WEBVTT 00:00:00.000 --> 00:00:00.500 align:middle line:90% 00:00:00.500 --> 00:00:01.973 align:middle line:90% [SQUEAKING] 00:00:01.973 --> 00:00:03.937 align:middle line:90% [RUSTLING] 00:00:03.937 --> 00:00:05.410 align:middle line:90% [CLICKING] 00:00:05.410 --> 00:00:09.743 align:middle line:90% 00:00:09.743 --> 00:00:10.660 align:middle line:90% JON GRUBER: All right. 00:00:10.660 --> 00:00:12.320 align:middle line:84% I was disappointed about my explanation 00:00:12.320 --> 00:00:13.780 align:middle line:84% about corporate taxation last time. 00:00:13.780 --> 00:00:14.947 align:middle line:90% Saw a lot of confused faces. 00:00:14.947 --> 00:00:17.072 align:middle line:84% It's a hard topic, but I think I'll make it easier. 00:00:17.072 --> 00:00:18.360 align:middle line:90% So I'm going to try again. 00:00:18.360 --> 00:00:20.840 align:middle line:84% If you remember last time, we were 00:00:20.840 --> 00:00:24.600 align:middle line:84% talking about how taxation affects corporation investment 00:00:24.600 --> 00:00:25.460 align:middle line:90% decisions. 00:00:25.460 --> 00:00:28.160 align:middle line:84% And we said that when you invest $1, 00:00:28.160 --> 00:00:32.140 align:middle line:84% you get a return, which is the marginal product of capital, 00:00:32.140 --> 00:00:33.520 align:middle line:90% absent taxation. 00:00:33.520 --> 00:00:36.480 align:middle line:84% Then we said, look, if the government comes in and has 00:00:36.480 --> 00:00:39.140 align:middle line:84% a corporate tax, then every dollar you take home, 00:00:39.140 --> 00:00:41.140 align:middle line:84% they're going to take some of it. 00:00:41.140 --> 00:00:44.440 align:middle line:84% So you're only going to take home MPK times 1 minus tau. 00:00:44.440 --> 00:00:45.080 align:middle line:90% OK? 00:00:45.080 --> 00:00:48.075 align:middle line:84% I think that part people seemed OK with. 00:00:48.075 --> 00:00:49.700 align:middle line:84% Stop me, once again, if it's not clear. 00:00:49.700 --> 00:00:51.560 align:middle line:84% But that's your net rate of return. 00:00:51.560 --> 00:00:53.213 align:middle line:90% Now, think of it this way. 00:00:53.213 --> 00:00:54.880 align:middle line:84% The government then comes along and says 00:00:54.880 --> 00:00:57.260 align:middle line:84% you know what, for every dollar of investment you make, 00:00:57.260 --> 00:00:58.920 align:middle line:90% I'm going to give you a deal. 00:00:58.920 --> 00:01:00.490 align:middle line:84% I'm going to give you two discounts. 00:01:00.490 --> 00:01:03.750 align:middle line:84% One discount is I'm going to give you a rebate, which 00:01:03.750 --> 00:01:09.330 align:middle line:90% is a depreciation deduction. 00:01:09.330 --> 00:01:12.670 align:middle line:84% And I'm going to express that in terms 00:01:12.670 --> 00:01:15.150 align:middle line:84% of the present value of the depreciation deduction, 00:01:15.150 --> 00:01:18.830 align:middle line:84% Z. So Z is basically the present value of all the tax 00:01:18.830 --> 00:01:20.270 align:middle line:90% benefits you're going to get. 00:01:20.270 --> 00:01:21.190 align:middle line:84% If they're in the future, they're 00:01:21.190 --> 00:01:22.607 align:middle line:84% worth less than if they're sooner. 00:01:22.607 --> 00:01:25.390 align:middle line:84% So accelerated depreciation has a higher Z 00:01:25.390 --> 00:01:28.790 align:middle line:84% than regular depreciation-- than straight-line depreciation. 