Wednesday, May 9, 2018

8/5/18: Law of Unintended Consequences and Complexity: Tax Cuts and Jobs Act 2017


The law of unintended consequences (or second order effects, as we call in economics) is ironclad: any policy reform has two sides to the coin, the side of forecasted and analyzed changes the reform engenders, and the side of consequences that appear after the reform has been enacted. The derivative proposition to this theorem is that the first side of the coin is what gets promoted by politicos in selling the reform, while the other side of the coin gets ignored until its consequences smack you in the face.

Behold the U.S. Tax Cuts and Jobs Act 2017, aka Trump's Tax Cuts, aka GOP's Gift for the Rich, aka... whatever you want to call it. Fitch Ratings recently released their analysis of the Act's unintended consequences, the impact the new law is likely to have on U.S. States' fiscal positions. And it is a tough read (see full note here: https://www.fitchratings.com/site/re/10025493).

"Recently enacted federal tax changes (H.R.1) are making budgeting and revenue forecasting more complex for many U.S. state governments," says Fitch. "...provisions including the cap on SALT deductions are a likely trigger behind a spike in state revenue collections for the current fiscal year. In Massachusetts for example, individual income tax collections through January 2018 were up nearly 12% from the prior year, this after the commonwealth recorded just 3% annual growth in January 2017. Many states are seeing robust year-over-year gains in revenue collections, though this will likely amount to little more than a one-time boost with income tax collections set to level off for the rest of the fiscal year."

State tax revenues can increase this year because, for example, of reduced Federal tax liabilities faced by households. As income tax at federal level falls, State tax deductions taken by households on their personal income for Federal tax liabilities will also fall, resulting in an increase in tax revenues to the States. Similarly, as Federal corporate income tax falls, and, assuming, corporate income rises, States will be able to collect increased revenues from the corporate activity domiciled in their jurisdictions. All of this implies higher tax revenues for the States. Offsetting these higher tax revenues, the Federal Government transfers to the individual states will likely decline as deficits balloon and as Pentagon demands an ever-greater share of Federal Budget.

In other words, the tax cuts are working, but do not expect these to continue working into the future. Or put differently, don't spend one-off revenue increases, folks. For high-spending States, like California, it is tempting to throw new money onto old bonfires, increasing allocations to public pensions and state hiring programs. But 2017 Tax Reform is a combination of permanent and temporary measures, with the latter more dominant than the former. Expiration of these measures, as well as complex interaction between various tax measures, suggest that the longer term effect of the Act on States' finances is not predictable and cannot be expected to remain in place indefinitely.

As Fitch noted: "Assessing the long-term implications of H.R. 1 will not be an easy task due to the complicated interrelationships of the law changes and because many of the provisions are scheduled to expire within the next decade. Yet-to-be finalized federal regulations around the tax bill and the possibility of additional federal legislation add more complexity and risk for states."

Tuesday, May 8, 2018

8/5/18: Germany's ifo: World Economic Climate Deteriorates


Here is the summary of the Germany's ifo Institute World Economic Climate outlook update (emphasis is mine):

"The ifo World Economic Climate has deteriorated. The indicator dropped from 26.0 points to 16.5 points in the second quarter, returning to more or less the same level as in the fourth quarter of 2017. Experts’ assessments of the current economic situation remained as favourable as last quarter, but their expectations are far less optimistic. The world economy is still experiencing an upturn, but it is losing impetus.

The economic climate deteriorated in nearly all regions. Both assessments of the current economic situation and expectations fell significantly in the USA. In the European Union, Latin America, the CIS countries, the Middle East and North Africa economic expectations also cooled down. Assessments of the current economic situation, by contrast, improved. Economic expectations also clouded over in the Asian emerging economies and developing countries. Assessments of the current economic situation, by contrast, remained more or less unchanged.

In line with rising inflation expectations, short and long-term interest rates will rise over the next six months. Experts also expect far weaker growth in world trade, partly because they are reckoning with higher trade barriers. Overall, experts expect world gross domestic product to increase by 3.9 percent this year."




