could reverberate through the financial markets. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky.

The big worry is that a spate of hurried sales could unleash a vicious circle within the hedge fund industry, with the sales leading to more losses, and those losses leading to more withdrawals, and so on. A big test will come on Tuesday, when many funds are scheduled to accept withdrawal requests for the end of the year.

“Everybody’s watching for redemptions,” said James McKee, director of hedge fund research at Callan Associates, a consulting firm in San Francisco. “And there could be a cascading effect, where redemptions cause other redemptions.”

(emphasis mine)

I wrote the following commentary over at Daily Kos:
My own view of the crisis is that the absolute first priority right now is to re-capitalize the banks as soon as possible and to worry about some of the other stuff later. I am so proud of the Democratic leadership today. I respect the views of Kossacks who opposed the legislation...but I think the Democrats who voted for this bill should earn a badge of courage. I don't like this bill that much either ... but really this is no time to be taking chances on another Depression. In my view no one knows what will happen but prudent risk management is to avoid the kind of contagion that I fear is coming down the pike.

Disaster (cross-posted)

I wrote an op-ed for my local newspaper about the bailout, and I'm hopeful that it'll appear tomorrow. If/when it does, I will post a link and/or text.

In the meantime, here's my cross-posted initial take on today's U.S. House of Abdication vote:


The House has just voted 206-227 to kill the bailout bill. It seem unclear what will happen next.

Unclear, that is, except that if nothing is done, our economy is headed for disaster.

From everything I've read, this bill was far from perfect. But it was above the line, given the possible costs.

I have tenure, and I am well paid, so I imagine I'll be fine. If you don't, or aren't, or you are worried about people who don't or aren't, then you might want to consider calling your House rep to explain that you would prefer not to tell your grandchildren about the time that the "leadership" of your country was too stupid to avoid repeating the mistakes of the Great Depression.

I'll try to write more about all this.

Sunday, September 28, 2008

What I Don't Understand About the Bailout Plan

Update: Peter Orszag, director of the Congressional Budget Office, just posted the CBO's very well-written summary and quick analysis of the proposal here.

Despite some additional bells and whistles, the basic plan is still to buy up mortage backed securities (MBS) at a price which is either their current market price or perhaps something closer to their "hold-to-maturity" value, which might be higher. Larry Summers and others have suggested that the taxpayers will not necessarily lose money on this deal because eventually their value may go up, above the value that we're paying.

If I understand correctly, the hold-to maturity value of these securities must be tied to the value of the properties on the underlying mortgages. If housing prices decline, the default probabilities increase (because more people end up with negative equity and no reason to keep paying their mortgages), and the value of foreclosed-on properties is lower. Both effects lower the value of mortgage-based securities.

The problem is, housing prices are still extraordinarily high--20% higher in real terms than in any pre-bubble point going back to 1987 (that's by the Case-Shiller index). So it's very likely that housing prices--and thus the value of the MBS's--will continue to fall and will not recover anywhere close to their current value in the forseeable future. This says to me that the most probable scenario is that the securities' market price and their hold-to-maturity value (if they are different) will plummet and not recover, meaning that the cost of the bailout will be very high. It still might be better than doing nothing, but it's not going to be at low cost.

Would Sara Palin Be Able to Buy Health Insurance Under McCain's Plan?

The answer is probably not. Health insurance companies stay as far away as possible from a family with a child with Down syndrome. According to the National Down Syndrome Congress:

The whole issue of access to health insurance places an extraordinary burden on families and persons with Down syndrome and other disabilities. Families and adults with Down syndrome are forced to consider issues of obtaining or maintaining health insurance coverage above career and other significant life decisions. Even when they are able to access health insurance coverage, the financial cost can be exorbitant.
Of course in the short-run, Palin is fortunate to have group coverage as a public employee in Alaska. Over time under the McCain proposal, however, such employer provided plans would fall apart as low-risk participants abandoned the plans to get nongroup coverage, leaving only high-risk, high-cost people in the group plan. Eventually, employers--including the Alaskan government--would kill their plans. Although there is much uncertainty as to how fast this process would take place, and the McCain campaign has intentionally obfuscated the issue, there is no doubt that the long-term vision is to eliminate employer-provided health coverage.

So what would a family with a Down syndrome child do in McCainland, when forced to fend for itself on the “nongroup” insurance market? In principle, the family would have to look for insurance from a state-based high-risk pool. Here's what the Health Affairs article on the McCain plan said about this idea:
High-risk pools can be helpful as a way to cover some of the very sick. But to make more than a small dent in reducing the number of uninsured people, high-risk pools would need to be well funded. Senator McCain has proposed spending $7-$10 billion to subsidize high-risk pools--not nearly enough to make them work to cover significant numbers of the uninsured....

State high-risk pools under Senator McCain's plan are likely to go the way that current high-risk pools have gone. Currently, thirty-four states sponsor such pools, but they cover fewer than 200,000 Americans. Because money is scarce, states deliberately restrict benefits and keep enrollment low. For example, Florida's high-risk pool has been closed to new enrollees since 1991. California has rationed access to its pool by limiting the amount of time enrollees can be covered through the program and by capping enrollment. As a result, a sizable number of consumers who are too healthy to qualify for coverage through a high-risk pool will be deemed "high risk" by nongroup insurers and will face very high premiums, restricted benefits, and, in some cases, outright denials of coverage.
This is the essential problem with the McCain plan. It would kill the current system of employer-provided group coverage, leaving many people with preexisting conditions unable to buy insurance on the private market. If Palin ever does another interview after her disastrous encounter with Katie Couric, this would be a good question for her: "How would a family like yours, with a child with a disability, be able to buy nongroup coverage under the McCain-Palin health care proposal?"

Updates to Economists for Obama

Two things:

First, I redirected the tax cut calculator links to this revised site, which has the same information as before, but with a better presentation.

Second, if you scroll down and look in the left column, you'll find our new blogroll with some of my favorite sites. My colleagues may add their own choices. For economic insights in general, and in particular for smart reflections on the financial crisis, I recommend Krugman's blog and Mark Thoma's site, Economist's View.

Saturday, September 27, 2008

Deliberate Error in Bush Speech?

Floyd Norris of the New York Times made a good catch about an error in Bush's speech the other night that I have not seen noted in the blogosphere. Bush said:

"Second, as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply, yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages.
The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal."

Norris writes:
"The most jarring part of the speech was his statement that his plan called for the government to buy troubled mortgage assets “at current low prices” and hold them until the value rises. In fact, the basis of the proposal is to buy assets at well above current market value — called fire-sale prices by the Federal Reserve chairman Ben S. Bernanke — and thus recapitalize the financial system. They hope the market value will rise above what they pay, but that is not the same as buying at current low prices. Does he not understand that, or does he not want to acknowledge it?"