00:01:28.790 --> 00:01:29.970 align:middle line:90% What is that worth to you? 00:01:29.970 --> 00:01:32.610 align:middle line:84% Well you get to deduct that from your tax base. 00:01:32.610 --> 00:01:34.090 align:middle line:90% So that's worth tau Z to you. 00:01:34.090 --> 00:01:36.990 align:middle line:84% Remember, this goes back to our individual taxation discussion. 00:01:36.990 --> 00:01:38.698 align:middle line:84% Deductions are not worth the full amount. 00:01:38.698 --> 00:01:41.240 align:middle line:84% They're only worth the amount of the deduction times your tax 00:01:41.240 --> 00:01:42.070 align:middle line:90% rate. 00:01:42.070 --> 00:01:43.690 align:middle line:90% So that's one discount. 00:01:43.690 --> 00:01:46.230 align:middle line:90% You get off the price. 00:01:46.230 --> 00:01:47.250 align:middle line:90% You get that. 00:01:47.250 --> 00:01:50.248 align:middle line:84% The other discount you get is in addition, 00:01:50.248 --> 00:01:51.790 align:middle line:84% for every dollar investment you make, 00:01:51.790 --> 00:01:55.430 align:middle line:84% I'm going to rebate you in a credit alpha cents. 00:01:55.430 --> 00:01:57.032 align:middle line:90% This is an additional incentive. 00:01:57.032 --> 00:01:59.240 align:middle line:84% So not only do you allow this depreciation deduction, 00:01:59.240 --> 00:02:01.365 align:middle line:84% I'm also going to give you alpha cents back in just 00:02:01.365 --> 00:02:04.180 align:middle line:90% a pure rebate, pure tax credit. 00:02:04.180 --> 00:02:05.200 align:middle line:90% So what does that mean? 00:02:05.200 --> 00:02:08.780 align:middle line:84% That means the price of your dollar of investment has fallen. 00:02:08.780 --> 00:02:10.240 align:middle line:90% What has it fallen to? 00:02:10.240 --> 00:02:15.460 align:middle line:84% It's fallen to 1 minus tau Z minus alpha. 00:02:15.460 --> 00:02:18.880 align:middle line:84% That's what the price of $1-- $1 investment, you spend $1, 00:02:18.880 --> 00:02:20.780 align:middle line:84% but you get tau Z and alpha back. 00:02:20.780 --> 00:02:23.340 align:middle line:90% So this is your net price. 00:02:23.340 --> 00:02:27.300 align:middle line:84% So now what that means is you want to compare-- 00:02:27.300 --> 00:02:29.180 align:middle line:84% this is what I didn't make clear last time. 00:02:29.180 --> 00:02:34.003 align:middle line:84% You want to say the net return to $1 of investment-- 00:02:34.003 --> 00:02:35.420 align:middle line:84% first of all, dollar of investment 00:02:35.420 --> 00:02:36.760 align:middle line:90% buys you more than $1. 00:02:36.760 --> 00:02:39.440 align:middle line:84% It buys me 1 minus tau Z minus alpha. 00:02:39.440 --> 00:02:40.860 align:middle line:90% So that's the denominator. 00:02:40.860 --> 00:02:42.640 align:middle line:90% $1 buys more than $1. 00:02:42.640 --> 00:02:44.580 align:middle line:90% This is less than 1. 00:02:44.580 --> 00:02:46.700 align:middle line:90% So it blows up my return. 00:02:46.700 --> 00:02:49.860 align:middle line:84% But then that blown-up return is knocked down by the tax rate. 00:02:49.860 --> 00:02:52.362 align:middle line:84% So two things are going on to my rate of return. 00:02:52.362 --> 00:02:53.820 align:middle line:84% I'm getting a higher rate of return 00:02:53.820 --> 00:02:56.028 align:middle line:84% than I might have thought because my dollar is buying 00:02:56.028 --> 00:02:58.150 align:middle line:84% more than $1, because I'm getting these rebates, 00:02:58.150 --> 00:03:00.650 align:middle line:84% but a lower rate of return, because the government is taking 00:03:00.650 --> 00:03:02.290 align:middle line:90% a share. 