By Jesse Griffiths
Cross-posted at ODI.
The 2019 Financing for Sustainable Development report from the Inter-Agency Task Force (IATF) on Financing for Development was launched today.
For those – like me – who worry that the world is sleepwalking into another crisis, it's not reassuring. It confirms that global debt is at record levels and 'financial fragilities' have built up across the globe. It's also disappointingly light on solutions that could reverse these trends.
The IATF is a group of fifty major international institutions that work on finance issues, including various United Nations bodies, the International Monetary Fund, World Bank and World Trade Organization.
This report is its annual stocktake on progress towards meeting commitments to finance the Sustainable Development Goals (SDGs). It's an impressive undertaking, covering all major financing sources, with a mandate to look at the global financial and economic system as a whole.
Three things stood out to me:
First, both public and private debt continue to grow in all country categories. As the graph shows, emerging economies should be particularly worried about corporate debt, which is close to 100% of GDP. This high level of debt makes these economies highly vulnerable – changes in the internal or external environment could trigger bankruptcies that could lead to a full-blown financial crisis.
Meanwhile, more than a decade after the global crisis, developed countries continue to have record levels of government debt. Clearly public finances in this group would be badly placed to weather any future crisis.
Second, global financial sector risks are very worrying. The graph shows how the financial sector has 'deepened' – grown relative to the size of the economy – in all categories of countries since the turn of century.
This can be a good thing for developing countries, but it depends on the way that the financial sector has developed. The report highlights that developing countries' financial sectors have internationalised, with international banks now making up 40% of their banking sector – a share which has doubled since mid-1990s.
This can bring advantages, but it also makes them more vulnerable to the international financial system, where risks have continued to grow despite reforms taken after the global crash. For example, the report notes that 'the global stock of high yield bonds and leveraged loans has doubled in size since the global financial crisis, driven by low borrowing costs, high risk appetite, and looser lending standards.'
Reports like this are prone to understatement. One conclusion it draws is that 'In the current uncertain environment, financial markets are highly susceptible to a sudden shift in investors' perception of market risk, which could result in a sharp and disorderly tightening of global financial conditions.'
In other words, it wouldn't take much to precipitate a crash. Add to this the fact that three quarters of countries are found not to have a financial sector strategy, and it's beginning to look like a warning cry.
Third, as might be expected from a report that is essentially a compromise between the differing perspectives of a wide range of institutions, recommendations on what to do to prevent another major crisis hitting the global economy are thin on the ground.
One key area I've highlighted before is what to do about the increasing risk of a widespread public or 'sovereign' debt crisis.
The report devotes a chapter to debt, and does mention some potential solutions. It has a section on the idea of making debt contracts dependent upon the ability of the debtor government to pay – known in the trade as 'state contingent debt instruments.' The idea of reducing the repayment burden when, for example, states face recessions or natural catastrophes is a good one, as a recent ODI report explores.
However, on the central issue of how to rapidly and fairly resolve debt crises that do occur – to prevent the lost years (and often decades) that can result – the report is spectacularly unambitious, saying only that it might be time to revisit this issue.
Perhaps I am expecting too much of a report produced by major international bureaucracies: the internal wrangling over each issue is likely to stymie creative, solution-oriented thinking.
The time is therefore ripe for others to pick up this baton and produce the companion set of solutions to help prevent or resolve the problems highlighted by the report, and ensure that the world can meet the ambition of the SDGs without suffering another major crisis.
Jesse Griffiths is Head of Programme at ODI and a specialist in development finance and the international development finance architecture. He has done work for a range of national governments, international organisations, non–governmental organisations and think–tanks, and has published widely on these topics.
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Wealth is a crucially important measure of economic health—it allows families to transfer income earned in the past to meet spending demands in the future, such as by building up savings to finance a child's college education.
That's why it's so alarming to see that, today still, the median white American family has twelve times the wealth that their black counterparts have. And that only begins to tell the story of how deeply racism has defined American economic history.
Enter EPI Distinguished Fellow Richard Rothstein's widely praised book, "The Color of Law," which delves into the very tangible but underappreciated root of the problem: systemic, legalized housing discrimination over a period of three decades—starting in the 1940s—prevented black families from having a piece of the American Dream of homeownership.