It's Like a College Exam in There

Staffers for the principal negotiators of the Wall Street bailout bill were asked to turn over their BlackBerries Saturday afternoon so as to prevent leaks

Friday, September 26, 2008

Risk vs. Return

Suppose if you win an election you get a payoff of one but if you lose you get a payoff of zero.
Two players are running for election and right now, given the information the median voter has, candidate O is beating candidate M. That is, the posterior of O's expected quality is higher than M's. If candidate M's actions continue to generate signals that leave his posterior to the median voter below O's, he will still lose and get zero. If he manages to generate high signals, he wins and gets one. Basically, the payoff structure generates a convex payoff structure that makes you risk-loving rather than risk averse. (Ironically, it is similar to the payoff structure of a lender who knows he is going to be bailed out from losses but enjoy the upside returns!)

So, if safe actions leave the posteriors roughly the same, the only way to win is to take risky actions that give you some chance of leap-frogging your opponent. This is what McCain is doing with the Palin pick and the "call off the debate and let me solve the bailout problem" strategies. It's kind of like an R+D model where the follower works harder if he is close enough to the leader so he can take leapfrog over him and win the race.

So, if rational choice theory predicts this, I guess it also predicts more of it in the future if the two attempted strategies fail - which they seem very likely to do. I'm trying to think of what McCain might do. Ditch Palin? Seems too drastic. So, I think he'll try to appoint a cabinet in waiting. Maybe try to get Colin Powell on board, maybe get Bloomberg to be Treasury Secretary etc. But will anyone serious want to sink with McCain when he is so obviously a wild card and likely loser? Who will take that risk for so little return?

PS Check out Jonah's great post below about mechanism design.

Thursday, September 25, 2008

...Meanwhile Back in the "Real" Economy

There's almost half a million more (493,000) whiners this week who filed initial claims for unemployment insurance. UI Claims are at their highest level since September 2001.

"Smart Friend" vs. Asymmetric Information

Earlier today, Greg Maniw posted a three-point defense of the Paulson bailout plan from someone to whom he referred only as "a smart friend".  I want to address point 2 of Mankiw's friend's argument:

2. "Taxpayers will be better off if Treasury gets warrants."

This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

For a smart guy, Mankiw's friend is making a pretty dumb argument. Sure, if everyone has the same information, then an asset with a value of $10 will cost $12 if it's required that a $2 warrant comes with it. But that totally misses the point. Based on what I've read, it appears that if everyone understood what these assets were worth, there wouldn't be any need for a bailout: the bailout is necessary because people with capital are scared witless that anything they buy will just be crud. Folks like Mankiw are constantly reminding us (and they're often right) that there's no reason to think government has better information than private parties. So how will Hank Paulson or his agents know any better than folks risking their own money?

In more concrete terms, the right way to think about the equity issue is as follows. (I'll abstract from debt-deflation spiral issues, which are no doubt important but are beside the point for this discussion.) Suppose a bailee has two assets, each of which has face value of one unit. However, actual value and face value diverge, say because the underlying security may default. The first asset is actually worth $10, and the other is actually worth $9 $8. The Treasury can't tell the difference, but the bailee can. 

Now suppose the Treasury declares that it is willing to pay $10 for one asset with a one-unit face value, with no equity transfer required. The bailee will certainly prefer to sell Treasury the $8 asset, as it will profit by $2. The bailee now has $10 in liquid capital, and Treasury books a real, long-term loss of $2. 

Now suppose that Treasury insists on getting warrants whose value is an increasing function of the loss Treasury books when it sells off the bailee's assets. Let's suppose for simplicity that the warrants' value have expected value equal to the difference between the price Treasury pays the bailee and the price for which Treasury sells the asset. Now if the bailee hands Treasury the $8 asset for $10, the bailee will expect to pay $2 later in warrants, so the bailee and Treasury each break even, though the bailee gets liquidity in the short run, which is the point. On the other hand, if the bailee hands over the $10 asset, then there will be no warrants issued later, since Treasury won't lose anything on the deal. 

In this example, the use of warrants has (1) gotten liquidity to the bailee, (2) made the bailee indifferent between transferring the two types of assets, and (3) ensured that Treasury doesn't get stuck with an adverse selection-induced loss. The moral of the story is that the use of equity claims makes truth-telling incentive compatible.

This is an example of simple mechanism design, a topic that is well understood by many microeconomists, no doubt including many smart friends of Greg Mankiw's. Obviously the real world is much more complicated than the simple example here (which I emphasize I took from Mankiw's smart friend). But the idea that the MM-type argument Mankiw's smart friend makes is at all relevant to a world full of informational asymmetries strikes me as bankrupt, tough to credit, and more than a little deflating.

Sarah Palin on Foreign Policy, or Has the Country Lost Its Mind?

It's hard to believe this woman could, with non-negligible probability, have her finger on the nuclear button four months. (Given a 40% chance of McCain-Palin victory and about a 25% chance that McCain will die, resign, or be incapacitated while in office, the odds are 1 in 10 that we will witness President Palin.) Keep in mind that this is after weeks of tutoring, and she's being asked to simply explain one of her signature campaign lines.

Pretend Suspend (Cross-Posted)

Cross-posted at PrawfsBlawg:

So far today, we have the following evidence concerning John McCain's alleged suspension of his campaign:
  1. His press office is doing its normal thing
  2. His talking heads have been on TV
  3. He gave a political speech (as if a major-party nominee could give any other type of speech this close to election day) at the Clinton Global Initiative
  4. He has claimed that bailout negotiations are going poorly, even though reports suggest the contrary
  5. He is supposedly headed to Washington to take part in a White House photo-op (I say "supposedly" because he told David Letterman the same thing YESterday, as Adam Sandler might put it)
In any case, putting it all together, I think the only appropriate term for what McCain is doing is Pretend Suspend. He and his campaign are an ever-growing farce.  

*I didn't list the fact that McCain's campaign ads are still running in multiple states, because the consensus around the net seems to be that a sincere effort to take them down would take a while. So we'll see about that one.

Wednesday, September 24, 2008

Sarah Palin on the Economy

Here's a transcript of her interview (via Atrios) on the economy with Katie Couric. It's hard to believe this is actually the vice-presidential nominee of a major political party. She can't even put together a half-coherent sentence about the economy, and that's after having been tutored by Doug Holtz-Eakin for weeks.

Stealing a bit from Yglesias, this is a pretty good approximation of Palin's answers:

Update: Here's the video. Compare and contrast:

More on Winners and Losers Under McCain's Health Plan

Last week, I posted on the complicated issues involved in assessing who would benefit from and who be harmed by McCain's health insurance proposals. The biggest element of uncertainty by far involves the question of how many employer provided health insurance (EPHI) plans are eliminated due to the possibly strong adverse-selection incentives McCain's plan introduces. 

That said, if we ignore adverse selection, the next big question is whether, in the absence of cost reductions, McCain's plan is a net bonus or cost for households.  Unlike current law, the plan would have the federal govt tax contributions to EPHI at a person's federal income tax rate (though apparently, the payroll tax would not be applied). In return, McCain would provide a refundable tax credit for people who purchase plans, whether from employers or otherwise.