00:03:02.290 --> 00:03:04.530 align:middle line:84% What that means is the effective tax 00:03:04.530 --> 00:03:09.070 align:middle line:84% rate is the-- so this is what happens after taxes come in. 00:03:09.070 --> 00:03:10.590 align:middle line:90% What's my effective tax rate? 00:03:10.590 --> 00:03:12.090 align:middle line:84% Well, it's what I would have gotten 00:03:12.090 --> 00:03:19.120 align:middle line:84% without taxes, which is MPK, minus what I get with taxes. 00:03:19.120 --> 00:03:20.870 align:middle line:84% It's what I would have gotten without tax. 00:03:20.870 --> 00:03:25.090 align:middle line:84% I would have gotten MP sub K. Now I get this beast with taxes. 00:03:25.090 --> 00:03:27.210 align:middle line:84% So what that means is, what is the effective tax 00:03:27.210 --> 00:03:28.070 align:middle line:90% rate equivalent to? 00:03:28.070 --> 00:03:30.050 align:middle line:84% Well, if you do the math on this, 00:03:30.050 --> 00:03:31.770 align:middle line:84% you end up finding that the effective tax 00:03:31.770 --> 00:03:33.570 align:middle line:90% rate can be written as-- 00:03:33.570 --> 00:03:35.150 align:middle line:84% I want to make sure I get this right, 00:03:35.150 --> 00:03:38.810 align:middle line:84% because I've already made this difficult enough. 00:03:38.810 --> 00:03:40.370 align:middle line:84% The effective tax rate can be written 00:03:40.370 --> 00:03:49.570 align:middle line:84% as tau minus tau Z minus alpha over 1 minus tau Z minus alpha. 00:03:49.570 --> 00:03:51.270 align:middle line:90% That is the effective tax rate. 00:03:51.270 --> 00:03:53.290 align:middle line:90% That's just basically take 1-- 00:03:53.290 --> 00:03:54.790 align:middle line:90% you basically subtract this. 00:03:54.790 --> 00:03:58.810 align:middle line:84% You pull MPK out, take 1 minus this thing, rearrange, 00:03:58.810 --> 00:04:00.970 align:middle line:90% and you get this term-- 00:04:00.970 --> 00:04:02.150 align:middle line:90% this ugly-looking term. 00:04:02.150 --> 00:04:04.130 align:middle line:84% But let's just stare at this for a minute. 00:04:04.130 --> 00:04:05.150 align:middle line:90% What does this mean? 00:04:05.150 --> 00:04:10.130 align:middle line:84% Let's imagine a world where Z is 0 and alpha is 0. 00:04:10.130 --> 00:04:12.410 align:middle line:84% Then what's the effective tax rate? 00:04:12.410 --> 00:04:14.310 align:middle line:90% Tau, right? 00:04:14.310 --> 00:04:19.810 align:middle line:84% That's the effective reduction in your rate of return. 00:04:19.810 --> 00:04:23.970 align:middle line:84% But as alpha gets positive and Z gets positive, 00:04:23.970 --> 00:04:27.050 align:middle line:90% the effective tax rate falls. 00:04:27.050 --> 00:04:27.610 align:middle line:90% OK? 00:04:27.610 --> 00:04:28.318 align:middle line:90% Why does it fall? 00:04:28.318 --> 00:04:31.910 align:middle line:84% Because you're losing it in the denominator. 00:04:31.910 --> 00:04:33.330 align:middle line:90% It's causing it to fall. 00:04:33.330 --> 00:04:36.970 align:middle line:84% So basically, as alpha gets positive and Z gets positive, 00:04:36.970 --> 00:04:39.210 align:middle line:90% your effective tax rate falls. 00:04:39.210 --> 00:04:42.490 align:middle line:84% So for example, with an alpha of 0-- 00:04:42.490 --> 00:04:51.450 align:middle line:84% let's say that tau was 35% and let's say that Z is 50%. 00:04:51.450 --> 00:04:54.138 align:middle line:84% So the depreciation deduction would be 50%. 00:04:54.138 --> 00:04:55.680 align:middle line:84% The PDV of the depreciation deduction 00:04:55.680 --> 00:04:57.078 align:middle line:90% is 50% of the purchase price. 