Financial Crisis & Williamson's Behavioral Taxonomy

The whole crisis in the financial sector made me reflect today on Oliver Williamson's thoughts on transactions costs economics and behavioral assumptions built into various models economists employ. The basic taxononmy can be represented by looking at agents' behavior in two dimensions, rationality (maximizing, bounded rationality, and organic rationality or rationality as an evolutionary process) and self interest motivation (opportunistic, simple self-interest, or obedient).

Mostly, the relationship in the crisis comes down to a philosophical question of rationality - how well did folks figure out what kind of trap they were getting themselves into - and greed - how willing were agents to take advantage of others to get ahead.

Realistically, if agents are acting opportunistically, the type of economic organization that leads to the best outcomes is mechanism design (regulation). Unfortunately, under those circumstances, the mechanism has to be well designed. Copouts and loopholes will basically lead to another way for agents (homeowners and banks and realtors) to game the system. Furthermore, even if we're all trying to be rational the lack of information should give us more pause. Why hasn't anyone with some authority noticed this and put the brakes on this crazy rush to do "something?"

More thoughts on Marginal Tax Rates

Alan Greenspan recently alluded to the fact that he doesn't support keeping tax rates low if it means increased debt. I couldn't agree more: It's called classic fiscal conservatism, not this low-tax rhetoric of today's Grand Old (really old) Party.

There are plenty of sophisticated studies that show that there is virtually no impact on investment from higher marginal tax rates on individual income. Other studies (equally (sophisticated) say that high levels of debt are damaging to economic performance, investment, and growth. But, as my graduate econometrics professor once told me, "if you torture the data enough, it will confess." In other words, maybe these studies are doing something high-falootin that is getting the data to tell us something that really isn't there. So, take these scatterplots (pictures) on for size (longitudinal data from World Development Indicators, 1998-2006):

Investment v. Government Debt:

Negative relationship. Classic fiscal-conservative result.

Investment v. Highest marginal corporate tax rate:

Negative relationship, not so bad, but now...

Investment v. Highest individual marginal tax rate:


Nothing!!! Even if there were, it's a positive trendline! Maybe some fancy-pants regressions will help:

	Coefficients	Standard Error	t Stat
Intercept	27.33017	1.984217	13.77378
Government Debt	-0.0221	0.010433	-2.11784
Highest Marginal Individual Tax	-0.0238	0.031682	-0.75128
Highest Marginal Corporate Tax	-0.0927	0.059525	-1.55728

Whew! At least that straightens out the signs to be as expected: Lower taxes (especially on individual incomes) are only useful for stimulating investment all else equal, i.e. if they don't lead to higher debt levels (exactly what Greenspan said!). Even then the impact of the debt is significant; the effect of taxation is not significant (in a statistical sense - significance roughly requires column 3 (t-stats) greater than 2 or less than -2).

Here's the punchline: anyone who tries to sell lower individual income taxes as a boon to investment is full of hooey (technical term).

What?

The WSJ today published an opinion piece, "The Deeper the Downturn, the Quicker the Recovery." I can scarcely think of a sillier premise to start from. Has he studied history, and the economic volitility of the US and world economies prior to WWII?

If you get past the silliness of his title and basic premise, the author (Christopher Wood) makes some interesting points about moral hazard and "debt deflation," but it would be unwise to conclude from those ideas that a steeper fall will mean a quicker recovery and a better long-term outlook. If the fall is deep then most of that "quicker recovery" will be wasted just trying to catch back up to where we were before.

Tax Cuts vs. Debt Reduction

More to come on this topic, but recently Greenspan was asked if he favord across-the-board taxcuts that would result in a net loss in revenue, a la the cuts Sen. McCain proposes. His response: “I’m not in favor of financing tax cuts with borrowed money,” (which is exactly what "W" has done, and what Mac proposes). Bottom line: Debt Reduction is more important for investment and growth than willy-nilly tax cuts. See also: classic fiscal conservatism.

Global Institutions

The bloggers at The Economist apparently don't read their own posts. This institutional report card for global institutions take a pithy route to imply that these institutions have done poorly.

