The NBER Reporter Winter 2006-2007: Conferences
Conference on Retirement Research
Macroeconomics and Individual Decision Making
Inter-American Seminar on Economics: Informality, Corruption, and Institutions
Financial Reporting and Taxation
Behavioral Responses to Taxation and Social Insurance Programs
20th Annual TRIO Conference
Conference on Retirement Research
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Liebman and Saez use SIPP data matched to longitudinal uncapped earnings records from the Social Security Administration for 1981 to 1999 to analyze earnings responses to increases in tax rates and to inform discussions about the likely effects of raising the Social Security taxable maximum. The earnings distribution of workers around the current taxable maximum is inconsistent with an annual model in which people are highly responsive to the payroll tax rate, even in the subset of self-employed individuals. Panel data on married men with high earnings display a tremendous increase in earnings over the 1980s and 1990s relative to other groups, with no clear breaks around the key tax reforms. This suggests that other income groups cannot serve as a control group for the high earners. This analysis does not support the finding of a large behavioral response to taxation by wives of high earners. The authors actually find a decrease in the labor supply of wives of high earners around both the 1986 and the 1993 tax reforms, which they attribute to an income effect caused by the surge in primary earnings at the top. Policy simulations suggest that with an earnings elasticity of 0.5, lost income tax revenue and increased deadweight loss would swamp any benefits from the increase in payroll tax revenue. In contrast, with an elasticity of 0.2, the ratio of the gain in OASDI revenue to lost income tax revenue and deadweight loss would be much greater.
Poterba, Rauh, Venti, and Wise examine how different personal retirement account (PRA) asset allocation strategies over the course of a worker's career would affect the distribution of retirement wealth and the expected utility of wealth at retirement. They consider rules that allocate a constant portfolio fraction to various assets at all ages, as well as "lifecycle" rules that vary the mix of portfolio assets as the worker ages. Their analysis simulates retirement wealth using asset returns that are drawn from the historical return distribution. The expected utility associated with different PRA asset allocation strategies, and the ranking of these strategies, is sensitive to four parameters: the expected return on corporate stock; the worker's relative risk aversion; the amount of non-PRA wealth that the worker will have available at retirement; and the expense ratios charged for the investment. At modest levels of risk aversion, or in the presence of substantial non-PRA wealth at retirement, the historical pattern of stock and bond returns implies that the expected utility of investing completely in diversified stocks is greater than that from any of the more conservative strategies. Higher risk aversion or lower expected returns on stocks raises the expected utility of portfolios that include less risky assets. There often exists a fixed-proportions portfolio of stocks and inflation-indexed government bonds that yields expected utility at retirement that is at least as high as that from typical lifecycle investment strategies. When asset allocation is near the allocation that generates the highest expected utility, variation in expense ratios is more important than variation in asset allocation for affecting retirement utility.
Implicit taxes in Social Security -- which measure Social Security contributions, net of benefits accrued, as a percentage of earnings -- tend to increase over the life cycle. Goda, Shoven, and Slavov examine the effects of three potential policy changes on implicit Social Security tax rates: extending the number of years used in the Social Security formula from 35 to 40; allowing individuals who have worked more than 40 years to be exempt from payroll taxes; and distinguishing between lifetime low-income earners and high-income earners who work short careers. These three changes can be achieved in a benefit- and revenue-neutral manner, and create a pattern of implicit tax rates that are much less distortionary over the life cycle, eliminating the high implicit tax rates faced by many elderly workers. The effects of these policies on progressivity and women are also examined.
Brown and Weisbenner provide new evidence on what types of individuals are most likely to choose a defined contribution (DC) plan over a defined benefit (DB) plan. Making use of administrative data from the State Universities Retirement System (SURS) of Illinois, they study the decisions of nearly 50,000 new employees who make a one-time, irrevocable choice between a traditional DB plan, a portable DB plan, and an entirely self-managed DC plan. Because the SURS-covered earnings of these employees are not covered under the Social Security system, this choice provides insight into the DB versus DC preferences of individuals with regard to a primary source of their retirement income. The authors find that a majority of participants fail to make an active decision and are thus defaulted into the traditional DB plan after 6 months. They also find that those individuals who are most likely to be financially sophisticated are most likely to choose the self-managed DC plan, despite the fact that, given current plan parameters, the DC plan is inferior to the portable DB plan under reasonable assumptions about future financial market returns. They discuss both rational and behavioral reasons that might explain this finding.
Around the world, Pay-As-You-Go (PAYGO) public pension programs face serious long-term fiscal problems primarily because of actual and projected population aging, and most appear unsustainable as currently structured. Some have proposed the replacement of such plans with systems of fully funded private or personal Defined Contribution (DC) accounts, but the difficulties of transition to funded systems have limited their implementation. Recently, a new variety of public pension program known as "Notional Defined Contribution" or "Non-financial Defined Contribution" (NDC) has been created, with the objectives of addressing the fiscal instability of traditional plans and mimicking the characteristics of funded DC plans while retaining PAYGO finance. Using different versions of the system recently adopted in Sweden, calibrated to U.S. demographic and economic parameters, Auerbach and Lee evaluate the success of the NDC approach in achieving fiscal stability in a stochastic context. (In a companion paper, these authors will consider other aspects of the performance of NDC plans in comparison to traditional PAYGO pensions.) They find that, despite its built-in self-correction mechanisms, the basic NDC scheme is still subject to fiscal instability: there is a high probability that the system's debt-payroll ratio will explode over time. With adjustments, however, the NDC approach can be made considerably more stable.
