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In a previous Cato blog post, I explained how the House Republican “Better Way” corporate tax plan, which replaces our current 35% corporate income tax with a 20% “destination-based cash flow tax” (DBCFT), could theoretically avoid litigation at the World Trade Organization (WTO) and member countries’ eventual, WTO-approved retaliation against billions of dollars worth of US exports. I concluded therein that, while there wasn’t yet enough concrete information about the DBCFT’s final form to determine its WTO-consistency, the conventional wisdom was wrong to assume that any US corporate tax plan would violate the United States’ international trade obligations. Today, on the other hand, I’ll explain the quickest way that the DBCFT could get into trouble at the WTO. 

Spoiler: it’s all about the deductions.

I won’t reiterate here how the DBCFT is intended to operate and again will acknowledge that we haven’t actually seen any legislative text yet. That said, there is a pretty clear consensus view among economists that the DBCFT would essentially operate as a modified “subtraction-method” value-added tax (VAT) on US corporations’ domestic sales revenue, minus taxable input purchases. This was helpfully summarized in a recent Paul Krugman blog post (emphasis mine):

[A] VAT is just a sales tax, with no competitive impact. But a DBCFT isn’t quite the same as a VAT. With a VAT, a firm pays tax on the value of its sales, minus the cost of intermediate inputs—the goods it buys from other companies. With a DBCFT, firms similarly get to deduct the cost of intermediate inputs. But they also get to deduct the cost of factors of production, mostly labor but also land. So one way to think of a DBCFT is as a VAT combined with a subsidy for employment of domestic factors of production. The VAT part has no competitive effect, but the subsidy part would lead to expanded domestic production if wages and exchange rates didn’t change.

Just so we’re clear that I’m not playing partisan favorites here, Krugman’s view was essentially echoed by Republican/conservative economist Greg Mankiw, who called the DBCFT “like a value-added tax” on corporations’ US sales with “a deduction for labor payments.”

While economists disagree about the economic and trade effects of the DBCFT, the aforementioned descriptions have generated significant (though certainly not consensus) concerns with respect the whether the new tax would be consistent with WTO rules—concerns that don’t arise with a VAT. As I discussed last time, the DBCFT would have to clear at least three hurdles at the WTO—two on the export subsidy side and one on the import side:

  • Export subsidy: The DBCFT would be found to confer prohibited export subsidies under the Article 3 of the WTO Subsidies Agreement where (1) the tax is found to be a “direct tax,” which the Agreement defines as “taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property” (VATs are a type of “indirect tax”); and (2) the “border adjustment” (i.e., tax exemption or rebate) for a company’s export sales is greater than the actual amount of tax due or collected.
  • Import discrimination: The DBCFT would violate the “national treatment” principle of GATT Articles II and III (on internal taxes) where it imposes a higher tax burden on an imported good than that imposed on an identical domestically produced product.

The concern among us trade lawyers rests in the deductions for labor and (maybe) land that a VAT doesn’t have but the DBCFT does—deductions that could generate violations of one or more of the aforementioned disciplines. This can be pretty difficult to see in the abstract, but the problems—as well as their absence for a normal VAT—become clearer through a simple hypothetical assessment of the tax’s effect on two identical US companies selling and exporting the same product, with one company selling only imported final goods and the other selling identical products with 100% US content. So let’s do that now, starting with a classic example used by the US Government Accounting Office to show how a standard subtraction-method VAT, which taxes corporations’ domestic (not export) sales revenue and permits one deduction for domestic (and thus taxable) input purchases, works in practice.

Effect of Basic Subtraction-Method VAT (No Export Sales)

The table below illustrates the tax treatment under a standard, 10% subtraction-method VAT for two different value chain scenarios. In this example, we presume no export sales by any company involved to make it as simple as possible.

Scenario 1: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

$20 $70 $80 $170

Taxable (US) Purchases

$0 $20 $70 $90

Net Receipts (i.e., Tax Base)

$20 $50 $10 $80

VAT Amount

$2 $5 $1 $8

 

Scenario 2: Import-Only Value Chain (VAT=10%)

 

US Retailer

Sales

$80

Taxable (US) Purchases

$0

Net Receipts (i.e., Tax Base)

$80

VAT Amount

$8

As shown above, the total effective tax paid on the final product (baseball bats) is the same in both value chain scenarios: $8. (This assumes, consistent with economic theory, that the full amount of the VAT in the US-only scenario is passed through in each stage to the final sale, so the retailer in this example is in effect paying the full $8 tax, even though he’s only paying $1 directly to the IRS. The tax is thus embedded in the “taxable purchases” value in each of the Scenario 1 tables shown throughout.) As a result, concerns that the VAT imposes a higher tax burden on the import-only retailer (Scenario 2)—thus raising a potential import discrimination problem under GATT Articles II and III—are minimal.

Effect of Basic Subtraction-Method VAT (Export Sales)

The next example shows the effects of a US corporation exempting 100% of its export sales value from its tax base (a “border adjustment”). For the sake of simplicity, only the retailer here exports—50% of total sales—in these scenarios.

Scenario 1A: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

US

Export

US

Export

US

Export

US

Export

$20 $0 $70 $0 $40 $40 $130 $40

Taxable (US) Purchases

$0 $20 $70 $90

Net Receipts (i.e., Tax Base)

$20 $50 $-30 $40

VAT Amount

$2 $5 $-3 (credit) $4

 

Scenario 2A: Import-Only Value Chain (VAT=10%)

 

US Retailer

 

US

Export

Sales

$40 $40

Taxable (US) Purchases

$0

Net Receipts (i.e., Tax Base)

$40

VAT Amount

$4

Even with the border adjustment on export sales, the effective tax burden is the same in both value scenarios, thus obviating concerns regarding discriminatory tax treatment against imports under the GATT. Furthermore, this tax raises no concerns regarding prohibited export subsidies because (i) VATs aren’t a “direct tax” under the Subsidies Agreement and (ii) the amount of the tax exemption ($4) for export sales isn’t greater than the amount of the tax that the exporter (retailer) in each scenario would have owed if the baseball bats had just been sold in the United States instead of exported (also $4). As a result, the risk of a WTO challenge to this type of tax system is low.

This risk increases significantly, however, once you add other deductions—such as the wage/salary deduction mentioned by Krugman and Mankiw above—to the corporate tax. This is shown in the next examples.

Effect of a “Modified” Subtraction-Method VAT with Wage/Salary Deduction (No Export Sales)

A provision that permits US corporations to deduct from the tax base both taxable input purchases and domestic wages and salaries would reduce the tax base for all upstream participants in the “US-only” value chain (Scenario 1), thus lowering the total tax paid on the product(s) at issue. However, because a retailer/importer (Scenario 2) would only be able to deduct its own wages/salaries, the imported baseball bats would face higher total tax burden than the 100% American-made baseball bats

Scenario 1B: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

$20 $70 $80 $170

Taxable (US) Purchases

$0 $20 $70 $90

Wages/Salaries

$10 $10 $5 $25

Net Receipts (i.e., Tax Base)

$10 $40 $5 $55

VAT Amount

$1 $4 $0.50 $5.50

 

Scenario 2B: Import-Only Value Chain (VAT=10%)

 

US Retailer

Sales

$80

Taxable (US) Purchases

$0

Wages/Salaries

$5

Net Receipts (i.e., Tax Base)

$75

VAT Amount

$7.50

In the example above, the total VAT paid on the imported good (baseball bats) is now greater ($7.50) than the VAT paid on the American baseball bats ($5.50), thus creating an apparent disincentive to sell the imported bats. In other words, if given the choice between selling an imported bat and an identical American-made bat, the US retailer operating under this “modified” VAT would have a financial incentive to buy American because he’d be paying higher total tax on the import. This same incentive would apply to other companies in the United States, and not just at the retail level. As such, the additional wage/salary deduction—very similar to the one described by Krugman and Mankiw above for the DBCFT—raises serious concerns that the DBCFT would be found to impermissibly discriminate against imports in violation of the United States’ national treatment obligations for internal taxes under GATT Articles II and III. 

