Reflections

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The New York Times, June 19, 2011

Seriously, Some Consensus About Health Care

By N. GREGORY MANKIW

WE are entering the season of polarization. With various Republicans vying

to replace Barack Obama, the president eager to keep his job, and both the

House and the Senate up for grabs, candidates from both sides of the aisle

will spend the next year and a half stressing their differences.

But beneath this veneer of partisanship lie a few fundamental agreements.

Consider health care, which will be at the center of the political debate.

Here are four aspects of the issue in which Republicans and Democrats

have stumbled into consensus.

THE VALUE OF COMPETITION

Representative Paul D. Ryan,

Republican of Wisconsin, has attracted much attention with his plan to

reform Medicare. He proposes replacing the current fee-for-service

program, in which the government picks up the bill for medical expenses,

with a “premium-support” system in which seniors use federal dollars to

choose among competing private insurance plans.

Democratic critics of the plan suggest that enacting it would be akin to

pushing Grandma over a cliff. But they rarely point out that the premiumsupport

model is in some ways similar to the system set up under President

Obama’s health care law. If choosing among competing private plans on a

government-regulated exchange is a good idea for someone at age 50, why

is it so horrific for someone who is 70?

Republicans, meanwhile, are eager to repeal Obamacare and so are also

reluctant to point out its parallels with Ryancare. We can take heart,

however, in the kernel of agreement about the value of private competition.

THE INSURANCE MANDATE

Perhaps the most controversial piece of

the Obama plan is the mandate for individuals to have health insurance.

But think for a moment about what this really means. No one has proposed

putting the uninsured in jail. Instead, those without insurance will be fined.

A mandate is just a financial incentive to have insurance.

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What is the Republican alternative for having more people insured? It is

unclear what the Republicans would do if they ever succeeded in repealing

the health care reform law. However, their last presidential nominee —

Senator John McCain — proposed a tax credit for buying health insurance.

That may seem more palatable than a mandate, because it uses a carrot

rather than a stick.

But consider who would pay for that tax credit. The answer is all taxpayers.

This tax burden would be particularly hard on the uninsured, who would

face higher taxes without enjoying the credit’s benefit. In other words,

giving a tax credit to those who buy insurance is a back-door way to impose

fines on those who don’t.

TAXING THE RICH

Democrats want to increase taxes on the rich to

fund the looming fiscal gap, which is driven largely by soaring health costs.

Republicans object, saying higher taxes create economic distortions,

discourage work and impede growth. Last month, John A. Boehner, the

House speaker, said that we should instead consider means-testing

Medicare. But what does that mean?

Here is how means-testing might work. We could start by choosing some

income threshold — say, $250,000 — and then require people over 65 with

higher annual income to pay more in Medicare premiums than they do

now. For example, for every $1,000 of income beyond the threshold, they

might have to pay an extra $10 in annual premiums.

Sounds good, right? But notice that the economic effects of means-testing

are much the same as a tax increase. This particular plan is like increasing

the income tax rate by one percentage point for high-income seniors. It is

only semantics as to whether the $10 is called a “tax” or a “premium.”

Indeed, means-testing could create more economic distortions than would

broad-based tax increases. Seniors have more flexibility in how much they

work than do typical Americans. In particular, for many people, the timing

of retirement is discretionary. The higher marginal tax rates implicit in

means-testing will induce people to leave the labor force earlier than they

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otherwise would. This would deprive the economy of some of its most

experienced and productive workers.

BLINKERED OPTIMISM

Democrats and Republicans generally have

different approaches to controlling the growth of health care spending.

Democrats often favor a top-down approach: a panel of experts set up by

the recent health care law will decide which medical procedures are costeffective

and which are wasteful. Republicans tend to prefer a bottom-up

approach: empower consumers to make their own choices, they say, and

the power of competition among private providers will keep costs down.

One thing that the two parties share, however, is the belief that controlling

health care costs is possible. Yet many economists believe that the rise in

health spending is largely the result of medical advances, which prolong

and enhance life at a high cost. Perhaps health spending will inevitably, and

even should, keep rising as a share of national income.

This possibility raises a question: If health care becomes an increasing

share of the economy, how will we allocate it, and how will we pay for it?

That is, if controlling the cost of health care fails, what is Plan B?

That is a question that candidates from both political parties agree on as

well: they all seem determined to avoid it.

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The New York Times, May 7, 2011

If You Have the Answers, Tell Me

By N. GREGORY MANKIW

AFTER more than a quarter-century as a professional economist, I

have a confession to make: There is a lot I don’t know about the economy.

