The Fed is breaking US federal law in two direct ways, skirting federal law in one important way, and disregarding the intent of Congress in a third crucial way. All of this shapes post-2008 monetary policy and distorts capital markets.

First, the Balanced Growth and Full Employment Act of 1978 fully amends the Employment Act of 1946 that regulates in law Federal Reserve action. This 1978 act stipulates an inflation rate target of 3% by 1983 and 0% thereafter. It allows leeway in not meeting this target if the unemployment rate is above 4% for aged 16 and over. This rate has been less that 4% since February 2022, and was less than 4% from May 2018 through February 2020.

In 2012 and still following this today, the Fed declared it would establish a 2% inflation rate target. This was done despite the 1978 Act’s stated provisions (Section 4.d) that only the President or Congress can modify the inflation rate or unemployment rate target. Further, the Fed in its 2012 statement disregarded the unemployment part of the 1978 Act by stating that “it would not be appropriate to specify a fixed goal for employment” even though this was already a part of the 1978 Act at a 4% unemployment rate. Declaring a 2% inflation rate target violates federal law guiding the Fed in the 1978 Act. Disregarding the 4% unemployment rate target in the 1978 Act is the second explicit violation of US statutory law.

Second the Fed is skirting federal law. Sponsored by now-retired Bill Gradison (R-Oh), the Federal Credit Reform Act of 1990 stipulates that all direct loan purchases by the US government need to be approved within Congress’s official budget by the Congressional Budget Reconciliation Act of 1974. Under President Bush, in 2008 the US Treasury bought mortgage-backed securities during the bank crisis. The expected loss on these at the time of purchase had to be included in the Congressional budget process. This is true even if the US eventually made a profit on such purchases, which is irrelevant to the Federal Credit Reform Act.

Under President Obama, instead of Treasury the Fed bought the MBS directly and continue to do this today. This skirted the Federal Credit Reform Act as the Fed purchases replaced the US Treasury purchases of MBS. In doing this, the Fed violated their own internal guidelines that prohibited action that benefited any one industry, which was the financial industry holding and issuing new mortgage loans. To address this violation, the Fed changed their guidelines to allow favoring any industry that the Fed chose. This displays the lengths by which the Fed went to skirt federal law as well as violated US law targets on inflation and unemployment.

A third action has blatantly disregarded the intent of Congressional law ever since 2008. The Fed began paying interest on all reserves held at the Fed. This was enabled through the Financial Services Deregulatory Relief Act of 2006. That act was meant to relieve small banks of the burden of holding more required reserves relative to assets than the large banks had to hold, the latter being close to negligible. Required reserves were limited up to a certain dollar amount and were set to zero on “non-depository” accounts such as money market funds. In the 2006 Act, its wording allows the Fed to pay “interest on reserves”, which was meant for the only reserves ever held previously at the Fed: required reserves. Excess reserves historically were as close to zero as banks could possibly make them. By emergency legislation in 2008, the Fed was allowed to move up the 2006 Act’s effective date of 2011 right to 2008, so that the Fed could immediately begin paying interest. But contrary to the clear Congressional intent of Senator Crapo who sponsored the legislation, the Fed paid interest on both required and all other reserves. This seemingly tiny change in the intent of federal law led to the build-up of trillions of dollars of reserves by private banks that were held at the Fed after 2008 instead of being lent out and invested in consumer and firm projects. As a result of the fungibility of money, the Fed interest rate paid on reserves then set the interest rates in all short term markets. This means that since 2008, the Fed has been setting short-term US Treasury debt rates by diktat rather than through natural equilibrium of supply and demand in capital markets.

Then the Fed totally eliminated reserve requirements on March 26, 2020 since they were no longer relevant given the “oceans of reserves” as one Fed white paper put it that were now held at the Fed instead of being invested in the US economy.

What did the Fed gain by all of these post-2008 policy changes that violated, skirted and undermined the intent of US statutory law? By financing the growing US Treasury debt after 2008, and again after 2020, the Fed could print money at an accelerated rate but it did not enter circulation as long as a large part of this was held as excess reserves at the Fed. This kept inflation down, or “suppressed.” Finally, the dam broke after 2021 when there were so much reserves created as the Fed bought US Treasury debt from banks that the reserves entered circulation at a fast rate and we found the US economy in a new prolonged episode of inflation. The Fed in the end gained little by circumventing federal law in myriad ways. But capital markets have remain distorted by interest rates lower than the inflation rate for some twenty years as a result of the Fed-set interest rate on reserves. The real return to short-term Treasury debt after inflation has remained negative and induced greater riskiness in bank equity portfolios worldwide to balance out the negative real return on Treasury debt.

