Fred Thompson: Steve Novick's First-of-Its-Kind CEO Tax

Fred Thompson checks in with another well researched post (unlike mine)

Portland’s so-called Business License Fee (BLF) levies a 2.5 percent tax on the adjusted net profits of about 43,000 companies operating in the city. Starting in 2018, Portland will impose a surcharge to this tax on some large, publicly owned C-corporations. The surcharge will apply to businesses, which are subject to the Dodd-Frank requirement that they disclose the ratio of their chief executive’s (CEO) compensation to the compensation of their median employee and which also have high compensation ratios. Portland’s department of revenue estimates that about 550 Portland businesses will be subject to this reporting requirement. Where reported compensation ratios are equal to or greater than 100, businesses will pay a 10 percent surcharge on their BLF (2.75 percent tax rate); equal to or greater than 250 times, a 25 percent surcharge (3.125 percent).

Portland’s BLF generates about $60 million in revenue per annum. The municipal revenue office estimates that the >500 businesses subject to Dodd-Frank compensation-ratio reporting contribute about one-third of BLF revenue, nearly $20 million per annum, and that the surcharge will boost municipal revenue by $2.5-$3.5 million per year, which implies that nearly all the reporting businesses will be subject to the surcharge, at least one-third of them at the 3.125 percent rate.

This is a novel tax experiment. As Branko Milanović explained: “What I find quite interesting is that it seems [to be] the first tax that targets inequality as such.” For Milanović, it’s novel because “it treats inequality as having a negative externality, like taxing carbon emissions.” Moreover, it isn’t at all clear how Portland’s experiment will play out, which makes it interesting, albeit probably still not in itself materially significant. Policy experimentation is cool, especially elsewhere.

The remainder of this post will focus on two issues:

1.     What is the purpose of this measure? Will it work?

2.     Are the municipal revenue estimates realistic?

Portland spends about $30 million per annum on low-income housing and homeless services. The revenue from the surcharge will be contributed to fighting homelessness, where presumably every bit will help. Moreover, this use of the funds, when combined with its source, ought to reinforce the symbolic power of the measure.

There is an implicit presumption that the measure will cause businesses (some C-corps, anyway) to moderate CEO compensation or boost median earnings. No doubt executive compensation plays a major explanatory role in the explosion in income inequality that has occurred over the past 30-40 years. Forbes magazine recently reported that the average annual total compensation for a Fortune 500 CEO was $10.5 million. This breaks down to $3.5 million in salary and bonus, $3.8 million in other compensation such as personal perk packages, and $3.2 million from exercising vested stock options and awards.

Source: Economic Policy Institute

However, compared to the combined total compensation of Fortune 500 CEOs of $5.2 billion, the $3 million that Portland expects to collect through this measure looks like a drop in the ocean. Unless a lot other jurisdictions follow Portland’s lead, it isn’t likely to meaningfully influence corporate compensation practices, one way or the other.

Furthermore, it is possible that Portland won’t even collect $3 million from this measure. As is the case with a lot of things, CEO compensation tends to be characterized by a Pareto distribution, i.e., 20 percent of CEOs get 80 percent of total compensation. That implies an average compensation for the 400 CEOs at the bottom of the Fortune 500 list of about $2.5 million each, well under the $4 million Portland used to estimate the cutoff for the surcharge. When compared with the average median worker compensation in Fortune 500 companies of about $80,000, which boosts the cutoff to $8 million, this implies that considerably less than half of Portland’s top C-corps will be on the hook for the surcharge. Moreover, looking only at the average median worker entirely omits from consideration the possibility that Bloom et al. are correct, that two-thirds of the rise in earnings inequality from 1978 to 2013 was due to increases occurring between businesses, not within them – let alone all the shadier expedients mandatory disclosers could avail themselves of to minimize reported compensation ratios.

Silicon Valley's Relentless Hype About Disruption is Questionable: The Case of Uber

Despite the hype, I have never been convinced by Uber, there is a reason taxi companies formed and is wasn't just radio dispatch.  Other things such as ability to select and keep skilled drivers, economizing on capital stock, insurance and maintenance seemed to me party powerful economic forces.