One could try to argue that this discrimination is not a WTO violation because (i) it’s equivalent to a labor/wage deduction provided through a separate tax measure like the payroll tax (which raises no WTO concerns); or (ii) its discriminatory effects are eliminated through currency adjustments or through an examination of the actual economic effects of US tax reform as a whole. However, there’s little indication that a WTO panel would undertake such a comprehensive analysis, instead of simply examining the basic, superficial impact of the DBCFT measure itself in a manner similar to what I just did above. Indeed, I doubt WTO Members—including the United States!—would want the WTO to undertake such a speculative economic and legal analysis (and panels have in the past shied away from examining actual trade effects).

The border adjustment for export sales provides one final concern, as shown next.

Effect of a “Modified” Subtraction-Method VAT with Wage/Salary Deduction (Export Sales)

If the “modified” VAT included a border adjustment on exports, while still permitting corporations to deduct 100% of wages/salaries (instead of proportional to export sales), the system could create a higher effective tax on an import-only value chain and a possible subsidy for exports due to the over-exemption of tax otherwise due on export sales. Again, in this scenario only the retailer exports (50% of its sales).

Scenario 1C: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

US

Export

US

Export

US

Export

US

Export

$20 $0 $70 $0 $40 $40 $130 $40

Taxable (US) Purchases

$0 $20 $70 $90

Wages/Salaries

$10 $10 $5 $25

Net Receipts (i.e., Tax Base)

$10 $40 $-35 $15

VAT Amount

$1 $4 $-3.50 (credit) $1.50

 

Scenario 2C: Import-Only Value Chain (VAT=10%)

 

US Retailer

 

US

Export

Sales

$40 $40

Taxable (US) Purchases

$0

Wages/Salaries

$5

Net Receipts (i.e., Tax Base)

$35

VAT Amount

$3.50

In this case, the same import discrimination issue arises as the one noted in the previous example, but the exported baseball bats in the US-only value chain also receive an extra $2.50 tax benefit ($4 in Scenario 1A versus $1.50 in Scenario 1C) due to the labor deductions taken at all stages of the US value chain. It would be difficult to argue, however, that the full value of that labor benefit was due on those exports where only a portion of the labor was used to produce taxable goods (i.e., domestic sales). Put another way, the export sales should not benefit from any tax deduction for labor because they did not generate any tax owed in the first place, and providing this benefit could be considered an export subsidy. Thus, there is a legitimate argument to be made that the DBCFT would generate prohibited export subsidies under Article 3 of the SCM Agreement (over-exemption/rebate of internal taxes owed/due) where it permitted a 100% deduction for a firm’s wages/salaries plus a 100% exemption for that firm’s export sales. That appears to be the case with the DBCFT, though we’ll have to wait for the final legislative text to be sure.

Finally, there is a risk—not shown in the charts above—that the DBCFT would be found to constitute a “direct tax” where it permits so many additional deductions that it more closely resembles a corporate income tax than a VAT or sales tax. In short, the more deductions, the more likely it’s a direct tax (and thus confers prohibited export subsidies, regardless of the over-exemption/rebate of taxes on exports). This question is far murkier, however, that the other two issues above.

Maybe the final DBCFT will resolve these WTO problems by eliminating the extra deductions, or maybe Congress just simply ignores them and takes its chances at the WTO (risking billions in US exports in the process). But that doesn’t mean the problems don’t exist, no matter what some DBCFT cheerleaders might have you believe.

It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.

Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed’s balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.

Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.

Andolfatto writes that the Fed’s “rate of return has generally followed the path of market interest rates downward.” While that was true in 2007-08, it should be noted that the Fed’s rate of return largely stopped following the downward path of market interest after 2008. As market rates on five-year Treasuries fell closer to the administered interest rate on reserves after 2008, the Fed shifted from a portfolio maturity of 5 years to one of around 12 years, as if determined to keep its interest income large. This is shown in the following two figures from a 2016 Cato Journal article of mine.

Here is Andolfatto’s closing pitch for embracing the status quo: “Reducing the Fed’s balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. … if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?” The Fed faces an “arbitrage opportunity.” Having the Fed hold Treasury debt, in place of the public holding it, yields a pure arbitrage profit, because the Fed can borrow to carry the debt at a rate lower than the rate at which the Treasury borrows.

Characterizing the situation this way, however, neglects the simple difference between borrowing short and borrowing long. When the Fed borrows short from the banks to lend long to the Treasury, it does not do so costlessly. Duration transformation carries a risk of capital loss, also known as duration risk. Suppose the yield curve shifts up, both short and long interest rates rising together. The Fed will experience a decline in present value of its assets that will swamp the smaller decline in the present value of its liabilities. Such an event is not unknown: in 1979-81 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits. In cash-flow terms, such an event would mean that the Fed would quickly have to start paying higher interest rates to borrow, while its asset portfolio continues to pay low yields and roll over much more slowly. The Fed’s annual net transfer to the Treasury might even go negative. Smaller or negative transfers from the Fed to the Treasury would mean a sudden jump in the present value of the public’s ordinary tax liabilities. Net interest income from playing the yield curve is not a free lunch.

The Fed has also been carrying significant default risk by holding $1.7 trillion of its portfolio not in Treasuries but in mortgage-backed securities. It was not so many years ago that MBS were trading well below par because of their default risk. Indeed it was to push their prices back towards par that the Fed purchased so many.

Responding to a commentator on his blog who pointed out the Fed’s duration risk, Andolfatto remarks: “the duration risk … could be mitigated considerably if the Fed restricted itself to short-duration assets.” He proposes that “If a one-year UST is yielding anything significantly higher than the interest on Fed liabilities, then the Fed can make a profit for the government.” But when we look at the actual numbers, we find that the yield on one-year UST is not significantly higher. The Fed could not in fact continue to make a profit for the government. One-year Treasuries are currently yielding just 82 basis points (0.82%), only 7 basis points more than the 75 basis points that the Fed pays on reserves. Multiplying 7 basis points by the Fed’s $4.45 trillion asset portfolio yields only $3.1 billion in net interest income, less than the Fed’s 2016 budget of $4.5 billion or its ex-post 2015 operating expenses of $4.2 billion. Mitigating the duration risk by going to a portfolio of one-year Treasuries would thus eliminate the Fed’s profit from borrowing from banks and relending to the Treasury.

The principal cases for normalizing the Fed’s balance sheet are (1) the Fed should not distort the allocation of credit by holding trillions in MBS, and (2) normalizing the size of the balance sheet would allow the Fed to normalize the conduct of monetary policy by making bank reserves scarce again. There is no fiscal-free-lunch case for holding off on normalization.

[Cross-posted from Alt-M.org]

How can unelected judges limit the power of an elected official like the president? Two political scientists offer some answers in The Washington Post.

First, the public should broadly agree “about the basic legitimacy of the procedures used to review the powerful.” Second, the public needs “accurate information about the behavior of public officials.”

The authors say a free press should and does provide that information in various ways. That’s a good answer as far as it goes, but it does not go nearly far enough. Many other parts of our polity have the power and responsibility to provide information about government. To name a few: interest groups, bloggers, think tanks, professors, leakers, labor unions, trade associations, grassroots groups, and many others who might spring to mind with more reflection.

The media does not have a monopoly on informing the public. “The freedom of speech and of the press” belongs to all Americans. This diffusion of power seems especially valuable at a moment when the media lack credibility for so many Americans.