00:04:57.078 --> 00:04:58.620 align:middle line:84% So every dollar of investment I make, 00:04:58.620 --> 00:05:01.280 align:middle line:84% I'm going to get $0.50 back in present value depreciation 00:05:01.280 --> 00:05:02.320 align:middle line:90% deductions. 00:05:02.320 --> 00:05:04.440 align:middle line:84% What that means is the effective tax rate, 00:05:04.440 --> 00:05:08.443 align:middle line:84% if you put these two in this formula, is 11.7%. 00:05:08.443 --> 00:05:10.360 align:middle line:84% That means that after you account for the fact 00:05:10.360 --> 00:05:12.760 align:middle line:84% you get depreciation deduction, really 00:05:12.760 --> 00:05:15.200 align:middle line:84% you're only paying 11.7% of your income 00:05:15.200 --> 00:05:18.660 align:middle line:84% in taxes on that marginal dollar of investment. 00:05:18.660 --> 00:05:22.012 align:middle line:84% So the marginal dollar of investment yields MPK. 00:05:22.012 --> 00:05:23.220 align:middle line:90% Some of that gets taken away. 00:05:23.220 --> 00:05:24.660 align:middle line:84% Some gets given back in a rebate. 00:05:24.660 --> 00:05:27.800 align:middle line:84% When you put it all together, that dollar of investment 00:05:27.800 --> 00:05:29.180 align:middle line:90% is taxed at 11.7%. 00:05:29.180 --> 00:05:29.680 align:middle line:90% Yeah. 00:05:29.680 --> 00:05:31.560 align:middle line:84% AUDIENCE: What does alpha represent again? 00:05:31.560 --> 00:05:32.477 align:middle line:90% JON GRUBER: I'm sorry. 00:05:32.477 --> 00:05:33.940 align:middle line:84% Alpha is the investment tax credit. 00:05:33.940 --> 00:05:36.315 align:middle line:84% It's like a rebate you get for-- you get alpha cents back 00:05:36.315 --> 00:05:37.880 align:middle line:90% on every dollar of investment. 00:05:37.880 --> 00:05:40.020 align:middle line:84% OK, does that make sense to folks? 00:05:40.020 --> 00:05:40.980 align:middle line:90% Please ask questions. 00:05:40.980 --> 00:05:41.480 align:middle line:90% Yeah. 00:05:41.480 --> 00:05:44.400 align:middle line:84% AUDIENCE: What's the intuition or logic behind dividing 00:05:44.400 --> 00:05:45.560 align:middle line:90% by the term in the bottom? 00:05:45.560 --> 00:05:45.980 align:middle line:90% JON GRUBER: Oh, yeah. 00:05:45.980 --> 00:05:47.215 align:middle line:90% This is what's confusing. 00:05:47.215 --> 00:05:48.340 align:middle line:90% It's different in the book. 00:05:48.340 --> 00:05:50.673 align:middle line:84% I'm going to rewrite it in the next edition of the book. 00:05:50.673 --> 00:05:54.470 align:middle line:84% The idea is that basically this is what you get per dollar. 00:05:54.470 --> 00:05:54.990 align:middle line:90% OK? 00:05:54.990 --> 00:05:57.630 align:middle line:90% But $1 is less than $1 now. 00:05:57.630 --> 00:06:00.490 align:middle line:84% This is the discount you're getting off the price. 00:06:00.490 --> 00:06:01.870 align:middle line:84% So in some sense, the bottom line 00:06:01.870 --> 00:06:04.950 align:middle line:84% is, every time you make an investment, 00:06:04.950 --> 00:06:09.110 align:middle line:84% it costs you this and yields this. 00:06:09.110 --> 00:06:11.990 align:middle line:84% So it's what it yields over what it costs. 00:06:11.990 --> 00:06:15.510 align:middle line:84% It yields this and it costs you this. 00:06:15.510 --> 00:06:16.990 align:middle line:90% OK? 00:06:16.990 --> 00:06:18.910 align:middle line:90% Questions about that? 00:06:18.910 --> 00:06:19.425 align:middle line:90% All right. 00:06:19.425 --> 00:06:21.050 align:middle line:84% So that's a form of effective tax rate. 00:06:21.050 --> 00:06:22.210 align:middle line:90% Here's the key point. 