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Ezekiel Emanuel, Rahm’s brother and former health care adviser to President Obama, acknowledges in today’s Wall Street Journal that adverse selection may prove to be a “bump in the road” in the implementation of the Affordable Care Act (ACA).  But never you mind.  He’s got solutions.  And, as usual, they all come down to messaging.

Emanuel describes the ACA’s adverse selection problem in what are, for this Administration and its surrogates, remarkably frank terms:

Here is the specific problem: Insurance companies worry that young people, especially young men, already think they are invincible, and they are bewildered about the health-care reform in general and exchanges in particular. They may tune out, forego purchasing health insurance and opt to pay a penalty instead when their taxes come due.

The consequence would be a disproportionate number of older and sicker people purchasing insurance, which will raise insurance premiums and, in turn, discourage more people from enrolling. This reluctance to enroll would damage a key aspect of reform.

Insurance companies are spooked by this possibility, so they are already raising premiums to protect themselves from potential losses. Yet this step can help create the very problem that they are trying to avoid. If premiums are high—or even just perceived to be high—young people will be more likely to avoid buying insurance, which could start the negative, downward spiral of exchanges full of the sick and elderly with not enough healthy people paying premiums.

Of course, Emanuel leaves out an important part of the story: the fact that the ACA itself encourages young, healthy people (the “young invincibles,” he calls them) to forego buying health insurance.  The statute does so by mandating that health insurance be sold on a “guaranteed issue” basis (meaning that insurance companies can’t deny coverage to people who waited to buy it until they became sick) and at prices based on “community rating” (meaning that those who are sick or susceptible to sickness can’t be charged more than the healthy).  Taken together, these provisions largely eliminate the adverse personal consequences of waiting to buy health insurance until you need medical treatment.  (You can’t be denied coverage or charged a higher premium reflecting your illness.)  They thereby decimate the incentive for young, healthy people to buy health insurance until they need it.  And since the law doesn’t (and can’t, according to the Supreme Court) require young, healthy people to carry insurance, many are likely to forego buying coverage in favor of paying a small “tax” — $95 in 2014, as opposed to the $2,480 out-of-pocket cost for an individual policy bought on a subsidized exchange by a 26 year-old earning $30,000.  As I have argued on this blog and elsewhere, the ACA is likely to generate a devastating spiral of adverse selection as the “young invincibles” drop out of the pool of insureds, causing premiums for the covered population to rise, encouraging even more of the marginally healthy to exit the risk pool, causing premiums to rise even further, etc., etc.

But don’t you worry.  Dr. Emanuel’s got it figured out.  He explains:

Fortunately, there are solutions [to this ACA-induced adverse selection problem]. First, young people believe in President Obama. They overwhelmingly voted for him. He won by a 23% margin among voters 18-29—just the people who need to enroll. The president connects with young people, too, so he needs to use that bond and get out there to convince them to sign up for health insurance to help this central part of his legacy. Every commencement address by an administration official should encourage young graduates to get health insurance.

Second, we need to make clear as a society that buying insurance is part of individual responsibility. If you don’t have insurance and you need to go to the emergency room or unexpectedly get diagnosed with cancer, you are free- riding on others. Insured Americans will have to pay more to hospitals and doctors to make up for your nonpayment. The social norm of individual responsibility must be equated with purchasing health insurance.

Finally, and most important, we should adopt some of Massachusetts’ practices. When state officials in 2006-2007 were rolling out their exchange—called the Massachusetts Connector—they mounted a sustained campaign to encourage enrollment by young people. One aspect of the campaign focused in particular on young men, even heavily promoting the new exchange on TV during Red Sox games and hosting an annual “Health Connector Day” at Fenway Park.

So we’re going to lick this pernicious adverse selection problem by combining President Obama’s legendary star power with a dollop of good old fashioned shaming and some targeted advertising during baseball games?  One is reminded of Homeland Security Secretary Tom Ridge’s 2003 statement that Americans should use duct tape to protect themselves from chemical weapons attacks.  But this is really worse.  The chance of a chemical weapons attack in 2003 was pretty small.  Insurance premiums’ rising as a result of ACA-inspired adverse selection, by contrast, is a near certainty. Let’s make sure we keep the President and HHS Secretary Sebelius on that commencement address circuit!

Another day, another (presumably) unintended consequence of the Affordable Care Act.  (I say presumably because there’s a plausible theory out there that the Act was engineered to fail and thereby pave the way for a single-payer health care system. I’m not cynical enough to embrace that view, though a close look at the Act reveals design flaws so fundamental that one wonders who ever could have expected the thing to succeed.)