Indeed, the area of economics where I have devoted most of my energy and

attention — the ups and downs of the business cycle — is where I find

myself most often confronting important questions without obvious

answers.

Now, if you follow economic commentary in the newspapers or the

blogosphere, you have probably not run into many humble economists. By

its nature, punditry craves attention, which is easier to attract with

certainties than with equivocation.

But that certitude reflects bravado more often than true knowledge.

So let me come clean and highlight three questions that perplex me. The

answers to them may well shape the economy in the years to come.

How long will it take for the economy’s wounds to heal?

When President Obama took office in 2009, his economic team

projected a quick recovery from the recession the nation was experiencing.

The administration’s first official forecast said economic growth, computed

from fourth quarter to fourth quarter, would average 3.5 percent in 2010

and 4.4 percent in 2011. Unemployment was supposed to fall to 7.7 percent

by the end of 2010 and to 6.8 percent by the end of 2011.

The reality has turned out not nearly as rosy. Growth was only 2.8

percent last year, and the first quarter of this year came in at a meager rate

of 1.8 percent. Unemployment, meanwhile, lingers well above 8 percent,

and according to Ben S. Bernanke, the Federal Reserve chairman, is

expected to keep doing so throughout this year.

Economists will long debate whether President Obama’s policies are

to blame or the patient was just sicker than his economists realized. But

there is no doubt that the pace of this recovery will come nowhere close to

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matching the one achieved after the last deep recession, when President

Ronald Reagan presided over a fall in the unemployment rate from 10.8

percent in December 1982 to 7.3 percent two years later.

Looking ahead, an open issue is whether the recession will leave scars

that prevent a return to jobless rates that were considered normal just a few

years ago. A striking feature of today’s labor market is the rise of long-term

joblessness. The average duration of unemployment is now almost 40

weeks, about twice what it reached in previous recessions. The long-term

unemployed may well lose job skills and find their future prospects

permanently impaired. But because we are in uncharted waters, it is hard

for anyone to be sure.

How long will inflation expectations remain anchored?

In 1967, Milton Friedman gave an address to the American Economic

Association with this simple but profound message: The inflation rate that

the economy gets is, in large measure, based on the inflation rate that

people expect. When everyone expects high inflation, workers bargain hard

for wage increases, and companies push prices higher to keep up with the

projected cost increases. When everyone expects inflation to be benign,

workers and companies are less aggressive. In short, the perception of

inflation — or of the lack of it — creates the reality.

Although novel when Professor Friedman proposed it, his theory is

now textbook economics, and is at the heart of Federal Reserve policy. Fed

policy makers are keeping interest rates low, despite soaring commodity

prices. Why? Inflation expectations are “well anchored,” we are told, so

there is no continuing problem with inflation. Rising gasoline prices are

just a transitory blip.

They are probably right, but there is still reason to wonder. Even if

expectations are as important as the conventional canon presumes, it isn’t

obvious what determines those expectations. Are people merely backwardlooking,

extrapolating recent experience into the future? Or are the

expectations based on the credibility of policy makers? And if credibility

matters, how is it established? Are people making rational judgments, or

are they easily overcome by fear and influenced by extraneous events?

Mr. Bernanke and his team may learn that, in turbulent times,

expectations can become unmoored more easily than they think.

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How long will the bond market trust the United States?

A remarkable feature of current financial markets is their willingness

to lend to the federal government on favorable terms, despite a huge budget

deficit, a fiscal trajectory that everyone knows is unsustainable and the

failure of our political leaders to reach a consensus on how to change

course. This can’t go on forever — that much is clear.

Less obvious, however, is how far we are from the day of reckoning.

Winston Churchill famously remarked that “Americans can always be

counted on to do the right thing, after they have exhausted all other

possibilities.” That seems to capture the attitude of the bond market today.

It trusts our leaders to get the government’s fiscal house in order,

eventually, and is waiting patiently while they exhaust the alternatives.

But such confidence in American rectitude will not last forever. The

more we delay, the bigger the risk that we follow the path of Greece, Ireland

and Portugal. I don’t know how long we have before the bond market turns

on the United States, but I would prefer not to run the experiment to find

out.

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So those are the three questions that puzzle me most as I read the

daily news. If you find an economist who says he knows the answers, listen

carefully, but be skeptical of everything you hear.

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The New York Times, October 22, 2011

Four Nations, Four Lessons

By N. GREGORY MANKIW

AS the economy languishes, politicians and pundits are debating what

to do next. When we look around the world, it’s hard to find positive role

models. But as we search for answers, it is useful to keep in mind those

fates that we would like to avoid.