Uber's premise is essentially that there need be no more central control thanks to smartphones and that there is no such thing as economies of scale in taxi service.  The former might be right, but the latter is questionable.

Now there is this exposé of Uber in the blog Naked Capitalism, nicely covered by the Financial Times' Alphaville blog.  It appears that Uber is one, losing money at an astonishing rate, and two, engaging in predatory pricing - deliberately pricing below cost to drive competitors out of business.

How You Get Away With a Lousy Public Education System

By many metrics Oregon has one of the worst public education systems in the Untied States.  Oregon's per-pupil funding is 15% below the U.S. average,  Oregon's low graduation rates are 48th worst in the nation, Oregon has the highest absentee rate, and one of the shortest school years in the nation and we have below average standardized test scores in math and reading.  And yet, Oregon's economy is doing well, we have a tech sector and a creative sector that are doing well and we are constantly seen as an attractive place to locate.

It is this last bit that is the key: if you are a complete failure in educating your own children, you better be good at importing educated young people from other states.  Luckily, we are.

So next time you get all worked up about the relentless migration of young people and families from California and other parts of the U.S., remember that without them, we'd have to rely on the poorly educated sons and daughters of Oregon.  Woe the thought.

Back to Blogging.....about Soccer

It has been a very long hiatus - I have had a series of things that have demanded my time and taken me away from blogging.  But through industry, time and fate I suddenly find myself (and by sudden I mean as of today) with a more manageable work-load and my thoughts drift to going back to doing some stuff I enjoy.  I imagine that I have lost nearly all my audience, which is okay, it is actually a lot easier to write when I imagine no one is reading, but I thank Fred Thompson for single-handedly keeping this thing alive and preserving a small audience of super-wonks....

...which I will now do my best to alienate.  I'd love to come back hard with a deep-dive into some state policy topic, an extended piece on my interpretation of the economic impacts of a Trump presidency but that would short-circuit my start before it even began because I would find it too daunting and not fun enough.  So I come back with thoughts on one of my favorite pastimes: soccer.

Yesterday the US Soccer Federation decided to fire the coach of the national team and its Technical Director, Jurgen Klinsmann. Bruce Arena, onetime coach of the US National Team and current LA Galaxy coach will be hired as his replacement.  To me this represents a switch back from the aspirational to the pragmatic and I, for one, am disappointed.  I am not sold on Klinsmann being a great coach, in fact I am pretty sure he is not.  But I think that is secondary to his role as an aspirational leader for the direction of the USSF.

In the past, and continuing to the present, elite soccer in the US has been built on two things: pay-to-play and athleticism.  Because of the socio-economic inequalities, this has caused the exclusion of youth from immigrant communities where technical ability and flair is prized and soccer IQ is extremely high.  It has promoted the advancement of big-fast-strong soccer robots who are taught to play very directly, do a set few things and limit their independent thought.  The problem with this approach is that the game based on direct-play, athleticism and lack of autonomy is boring to play, boring to watch and ever less competitive in top-flight professional soccer. And yet our entire national soccer mechanism incentivizes exactly this.  This is a very coach-centric approach and is a spill over, I think, of the sports culture of the US which is based on coaches being in charge.  But soccer is pretty unique in that it is not like that at all.  Once the game begins the coach has almost no control- it is up to the players to figure it out themselves.

So the US National Team in the past has reflected this culture and the American coaches hired to coach the team have been very good, very pragmatic coaches.  They know the talent they have and they know how to maximize it - play direct counter-attacking soccer that relies on athleticism.  That is a fine an defensible approach but it reinforces the problem: there is too little emphasis on technical quality and intelligent play.  As the US team is a model for kids in this country much more than the pro leagues (unlike most of the world) it only causes an exacerbation of the problem.  It is an emphasis on winning, full stop.