However, these posts and articles (1, 2, 3), most published last spring, suggest that those same institutions have done "OK." Has the world spun off it's wheels since they took these positions? Methinks not.

Voting and Economic Interests

There's some notion running around that folks aren't voting their economic interests or that they are being somehow irrational when they vote Republican. I don't know if I agree with this. I mean, it may be correct, on average, but not necessarily evidence that they are being in any way irrational. Maybe middle-class families are simply making a "high" guess at their chances of moving upward in the income distribution (becoming rich). If we think of the market economy as partly based purely on hard work, partly on ability, and partly on luck, then at least part of the outcome is based on a sort of lottery, and there's plenty of anecdotal evidence that suggests that many people overestimate their chances in a lottery. Perhaps middle class voters who support McCain's tax structure are (often wrongly) estimating that they will be one of the few who move upward into the $250,000+ income range, the top 5%.

Thoughts on Evacuations

Do people undervalue their own lives? I found this doing a google search for "evacuation fines." An interesting point rises. If people are valuing their worldly possessions over their lives (in hurricanes, etc.) and do not evacuate, then what is our responsibility to help them? Furthermore, what is their responsibility if we do? Here's thought: maybe we should announce "mandatory evacuations" with the warning that anyone for whom the authorities have to provide emergency rescue gets fined some large amount, say $5,000. This might help ensure higher evacuation rates, and also curb some of the costs of risky rescue operations.

Bayes' Rule and Tax Hikes for the Rich

This is interesting. Keep in mind it's only for the 35% bracket. I guess that's why nobody's made a "read my lipstick" comment.

CBS News - Not biased, just dumb

I can't believe this from CBS NEWS - http://www.cbsnews.com/video/watch/?id=4433164n

The family just over 200k in income owns a business, and currently fall in the 28% bracket. They estimate income for next year to be a bout 213k and they "worry" about their income going into what is currently the 33% bracket, the second-highest bracket, and the lowest bracket for which Obama's plan would raise taxes. The increase for this bracket begins to offset the increases from lower brackets at about 250,000 in income, but here's the point.

Their worry was that, with next year's cutoff for the highest bracket proposed at 200,300, that they would pay "another 8% of their income" in taxes. Not true. Most of their income is still going to be taxed at the lower-bracketed rates and only their income ABOVE 200,300 will be taxed at the higher rate. In fact, with Obama's overall restructuring plan, the TAX CUT that family would get on their incomes UP TO 200,300 would more than offset the portion of their income that falls in the higher bracket

YOU ONLY PAY THE GIVEN RATE FOR THE PORTION OF YOUR INCOME THAT FALLS IN A GIVEN RANGE. Here are the tax brackets, and we can calculate the net impact of raising the next-to-highest bracket from 33 to 36, assuming no other changes (and without applying the built in cutoff adjustments for 2009):

Marginal Tax Rate	Single	Married Filing Jointly or Qualified Widow(er)	Married Filing Separately	Head of Household
10%	$0–8,025	$0–16,050	$0–8,025	$0–11,450
15%	$8,026–32,550	$16,051–65,100	$8,026–32,550	$11,451–43,650
25%	$32,551–78,850	$65,101–131,450	$32,551–65,725	$43,651–112,650
28%	$78,851–164,550	$131,451–200,300	$65,726–100,150	$112,651–182,400
33%	$164,551–357,700	$200,301–357,700	$100,151–178,850	$182,401–357,700
35%	$357,701+	$357,701+	$178,851+	$357,701+

Under the current plan, this individual pays: $0.1*(15650) + $0.15*(63700-15650) + $0.25*(128500-63700) + $0.28*(195,850-128,500) + $0.33*(213,000-195,850) = $49,019, an average rate of about 23%. Ignoring the scheduled shift in the brackets (to account for inflation and stave off "bracket creep"), then for that same family the tax increase for the last bracket only applies to PART of their income, so they pay 49,400, 381 bucks more, but not 8% of their income more, and that ASSUMES they wouldn't benefit from the tax CUTS to the other portions of their income in the plan, which they would at a net gain to them.