Ignoring adverse selection and overall health costs, the question of whether McCain's plan would cut or raise your taxes depends on whether his credit exceeds the value of the current tax deduction given your health plan and federal marginal income tax rate (there's also the issue of state taxes, as well as bracket creep, which Don Pedro raised in comments to my initial post). In the short run, most people would benefit from McCain's plan. However, his tax credit is indexed to overall inflation rather than health-sector inflation, which means that over time, the credit's real value would shrink. The interesting question is how quickly.

The Tax Policy Center has just released some new estimates on this issue (for both candidates' plans). See their post for more, but here's the money quote vis-a-vis McCain's plan:
By 2014, the non-refundable portion of [McCain's] credit is worth less than the tax exclusion and, by 2018, income taxpayers pay $62 billion more in tax in the aggregate (although many middle-income taxpayers still come out ahead under the proposal).
For more, see the TPC post.

Take That, Campbell Brown!

A rare quote-of-post-in-full:

Suspending The Palin Debate?

The other shoe drops. CNN reports:

McCain surrogate Sen. Lindsey Graham tells CNN the McCain campaign is proposing to the Presidential Debate Commission and the Obama camp that if there's no bailout deal by Friday, the first presidential debate should take the place of the VP debate, currently scheduled for next Thursday, October 2 in St. Louis.

In this scenario, the vice presidential debate between Joe Biden and Sarah Palin would be rescheduled for a date yet to be determined, and take place in Oxford, Mississippi, currently slated to be the site of the first presidential faceoff this Friday.

A "date yet to be determined." Let me guess: November 5th. I mean: why does she need to debate at all? She won't give press conferences, so why should she debate?


I just wanted to let you know that, due to the financial crisis currently roiling our nation, I have decided to suspend my professional activities until further notice. 

Among other things:
  • I am considering going to Washington, DC, to request a meeting with President Bush and other irrelevant players in the bailout package. 
  • I do not expect to attend Friday night's foreign policy debate at the University of Mississippi.
In light of the very serious challenges facing our nation, this is not a time for useful activity by me. If you need to reach me, please make a blog posting and I will respond within seconds.

Yours in liquidation,


The FP Debate Must Go On!

From a cross-post at PrawfsBlawg:

I've wanted to post on the financial crisis. Some of the issues here are simple, but others are quite complicated, and that's why I haven't done posted on this to date. Hopefully I'll get some time to put something up fairly soon.

In the meantime, though, I want to note that I think that

(a) it would be a mistake for the campaigns to cancel Friday's debate, as McCain has just proposed, and

(b) it would be an even bigger mistake for them to change the debate topic to the financial crisis.

From what I can tell, it's critical that there be a sensible bailout. Both Democrats and Republicans on the Hill have signaled rather clearly that this will not happen unless McCain gets on board. And no one should be surprised by that, given these sorts of antics from supposedly new-thinking conservatives. So it makes a lot of sense to me that the two campaigns should agree to a joint statement of principles for a bailout, effectively taking this issue off the table as a nuclear weapon (no doubt each will still use it as a conventional one). According to the Obama campaign, such discussions are under way, and I haven't seen a denial from Team McCain. The key thing is for both candidates to either vote for whatever package ends up passing, or to declare that they would if they voted.

But neither of these guys is president yet, and neither is particularly a congressional force on banking policy. So it seems to me that the bailout legislation can be written without their direct participation. In fact, having them in the room probably just makes things worse by tempting each to demagogue the issue.

For the same reason, switching the debate topic to the crisis, as I've seen some Obama fans propose in the last hour or so, is a terrible idea. Given a statement of principles and a commitment to vote for a bill that satisfies them, the best thing would be for the candidates to avoid this topic til the vote is over; then they can say what they like, blame each other, whatever.

In the meantime, the voters deserve to see the candidates take real questions. Foreign policy is obviously a critical topic. Especially given some voters' concerns about Obama's experience, and others' concerns about McCain's repeated mistakes concerning the most basic foreign policy facts, this show ought to go on. And that view is only strengthened by the bizarre chokehold that McCain and Palin have placed on the vast majority of serious media questions.

McCain Economic Adviser Too Cowardly to Debate

This is pretty funny. McCain economic adviser Kevin "Bubbles" Hassett is hiding in his hotel room because he's too scared of Obama-supporter Brad DeLong to show up at their scheduled debate on the candidates' economic programs. Apparently, Brad strikes fear into his heart because in the past he has ridiculed Kevin's 1999 prediction that the Dow would hit 36,000 within 3-to-5 years.

Tuesday, September 23, 2008

Graphical Representations of Competing Tax Plans

As discussed in the Freakonomics blog on NYT, graphical representations of the competing tax plans differ in their ability to convey an accurate and informative picture of the true impact of each candidate's tax plan. Viveka Weiley's graph at chartjunk effectively combines the tax effect on different income brackets and the percent of the population those brackets represent:

Obama Outlines 4 Principles for Bailout

Paulson, Bernanke, and Cox received a deservedly skeptical reception on Capitol Hill today, which is hardly surprising considering the Bush Administration's drunken sailor response to blank checks with no oversight. In a press conference today, Obama outlined four principles the bailout package must meet:

1) Prevent taxpayer dollars from being used to pay Wall Street salaries or bonuses;
2) Establish a bipartisan, independent board to oversee the use of funds;
3) Ensure an equity stake for the government/taxpayers in any firms assisted; and
4) Provide assistance to families struggling to pay their mortgages and stay in their homes.

Obama also proposed a "Financial Stability Fee" to recoup some of the costs of the bailout after the crisis has subsided, but did not provide further detail.

Economists Against the Paulson Bailout Proposal

A letter signed by many economists was sent to Congress today. The effort was coordinated by Paola Sapienza at Northwestern. Here's the text:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

Monday, September 22, 2008

Krugman Discusses Paulson's Bailout Bill on Olbermann

Paul Krugman discussed Paulson's bailout proposal on Olbermann's countdown, stating that "this is a very scary financial crisis" but expressing serious concerns about the "very odd" bill and Paulson's arrogance in demanding carte blanche authority to commit taxpayer funds.

The McCain Campaign Doth Protest Too Much

The Politico:

Sen. John McCain’s top campaign aides convened a conference call today to complain of being called “liars.” They pressed the media to scrutinize specific elements of Sen. Barack Obama’s record.

But the call was so rife with simple, often inexplicable misstatements of fact that it may have had the opposite effect: to deepen the perception, dangerous to McCain, that he and his aides have little regard for factual accuracy.

Obama's Speech Today on the Economy

The text is here. It starts like this:

The era of greed and irresponsibility on Wall Street and in Washington has led us to a perilous moment. They said they wanted to let the market run free but instead they let it run wild, and in doing so, they tramped our core values of fairness, balance, and responsibility to one another. As a result, we are facing a financial crisis as profound as any we have faced since the Great Depression. As a result, your jobs, your savings, and your economic security are now at risk.