The higher is the inflation rate, even above 0%, the more variable are both the inflation rate expectations and the effective inflation tax that is imposed on capital markets. This causes greater risk-premiums to be built into government debt returns. Greater risk is faced when holding “risk-free” US Treasuries, the most fundamental liquid asset used globally to create immediate reserves when needed. The increase in risk from the Fed targeting higher inflation rates than stipulated under US statutory law increases the risk of the aggregate market portfolio that is divided between “risk-free” Treasury government debt and a more risky equity portfolio. The increased risk of the aggregate market portfolio increases the riskiness of the global financial system.

Max Gillman is Hayek Professor of Economic History at the U. of Missouri – St. Louis and author of The Spectre of Price Inflation (2023).

Here we present the graph showing the amount of US money that actually entered circulation since 2003. Gathering the data from the Federal Reserve Bank of St. Louis economic data base called FRED, the graph shows in the dashed black line this amount of money that entered circulation. It equals the amount of money that was printed by the Fed as they bought Treasury debt and, since 2008, Mortgage backed securities (MBS), that first entered as reserves held at the Fed and subsequently entered circulation when the reserves were lent out.

The total assets of the Fed is given in the blue line that is in large the sum of the Treasury debt the Fed bought (solid black line) and the MBS (red line). The money that entered circulation is the total assets of the Fed (blue) minus the reserves (green), which gives the dashed black line. This line coincides almost exactly with the Treasury debt bought by the Fed (solid black) and with the total assets of the Fed (blue), before 2008 but not after 2008. The required reserves before 2008 are shown in the green line near to zero on the horizontal axis.

In 2008, after the Fed began skirting the Congressional Budget Reconciliation Act of 1974 by directly buying mortgage-backed securities, which by the Federal Credit Reform Act of 1990 have to be approved as loan purchases in the annual Congressional budget process, the Fed also skirted another law and began paying interest on all reserves.

The interest rate paid on reserves was authorized by the Financial Services Deregulatory Relief Act of 2006, but this was designed only for required reserves and legislated to become effective in 2011. The legislative history is clear that the idea was to pay interest on required reserves so that small banks were not penalized relative to large banks, since small banks had a larger proportion of their deposits held as reserves as compared to large banks. And the required reserves earned no interest. So the deregulation was to level the field slightly between small and large banks by paying interest on required reserves, but not on all reserves. Unfortunately, the law as written says it allows the Fed to pay “interest on reserves”. It should have read “interest on required reserves”, but it would be fair to say that no one envisioned (except the Fed itself perhaps) that this interest would ever be paid on all reserves.

The Fed took advantage of the wording of the 2006 Act, had the effective date moved up to 2008, and instead paid interest on all reserves. The green line shows that reserves built up almost exactly in line with the Treasury debt bought by the Fed. This sterilized the money creation of the Fed by leaving it in the coffers of the Fed, in the accounts of the large banks that sold the Treasury debt to the Fed and then left this in the Fed: This account at the Fed for the banks is called their “reserves.” Getting paid not to lend out these reserves, the reserves built up until 2014. And the Fed could claim it met its self-proclaimed inflation rate target of 2%, implying that their policy was successful.

However, once the Fed began raising the interest rate on reserves, the private banks began lending out this money held at the Fed and the reserves began entering circulation.

The dashed line shows that the amount of newly printed Fed money entering circulation is growing largely at a rate up to 2014 as it had in all previous history. But then the dashed line slopes up after 2015 as reserves enter circulation at a faster rate. Inflation remained moderate but increased from 0% in January 2015 to 2.5% two years later in January 2017.

However, the money entering circulation (black dashed line) shoots up beginning in 2020. Even though reserves built up even higher than their September 2014 peak of $2.8 trillion, to $4.2 trillion in September 2021, the Fed bought so much Treasury debt and MBS after 2020 that the money entered circulation at a hugely accelerated rate.