Over the years, this disparity was compounded by not only ongoing discrimination but also the legacy of prior practices.
"This enormous difference in (wealth) is almost entirely attributable to federal housing policy implemented through the 20th century," says Rothstein as the narrator in animated film about his book, entitled "Segregated by Design."
Director Mark Lopez uses innovative visual techniques to walk the viewer through Rothstein's story, and the results are moving and compelling.
"African American families that were prohibited from buying homes in the suburbs in the 1940s and 50s, and even into the 1960s, by the Federal Housing Administration gained none of the equity appreciation that whites gained," Rothstein says in the short film.
The discrimination happened on several levels—and often culminated in violence against black families trying to move into neighborhoods that had been effectively designated as white by government policy. Sometimes these designations took place quite literally as maps were divided up along racial lines with different colors on the maps. Black neighborhoods were painted red—hence the term "redlining"—which only became illegal after the Fair Housing Act of 1968.
In addition, "state sponsored violence was a means, along with many others, at which all levels of government maintained segregation."
Rothstein acknowledges that the problem runs so deep that it can never be completely untangled, but also argues that partial reversal are possible and can be encouraged by sound economic and housing policies. It starts with knowing how it happened.
"If we understand the accurate history—that racially segregated patterns in every metropolitan area like St. Louis were created by de jure segregation—racially explicit policy on the part of federal, state, and local governments designed to segregate metropolitan areas, then we can understand we have an unconstitutional residential landscape," Rothstein says.
"And if it's unconstitutional, then we have an obligation to remedy it," he adds. "We must build a national political consensus leading to legislation, a challenging but not impossible task, to develop policies that promote an integrated society."
Until then, the legacy of racist housing practices will remain a fact of life in most American cities.
The Brookings Institute
January 10, 2019
Did we do right thing?
No. Then yes. Then no.
If you looked at what was happening to the economy in 2007, at the runup to Bear Stearns failing and what happened to after Bear Stearns failed, there was obviously a gathering storm. Nobody did much except react. Banks were allowed to continue paying dividends. Nobody was forced to recapitalize. The situation drifted along. There should have been shock and awe of capital, a recognition that maintaining demand was the most important objective of macro-economic policy. Yet nobody did much. It was an obvious mistake, even at the time.
But in the crucial period of six months between the time Lehman Brothers fell and the period after the stress test, America rose to the occasion. The banks were substantially recapitalized; significant fiscal stimulus was delivered; substantial interventions to provide liquidity to the financial markets were engineered; and the sharpest "V" in the history of the major economies was recorded between the first and second quarters of 2009. On the precipice of a truly historic economic calamity, we acted decisively, appropriately, and effectively. And this was by far the most important period to get it right.
By the end of 2009, however, driven by misguided concern about budget deficits and a desire to get to long-run agendas, we declared that the green shoots of recovery were at hand and left the battlefield. Demand was still too weak to drive a robust recovery, and as a consequence, the expansion was substantially slower than it could have been, with less capital investment and more people unemployed for a longer period of time. The lost output certainly cast a shadow forward.
So at the most important moment, we acted. But we waited too long and declared victory prematurely.
Could we have avoided a populist backlash?
There are reasons rooted financial crises in general that serve as catalysts for populist uprisings: in particular the need to provide support to existing financial institutions, especially powerful ones, at the same time that masses of people suffer dislocation. But had we adopted more draconian policies towards the financial institutions, would it have somehow curbed the populist pressure? The best natural experiment says no. Britain nationalized two of their four major banks, yet they got "Brexited" at about the time that we got Trump.
Then there's the more extreme anti-establishment solution: the government simply stands back and lets businesses fail. The economic fires burn themselves out, the theory goes, without taxpayers putting any money in. We have a natural experiment for that, too, and it was what made the Great Depression great.