A number of proposals to introduce personal accounts to the Social Security program contain provisions that would "guarantee" account holders against relatively poor investment performance that would make their total benefits fall below the level scheduled under current law. Presently, most of the focus is on the expected cost of such guarantees, as few estimates evaluate the potential market cost of insuring against the associated risk. Biggs, Burdick, and Smetters demonstrate how a simple modification of parameter inputs used to calculate the expected cost of guarantees would allow analysts to estimate the market cost of the underlying risk.
During most of 2005, the United States was engaged in a heated debate about whether to replace part of the current, defined-benefit Social Security system with a system of defined contribution personal accounts. A political stalemate has emerged. Democrats who advocate retaining the current system will not budge from three core goals, related to regarding Social Security as social insurance : 1) Social Security should redistribute wealth from those who have earned more over their working lives to those who have earned less; 2) different generations should share the risks of aggregate shocks; and 3) security should be achieved via inflation-indexed payments received for life. Republicans, on the other hand, will not give up on what they regard as their core goals, namely 1) individual ownership within Social Security accounts of tangible assets that cannot be revoked by a future government, 2) market valuation of account assets, 3) transparency regarding accrual of assets, 4) equity-like returns, and 5) individual choice of asset allocation. Geanakoplos and Zeldes seek a common ground between these two approaches that preserves the core goals of each. They show that it is possible to convert Social Security into a system of personal accounts, with irrevocable ownership of assets that have market prices and market rates of return, while at the same time redistributing benefits based on lifetime income, sharing risks across generations, and providing retirees an inflation-indexed life annuity. They call this system progressive personal accounts. Implementing these accounts requires the creation of a new kind of derivative security (which they call a PAAW for Personal Annuitized Average Wage security) - it pays its owner one inflation-corrected dollar during every year of life after the fixed retirement date, multiplied by the economy wide average wage at the retirement date. Redistribution occurs via a variable government match of private contributions. The authors show that by choosing a particular variable match and restricting accounts to hold only PAAWs, it is possible to create a system of progressive personal accounts that exactly mimics the promised taxes and payouts of the current system. They describe how to create pools of PAAWs that could be traded in financial markets (yielding market prices), and then consider allowing individuals some (limited) flexibility to sell PAAWs in exchange for other marketable securities. Finally, they discuss ways to modify the system to make it self-balancing - reducing or avoiding the need for politicians to alter the tax and benefit rules affecting participants. They argue that this would lead to enhanced property rights and reduced political risk relative to the current system.
Demographic change has an important effect on the stock of assets held in defined benefit pension plans. Poterba, Venti, and Wise project the impact of changes in the age structure of the U.S. population between 2005 and 2040 on the stock of assets held by these plans. They project the net contributions to, and withdrawals from, these plans. These projections are combined with estimates of the future evolution of the stock of assets in defined contribution plans to describe the prospective impact of demographic change on the stock of retirement saving assets. Information on demography-linked changes in asset demand is a critical input to evaluating the potential impact of population aging on asset returns.
Boersch-Supan, Krueger, and Ludwig present the main findings of recent research on the impact of the demographic transition towards an older population in industrialized countries on world-wide rates of return to capital, international capital flows, and the distribution of welfare in the OECD. To quantify these effects, they develop a multi-country large scale Overlapping Generations model with uninsurable labor productivity and mortality risk. Because of the predicted relative abundance of the factor capital, the rate of return falls between 2005 and 2080 by roughly 90 basis points. The simulations indicate that capital flows from rapidly aging regions to the rest of the world will initially be substantial, but that trends are reversed when households de-cumulate savings. Capital flows from the important European countries - France, Germany and Italy - are initially positive at 2 percent and then decrease to about about - 2 percent by 2040. In contrast, the U.S.current account deficit is predicted to increase by 2 percentage points until 2030. In terms of welfare, the model suggests that young agents with few assets and currently low labor productivity gain up to 1 percent in consumption from higher wages associated with population aging. Older, asset-rich households tend to lose because of the predicted decline in real returns to capital.
Samwick analyzes the progressivity of the Social Security benefit formula as a means of lessening the risk inherent in investment-based Social Security reform. Focusing on a single cohort of workers who will reach their normal retirement age as the Social Security trust fund is projected to be exhausted, he simulates the distribution of benefits subject to both earnings and financial risk. The simulations show that the maximally progressive traditional benefit allows over two thirds of the equity risk to be eliminated. Similarly, using progressive benefit reductions in which replacement rates for lower earnings are reduced by less than those for higher earnings, about half of the equity risk can be eliminated. Sensitivity tests show that these patterns hold over a wide range of assumptions about risk aversion, the equity premium, and the size of the personal retirement accounts established by the reform.
Feldstein describes the risks implied by a mixed system of Social Security pension benefits with different combinations of pay-as-you-go taxes and personal retirement account (PRA) saving. The analysis shows how these risks can be reduced by using alternative private market guarantee strategies. The first such strategy uses a blend of equities and TIPS to guarantee at least a positive real rate or return on each year's PRA saving. The second is an explicit zero-cost collar that guarantees an annual rate of return by giving up all returns above a certain level. One variant of these guarantees uses a two-stage procedure: a guaranteed return to age 66 and then a separate guarantee on the implicit return in the annuity phase. An alternative strategy provides a combined guarantee on the return during both the accumulation and the annuity phase. Simulations are presented of the probability distributions of retirement incomes relative to the "benchmark" benefits specified in current law. Calculations of expected utility show that these risk reduction techniques can raise expected utility relative to the plans with no guarantees. The ability to do so depends on the individual's risk aversion level. This underlines the idea that different individuals would rationally prefer different investment strategies and risk reduction options.