The latest unintended development is the move by employers to cut workers’ hours so as to avoid having to provide ACA-compliant (generous) health insurance policies. Under the Act, an employer with 50 or more employees faces an annual fine of $2,000 per worker if it fails to offer high-benefit insurance at an affordable rate and a full-time employee therefore purchases subsidized insurance on a state exchange.  One way to avoid this liability is to hold employees’ hours below thirty per week so that they are not deemed full-time.  The CEO of Papa John’s Pizza recently announced that his franchisees are likely to take that tack.  Darden Restaurants, which operates 2,000 restaurants under Olive Garden, Red Lobster, and Longhorn Steakhouse labels, is currently experimenting with a 29.5 hour work week aimed at evading the ACA’s so-called employer mandate. Applebee’s and Jimmy John’s are making similar plans, as are, according to the Wall Street Journal, Pillar Hotels and Resorts (owner of 210 franchise hotels), CKE Restaurants (parent of Carl’s Jr. and Hardee’s restaurants), and Anna’s Linens.

ACA proponents are incensed.  Referencing an interview in which Jimmy John thanked his parents for the start-up money they provided him and stated “I hope that I can give back to society the way they have,” one blogger wrote:  “Maybe Jimmy John can start ‘giving back to society’ by giving his employees health care? What a loser.”

In actuality, the kindest thing employers can do for their low-wage employees is to drop their health insurance coverage.  Here’s why:

  • It is well understood in labor economics, and a vast body of empirical research demonstrates, that employee benefits are a one-for-one substitute for salary. When an employer purchases benefits for an employee, she normally reduces the employee’s take-home pay by an amount equal to the amount she spends on the benefit. The employer thus faces a “wage or benefits” decision whenever she sets up a employee’s compensation package, and she should settle on the combination that provides the most total benefit to the employee.
  • When the employer buys health insurance for her employees, they receive an effective subsidy from the federal government because compensation paid in the form of health insurance benefits, rather than salary, is not taxed. The amount of the effective subsidy is the sum of the payroll tax rate and the employee’s marginal income tax rate times the policy price paid by the employer. Because marginal tax rates increase with income, the effective subsidy for high-wage earners is much greater than for low-wage employees. (For most lower-income workers, the effective subsidy will be 22.65% * the policy price. That assumes a 7.65% payroll tax (1.45% Medicare + 6.2% Social Security) and a marginal income tax rate of 15%.)
  • If, but only if, an employer declines to purchase ACA-compliant insurance for her lower-wage employees (those earning up to 400% of the Federal Poverty Level), they may purchase federally subsidized insurance on a state exchange. The amount of the subsidy available on an exchange is greater at lower-income levels. It generally swamps the effective subsidy for employer-provided health insurance, especially at lower wage levels.
  • Because higher-wage employees (1) receive relatively higher effective subsidies for employer-provided health benefits, and (2) are not eligible for ACA subsidies on state exchanges, it makes sense for their employers to continue providing them with health insurance benefits. Lower-wage workers, by contrast, are better off if their employers stop compensating them with health insurance, for which only relatively small subsidies are available, and thereby enable them to take advantage of the large subsidies available to employees without employer-provided health care coverage.

An example may help here. Suppose an employer wishes to provide $40,000 in total compensation to a 40 year-old employee who is the head of a four-person household. If the employer purchases a family policy for the employee (approximate cost $12,000/year), it will pay the employee $28,0000/year.  The employee will pay no payroll or income tax on the component of her compensation provided as health insurance, so she receives an effective federal subsidy of $2,718 (22.65% * $12,000).  If the employer were to drop health care coverage, the employee would receive all her compensation — all $40,000 — as take-home pay.  On the incremental $12,000 paid as cash rather than benefits, she’d have to pay $2,718 in tax, but she would now be eligible to purchase her own insurance at a subsidized rate. The ACA would limit her out-of-pocket insurance expense to 4.95% of annual income ($1,980), which means she would receive a whopping $10,020 subsidy on the $12,000 family policy. This employee is $7,302 better off if her employer drops coverage (costing her $2,718 in foregone tax subsidy) and allows her to access the more generous subsidies available on state exchanges (benefiting her by $10,020).

In a competitive labor market, we can expect all sorts of employers seeking to attract lower-wage workers to follow this “pro-employee” practice. We can also expect ACA-proponents and a compliant press to pillory such employers. The real culprit, though, is the group of policymakers who forced upon us the perverse set of incentives known as the Affordable Care Act.  Sadly, it seems it’s here to stay.