The quantity theory of money is well alive. As the Fed-printed money entered circulation at a dramatically accelerated rate, the US inflation rate rose dramatically after 2020. When the new money supply was effectively sterilized by banks holding it as reserves in their accounts at the Fed from 2008 to 2014, the money supply grew but the money supply that entered circulation did not grow much because it remained as reserves at the Fed. After 2020, the US Treasury borrowed so much to cover Treasury deficits, which rose above 10% of GDP, that the Treasury debt to GDP ratio rose dramatically, from 107% of GDP in the first quarter of 2020 to 134% of GDP in the second quarter of 2020. As in most major crises, the Fed helped out by buying large swathes of the new Treasury debt. After 2020, this time the new money did not all stay sterilized as reserves held at the Fed. Rather much of it was lent out, the money in circulation surged upwards, and the inflation rate followed with its surge upwards.

This is how the US got its inflation.

Professor Max Gillman invited to speak at Turkish summit on “Economic Transformation and New Paradigms”

Max Gillman, the Friedrich A. Hayek Professor in Economic History at the University of Missouri–St. Louis, joined a select group of economists from around the world at Turkey’s first Economic Transformation Summit, held Sept. 29 in the capital city of Istanbul.

The Turkish Treasury and Finance Ministry organized the one-day summit, “Economic Transformation and New Paradigms,” which explored major shifts that have taken place in the global economy in recent years, including but not limited to those caused by the COVID-19 pandemic.

Gillman joined a panel of economists from South Korea, the Netherlands and Italy discussing the “Importance of Investment-Production-Export model for Developing Countries.”

Turkey has this new economic model, which is part of non-orthodox policies called heterodox economics. The panel put into perspective the Turkish economic model, which is emphasizing investment in infrastructure. Gillman was emphasizing also investment in the education sector. Human capital investment is essential for the developing economies to become developed economies. He stressed the structural transformation of moving from agriculture towards manufacturing towards high-tech industry.

Last year, Gillman published a paper in the journal Economic Modelling titled “Steps in Industrial Development through Human Capital Deepening” that served as the foundation for the talk. The paper presents a model for industrial development in which human capital is deepened, education time increases and labor shifts away from agriculture. As that occurs, labor shifts toward new industry and away from traditional industry.

“The model explains rising education levels, growth and labor reallocation using a minimally complex approach that jointly explains stylized facts through human capital deepening within each industry,” according to its abstract.

Other panels explored “New trends in economic policies in the post-pandemic period,” the “Growing importance of infrastructure investments in the new period” and the “Growing importance of a financial architecture that supports growth in the new period” with economists from Australia, Germany, Japan, the Philippines, Portugal, Sweden, Singapore, the United Kingdom and the United States.

The next morning, the speakers were invited to a breakfast with Turkish President Recep Tayyip Erdoğan at the Presidential Palace.

Gillman along with his fellow economists had an opportunity to offer advice to the Turkish leader. A wide range of nuanced views was presented by the professors that supported the path that Turkey was taking.

Gillman, who researches inflation, stressed the importance of Turkey to the Western economy and the Western alliance, while agreeing that controlling inflation is an important objective. Gillman acknowledged the tightrope that Turkey was balancing along as one of the most important countries in the world that intermediates the aspirations of the East with those of the West, while remaining a key part of the Western firmament.

Gillman also expressed confidence in the economic policy path that Turkey was taking as shepherded by the Minister of Treasury and Finance, in terms of its investment strategy as long as inflation could be brought under control.

Friedrich A. Hayek’s 1944 acclaimed Road to Serfdom (reproduced by the Institute for Economic Affairs online) supports social insurance for when markets work imperfectly, a long tradition in neoclassical economics now reflected in practice by the implicit or explicit social insurance linked to nearly all fiscal policy:

“Nor is there any reason why the state should not help to organize a comprehensive system of social insurance in providing for those common hazards of life against which few can make adequate provision (Hayek, p. 67)….If we are not to destroy individual freedom, competition must be left to function unobstructed (p. 69).”

Our bank insurance system is a part of social insurance for aggregate financial risk to competitive asset markets; efficient social insurance “completes markets” rather than distorting either competition or capital markets. Our monetary policy likewise provides social insurance based trust in exchange means that allows competitive goods markets to optimally allocate resources.

With respect to banking, also from the Institute for Economic Affairs, consider my 2009 “Commentary” found  on their website at

International Deposit Insurance

and attached Gillman Economic Affairs of Institute for Economic Affairs 2009.

 

 

Time for Positive Interest Rates for Savers

Federal Reserve interest rates of 2% to 2.25% aren’t neutral if the inflation rate is 2.61%.

