Mr. Obama’s Sugar-coated Doughnut

There are about 116 million households in the U.S. About 22 million of them have incomes over $100 thousand per year while only 2 million have incomes over $250 thousand. Many of those 20 million households in the 100-250K range are Obama voters. Mr. Obama doesn’t want to hit them with a huge tax increase. Hence the idea of the doughnut. The doughnut is a creative tax structure in which all taxpayers who earn under about $104,000 will pay standard social security taxes. Those who earn between $104,000 and $250,000 will pay taxes only on the first $104,000, and those who earn more than $250,0000 will pay taxes up to $104,000 and then on all dollars exceeding $250,000. It is a big tax increase with a nice doughnut hole right over about 17% of the electorate.

This policy is completely understandable in light of Mr. Obama’s positioning with the electorate, make the rich pay more but protect middle, and even upper-middle income voters from tax increases. But this policy is also going to back him into a rhetorical corner at some point in the campaign.

Is it reasonable to use Social Security taxes to fund a social welfare program? The word “welfare” here is political dynamite, particularly when applied to Social Security because from its inception it was clearly never intended as a welfare program. But if you require those who make over $250,000 to pay social security taxes on those dollars without adjusting their future payout schedule to reflect those increased contributions a welfare program is exactly what it is . Already some semi-official sounding Obama supporters have backed away from the notion that future payouts would not be adjusted to reflect increased contributions. But, if you do adjust future payment schedules that creates a liability on Social Security’s books that must be paid at some point in the future. How does that help the solvency of the system, as Mr. Obama claims this proposal does? That looks more like a shell game.

It is either the case that he expects richer Americans to contribute new monies that they will never receive in return as Social Security payments, a welfare program, or this is a policy that simply kicks the problem of solvency down the road. Even the middle ground, the rich pay more but only receive a portion of it back, will still (correctly) be labeled a welfare program. Turning Social Security into a welfare program is bad policy and it will ultimately prove to be bad politics for Mr. Obama. Social Security is not nearly as complicated as Medicare. It can be fixed with a few straightforward changes that would be fair to everyone. He doesn’t need this sugar-coated doughnut.

Fat and Broke in Suburbia

Does living in suburbia cause us to get fat and go broke? Maybe.

According to a recent article article in Slate (Hey fat spender) having love handles and a bare wallet are related. The crux of the argument is that eating out is both expensive and at the same time also makes you fat. All that butter and cheese costs money you know. And as every restaurant cook knows, the key to very tasty food is —- add more fat. So, a very casual look at the U.S. savings rate and obesity rates finds that they are inversely related. So, maybe we could all go on a diet and increase the savings rate!

I doubt it.

The issue that is helping drive both of these outcomes (big and broke) is suburban living (see my post “Can High Gas Prices Help Us Save”). Yesterday’s NY Times had an article about families rethinking suburbia in light of high gas prices. And there has been a flurry of recent articles about the implications largescale re-urbanization (e.g. Suburbs a Mile Too Far and Ghosts of the Cul de Sac). You can now add high food prices to high gas prices as components of the increasing cost of the long commute .

Eating out has always been a lot more expensive than cooking, but restaurant prices typically rise faster than food prices on a per dollar basis because a common pricing rule at restaurants is to use a constant percentage mark-up based on the cost of the food. So, if the mark-up is 300% (not uncommon) a $1 increase in food price for a particular dish leads to a $3 increase in the menu price. A restaurant could lower its margins, but there is a limit to this as many of their other costs (heating, gas for cooking) are increasing as well. So food is getting more expensive, and eating out is getting a lot more expensive.

People with long commutes eat out (or get carry-out) more often. They spend more money on gas. They walk less and drive more when they run their errands So, we are back to the link found in the Slate article, fat and broke in suburbia.

An Unintended Consequence of Student Loans

My own institution, The University of Virginia (UVA), has undergone a transformation in funding that is not substantially dissimilar from the changes in funding at many public colleges and universities. The proportion of the annual operating budget that is derived from state funds has declined precipitously over the course of the last decade and now stands at only 8 or 9%  of the overall budget. UVA is one of the lucky ones as its ability to attract private dollars far exceeds that of most public institutions, but even from this relatively privileged vantage point the state budge cuts have produced real economic consequences for the School. As public monies have dried up for higher education tuition rates have moved up rapidly. Although many public universities have collected and allocated more private money for student aid, an increasing number of students leave college with a great deal student loan debt. 