In fact, if you look at a graph of any interesting economic statistic from the beginning of the fall of 2008 to the beginning of 2009, it looks kind of just like the Great Depression did after 1929. And if you look at the subsequent five years, although our economy could've been better, it doesn't look anything like the Depression. Unemployment peaked at 10 percent, not 25. Had we decided against government action, we would have had something like the Great Depression. And even in terms of the federal budget alone, the government would lost 10 times as much revenue from the destruction of our economy as it would have gained from not having to spend money on bail outs—the vast majority of which came back to the government anyway.
Should we have nationalized banks?
When you nationalize an institution, the first question everyone asks is, "What happens next?" The situation is temporary, so how does it end?
Inside the bank, employees will generally make a fairly obvious calculation: If the government's going to own and liquidate it, people who can get other jobs usually do. Talent leaves.
On the consumer side, debtors owing money to a bank that will never give them a new loan feel less pressure to pay back the old one. New customers give their business to banks that aren't in liquidation and run by the government. For all these reasons our experience is that government intervention in banks is invariably a major destroyer of asset value. It would have been far more expensive for taxpayers had the government intervened in the banks. And those weaker banks would have been far less helpful in contributing to the recovery.
There were those who said at the time, "Well, what about the Swedish model?" But the Swedish government already owned 80 percent of the banks before the crisis started: The government putting additional capital into a bank that it already 80 percent owns really isn't analogous to the situation we were facing. As for comparing this crisis to a standard intervention by the FTC, there certainly wasn't anybody sitting around in the middle of the biggest financial crisis in 60 years ready to absorb a big bank as if it were a community bank.
Others simply say that banks didn't suffer enough compared to everybody else. But if you were a shareholder in the banks that people talked about nationalizing, after we've had a 10-year recovery your investment is worth about 10 percent of what it was before the crisis started. To enact a harsher penalty, you would have had to destroy an enormous amount of value.
Is capitalism itself in crisis?
Many of the problems of capitalism are actually a feature of its success. It is a truism that middle-class wages have been stagnating. But we should remember how dramatically more efficient our economy has become. It takes takes about a third as many working hours to purchase a refrigerator as it did in 1973. It takes half as many hours to buy a shirt; one-sixth to buy a television. If you take the goods produced by what we think of as capitalism, there has been a massive increase in purchasing power over the last 45 years.
The challenge is how do we adapt to that increased efficiency, which is very much like what happened to agriculture. Agriculture has become so efficient that now it's kind of irrelevant to the economy, less than two percent of our working population. And that what's happening to traditional capitalist—particularly manufacturing—activity. Today in America only a four-and-a-half percent of workers are doing production work in manufacturing. There are more 50-year-old men on disability than doing production work in manufacturing—precisely because it's become so productive. Fewer people are producing goods. More people are producing services.
What do we do in healthcare? What do we do in education? What do we do in housing? How do we handle social media? The difficulties and challenges come not from not the workings of capitalism but from the particular activities our workers move to as traditional capitalism succeeds. These are the economic policy challenges for the next generation. You can't think about healthcare the way you think about the market for shirts. You can't think about taking care of the aged the way you think about selling automobiles.
So is traditional capitalism enough? No. But rejecting traditional capitalism would not—if you look at places such as Venezuela, Cuba, and North Korea—seem to be the answer either. As for China, anyone who looks at it thoughtfully has to say that, for the most part, the reason China has done phenomenally well over the last 40 years is that there are a lot more markets, a lot more property, and a lot more openness to the rest of the world than there used to be. A broad rejection of capitalism is a poor substitute for taking on the real economic challenges that face the United States today.
This revenue increase — unlike a revenue increase from new taxes or higher rates — will have favorable incentive effects. It will encourage people to participate in the above-ground economy. And what could be more of a step toward fairness than collecting from wealthy scofflaws?
Closing corporate tax shelters. All too often, corporations are able to make use of tax havens, differences in accounting treatment across jurisdictions, and other devices to reduce tax liabilities. Economist Kimberly Clausing estimates that profit-shifting to tax havens costs the United States more than $100 billion a year. Although the Trump tax plan sought to reduce the incentives for profit-shifting, various exemptions and design flaws mean that the new system does little to deter shifting revenues to tax havens. Fairly incremental changes will have a large impact: For example, a per-country corporate minimum tax rather than a global minimum tax will increase tax revenues by nearly $170 billion in a decade.