A few nightmare scenarios haunt the dreams of civil libertarians—scenes drawn from our long and ignominious history of intelligence abuses.   One—call it the Nixon scenario—is that the machinery of the security state will fall into the hands of an autocratic executive, disdainful of the rule of law, who equates “national security” with the security of his own grip on political authority, who is all too willing to turn powers meant to protect us from foreign adversaries against his domestic political opponents, and who lacks any qualms about quashing inquiries into his own illegal conduct or that of his allies.  Another—call it the Hoover scenario—is that the intelligence agencies anxious to protect their own powers and prerogatives will themselves slip the leash, using their command of embarrassing secrets to intimidate (and in extreme cases perhaps even select) their own nominal masters.  As the American surveillance state has ballooned over the past 15 years, we’ve often invoked those scenarios to argue out that the slippery slope from a reasonable-sounding security measure a tool of anti-democratic repression is disquietingly short and well-oiled. You may trust that some new authority will only be used to monitor terrorists today, but under a more authoritarian administration, might it be used to suppress dissent—as when civil rights and anti-war activists became the targets of the FBI’s notorious COINTELPRO?  You may be reassured by all the rigid rules and layers of oversight designed to keep the Intelligence Community accountable, but will those mechanisms function if the intelligence agencies decide to use their broad powers to cow their own overseers?

We are now, it seems, watching both scenarios play out simultaneously.  Perhaps surprisingly, however, they’re playing out in opposition to each other—for the moment. Whatever the outcome of that conflict, it seems unlikely to bode well for American liberal democracy.

On the one hand we have Donald Trump, whose thin-skinned vindictiveness and contempt for judicial checks on his whims are on daily display, and who during his presidential campaign revealed a disturbing instinct for lashing out at political opponents with threats to disclose embarrassing personal information. (Recall his tweets promising to “spill the beans” on Heidi Cruz, wife of primary opponent Ted, or his warning that the Ricketts family, which funded ads opposing him, had “better be careful” because they “have a lot to hide”.) As a private citizen, Trump treated the legal system as a tool to harass people who wrote unflattering things about him; as a candidate, he thought nothing of offhandedly suggesting he could use the power of the Justice Department to jail his opponent. Even before taking the Oval Office, then, Trump had provided civil libertarians and intelligence community insiders with a rare point of consensus: Both feared that with control of both the intelligence agencies and the institutional checks on those agencies within the executive branch, Trump would fuse a disposition to abuse power with an institutionally unique ability to get away with it.  On the flip side, Trump’s dismissive attitude toward the intelligence consensus that Russia had intervened to aid him in the election; his frankly bizarre, fawning posture toward Russia’s strongman leader; and his insistence on defying decades of political norms to shield his finances from public scrutiny signaled that inquiries into illicit conduct by himself or his allies and associates would be likely to wither on the vine once Trump loyalists had been installed at the heads of law enforcement agencies. As Nixon scenarios go, to steal a turn of phrase from my colleague Gene Healy, Trump is a civil libertarian’s grimmest thought experiment come to life.

And yet.  

For all that, it’s difficult not to be a bit uneasy about the way the way the national security establishment, or factions with in it, appear to be pushing back—at least, assuming the leaks that have dominated headlines in recent weeks are originating within the IC. We have witnessed the torpedoing of the president’s appointed national security adviser—by means of a decision to illegally leak the contents (or, more precisely, sources’ characterizations of the contents) of foreign intelligence intercepts of his phone conversations with the Russian ambassador. That was followed almost immediately by the explosive, albeit vague, news that—contra the administration’s denials—senior Trump associates and campaign aides had regular contact with Russian intelligence officials over the past year, though this time without any description of what those conversations concerned.  

The public interest in knowing these facts is clear enough, and under the circumstances, it is not hard to reconstruct why officials within the intelligence community might regard the drastic step of going directly to the press as necessary under extraordinary circumstances.  We can infer that the ongoing investigation into the Trump campaigns Russian ties hasn’t turned up any smoking gun evidence of collusion yet, or that would likely have leaked already as well.  Yet there’s presumably enough smoke that investigators are anxious to either render it politically impossible for the new administration to kill any ongoing inquiry, or—failing that—ensure that Congress feels constrained to pick up the baton after the agents working the case are reassigned to Juneau.  Critically, however, this is not traditional “whistleblowing” about misconduct that a leaker has observed within their own agency, but rather disclosure of information gleaned from intelligence collection on Americans. 

That ought to raise disturbing echoes of J. Edgar Hoover’s notorious “Official and Confidential” and “Personal and Confidential” archives—troves of salacious dirt on public figures that made the FBI director a dangerous man to cross.  As Hoover’s aura of omniscience grew over his three decade tenure, policymakers and even presidents were cowed by the prospect of finding their dirty laundry aired in the tabloids should they earn Hoover’s ire.  Whether or not the leakers intend it, the perception that the IC is waging war on Trump is likely to resurrect that toxic chilling effect.  The lesson many commentators are now drawing—some apprehensively, a few with gloating enthusiasm—is “getting on the wrong side of the Deep State can be hazardous to your political health,” which is an unhealthy notion for officials in a liberal democracy to have lodged in their heads.    

Moreover, the tension between these two scenarios is inherently unstable.  “If you come at the king,” as one great political thinker has observed, “you’d best not miss,” and doubly so when the king is your employer.  The New York Times recently reported that the Trump would be tapping an old business associate—who notably lacks any intelligence background—to conduct an overarching review of the intelligence community, perhaps as a prelude to a future leadership role. That has reportedly created a fair amount of anxiety in intelligence circles.  Trump allies like Rep. Steve King (R-Iowa) have already ominously suggested that “people there need to be rooted out,” and the narrative of a disloyal or hostile intelligence community could help give Trump cover to launch a purge within the agencies and install his own loyalists.

That might be the truly worst-case scenario. The career bureaucracy of the intelligence agencies, whatever its own biases and pathologies, constitutes in practice one of the few real bulwarks against the twin threats of politicized intelligence and abuse of surveillance powers.  Congress, the secret FISA Court, and the IC’s Inspectors General conduct largely reactive oversight over the intelligence agencies, typically relying on internal reports of problems or some public scandal to spur them to action. Day-to-day, the primary guarantor we have that intelligence powers are being used lawfully—and that intelligence products reflect a sincere attempt to assess the truth rather than provide cover for an administration’s agenda—is the culture within the intelligence agencies, maintained largely by the middle-tier of career professionals who normally serve across multiple administrations.  In what I’ve somewhat crudely called the Hoover Scenario, the intelligence establishment can become a kind of unaccountable “double government” free to serve its own interests and agendas. But that may be the lesser evil when compared with an intelligence bureaucracy that is too completely the tool of the political branches—more loyal to the president to whom they owe their careers than to the norms and mission of their agencies, and more concerned with keeping him satisfied than telling uncomfortable truths. 

Judge Jeffrey Sutton, writing for a Sixth Circuit panel, has reversed a Tax Court ruling in an opinion [Summa Holdings v. Commissioner of Internal Revenue] beginning thus:

Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That’s not a good idea, we can all agree. How can citizens comply with what they can’t see? And how can anyone assess the tax collector’s exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.

In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes.

And taking issue with the IRS Commissioner’s decision to disallow the combined use of two Congressionally approved devices, the Roth IRA and DISC (domestic international sales corporation), in a way said to trigger the so-called substance-over-form doctrine:

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

[cross-posted from Overlawyered]

If you’re a regular Alt-M reader (and may the frost never afflict your spuds if you are), I needn’t tell you that I’m the last person to exalt the pre-2008 Federal Reserve System. Among other things, I blame that system for fueling the 2003-2006 boom, and for creating a credit famine afterwards. I also blame it for contributing to the dot.com boom of the 90s, for the rise of Too Big to Fail in the 80s, for the  inflation of the 70s, and for the disintermediation crisis of 1966, to look no further back than that.

Yet for all its flaws that old-time Fed set-up was a veritable monetary Shangri-La compared to the one now in place. For while the newfangled Federal Reserve System is no less capable of mischief than the old one was, it also has the Fed playing a far larger role than before in commandeering and allocating scarce credit.