Extract from new forthcoming Berkeley E Journal of Macroeconomics: Advances, “The Welfare Cost of Inflation with Banking Time”, Max Gillman, 2018.

Below is Section 2 of this article:

“US Law on the Target Inflation Rate”

According to the US Federal Reserve Bank the FOMC (Federal Open Market Committee) has since 2012 adopted an explicit inflation target of 2%. In January 2012 the FOMC stated ( https://www.federalreservehistory.org/essays/humphrey_hawkins_act#footnote3)

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate (Board of Governors of the Federal Reserve System 2012).”

The same January 2012 FOMC statement continues that it will not specify the level of employment to be targeted:

“The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment” [bold added].

In contrast, current US law in the form of the 1978 Amendments to the 1946 Full Employment and Stability Act precisely sets both the targeted US inflation rate and the US unemployment rate. For inflation, it states that the US inflation rate should be 3% by 1983 and should be 0% by 1988 and afterwards, unless it conflicts with the employment goal. For unemployment, rates of 4% for aged 16 and over, and 3% for aged 20 and over, are to be met within 5 years of the passing of the 1978 Act (so by 1983).

Further, the Act specifies that only the President or Congress can change these goals. The US Federal Reserve Bank (Fed) is not allowed, by any existing law, to change these goals. Therefore, it is not authorized, without Presidential or Congressional mandate, to set a 2% inflation rate target as it did in 2012, because the target is currently specified in law as zero percent unless it conflicts with achieving the unemployment target. And it is not authorized to change the target unemployment rate of the 1978 Act.

(Public Law 95-523, passed October 27, 1978, is known as the Humphrey-Hawkins Act or officially within its Section 1 as “Full Employment and Balanced Growth Act of 1978”. https://www.govtrack.us/congress/bills/95/hr50/text
Alternatively, a pdf of the law is found at https://onlabor.org/wp-content/uploads/2016/12/STATUTE-92-Pg1887.pdf)

The Fed seemingly has a big loophole in that the 1978 Act specifies that the inflation rate target may be higher if it conflicts with the unemployment rate targets. But when the Fed set its 2% inflation target, it also specifically stated that the inflation target does not affect the unemployment rate, in that this is set by “nonmonetary factors”. So the Fed closes the loophole offered to it under the 1978 Act by saying the inflation and unemployment rates are “largely” unrelated.

However the Fed’s logic for not setting an unemployment rate goal is faulty. Rather than its authority to set unemployment rate targets being based on some envisioned relation between the inflation rate and the unemployment rate, the Fed has no authority to set unemployment rate targets since the fact is that these are already set in the 1978 Act, which provides no authority to the Fed to alter these targets. It is the specific US 1978 statutory law, which specifically precludes the Fed from having authority to change the unemployment rate targets, that implies that for the Fed: “it would not be appropriate to specify a fixed goal for employment”. The end result is that today the Fed has given no Congressionally valid reason for setting a 2% inflation rate target in deliberate contradiction of the 1978 Act’s target of a zero inflation rate.

There are four relevant sections of the Act, 4.b1.-4.b.4, which respectively set out the unemployment rate goal, the inflation rate target for the first five years, the inflation rate target for all years after 1988, and the authority for changing these targets.

“Section 4.b.(1). reducing the rate of unemployment, as set forth pursuant to section 3(d) of this Act, to not more than 3 per centum among individuals aged twenty and over and 4 per centum among individuals aged sixteen and over within a period not extending beyond the fifth calendar year after the first such Economic Report; and
Section 4.b.(2) reducing the rate of inflation, as set forth pursuant to section 3(e) of this Act, to not more than 3 per centum within a period not extending beyond the fifth calendar year after the first such Economic Report: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

“Section 4.c.(2). Upon achievement of the 3 per centum goal specified in subsection (b) (2), each succeeding Economic Report shall have the goal of achieving by 1988 a rate of inflation of zero per centum: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

Section 4.d states that only the President or Congress may change these goals:

“if the President finds it necessary, the President may recommend modification of the timetable or timetables for the achievement of the goals provided for in subsection (b) and the annual numerical goals to make them consistent with the modified timetable or timetables, and the Congress may take such action as it deems appropriate consistent with title III of the Full Employment and Balanced Growth Act of 1978.”

Using data from the US Bureau of Labor Statistics, the unemployment goal of 4% for over 16 years of age was achieved for briefly in December 1999, and for several months into 2000, when it dipped into the 3+% range. Now, in April, May, and June 2018, the rate has been again below or equal to 4%.