Beshears, Choi, Laibson, and Madrian summarize the empirical evidence on how defaults affect retirement savings outcomes. After outlining the salient features of the various sources of retirement income in the United States, they present the empirical evidence on how defaults affect retirement savings outcomes at all stages of the savings life-cycle, including savings plan participation, savings rates, asset allocation, and post-retirement savings distributions. They then discusses why defaults have such a tremendous impact on savings outcomes. The paper concludes with a discussion of the role of public policy towards retirement saving when defaults matter.
Cutler, Glaeser, and Rosen compare the risk factor profile of the population in the early 1970s with that of the population in the early 2000s. They find that for the population aged 25-74, the 10-year probability of death fell from 9.8 percent in 1971-5 to 8.4 percent in 1999-2002. Among those aged 55-74, the same measure fell from 25.7 percent to 21.7 percent. The largest contributors to these changes were the reduction in smoking and better control of blood pressure. Despite substantial increases in obesity in the past three decades, the overall population risk profile is healthier now than it was.
These papers will be published by the University of Chicago Press in an NBER Conference volume. Its availability will be announced in a future issue of the NBER Reporter.
Macroeconomics and Individual Decision Making
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Psychologists have developed effective survey methods of measuring how happy people feel at a given time. The relationship between how happy a person feels and utility is an unresolved question. Existing work in economics either ignores happiness data or assumes that felt happiness is more or less the same thing as flow utility. The approach Kimball and Willis propose steers a middle course between the two polar views that "happiness is irrelevant to economics" and the view that "happiness is a sufficient statistic for utility." They argue that felt happiness is not the same thing as flow utility, but that it does have a systematic relationship to utility. In particular, they propose that happiness is the sum of two components: 1) elation - or short-run happiness - which depends on recent news about lifetime utility; and 2) baseline mood - or long-run happiness - which is the output of a household production function like the household production functions for health, entertainment, and nutrition. Because happiness is itself one of the arguments of the utility function, the determinants of happiness affect behavior. Moreover, because happiness depends on recent news about lifetime utility, short-run movements in happiness data provide important information about preferences. This theory of the relationship between utility and happiness provides a new explanation for the Easterlin paradox of secularly non-increasing happiness as the consequence of the Baumol cost disease for happiness and an explanation for loss-aversion based on the dependence of happiness on recent news.
In an earlier paper, Blinder and Morgan created an experimental apparatus in which Princeton University students acted as ersatz central bankers, making monetary policy decisions both as individuals and in groups. In this study, they manipulate the size and leadership structure of monetary policy decisionmaking. They find no evidence of superior performance by groups that have designated leaders. Groups without such leaders do as well as or better than groups with well-defined leaders. Furthermore, they find rather little difference between the performance of four-person and eight-person groups; the larger groups outperform the smaller groups by a very small margin. Finally, they successfully replicate their Princeton results, at least qualitatively: Groups perform better than individuals, and they do not require more "time" to do so.
Gabaix and Landier develop a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO's pay changes one-for-one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The six-fold increase in CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large U.S. companies during that period. The authors find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.
Mullainathan, Schwartzstein, and Shleifer present a model of coarse thinking, in which individuals group situations into categories, and transfer information from situations in a category where it is useful to situations where it is not. The model explains how uninformative messages can be persuasive, particularly in low involvement situations, and how objectively informative messages can be dropped by the persuader without the audience assuming the worst. The model sheds light on several aspects of mutual fund advertising.
Based on experience over the past three decades, growing inequality appears to be a serious risk. A change in the tax system to index against changes in inequality is motivated both by financial theory and by classical welfare economics. Inequality indexation would insure, at least partially, against future increases in after-tax inequality. Tax rates would endogenously adjust to changes in inequality. Burman, Rohaly, and Shiller develop a method of implementing the system using U.S. tax returns data and the Tax Policy Microsimulation Model. They study the outcomes if inequality indexation had begun in 1979, or 1994, and describe the distributive and incentive effects.
Benabou and Tirole analyze social and economic phenomena involving beliefs that people value and invest in. Uncertain about their "deep values", agents infer them from their own choices, which then come to define "who they are". Identity investments increase in unfamiliar settings or when a greater endowment (wealth, career, family, culture) raises the stakes on viewing an asset as valuable (escalating commitments). Taboos against certain transactions or their mere contemplation arise to protect beliefs about the "pricelessness" of certain assets (life, freedom, love, faith) or things one "would never do". Whether such behaviors are welfare-enhancing or reducing depends on whether beliefs are sought for a functional value (self-disciplines, sense of direction) or as affective consumptions (self-esteem, anticipatory feelings). Thus, a "hedonic treadmill" may arise, or competing identities may cause dysfunctional failures to assimilate, acquire new skills, or adapt to globalization. In social interactions, norm violations trigger forceful reaffirmation, exclusion, or harassment when threatening a strongly held identity, but further erode an initially weak morale. Dignity, pride, or wishful thinking lead to inefficient breakdowns of bargaining even under symmetric information, as partners seek to self-enhance and shift blame by rejecting "insultingly low" offers.
Inter-American Seminar on Economics: Informality, Corruption, and Institutions
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Many countries, especially developing ones, follow procyclical fiscal polices; that is, spending goes up (taxes go down) in booms and spending goes down (taxes go up) in recessions. Alesina and Tabellini provide an explanation for this suboptimal fiscal policy based upon political distortions and incentives for a less-than-benevolent government to appropriate rents. Voters have incentives similar to the "starving the Leviathan" classic argument, and demand more public goods or fewer taxes to prevent governments from appropriating rents when the economy is doing well. They test this argument against more traditional explanations based purely on borrowing constraints, with a reasonable amount of success.
