Saturday , April 21 2018

Unraveling

Summary:
Economists delight in unravelings -- behavioral responses that undo bright ideas. A subsidy for skunks produces cats with white stripes. Two good ones came up this week.As hare-brained as they are, I have to opine that the actual economic consequences of US steel import tariffs and Chinese soybean tariffs are essentially zero.(Political comment: tariffs are ...

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Economists delight in unravelings -- behavioral responses that undo bright ideas. A subsidy for skunks produces cats with white stripes. Two good ones came up this week.

As hare-brained as they are, I have to opine that the actual economic consequences of US steel import tariffs and Chinese soybean tariffs are essentially zero.

(Political comment: tariffs are taxes on imports. It would do fans of the Administration's trade policies good to utter the correct "tax" word to describe tariffs. Or "self-inflicted sanctions." )

Why do I say that? Each country is assessing a tariff on goods produced only by the other country. Well then, why not park the ships overnight in Vancouver, or Tokyo, fill out some paperwork, and say steel is imported first from China to Canada, and then Canada to the U.S., and vice versa?

Trade bureaucrats are smart enough to catch that. But they cannot hope to stop essentially the same thing: China sells steel to Canadian steel users, who currently buy from Canadian firms. Canadian steel producers reorient their production to the US, and sell to US companies who formerly bought from China. The steel is genuinely Canadian.


US soybean producers, rather than sell to China, sell to Canada, Brazil, and Europe. Producers there sell to China. The total amount made is the same in each country. The total amount used is the same in each country. It is just as if we parked the ships.

It's not exactly the same cost, because ships have to go further. People have to find new suppliers. But these rearrangements ought to be a very small proportion of the cost.

More. US farmers can take land that used to make soybeans and make wheat. Chinese farmers can take land that used to make rice and make soybeans. OK, not all land is great for all crops, but it is the kind of adjustment that quickly occurs.

Multiplying current trade patterns by a tariff to calculate the price impact is hopelessly wrong.

The second sad story comes from the Ruth Simon and Richard Rubin at the Wall Street Journal, on how passthrough businesses are adapting to the new corporate tax code -- largely as many people warned on its passage.

The issue: Corporations, pass-through businesses, and the highest income individuals, all used to pay about the same rate. The tax reform lowered the corporate rate to 21%. If it left the pass through rate intact, many of those businesses would incorporate. Also, the same economic arguments for a lower corporate tax apply equally to pass throughs. So, they lowered the pass through rate as well. But now high income people, facing a 40% federal rate (plus a 13.2% state rate in California, plus other taxes) have an incentive to become a pass through business rather than take wages. So Congress came up with a bunch of rules to try to limit that. Certain kinds of businesses -- doctors, lawyers -- couldn't become pass throughs. There are income limits and...
Dallas attorney Garry Davis plans to break up his immigration-law practice. One firm will have all the lawyers. The other will record the profits.
...Mr. Davis... figures he can still benefit from the break by splitting his law firm, Davis & Associates, into one entity holding four lawyers and another holding the 26-person administrative staff, who take information from new clients, put together immigration applications and handle other tasks. Profits in this part could be subject to lower taxes. 
... Mr. Davis’s approach, which some have dubbed “crack and pack,” seeks to get around a provision denying high-earning lawyers, doctors and other professionals a tax break available to plumbing contractors, restaurateurs and architects...By separating the lawyers from other parts of the business, he hopes to lower the business’s overall tax bill while changing little in his day-to-day operations.
Another:
Karen Brosi, an accountant in Palo Alto, Calif., is telling high earners who consult on engineering projects to indicate on tax returns that they are “engineers”—a group not subject to the income limits for service businesses—rather than “consultants,” who are. 
The article goes on with scheme after scheme. It didn't touch real estate, where the real pass through bonanza is.