Monetary Control, Then and Now

You see, back in those (relatively) halcyon days, the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks’ legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed’s balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed’s immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could  influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Today, in contrast, the Fed presides over a vast portfolio, with assets consisting mainly of long-term Treasury securities and mortgage-backed securities, instead of the short-term Treasuries it once held; and that portfolio is funded more by banks’ holdings of substantial excess reserves than by circulating Federal Reserve notes. Yet instead of enhancing the Fed’s conventional powers of monetary control, the ballooning of the Fed’s balance sheet has sapped those powers by making it unnecessary for banks to routinely borrow from one another in the federal funds market to meet their legal reserve requirements. Consequently, the Fed can no longer target the effective federal funds rate, and influence other short-term interest rates, just by making modest changes to the stock of bank reserves.

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions’ demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping  balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target “range,” because most of the limited trading  that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base. The counterpart of that reduced multiplier is an increase in the Fed’s overall command of the public’s savings, for it’s the public that ultimately supplies the funds that financial institutions in turn hand over to the Fed, by holding those institutions’ IOUs.

Confiscatory Credit Control

As no one has yet come up with a catchy or at least convenient name for this new arrangement for credit control, allow me to propose one: “confiscatory credit control.”  Why “confiscatory”? Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases. When the central banks of other, and especially poorer, nations do this sort of thing, economists (including some who work for the Fed) refer to their policies, not as examples of enlightened monetary management, but as instances of financial repression. So it seems only fair to characterize our own central bank’s similar policies in a like manner. Although it’s true that financial repression has traditionally been practiced using the stick of high mandatory reserve requirements, whereas the Fed has instead been employing carrots in the shape of ON-RRP and IOER interest incentives, the ultimate result — more credit for the government, and less for everyone else — is the same. And though banks and bank depositors are better compensated for the governments’ takings, that compensation comes at taxpayers’ expense, because it translates either into an immediate reduction in Fed remittances to the Treasury or (as has been the case in fact) in an enhanced risk of reduced remittances in the future.

Whatever you call it, the Fed’s new monetary control framework involves a dramatic increase in the Fed’s credit footprint. To grasp the extent of the increase, have a gander at the chart below, showing the value of the Fed’s assets expressed as a percentage of total commercial bank assets. Whereas in the months prior to June 2008, Fed assets amounted to less than 8 percent of those held by U.S. commercial banks, its relative size has since increased five-fold. Of this overall increase, $2.5 trillion has gone into Treasury notes and bonds, while $1.75 trillion has been invested in MBS and housing-agency debt securities.

Thanks to the combined effects of LSAP’s, IOER, and ON-RRP, among other Fed programs and policies, the Fed now lords over a far greater share of the public’s savings than it has at any time since World War II, when it resolved “to use its powers to assure at all times an ample supply of funds for financing the war effort.” Even allowing, as many authorities do, that the Great Recession was a national crisis warranting a similar expansion of the Fed’s role, that fact alone can hardly continue to justify the Fed’s vast expansion now that the recovery is well-nigh complete.

Why should we mind a permanently enlarged Fed footprint? We should mind it because the Fed’s mandate doesn’t include commandeering a huge chunk of the public’s savings; and we should mind it because the Fed isn’t designed to employ our savings efficiently. Its business, like that of all modern central banks (but unlike that of, say, the Gosbank), is that of keeping the overall scale of credit creation within bounds consistent with macroeconomic stability, while leaving private financial institutions as free as is consistent with preserving that stability to decide how best to employ scarce credit.

The bigger the Fed’s credit footprint, the more it interferes with the efficient employment and pricing of credit. By directing a large share of savings to purchases of longer-term MBS and Treasury securities, for example, the Fed has artificially raised both the prices of those securities, and the importance of the housing market and the federal government relative to the rest of the U.S. economy. It has also dramatically increased its portfolio’s duration gap and, by so doing, the risk that it will suffer losses should it sell assets before they mature. In other words, the Fed has undermined its own flexibility, by increasing the likely cost, directly to the U.S. Treasury and indirectly to itself, of using open-market sales to tighten credit. Finally, by flattening the yield curve, the Fed’s purchases have harmed commercial banks, the profits of which come mainly from borrowing short, lending long, and pocketing the difference.

Promises, Promises

The presumption that the Fed’s credit footprint should be as small as possible was once shared by most experts, including Fed officials. For that reason, when QE was just getting started, and for some time afterwards, those officials were anxious to assure everyone that the Fed ‘s growth was only temporary.

In speaking at the LSE back in January 2009, for example, Ben Bernanke promised that

As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. …  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy — namely, by setting a target for the federal funds rate.

Later that same year Fed Vice President Donald Kohn, speaking at a Shadow Open Market Committee meeting held here at the Cato Institute, complained that “the large volume of reserves is contributing to the loose relationship of our deposit rate and market rates,” while assuring those present that the Fed would eventually “drain the banking system of excess reserves for that reason.” [1]  In their April 2010 meeting, most FOMC members hoped that the Fed would dispose of all its QE1 assets within 5 years of its first post-crisis rate hike, while a few wanted it to start selling assets before its first rate increase. A year later the FOMC was still committed  to having the Fed dispose of its agency securities rapidly, so as “to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy.”

Finally, when, in 2014, the Fed began to increase the magnitude of its ON-RRP operations, some FOMC members worried about that facility’s influence on credit allocation. Nor were their concerns unwarranted. According to a study prepared by a group of Fed economists some months later, an enlarged ON-RRP program “would expand the Federal Reserve’s footprint in short-term funding markets and could alter the structure and functioning of those markets in ways that may be difficult to anticipate.” Among other things, Fed experts feared that, by substantially increasing the Federal Reserve’s role in financial intermediation, the new facility “might magnify strains in short-term funding markets during periods of financial stress.”

Alas, despite such concerns, and the progress of the recovery, the Fed has yet to take steps to shrink its balance sheet. Instead, it continues to reinvest both the proceeds from maturing Treasuries and  principal payments from its agency debt and MBS. More disturbingly still, arguments to the effect that the Fed should make its gigantic footprint permanent, or even increase it, seem to be gaining ground both within and beyond the Fed. (An early convert to the new view was Ben Bernanke himself, who, at a May 2014 conference in which yours truly also took part, declared that “There is absolutely no need or requirement for the balance sheet to go back to normal as monetary policy normalizes. The balance sheet could be kept where it is for a very long time if necessary.”)

On the other hand, some other Fed officials, including St. Louis Fed President James Bullard, still hope to get the Fed to go on a diet. So, apparently, does Kentucky representative Andy Barr, who favors legislation that would give the Fed no choice but to shrink. Writing recently in Investor’s Business Daily, Barr observed that the Fed’s “enormous balance sheet puts taxpayers at risk, especially if interest rates rise, and distorts the free flow of capital that has sorely gone missing from our low-productivity recovery.”

The Demand Side of Fed Shrinkage

Barr hopes that pending legislation “will include an effective strategy to shrink the Federal Reserve’s balance sheet and limit its holdings to U.S. Treasuries.” If that’s what it’s going to take to cut the Fed back down to size, I’m for it as well. But Barr’s proposal begs the question, just what is an “effective strategy” for shrinking the Fed?

Most discussions treat such a strategy as being entirely a matter of setting a schedule, like those the FOMC has toyed with since 2010, for ending or limiting Fed re-investments of maturing securities and dividends, and (in more aggressive plans) for outright MBS sales. But there’s more to it than that, because the size of the Fed’s footprint is ultimately determined, not by the dollar-value of the Fed’s assets, but by the real demand for its liabilities. The greater the latter demand, the larger the Fed is bound to be in real (that is, inflation-adjusted) terms.

Just before the crisis, the demand for Fed liabilities consisted mainly of the public’s demand for paper dollars, about $800 billion of which were outstanding. The demand for Fed deposit balances, including banks’ demand for reserves, was, in contrast, quite limited. The Treasury and the GSEs kept modest balances amounting in all to about $100 billion, while banks held even less, in reserves  barely exceeding minimum legal requirements. Today, thanks to IOER, ON-RRP, and other Federal Reserve programs and powers put into effect during the crisis, the demand for Fed balances has dramatically increased. Unless these special sources of demand are themselves dealt with, shrinking the Fed’s balance sheet alone won’t suffice to reduce the Fed’s size, either in real terms or relative to the credit system as a whole. Instead, Fed asset sales will, other things equal, cause private financial institutions to reduce their holdings of assets other than balances at the Fed, so as to retain the same ratio of Fed balances to other assets.