What I have just written above is not news. Tamara Draut’s book “Strapped” examines the issue of the rise in student loan debt in detail and a recent  report published by Demos updates and extends that discussion.

But I think there is a side effect of this debt that is important to explore. One common psychological phenomenon that occurs when people make decisions about money is that they tend to compare the amount they are thinking of spending with other dollar figures that seem most salient to them at the time. They form ratios between these dollar figures as a way for them to decide if the amount they are thinking of spending is “a lot” or “a little.” For example, on most days spending $200 for car seat fabric protector might like a very bad idea, but on the day you just spent $25,000 on a car it might seem like a very reasonable idea. It is easy to convince yourself that $200 is “nothing” in the grand scheme of things even though that same amount that would have seemed large a week ago. 

I fear that student loan debt may work in a disturbingly similar way. Once a 22 year-old has $30,000 in debt it is easy to justify other kinds of debt because it “really is not that much money.” An extra $3,000 in credit card debt only moves the needle on overall debt from $30,000 to $33,000.  The large debt overhang also dampens the psychological pain associated with a new car loan. Am I sure this is true? No, I am not. To my knowledge no one has studied this phenomenon. But, my speculation is that it is true for many students and that the changes in funding for higher education have resulted in a self-reinforcing debt cycle among recent college graduates that is much more powerful than a strict economic analysis of student loans suggests.

Investments for the Young

I ran across a paper that is quite interesting while on the blog Nudges, a blog I frequent.  Most of the folk wisdom surrounding how much money to allocate to stocks and bonds in your retirement portfolio use simple rules of thumb such as “the percentage of your assets in stocks should be 110 minus your age.” In other words, if you are 30 years old you should hold about 80% of your portfolio in equities. This paper explored the accuracy of these common rules using historical data on stock and bond returns and finds that they typically produce portfolios that are far too conservative for younger workers. Younger workers should essentially hold all of their retirement portfolio in stocks, and should even borrow to buy those stocks if they are able to do so.

 

Even though the authors are probably giving us some very good advice, I suspect people will resist this kind of information because one well-ingrained and often-repeated mental heuristic for dealing with money is “don’t put all of your eggs in one basket.” Even if this bit of folk wisdom is meant to advise people against concentrating their money in a single asset (i.e. the stock of a given company) rather than in a particular asset class (i.e. equities), for many people it would still feel like they were violating some kind of sage rule of investing. It is difficult to overcome this neuroeconomic reaction, even if it flies in the face of demonstrably good advice.

 

The reason this problem is particularly interesting to me is because one of the consistent patterns we see in individual portfolio data is that many people, but particularly those of more modest means, do not hold enough equity. This is one reason why the poor are particularly at risk for financial shortfalls in retirement (see post “Into the Wild” and “Presidential Candidates Duck Hard Issues on Savings”).

 

Research that reinforces, and extends, our understanding of the benefits of equity ownership from an early age are important stepping stones for constructing sensible public policy. But in so doing we will also need raise our eyes from prescriptions that assume a high degree of economic rationality and consider people’s automatic, or gut level, responses. Only prescriptions that are congruent rather than contradict these basic instincts are likely to be successful.

 

Annuicide

As Baby Boomers approach retirement some of them will consider annuitizing their money, making a lump sum payment in return for a constant income stream for the rest of their lives. That’s a good idea for many of them. Classic research suggests that almost everyone should annuitize some (or even all) of their money as they enter retirement and more recent research finds evidence that people are often happier when they have an annuity in retirement.

That’s all well and good but many annuities are purchased with the help of a financial advisor and herein lies a serious problem in this marketplace.  Financial Advisors/Planners are often compensated as a proportion of the assets they are managing. For example, they might charge you 1% of assets annually. Once they sell you an annuity that money essentially vanishes for them. The money is now being held by the insurance company who is obligated to make payments to you. Even if they receive a commission for the sale, they have now given up 1% of those assets for potentially many years going forward.

So, what do you think happens in this situation? You guessed it, despite their fiduciary responsibility to do what is in their client’s best interest many are reluctant to advise people to purchase annuities. The industry buzzword for this behavior is “annuicide.”

Annuities are yet another example of an issue I have brought up before on this blog. Federal oversight in many of these financial services marketplaces is woefully inadequate. We need some individual legislators to make disclosure and regulatory oversight in these growing marketplaces a priority.

