Comments on Diamond-Viard, Dharmapala, & Auerbach-Hassett in TAX POLICY: LESSONS FROM THE 2000s

1. Comments on Diamond-Viard, Dharmapala, & Auerbach-Hassett in TAX POLICY:LESSONS FROM THE 2000s Daniel Shaviro NYU Law School

2. 1) Comments on Diamond-Viard Great paper – idea & execution. Should be required reading for, among others, the WSJ editorial board & members of Congress (Republicans especially). Central point: tax cuts with financing that isn’t currently implemented generally reduce national saving & future generations’ welfare. Well, duh … but it needed to be said (recall dynamic scoring debate). Key design problem: financing for the tax cuts is not just unimplemented but unannounced.

3. Decomposing unfinanced tax cuts Conceptually, 2 pieces: (a) revenue reduction plus pay-for; (b) pay-for is unimplemented and unannounced. Best-case scenario: the pay-for is much better policy than the tax that was reduced. E.g., reduce income tax MTRs, pay for by reducing transfers – improving efficiency (whether or not distribution). Ignoring (b) above, this will increase output. But adding (b), which is conceptually distinct & at this stage unmotivated, can only reduce the gain in output by reducing saving. If we like (a) above, why isn’t the pay-for immediately announced & implemented?

4. Effect of delayed implementationon the pay-for Clearly the tax cut + pay-for might be good on balance. But delayed implementation, in the face of a huge preexisting fiscal gap, pushes against this. Case 1: cutting tax rates today in exchange for raising the same tax rates (even more) tomorrow violates tax smoothing. Incentives to shift between periods; greater overall distortion even if people can’t shift. Case 2: cutting outlays (say, Social Security or Medicare) asymmetrically in the future rather than smoothly. See Shaviro, The Long-Term U.S. Fiscal Gap: Is the Main Problem Generational Inequity?, forthcoming 2009 in GWU L. Rev.

5. Why delay announcement of the pay-for? This is clearly a political economy choice (though w/ adverse effects on people’s ability to plan). Supposedly motivated by “starve the beast” rationale. Better explained as chicken games & other strategic behavior from the political economy literature (Alberto Alesina et al). Can lead to dangerous departures from collectively rational behavior. See again Shaviro (2009) as well as Rebel Without a Cause (1955).

6. Back to the paper One great virtue of Diamond-Viard: showing how the tradeoffs play out (even disregarding the lack of motivation for delay). In all simulations (w/ 10-year lag), even if the tax cut + pay-for substantially improve efficiency, macroeconomic gains are significantly reduced & future generations lose. Per their literature review, no reason to think the full package will increase efficiency (e.g., little evidence that tax cuts -> spending cuts a la “starve the beast”). For policymaking, should the default assumption be that tax cuts + pay-fors will generally be bad policy given the smoothing problem & political dynamics?

7. A quibble re. the model A result of the model that I question: dividend tax cuts do more for growth than corporate rate cuts. This correctly reflects “wasting” some of the corporate rate cut on deferred tax liabilities for old investment given ACRS. But (as D-V acknowledge) it alsoreflects old-view dividend model in which the dividend tax cut isn’t wasted with respect to past earnings. Plus, as they note, in an open-economy model the rate cut might generate inbound capital flows even assuming some response from other countries.

8. A non-quibble re. the model Kotlikoff response may have made D-V too apologetic about their bequest model. In their model, “joy of giving” means I’m happier if I give my kids $X than if the state takes $X from me & gives it to my kids. Kotlikoff calls this “irrational” – but that’s like saying that going to the movies is irrational because you don’t get good stock tips. Inputs to the utility function cannot be irrational in his sense – rationality pertains, rather, to making choices given one’s utility function & opportunity set.

9. 2) Comments on Dharmapala Paper surveys lessons of 2003 dividend rate cut re. (a) payout policy & firm value, (b) international portfolio choices, & (c) corporate integration. Underlying problems: (a) lots was happening; (b) permanent or temporary?, (c) lack of clear theoretical models for understanding corporate tax. E.g., new view of dividends (no tax incentive effects on timing of distributions) is a tautology, not debatable, under uniform distributions tax. Likewise, Miller view (corp tax offers a choice between paying tax at the corporate rate or one’s own rate) follows ineluctably if debt vs. equity is wholly elective & distributions are never necessary. Corp tax poses an “ill-posed problem” (Shaviro, DECODING THE CORPORATE TAX, 2009) given the lack of coherent building blocks.