This is in line with my recent warnings on the pressures building up in the global economy, as raised in a series of recent articles for the Sunday Business Post see http://trueeconomics.blogspot.com/2018/04/27418-global-growth-and-irelands.html and http://trueeconomics.blogspot.com/2018/02/27218-volatility-uncertainty-are-back.html, and for the Cayman Financial Review see: http://trueeconomics.blogspot.com/2018/04/27418-goldilocks-economy-of-state.html.

Sunday, April 29, 2018

28/4/18: Unintended Consequence of Tax Audits


The law of unintended consequences applies to all policies and all state systems design, including tax policies, tax laws and tax enforcement. This is a statement of truism. And it  works both ways. A well-designed policy to promote income supports and aligned incentives to work, for example, can have an unintended impact of increasing fraud. Conversely, a measure to enforce the policy to prevent fraud can result in undoing some of the positive impacts of the policy which it was designed to deliver. These statements are also a form of truism.

However, rarely do we see research into the unintended consequences of core tax policies delivering a negative view of the perceived wisdom of regulators and enforcers. Instead, we tend to think of tax laws enforcement as an unquestionable good. Fraud and tax evasion prevention are seen as intrinsically important to the society, and the severity of penalties and punishments imposed on non-compliance (whether by error or design) is seen as being not only just, but pivotal to the sustainability of the entire tax system. Put differently, there is an inherent asymmetry in the relationship between tax payers and tax enforcers: the former face potentially devastating penalties for even minor infringements, while the latter face zero cost for wrongfully accusing the former of such infringements. Tax audits are free of consequences to enforcers, and tax audits are of grave consequences to those being audited.

In this environment, tax audits can lead to severe distortions in the balance of intended and unintended consequences of the tax law. Yet, rarely such distortions are considered in the academic literature. The prevalent wisdom that the tax authorities are always right to audit and severely punish lax practices is, well, prevalent.

One recent exception to this rule is a very interesting paper, titled “Tax Enforcement and Tax Policy: Evidence on Taxpayer Responses to EITC Correspondence Audits” by John Guyton, Kara Leibel, Dayanand S. Manoli, Ankur Patel, Mark Payne, and Brenda Schafer (NBER Working Paper No. 24465, March 2018).  Five of the six authors work for Uncle Sam in either IRS or Treasury.

The paper starts by explaining how EITC audits work. "Each year, the United States Internal Revenue Service (IRS) sends notices to selected taxpayers who claim Earned Income Tax credit (EITC) benefits to request additional documentation to verify those claims." Worth noting here, that IRS' EITC audits are the lowest cost audits from the point of view of the taxpayers who face them: they are based on email exchanges between IRS and the audited taxpayer and request pretty limited information. In this, the EITC audits should create lower unintended consequences in the form of altering taxpayers' behavior than, say, traditional audits that require costly engagement of specialist accountants and lawyers by the taxpayers being audited.

So, keep in mind, fact 1: EITC audits are lower cost audits from taxpayer's perspective.

The study then proceeds to examine "the impacts of these correspondence audits on taxpayer behavior." The study specifically focuses on the labor market changes in response to audits. Now, in spirit, EITC was created in the first place to incentivise greater labor force participation and work effort for lower income individuals. The authors describe the EITC as "the United States’ largest wage subsidy antipoverty program."

Thus, keep in mind, fact 2: EITC was created to improve labor supply choices by lower income individuals.

As noted by the authors, "because these correspondence audits often lead to the disallowance of EITC benefits for many individuals, we are able to examine how the disallowance of EITC benefits affects individuals’ labor supply decisions." The authors use audits data for 2010-2012 and have accompanying administrative data for 2001-2016, so the "data allow for analysis of short-term changes in behaviors one year after the audit, as well as persistent or longer-term changes in behaviors up to six years after the audit".

The study "results indicate significant changes in taxpayer behavior following an EITC correspondence audit. In the year after being audited, we estimate a decline in the likelihood of claiming EITC of roughly 0.30, or 30 percentage points. The decrease in the likelihood of claiming EITC benefits persists for multiple years after the EITC correspondence audits, although the size of the effect is reduced over time." In year four, the likelihood of audited EITC filers still filing EITC claims is 1/4 of that for non-audited higher risk EITC filers.