Presidential Candidates Duck Hard Issues on Savings

For all the rhetoric about change, the current Presidential candidates have proposed precious little that will address the United States’ problem of historically low levels of household savings.  And unless something is done, and soon, our public policy hands may be tied into the types of solutions that no one wants, large tax increases to fund the many impoverished or nearly-impoverished elderly.

John McCain started the campaign season on a positive note, vowing to cut capital gains taxes.  Few results in economics have as much across-the-board support among those who study tax policy as the impact of capital gains taxes on savings and investment. Capital gains taxes discourage savings by reducing the expected returns to savings and inhibit businesses from expanding their operations. All taxes distort economic activity in some way or the other, but it is the capital gains tax that is most pernicious.

That is why it is disappointing that Mr. McCain recently reversed his decision to push for cuts in capital gains taxes. An interesting question emerges as to why Mr. McCain made this decision. One view might be that he thought the tax cut too expensive.  If that is the case he certainly has not communicated this message.  And appeals to tax cuts being too expensive are not part of his recent political language. An alternate, and in my mind more persuasive, interpretation is that he is bowing to the fact that most of the benefits of a capital gains tax cut would accrue to wealthier Americans and he does not want to be attacked by Mr. Obama on this basis. This nod to populism would be consistent with his uber-populist gas tax holiday proposal. Is Mr. McCain using quiet shifts in tax policy in an attempt to grab the populist mantle that Mrs. Clinton has now laid down? It sure looks like it.

Mr. Obama has forwarded some modest proposals for enhancing personal savings. The first is a small-business IRA plan that looks very similar to the “Automatic IRA” plan that has been floating around the Brookings Institute and Heritage Foundation for quite some time. Mr. Obama’s plan would require small businesses to offer their employees access to a direct deposit retirement account of the type we now see in large companies. What is left unsaid is how small businesses would pay for this arrangement; many would be too small to be able to generate the pools of money that would be interesting to private-sector financial services providers. Perhaps Mr. Obama is advocating a government-run plan, but from the current state of his policy briefs it is impossible to tell.

He has also advocated a cash-match savings program for lower- and middle- income Americans. In this plan, individuals would receive a match of fifty cents on the dollar and could contribute up to $1000 for money set aside in a designated retirement fund.  These kinds of cash matching programs for lower income Americans have previously been tried on a much smaller scale and have produced some success at increasing savings rates. What is striking about Mr. Obama’s version of the plan is the income cap for eligibility, $75,000. With that kind of cap, it is sure to be a very expensive program. And it is hard to come up with a compelling reason for taxpayers to fund savings match plans for someone making $70,000 per year.

The larger issues that would affect savings are being completely ignored. Taxing income creates disincentives to work. Taxing capital creates disincentives for investment. Taxing consumption creates disincentives for…..well consumption.  Consumption taxes are the right approach for incentivizing savings relative to spending.  And despite cries to the contrary, a consumption tax can be made just as progressive (even more progressive) than the income tax.  It is also hard to find an economist who doesn’t have some good things to say about how consumption taxes would benefit the economy, and even the environment, as a whole.  While, as in any profession, political opinions vary; the preponderance of the evidence for income versus consumption taxes indicate the latter would be a boon for the economy. Neither Mr. McCain nor Mr. Obama has addressed this more fundamental issue.

Looming over each of the candidates’ laundry list of proposals is how much they will cost.  Continued large budget deficits implicitly tax our savings, making future tax increases inevitable and reducing the proportion of our savings we will actually have to spend. The nonpartisan groups that have looked at the cost of each candidate’s proposals have been consistent in their view that Mr. McCain’s proposals will create larger budget deficits than Mr. Obama’s.

If we are serious about increasing household savings in the U.S. we have to take a hard look at the disincentives the current tax regime imposes on savings. And we need to play the role of deficit hawks, making sure what we save today isn’t mortgaged to pay the bills tomorrow.

Yes, It Matters Whether Your Neighbor Saves

A recent blog posting on Cafe Hayek, from the chair of the George Mason University (GMU) Economics Department, asserts that it does not matter whether those who live in the U.S. are saving enough money as long as foreign capital inflows are sufficient to allow U.S. businesses to borrow and expand.

I could not disagree more.

