Pick a Door

The New York Times revisits an absolutely classic problem — the Monty Hall Problem in a neat article about humans handle cognitive dissonance. I get this wrong nearly every time I try it, despite learning it in my statistics class and repeated the problem several times at different points in my life. I have excerpted the description of the problem entirely, but for the answer, you will need to refer to the original article.

Here’s how Monty’s deal works, in the math problem, anyway. (On the real show it was a bit messier.) He shows you three closed doors, with a car behind one and a goat behind each of the others. If you open the one with the car, you win it. You start by picking a door, but before it’s opened Monty will always open another door to reveal a goat. Then he’ll let you open either remaining door.

Suppose you start by picking Door 1, and Monty opens Door 3 to reveal a goat. Now what should you do? Stick with Door 1 or switch to Door 2?

….

Before you write, at least try a few rounds of the game, which you can do by playing an online version of the game.

I’ll leave it at that — this one should give you well enough fodder for dinner table conversation tonight.

Who should pay taxes?

I recently received this email forward from a friend of mine. I’ve attached the forward and my response below.

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1. Dems want to increase marginal tax rate at highest end. And decrease the lower rates “applicable to middle class”

2. lst thing: doing this also decreases tax rates paid by rich at all levels but top marginal rate. That is because rich pay in each of the lower brackets as they work up to highest marginal rate

3. So, cutting “middle” rates results in very large loss of revenue

4. Now, need to look at impact on revenues of increasing the highest tax rate on the riches of the rich.

5. BTW, 99% of all taxpayers pay at only 10% rate. So cutting their rate is just dead bang revenue loss of major proportions.

6. Now  what actually happens to tax receipts by income tax bracket when tax rates change? What will happen if increase top bracket?

– The highest marginal income tax rate in 1980 was 70%. Today it is 35%. In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes.

- From 1981 to 2005, the income taxes paid by the top 1% rose to 2.96% of GDP, from 1.59% of GDP. There was also a huge absolute increase in real tax dollars paid by this group. In 1981, the total taxes paid in 2005 dollars by the top 1% of income earners was $94.84 billion. In 2005 it was $368.13 billion

-From 1981 through 2005, the share of all income taxes paid by the bottom 75% of all income earners (as reported on the individual income tax returns) declined to 14.01% from 27.71%. As a share of GDP, total taxes paid by the bottom 75% fell to 1.05% from 2.50%. The bottom 75% of all taxpayers today pay less than 35% of all the taxes paid by the top 1% of all income earners.

– With the Kennedy tax cuts of the 1960s, when the highest tax rate fell from to 70% from 91%, the story was the same. When you cut the highest tax rates on the highest-income earners, government gets more money from them, and when you cut tax rates on the middle and lower income earners, the government gets less money from them.

- Turns out that average EFFECTIVE rate on top 1% does NOT change regardless of what Congress does to the ACTUAL rate.  Top rich guys figure out ways of using accts,lawyers,to control the rate they pay.

7. So over the last 25 years, the bottom 75% of all taxpayers’ tax payments fell and their tax rates fell. This is the group the Democrats are targeting for tax cuts.

The important point here is that, over the last 25-plus years, as top tax rates dropped,  the only group that experienced an increase in income taxes paid as a share of GDP was the top 1% of income earners. Even the top 2%-5% of income earners saw a decline in the GDP share of their income taxes paid.

For the low- and middle-income earners, the effective average tax rate has tumbled over the past 25 years, and so have tax revenues no matter how they’re measured.

Using recent data, in other words, it would appear on its face that the Democratic proposal to raise taxes on the upper-income earners, and lower taxes on the middle- and lower- income earners, will result in huge revenue losses on both accounts

It is EXACTLY the opposite of what should be done. EXACTLY  –

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Here is my response, for what it’s worth:

The facts

The facts, as laid out below, are essentially correct. The portion of taxes paid by the Top 1% of income earners has gone up at the same time as their effective tax rates have fallen, both average (i.e., the total amount of tax paid divided by the total amount of income) and marginal (i.e., the tax paid on each incremental dollar earned). The way tax system works is that the tax rate increases as you move into different income bands – e.g., if you make less than $30,000 the tax rate might be 10%, if you make $50,000 per year, then you would pay 10% on the first $30,000 you earned and 15% on the next $20,000 (i.e., $50,000 – $30,000 = $20,000). This system is uniform and applies to all taxpayers (assuming you don’t pay the AMT, another kettle of fish altogether).

Why?