What Klinsmann represented to me was the idea that we could and should strive to be more.  That we should aspire to create intelligent technical players, that we could play an attacking style with flair and skill, that we could keep possession of the ball and complete with the best.   What I think Klinsmann recognized is that without a native soccer culture and as the touchstone for all of US soccer, the National team had the unique power to be the agent of change in the US.  To become an aspirational model for what US soccer could look like.  This is why, I believe, he looked so hard for players in Europe who were more technical and intelligent, to show the way to younger players.

He did a lot to move the USSF along behind the scenes as the Technical Director - from the youngest ages on up.  As a youth coach myself, I have seen the changes first-hand and though I don't always agree, I mostly do and I see the results every weekend as every year (and this past fall in particular with a number of rule changes, the most important being that U11 and U12 players play 9v9) I see more and more teams playing a possession-style game and eschewing the direct play that used to be the norm. But there is a long way to go: the very elite levels of youth soccer are still results-based and thus the all too easy shortcut of selecting on aggressiveness and athleticism still wins the day.   They are also extremely expensive and exclude the very best talent which is in poorer immigrant communities (largely Latin American but not exclusively). So we have still have a very long way to go and the youth clubs themselves, whose existence is based on the pay-to-play model, will resist change.  This is why an iconic figure like Klinsmann was important - he had the power of persuasion to get all the thousands of clubs (and the USSF) itself moving on down the road.  In other countries there are soccer clubs with senior teams that compete in an open system with promotion and relegation where there are incentives for the clubs to find and develop players, in the US it has to come from the top.

So now we are back to pragmatism.  I hear the term 'American style' of play - as in 'Klinsmann did not understand the American style and thus players were uncomfortable and under-performed.' To me this is just saying that all American players are good at is running and fitness so don't ask them to do more or be more.  Apparently, that is what we are going back to.  If that is a good thing for soccer players, why are there so few Americans playing in European professional leagues?   American exceptionalism does not translate to soccer and I lament the passing of the Klinsmann era.

Fred Thompson: Last Thoughts on M-97 (if it is defeated)

Fred Thompson checks in with another post on M-97

I dislike M-97. Sufficiency aside, it violates all of the criteria that for 40 years I have taught my students should be employed to evaluate tax proposals: Neutrality, Efficiency, Horizontal and Vertical equity, Transparency, and Certainty. Most tax proposals envision some tradeoffs between these criteria. M-97 abuses them all.

Nevertheless, Yes on 97 looks to be more right than not on three points. M-97 would be good for small businesses (and big LLCs and S-corps), most of the new money will be spent on education and health, and, going back to at least 2003, the state has failed to prioritize education funding. Even where it has increased education funding it has too often directed monies to special interest projects or categorical programs, more frequently it has simply imposed mandates on schools. These have often bled resources away from district priorities, but have not measurably promoted student learning or welfare. What it has not done is stabilize school funding or support it at a satisfactory level.

I think M-97 is a wretched mess, although I acknowledge it could work out fine. Nobody knows; the simple fact is that state taxes per se usually don’t matter very much to the health of state economies. My fellow economists, who have thought about the effects of M-97, and I believe that the best real-world analogy to how it would work is an ad valorem tariff. Depending on market structure and the economic power of the businesses subject to tariffs, they can be partly, fully, or more than fully passed through to final (domestic) consumers. If they are high enough, they can cause foreign competitors to exit domestic markets. On occasion, foreign businesses are forced to eat the full tariff themselves, which is what yes on 97 says will happen, pretty much across the board. Of course, M-97 would be good for non-C-corps, including small businesses, for precisely the same reason that tariffs are good for some domestic producers: they let them increase their prices without losing market share.

Finally. I have talked to folks who agree that M-97 is a train wreck waiting to happen, but plan to vote for it nevertheless. Their logic goes something like this: its threat will push the legislature to put together a higher yielding (and perhaps sounder) tax system than the one we have now. I see their logic, but I don't see a path from this ugly thing to a sound tax system (historically, gross receipts taxes have simply devolved into retail sales taxes). It's rather like M-47, which was a mess; in M-50 the legislature made it into something OK, but by no means ideal, or even close. I also recall that Willamette Week, in supporting Measure 5 in 1990, argued that it would force the legislature to confront the need for fundamental tax and school finance reform. Evidently, Willamette Week learned better. It opposes M-97.