10. The sound of two hands clapping Paper’s many virtues include its literature review, theoretical grounding, new empirical finding, & policy implications. Payout policy: large increase in dividends, (a) mainly from previously non-div-paying firms, (b) esp’ly for firms w/ taxable SHs, (c) esp’ly for firms where managers held stock rather than stock options. Firm value: increased for high-div firms, but even more for non-div-payers. Normative lessons: ambiguous & largely unclear (problems w/ the policy experiment & complexity of theoretical models) except that we’re reminded of the importance of agency costs. Clearest case for efficiency gain: possibly a shift of investment $$ to high-yield firms (mgrs more willing to forego pet projects, SHs reinvest in good companies).

11. International portfolio choice Paper notes, per Miller model, that the div tax cut made equity more appealing, but only for U.S. & treaty-country firms. New result: equity-to-debt ratio stayed the same for outbound US portfolio investors in treaty countries, but fell for non-treaty. Hence it rose in relative terms for treaty countries (as one should expect from the dividend tax cut). Great job in the paper of drawing lessons. E.g., had the reform applied to all foreign equity: (a) less distorted debt-equity choice, but “conceptualizing – not to mention quantifying – the social costs of these distortions is not entirely straightforward,” (b) WW dissipation of any hoped-for increase in U.S. equity investment.

12. Corporate integration Paper notes that exempting dividends from US tax while foreign 15% withholding taxes remained would discourage international diversification. And it notes that maximizing the US economic impact of US tax law changes requires operating at the firm, not the SH, level. ACE/BEIT systems do this via firm-level deductions for the normal return on equity (treating it like debt). This achieves corporate integration w/o biasing financial instrument choice via Miller-style electivity. They also fit well w/ another direction for reform that the paper mentions: lowering the U.S. corporate tax rate, w/o excessive income-shifting from the individual to the corporate tax base.

13. 3) Comments on Auerbach-Hassett Nice review re. two expressly temporary features in recent tax legislation: (A) bonus depreciation and (B) dividend rate cut. (A) was temporary by design, (B) due to budgetary games. But both expected to be permanent? (Desai-Goolsbee 2004) Temporary bonus depreciation: business-cycle-neutral at worst? Paper notes surprisingly strong theoretical grounds for NOT getting stimulus from temporary bonus deprec – price increase scenario, mere shift from short-lived to long-lived assets. A-H find that the literature supports modest stimulus from 2003 bonus depreciation – but for idiosyncratic reasons?

14. “Three bears” scenariofor bonus depreciation For 2009 bonus depreciation, it’s encouraging that the 2003 version seems to have worked a bit – but discouraging that this may have been for idiosyncratic reasons. If the 2009 version doesn’t work, this might support a “Three Bears” view of bonus depreciation. “Too hot” = capital asset supply too tight; price increase instead of more investment (House-Shapiro 2008). “Too cold” = demand too slack; not enough of a jolt (especially at low interest rates that reduce the time value benefit) – 2009 scenario? “Just right” = 2003 bonus depreciation (?).

15. Dividend rate cut In theory, could be anti-stimulative. Say firm would have invested its own funds (Chetty-Saez) butSHs save &, in a downturn, the $$ aren’t put in equity & don’t otherwise cycle back to bus. investment. This might happen whether the rate cut was expected to be temporary (via rush to issue dividends)or permanent (via shifting to stable high-dividend policy). For 2003, A-H cite their study (w/ Chaney) suggesting stimulative effect via value shift to immature firms. This presumably reflected expectation that the rate cut would be permanent (new view capitalization story, not rush to issue dividends).

16. Final thoughts Three excellent papers with important lessons for current policy. Diamond-Viard: Address the fiscal gap ASAP subject to business cycle issues (& note possible stimulative effect of enacting deferred tax increases today)? Dharmapala: importance of international issues to corporate tax reform; strong case for shifting taxation from corporate to SH level (contrary to CBIT & the 2003 dividend rate cut). Auerbach-Hassett: temporary tax cuts CAN boost current business activity, but don’t bet on it.