This week, we must work quickly, in a bipartisan fashion, to resolve this crisis and avert an even broader economic catastrophe. And as we do act, Washington must recognize that true economic recovery requires addressing not just the crisis on Wall Street, but the crisis on Main Street that so many of you have been feeling in your own lives long before the news of last week. We need a plan that helps families stay in their homes, and workers keep their jobs; a plan that gives hardworking Americans relief instead of using taxpayer dollars to reward CEOs on Wall Street. And we cannot give a blank check to Washington with no oversight and accountability when no oversight and accountability is what got us into this mess in the first place.

New Features on Economists for Obama

I added the new line at the bottom of each post which allows you to share the post with friends by e-mail or via Digg, Facebook, StumbleUpon, or del.icio.us.

It took me an embarrassingly long time to figure out how to do this. Thanks to Chris Blattman, who runs the best development economics blog around, for pointing me to the FeedFlare feature available from Feedburner.

Sunday, September 21, 2008

Conflicts of Interest for the Bailout Plan

McCain adviser Martin Feldstein was the runner-up for the Fed chairmanship, the job now held by Ben Bernanke. When the AIG bailout was announced, I wondered if it would have been possible had Feldstein been heading the Fed, given that he has been on AIG's board since 1988. What would Feldstein have done? Bowed out and let Vice Chair Don Kohn take over?

And yet, Treasury Secretary Paulson now has conflicts of interest that are at least as great. He's the former CEO of Goldman Sachs, and as Yglesias points out, he'll be unemployed in just 4 months time and presumably looking for a new job with a Wall Street company. How could Congress possibly give him $700,000,000,000 to buy bad debt of his choice from companies that will include his former and probably also his very-soon-in-the-future employers?

Obama on the Treasury Proposal

The Bush Administration is playing a game of chicken with its bailout proposal. It's essentially saying to Congress: I need $700 billion to buy bad debt. Give me the money, no questions asked, or the collapse of the financial system will be on your shoulders.

In his statement, below, Obama says "No deal, but let's talk." What will McCain say? This is a tough call for Holtz-Eakin and Gramm.

My guess is that the Administration will push for a vote very quickly, the Democratic leadership will roll over and agree, the Paulson proposal will pass--with vague promises of action on the points Obama raises--and voters will be pissed. Neither Obama nor McCain wants to be on the receiving end of that anger.

From the Obama campaign:

Senator Obama recently issued a Statement of Principles for the Treasury Proposal...

The era of greed and irresponsibility on Wall Street and in Washington has led to a financial crisis as profound as any we have faced since the Great Depression.

But regardless of how we got here, the circumstances we face require decisive action because the jobs, savings, and economic security of millions of Americans are now at risk.

We must work quickly in a bipartisan fashion to resolve this crisis and restore our financial sector so capital is flowing again and we can avert an even broader economic catastrophe. We also should recognize that economic recovery requires that we act, not just to address the crisis on Wall Street, but also the crisis on Main Street and around kitchen tables across America.

But thus far, the Administration has only offered a concept with a staggering price tag, not a plan.

Even if the Treasury recovers some or most of its investment over time, this initial outlay of up to $700 billion is sobering. And in return for their support, the American people must be assured that the deal reflects some basic principles.

• No blank check. If we grant the Treasury broad authority to address the immediate crisis, we must insist on independent accountability and oversight. Given the breach of trust we have seen and the magnitude of the taxpayer money involved, there can be no blank check.

• Rescue requires mutual responsibility. As taxpayers are asked to take extraordinary steps to protect our financial system, it is only appropriate to expect those institutions that benefit to help protect American homeowners and the American economy. We cannot underwrite continued irresponsibility, where CEOs cash in and our regulators look the other way. We cannot abet and reward the unconscionable practices that triggered this crisis. We have to end them.

• Taxpayers should be protected. This should not be a handout to Wall Street. It should be structured in a way that maximizes the ability of taxpayers to recoup their investment. Going forward, we need to make sure that the institutions that benefit from financial insurance also bear the cost of that insurance.

• Help homeowners stay in their homes. This crisis started with homeowners and they bear the brunt of the nearly unprecedented collapse in housing prices. We cannot have a plan for Wall Street banks that does not help homeowners stay in their homes and help distressed communities.

• A global response. As I said on Friday, this is a global financial crisis and it requires a global solution. The United States must lead, but we must also insist that other nations, who have a huge stake in the outcome, join us in helping to secure the financial markets.

• Main Street, not just Wall Street. The American people need to know that we feel as great a sense of urgency about the emergency on Main Street as we do the emergency on Wall Street. That is why I call on Senator McCain, President Bush, Republicans and Democrats to join me in supporting an emergency economic plan for working families – a plan that would help folks cope with rising gas and food prices, save one million jobs through rebuilding our schools and roads, help states and cities avoid painful budget cuts and tax increases, help homeowners stay in their homes, and provide retooling assistance to help ensure that the fuel-efficient cars of the future are built in America.

• Build a regulatory structure for the 21st Century. While there is not time in a week to remake our regulatory structure to prevent abuses in the future, we should commit ourselves to the kind of reforms I have been advocating for several years. We need new rules of the road for the 21st Century economy, together with the means and willingness to enforce them.

The bottom line is that we must change the economic policies that led us down this dangerous path in the first place. For the last eight years, we’ve had an “on your own-anything goes” philosophy in Washington and on Wall Street that lavished tax cuts on the wealthy and big corporations; that viewed even common-sense regulation and oversight as unwise and unnecessary; and that shredded consumer protections and loosened the rules of the road. Ordinary Americans are now paying the price. The events of this week have rendered a final verdict on that failed philosophy, and it is a philosophy I will end as President of the United States,” said Senator Barack Obama.

Cheerleader for a Team of Arsonists

Austan Goolsbee on CNN about John "I'm always for less regulation" McCain's about-face on regulation:

It’s good Senator McCain has suddenly become a champion of financial oversight and regulatory oversight. He, George Bush, Phil Gramm, and their crew have been about burning down the rules of the road and trying to deregulate the financial environment. It’s a little strange for a guy who was cheerleader for a team of arsonists to now be coming forward and saying he’d be a great fire department chief.

McCain Approves New Ads on Saturday Night Live

Very funny, and not far from reality:

On the Bailout Plan

I'm watching Treasury Secretary Paulson on Fox News Sunday. Chris Wallace is asking all the right questions, and Paulson doesn't have good answers. Let's see if he has any better answers when he appears on NBC, CBS, ABC, and CNN later this morning. For informed commentary on the plan, I suggest Krugman and Delong, especially "No Deal" by Krugman, and also Sebastian Mallaby's column today. Here is also an excellent extended discussion of what's wrong with the plan.

The plan is not complicated: it would give the Treasury Secretary a checkbook enabling him to spend $700 billion of taxpayer money to buy mortgage-backed assets from financial institutions. This would be a transfer of money from taxpayers to the stockholders and executives of these companies.