The good news is that reducing the demand for Fed balances to pre-crisis levels is relatively easy. Today’s exceptional demand is mainly the result of heightened bank liquidity needs combined with the Fed’s practice of setting the IOER rate above the yield on Treasury securities, and on short-term securities especially. Banks’ heightened liquidity needs initially stemmed from the crisis itself, but have since been sustained by the Fed’s liquidity stress testing and, more recently, by the U.S. implementation of Basel’s Liquidity Coverage Ratio.[2] But these needs alone don’t account for banks’ extraordinary demand for excess reserves, because Treasury securities are themselves high-quality liquid assets, which banks would normally favor over excess reserves for their higher yields. It’s only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills.  Were  it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions’ demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks’ own demand for such reserves, both policies are expansionary. They don’t alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks’ capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

In practice, the Fed may prefer (if it isn’t forced) to shrink its portfolio according to a preset schedule, rather than at whatever rate it takes to compensate for a declining demand for Fed balances. In that case, it has another tool it can use to keep a lid on credit: its Term Deposit Facility. As the Federal Reserve Board’s own description of that facility  explains, by inducing banks to keep term (rather than demand) deposits with it, the Fed drains as many reserve balances from the banking system. So, to the extent that the Fed’s gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed’s federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks’ excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.

____________________________

[1] Kohn also observed, by the way, that “the high volume of reserves evidently has not increased bank lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury rates,” while acknowledging that “an increase in lending and narrowing of spreads on bank loans is a necessary and desirable aspect of the return to better-functioning markets and intermediation to promote economic growth.” That sounds to me rather like an admission that QE was, up to that point at least, a flop.

[2] The Liquidity Coverage Ratio (LCR) calls for banks to have enough unencumbered “high quality liquid assets” (HQLA) to meet a 30-day stressed liquidity outflow scenario. Banks that rely heavily on wholesale funding are subject to a higher required LCR than those funded chiefly by retail deposits. The different requirements accounts for the fact that larger U.S. banks hold a disproportionate share of total excess reserves. Although the U.S. first began enforcing Basel-based LCR requirements in January 2015, it appears that U.S. banks that were to be subject to those requirements started accumulating qualifying liquid assets in 2013.

[Cross-posted from Alt-M.org]

A new study at Downsizing Government looks at low-income housing aid. Howard Husock of the Manhattan Institute examines the history of federal aid and discusses problems with current policies, particularly rental subsidies and public housing.

One problem is that housing aid is costly to taxpayers. The federal government spent $30 billion on rental subsidies (Section 8 vouchers) and almost $6 billion on public housing in 2016.

Another problem is that housing aid and related rules are costly to urban communities. Howard argues that federal interventions undermine neighborhoods, encourage dependency, and create disincentives for long-term maintenance and improvements in housing.

In urban politics, there are frequent calls for “affordable housing.” But Howard says that it is a myth that markets cannot provide decent housing for people at all income levels. He discusses the vast private housing investment in the decades prior to the 1930s, which was a time of rapid growth in America’s big cities.

The problem today is that government rules and regulations inflate housing costs, which is the topic of an upcoming study by Cato’s housing expert, Vanessa Calder.

What should Ben Carson do? The new Secretary of Housing and Urban Development should heed Howard’s advice and work to cut federal subsidies. Carson should also follow through on his conviction that HUD imposes too many “social engineering” rules on local governments.

Vanessa provides further policy guidance for Carson here, and she discusses an example of the sort of top-down HUD mandate that should be on the chopping block here.

Howard’s vast scholarship on housing policy is here.

More information on HUD is here. I would particularly recommend HUD Scandals. My god, Ronald Reagan’s HUD was appalling.

In recent House testimony, I said that energy subsidies should be repealed because they distort business decision making. They induce firms to invest in activities that do not make sense in the marketplace.

That appears to be the case with Southern Company’s “clean coal” plant in Kemper County, Mississippi. The plant is far behind schedule and massively over budget—a first-class boondoggle. The Wall Street Journal reports that the estimated cost has soared from $3 billion to $7.1 billion. (This says the original estimate was $2.2 billion). The utility’s customers could be in for a $4 billion rate hike.

What the WSJ leaves out is that the Kemper plant received federal subsidies and Obama administration support, which may have tilted company executives in favor of the wasteful project instead of a far cheaper natural gas plant. The project had been scheduled to receive hundreds of millions of dollars in grants and tax credits, although I understand that some of the bounty was later rescinded.

Federal subsidies covered only part of the original estimated cost, but they were likely the tail that wagged the dog. When subsidies induce private businesses to invest in dubious projects, the damage comes not just from wasting taxpayer dollars, but also from misallocating private investment funds.

More on energy subsidies, here, here, and here. More on Kemper, here, here, and here.

President Trump’s administration has rescinded the Obama administration’s “Dear Colleague” letter requiring that public schools let transgender students use the bathrooms and locker rooms of their choice. It was probably the right thing do, and there was nothing “shameful” about the decision: equally decent people can, and do, have competing views of what is good.

There is no reason, of course, to believe anything other than that the Obama administration’s initial guidance was well-intended, driven by a desire to see transgender students empowered to make decisions for themselves about who they are. It is also absolutely a legitimate worry that school districts might discriminate against transgender students.

But equally decent people could feel very uncomfortable sharing a bathroom or changing room with someone of the opposite biological sex — sex-based privacy has been a time-honored norm — and could also have religious objections to such mixing. What about their rights? There were also legitimate worries about the legality of the order, delivered as a sudden reinterpretation of long-standing regulations.

Finally, societal evolution takes time. It may well be better to let smaller units (states, communities, families) grapple with and adjust to social change than suddenly impose one vision of the good on everyone.

Of course, there may be no solution in a diverse school or district that equally respects the values and desires of all. This is a major reason that school choice is so crucial: it enables families and educators to freely choose the values they want taught and respected, rather than government choosing one side to win and the other to lose.

Alas, some high-profile defenders of the Obama guidance immediately sprang into moral condemnation or hysteria mode, continuing to poison the national debate that has been degenerating for decades, but has seemingly collapsed in the era of Trump. Sen. Patty Murray, D-Wash., condemned the administration’s action as “shameful,” as if it were impossible that any morally-upright person could have a position against federally-forced transgender bathroom access. American Federation of Teachers president Randi Weingarten declared, “Reversing this guidance tells trans kids that it’s OK with the Trump administration and the Department of Education for them to be abused and harassed at school for being trans.”

No, the new guidance does not say that. Indeed, the letter announcing it says that “all schools must ensure that all students, including LGBT students, are able to learn and thrive in a safe environment.” There is not a shred of meaningful evidence that anyone in the Trump administration is trying to essentially declare open season on transgender kids.

There are fine reasons to oppose what the Trump administration has done on bathroom and locker room access in public schools. But there are also perfectly decent reasons to support it — indeed, I think more compelling. Perhaps just as important, it is long past time that we cease with unfair, incendiary, cohesion-shredding rhetoric, and accept that good people can have different opinions than we do.

What better place to start than with the education of our children?

This piece originally appeared in the Washington Examiner.

A shocking statistic has come to light: Venezuelans lost 19 pounds on average over the past year because of food shortages. 

There was a time when hunger was a near-universal experience. As Kevin D. Williamson put it, “Not long ago, the great dream and aspiration of most of the people walking this Earth was to have enough to eat, for themselves and for their children, and to be liberated from worrying about whether they would eat again tomorrow or the next day.”

Then, something changed. Exchange and specialization helped bring down food prices. A burst of innovations called the Green Revolution led to higher agricultural productivity and decreased food prices even further. Even as the world’s population grew, the market ensured that the supply of food rose to meet growing demand. 