What explains the paradox of why the top 1% of income earners have been paying more taxes (both absolutely and relatively) while their effective tax rates have been going down?

They’re incomes have been growing faster than average, and a lot faster than the incomes of the poorest Americans. I ran some #’s, and from 1980 -2005, reported adjusted gross income (AGI) of the top 1% of earners rose 8.7% per year, while the reported AGI of the bottom 50% of earners rose only 3.5% per year (nominally). This fact is crucially left out of the argument below.

What explains the differential in earnings growth for the top 1% of earners and the bottom 50% of earners?

The argument below implies that there is a CAUSAL LINK between a decrease in the tax rate on the top 1% of earners and an increase in the taxes that they pay. The classic argument for why this might be the case is that a reduction in taxes encourages people to work more because they get to keep more of each dollar they earn. In extreme cases, this is certainly true. Before Kennedy, the tax rate on the highest income earners was actually 90%. Would you ever risk starting a new venture that could make millions of dollars if you knew the government was going to keep 90% of the gain? No. This argument is less compelling when you think about Bush’s most recent tax cuts, which cut taxes on high earners from something like 35% to 27% (I’m sure I’m getting the #’s wrong, but this is roughly right). Without any statistical evidence to support me, I believe such a cut does not nearly as much “bang for the buck” in terms of freeing the creativity and entrepreneurial spirit among America’s top earners.

Why else might we have seen a decrease in the tax rate on the top 1% of earners and an increase in the taxes that they pay. There would have to be some exogenous change in the economy (i.e., not related to the tax regime) to bring this about. I can think of several, but the most obvious are globalization and technological change, both of which have tremendously favored highly skilled workers at the expense of the poor. I would argue that top earners would have grown their incomes faster than bottom earners over the past 20 years REGARDLESS OF ANY CHANGE IN TAX RATES. The truth is: now more than ever it pays really well to be really smart and really well-connected, because the rewards for being at the top are ever more attractive, on a relative basis.

The truth is probably a combination of both of these forces.

What should we do about it now?

Unfortunately, your friend is right – a reduction in income taxes for the middle classes will be hugely costly, because it impacts a larger number of taxpayers, both the top 1% and the middle class. But this debate is really about what kind of country we want to live in: one that will grow more slowly and more equitably (higher taxes for the rich and lower taxes for the middle class) or one that will grow faster, probably across the board, but more inequitably (lower taxes across the board, especially for activities that produce massive gains for the economy, such as carried interest for private equity funds and capital gains).

I choose the latter, but with safeguards to ensure that those who are lose out are eased into the transition. Tax rates are a blunt instrument, whereas the government has any number of policy tools available to help redress inequality (if that is what we agree we should do).

Venturing into uncharted territory, here are a few proposals. We don’t need a middle-class tax cut – this is actually a costly, populist move that enables the Democrats to rail against the rich without really addressing some of the fundamental problems in our economy. Here are a couple things that I think would cost less, both in dollar terms and in terms of reduced growth prospects for the American economy. They are equally redistributive, too, in that they favor poor and middle-class taxpayers over rich taxpayers.

- Reduce taxes for the middle class but add an incremental sales tax across the board (with exemptions for key items such as bread, milk, and diapers). Why do we tax income at all? Is “working” an activity that we want to deter? No. It makes much more sense to tax consumption—we can use this revenue to offset the tax cuts for the middle class, without deterring the incentive of skilled, wealthy professionals to create new ventures and take entrepreneurial risks.

- Eliminate Social Security entirely for those who make above $200,000 (inflation-adjusted) per year. Social Security is a safety net for poor pensioners, not a substitute for your private savings account. So, if you earn over $200,000 per year in 3 of the 5 years prior to becoming eligible for Social Security, you are no longer eligible for Social Security payments. (There’s probably a better way to organize this, but this is just one idea). I know plenty of people who would willingly HAND BACK THEIR SOCIAL SECURITY CHECKS if the government would let them and if they felt that the government would spend them wisely.

- Get healthcare costs under control, perhaps by creating a universal healthcare system, which explicitly subsidizes health care for the poor. If we can reduce the effective health care spending of the poor and the middle class, this has just as much of an effect on increasing their disposable incomes as reducing the tax rate.