A couple of weeks ago, I argued that the Supreme Court’s decision upholding the constitutionality of the Affordable Care Act will ultimately doom the Act to failure. The problem, I argued, is that the ACA’s guaranteed issue and community rating provisions create a perverse incentive for young, healthy people not to buy insurance until they need it, and the Supreme Court’s reasoning that the penalty for failure to carry insurance is a “tax” because it is small relative to the price of insurance precludes Congress from increasing the no-insurance penalty to the point at which it prevents young, healthy people from dropping coverage. As those folks remove themselves from the pool of insureds, insurance premiums (reflective of the per capita expected health care costs of the covered population) will rise, leading even more relatively healthy people to exit the pool and thereby exacerbating the “healthy flight” problem. In short, guaranteed issue (i.e., insurers have to insure you regardless of your health) + community rating (i.e., insurers can’t charge you more if you’re sick) + constitutionally limited low penalties for failure to carry insurance (a result of the Supreme Court’s reasoning in NFIB v. Sebelius) = adverse selection that will drive insurance premiums through the roof.

Some readers noted flaws in my analysis. One correctly observed that I had ignored the premium support subsidies the ACA provides for lower- and middle-income people (those earning from 1.33 to four times the Federal Poverty Level). Those subsidies may prevent many younger, healthier people from failing to buy or dropping coverage because the no-insurance penalty will exceed the out-of-pocket cost of insurance (i.e., the policy price minus the amount of the federal subsidy). Someone else observed that I had ignored the ACA’s employer mandate, which requires employers with more than 50 employees to provide insurance coverage or else pay a penalty for each employee that buys her own subsidized insurance on a state exchange. Since most people get their insurance coverage through their employers—an unfortunate result of the federal tax code—perverse incentives in the individual insurance market might not be that significant.

Unfortunately, neither the ACA’s premium support subsidies nor its employer mandate will save the Act from failure. Here’s why:

Premium Support Subsidies

The ACA’s premium support subsidies are unlikely to prevent substantial “healthy flight” for two reasons. First, they’re too small. When a young, healthy person is deciding whether to buy insurance now or to hold off, pay the penalty, and sign up for coverage when her family needs it, she will compare the no-insurance penalty with her out-of-pocket expense for a subsidized policy. If the penalty exceeds out-of-pocket expenses (policy price minus available subsidies), then it makes sense to purchase insurance. Otherwise, it makes sense to pay the “tax” until insurance coverage is needed, at which point it will be available (guaranteed issue) at rates not reflecting the family’s particular health care needs (community rating). To assess the risk of adverse selection, then, we must consider the magnitude of penalties, expected insurance premiums, and available subsidies.

The ACA provides that the penalty for failure to purchase insurance shall be the greater of:

  • A flat dollar amount per person (for adults, $95 in 2014, $325 in 2015, $695 in 2016 and beyond, adjusted for inflation; for children, half the adult penalty), with the flat amount per family never exceeding three times the adult amount; or
  • A percentage of income (1% in 2014, 2% in 2015, and 2.5% in 2016 and beyond) above the tax-filing threshold (estimated to be around $10,250 for single filers and $20,500 for joint filers in 2016).

For four-person families eligible for premium support subsidies (those earning from 133% to 400% FPL), the flat rate will always exceed the income percentage, so the maximum penalty will be $2,085 (adjusted for inflation from 2016 dollars). Insurance premiums will be substantially higher than that amount. According to Kaiser Family Foundation estimates, the 2014 price of “silver level” (70% actuarial value) insurance coverage for a family of four living in a moderate cost region will range from $10,108 for a family headed by a 30 year-old to $19,750 for a family headed by a 55 year-old. Since the ACA mandates only “bronze level” (60% actuarial value) coverage, so we can estimate prices of qualifying policies to be about 86% (60/70) of those levels, or from $8,693 for the 30 year-old’s family to $16,985 for the family of the 55 year-old.

The important comparison, however, is between the penalty amount ($2,085) and the subsidized price of qualifying insurance. For qualifying individuals and families, the ACA lavishes generous subsidies that are inversely related to income. Even after accounting for available subsidies, though, most families will find it more advantageous to pay the penalty than to purchase insurance.