It's hard to imagine that Obama, or McCain for that matter, could support such a plan. Neither candidate will want to end up supporting a plan which the other candidate scorns as a bailout of stockholders and the corporate executives who got us in this mess in the first place.

As Delong points out, even if you think this is the right plan, and you have total confidence in Paulson, there's still a 40% chance McCain will be president in 4 months. Would you want Treasury Secretary Phil Gramm, a candidate for "lead perp" in the crisis, to have a blank check worth $700 billion in his hands?

An awful article in the NY Times today which presents the plan as a fait accompli, quotes Paulson:

There was only one way that we could reassure the markets and deal with a very significant and broad-based freezing of the credit market.
This is not correct. There are other options. Mallaby's column has a good discussion.

Saturday, September 20, 2008

Reader Mailbag: The Tax Calculator

One reader wrote to us:

Thanks for building such a great and informative website. I have sent it to my entire family as we are in the midst of an important family debate about this year's election.

Quick question: Why can't I put in my families income as $300,000 or 400,000 in the tax calculator? Is this a blind spot in the Tax Policy Center's research? Or is Obama planning on taxing the hell out of this group of people and doesn't want to publicize it?

Either way it seems really weird that this area: 2 earner families who make between 250,000 and 450,000 dollars have to pick between either making 200,000 or 500,000 on the calculator. Is it possible to calculate the tax implications with more precision?
While we endorse the tax calculator, we didn't put it together or calculate the underlying numbers. The numbers come from the non-partisan analysis of the Tax Policy Center (TPC), and we don't know the people who built the calculator.

(A little more background: while I was blogging at the Democratic National Convention, it became clear that a key part of McCain's strategy was going to be to lie shamelessly about Obama's tax plan, and I realized that producing an online calculator was a good idea. I started
working on a calculator using the TPC data but discovered through a comment on our blog that it had already been done. The calculator we link to presents exactly the same information I would have used.)

The figures in the calculator are taken from the TPC's estimates for some typical taxpayers, with incomes at a select number of levels, using average characteristics at those incomes. They calculate these figures using a large dataset with a sample of IRS returns from a recent year. Obviously the estimates they produce are only a very rough guide to what someone with a given income will actually pay in taxes. That's because no one has average characteristics. For example, mortgage interest payments, charitable donations, and state tax deductions will all vary a great deal and have a big effect on tax payments. Plus the mix of types of income (wage, dividend, capital gains, etc.) makes a substantial difference.

Why does TPC use the income levels it does? I'm not sure. These are the levels it always uses for this kind of analysis. It's certainly not due to any Obama-favoring conspiracy. Not many taxpayers have over $200K adjusted gross income (less than 4%). For people at the high end, my guess is the TPC estimates are an especially rough estimate for a particular taxpayer, for all the reasons mentioned above. That's to say that even if TPC broke down their figures more and gave you tax incidence estimates at, say, incomes of $250K, $300K, etc., I doubt they would really give you a much precise estimate of how much you would pay.

For details of the Obama tax proposals, see this article by his advisers or Obama's site. In my original post about the calculator, I link to the TPC tables on which it's based.

Friday, September 19, 2008

As a Lobbyist, Rick Davis Claimed that Fannie and Freddie Reduce Systemic Risk

It takes unbelievable gall for McCain to try to pin Obama to Fannie and Freddie when his current campaign manager and numerous other McCain campaign officials lobbied (see Halperin and Aravosis for some great documentation) on behalf of the GSEs.

But not only did Rick Davis lobby for Fannie and Freddie, I dug up (really a simple google search) this letter Davis wrote to OFHEO in 2001 (PDF) where he makes the argument that not only did Fannie and Freddie not pose a threat of systemic risk but he actually claims that they decreased systemic risk:

"Still others have and will try to make the argument to OFHEO that Fannie Mae and Freddie Mac create systemic risk. Those that say that do so either because they are hostile to homeownership or because they have competitive needs to try to hamper the two most efficient private sector engines for homeownership. The Homeownership Alliance hopes that OFHEO will scrutinize the motives of those who make such claims.
Any objective analysis of the roles played by Fannie Mae and Freddie Mac would show that they in fact reduce systemic risk while anchoring a housing finance system in which consumers have the upper hand."

How Rick Davis even has a campaign job after writing that in the aftermath of the Fannie and Freddie disaster is beyond me. Could you imagine if that was David Plouffe? Maybe some journalist can ask McCain about Davis' quote.

But I guess making wrong predictions that should humiliate most of us actually is a badge of honor with McCain (I'm thinking of you Kevin Hassett --author of "Dow 36000" and McCain advisor)

How Much is a Trillion?

I've now seen the following argument made in a couple places in the last few days: because the costs of the financial-system bailout are so big, neither candidate will have the money to implement his proposals if elected. 

Here's Ben Smith, for example:

Mike Allen reports that Hank Paulson will announce a trillion dollar plan shortly.

A consequence of this, and of the crisis: Whoever is in office next year will likely have to toss his taxing and spending plans out the window.

Maybe this is true. But if it is, then the MSM need to do a better job of explaining why a trillion bucks is such a huge amount. To understand why, let's take a look at a key excerpt from the latest analysis by the widely-accepted-as-refereee Tax Policy Center:
Although both candidates have at times stressed fiscal responsibility, their specific non-health tax proposals would reduce tax revenues by an estimated $4.2 trillion (McCain) and $2.9 trillion (Obama) over the next 10 years. Both candidates argue that their proposals should be scored against a "current policy" baseline instead of current law. Such a baseline assumes that the 2001 and 2003 tax cuts would be extended and the AMT patch made permanent. Against current policy, Senator Obama's proposals would raise $600 billion and Senator McCain's proposals lose a similar amount.
The point here is that McCain's plan is currently forecast to cost $1.3 trillion more than Obama's. In past analyses, I believe that number has been $1.4 trillion; it certainly has consistently been more than a trillion.

So, if being down a trillion bucks relative to expectations is so much that Obama should be considering scrapping his whole deal, then it seems to me that for the last several months, McCain should have been facing articles noting the impossibility of his plan. (I should note that Megan McArdle argues that the Wall Street meltdown means that at least in the short run Obama won't be able to raise much revenue by increasing the highest-income bracket's marginal rate; I don't know whether Megan's right empirically, but her argument's a plausible one.)

I could go on about how, while a trillion dollars is a lot, we've added X-trillion dollars in debt over the last 7 years, and so on. 

I want to be clear that I'm not accusing the press of bias here. Rather, I think the issue is that people look at the same facts differently when they occur during a crisis versus day-to-day situations. 

I do hope that folks in the media will think hard about this issue: if a trillion dollars is so much money, then even leaving aside distributional issues, John McCain's tax plan is and has always been way irresponsible.

Obama's Ad On McCain's Economic Advisers

McCain Voted to Raise Taxes 477 Times

Let's go through the lies and distortions about Obama's tax plan that McCain is made in a speech this morning in Wisconsin:

McCain Distortion #1: "At the beginning of this campaign he promised to raise taxes on your savings and investments."