(https://fred.stlouisfed.org/series/UNRATENSA)

The rate for ages over 20 has been below 4% since September 2017.
The legislatively binding US law, which sets the US inflation rate to be 0% permanently, seems to be contraindicted permanently such that a permanent 2% inflation rate target is set “de facto” by the Fed. Would this contradiction of US law be based on the inability to meet some unemployment goal, it might be acceptable as an interim policy. But, 1) the Fed FOMC openly admits in January 2012 that monetary policy has little if any ability to affect the long term employment rate (as quoted above). And 2), the goals of the 1978 law on unemployment are now largely met, although having taken longer than the five years allowed. This achievement of the statutory US unemployment goals seems to imply unambiguously that the inflation target should now be zero.

To summarize and emphasize the conundrum here: First, the Fed claims the 2% inflation target is not chosen to achieve the unemployment goal, since it cannot affect unemployment. Second, the unemployment goal appears to have been met as of now anyway. Third, the inference results that the Fed appears to be contravening statutory law of a 0% inflation rate by their self-established 2% target. If so, then by US law, the Fed 2% inflation target is a judicially challengable over-reach by the Fed relative to US statutory law. While economists can consult the lawyers, this is clearly controversial, if not illegal, policy practice by the Fed, even though there not much of a fuss made over it by academics. Economists though can propose ways to quantify the cost of the Fed’s contraindiction of the zero inflation rate in favor of the 2% target. This is done here through the standard approach of the welfare cost of inflation, in terms of a 2% rate compared to zero.

The Wall Street Journal: Letter

“Fed Should Slowly Unwind Excess Reserves”

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves.

4 Comments

Sept. 26, 2018 3:15 p.m. ET

SEC chairman, Jay Clayton in April Photo: Yuri Gripas/Bloomberg News

Regarding your editorial “Sharing the Wealth of Markets” (Sept. 21): Yes, recent stock price increases aren’t creating new wealth as broadly as most would like because the market isn’t providing adequate liquidity for the kind of firms that drive economic growth. We believe that much of the blame rests with Federal Reserve policy.

The New Keynesian model the Fed uses led, in part, to paying banks interest on excess reserves in 2008. Before 2008 excess reserves were virtually zero but now hover near $2 trillion. This is no longer a rational response to the financial panic of 2008-09. Interest payments made by the Fed on those reserves have helped make major banks richer by not issuing loans from reserves but instead earning interest at no risk.

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves. This produced new economic activity that produced economic gains outside the banking sector. If the Fed began reducing the interest paid on excess reserves, the excess reserves would begin to enter the system and make capital available to startups by increasing liquidity.

If the near $2 trillion of excess reserves entered circulation tomorrow, it would soon expand the money stock, igniting a major inflation. Interest rates paid on excess reserves should therefore be cut in several stages. But if there ever was a compelling argument for paying banks to hold on to excess reserves, that time is past. The sooner the Fed unwinds this practice the sooner we can avoid frustrating the emergence and expansion of a new generation of wealth-creating firms.

Profs. Max Gillman and David C. Rose

University of Missouri-St. Louis

Thomas Gordon : Writing in Wall Street Journal: December 14, 2017

@Max Gillman Good comments and informatory about why banks are now paid interest  on reserves.   As it concerns the article, I don’t think they were paying a huge interest rate (I thought it was less than 1%, but probably more than most banks were paying depositors ).   Not enough in my mind to get banks to hold excess reserves, but I suppose it is risk free.   The other unspoken thing is that back when Wachovia and WaMu were going broke maybe Fed/Treasury type people were looking for ways to strengthen the banks.  Pay them directly and you get a riot about subsidizing hated banks.   Do it this way and you’re “paying interest on reserves”, a topic that puts most people to sleep.

Max Gillman just now

@Thomas Gordon @Max Gillman

Thomas, Thank you. The reason why the interest is still “high” is that every time the Fed “raises interest rates”, it is actually raising the Interest rate on excess reserves; the Federal Funds rate remains (since 2008) below the interest rate on excess reserves. This way the Fed induces these 10 systematically important banks to keep holding the (now) $2.1 Trillion in excess reserves. If lent out, and so there were zero excess reserves,  a normal “money multiplier” would cause the money supply to jump by 10 times $2.1 Trillion, or by $21 Trillion dollars. GDP is about that now, so it would be an amount of new money equal to GDP. Inflation would rise significantly, but capital markets would “normalize”. Real interest rates on short term debt would no longer be negative. So I believe the jump in inflation would be best overall, and the elimination of interest on excess reserves the route to such normality in Capital markets.