True, to the business looking to expand it does not matter whether the money they need to borrow is coming from the U.S. or China. Either one will work just fine. But that is only one of several reasons I should worry about whether or not the savings rate in the U.S. is low. Let me give you another very concrete reason — one that money from China will not solve. If many people in the U.S. are short of funds upon retirement they will pressure the federal government, through organizations such as the AARP, to pass new taxes and increase current taxes designed to transfer wealth from those who have saved responsibly to those who have not. Older Americans vote in large numbers, and if this historic voting pattern persists who could doubt they will be successful in their petitions. A strict economic analysis of capital flows is by itself not capable of capturing the political implications of this phenomenon.

Even in this world of global capital flows, it still matters who is saving and who is not. The political power of countries as well as the domestic policies they will pursue depends in no small measure on it.

The Controversy About the Savings Rate

One rather wonkish question I am often asked by people casually interested in the problem of low U.S. household savings is “aren’t all the statistics that measure savings wrong — aren’t things better than those numbers make it appear?” It is well known that the most frequently quoted measure of household savings, the National Income and Product Accounts (NIPA) measure provided by the Labor Department, has a considerable number of flaws. It doesn’t count some of the things that many of us would consider savings. The most critical and cited of these shortcomings is that the NIPA measure does not include capital gains in stocks, a huge store of wealth for the economy at large. Many people have commented on this exclusion and attempted to adjust the savings numbers to include capital gains. Here is one example. Maybe the low savings rate isn’t such a big social problem after all?

I don’t think so. One issue these studies consistently fail to take into account is that stock ownership in the U.S. is highly skewed towards those who have higher incomes. Most households that have higher than average incomes own equities either directly or indirectly though mutual funds. Most households with below average income do not. NIPA is not perfect, but it is far less perfect for very high income households. The trajectory of their wealth accumulation is much higher than the statistics suggest. Conversely, for lower and middle income Americans, who often hold little wealth in equities, the criticisms of NIPA are almost beside the point. They are indeed saving very little, much less than they need to secure their economic future, and the flaws in the government measures of savings to not blunt this fact.

Into the Wild

In his book The Great Risk Shift, Jacob Hacker describes the transformation of American society from one in which government and private businesses protect citizens and employees from many risks to one with a much more libertarian ethos, every man for himself. Hacker argues that we have moved too far towards this view, and that civil society would be better off with a return to more risk sharing among citizens, businesses and the government — particularly in the areas of health care and pensions.

Hacker is more enamored with top-down federal government solutions than I am, but much of what he says rings true. Americans, more than at any other time since the Great Depression, are asked to shoulder the burden of providing for their income in retirement. They face this task by confronting a bewildering array of investment options, risks that are difficult to gauge, and costs (fees) that even sophisticated investors would have difficulty explaining. And these products are all-too-often marketed by individuals that act as faux-fiduciaries, easily convincing otherwise-intelligent people that they have their best interests in mind when that is not always the case.

It is not the government’s responsibility in these situations to make people’s decisions for them. But it is their responsibility to ensure that individuals of middling financial sophistication at least have information presented them in a way that allows them to make a reasonable choice for themselves. The Federal Trade Commission demands a high level of product and price transparency when we enter the grocery store, but the same cannot be said for the market for financial services. Today’s employee and tomorrow’s retiree heads into this wild marketplace with little confidence that what they see is what they get. And they have good reason to feel that way.

Federal disclosure regulation for insurance, mutual funds, mortgages, annuities, and even some markets for basic assets such as bonds are so far out of date it almost hard to overstate their impotence. This lack of transparency has two important effects, some people are sold products and services they don’t need or worse yet do them financial harm while others do not enter markets that might be beneficial to them. The first part of this problem has garnered some modicum of attention in media, but the second has not. Lack of transparency and its associated confusion causes some people who should own stock mutual funds not to own them, some who should have a life annuity as a part of their retirement income plan not to have it.  This is a powerful, but hidden, cost of this problem.

People of good will can disagree about how much risk should be born by the government and how much of life’s risks and rewards should be left to the individual, but regardless your political views it is absolutely essential that to the extent we vest individuals with these important decisions we compel those who seek to affect their choices to provide them with clear and correct information — the kind that can be read by normal human beings and not just attorneys. Transparency in these marketplaces needs to be a priority of whichever administration takes office next January.

David Brooks on Thrift

I attended a conference a few weeks ago, sponsored by the Institute for American Values, where I presented material from my book. That conference, and the document that emerged out of it, was the subject of David Brooks’ column this morning. It is a wonderful perspective on the motivation for “Whatever Happened to Thrift” and the seriousness of the problem the U.S. faces.