Truth: This refers to capital gains and dividend taxes. The statement is false, unless the people he's addressing are exclusively people who make over $250K. Here's what Obama's advisers said in a Wall Street Journal article about his plan:

Sen. Obama believes that one of the principal problems facing the economy today is the lack of discretionary income for middle-class wage earners. That's why his plan would not raise any taxes on couples making less than $250,000 a year, nor on any single person with income under $200,000 -- not income taxes, capital gains taxes, dividend or payroll taxes.
The top capital-gains rate for families making more than $250,000 would return to 20% -- the lowest rate that existed in the 1990s and the rate President Bush proposed in his 2001 tax cut. A 20% rate is almost a third lower than the rate President Reagan set in 1986.

The tax rate on dividends would also be 20% for families making more than $250,000, rather than returning to the ordinary income rate. This rate would be 39% lower than the rate President Bush proposed in his 2001 tax cut and would be lower than all but five of the last 92 years we have been taxing dividends.
The "At the beginning of this campaign" part of the phrase is probably intended to refer to the fact that initially Obama only said that his plan would have no tax increases for those making under $250K, and he did not explicitly say (as the WSJ article does) that this included dividend and capital gains taxes as well as tax on wage income.

McCain Distortion #2: "He said he won’t raise taxes for most people but he has voted 94 times in his short Senate career for tax increases and against tax cuts."

Truth: As Factcheck.org has documented, the 94 figure is bogus. And as Jason Furman has pointed out, if you count this way, McCain has voted to raise taxes 477 times.

McCain Deception #3: "He said he would only tax the rich, but he voted this year to raise taxes on those making just $42,000."

Truth: Factcheck.org has explained that this was a vote on a meaningless resolution that has nothing to do with what Obama is actually proposing.

For the full truth on Obama's tax plan, see the links from this post.

Thursday, September 18, 2008

Correcting Some Misperceptions About McCain's Health Plan

Update, Saturday night September 20: Don Pedro points me to a Brad DeLong post quoting Robert Carroll of the Tax Foundation. According to Carroll, the McCain plan would keep "the payroll tax exclusion for employer-based health insurance". This is news to me, though Don Pedro tells me it's in one of the Tax Policy Center's analyses of McCain's proposals. This means that the McCain plan would be less likely to crash EPHI via adverse selection (how much less is an empirical question the answer to which I do not know). It also means that the McCain plan would be less of a hit to people who continue to receive EPHI than is described below. Over time, the fact that the McCain plan's credit would be indexed to the CPI rather than to health-specific inflation still means that the plan's would tend to be less generous than current policy, though it would take longer for that effect to occur than my discussion below suggests. There are other specific ways in which the analysis below would need to be modified in light of this difference (e.g., which taxpayers would benefit/be harmed least/most), though the qualitative discussion below remains accurate. One last note in light of this new (to me) information is that, at least in the short run, it seems that the McCain plan's fiscal impact would have to be considerably more expensive than current policy. You can't give people more than they get now and save money, unless there are sizable reductions in health expenditures. And any such reductions would likely take some real time to occur--by which point the real value of the McCain credit would have eroded. In any case, my original post follows.

In this post I want to discuss some misperceptions that a number of Democrats and Obama supporters have exhibited concerning McCain's health plan. First, I want to emphasize that it is true that McCain's plan would tax health benefits; there's nothing wrong with pointing that out. Second, though, a key comparison I've seen a number of people make is the wrong one. Much of the criticism I've seen of McCain's plan is based on the observation that the average family HI plan costs something like $12,000, which is more than the $5,000 credit McCain proposes. Brad DeLong makes this argument intemperately here, for example; Matt Yglesias picks it up with some bonus philosophical musings. The discussion below shows that both of these otherwise very smart guys are making a very dumb argument (and doing it in nasty tones, I should add).

This post is very long, so I will summarize my conclusions here. The moral of the story is that if it were implemented, McCain's plan could lead to major changes in the way health insurance is provided in the US. For example, it could lead to huge reductions in the share of people who get coverage through employers, greatly changing the degree of risk pooling and adverse selection, and possibly leading to substantial increases in premium costs for people working for small and mid-sized employers. Without knowing the answers to these questions, it's very hard to know how to evaluate the plan's net costs to any given set of people.

In addition, it seems clear that the plan would have very heterogeneous effects on the out-of-pocket costs faced by different people. Those with middle incomes living in states with high income taxes would be hit hardest, while those living in no-income tax states and having very low or relatively high incomes would benefit in the short run. However, unless health cost inflation is somehow greatly reduced, McCain's plan would be a net loser for virtually everyone in just a few years.

Personally, I see no reason to place the sort of general-equilibrium gamble that McCain proposes. I think the plan's indexing to overall inflation is another example of the McCain campaign's attempt to trick people into thinking they're getting a sports car when they're really getting a jalopy. But that's no reason not to get our facts right.

Anyway, let me turn to the economics of the issue. There are two key economic reasons that health insurance is provided by employers in today's US economy:

  1. In the absence of some other pooling mechanism, risk pooling gives employers an obvious advantage. Thus, employees benefit when health insurance is purchased by employers instead of individually.
  2. The tax deduction provides a very strong incentive to buy health insurance (HI) through employers, with pre-tax dollars.
The features of the McCain plan that I'll discuss here are that it will
  1. Eliminate the tax deduction for employer-provided health insurance (EPHI)
  2. Add a tax credit in the amount of $2,500 for singles and $5,000 for married couples. As I understand it, this credit would be refundable, in the sense that if a person paid less than the credit amount for a policy, the balance could be deposited in a health savings account (HSA).
For the moment, I'm going to ignore reason 1, risk pooling advantages, for employer-provided HI. That's not because risk pooling isn't extremely important, but rather because the confusion about McCain's plan stems from misunderstanding the current tax treatment of EPHI.

Under the current system, employees receive some compensation through cash and some through fringe benefits. For simplicity, assume the only fringe benefit is HI.

Let's call the (pre-tax) value of EPHI, B (for benefits); for an employer paying 75% of the average HI premium of $12,000, the value of B would be B=$9,000, with the rest of the premium being paid for out of cash compensation by the employee. Let's call the pre-tax amount of cash compensation C; as a concrete example, I'll use the value C=$50,000. For the moment, I will ignore the fact that we have progressive taxation and assume that there is a single tax rate, T. I'll also assume that employees place a value of exactly one dollar on each dollar spent on EPHI. All of the above assumptions are empirically wrong, but making them will simplify the discussion, and I'll return to them below.

An employer's cost of paying an employee C in cash and B in benefits is C+B, or $59,000 in our example. This means that an employer is equally happy paying $59k in cash or $50k cash plus $9k in HI. If there were no EPHI subsidy and no risk-pooling gains from purchasing HI through employers, then our employer in this example could just as well pay $59k cash and continue to attract the same workers.