Now, logical question is: was the decrease down to audits weeding out fraudulent claims? The answer is, not exactly. "Much of the decline in claiming EITC benefits following an EITC correspondence audit appears driven by decreases in the likelihood of filing a tax return." Authors suggest that 2/3rds of the decline in EITC filings post-audit is down to taxpayers stopping filing any tax returns post-audit. Which means that even some of the taxpayers who continue to file returns post-EITC audit are dropping out of EITC system.


Audits seem to trigger reductions in tax liabilities post-audit for self-employed taxpayers (ca $300 in a year following the audit) and no changes in tax liabilities post-audit for wage earners. This suggests that post-audit reported incomes either fall (for the self-employed) or remain static for those in employment. This, in turn, suggests that EIDC audits do not lead to improvements in income status for those audited by the IRS. In other words, audits do not reinforce or improve the stated objectives of EITC (see fact 2 above).

"For the Self-Employed, we estimate an increase in labor force participation (where labor force participation is defined in terms of having positive W-2 wage earnings), possibly indicating some reallocation of labor supply from self-employment to wage employment. In contrast, for Wage Earners, we estimate a decrease in labor force participation following the EITC correspondence audits."

Thus, we have fact 4: self-employed are likely to switch their income from self-employment to wages post-audit, while wage earners tend to drop their labor force participation post-audit.

The former part of fact 4 suggests can be reflective of fraudulent behavior by some self-employed who might over-state their self-employment income prior to audit in order to draw EIDC tax credits. The latter effect, however, clearly contravenes the stated objective of the EIDC system. On the first point, quick clarification via the authors of the study:"Intuitively, some lower-income individuals may increase reported self-employment (non-third-party verified) income, possibly by choosing to disclose more income, invent income, or not disclose expenses, to claim the EITC, but if they are detected by audit, they may become averse to inventing self-employment income for purposes of claiming EITC and without this income they may not file a tax return. These taxpayers may perceive the payoff from not filing as better than the payoff from filing and correctly reporting income."

Now, one can think of the effect on self-employment to be a relatively positive one. "Following the disallowance of EITC benefits due to an EITC correspondence audit, taxpayers with self-employment income on their audited returns appear more likely to have wage earnings in the next year, perhaps to offset the loss of EITC as a financial resource." But that is only true if we consider self-employment as a substitute for employment. In contrast, if self-employment is viewed as potentially entrepreneurial activity, such substitution harms the likelihood of entrepreneurship amongst lower earners. The study does not cover this aspect of the enforcement outcomes.

In measured terms, if EITC audits were successful in reinforcing EITC intended objectives, post-audits, we should see increases in wages and earnings for EITC audited individuals. Thus, we should see migration of lower earners EITC recipients to higher earners. Put differently, the share of higher earners within EITC eligible population should rise, while the share of lower earners should fall.

This is not what appears to be happening. Instead, we see increase in density (share) of lower earnings and slight decreases in densities of higher earnings:


Unambiguously, however, the study shows the damaging effects of audits: they tend to reduce labor force participation, offsetting the intended positive effects of the EITC program, and they tend to increase income tax non-filing, effectively pushing taxpayers into a much graver offence of income tax non-compliance.

Yet, still, we continue to insist that punitive, aggressive audit practices designed to impose maximal damage on tax codes violating taxpayers is a good thing. There has to be a more effective way to enforce the tax codes than throwing pain of audits around at random.

Saturday, April 28, 2018

28/4/18: The Great Recovery with No Savings: U.S. Households' Meet 'Exceptionalism'


Via @bySamRo, a chart from Deutsche Bank research:


Which, of course, illustrates the marvels of the current 'recovery' cycle - a steady rise in the proportion of U.S. households with no wealth. More than 30 percent of all U.S. households have zero or negative non-housing wealth.