Loayza and Rigolini study the trends and cycles of informal employment. They first present a theoretical model in which the size of informal employment is determined by the relative costs and benefits of informality and the distribution of workers' skills. In the long run, informal employment varies with the trends in these variables, and in the short run it reacts to accommodate transient shocks and to close the gap that separates it from its trend level. They then use an error-correction framework to examine empirically informality's long-and short-run relationships. For this purpose, they use country-level data at annual frequency for a sample of developed and developing countries, with the share of self-employment in the labor force as the proxy for informal employment. They find that, in the long run, informality is larger in countries that have lower GDP per capita and impose more costs to formal firms, in the form of more rigid business regulations, less valuable police and judicial services, and weaker monitoring of informality. In the short run, informal employment is found to be countercyclical for the majority of countries, with the degree of counter cyclicality being lower in countries with larger informal employment and better police and judicial services. Moreover, informal employment follows a stable, trend reverting process. These results are robust to changes in the sample and to the influence of outliers, even when only developing countries are considered in the analysis.
Edwards investigates whether restrictions to capital mobility reduce countries' vulnerability to major external shocks. More specifically, he asks if countries that restrict the free flow of international capital have a lower probability of experiencing a sudden stop and being subject to contagion than countries with a freer degree of capital mobility. Edwards uses three new indexes on the degree of international financial integration and a large multi-country dataset for 1970-2004 to estimate a series of random-effect probit equations. The results from these probit equations are used to compute marginal effects of different indicators on the likelihood of a country facing a major external crisis. Edwards also analyzes the role played by other variables in determining the probability of experiencing a sudden stop, including large current account deficits; the exchange rate regime - fixed or flexible; holdings of international reserves; fiscal imbalances; world interest rates; and the degree of dollarization, among others. The most important finding is that countries with greater capital mobility are somewhat more subject to contagion than countries that restrict the free mobility of capital.
Maloney, Goni, and Bosch study gross worker flows to explain the rising informality in Brazilian metropolitan labor markets from 1983-2002. This period covers two economic cycles, several stabilization plans, a far-reaching trade liberalization, and changes in labor legislation through the Constitutional reform of 1988. Focusing first on cyclical patterns, they confirm Bosch and Maloney's (2006) findings for Mexico that the patterns of worker transitions between formality and informality correspond primarily to the job-to-job dynamics observed in the United States and not to the traditional idea of informality constituting the inferior sector of a segmented market. However, they also confirm distinct cyclical patterns of job finding and separation rates that lead to the informal sector absorbing more labor during downturns. Second, focusing on secular movements in gross flows and the volatility of flows, they find the rise in formality to be driven primarily by a reduction in job finding rates in the formal sector. A small fraction of this is driven by trade liberalization, and the remainder seems driven by the rising labor costs and reduced flexibility arising from Constitutional reform.
Maul deals with the processes of integrating into the global markets an economy with a large informal sector. He argues that Guatemala's XXI century informal economy can be described as a "Penny Capitalism" system, a term coined by Sol Tax, and later used by T. Schultz, to describe Guatemalan's indigenous communities in the 1930s. This capitalist system works on a "microscopic scale," and is characterized by limited access to larger markets, technology, and credit, but highly efficient on very small scale. Most of the literature reduces informality to a single dimension (labor market, property rights, or Micro a Small Enterprises phenomenon). In contrast, in this paper Maul defines economic informality as a process of individual adaptation to a spectrum of regulatory contracts that the political authorities impose on workers and business firms. In this context, and given the ubiquitous nature of the informal economy, if globalization means the integration of formal firms to international trade, then for poor underdeveloped economies, such as Guatemala, there is a big challenge coming. Reducing informality in such an institutional environment implies much more than just reducing the costs and increasing the benefits of becoming formal. In such a context, limiting the access to national, regional, and global markets to "Doing Business" type of firms will seriously curtail the options for the country, as whole, and for the great majority of the labor force that operates in the informal economy, especially women, young people and indigenous communities.
Fajnzylber, Maloney, and Montes use Regression Discontinuity methods to identify the impact of the reduction of registration costs and taxes on newly born Brazilian micro firms. The introduction of the SIMPLES program in 1996 provides a quasi-natural experiment that permits them to eliminate many of the endogeneity issues surrounding the impact of registration on firm performance. They find that newly created firms that opt for operating formally use more paid workers, are more capital intensive, and exhibit higher levels of total factor productivity. Increased access to credit and government provided technical assistance is not responsible for more than a small fraction of those formality effects. Rather, the observed greater willingness of formal firms to operate out of a fixed locale appears to be responsible for a large share of the formality-firm performance link. Further, the impact seems largest on poorly performing firms.
Bernal and Cardenas study the magnitude and nature of child labor in Colombia. In particular, they evaluate the factors that determine joint child labor and school attendance decisions within the household. In addition, they investigate the characteristics of children, parents, and households that are associated with certain types of child labor, for example, work with relative versus work with non-relatives, and work in certain economic sectors. The authors use various sources of data including the Child Labor Survey (2001), Child Labor Module Follow-up included in the National Household Survey (2003), the Living Standards Survey (2003) and the Familias en Accion database (2002-3). Total child labor participation, which includes all working children from 5 to 17 years of age, was approximately 14.5 percent in 2001. Approximately two-thirds of this group also attended school. Child labor participation rates in rural areas were twice as large as those in urban areas. Around two-thirds of working children worked for their parents or other relatives. The majority of children work in the agriculture sector (approximately 38 percent) followed by retail, manufacturing, and services. Bernal and Cardenas estimate a model in which child labor and school attendance are simultaneous decisions. Higher educational attainment of the head of the household, older head of household, and higher adult employment rates within the household are all positively and significantly associated with higher probabilities of child labor. In addition, the probability that a child works increases for those in the lowest income quintile, for children living in larger households and living with extended family. The most vulnerable children (for example, ethnic minorities, with low-educated parents, living in very poor households, and the like) are more likely to work in agriculture, whereas less disadvantaged children (that is, those with highly educated parents, higher adult employment rates within the household, male head of household, and so on) are more likely to work in retail and in particular, in family-owned businesses. Finally, the authors find robust evidence that a conditional cash transfer program, Familias en Accion, has had significant effects on child labor, especially in the case of boys.