The following table, based on Kaiser’s Health Reform Subsidy Calculator, shows for different family income levels the maximum income percentage and out-of-pocket dollars the family would have to pay for subsidized insurance, the percentage difference in outlays for the family’s two options (buy insurance or pay penalty), and the family’s likely decision (buy or don’t buy):

 Family   income

Maximum % of income to be spent on insurance

Maximum dollar amount to be spent on insurance

Comparison of insurance expenses
vs. penalty

Likely decision

$35,000

3.97%

$1,388

 Penalty is 50% more than ins.

Buy

$40,000

4.96%

$1,982

 Penalty is 5.2% more than ins.

Buy

$45,000

5.94%

$2,672

 Ins outlays are 1.28 times penalty amount.

Don’t buy

$50,000

6.77%

$3,385

 Ins outlays are 1.62 times penalty amount.

Don’t buy

$55,000

7.52%

$4,135

 Ins outlays are 1.98 times penalty amount.

Don’t buy

$60,000

8.23%

$4,937

 Ins outlays are 2.36 times penalty amount.

Don’t buy

$65,000

8.85%

$5,751

 Ins outlays are 2.76 times penalty amount.

Don’t buy

$70,000

9.47%

$6,626

 Ins outlays are 3.18 times penalty amount.

Don’t buy

$75,000

9.50%

$7,125

 Ins outlays are 3.42 times penalty amount.

Don’t buy

$80,000

9.50%

$7,600

 Ins outlays are 3.65 times penalty amount.

Don’t buy

$85,000

9.50%

$8,075

 Ins outlays are 3.87 times penalty amount.

Don’t buy

$90,000

9.50%

$8,550

 Ins outlays are 4.1 times penalty amount.

Don’t buy

$95,000

No maximum.

Policy cost

 Ins outlays (dependent on ages) significantly exceed penalty amount.

Don’t buy

$100,000

No maximum.

Policy cost

 Ins outlays (dependent on ages) significantly exceed penalty amount.

Don’t buy

 

As the table reveals, at all but the lowest income levels it makes more sense for healthy families to refrain from purchasing insurance and pay the penalty until insurance coverage is needed. In fact, until 2016, even families with the lowest two income levels on the table would be better off foregoing insurance purchases. Because the no-insurance penalties are phased in between 2014 and 2016 (they’re only $285 in 2014 and $975 in 2015), they are initially less than the out-of-pocket cost of a qualifying insurance policy. It is likely, then, that even low-income healthy families will drop out of the insurance pool in 2014 and 2015, driving up insurance premiums for those remaining in the pool.

In addition to being too small, the ACA’s premium subsidies may not be available in many states. As Jonathan Adler and Michael Cannon have demonstrated, the text of the ACA provides for premium support subsidies only on purchases made through exchanges that the states establish.  While proponents of the ACA presumably assumed that all states would voluntarily establish such exchanges so as to make subsidies available to their citizens, a great many states (36 at this point) either have declared an intention not to set up a state exchange or have made little movement in the direction of doing so. The IRS has taken the position that the subsidies should also be available through federal exchanges set up as a “fallback” in states that do not establish their own. It insists that expanding the subsidies is consistent with the purpose of the statute. But that’s far from clear. As Adler and Cannon show, the ACA’s legislative history suggests that Congress deliberately provided subsidies only through state-established exchanges in order to encourage states to set up and manage such exchanges.  In any event, the statutory language limits subsidies to state exchanges, and courts are generally loathe to exalt a statute’s purported purpose over its clear text, particularly when congressional intent is ambiguous.

Because the premium support subsidies (1) are too small and (2) may not be available in many states, they’re unlikely to correct the adverse selection problem resulting from the toxic combination of guaranteed issue, community rating, and constitutionally constrained low penalties for failure to purchase health insurance.

The Employer Mandate

But what about the fact that the ACA penalizes employers who fail to provide insurance coverage for their workers? Won’t that be enough to prevent large numbers of young, healthy people from failing to purchase or dropping health insurance? No, because the ACA’s subsidy provisions actually encourage employers to drop health plans for lower-income employees, many of whom will not be motivated to purchase insurance on their own.

As we’ve frequently discussed, the federal tax code currently exempts employer-provided health insurance benefits from taxation.  That exemption, which does not apply to individually purchased health insurance, amounts to an implicit subsidy percentage equal to the payroll tax rate plus the recipient employee’s marginal income tax rate. Because high-income workers are subject to higher marginal tax rates than are lower-income workers, the subsidy is greatest for them. Moreover, workers earning more than 400% of FPL will get no subsidy to buy insurance if their employer stops providing it.  Lower-income workers, by contrast, get less of an implicit subsidy for employer-provided health insurance, are eligible for more generous subsidies on state exchanges if their employer does not provide health insurance benefits, and would therefore prefer to work for employers that do not offer such benefits. Employers competing for workers will respond to these preferences.