To pair this with other data, here is the U.S. household saving rate:


And here are the median saving account levels by age:

Not scared yet? Ok, here's another fact: according to Bankrate's financial security index survey, released in January 2018, only 39 percent of Americans said they would be able to finance a $1,000 emergency spending using their savings. In 2016, a survey found that 69 percent of Americans had less than USD1,000 in savings, while 34 percent had zero savings.

A dental emergency, even with a dental insurance coverage, can knock a good half of 69 percent of the U.S. households into zero savings territory. Credit cards and personal loans are de facto shoring up the Great American Dream for the vast swathes of the middle classes. Some 'exceptionalism', folks...

Wednesday, April 25, 2018

25/4/18: 90 years of Volatility: VIX & S&P


A great chart from Goldman Sachs via @Schuldensuehner showing extreme events in markets volatility using overlay of VIX and realised volatility from 1928 on through March 2018:


For all risk / implied risk metrics wonks, this is cool.

25/4/18: Draining of the Washington Swamp Reveals Mulvaney


Quote of the month, if not of the year, belongs to yet another Trump Administration 'draing the swamp hero, Mick Mulvaney, currently the White House budget director and, according to some rumours, a prime candidate to be the next Chief of Staff. Speaking at the American Bankers Association, Muvaney, who previously served as a Congressman declared: "We had a hierarchy in my office in Congress. If you're a lobbyist who never gave us money, I didn't talk to you. If you're a lobbyist who gave us money, I might talk to you."

So here we have it, folks: top Trump official claiming on the record to have engaged in a cash-for-influence peddling, the very same offence that Trump campaign routinely accused the Clinton Foundation of.

That is some draining of the Washington swamp that President Trump accomplished. Right there, in swamp's prime dweller's own words.

Link to the quote: http://www.businessinsider.com/mick-mulvaney-tells-bankers-donate-to-congress-for-influence-2018-4.

As an aside, Pew Research data shows that the American people, by a large majority, are aware of the deep corruption in Washington. "Americans think that those who donate a lot of money to elected officials have more political influence than others. An overwhelming majority (77%) supports limits on the amount of money individuals and organizations can spend on political campaigns and issues. And nearly two-thirds of Americans (65%) say new laws could be effective in reducing the role of money in politics." (see http://assets.pewresearch.org/wp-content/uploads/sites/5/2018/04/26140617/4-26-2018-Democracy-release.pdf).

One the results: "Overall, nearly six-in-ten Americans (58%) say democracy in the United States is working very or somewhat well, though just 18% say it is working very well. Four-in-ten say it is working not too well or not at all well."
Any surprise, when the likes of Mulvaney are running public offices?

25/4/18: Dombret on the Future of Europe


An interesting speech by y Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, on the future of Europe, with direct referencing to the issues of systemic financial risks (although some of these should qualify as uncertainties) and resilience of the regulatory/governance systems (I wish he focused more on these, however).

25/4/18: Tesla: Lessons in Severe and Paired Risks and Uncertainties


Tesla, the darling of environmentally-sensible professors around the academia and financially ignorant herd-following investors around the U.S. urban-suburban enclaves of Tech Roundabouts, Silicon Valleys and Alleys, and Social Media Cul-de-Sacs, has been a master of cash raisings, cash burnings, and target settings. To see this, read this cold-blooded analysis of Tesla's financials: https://www.forbes.com/sites/jimcollins/2018/04/25/a-brief-history-of-tesla-19-billion-raised-and-9-billion-of-negative-cash-flow/2/#3364211daf3d.