Secure property rights are considered a key determinant of economic development. However, the evaluation of the causal effects of property rights is a difficult task, as their allocation is typically endogenous. Schargrodsky and Galiani exploit a natural experiment in the allocation of land titles to overcome this identification problem. More than twenty years ago, a group of squatters occupied a piece of land in a poor suburban area of Buenos Aires. When the Congress passed a law expropriating the land from the former owners with the purpose of entitling it to the occupants, some of the original owners accepted the government compensation, while others are still disputing the compensation payment in the slow Argentine courts. These different decisions by the former owners generated an allocation of property rights that is exogenous in equations describing the behavior of the squatters. The authors find that entitled families increased housing investment, reduced household size, and improved the education of their children relative to the control group. However, effects on credit access are modest and there are no effects on labor income.
Hunt examines the role of household income in determining who bribes and how much they bribe in health care in Peru and Uganda. She finds that rich patients are more likely than other patients to bribe in public health care: doubling household consumption increases the bribery probability by 0.2-0.4 percentage points in Peru, compared to a bribery rate of 0.8 percent; doubling household expenditure in Uganda increases the bribery probability by 1.2 percentage points compared to a bribery rate of 17 percent. The income elasticity of the bribe amount cannot be precisely estimated in Peru, but is about 0.37 in Uganda. Bribes in the Ugandan public sector appear to be extorted from the richer patients amongst those exempted by government policy from paying the official fees, and reflect the same combination of fee for service and price discrimination as official fees. Bribes in the private sector are flat-rate fees paid by patients who do not pay official fees. Hunt does not find evidence that the public health care sector in either Peru or Uganda is able to price-discriminate less effectively than public institutions with less competition from the private sector.
How do weak private property institutions influence human capital investment decisions? Empirical challenges have limited research on this potentially important facet of how institutions influence prosperity. Edmonds and Sharma argue that a debt-bondage institution prevalent in the western plains of Nepal is an unusually good setting in which it is possible to explore how institutions affect investments in education. They observe substantially more child labor, lower schooling attendance and attainment, and significantly elevated fertility in families vulnerable to debt-bondage. The data are most consistent with diminished returns to education in the vulnerable population as an explanation for our findings. They argue that this diminished return to education owes to a substantive expropriation threat. That is, the absence of secure property rights over human capital's output is a significant deterrent to educational investments.
It is anticipated that these proceedings will be published in an NBER conference volume. Its availability will be announced in a future issue of the NBER Reporter.
Financial Reporting and Taxation
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Hanlon and Maydew examine the implications for multinational firms of recent proposals to conform tax and financial reporting (that is, book-tax conformity). Proponents of book-tax conformity argue that the current dual system in the United States allows firms to simultaneously manage their taxable income down while managing their book income upward. By requiring book-tax conformity, they contend that firms will be forced to trade-off reporting high earnings numbers to shareholders and reporting low earnings to the taxing authority, resulting in improved financial reporting and less tax avoidance. Reduced compliance costs and easier auditing also have been cited as potential benefits of book-tax conformity. Aspects of book-tax conformity that have not been examined, however, include its international implications, particularly regarding the foreign operations of U.S. multinationals. The authors describe several possible approaches to implementing book-tax conformity for firms that have both domestic and foreign operations. They discuss issues likely to arise with each approach and conjecture at the behavioral responses to each. Using firm-level financial data from Compustat, they simulate the effects of book-tax conformity on publicly traded U.S. firms. Specifically, they simulate the effects of book-tax conformity on the level and variability book earnings and tax payments/collections.
Shackelford, Slemrod, and Sallee model the impact of taxes on both the real decisions and the accounting choices of firms. Their goal is to enhance understanding of the behavioral effects of taxation by merging the approach to the study of corporate taxation taken by economists and accountants. Economists typically study the effects of taxes on real decisions, ignoring the role of financial reporting. Accountants usually focus on the coordination of tax and accounting choices, with little attention to real economic effects. Both approaches yield important insights, but neither is complete because real and accounting decisions interact in important ways. As a result, studies of real (accounting) choices that ignore the incentives and constraints that affect accounting (real) decisions may misinterpret behavioral responses to taxation. Therefore, a unifying framework that incorporates both real and accounting choices is needed for comprehensive treatment of the behavioral responses to taxation. The authors propose that corporations make real and accounting decisions to maximize a function whose arguments include the present value of the after-tax cash flows and also after-tax book income in each of two periods. Corporations have limited discretion to shift across periods pre-tax book income, taxable income, and the book tax provision. Some real decisions are more attractive than others because they provide managers with discretion over the timing of taxable income and book income; this is especially true for companies for which this discretion has relatively high value. The authors show how the presence of discretion modifies the optimal decisions of firms, in theory, and we provide examples that illustrate this behavior in the real world. The source of this discretion may be either the accounting rules or the tax law. It is critical to know whether the book and tax accounting either must by law be conformed, or will be conformed by choice because of the private costs of maintaining separate accounting systems. When they are not conformed, divergence between the two may be costly to the extent that it alerts the IRS to possibly aggressive tax planning or the capital markets to poor earnings quality.