Consider, for example, a previously uninsured 45 year-old who earns $35,000 and is required by the ACA to purchase a family insurance policy expected to cost around $15,000 in 2016.  If the employer provides the policy, the cash component of the employee’s compensation will fall to $20,000 (benefits generally being a dollar-for-dollar substitute for wages). The employee, however, will not have to pay the approximately $3,400 in federal income, Social Security, and Medicare taxes that would otherwise be due on the $15,000 received as insurance rather than cash.  On the other hand, if the employer does not provide health insurance and the employee purchases it on a state exchange, the employee will be eligible for a federal subsidy worth around $13,600.  Given the choice between a $3,400 implicit tax subsidy and a $13,600 subsidy on the exchange, the employee would prefer the latter. Now, if the employer employed more than 50 workers and failed to provide coverage, it would be charged a penalty of $2,000 for each worker that purchased subsidized insurance (after the first 30 workers).  It would likely choose to pay that penalty, however. It could finance the payment by reducing the employee’s salary by $2,000, and the employee would gladly agree to that arrangement. Even after having his salary diminished by $2,000, the employee would be better off gaining access to the larger government subsidy available only to individuals without employer-provided coverage.

But this analysis shows merely that the ACA encourages employers to drop coverage for lower-income workers. Won’t those workers turn around and purchase subsidized policies on the state exchanges? Perhaps not. For many of those workers, it will make more sense to pay the penalty and wait until health care is needed before purchasing insurance.  A one-income family of four headed by a 40 year-old earning $50,000, for example, would have to pay $3,385 for qualifying insurance or incur a no-insurance penalty of $2,085,  and it could always purchase insurance on a state exchange—with a $9,900 subsidy—the moment coverage became necessary. Such a family’s income level is low enough that the family is better off without employer coverage yet high enough that the family’s out-of-pocket insurance expenses will exceed the no-insurance penalty. Families in this situation can be expected both to lose employer coverage and to refrain from purchasing insurance on a state exchange.

Of course, all this assumes that premium subsidies are indeed available. For the reasons Adler and Cannon set forth, the ACA seems not to authorize such subsidies in states that fail to establish exchanges and instead rely on the federal government to do so.  Employers in such states would have less incentive to drop coverage for low-income employees, but lower income citizens who do not have employer-provided health insurance would not be likely to purchase insurance in such states, where the difference between the non-coverage penalty and the out-of-pocket cost of insurance (without subsidies) would be quite large.

In the end, then, neither the ACA’s premium support subsidies nor its employer mandate is sufficient to prevent the pernicious adverse selection cycle that results from combining guaranteed issue, community rating, and constitutionally limited deficient penalties for failure to carry insurance.

Broken Tax Promises

Thom Lambert —  28 June 2012

Remember this?

How about this?:

GEORGE STEPHANOPOULOS:  You were against the individual mandate…

PRESIDENT OBAMA:  Yes.

STEPHANOPOULOS:  …during the campaign.  Under this mandate, the government is forcing people to spend money, fining you if you don’t. How is that not a tax?

OBAMA:  Well, hold on a second, George. Here — here’s what’s happening.  You and I are both paying $900, on average — our families — in higher premiums because of uncompensated care.  Now what I’ve said is that if you can’t afford health insurance, you certainly shouldn’t be punished for that.  That’s just piling on. If, on the other hand, we’re giving tax credits, we’ve set up an exchange, you are now part of a big pool, we’ve driven down the costs, we’ve done everything we can and you actually can afford health insurance, but you’ve just decided, you know what, I want to take my chances.  And then you get hit by a bus and you and I have to pay for the emergency room care, that’s…

STEPHANOPOULOS:  That may be, but it’s still a tax increase.

OBAMA:  No.  That’s not true, George.  The — for us to say that you’ve got to take a responsibility to get health insurance is absolutely not a tax increase.  What it’s saying is, is that we’re not going to have other people carrying your burdens for you anymore than the fact that right now everybody in America, just about, has to get auto insurance. Nobody considers that a tax increase. People say to themselves, that is a fair way to make sure that if you hit my car, that I’m not covering all the costs.