The global numbers are heartening. The share of the world’s population suffering from hunger is shrinking. Despite population growth, the total number of undernourished persons is lower as well. Even those who are food-deprived are less severely malnourished than in the past. Humanity now produces more than enough food to theoretically feed everyone on Earth the recommended 2,000 calories per day.

Hunger was declining in Venezuela too until recently. The percentage of Venezuela’s population suffering from undernourishment fell from 14% in 1991 to “5% or lower” in 2015, the latest year for which the United Nations has data. Since then, the situation has rapidly deteriorated. In a single year, the number of cases of severely undernourished children in Venezuela’s capital city, Caracas, doubled

The reason? Venezuela’s socialist economic policies, briefly sustained by fleeting high oil prices, led to hyperinflation and a societal collapse. If Venezuela continues on its present course, hunger is likely to become more widespread. 

We can all be thankful that undernourishment has become rarer globally. But the case of Venezuela demonstrates that progress is not inevitable—suicidal economic policies, like socialism, can rapidly extinguish the prosperity we enjoy. 

“The legacy of the Rio Olympics is a farce,” writes sports columnist Nancy Armour in USA Today. She continues:

The closing ceremony was six months ago Tuesday, and already several of the venues are abandoned and falling apart. The Olympic Park is a ghost town, the lights have been turned off at the Maracana and the athlete village sits empty…. the billions that were wasted, the venues that so quickly became white elephants, the crippling bills for a city and country already struggling to make ends meet…

She notes that more and more cities are realizing that Olympic games are glamorous but not economically sound. I made that point two years ago when Boston withdrew its bid to host the 2024 Summer Olympics:

Columnist Anne Applebaum predicted a year ago that future Olympics would likely be held only in “authoritarian countries where the voters’ views will not be taken into account” — such as the two bidders for the 2022 Winter Olympics, Beijing and Almaty, Kazakhstan.

Fortunately, Boston is not such a place. The voters’ views can be ignored and dismissed for only so long.

The success of the “10 people on Twitter” and the three young organizers of No Boston Olympics should encourage taxpayers in other cities to take up the fight against megaprojects and boondoggles — stadiums, arenas, master plans, transit projects, and indeed other Olympic Games.

I cited then some of the evidence about the impact of the Olympics on host cities:

The critics knew something that the Olympic enthusiasts tried to forget: Megaprojects like the Olympics are enormously expensive, always over budget, and disruptive. They leave cities with unused stadiums and other waste.

E.M. Swift, who covered the Olympics for Sports Illustrated for more than 30 years, wrote on the Cognoscenti blog a few years ago that Olympic budgets “always soar.”

“Montreal is the poster child for cost overruns, running a whopping 796 percent over budget in 1976, accumulating a deficit that took 30 years to repay. In 1996 the Atlanta Games came in 147 percent over budget. Sydney was 90 percent over its projected budget in 2000. And the 
Athens Games cost $12.8 billion, 60 percent over what the government projected.”

Bent Flyvbjerg of Oxford University, the world’s leading expert on megaprojects, and his co-author Allison Stewart found that Olympic Games differ from other such large projects in two ways: They always exceed their budgets, and the cost overruns are significantly larger than other megaprojects. Adjusted for inflation, the average cost overrun for an Olympics is 179 percent.

In the latest edition of Cato Policy Report, Flyvbjerg examined “the ‘iron law of megaprojects’: over budget, over time, over and over again.”

Brazil has great resources, great ambitions, and great problems, including a vast corruption scandal that has taken down numerous public officials including President Dilma Rousseff. But the lives of its people will not improve through grandiose projects. Brazil needs financial reform, tax and regulatory reform, fiscal reform, and more. Megaprojects are not the road to prosperity.

The Constitution’s Framers had one primary thought in mind when they set out to draft the Constitution: Securing ordered liberty so that the people could pursue happiness. To accomplish this goal, they drew on the ideas of Enlightenment philosophers like Locke and Montesquieu to design a political system that divided power between the new national government and the states (federalism) and also among the federal branches (separation of powers). The separation of powers would be the front line of defense from an overreaching government, because it would allow each branch to “check” and “balance” the other—thereby limiting the ability of any one department to accumulate too much power over the people.

Yet the modern administrative state has been allowed to evade many of the Constitution’s structural protections for liberty. It has become what some have called the “fourth branch of government,” combining all three functions—legislative, executive, and judicial—into one body that does not have to jump through the Framers’ hoops. National Restaurant Association v. Department of Labor is a prime example of how far down the rabbit hole we have come from the Framers’ original vision.

In 2010, the U.S. Court of Appeals for the Ninth Circuit ruled that a section 203(m) of the Fair Labor Standards Act (FLSA) did not prevent employers from instituting a policy of tip-pooling (redistributing tips from individual employees to other workers) when the employer did not take a tip-credit (where the employer uses an employee’s tips to satisfy the FLSA’s minimum-wage requirement). The court held that the statute’s “plain meaning” did not explicitly forbid this practice, so it was legal.

The Department of Labor (DOL) didn’t like the court’s opinion, however, and in 2011 conducted a “rulemaking” that would reinterpret the FLSA to say that tip-pooling was illegal in certain situations—even when the employer didn’t take a tip-credit. The National Restaurant Association and several other groups challenged the rulemaking, arguing that an executive agency can’t ignore federal-court precedent and unilaterally rewrite a statute that is unambiguous. The district court agreed and quickly struck down the rulemaking. But the Ninth Circuit ignored its own 2010 precedent and upheld the DOL’s new statutory interpretation.

Undeterred, the groups sought en banc review (where all of the judges in the circuit rehear a case), but—over a strongly worded dissent, calling the circuit court’s reasoning “entirely alien to our system of laws”—the court declined the request. Cato has now filed an amicus brief supporting the National Restaurant Association’s petition for Supreme Court review.

We argue the circuit court’s opinion raises serious separation-of-powers concerns by allowing the DOL to exercise legislative power when it essentially rewrote an unambiguous FLSA provision. Moreover, upholding the new DOL regulation effectively overturned a federal court’s precedent in direct circumvention of the judicial branch’s duty to “say what the law is.” The Court should take this case and show that the Constitution’s separation of powers does not allow such judicial enabling of executive mischief. Administrative agencies simply cannot take it upon themselves to ignore or rewrite the law.

 

As we approach Cato’s 40th anniversary, if you’re interested in knowing a little more about the origin and history of Cato’s Center for Constitutional Studies, which I founded 28 years ago, take a look at Mimesis Law’s lengthy interview of me that they posted just this morning.

A year ago they interviewed Wally Olson, who put them on my trail. This morning’s interview is actually more of a “life story”—from a boyhood in rural America, trapping muskrats and beaver and starting my school’s first rock-‘n’-roll band, through the twists and turns that brought me to today and the center. But in the course of telling the tale I discuss the intellectual history that led to the center’s creation and informed its mission And along the way I discuss some of the issues we’re still wrestling with. At the least, you’ll get a few laughs!

The Supplemental Nutrition Assistance Program (SNAP) aims for recipients to “make healthy food choices within a limited budget.” SNAP is supposed to “permit low-income households to obtain a more nutritious diet.”

However, the lofty goals of federal programs often differ from the actual results. It turns out that about $15 billion of SNAP benefits are for junk food. Apparently, recipients are not making the nutritious and healthy choices that the government promised.

SNAP, or food stamp, benefits totaled $67 billion in 2016. Food stamps can be used to buy just about any edible item in grocery stores other than alcohol, vitamins, and hot food. But exactly what is being purchased by the program’s 44 million recipients has been mainly shrouded in secrecy—until now.

A November study by the U.S. Department of Agriculture finally shed light on food stamp purchases. The study examined detailed data for SNAP and non-SNAP shoppers for one large food retailer over a one-year period.