By MAX GILLMAN and DAVID C. ROSE

April 2017

Two weeks ago President Trump told House leaders that he liked most of the House Ways and Means Committee’s “Blueprint” for tax reform. The blueprint does indeed significantly improve tax policy in a number of ways. But a careful consideration of what the latest economic theory has to say about economic growth suggests that it could be even better. Republicans should not miss this once in a generation opportunity to significantly improve the US tax code.

Governments tax so they can spend. An important fact about federal spending is that in the US over the last 60 years it has been a rather stable proportion of GDP (we ignore entitlement spending since, for the most part, these programs have dedicated funding). The trend is downward from about 24% (in 1958 and 1967) to about 18% (1998-2000). In 2016 it was a little over 19%.

As a practical matter, then, the ultimate objective of tax policy should be to extract enough resources from the economy to support spending of 18-20% of GDP as efficiently and as fairly as possible. Extracting less, such as what has been the average tax revenue share of GDP over the last 60 years of 17% leads to ever increasing debt. Extracting more reduces consumption for no good reason and weakens incentives that support rapid growth.

The blueprint can be improved by adopting a top rate of 22% on personal income and a 22% rate on all corporate profit coupled with: 1) eliminating taxation on dividends (to avoid double-taxation of dividends and remove the differential treatment of debt and equity), 2) eliminating capital gains taxes on stock holdings, and 3) removing all deductions and loopholes except those that exist to properly define corporate and personal income.

There is a very important finding in macroeconomic theory that has gotten surprisingly little attention. In pioneering work Robert Barro, in an article in the Journal of Political Economy (1990), considered government spending to be a constant share of GDP. Then Stephen Turnovsky, in an article in the Journal of Monetary Economics (2000), showed that under this condition income tax policy should be neutral with respect to rates applied to human capital (personal income) and physical capital (corporate profit).

This type of tax neutrality is an established result that no one we know of has successfully challenged. It makes intuitive sense that policy should not favor one over the other and thereby distort resource allocation.

Moreover, no serious economist we know of supports the double taxation of corporate profit. So the real question is, therefore, how to best insure that all corporate income is actually taxed, but only once. Some favor accomplishing this by not taxing corporate profit because dividends will produce personal income which will ultimately be taxed anyway.

This approach is attractive because it recognizes that it is people, not firms, who ultimately bear the burden of paying taxes. But the problem with this approach is that not all corporate profit is distributed as dividend income that is later subject to the personal income tax. This simple fact is particularly relevant when considering a zero corporate profit tax rate.

A zero corporate profit tax rate will induce firms to hold back on dividends so as to reward shareholders mainly through capital gains appreciation arising from retained earnings. This subsidizes physical capital relative to human capital by inducing more earnings retention at zero cost to the firm. If retaining such amounts for firm reinvestment was the best use of these funds, it would have happened already without the tax code inducing such action.

There is another benefit from taxing corporate profits at the source rather than indirectly through personal income that is increased by dividends. The latter approach requires monitoring over 100 million payers to minimize avoidance. Our society makes it hard for government to know much about each household’s finances. Taxing corporate profits at the source, however, requires the monitoring of far fewer firms. And with corporate firms especially, their financial situations are very transparent. This means the effective rate – after accounting for avoidance – is more likely to be close to the official marginal rate when corporate profits are taxed at the source.

Achieving neutrality in how human capital and physical capital is taxed also affects how capital gains should be treated. If we choose to tax corporate profits at the source, then capital gains realized through the appreciation of the value of stock holdings should not be taxed. This approach also cuts off a means by which the federal government can increase taxes through inflating the value of the currency to drive up the price of stocks.

This problem is often cited as a rationale for having a lower tax rate on capital gains, but our approach renders this issue moot. It also vastly simplifies the filing of tax returns by eliminating at one stroke the vast financial industry of “cost-based” accounting of stocks, needed to determine the size of the reported capital gain.

Most discussions about tax rates involve a false choice between having a flat or progressive tax system. We think the blueprint can be greatly improved by not falling prey to this false choice. For personal income, an approach that is better than a pure flat or a thoroughly progressive tax is a progressive system that reaches its top bracket so quickly that it is effectively flat for the vast majority of income for the majority of tax payers. This is where progressivity is needed most – to have a lower or zero rate for those who earn the least. What matters most is not that the rate be perfectly flat, only that it is flat for the people who will be paying most of the taxes.