STEPHANOPOULOS:  But it may be fair, it may be good public policy…

OBAMA:  No, but — but, George, you — you can’t just make up that language and decide that that’s called a tax increase.  Any…

STEPHANOPOULOS:  Here’s the…

OBAMA:  What — what — if I — if I say that right now your premiums are going to be going up by 5 or 8 or 10 percent next year and you say well, that’s not a tax increase; but, on the other hand, if I say that I don’t want to have to pay for you not carrying coverage even after I give you tax credits that make it affordable, then…

STEPHANOPOULOS:  I — I don’t think I’m making it up. Merriam Webster’s Dictionary: Tax — “a charge, usually of money, imposed by authority on persons or property for public purposes.”

OBAMA:  George, the fact that you looked up Merriam’s Dictionary, the definition of tax increase, indicates to me that you’re stretching a little bit right now.  Otherwise, you wouldn’t have gone to the dictionary to check on the definition.  I mean what…

STEPHANOPOULOS:  Well, no, but…

OBAMA:  …what you’re saying is…

STEPHANOPOULOS:  I wanted to check for myself.  But your critics say it is a tax increase.

OBAMA:  My critics say everything is a tax increase.  My critics say that I’m taking over every sector of the economy.  You know that. Look, we can have a legitimate debate about whether or not we’re going to have an individual mandate or not, but…

STEPHANOPOULOS:  But you reject that it’s a tax increase?

OBAMA:  I absolutely reject that notion.

Let the spinning begin.

An interesting story in the WSJ Online today about American International Group (AIG)’s use of a standard tax write-off and the political firestorm it is creating…all because the Washington establishment thought it could hide behind semantics during the bailout era.

The benefits at issue were accrued by AIG as it amassed record losses amid the financial crisis; the U.S. tax code allows businesses to “carry forward” such net operating losses to offset future tax obligations, in effect saving on future tax bills. But those carry-forwards can vanish if a company is taken over or sold, an exception that prevents healthy companies from avoiding taxes by buying firms with significant losses.

The criticism from the former members of the congressional panel stems from a series of Treasury determinations beginning in late 2008 that said the federal government’s bailout of AIG, General Motors Co. and other firms didn’t constitute a sale.

The US government acquired as much as 90% ownership in AIG during the bailout era. Under most any definition, such a shift would be considered a change in corporate control. However, because the Treasury Dept. wanted to maintain the illusion that government was not taking over large swaths of the US economy, it pronounced that these bailouts were not what any student of financial markets understood them to be: an exchange of equity control and strings on management for access to cash. In short, a sale of control.

Now the Treasury Department’s ruling is coming back to bite. Under the US tax code, AIG and its investors have a legal right to carry forward losses from the financial crisis to offset taxable earnings now. But now legal-scholar-turned-bureaucrat-turned-politician Elizabeth Warren, and others, want to change the rules after the fact. Warren is calling on Congress to “end this special tax break”. I’m not sure what exactly is so “special” about this tax break, since it applies to any business, not just those bailed out by the Feds. So is Warren suggesting all businesses should be prohibited from carrying forward losses? Or only businesses whose losses the Federal government wasn’t willing to tolerate in the first place? After all, if the Treasury had let nature take its course, AIG (and many other bailout recipients who are now wondering about their own ability to carry forward losses) would have been bought–albeit likely in pieces–and this whole issue would be moot.

What’s really interesting about this whole argument is that Treasury still holds 70%–a controlling interest–of AIG’s stock. AIG reported their beneficial tax breaks weeks ago. Presumably Treasury is paying attention to their investments and knew about that decision, possibly even before it was publicly released. So why didn’t they exercise their controlling interest and stop management from electing to use the carry forward? More importantly, Treasury is the “owner” that stands to gain the most from this tax benefit. So what exactly is Ms. Warren and others complaining about?

Either way, this is a mess of Treasury’s own making with its semantic gamesmanship on whether the bailout should be named for the government take-over that it was. Seems like we have a bit of non-buyer’s remorse.

A new rule kicks in today requiring airlines to include all taxes and mandatory fees in their advertised fares.  The rule, part of a broader “passengers’ bill of rights”-type regulation promulgated by the Department of Transportation, is being sold as a proconsumer mandate:  It purportedly protects consumers from the sticker shock that results when they learn that the true consumer price for a flight, due to taxes and mandatory fees, is much higher than the advertised price.