Fred Thompson: The LRO’S Research on Measure 97

Fred Thompson checks in with the forth in a series of posts on Measure 97 (IP28).

Proponents of Measure 97 deny that most of its burden will be shifted forward to consumers and that it will thereby reduce the progressivity of Oregon’s tax system. Moreover, they have consistently questioned the expertise and impartiality of the Legislative Revenue Office (LRO) for reporting that both claims are likely correct. In my opinion, their criticism of the LRO is entirely unjustified. If anything, the LRO has bent over backwards to treat M-97 in an even-handed fashion.

It is very hard to address these issues without getting wonky, but I’ll start by saying that economists who study tax questions agree that taxes on sales (gross receipts, turnover, value-added, retail-sales, etc.) are for the most part shifted forward to consumers. We would also insist that this is not necessarily the case with all of the taxes that businesses remit to the government. For examples, the incidence of taxes on property, business income (profit or earnings), payroll, or the extraction of raw materials, tends to fall on business owners or is shifted back to factor suppliers.

Nevertheless, M-97 is different from any known sales or gross receipts tax. Typical sales taxes discriminate along jurisdictional lines or by type of product. M-97 proposes to discriminate on the basis of the seller’s identity, levying the tax ONLY on the sales of certain C-corporations, those with Oregon sales in excess of $25 million. The LRO tried to deal with this issue by making the portion of the tax that would be shifted forward to consumers proportional to the concentration of affected businesses in each class of business, so that, if big C-corps represented 50 percent of sales in that market segment, only 25 percent of the tax would be shifted forward, 90 percent of sales = 80 percent shifted, and 100 percent = all. Because affected firms tend to dominate the business categories in which they operate, the LRO concluded that overall more than 60 percent of the tax take of ≥$3 billion would be shifted forward from business owners to consumers.

Maybe this is an overestimate, maybe even a big one. Perhaps, most of the burden of M-97 really will be born by the shareholders of extremely large, mostly out of state companies or even out of state consumers.  We really cannot know for sure until M-97 is put into effect – which is in my opinion a bug not a feature. But on theoretical grounds, it can be argued with some justification that the LRO has, if anything, underestimated the amount of forward shifting M-97 will induce. In imperfectly competitive markets, economists usually assume that market leaders are price setters: that, when their cost of goods-sold increases, they will raise their prices and, depending on their market power, the increase may be less than the cost increase, but may also be MORE. Since market power is usually assumed to be a function of concentration, this is essentially the logic that underlies the LRO’s very reasonable position.

What the LRO’s position rules out is the possibility of over-shifting and, especially, over-shifting due to the behavior of the competitive fringe, in this instance the businesses not facing the M-97 induced cost increase. The standard assumption in competitive analysis is not, as proposed by M-97 supporters, that they will undercut the price of the dominant businesses in the area, but will, instead, tend to meet the price increase of the market leaders. Where this is the case, the price increase borne by consumers as a result of a tax may and, in some cases, will exceed the tax take.

Moreover, this is generally what the evidence shows happens. The closest analogy to M-97, that I know of, occurs at borders, where one jurisdiction has a higher embedded excise than another, typically on things like motor fuels, alcohol, or tobacco products. Not surprisingly, prices just across the border in the higher taxing jurisdiction tend to be higher on average than in low-tax jurisdiction, but not by as much as in the rest of that jurisdiction, where various studies show that between 80 and 400 percent of the tax take tends to be recouped by businesses. What might seem surprising, however, is that prices just across the border in the low-tax jurisdiction are also typically higher than elsewhere in that jurisdiction – and, of course, retail booze, cigarettes, and gas sales are probably characterized by more price taking than one is likely to see in a lot of affected business segments under M-97.

My point is not that the LRO has underestimated the amount of tax shifting likely to occur under M-97. Rather, they have made a prudent, middle-of-the-road estimate, which is their job. The extreme estimates? They come from M-97’s supporters, and are based neither on economic theory nor independent evidence.

Measure 97: Any Pinocchios Yet?