Tesla, however, isn't that great at building quality cars in sustainable and risk-resilient ways. To see that, consider this:

  1. Tesla can't procure new parts that would be consistent with quality controls norms used in traditional automotive industry: https://www.thecarconnection.com/news/1116291_tesla-turns-to-local-machine-shops-to-fix-parts-before-theyre-installed-on-new-cars.
  2. Tesla's SCM systems are so bad, it is storing faulty components at its factory. As if lean SCM strategies have some how bypassed the 21st century Silicon Valley: http://www.thedrive.com/news/20114/defective-tesla-parts-are-stacked-outside-of-california-machine-shop-report-shows.
  3. It's luxury vehicles line is littered with recalls relating to major faults: https://www.wired.com/story/tesla-model-s-steering-bolt-recall/. Which makes one pause and think: if Tesla can't secure quality design and execution at premium price points, what will you get for $45,000 Model 3?
  4. Tesla burns through billions of cash year on year, and yet it cannot deliver on volume & quality mix for its 'make-or-break' Model 3: http://www.thetruthaboutcars.com/2018/04/hitting-ramp-tesla-built-nearly-21-percent-first-quarter-model-3s-last-week/.
  5. Tesla's push toward automation is an experiment within an experiment, and, as such, it is a nesting of one tail risk uncertainty within another tail risk uncertainty. We don't have many examples of such, but here is one: https://arstechnica.com/cars/2018/04/experts-say-tesla-has-repeated-car-industry-mistakes-from-the-1980s/ and it did not end too well. The reason why? Because uncertainty is hard to deal with on its own. When two sources of uncertainty correlate positively in terms of their adverse impact, likelihood, velocity of evolution and proximity, you have a powerful conventional explosive wrapped around a tightly packed enriched uranium core. The end result can be fugly.
  6. Build quality is poor: https://cleantechnica.com/2018/02/03/munro-compares-tesla-model-3-build-quality-kia-90s/.  So poor, Tesla is running "reworking" and "remanufacturing" poor quality cars facilities, including a set-aside factory next to its main production facilities, which takes in faulty vehicles rolled off the main production lines: https://www.bloomberg.com/view/articles/2018-03-22/elon-musk-is-a-modern-henry-ford-that-s-bad.
  7. Meanwhile, and this is really a black eye for Tesla-promoting arm-chair tenured environmentalists, there is a pesky issue with Tesla's predatory workforce practices, ranging from allegations of discrimination https://www.sfgate.com/business/article/Tesla-Racial-Bias-Suit-Tests-the-Rights-of-12827883.php, to problems with unfair pay practices https://www.technologyreview.com/the-download/610186/tesla-says-it-has-a-plan-to-improve-working-conditions/, and unions busting: http://inthesetimes.com/working/entry/21065/tesla-workers-elon-musk-factory-fremont-united-auto-workers.  To be ahead of the curve here, consider Tesla an Uber-light governance minefield. The State of California, for one, is looking into some of that already: https://gizmodo.com/california-is-investigating-tesla-following-a-damning-r-1825368102.
  8. Adding insult to the injury outlined in (7) above, Tesla seems to be institutionally unable to cope with change. In 2017, Musk attempted to address working conditions issues by providing new targets for fixing these: https://techcrunch.com/2017/02/24/elon-musk-addresses-working-condition-claims-in-tesla-staff-wide-email/. The attempt was largely an exercise in ignoring the problems, stating they don't exist, and then promising to fix them. A year later, problems are still there and no fixes have been delivered: https://www.buzzfeed.com/carolineodonovan/tesla-fremont-factory-injuries?utm_term=.qa8EzdgEw#.dto7Dnp7A. Then again, if Tesla can't deliver on core production targets, why would anyone expect it to act differently on non-core governance issues?
Here's the problem, summed up in a tight quote:


Now, personally, I admire Musk's entrepreneurial spirit and ability. But I do not own Tesla stock and do not intend to buy its cars. Because when on strips out all the hype surrounding this company, it's 'disruption' model borrows heavily from governance paradigms set up by another Silicon Valley 'disruption darling' - Uber, its financial model borrows heavily from the dot.com era pioneers, and its management model is more proximate to the 20th century Detroit than to the 21st century Germany.

If you hold Tesla stock, you need to decide whether all of the 8 points above can be addressed successfully, alongside the problems of production targets ramp up, new models launches and other core manufacturing bottlenecks, within an uncertain time frame that avoids triggering severe financial distress? If your answer is 'yes' I would love to hear from you how that can be possible for a company that never in its history delivered on a major target set on time. If your answer is 'no', you should consider timing your exit.