The study found that SNAP shoppers bought slightly more junk food than non-SNAP shoppers. For example, 9.25 percent of total purchases by SNAP shoppers were for “sweetened beverages” such as cola, which compared to 7.1 percent for non-SNAP shoppers. At the same time, SNAP shoppers spent relatively less on nutritious foods such as fruits and vegetables.

For SNAP shoppers, “sweetened beverages,” “prepared desserts,” “salty snacks,” “candy,” and “sugar” accounted for 22.6 percent of purchases. These junk food items thus accounted for $15 billion of SNAP purchases in 2016, if the study is representative of all SNAP purchases.

SNAP is a bloated program, and cutting out junk food would be one way to reduce costs. The program was created to tackle hunger, but Harvard University’s Robert Paarlberg noted that on a typical day less than 1 percent of households now face “very low food security.” That low figure contrasts with the 17 percent of U.S. households that currently receive food stamps.

The main food-related health problem for low-income households today is not hunger, but obesity. CDC data show that people with low incomes are more obese than people with high incomes, on average. In general, low-income Americans are suffering not from too little food, but from too much of the wrong kinds of food.

Ending SNAP’s junk food subsidies would likely cut demand for the program and reduce taxpayer costs. If policymakers decided that food stamps could only be used for items such as fruits and vegetables, fewer people would use the program, which would be a good thing.

An even better reform would be to end federal involvement in food stamps. Each state could then decide on the overall level of benefits it wanted, and on whether taxpayers should be subsidizing cola, candy, crackers, and cookies.

For more on food stamps, see here and here.

As any pedantic patriot can tell you, there’s really no such thing as “Presidents’ Day”–the official name for the federal holiday we celebrated on Monday is “Washington’s Birthday.” And it wasn’t the first president’s actual birthday, which is today, February 22.

Washington had his faults, but, especially when compared to most of those who followed him, he provided an admirable model of probity and restraint. The teenage Washington copied in his own hand 110 precepts on etiquette: “The Rules of Civility and Decent Behavior in Company and Conversation,” and, as I noted recently, they make for a pretty stark contrast with the deportment of 1600 Pennsylvania’s current occupant. So, in honor of Washington’s (actual) Birthday, contemplate the distance between our first president and our 45th, with a selection of Washington’s “Rules”–and Trump’s:

Washington’s “Rules”:

Shew Nothing to your Freind that may affright him.

The U.S. must immediately stop all flights from EBOLA infected countries or the plague will start and spread inside our “borders.” Act fast!

— Donald J. Trump (@realDonaldTrump) August 2, 2014

Speak not when you Should hold your Peace

The United States must greatly strengthen and expand its nuclear capability until such time as the world comes to its senses regarding nukes

— Donald J. Trump (@realDonaldTrump) December 22, 2016

do not Presently play the Physician if you be not Knowing therein.

If I were President I would push for proper vaccinations but would not allow one time massive shots that a small child cannot take - AUTISM.

— Donald J. Trump (@realDonaldTrump) March 27, 2014

Undertake not what you cannot Perform but be Carefull to keep your Promise.

Trump: “I will give you everything. I will give you what you’ve been looking for for 50 years. I’m the only one” (campaign rally, North Dakota).

Reproach none for the Infirmaties of Nature, nor Delight to Put them that have in mind thereof.

Trump: “Look at that face! Would anyone vote for that? Can you imagine that, the face of our next president?” (on Carly Fiorina)

In writing or Speaking, give to every Person his due Title According to his Degree & the Custom of the Place.

The opinion of this so-called judge, which essentially takes law-enforcement away from our country, is ridiculous and will be overturned!

— Donald J. Trump (@realDonaldTrump) February 4, 2017

When in Company, put not your Hands to any Part of the Body, not usualy Discovered.

…this one’s just too easy.

wherein you reprove Another be unblameable yourself; for example is more prevalent than Precepts.

Hillary Clinton has announced that she is letting her husband out to campaign but HE'S DEMONSTRATED A PENCHANT FOR SEXISM, so inappropriate!

— Donald J. Trump (@realDonaldTrump) December 27, 2015

Be not hasty to beleive flying Reports to the Disparag[e]ment of any.

“His father was with Lee Harvey Oswald prior to Oswald’s being — you know, shot. I mean, the whole thing is ridiculous…. I mean, what was he doing — what was he doing with Lee Harvey Oswald shortly before the death? Before the shooting? It’s horrible.”–Trump on Sen. Ted Cruz’s father

Being to advise or reprehend any one, consider whether it ought to be in publick or in Private… & in reproving Shew no Sign of Cholar but do it with all Sweetness and Mildness.

.@katyperry Katy, what the hell were you thinking when you married loser Russell Brand. There is a guy who has got nothing going, a waste!

— Donald J. Trump (@realDonaldTrump) October 16, 2014

When a man does all he can though it Succeeds not well blame not him that did it.

Trump: “He’s not a war hero. He’s a war hero because he was captured. I like people that weren’t captured, OK? I hate to tell you” (on Sen. John McCain)

Be not immodest in urging your Freinds to Discover a Secret.

Did Crooked Hillary help disgusting (check out sex tape and past) Alicia M become a U.S. citizen so she could use her in the debate?

— Donald J. Trump (@realDonaldTrump) September 30, 2016

Be not apt to relate News if you know not the truth thereof. 

How amazing, the State Health Director who verified copies of Obama’s “birth certificate” died in plane crash today. All others lived

— Donald J. Trump (@realDonaldTrump) December 12, 2013

A Man o[ug]ht not to value himself of his Atchievements, or rare Qua[lities of wit;

Sorry losers and haters, but my I.Q. is one of the highest -and you all know it! Please don't feel so stupid or insecure,it's not your fault

— Donald J. Trump (@realDonaldTrump) May 9, 2013

…much less of his rich]es 

Trump: “part of the beauty of me is that I’m very rich”

Labour to keep alive in your Breast that Little Spark of Ce[les]tial fire Called Conscience.

Trump: I’m really not a bad person, by the way. No, but the tone is such — I do get good ratings, you have to admit that” (last Friday’s press conference)

As The Wall Street Journal notes, “Mr. Trump and his advisers see the U.S. goods trade deficit as an indicator of U.S. economic weakness.” 

Yes, they do. But why?  As the graph clearly shows, the real gross output of U.S. manufacturing rises when the goods trade deficit (both measured in 2009 dollars) is also rising.  When trade deficits fall, so does U.S. manufacturing.  Sinking industries need fewer imported parts and materials, and their unemployed workers can’t afford imports.

Measured in 2009 dollars, the goods trade deficit fell from $863.4 billion in 2006 to $525.2 billion in 2009.  Peter Navarro, the President’s liberal protectionist trade adviser, would apparently call that good news.  The rest of us called it The Great Recession.

Since at least World War II, U.S. foreign policy has been shaped by the necessity of securing scarce oil supplies. And for more than 30 years, it has been shaped by a commitment to safeguard the flow of oil from the Persian Gulf. Many of the defining moments in U.S. foreign policy since then– including the Arab oil embargoes of the 1970s, the 1980s ‘tanker war’ and even the 1991 Persian Gulf War – have been shaped by this commitment, perhaps most clearly articulated by President Carter in 1980:

Let our position be absolutely clear: An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such an assault will be repelled by any means necessary, including military force.

Yet recent years have seen profound changes in the global oil market. Growth in U.S. domestic production – a result of the shale gas revolution – has returned the United States to the top of global hydrocarbon producer rankings for the first time in decades. A more general shift in production from global south to north has made the United States substantially less reliant on Middle Eastern sources of oil, and more on close neighbors like Canada.

These changes, combined with dramatic shifts in the Middle Eastern balance of power raise a key question: should the United States continue to use its military to guarantee the flow of oil from the Persian Gulf?

On February 27th, Cato will host a book forum to discuss the recently published book Crude Strategy: Rethinking the U.S. Military Commitment to Defend Persian Gulf Oil. The book addresses many of these key questions, pulling together an interdisciplinary team of political scientists, economists, and historians to explore the links between Persian Gulf oil and U.S. national security.