The margin of incorporating to take advantage of the full 21% rate is still there, only incorporating just the cash flows that fully benefit from that treatment>
Marvin Blum, a wealth planner in Fort Worth, Texas, is pitching a related strategy to his clients: Profit meant to be reinvested into a business is channeled into an entity that pays the new, lower 21% corporate tax rate, while profit that is meant to be distributed to owners in the near term goes into a pass-through entity that pays just the individual taxes. He calls it the “half and half.”

The economic lesson is the same -- trying to tax one kind of income, like commodity imports from one country -- is likely to fail. As I've argued before, here for example, once we try to tax income, we're pretty much stuck with the current mess of individual, corporate, and estate and gift taxes.   The only real solution is to tax consumption rather than income.

The political lesson is more somber. As the article wryly notes:
It isn’t clear how the IRS will look at such arrangements or how it will determine where profits are made. The agency hasn’t yet issued regulations in this area.
The private sector’s old game of cat-and-mouse with the Internal Revenue Service and Congress, in other words, is intensifying, and is likely to play out over years in regulations, audits, appeals and litigation.
Forget the rates. My great sadness at this tax "reform" is that the once in a generation chance to radically simplify the tax code went up in smoke. Instead, you can see that we will have 20 years of wealthy business owners -- just the type to make sure they know their local congressperson well -- in and out of Washington pleading for an IRS ruling or a line in a bill treating this or that kind of pass through income differently. The lawyers, accountants, and lobbyist full employment act is in good shape. 
Back when the Federal Government was funded by tariffs, by the way, the same great game went on with dizzying differential tariff treatment for different kinds of goods.

One has to admire the capacity of Americans for innovation. My, our people are good at restructuring corporate forms towards better efficiency. Too bad we are devoting so much immense talent to gaming regulations and the tax code rather than productive innovation.

Important Update: 

A fellow economist, and tax expert, writes:
Corporate profit is taxed again when it reaches the investor, as dividends and capital gains. The advantage of passthrough taxation was already substantial before the lowering of the tax on the capital portion. It was deluded to think that the corporate rate should be the same as the capital rate for passthroughs. Rather, neutrality would call for a zero corporate rate, given that capital gains and dividends are taxed at the same rate as passthrough income.
The point: corporate profit is taxed at 21%. When they pay out dividends or capital gains, you pay another 20%, for a total of 1-0.79 x 0.80 = 37% rate. And that's after the corporate tax cut! (And just Federal.) Before, that rate was higher so pass throughs that only paid personal tax rates had a big advantage. I agree entirely that the correct corporate tax rate is zero.

I replied:
But… I thought the standard view was that people avoid the second round of corporate taxation...people defer capital gains. Or at least they should!
Response:
Well, they can't avoid the tax on dividends. Remember that dividends are taxed both at the notional rate and again by the investment income provision of the ACA. And entrepreneurial capital gains are always taxed when the entrepreneur diversifies. You are right that the conventional view is to ignore personal taxation of corporate income, but it's a big mistake.
This rings true. The strategy to avoid capital gains is to never sell anything, borrow against it if you must, and let the basis step up in your estate. I know enough people running high frequency hedge funds catering to rich people to know not everyone is doing that.

More importantly, according to my correspondent everyone in the article may be wasting their time, and going to jail:
Your discussion of fake passthroughs ignores the key point that the second branch of the coverage rule that defines the capital portion of a passthrough's income refers to the capital owned by the passthrough. None of the gimmicks you cite would actually be legal. The people you quote have not read the law.
The lower rate in the passthrough law applies only to what is deemed capital income. The key provision is that capital income cannot exceed a statutory return rate multiplied by book capital. That engineer who is trying to say he is not providing professional services (a position that would never fly in the first place) will certainly fail to have any significant income at the passthrough rate. It will remain ordinary income.
Another provision of the new law is that capital income cannot exceed wage income of the entrepreneur and employees. That would cut your engineer's capital income at least in half, even without the capital limitation. 
Nobody has given the Republicans credit for the intelligent design of the new passthrough provisions.  
My correspondent is a Democrat, by the way.

I stand by my comment that this is insanely complicated. Are we really achieving a result a whole lot better than a uniform VAT?
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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