 Fred Thompson checks in with an third post on Measure 97 (IP28). 

So far, my criticisms have been directed to the pro-97 camp – to claims like Gov. Brown’s that “there is a basic unfairness in our tax system that makes working families pay an increasing share for state and local services.” Not so. Oregon has long had one of the US’s least regressive state and local tax systems and recent changes have increased its progressivity. For example, the state already has the nation’s highest capital-gains tax rate. And, even if it were so, Measure 97 wouldn’t make the tax system fairer, but would cause ‘working families’ to pay more for government services and to pay for them more regressively.

I acknowledge that most of the claims I have criticized are at least somewhat arguable – mostly wrong, not Pinocchios. For example, the pro-camp claims that some of the $3 billion or so that Measure 97 will collect each year “will come out of CEO pay, some out of dividends, some out of consumers in other states.” But, they acknowledge, “Some will come from some of us.” That’s basically the position of the Legislative Revenue Office, except that they estimate that the “some [that] will come from some of us” is about 2/3 the total, that most of the rest will be shifted to the IRS, with the remainder borne by shareholders (about $200 million a year, which is enough to explain a lot of opposition) and corporate employees (about $100 million).

Think what it would look like, were Measure 97 truly a tax on corporations: total Oregon profits run about $20 billion a year. The share earned by C-corps, the only businesses subject to the tax under Measure 97, is about half that, or $10 billion, of which 70 percent comes from corporations with more than $25 million a year in Oregon sales, or about $7 billion, from whom the state currently collects about $375 million a year. If Measure 97 were to increase the tax take from these corporations by $3 billion a year, we would be talking about an average effective state corporate income tax (CIT) rate of nearly 50 percent – five times the highest state CIT rate in the US. Because gross receipts taxes are recorded as ordinary expenses and reduce ‘‘earnings from operations,’’ remittances to the state would cut federal CIT obligations by about $1 billion (given the 35 percent federal CIT rate), but, even so, this implies an average combined CIT rate of over 60 percent.  Bizarrely, however, this tax only hits businesses with low profit rates (as a proportion of turnover); really high profit businesses would continue to be unaffected by it. How credible is that? And, if it’s credible, imagine what this could do to the state’s economy.

This is also an area where Measure 97’s opponents have crossed the line. Many of them condemn Measure 97 as unfair because unprofitable businesses, which appear to have no ability to pay, are nonetheless obliged to pay the tax. They express similar concerns with respect to low-margin, high-turnover businesses, for example, grocery stores. However, as Fox, Luna, and Murray observe, economists generally do not share these concerns, “because the base is not intended to be profits and the tax is likely shifted forward to consumers.” Arguably, these anti-claims merely take the pro-side’s argument about who pays seriously, but it’s probably not how this would play out.

Of course, gross receipts taxes, like most taxes, create tax wedges. In this instance the wedges affect both interstate and intrastate commerce. They arise because some of the goods and services providers that are subject to the tax must compete with those that are not. This may induce them to shift activities out of state or to purchase out-of-state inputs to avoid the tax. Compared with a retail-sales tax say, Measure 97’s distortions are potentially more severe, both because of pyramiding and because of the discrepancy between the tax rate faced by C-corps (2.5 percent) and the implicit rate (zero) faced by pass-through entities. But this looks to be a matter of degree, not of kind.

Measure 97’s supporters make a big deal of the fact that only about a 1,000 businesses will be directly affected by it: “It will raise taxes on only the largest corporations, affecting one-quarter of 1 percent of the companies doing business in Oregon.” (Of course, many more, probably most, will be indirectly affected by it through their supply chains – for example, most businesses in the state will face higher utility costs). However, $3 billion doesn’t grow on trees – to give some idea of the magnitude of what we are talking about here, that’s about what a 6.5 percent retail sales tax would produce. If the businesses affected by Measure 97 weren’t major players in the state’s economy, a 2.5 percent tax wouldn’t yield $3 billion. They are, The 1,000 corporations directly affected by Measure 97 employ 40 percent of the state’s business labor force, account for over half of the state’s value added and over half of its private-sector wages. In other words, they comprehend the state’s most productive enterprises and those that pay the best salaries.