Graham and Mills simulate marginal tax rates (MTRs) from 1998 to 2000 using U.S. tax return data for public corporations. They compare the tax-return tax rates to tax rates calculated from public financial statement data (Compustat) and find that Graham's (1996a) simulated tax rate is the book variable most highly correlated with the tax-return variable. They also find that the correlation between book and tax MTRs improves substantially for firms with similar consolidated groups. They identify ways to improve upon Compustat MTRs in terms of more closely approximating tax-return based tax rates. Finally, they find that tax return MTRs are significantly correlated with financial statement corporate debt ratios, although less so than the correlation between book MTRs and debt ratios.
Plesko examines the tax reporting consequences of financial reporting discretion. Using a matched sample of financial statements with tax returns, he estimates the accuracy of tax return information inferred from financial statements. To examine the trade-offs between financial and tax reporting, he models the relation that discretionary financial accounting accruals have to discretionary federal tax accruals. The methodology takes advantage of the contemporaneous nature of reporting to mitigate the econometric problems identified in earnings management studies. He finds that the extent that tax reporting reflects discretionary financial reporting varies dramatically by industry, profitability, and the sign of discretionary accruals measured under the tax system. Further, focusing on tax reporting, he finds that managers are able to undertake tax reducing activities with less of an effect on financial reporting than tax increasing accruals, consistent with recent evidence on the differential growth of book and tax income, and with tax avoidance activities.
Hanlon and Slemrod study the stock price reaction to news about tax aggressiveness. They find that, on average, a company's stock price declines when there is news about its involvement in tax shelters, but the reaction is small relative to reactions to other corporate misdeeds. They find some limited evidence for cross-sectional variation in the reaction. For example, the stock price decline is smaller for companies with relatively high effective tax rates, possibly because news about tax aggressiveness is more favorably viewed for those firms where public information would suggest otherwise. The stock price decline is also smaller for firms that have good governance, which is consistent with the idea that, for these firms, the news is less likely to trigger concern about insiders' aggressiveness toward the investors themselves. Indeed, these results suggest that for well-governed firms with especially high effective tax rates, news that they have been involved in a tax shelter is received favorably by the market. The reaction is more negative for firms in the retail sector, suggesting that part of the reaction may be a consumer/taxpayer backlash. Hanlon and Slemrod also explore the stock price reaction to reports of effective tax rate calculations released by Citizens for Tax Justice. They hypothesize that these reports signal tax aggressiveness without the implications for tax penalties or illegal behavior that tax shelter news carries, and therefore any market reaction represents a pure reputation effect. They find no statistically significant stock price reaction to the reports, suggesting that the negative reaction to tax shelter news is not predominantly a reputation effect. All in all, their analysis suggests that tax shelter news is viewed as a negative event by the market, although the stock price reaction is much smaller than the reaction to major accounting mishaps.
Poterba, Rao, and Seidman collect data from the tax footnotes of a sample of large U.S. corporations between 1994 and 2004 and use it to investigate two issues concerning financial accounting for taxes. They document the importance of deferred tax assets and liabilities for their sample firms and demonstrate the substantial heterogeneity in firm tax positions. In 2004, 47 firms in the sample of 71 reported net deferred tax assets and 24 reported net deferred tax liabilities. In this sample, total deferred tax assets for firms with such assets in 2004 were $57.6 billion, while total deferred tax liabilities for firms with such liabilities were $212.8 billion. This implies that a 5 percentage point decline in the federal statutory corporate tax rate would reduce net income by roughly $8.2 billion at sample firms with net deferred tax assets, because these assets would decline in value and this in turn would reduce net income. Firms differ substantially in the composition of deferred tax assets and liabilities. The authors demonstrate this by disaggregating deferred tax accounts for their sample firms. They also explore the role of managerial discretion in reporting tax expense. They find evidence of tax management when firms will otherwise miss earnings targets, and extend prior research by analyzing which components of tax expense are most likely to be used for earnings management.
Robinson and Sansing develop and analyze a model in which tax considerations and financial reporting considerations have countervailing effects on a firm's investments in internally developed intangible assets. They also propose and estimate a new measure of tax preferences, the economic effective tax rate. This measure reflects both investments in intangible assets and the use of debt financing, neither of which generates book-tax differences. Their measure indicates that the economic effective tax rate was about 16 percent between 1988 and 2005, when the statutory tax rate was either 34 or 35 percent. On average, about two-thirds of the difference between their measure and the statutory tax rate is attributable to intangible assets and about one-third is attributable to the use of debt financing. Both the effect of intangible assets and the use of debt financing on their measure vary across industries.
Blouin and Tuna study firms' tax contingencies (aka tax cushion). A recent call for corporate tax reform has highlighted the disparity between financial and income tax reporting. In this paper, the authors create a broad-based measure of a cushion that appears to capture cross-sectional variation in tax aggressiveness. After controlling for tax aggressiveness, they find some evidence that firms appear to be using cushions to smooth earnings. Specifically, a tax cushion is used to smooth earnings by firms with larger option incentive pay as a proportion of total compensation and larger implicit claims. Finally, these findings are consistent with firms asymmetrically reporting good news, providing additional evidence that firms strategically report non-recurring income components (Schrand and Walther 2000). Overall, the findings support the need for FIN48, which attempts to improve conformity in the reporting of tax contingencies.