Now, the pre-tax value to workers of the 50cash+9fringe package is higher than $59k. To see why, note that under the current system, the value of *after*-tax compensation is in our concrete example is

(1)        A = (1-T)*$47,000 + $12,000

The taxable compensation here is $47,000 because workers must pay tax on only the part of cash compensation that isn't spent on EPHI, i.e., $50,000-$3,000=$47,000. The $12,000 part in equation (1) arises because that's the value of the EPHI plan ($9,000 comes directly from the employer, and $3,000 is paid by the employee out of pre-tax compensation).

Now consider a company that paid only cash, i.e., made no employer contributions to EPHI, so that B=0 for this employer. Imagine that employees have access to the very same plan that they did above, but they have to pay for it out of pocket, with no tax subsidy. If this company paid the worker $50,000, then the value of the worker's after-tax compensation would be only (1-T)*$50,000, which is less than A in equation (1) as long as the tax rate is greater than 0 (which it is).

The proper inference to draw from this example is that a company that didn't want to pay for HI would have to pay a higher salary to its workers. If it didn't, it would not be able to attract workers of the same quality. The next question is, What is the amount of fully taxable cash compensation, C', that would leave a worker exactly as well off as if she received A in equation (1)? To answer this, we simply set

(1-T)*C' = (1-T)*$47,000 + $12,000

and solve for C'. The answer is that

(2) C' = $47,000 + $12,000/(1-T).

Suppose that the tax rate is 0.4 (more on this below). Then 1-T=0.6, and $12,000/(1-T) = $20,000. And this implies that C'=$67,000. In other words, the compensation package that costs the employer $59k has a pre-tax value of $67k to workers, for a difference of $8k in pre-tax value. Since the tax rate is 0.4 in this case, the after-tax value of the additional $8k is (1-0.4)*$8k, or $4,800. What this means is that if the worker is paid $59k in cash, all taxable, and is then given $4,800 in a (nontaxable) tax credit by the government, the worker will be just as well off as with the cash-and-fringe compensation package.

Another, much simpler, way to see this is to note that the value of the current tax deduction is simply the product of the tax rate, T, with the amount of compensation that is not taxed. Since this amount is $12k in our example, at a tax rate of 0.4, the value of the subsidy is 0.4*$12k=$4,800. So, in this case, the employee's net cost is $7,200, not $12,000. So if the price of the HI policy were the same under either policy (a huge if to which I return below), the net cost to the employee would be $7,000 with McCain's credit of $5,000 and $7,200 under the current system. In other words, the proper comparison in this example is $4,800 with $5,000, not $12,000 with $5,000. More generally, the comparison should be T*$12,000 with $5,000, where T is the worker's marginal tax rate.

This discussion shows that the 12-versus-5 critique of McCain's plan compares the wrong numbers. It assumes that the EPHI subsidy has the value of the full $12k in policy costs, but the value of the tax subsidy is much less: the difference between the out-of-pocket cost of the policy with and without the subsidy.

As noted above, though, McCain's plan would index the value of his credit to the overall inflation rate, not to health inflation. According to this organization, "Since 2000, employment-based health insurance premiums have increased 100 percent, compared to cumulative inflation of 24 percent". If the same thing happened over the next 7 years, the cost of a $12,000 HI plan would become $24,000, while the value of the McCain tax credit would rise to only $6,400. With a value of T=0.4, this means that the current subsidy value is $9,600 (0.4 times $24k), which is $3,200 more than McCain's subsidy in new prices (and roughly $2,600 in today's). That's a huge hit.

There are several further issues to discuss:
  1. By all accounts, the value of the McCain credit would be indexed to the consumer price index (CPI), not a health-costs price index. This is very important because health costs have typically risen much more quickly than the CPI. For example, one estimate I've seen is that health inflation for 2007 was 6.9%, or roughly twice the CPI. No doubt, McCain's advisers would claim that by indexing only to the CPI, they are going to induce people to be more price-sensitive. There's obvious logic to this argument, but it's hard to explain the fact that health inflation regularly has exceeded overall inflation with this sort of logic. The current system has been in place for many years, and if anything, in terms of services (not expenditures on them), it's become less generous, not more, in recent years. So it seems very likely that health costs will continue to rise more quickly than the CPI, in which case the real value of the McCain credit would shrink. See point 5 below for more on this issue.
  2. Under the McCain plan, what would happen to wages? The current EPHI subsidy is a subsidy for a particular good, health insurance expenditures, not a wage subsidy. The only way to get the subsidy is to purchase HI through employers, which helps explain the prevalence of EPHI: even ignoring risk pooling, why buy something in an unsubsidized way when you can buy it in a subsidized way? Since the current system is not a wage subsidy, eliminating it should not affect employer costs (except through whatever general equilibrium effects arise from changes in the use of health care, costs of policies, etc). If employers did stop offering HI plans, in the new labor market equilibrium they would simply pay workers the total employer cost of all compensation previously paid, i.e., $59k in the above example. If employers continued to offer HI plans, say due to risk pooling advantages, one would expect them to pay a total of $59k in any combination of cash and fringe, all of which would then be taxed.
  3. Under the McCain plan, would employers continue to offer HI policies? This is a difficult question to answer in the absence of detailed evidence. If there were no adverse selection problems, then one would expect employers to continue offering HI plans if employers have a cost advantage in purchasing them relative to individual employees. However, the main argument for an equilibrium cost advantage is the *existence* of adverse selection problems. Therefore, it seems reasonable to think that some employers, especially small but possibly mid-sized and larger ones, would stop offering HI policies. The adverse selection argument here is standard. If employers can get a better deal, it's because there's reason to think that low-risk people don't opt out of EPHI. The current reason for this is easy: the tax subsidy. Even if you're receiving less than the full actuarial value of the cost of an EPHI plan, the tax subsidy encourages you to retain coverage. Once the subsidy is gone, one can expect lower-risk, healthier people to exit employers' group plans and look for cheaper plans on the individual market (if these exist; more below). Thus while I'm not certain that McCain's plan would destroy the EPHI system, it strikes as completely plausible that it could, at least for some employer-size classes.
  4. Under the McCain plan, would overall health costs fall? By making its tax credit refundable, the McCain plan is essentially the same as saying "here's money, spend it how you like", provided that people buy some sort of HI plan, however minimal its coverage. That means that people will pay $1 for $1 worth of HI coverage, rather than the current (1-T)*$1. The higher a person's current marginal tax rate, the greater the incentive to reduce her HI plan costs. This means that the McCain plan will encourage those with relatively high incomes to buy so-called catastrophic plans, those with high deductibles and copays. To the extent that people then choose to decline treatment or search out less expensive treatments than those prescribed by their doctors, total health care utilization would fall, lowering costs. One would also expect more risk-loving people with lower incomes to do the same thing. People who don't fully appreciate the health risks they face could find themselves under-insured, leading to the Samaritan's dilemma: people show up at doctors' offices and emergency rooms without the ability to pay and are treated anyway. This kind of situation is the classic privatized gains-socialized losses picture and would tend to increase costs if people delay care until it is more costly.
  5. Does McCain's plan pay for itself? The answer to this question depends on two key things. First, if McCain's plan does not affect health costs but reduces the total out-of-pocket costs to consumers of buying HI, then it will necessarily add to the deficit: you can't give people more than they're getting now without reducing costs and save money in the process. Second, if the plan reduces health costs, then in principle it could both reduce out-of-pocket costs and reduce the deficit. The opposite is also true of course: if the plan screws up the HI market via increased adverse selection, we could wind up with increased total costs of a given quality of care, both increasing out-of-pocket costs and increasing the deficit.
  6. Would the McCain plan increase or decrease people's net costs of health insurance? Essentially, this question asks whether Obama partisans' criticism that the McCain plan taxes health insurance (which it certainly does) is appropriately balanced by a defense that McCain's plan reduces net costs. Leaving aside the issues of adverse selection and health costs discussed in points 2 and 3 above, there are two key issues here:
A. What is a person's marginal tax rate?