But how consumer-friendly is this rule?  Won’t it be easier to raise taxes and fees when they aren’t presented as a line item, when consumers aren’t “startled” to see the exorbitant amount they’re paying for government services?  Value-added taxes (VATs), which tax the incremental value added at each stage of production and are generally included in the posted price for an item, have proven easier to raise than sales taxes, which are added at the register.  That’s because the latter are more visible so that increases are more likely to generate political opposition.  While VATs are common throughout Europe, they’re virtually non-existent in the United States, in part because we Americans have recognized the important role “tax sticker shock” plays in creating political accountability.

Consumer advocates, nevertheless, are lauding the new Department of Transportation rule.  They don’t seem to realize that higher taxes are bad for consumers and that taxes are more likely to rise when the government can hide them.  They also seem to care little about consumer sovereignty.  Don’t consumers have a right to know how much they’re paying to have scads of Homeland Security officers bark orders at them and gawk at their privates?

 

As I discussed last May, corporations are hoarding cash.  According to today’s WSJ, they’re still hoarding cash.

Mira Ganor writes, in Agency Costs in the Era of Economic Crisis, that it could be about CEO compensation. Here’s the abstract:

This Article reports results of an empirical study that suggests that the current economic crisis has changed managerial behavior in the US in a way that may impede economic recovery. The study finds a strong, statistically significant and economically meaningful, positive correlation between the CEO total annual compensation and corporate cash holdings during the economic crisis, in the years 2008-2010. This correlation did not exist in comparable magnitudes in prior years. The finding supports the criticism against current managerial compensation practices and suggests that high CEO compensation increases managerial risk aversion in times of crisis and contributes to the growing money hoarding practices that worsen an economic slowdown. One possible explanation for the empirical findings is that during the last economic crisis, managerial risk seeking transformed into risk aversion that stalls economic recovery. The study has implications for the discussion on managerial pay arrangements and the implementation of the Dodd-Frank Act concerning say-on-pay

Whatever the cause, as I wrote last May there is a possible solution for cash hoarding (and possibly a better way to deal with agency costs generally), at least for some types of firms:

As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with.

And the underuse of the uncorporate form itself comes down to another problem:  the corporate tax.

John Steele Gordon, writing in the WSJ, peels the corporate veil away from Warren Buffett’s tax situation:

Warren Buffett recently claimed that he had paid only $6.9 million in taxes last year. But Berkshire Hathaway, of which Mr. Buffett owns 30%, paid $5.6 billion in corporate income taxes. Were Berkshire Hathaway a Subchapter S corporation and exempt from corporate income taxes, Mr. Buffett’s personal tax bill would have been 231 times higher, at $1.6 billion.

Gordon describes our two tax systems — corporate and personal tax — as an “original sin.” According to Gordon, the system lets the rich play tax games by arbitraging differences between corporate and personal rates. It also creates a “field day for demagogues and the misguided to claim that the rich are not paying their ‘fair share’” by ignoring the effect of the so-called “corporate” tax on the real people who own corporations.

Actually, the mischief goes deeper than Gordon suggests.  First, the corporate tax has helped entrench in the popular mind the idea that the merely legal creation of the corporation is actually flesh and blood.  This fuels the post-Citizens-United rhetoric on the evils of “corporate” speech as being somehow magically different from all other political activity by associations.

Second, the corporate tax has been a great engine of agency costs.  As discussed in my Rise of the Uncorporation, business associations such as LLCs and partnerships can mitigate corporate managers’ misuse of the owners’ money by replacing cumbersome corporate-type monitoring with obligations to distribute excess cash.  If more firms were uncorporations, we would not see the enormous cash hordes of today’s firms.  Lacking investment opportunities, they (e.g. Berkshire Hathaway?) would return the cash to their owners. But the “second” tax on distributions gives managers (Warren Buffett?) a powerful argument against distributing cash.  In fact, Steven Bank has adduced strong evidence that the corporate tax originated in 1936 as part of a deal promoted not by populists but by corporate managers (Bank, Corporate Managers, Agency Costs, and the Rise of Double Taxation, 44 Wm. & Mary L. Rev. 167 (2002)).

Third, the tax manipulations run deeper than Gordon suggests.  The difference between corporate and personal taxation helps maintain the sharp separation in the U.S. between the corporation and the uncorporation.  Only certain types of firms — those engaging in “passive” types of business such as resource management — can be both publicly held and free of corporate taxation.  Yet many other types of firms could benefit from uncorporate governance.  As a result, as discussed in my book, “uncorporate” governance must operate indirectly, through entities such as hedge and private equity funds.  Abolition of the “corporate” tax would encourage the use of more direct mechanisms for loosening managers’ reins over firms’ cash in a wide variety of firms.