But there is much more to be done. A robust attack on tax shelters — that included, for example, tariffs or penalties on tax havens as well as stricter penalties for lawyers and accountants who sign off on dubious shelters — could raise twice the revenue attainable from a per-country minimum tax, or about 30 billion annually. It would also encourage the location of economic activity in the United States and discourage the vast intellectual ingenuity that currently goes into tax avoidance.
Closing individual tax shelters. Like the corporations they own, wealthy individuals make use of myriad loopholes in the tax code to shelter their personal income from taxation. Most high-income taxpayers pay a 3.8 percent tax that pays into entitlement programs like Social Security and Medicare. However, some avoid these payroll taxes by setting up pass-through businesses and re-characterizing large shares of their income as profits from business ownership, rather than wage income. The Obama administration's proposals to close payroll tax loopholes were estimated to generate $300 billion over a decade.
Another egregious loophole is 1031 exchanges, which allow real estate investors to sell property, take a profit, and defer paying taxes on those profits so long as they reinvest them in similar investments. There is no limit on the number of these exchanges that investors can make. Consequently, the wealthy use 1031 exchanges to build up long-term tax-deferred wealth that can eventually be passed down to their heirs without taxes ever being paid. Outright repeal of 1031 exchanges were estimated in 2014 to raise around $40 billion in a decade and would raise almost $50 billion today.
Another tool used to shelter individual income from taxation is carried interest. Income that flows to partners of investment funds is often treated as capital gains and taxed at lower rates than ordinary income. This creates a tax-planning opportunity for investors to convert ordinary income into long-term capital gains that receive much more generous tax treatment. President Trump repeatedly vowed that his signature tax cuts would eliminate the carried-interest loophole, saying it was unfair that the ultra-wealthy were "getting away with murder." However, in the face of significant lobbying pressure, the administration abandoned these plans. The Joint Committee on Taxation estimates that taxing carried profits as ordinary income would generate over $20 billion in a decade.
There are better ways to shake money out of the tax system than a wealth tax.
Other ways in which individuals can shelter income include misvaluing interests such as shares in investment partnerships when putting them in retirement accounts as well as schemes involving nonrecourse lending.
Closing tax shelters would level the playing field in favor of investments by companies that create jobs and to the detriment of various kinds of financial operators. This would raise employment and incomes as well as contributing to fairness.
Eliminating "stepped-up basis." Wealth tax advocates rightly point to an important gap in our current system. An entrepreneur starts a company that turns out to be highly successful. She pays herself only a small salary, and shares in the company do not pay dividends, so the company can invest in growth. The entrepreneur becomes very wealthy without ever having paid appreciable tax, as the income that made the wealth possible represents unrealized capital gains.
Unrealized capital gains explain how Warren Buffett can pay only a few million dollars in taxes in a year when his wealth goes up by billions. Astoundingly, no capital gains tax is ever collected on appreciation of capital assets if they are passed on to heirs. Specifically: When an investor buys a stock, the cost of that purchase is the tax basis. If the stock rises in value and is then sold, the investor pays taxes on the gains. If an investor dies and leaves stock to her heir, that cost basis is "stepped up" to its price at the time the stock is inherited. The gain in value during the investor's life is never taxed.
Implementing the Obama administration's proposals for constructive realization of capital gains at death would raise $250 billion in the next decade. This is a progressive change that would impact only the very wealthy: Ninety-nine percent of the revenue from ending stepped-up basis will be collected from the top 1 percent of filers.
Eliminating stepped-up basis will also make the economy function better and so would be desirable even if it did not raise revenue. The fact that capital gains passed on to children entirely escape taxation provides aging small-business owners or real estate owners a strong incentive not to sell them to those who could operate them better while they are alive. It also makes it much more expensive to realize capital gains and use the proceeds to make new investments than it would be if the capital gains tax was inescapable.