The recent economic histories of four nations are noteworthy: France,

Greece, Japan and Zimbabwe. Each illustrates a kind of policy mistake that

could, if we are not careful, presage the future of the United States

economy. Think of them as the four horsemen of the economic apocalypse.

Let’s start with Zimbabwe. If there were an award for the world’s

worst economic policy, it might well have won it several times over the past

decade. In particular, in 2008 and 2009, it experienced truly spectacular

hyperinflation. Prices rose so fast that the central bank eventually printed

100 trillion-dollar notes for people to carry. The nation has since

abandoned using its own currency, but you can still buy one of those notes

as a novelty item for about $5 (American, that is).

Some may find it hard to imagine that the United States would ever

go down this route. But reckless money creation is apparently a concern of

Gov. Rick Perry of Texas, who is seeking the Republican nomination for

president. He suggested in August that it would be “almost treasonous” if

Ben S. Bernanke, chairman of the Federal Reserve, were to print too much

money before the election. Mr. Perry is not alone in his concerns. Many on

the right fear that the Fed’s recent policies aimed at fighting high

unemployment will mainly serve to ignite excessive inflation.

Mr. Bernanke, however, is less worried about the United States

turning into Zimbabwe than he is about it turning into Japan.

Those old enough to remember the 1980s will recall that Japan used

to be an up-and-coming economic superpower. Many people then worried

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(too much, in my view) that Japan’s rapid growth was a threat to prosperity

in the United States, in much the same way that many people worry today

(too much, in my view) about rapid growth in China.

The concerns about Japanese hegemony came to a quick end after

bubbles in the real estate and stock markets burst in the early 1990s. Since

then, Japan has struggled to regain its footing. Critics of the Bank of Japan

say it has been too focused on quelling phantom inflationary threats and

insufficiently concerned about restoring robust economic growth.

One of those critics was Mr. Bernanke, before he became Fed

chairman. Watching Japanese timidity and failures has surely made him

more willing to experiment with unconventional forms of monetary policy

in the aftermath of our own financial crisis.

The economists in the Obama administration are also well aware of

the Japanese experience. That is one reason they are pushing for more

stimulus spending to prop up the aggregate demand for goods and services.

Yet this fiscal policy comes with its own risks. The more we rely on

deficit spending to keep the economy afloat, the more we risk the kind of

sovereign debt crisis we have witnessed in Greece over the past year. The

Standard & Poor’s downgrade of United States debt over the summer is a

portent of what could lie ahead. In the long run, we have to pay our debts —

or face dire consequences.

To be sure, the bond market doesn’t seem particularly worried about

the solvency of the federal government. It is still willing to lend to the

United States at low rates of interest. But the same thing was true of Greece

four years ago. Once the bond market starts changing its mind, the verdict

can be swift, and can lead to a vicious circle of rising interest rates,

increasing debt service and budget deficits, and falling confidence.

Bond markets are now giving the United States the benefit of the

doubt, partly because other nations look even riskier, and partly in the

belief that we will, in time, get our fiscal house in order. The big political

question is how.

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The nation faces a fundamental decision about priorities. To maintain

current levels of taxation, we will need to substantially reduce spending on

the social safety net, including Social Security, Medicare, Medicaid and the

new health care program sometimes called Obamacare. Alternatively, we

can preserve the current social safety net and raise taxes substantially to

pay for it. Or we may choose a combination of spending cuts and tax

increases. This brings us to the last of our cautionary tales: France.

Here are two facts about the French economy. First, gross domestic

product per capita in France is 29 percent less than it is in the United

States, in large part because the French work many fewer hours over their

lifetimes than Americans do. Second, the French are taxed more than

Americans. In 2009, taxes were 24 percent of G.D.P. in the United States

but 42 percent in France.

Economists debate whether higher taxation in France and other

European nations is the cause of the reduced work effort and incomes

there. Perhaps it is something else entirely — a certain joie de vivre that

escapes the nose-to-the-grindstone American culture.

We may soon be running a natural experiment to find out. If

American policy makers don’t rein in entitlement spending over the next

several decades, they will have little choice but to raise taxes close to

European levels. We can then see whether the next generation of Americans

spends less time at work earning a living and more time sipping espresso in

outdoor cafes.

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The New York Times, March 4, 2012

Capital Gains, Ordinary Income and Shades of Gray

By N. GREGORY MANKIW

WHAT is carried interest? And why does it get the tax treatment it

does?