A tax blueprint with a top rate of 22% on personal income and a flat rate on all corporate income would be a better blueprint. It would move us much closer to taxing human and physical capital equally, which removes a major inefficiency of the current system and the existing blueprint. Its rate of 22% should be high enough to ensure sufficient revenue yield to cover 18% – 20% of spending out of GDP given there is always some avoidance and given that the lowest income individuals will pay lower rates (some zero). Finally, 22% is just below the corporate rate for a number of large countries. This will give American firms a stronger incentive to stay in the US and foreign firms a powerful incentive to move to the US.

Max Gillman is the F.A. Hayek Professor of Economic History and David C. Rose is a Professor Economics, both at the University of Missouri-St. Louis.

St. Louis Post-Dispatch

stltoday.com

St. Louis Post-Dispatch Column

Is the House blueprint for tax reform good for St. Louis?

• By Max Gillman and David C. Rose
• Mar 8, 2017

President Donald Trump recently stated that he will release an outline for comprehensive tax reform in the coming weeks, and if his previous statements are accurate, his eventual plan will likely look substantially similar to the House Ways and Means Committee’s blueprint for tax reform. It is not too early to ask if the other parts of the plan are generally good for the country and St. Louis.

The blueprint plan reduces both personal income tax rates and the corporate profits tax rates. It also simplifies a number of elements of the tax code. Current rates are high enough to reward avoidance behavior for both individuals and firms. This reduces the effective base upon which the rate is applied and suggests that a reduction in rates might actually increase tax revenues.

Modern models of the economy show that the lower rates are on personal income and corporate profits, and the closer these rates are to being equal on average, the better for economic growth. These models also show that the flatter both rates are, the better. The House blueprint plan moves in the right direction on each of these fronts.

Through most of the 20th century, the U.S. was the manufacturing juggernaut of the world. As a competitor to U.S. firms and workers, China, which is today an industrial giant, was completely out of the picture. This was also true for many countries in Eastern Europe. But all of that has changed. Whereas the U.S. federal tax rate is 35 percent, the European Union and world averages are both about 22.5 percent, and Russia’s rate is 20 percent. Higher rates relative to the rest of the world drive firms out of the U.S. so they can enjoy lower tax bills.

Our firms and workers must now compete with firms and workers from not only China and Eastern Europe, but increasingly with South Korea and Southeast Asia. Even in Northern European countries like Ireland, with its 12.5 percent corporate tax rate, the competition is heating up.

The St. Louis region has been hit hard in recent years by this foreign competition, particularly in manufacturing. Unfortunately, the harm caused by this trend does not fall equally. Those hurt the most are honest, hardworking, unskilled workers who could have earned a good living in manufacturing employment.

These changes have hit St. Louis especially hard because manufacturing has historically been such an important foundation for our regional economy. It follows that increasing the net rate of return on capital investment as well as relaxing and streamlining capital deduction rules will help the St. Louis region more than many other regions since the St. Louis region has been faltering because of the lack of manufacturing jobs.

Still, St. Louis has many natural advantages. Being centrally located and serving as a rail and interstate hub, it is cheap to bring unrefined resources in and cheap to ship them out. Fresh water is a very important resource, and we have it in great abundance. Strong education produces a good workforce even among unskilled workers. Remove the corporate profit tax impediment and St. Louis’ natural advantages will likely reassert themselves.

Additionally, in the U.S., politicians have been using corporate tax policy as a political game. The higher the average effective rate, the more valuable are tax loopholes. This makes it easier for politicians to buy votes from corporations in return for loopholes. The result is a system with high rates and low yield in part because it is riddled with loopholes that reward the politically savvy at the expense of everyone else.

These loopholes are not just unfair to the rest of us. They also distort investment decisions. The richest firms are able to pay the most to get loopholes that are favorable to them, so high rates plus lots of complexity that hides loopholes is a good example of how the rich get richer at the expense of everyone else.

The House blueprint brings down the top and average effective rates significantly but, even more importantly, it closes many of these loopholes. This is fairer and better for general economic growth, and we think the St. Louis region stands to benefit.

Max Gillman is a professor of economic history and David C. Rose is a professor of economics, both at the University of Missouri-St. Louis.