Behavioral Responses to Taxation and Social Insurance Programs
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Korinek and Stiglitz develop a life-cycle model of the firm to analyze the effects of dividend tax policy on aggregate investment. They find that new firms raise less equity and invest less the higher the level of dividend taxes, in accordance with the traditional view of dividend taxation. However, the dividend tax rate is irrelevant for the investment decisions of internally growing and mature firms, as postulated by the new view of dividend taxation. Since aggregate investment is dominated by these latter two categories, the level of dividend taxation, as well as unanticipated changes in dividend tax rates, have only a minor impact on aggregate investment and output. Anticipated dividend tax changes, on the other hand, allow firms to engage in inter-temporal tax arbitrage so as to reduce investors' tax burden. This can significantly distort aggregate investment. Anticipated tax cuts (increases) delay (accelerate) firms' dividend payments, which leads them to hold higher (lower) cash balances and, for capital constrained firms, can significantly increase (decrease) aggregate investment for periods after the tax change. Furthermore, the authors show that the analysis of dividend taxation in a contestable democracy has to take into account expectations about future regime changes and the ensuing dividend tax changes. This can significantly change the evaluation of a given dividend tax policy.
Slemrod and Wilson develop a tax competition framework in which some jurisdictions, called tax havens, are parasitic on the revenues of other countries. The havens use real resources to help companies camouflage their home-country tax avoidance, and countries use resources in an attempt to limit the transfer of tax revenues to the havens. The equilibrium price for this service depends on the demand and supply for such protection. Recognizing that taxes on wage income are also evaded, the authors solve for the equilibrium tax rates on mobile capital and immobile labor, and demonstrate that the full or partial elimination of tax havens would improve welfare in non-haven countries, in part because countries would be induced to increase their tax rates, which they have set at inefficiently low levels in an attempt to attract mobile capital. They also demonstrate that the smaller countries choose to become tax havens, and show that the abolishment of a sufficiently small number of the relatively large havens leaves all countries better off, including the remaining havens.
Amromin, Huang, and Sialm show that a signicant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA). Using data from the Survey of Consumer Finances, the authors show that at least 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these mis-allocated savings are costing U.S. households about 1.5 billion dollars per year. Finally, the authors show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain, to some extent, the preference for paying off debt obligations early and hence the propensity to forgo the proposed tax arbitrage.
As health care costs continue to rise, medical expenses have become an increasingly important contributor to financial risk. Economic theory suggests that when background risk rises, individuals will reduce their exposure to other risks. Maestas and Goldman present a test of this theory by examining the effect of medical expenditure risk on the willingness of elderly Medicare beneficiaries to hold risky assets. They measure exposure to medical expenditure risk by whether an individual is covered by supplemental insurance through Medigap, an employer, or a Medicare HMO. They account for the endogeneity of insurance choice by using county variation in Medigap prices and non-Medicare HMO market penetration. They find that having Medigap or an employer policy increases risky asset holding by 6 percentage points relative to those enrolled in only Medicare Parts A and B. HMO participation increases risky asset holding by 12 percentage points. Given that just half of their sample holds risky assets, these are economically sizable effects. It also suggests an important link between the availability and pricing of health insurance and the financial behavior of the elderly.
How wages and non-labor income affect both the decision to work and hours of work among single mothers is critical to understanding the work disincentive effects of tax and welfare policies, and the attendant design of optimal income tax and transfer schemes. Ziliak uses data from the Current Population Survey and variation induced by fundamental reforms to the U.S. tax and welfare systems over the 1979-2001 period to estimate the labor-supply response of single mothers to changes in their after-tax and transfer wage rate and nonlabor income, conditional on whether or not they also participate in AFDC/TANF, food stamps, or SSI. He finds that wage changes have a large effect on the decision to work (the average elasticity of employment is 1.3), but a small effect on hours of work (average compensated wage elasticity of 0.16) unless the wage change also alters the mother's decision to participate in AFDC/TANF, food stamps, or SSI. These estimates are consistent with a recent theoretical model by Saez (2002) that suggests that the optimal transfer policy is one that involves a modest income guarantee for non-workers coupled with subsidies for low-income workers much like the current EITC program.
Employer matching of employee 401(k) contributions can provide a powerful incentive to save for retirement and is a key component in pension-plan design in the United States. Using detailed administrative contribution, earnings, and pension-plan data from the Health and Retirement Study, Englehardt and Kumar formulate a life-cycle-consistent econometric specification of 401(k) saving and estimate the determinants of saving, accounting for non-linearities in the household budget set induced by matching. The participation estimates indicate that an increase in the match rate by 25 cents per dollar of employee contribution raises 401(k) participation by 3.75 to 6 percentage points, and the estimated elasticity of participation with respect to matching ranges from 0.02-0.07. The parametric and semi-parametric estimates for saving indicate that an increase in the match rate by 25 cents per dollar of employee contribution raises 401(k) saving by $400-$700 (in 1991 dollars). The estimated elasticity of 401(k) saving to matching is also small and ranges from 0.09-0.12 overall, with just under half of this effect on the intensive margin. Overall, the analysis reveals that matching is a rather poor policy instrument with which to raise retirement saving.
Looney examines the economic incidence of non-refundable child-related tax benefits in low-income single parent families. Because non-refundable tax benefits only reduce taxes due, many argue that they cannot help low-income families without tax liability. Single parents may be an exception because tax law permits separated or divorced parents to exchange the tax benefits tied to their children. If parents exchange child-related tax benefits and custodial parents are compensated for the trade, then the incidence of such benefits is more progressive than a naive estimate would suggest. Using data from the Survey of Income and Program Participation (SIPP) and exploiting variation in the value of child-related tax benefits due to differences in state tax systems and changes in federal tax law, Looney finds that parents exploit these arbitrage opportunities and that custodial mothers receive increased child support as a result.
Karlan and List conducted a natural field experiment to further their understanding of the economics of charity. Using direct mail solicitations to over 50,000 prior donors of a non-profit organization, they tested the effectiveness of a matching grant on charitable giving. They find that the match offer increases both the revenue per solicitation and the response rate. However, larger match ratios (that is, $3:$1 and $2:$1) relative to a smaller match ratio ($1 :$1) had no additional impact. The results provide avenues for future empirical and theoretical work on charitable giving, cost-benefit analysis, and the private provision of public goods.