The book’s essays explore key questions such as the potential economic cost of disruption in oil supply, whether disruptions can be blunted with nonmilitary tools, the potential for instability in Saudi Arabia, and the most effective U.S. military posture for the region. By clarifying the assumptions underlying the U.S. military presence in the Persian Gulf, the authors conclude that the case for revising America’s grand strategy towards the region is far stronger than is commonly assumed.

The discussion will feature the book’s editors, Charles Glaser, Professor of Political Science and Director, Institute for Security and Conflict Studies at the George Washington University and Rosemary Kelanic, Assistant Professor of Political Science, Williams College. Joining them will be Kenneth Vincent, Visiting Fellow, Institute for Security and Conflict Studies, George Washington University and John Glaser, Cato’s Associate Director of Foreign Policy Studies.

The event promises a fascinating discussion on the energy security roots of America’s foreign policy in the Middle East, and the future of the U.S. commitment to the region’s oil supplies. You can register for the event here.

Margaret Thatcher came to power in 1979 determined to revive the stagnant British economy with market-based reforms. During her 11 years as prime minister, she deregulated, cut marginal tax rates, repealed currency exchange controls, and tamed militant labor unions.

However, it was privatization that became Thatcher’s most important and enduring economic legacy. She popularized the word privatization and oversaw the sale to the public of British Airways, British Telecom, British Steel, and British Gas, and other major businesses.

Spurred by the success of Thatcher’s reforms, privatization swept the world. Governments in more than 100 countries moved thousands of state-owned businesses to the private sector. Since the Iron Lady’s campaign to give ownership of Britain’s economy back to the people, more than $3.3 trillion of government businesses have been privatized around the world.

I take a look back at Thatcher’s privatization reforms in this month’s Cato Journal.

What is the relevance for U.S. policymaking today? Many types of businesses that Britain privatized are still partly or fully owned by governments in this country, including airports, seaports, postal services, air traffic control, electric utilities, and passenger rail. So there is an opportunity here for our leaders to spur growth and innovation by adopting Thatcher’s playbook.

But privatization is important for more than just the economic benefits. Thatcher said privatization is also about “reclaiming territory for freedom” and ensuring that “the state’s power is reduced and the power of the people enhanced.”

In toasting Margaret Thatcher in Washington, February 27, 1981, President Ronald Reagan said “everywhere one looks these days the cult of the state is dying.” Thatcher’s privatization program would help make that promise come true.

The photo shows the free-market friends at the White House, February 28, 1981.

There is considerable debate in both academic and policy circles about the utility of nuclear weapons. Of what use are they? Some say just about all nuclear weapons are good for is self defense. States that possess them can more easily deter attack or invasion. Others argue that possessing nuclear weapons also gives states added leverage to get their way in international politics. In this conception, nuclear weapons add to the ability to coerce other states. Not only can they deter actions we don’t like, but they can help compel others to take actions that we do like.

A new and important book, Nuclear Weapons and Coercive Diplomacy by Todd S. Sechser and Matthew Fuhrmann, evaluates the empirical record to test whether or not nuclear weapons aid in coercive diplomacy. Their findings are clear: no, nuclear weapons do not have much coercive utility. States with nukes don’t have more leverage in settling territorial disputes, they’re not more likely to initiate military challenges, they are not more likely to escalate ongoing disputes, and they are not more successful in blackmailing rivals. 

This has significant implications for U.S. foreign policy. What do these findings suggest we should expect from our nuclear-armed rivals, like Russia and China? Does it make sense to undertake preventive military action against nascent nuclear weapons programs in countries like North Korea? If Iran were to get nuclear weapons once the time-limited restrictions in the JCPOA expire (as critics of the deal suggest), how would that influence its behavior in the region?

The authors are coming to the Cato Institute on March 7 to discuss their book and explain their theoretical and empirical findings. Matthew Kroenig will be a discussant and offer comments on the book. You can register to attend the event here

During Trump’s surprising presidential campaign, pundits became fond of pointing out that Trump’s supporters took his often-shocking rhetoric seriously, but not literally, whereas his opponents took his rhetoric literally, but not seriously. Today, however, it is obvious that one should take Trump’s words both seriously and literally. In his first month Trump has been busy matching actions to words, temporarily banning immigration from seven Muslim-majority nations and ordering sanctuary cities to detain illegal immigrants, launching work on the U.S.-Mexican border wall, and preparing to lift the ban on the CIA black sites where the United States carried out “enhanced interrogation techniques.”

For those who voted for Trump this first month must surely be a heady viewing experience. For much of the country, however, Trump’s efforts are taking things in the wrong direction, as even his most extreme campaign proposals become reality. From the perspective of the polls, Trump’s first month has met decidedly mixed reviews.

On immigration, for example, Trump signed a short-lived executive order threatening to halt federal funding to so-called “sanctuary cities” that offer protection to illegal immigrants if they do not detain illegal immigrants and turn them over to federal authorities. And before signing two executive orders directing the construction of the U.S.-Mexican border wall, Trump argued that the United States is “in the middle of a crisis border” and that “A nation without borders is not a nation.”

Most Americans see things differently. When asked about illegal immigrants currently living in the United States, a CBS News Poll this month found that 74% of the public thinks they should be allowed to stay, while just 22% thinks they should be required to leave. 61% believe illegal immigrants should eventually be allowed to apply for citizenship. The same poll found that 59% oppose Trump’s plan to build a wall along the U.S.-Mexico border, with 37% favoring it.

On the question of torture Trump faces a polarized public. Just yesterday Trump reaffirmed his belief in the utility of torture, telling an interviewer that the United States must “fight fire with fire” and that “Absolutely I feel it works.” Many Americans, however, are not so sure. A recent poll by the Pew Research Center finds that 49% of the public does not believe there are any circumstances that justify torture; while 48% believes that there are some circumstances that do. When asked about specific interrogation techniques, Americans have tended to be even less supportive. Gallup polls from 2005, for example, found 82% opposed water boarding, 79% opposed keeping prisoners naked and chained in uncomfortable positions. 62% felt it was wrong to threaten to transfer a prisoner to a country know for using torture – relevant given Trump’s order to reestablish overseas CIA black sites, which were used for just such purposes.

On the question of banning Muslims from entering the United States Trump’s support is far from overwhelming. Earlier this month a Quinnipiac University poll found that 48% support suspending immigration from “terror prone regions” compared to 42% who oppose doing so. This represents a slip from the summer of 2016, when a NBC News/Survey Monkey poll taken days after the Orlando nightclub attack found 50% support for Trump’s call for a ban, with 46% opposing.

It is too early to make bold predictions about the popularity of Trump’s policies down the road or what the polls today might tell us about how the polls will look two or four years from now. Even so, though Trump is enjoying the rush of power that comes with the Oval Office, his administration would do well to take these poll numbers both literally and seriously. Racking up policy “wins” that don’t have majority support is a sure way to lose political capital in Washington and a terrible strategy for getting reelected.

This goes double for Trump, given his historically low approval and favorability ratings. Trump is the first elected president with an approval rating under 50% (42% in the latest Gallup poll) and the latest Pew Research Center poll has his net favorable/unfavorable rating at minus 16%. Trump, with his mobile phone and millions of Twitter followers, may believe he can use the bully pulpit to win hearts and minds. In this, however, he will learn that he is sadly mistaken. Scholars of presidential communication have long since shown that presidents with approval ratings below 50% find their ability to move public opinion vastly diminished, if not completely destroyed.

At his current approval levels, it doesn’t matter how many tweets Trump fires off, he is unlikely to turn opposition toward unpopular programs into support. On the other hand, Trump will fare much better as he moves on to policies that enjoy majority support to begin with like his infrastructure package, tax cuts for the middle class, spending more for defense, or improving veterans’ services.

In the final analysis, assessments of Trump’s presidency won’t hinge primarily on attitudes towards specific policies but on the public’s judgments of the broader sweep of economic and social trends over his time in office. And for that we shall have to wait. 

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