Following up on the last point, in performing its analysis of the effects of Measure 97, both the Legislative Reference Office and the analysts at PSU presumed that the financial services industry would be largely unaffected by it. That is the case for two reasons. First, this industry is heavily weighted to pass-through entities, which are exempt from the gross receipts tax under Measure 97 (see Figure 4 from Owen Zidar).

 Second, both explicitly assumed that Oregon would exclude the sale of real property, investment receipts, including interest, dividends, and capital gains, and sales of financial instruments, including bonds, mortgages, debentures, etc., in calculating gross receipts. Consequently, most financial service companies would only be on the hook for their management fees. And, given that the gross receipts tax under Measure 97 is an alternative minimum tax and that, where financial transactions are excluded, financial service companies tend to be high-margin, low-turnover businesses, this means that, for the most part, they will be unaffected by Measure 97 – C-corps in the financial services industry tend to pay fairly high corporate income taxes now, they would continue to do so under Measure 97.

Excluding sales of financial instruments is standard practice where financial services are concerned, since financial transactions vastly exceed state product. This issue hadn’t come up in Oregon previously because it’s irrelevant to defining the corporate-income tax base or to determining the existing alternative minimum tax, which is capped at $100 thousand. But it is inconceivable that the legislature wouldn’t address this issue if Measure 97 were to pass. Otherwise the results could be pretty scary. Interestingly, there is one financial service industry where this exclusion typically doesn’t apply, insurance. Presumably, Measure 97’s gross receipts tax would apply to insurance premiums purchased by Oregonians – indeed, the LRO estimates that 20 biggest insurers doing business in Oregon would see their state tax remittances increase from average of $200,000 to $3.5 million per annum.

This quasi-anomaly is partly due to the distinction between apportionment on the basis of “market” or “activity.” Oregon’s CIT apportionment is currently governed by the taxpayer’s principal business activity (PBA) code on their federal tax returns – and these codes are largely based on the NAICS code, which classifies business activities as goods or services – goods are currently apportioned on a market basis (defined in terms of their customers location) and services on an activity basis (where the bulk of the work is performed). Consequently, PBA codes control which apportionment method applies to a taxpayer when computing Oregon’s business tax. Most finance services, for example, take a service code. However, this isn’t necessarily the case. Grant Thornton offers the following illustration: “A company that processes financial transactions using advanced technology has all of its employees located in Oregon. It determines for Oregon tax purposes that a ‘technology’ NAICS code is most appropriate. Businesses that use the ‘technology’ code apportion receipts to Oregon based on the location of the business’s customers, which often results in apportionment of less than 100 percent.” In contrast, if the company chooses a ‘financial’ code, the apportionment percentage would be based on the company’s payroll in Oregon, which for this business would be 100 percent. However, because the federal PBA code disclosure doesn’t affect the computation of federal tax, the feds don’t require businesses to choose a code with any precision or consistency (one important caveat aside, where the selection of NAICS codes affects tariffs paid on goods/services crossing international borders, customs authorities strictly constrain gaming by multinational corporations of NAICS codes) – this is important because state administration of income taxes piggybacks on federal reporting, and playing with these codes is one of the ways that C-corps currently shift their tax liabilities away from higher-tax jurisdictions, like Oregon, to those with lower CIT rates, like Washington.

Gov. Brown has proposed to fix this anomaly, should Measure 97 pass, by basing all business taxes on the location of the customer buying the service, rather than the location of the company selling the service.  Unfortunately, the state doesn’t have a mechanism for tracking in-state sales or following them back up the value chain. Right now, we pretty much rely on businesses to tell us what their Oregon sales are. Unfortunately, it is easy for businesses with out-of-state sales to fiddle this figure. Indeed, our inability to track in-state sales is one reason for Measure 67’s adoption of dollar limits for its alternative minimum tax. Consequently, the claim made by the pro-97 camp, that, because the measure targets sales rather than profits, businesses will find it harder to avoid Measure 97 taxes, may, in fact deserve a couple of Pinocchios.