As noted above, the value of the current subsidy is the product of a person's marginal tax rate and the total (employer-paid plus employee-paid) cost of the HI plan. I'll continue to focus on a family plan, assuming that the total cost is $12,000. The relevant marginal tax rate is the sum of the employee's federal income-tax marginal rate, her state rate if applicable, and the payroll tax.

The possible federal income-tax marginal rates are 0, 0.10, 0.15, 0.25, 0.28, 0.33, and 0.35. State marginal income tax rates range from 0, since many states have no income tax, to roughly 0.10 (e.g., places like California and DC). Let's split the difference and consider the case of 0.05. The payroll tax is a total of 0.153. Only half of this is paid out of employee funds, with the other half paid by employers. It's a truism of introductory microeconomics that this distinction is irrelevant; what matters is the total impact of the payroll tax, which is 0.153. (There's a much deeper question that has to do with whether one should regard payroll taxes as being taxes or simply forced investment in/purchase of Social Security and Medicare coverage; it's true that some people's SS benefits would rise due to taxation of their now-cash compensation for HI, but I will ignore that for this discussion.) Anyone who earns more than the cap has a payroll tax of 0.029 (the Medicare part only); everyone with a federal marginal rate above 0.25 will be over the cap, and virtually everyone with a 0.10 rate will be below the cap.

Putting all this together means that our lowest total marginal rate is 0.153 (federal rate of 0.10, no state income tax, and payroll tax of 0.153), and our highest is 0.503 (federal=0.25, state=0.10, payroll=0.153). I note that because the people with the highest federal rate don't pay the full payroll tax, their marginal rate for HI subsidy purposes will be between 0.379 and 0.479 (the lower being with no state income tax, the higher being with a state mtr of 0.10).

Someone with a marginal rate of 0.153 gets a subsidy value of roughly $1,800 from a $12,000 plan, while someone with a marginal rate of 0.503 gets a subsidy value of roughly $6,000 from this plan. Thus even if we assume all plans are priced the same after McCain's plan takes effect, there is a LOT of variation in the net effect of the McCain plan, both in dollar terms and in whether his tax credit makes up for the loss of the current tax subsidy. One thing worth noting, though, is that (a) few people in the 0-rate federal bracket likely receive EPHI benefits, which makes McCain's plan even better for them, but (b) these folks' ability to pay more than the amount of the McCain credit for a plan is likely very limited due to their low incomes, so they are likely to get a very low-quality plan (still better than nothing, of course).

The typical person paying more under McCain's plan would be middle-income (federal marginal rate of 0.25), with earnings below the payroll tax cap (i.e., below roughly $104k), and living in a state with a sizable income tax. The typical person paying less would be living in a state with a low income tax rate, or with either very low or high income (in the first case, the federal marginal rate is low, and in the second case the person is above the SS cap).

Make sure to read point C below!

I note also that the $12k figure is an average, which means there's lots of room for people to do better or worse than the above analysis discusses.

Note: I don't think the point about geographical variation has been much noted. A related question is whether states would follow the federal lead in eliminating the EPHI tax subsidy, as I've assumed. If they did, they'd have increased tax revenue. If not, more employees would benefit from the McCain plan.

B. What happens to the out-of-pocket costs of a health insurance plan?

Quite apart from the questions discussed in points 3-4 above, one would expect the price of HI plans to change under the McCain plan. This is because the current system subsidizes each dollar spent on HI, which shifts the demand for HI (actually, it rotates the HI demand curve out and to the right from its horizontal-axis intercept). In a competitive market, this could be expected to increase the equilibrium price of HI plans. No one seriously thinks this market is competitive, but no doubt we see at least some of this effect relative to a no-subsidy world. Because the McCain credit is similar to cash, it would create something a lot like a no-subsidy world, and therefore we would expect the supplier's price to fall relative to the current supplier's price (with today's subsidy in place, the supplier's price exceeds the consumer's price by the amount of the effective subsidy, i.e., T times the cost of the plan). How much this price would fall depends critically on whom the marginal consumer is, and I have no special insight on this front.

Equally important is the adverse selection issue. If McCain's plan induces many employers to drop coverage and/or causes many employees to seek coverage in the nongroup market, then that would put upward pressure on the consumer price paid for HI plans.

C. What happens to health and overall inflation?
Let's follow the post-2000 numbers cited above and assume that health cost inflation rises 100% over the next 7 years, and overall inflation by only 24%. This means that the value of the McCain credit would be $6,400, while the cost of today's $12,000 HI plan would be $24,000 (other things equal).
Because $6,400 is less than 0.27 of $24,000, if health inflation continues apace, then other things equal, everyone in the US making enough money to have a marginal rate of 0.27 or higher--which is to say, just about anyone paying any federal income taxes at all--will be at best no better off under McCain's plan, and most people would be worse off. 

"Zapatero" is the 16th major foreign policy gaffe

The latest McCain gaffe (not knowing the Spanish Prime Minister) is number 16 on my list of recent foreign policy gaffes by McCain that I put together in this post "At the Feet of the Master"

We learned from McCain's campaign manager Charles Black that apparently Sarah Palin will:
" learn national security at the foot of the master for the next four years, and most doctors think that he'll be around at least that long"

I guess that means that Sarah Palin will learn:
to confuse the sunnis and shiites
that Iraq borders Pakistan
to mispronounce the name of the President of Georgia
that Czechoslovakia still exists
that Vladimir Putin is the President of Germany
that Somalia is the same as Sudan
to "misunderestimate" the number of US troops in Iraq
to not know the timing of the surge relative to the Anbar awakening
that McCain's "cap and trade" policy doesn't have a cap (even though it does)
that iraq (not afghanistan) was the first major war after 9/11
that iran supports al qaeda
to wish the death of foreign leaders (Castro)
to insult an important ally in Afghanistan by (France) by comparing her to an aging actress
to sing song songs about bombing other countries
to joke about killing people in other countries through cigarette exports