- Privatize the lottery. Government run lotteries are one of the most regressive taxes we place on our citizens. Do you know anyone who makes over $100,000 per year who plays the lottery? No. Only poor people play it, which is why there is a lotto shop on every corner in Harlem. By running the lottery and keeping the proceeds for itself, the government is sanctioning a hugely regressive tax – why not privatize it and see what happens? It will still cater to poor people (unfortunately, the willingness to pay for “hope in a ticket” is higher among the poor than among the rich), but a publicly-lister lottery company would be driven to innovate, perhaps even finding ways to convince me to play it.

In summary

In short, the facts laid below are right. Their implications are right and wrong – right that a tax cut for the middle class would bite into a budget that is already in deficit and wrong that there is definitely a causal link between lower tax rates (at these levels) and higher earnings from America’s top earners. However, Democrats repeated calls for tax increases for the rich and cuts for the middle class miss the point – we should not focus on constantly redistributing the pie, but rather focus on how to grow the pie as fast as possible. Once we’ve grown it (and we demonstrate that we can continue to grow it), then we can implement targeted redistributive policies (such as those suggested above).

Kelo decision begins to bite

Normally, I take the same level of interest in Supreme Court decisions that I do in Vogue – mildly interesting for a cultural perspective, but will only impact my life if someone i know becomes involved. But Kelo vs. the City of New London is downright scary. This is an old one (the decision came down in 2005) but as with many Supreme Court cases, the ramifications are only being felt throughout the American economy. Basically, Kelo says that the government has the right to seize land from private individuals for private development purposes, providing that fair compensation is paid to the private individuals. Sounds innocuous, right?

Check out this little story from my old lunch-time stomping grounds, Port Chester, NY, featured in Forbes….

n 1999 Port Chester established a redevelopment area, in which new projects could be built only after getting approval from a village-designated private individual, Gregory Wasser, to whom the municipality inexplicably delegated its regulatory authority. In 2003 two owners of a plot within the redevelopment zone, Bart Didden and Domenick Bologna, asked Wasser for permission to build a CVS pharmacy. According to Didden and Bologna, Wasser responded: Either pay me $800,000 to build, give me a piece of the action, or I’ll have the village take the property. The day after they spurned the offer, Port Chester did indeed start the takings process. Wasser then arranged for Walgreen to develop the site.

This little episode represents a sorry example of what political actors can legally do with unchecked condemnation power. Why, one might ask, wasn’t Wasser’s land grab an unconstitutional taking for private purposes? (Didden sees it as extortion; Wasser defends his actions as promoting urban renewal.) This constitutional question of when takings are “for public use” has been front and center since the Supreme Court’s 2005 decision in Kelo v. City of New London, which allowed the city to take private homes for private development.

This seems to me to be a serious threat to American competitiveness. No joke — anyone who questions the value of private property to economic development need only read Hernando de Soto’s The Mystery of Capital.

I’m left wondering how such a decision came out of a supposedly conservative-minded Supreme Court? Isn’t this decision the exact opposite of small-government conservatism?

the price of water

For those of you who love free markets, i really would like you to have a think about whether we are appropriately pricing water. I would argue that we are drastically under-pricing water, especially in places where we need to be thinking intelligently about how to ration water. My water bill last month was $6.41. I can double my usage of water, run my dishwasher with one plate in it, and give myself a ride in the laundry machine, and my bill will not be more than $15.00. What incentive do I have to save? So I leave the taps running, and so do you.

The FT today intelligently argues for the need for a more appropriate water-pricing regime. You want instant ROI –

If the number of people lacking safe drinking water were halved, at a cost of about $10bn, the world would benefit by $38bn in annual economic growth, according to the United Nations Development Programme.

(Of course, you have to trust UNDP’s ability to assess cost-benefit for this. )

Now, in order to fix this problem, we may need to tackle that other bugbear, the farm lobby.

Farmers in Spain are estimated to pay a price for water that is only about 2 per cent of its real cost. Rice and wheat farmers in California’s central valley use one-fifth of the state’s water but the low prices they pay represent a yearly subsidy estimated at $416m for 2006.

….

Mr Krupp acknowledges that there would be legal and governance problems and vested interests to be overcome – particularly the farming lobby, as agriculture receives the best treatment almost all over the world when it comes to water rights and pays less for its water than any other industry. He says: “There is no question that we have much to do to ensure that water trading occurs in a way that is cost-effective and prevents undue windfalls. We also need to ensure that water transfers don’t hurt rural communities, low-income populations or the environment. An effective system of cap-and-trade for water will require lots of metering and enforcement.”

For those of you who care about climate change, ask yourselves this: in 50 years, would you rather live in a world that is 0.5 degrees warmer, on average, or a world where we are running out of water.