These arcane questions are usually reserved for the green-eyeshade

crowd. And for good reason: they can be so bewildering that they seem to

be taken from an I.Q. test written just for accountants. But because they

concern a few very high-income individuals, including the presidential

candidate Mitt Romney, for whom I am an adviser, they have been getting

broader attention lately. So let’s examine the issue.

Throughout almost the entire history of the United States income tax,

the tax rate on capital gains has been lower than that on ordinary income.

Today, the top rate is 15 percent for capital gains and 35 percent for

ordinary income. There are good reasons for this — including, for example,

the fact that capital gains are not indexed for inflation. But put that aside. If

we are going to tax capital gains at a lower rate, one question necessarily

arises: What is a capital gain, and how can we distinguish it from ordinary

income?

The answer seems simple. If you have a job, the money you are paid

for your work is ordinary income. If you buy an asset at one time and sell it

later for a higher price, the profit you made from holding it is a capital gain.

But is it really that easy? Consider five examples, and see if you can

identify what is ordinary income and what is a capital gain:

• Abe buys a vacation home for his family for $800,000. Some years

later, when his children have grown and left home, he sells it for $1 million.

He makes $200,000.

• Bob is a real estate investor. After scouring the market for the best

investment opportunities, he buys a house for $800,000 that he believes is

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undervalued. A few years later, he sells it at $1 million, for a profit of

$200,000.

• Carl is a real estate investor and a carpenter. He buys a dilapidated

house for $800,000. After spending his weekends fixing it up, he sells it a

couple of years later for $1 million. Once again, the profit is $200,000.

• Dan is a real estate investor and a carpenter, but he is short of

capital. He approaches his friend, Ms. Moneybags, and they become

partners. Together, they buy a dilapidated house for $800,000 and sell it

later for $1 million. She puts up the money, and he spends his weekends

fixing up the house. They divide the $200,000 profit equally.

• Earl is a carpenter. Ms. Moneybags buys a dilapidated house for

$800,000 and hires Earl to fix it up. After paying Earl $100,000 for his

services, Ms. Moneybags sells the home for $1 million, for a profit of

$100,000.

How much capital gains and ordinary income do we attribute to Abe,

Bob, Carl, Dan and Earl? (To keep things simple, assume that Ms.

Moneybags is untaxed. Think of her as running a pension fund or university

endowment.)

Let’s take the easy cases first. It seems clear that Abe has a capital

gain. His profit of $200,000 comes from simply holding an asset over time.

And it seems equally clear that Earl’s $100,000 is ordinary income. He is

being paid for providing his services.

But between these cases, the situation gets murky. Bob and Carl are

being rewarded in part for the time they spend, but the tax law treats both

as having earned entirely capital gains. The tax code does not count the

time that Bob spent looking for investments as employment and his gain as

taxable labor compensation, even though some of it arguably is. Nor does it

try to tax Carl’s sweat equity as labor compensation.

This brings us to Dan and his partnership with Ms. Moneybags. The

tax law treats this partnership as exactly equivalent to Carl’s situation. In

this case, however, the $200,000 capital gain is divided into halves: some

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of it goes to Ms. Moneybags, who provided the cash, and some goes to Dan,

who provided the sweat equity. Once again, nothing is treated as ordinary

income.

In some ways, this treatment makes sense. After all, Dan is doing half

of what Carl did, so why should he have to pay a higher tax rate than Carl

did on that half of his income? On the other hand, it seems that Dan is

getting off easy. Dan does not seem very different from Earl, because both

are getting $100,000 for fixing up the house.

If these examples leave your head spinning, you are not alone.

Economists and tax lawyers who study these issues are unsure about the

best way to handle these situations in practice.

Here is where carried interest enters the picture. Carried interest

from a private equity partnership is like the income that Dan earns from his

real estate partnership. In this case, however, Dan is not a carpenter but a

specialist in business turnarounds. The partnership does not buy

dilapidated houses to fix up and sell; it buys troubled businesses to fix up

and sell. And just as Dan the carpenter can treat his share of the

partnership income as a capital gain, Dan the business specialist can do the

same.

Critics of current law think it is unfair that these private equity

partners are taxed at capital gains rates, whereas other high-income

individuals like doctors and lawyers pay the much higher tax rates for

ordinary income. It is a reasonable point, and some reform may well be

appropriate. But as the tax situations of Abe through Earl illustrate, it is not

obvious what the best approach would be. Not all problems have easy

answers.