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Strategic alliances range from short-term cooperative projects, through long-term partnerships and joint ventures, to transactions that permanently restructure firm boundaries and asset ownership. Baker, Gibbons, and Murphy draw on detailed discussions with practitioners to present a rich model of feasible governance structures. Their model focuses on two issues emphasized by practitioners: spillover effects (as opposed to hold-ups motivated by specific investments), and contracting problems ex post (as opposed to only ex ante). They use this model to generate a large number of strategic alliance possibilities, including simple cooperative arrangements (coopetition), strategic divestitures, total divestitures, licensing agreements, and royalty agreements. They show that any of these possible strategic alliances could be optimal.
In an earlier paper, Kvaloy and Olsen analyzed the conditions for implementing peer-dependent incentive regimes when agents have ownership rights. They showed that compensation tied to peer-performance can induce employee-hold-up and obstruct the implementation of relational incentive contracts. In this paper, they present some extensions: they argue that the costs of transferring ownership rights to agents may depend on whether there exist conditions that call for peer-dependent incentives. In particular, they show that if there exists common noise that makes relative performance evaluation optimal, or peer pressure that makes joint performance evalauation optimal, then the firm will be more reluctant to give up ownership rights.
Itoh, Hayashida, and Kikutani offer an empirical test of complementarities among delegated authority, responsibility, and monitoring, using unique survey data collected from group-affiliated companies in Japan. The survey provides information about how various decisions are made within business groups, each of which consists of a large core parent firm and its network of affiliated firms, such as subsidiaries and related companies. The authors find some evidence that delegated authority and responsibility are complementary, implying that increasing assigned responsibility raises the marginal return from increasing delegated authority. They also obtain a stronger result, that performance is likely to be higher under the combination of low authority and low responsibility, or that of high authority and high responsibility, than under the "mix and match" combinations where one of them is low and the other high. They then study the effects of monitoring intensity on the authority-responsibility pair and find that performance of the firm with the combination of high authority and high responsibility is increasing in monitoring intensity, while the combination of low authority and low responsibility is not. The result is consistent with the theoretical hypothesis that increasing monitoring intensity raises the marginal return from increasing delegated authority and responsibility.
What determines the boundaries of organizations and the cost-based incentives within and between contracting entities? These questions have received much attention, and many approaches have been developed. Building on ideas from transaction cost economics, agency theory and property rights theory, Levin and Tadelis develop a general procurement model that highlights the trade-off between productive efficiency and the costs of administrating performance contracts. They recast the question of firm boundaries as one of contracting over inputs or outputs, resulting in empirically testable predictions that are consistent with several previous studies. Their results demonstrate why control and cost incentives will shift in complementary ways, laying some foundations to the definition of hierarchy and market transactions within transaction cost economics.
Since Coase's (1937) seminal work, the boundaries of the firm have long been one of the most important issues for researchers, and the auto industry has been one of the most investigated industries. One example is Monteberde and Teece (1982), which demonstrated that transaction cost - measured by engineering efforts and firm-specificity to design component - indeed did matter for the vertical integration decision by OEMs (GM and Ford). Takeishi, Nagaoka, and Noro extend their analysis in three directions. First, for the dependent variable, in addition to the two choices (make internally or buy from the market), they put forward the third choice, "buy from affiliated ('keiretsu') suppliers." Second, for independent variables, they examine a set of new variables to measure multiple dimensions of contractibility. Third, they use a set of panel data of the Japanese auto industry, which they have built up to cover the make-or-buy decisions of 7 OEMs on 54 types of components for almost two decades from 1984 to 2002.
Current theoretical and empirical research suggests that small banks have a comparative advantage in processing soft information and delivering relationship lending. The most comprehensive analysis of this view found using U.S. data is by Berger, Miller, Petersen, Rajan, and Stein, 2005 (BMPRS). Uchida, Udell, and Watanabe use essentially the same methodology as BMPRS on a unique Japanese dataset. Like BMPRS, they find that larger firms tend to borrow from larger banks. However, unlike BMPRS, they do not find that this is because larger firms are more transparent. Their results imply that large banks do not necessarily have a comparative advantage in extending transactions-based lending. They also find, like BMPRS, that smaller banks have strong relationships with their borrowers. However, the banking relationships in the United States and Japan are strong in somewhat different dimensions.This paper clarifies these and other interesting similarities and differences between the United States and Japan.
Oyer studies the human capital development and firm-worker matching processes for PhD economists. This group is useful for this purpose because the types of jobs they hold can be easily categorized and they have an observable productivity measure (that is, publications.) He derives a two-period model to motivate an empirical analysis of economist job matching upon graduation, matching ten years later, and productivity in the first ten years. He shows that matching to a higher ranked institution affects productivity. He presents evidence that employers improve their estimates of economists' ability early in their career in a way that determines longer-term job placement. He also finds that the initial placement of economists to institutions does not show much evidence of systematic misallocation along observable characteristics.
Ghosh and Morita explore the managerial implications and economic consequences of platform sharing under models of horizontal and vertical product differentiation. By using a common platform across different products, firms can save on fixed costs for platform development. At the same time, platform sharing imposes restrictions on firms' ability to differentiate their products, and this reduces their profitability. It might appear that platform sharing across firms makes consumers worse off because firms cooperate in their product development processes to maximize their joint profit. The authors find, however, that platform sharing benefits consumers in their framework because it intensifies competition in their horizontal differentiation model, and because it increases the quality of the lower-end product in our vertical differentiation model. They also show new channels through which a merger makes consumers worse off in the presence of platform sharing.