Will the Fiscal Conservatives Please Step Forward?

We're at war. We're not paying for it. Will anyone have the cohones to say we might need to raise someone's taxes to pay for it? She won't. He won't.

McCain, Substance

Just wanted to go out there and say that through all the other stuff that some folks might criticize about Mac's speech, the one (maybe only) substantive idea in it that resonated with economic theory was his portion about trade, openness, and adjustment assistance. His proposal seemed to mirror what J. David Richardson of Syracuse has proposed - some wage assistance while you take a lower wage job in transition to sectors that are growing.

The rest of the speech seemed like all the others, from both conventions. That is to say, it was full of political fluff and rancor.

Bid Baby Bid

There's a lot of baloney out there about drilling. One group of dolts wants you to think it should be done at all costs because it will "crah-ate jawbs fir hurd-wurkin Amuhricans" and "rah-doos ahr dahpendens on furrin awl." Silliness. The other thinks it's being clever by pointing out that "drilling in these areas will harm the environment" and "have virtually no impact on prices." Highbrow silliness.

As Free Exchange and Tyler Cowen point out, the reason that drilling might be useful is that it generates a whole lotta money, and these fiduciary benefits may simply dwarf the costs - cost benefit, plain and simple. But really, they're missing the point too!

Drill baby drill is a silly oversimplification of what should be done. The government OWNS that land, and shouldn't simply write over the mineral rights to it to the oil companies; these rights should be sold, preferably by auction, and preferable for at least a couple hundred billion dollars (based on reserve estimates). That way, the excess benefits that can be anticipated can be captured, and redistributed towards environmental restoration, transfers, and debt reduction.

Menu Costs and Information

Are the costs of changing menus really the main barrier that makes restaurants not want to print caloric and nutritional information?

Selection Bias and the Truthfulness of Palin

Last night, Palin said Obama would raise "your" taxes. I take her at her word, assuming her words were intended only for those individuals in the halls of the convention. Chances are those convention attenders are mostly among the top 5% of Americans (those earning above $250,000) whose taxes would go up under the Obama plan. But out there in TV land, peoples' taxes would be HIGHER under MCCAINS plan. Check it out at the Tax Policy Center or play around at Obamataxcut.com.

Desks, like Lunch, is not Free

This is an interesting counterpoint to the Huckabee tear-jerking, flag-waving anecdote at the end of his speech. Publicly provided things (including the wars we fight) cost money. In the end you can't spend more and sustain tax cuts. The taxes needed to finance W's reckless spending will come, now or later. Pass it along and Bush might get the memo.

Random but Interesting

Check this out.

Markets and Sea Turtles

Interesting story on how the market and incentives can help people in poor countries be more environmentally/ecologically responsible. (Source: Deutsche Welle TV.)

Let the experts talk a little...

HARDtalk Professor Goolsbee 1

HARDtalk Professor Goolsbee 2

Name that Candidate

Who is the New York Times describing here?

From the beginning, X has sought out academic economists, rather than lawyers or former White House aides. His first economic adviser, Y, is a young University of Chicago professor who shares X’s market-oriented [Party] views. This summer, X added Z, who has a more traditional background ... but he, too, has a Ph.D. in economics, from Harvard.

As anyone who has spent time with X knows, he likes experts, and his choice of advisers stems in part from his interest in empirical research. (James Heckman, a Nobel laureate who critiqued the campaign’s education plan at Y’s request, said, “I’ve never worked with a campaign that was more interested in what the research shows.”) By surrounding himself with economists, however, X was also making a decision with ideological consequences. Far more than many other policy advisers, economists believe in the power of markets. What tends to distinguish [Party] economists is that they set out to uncover imperfections of the market and then come up with incremental, market-based solutions to these imperfections. This helps xplain the X campaign’s interest in behavioral economics, a relatively new field that has pointed out many ways in which people make irrational, short-term decisions. To deal with one example of such myopia, X would require companies to automatically set aside a portion of their workers’ salary in a 401(k) plan. Any worker could override the decision — and save nothing at all or save even more — but the default would be to save.