Capping tax deductions for the wealthy. Today, a homeowner in the top tax bracket (post-Trump tax cuts, 37 percent) who makes a $1,000 mortgage payment saves $370 on her tax bill. Under an Obama administration proposal to limit the value of itemized deductions to 28 percent for all earners, that same write-off would save this wealthy taxpayer just $280. Importantly, such a cap would raise tax burdens only for the rich: Those with marginal rates under the cap would still be able to claim the full value of their itemized deductions. The plan to cap top-earners' itemized deductions was estimated to raise nearly $650 billion in a decade. Recognizing that the Trump tax plan scaled back the mortgage interest deduction and state and local tax deductions, we estimate that additional limits on top-earner deductions could generate around $250 billion in a decade.
As with the elimination of stepped-up basis, the distributional case for capping tax deductions is strong. The mortgage interest deduction provides a tax advantage to homeowners; promoting homeownership is a worthy goal. But there is little rationale for subsidizing home ownership at higher rates for richer rather than poorer taxpayers.
End the 20 percent pass-through deduction. Perhaps the most notorious of the Trump tax changes, the pass-through deduction provides a 20 percent deduction for certain qualified business income. This exacerbated the tax code's existing bias in favor of noncorporate business income and so reduces economic efficiency. And the complex maze of eligibility is arbitrary, foolish, and a drain on government resources: The Joint Committee on Taxation estimates that this provision will reduce federal revenues by $430 billion in the next decade. Eliminating the pass-through deduction will reduce incentives for tax gaming and raise revenue primarily from taxpayers making more than $1 million annually.
Broaden the estate tax base. Prior to the Trump tax reform, only 5,000 Americans were liable for estate taxes. The recent changes more than halved that small share by doubling the estate tax exemption to $22.4 million per couple. The Joint Committee on Taxation estimates that this change costs around $85 billion, with the benefits accruing entirely to 3,200 of the wealthiest American households. Repealing the Trump administration's changes and applying estate taxes even more broadly — for example, as the Obama administration proposed, by lowering the threshold to $7 million for couples — would raise around $320 billion in a decade. The estate tax would still only impact 0.3 percent of decedents.
In addition to the question of the appropriate floor on estates, there is also ample room to attack the many loopholes that enable wealthy families to largely avoid paying taxes when transferring wealth to their progeny during their lifetimes. This happens through a mix of trust arrangements, intra-family loans, and dubious valuation practices to evade gift-tax liability. Strengthening the taxation of estates would raise revenue and be efficient, diverting resources from tax planning and increasing work incentives for the children of the wealthy. We are enthusiastic about proposals, notably by Lily Batchelder, that call for the conversion of the estate tax into an inheritance tax, to appropriately tax inherited privilege and discourage large concentrations of wealth.
Increasing the corporate tax rate to 25 percent. When corporations began lobbying efforts on corporate tax reform, their stated objective was a 25 percent corporate rate. Business leaders produced estimates showing how this 25 percent rate would have prevented foreign purchases of thousands of companies and shifted billions in corporate taxable income to the United States. The Trump tax cuts delivered more than the business community asked, slashing the corporate rate to 21 percent. The CBO estimates that a 1 percentage point increase in the corporate tax rate will generate $100 billion in the next decade. Based on this estimate, a 4 percentage point increase to 25 percent will generate an additional $400 billion in revenue.
Raising the corporate tax rate would not increase the tax burden on most new investment, because it would raise in equal measure the value of the depreciation deductions that corporations could take when they undertook investments. The principle losers from an increase in the rate would be those earning economic rents in the form of monopoly profits and those who had received enormous windfalls from the Trump tax cut.
Closing tax shelters used by the wealthy alone raises more revenue than Ocasio-Cortez's proposal. And together, the reforms we propose raise far more than a 70 percent top tax rate, and more too than Warren claims her wealth tax will generate. These base-broadening, efficiency-enhancing reforms are the best way to start raising revenue as progressively and efficiently as possible. To be sure, it may well be that wealth taxation or large increases in top rates are necessary to adequately fund government activities. But we advocate these approaches only after the revenue-raising potential of base-broadening is exhausted.
Tomorrow: The challenges in the rate hike and wealth tax proposals.
Natasha Sarin is an assistant professor of law at the University of Pennsylvania Law School and an assistant professor of finance at the Wharton School. Lawrence H. Summers is the Charles W. Eliot University Professor at Harvard and former US Treasury secretary.