In short, the corporate tax obfuscates analysis of business forms and helps inflate agency costs.  It’s not just unfair, as Gordon suggests.  It’s stupid.

Obama’s Fatal Conceit

Thom Lambert —  21 September 2011

From the beginning of his presidency, I’ve wanted President Obama to succeed.  He was my professor in law school, and while I frequently disagreed with his take on things, I liked him very much. 

On the eve of his inauguration, I wrote on TOTM that I hoped he would spend some time meditating on Hayek’s The Use of Knowledge in Society.  That article explains that the information required to allocate resources to their highest and best ends, and thereby maximize social welfare, is never given to any one mind but is instead dispersed widely to a great many “men on the spot.”  I worried that combining Mr. Obama’s native intelligence with the celebrity status he attained during the presidential campaign would create the sort of “unwise” leader described in Plato’s Apology:

I thought that he appeared wise to many people and especially to himself, but he was not. I then tried to show him that he thought himself wise, but that he was not. As a result, he came to dislike me, and so did many of the bystanders. So I withdrew and thought to myself: “I am wiser than this man; it is likely that neither of us knows anything worthwhile, but he thinks he knows something when he does not, whereas when I do not know, neither do I think I know; so I am likely to be wiser than he to this small extent, that I do not think I know what I do not know.”

I have now become convinced that President Obama’s biggest problem is that he believes — wrongly — that he (or his people) know better how to allocate resources than do the many millions of “men and women on the spot.”  This is the thing that keeps our very smart President from being a wise President.  It is killing economic expansion in this country, and it may well render him a one-term President.  It is, quite literally, a fatal conceit.

Put aside for a minute the first stimulus, the central planning in the health care legislation and Dodd-Frank, and the many recent instances of industrial policy (e.g., Solyndra).  Focus instead on just the latest proposal from our President.  He is insisting that Congress pass legislation (“Pass this bill!”) that directs a half-trillion dollars to ends he deems most valuable (e.g., employment of public school teachers and first responders, municipal infrastructure projects).  And he proposes to take those dollars from wealthier Americans by, among other things, limiting deductions for charitable giving, taxing interest on municipal bonds, and raising tax rates on investment income (via the “Buffet rule”).

Do you see what’s happening here?  The President is proposing to penalize private investment (where the investors themselves decide which projects deserve their money) in order to fund government investment.  He proposes to penalize charitable giving (where the givers themselves get to choose their beneficiaries) in order to fund government outlays to the needy.  He calls for impairing municipalities’ funding advantage (which permits them to raise money cheaply to fund the projects they deem most worthy) in order to fund municipal projects that the federal government deems worthy of funding.  (More on that here – and note that I agree with Golub that we should ditch the deduction for muni bond interest as part of a broader tax reform.)

In short, the President has wholly disregarded Hayek’s central point:  He believes that he and his people know better than the men and women on the spot how to allocate productive resources.  That conceit renders a very smart man very unwise.  Solyndra, I fear, is just the beginning.

Uncorporate Kodak!

Larry Ribstein —  11 August 2011

There are reports in the press that corporations are sitting on a huge cash pile — $1.2 trillion.  Apple has over 70 billion.  Today’s WSJ discusses Kodak (remember film?) which is burning through money it’s collected in patent litigation in a so far futile effort to compete in selling computer printers.

Since the government can’t throw around much more cash, maybe part of the solution to our economic woes is to encourage firms like Apple and Kodak to become uncorporations — i.e., limited partnerships or LLCs — whose dividends are not subject to the corporate “double” tax.  They can’t do this now because they aren’t in the small category of firms (e.g., pipelines) that can be publicly held and taxed like partnerships.  A simple change in the tax laws would solve this.  For more on all this, see my Rise of the Uncorporation.

If these firms were uncorporations they would be subject to agreements that require cash distributions and liquidation at some point.  The owners would not tolerate being taxed on earnings that’s not either working for them or being distributed to them. When the firms’ rate of return on retained earnings fell enough (consider the negative interest rate being paid on corporate cash sitting around in bank accounts) they would have to distribute it.

Consider what would happen if mature firms like Kodak (and, yes, maybe even Apple) could uncorporate.  Retained earnings would go back to the shareholders who would either invest it in or spend it on young and adolescent growth companies — the Apples and Kodaks of the future.  The government might lose some tax revenues, but there also would be a way to construct this system so that it’s revenue neutral.  In any event, the decisions would be made by the owners of the cash, not by politicians and bureaucrats who haven’t been doing such a good job lately.

Think about it.