00:06:22.210 --> 00:06:24.590 align:middle line:90% What do you get if Z-- 00:06:24.590 --> 00:06:27.130 align:middle line:84% what do you get if Z equals 1 and alpha equals 0? 00:06:27.130 --> 00:06:30.450 align:middle line:90% What's the effective tax rate? 00:06:30.450 --> 00:06:31.470 align:middle line:90% Yeah. 00:06:31.470 --> 00:06:32.050 align:middle line:90% 0. 00:06:32.050 --> 00:06:36.238 align:middle line:84% If Z equals 1, then the numerator is 0. 00:06:36.238 --> 00:06:37.530 align:middle line:90% So the effective tax rate is 0. 00:06:37.530 --> 00:06:41.070 align:middle line:84% So with expensing, literally there's 00:06:41.070 --> 00:06:43.190 align:middle line:90% no tax burden on investment. 00:06:43.190 --> 00:06:46.750 align:middle line:84% Because basically I tax you on it, but I let you deduct it. 00:06:46.750 --> 00:06:49.150 align:middle line:90% So there's no tax burden. 00:06:49.150 --> 00:06:52.860 align:middle line:84% And if alpha was also positive, the effective tax rate 00:06:52.860 --> 00:06:54.740 align:middle line:90% would be negative. 00:06:54.740 --> 00:06:59.740 align:middle line:84% So with an alpha of 0.1 and a Z of 1, 00:06:59.740 --> 00:07:04.180 align:middle line:84% the effective tax rate is minus 14%. 00:07:04.180 --> 00:07:09.040 align:middle line:84% So the point is, because of the way they set up the tax system, 00:07:09.040 --> 00:07:11.180 align:middle line:84% it can actually incentivize-- literally, 00:07:11.180 --> 00:07:14.700 align:middle line:84% the US tax code can incentivize investment. 00:07:14.700 --> 00:07:15.780 align:middle line:90% And how can it do so? 00:07:15.780 --> 00:07:18.460 align:middle line:84% By effectively making the price of investment 00:07:18.460 --> 00:07:21.620 align:middle line:84% less than-- makes it less than free-- better than free, 00:07:21.620 --> 00:07:23.500 align:middle line:84% from, a tax perspective because you 00:07:23.500 --> 00:07:26.320 align:middle line:84% get this depreciation deduction plus investment tax credit. 00:07:26.320 --> 00:07:26.980 align:middle line:90% Yeah. 00:07:26.980 --> 00:07:28.680 align:middle line:84% AUDIENCE: So tau is the corporate income tax. 00:07:28.680 --> 00:07:29.060 align:middle line:90% JON GRUBER: Yes. 00:07:29.060 --> 00:07:30.840 align:middle line:84% AUDIENCE: And this is how that affects investment. 00:07:30.840 --> 00:07:31.540 align:middle line:90% JON GRUBER: Yes. 00:07:31.540 --> 00:07:32.380 align:middle line:90% Yes. 00:07:32.380 --> 00:07:34.260 align:middle line:90% Good clarifications. 00:07:34.260 --> 00:07:36.980 align:middle line:84% So basically, this is for the dollar of investment, 00:07:36.980 --> 00:07:38.300 align:middle line:90% what are you getting back? 00:07:38.300 --> 00:07:40.940 align:middle line:84% The point is, what you're getting back-- 00:07:40.940 --> 00:07:44.420 align:middle line:84% what is the difference between what you get back in a world 00:07:44.420 --> 00:07:47.280 align:middle line:84% without taxation and a world with taxation? 00:07:47.280 --> 00:07:48.060 align:middle line:90% That's the key. 00:07:48.060 --> 00:07:49.740 align:middle line:84% It's the difference between what you get back in a world 00:07:49.740 --> 00:07:51.323 align:middle line:84% without taxation and what you get back 00:07:51.323 --> 00:07:53.010 align:middle line:90% in a world with taxation. 00:07:53.010 --> 00:07:55.690 align:middle line:84% That difference is this function, which 00:07:55.690 --> 00:07:58.250 align:middle line:90% can be positive or negative. 00:07:58.250 --> 00:08:05.330 align:middle line:84% So basically, we have a situation where-- 00:08:05.330 --> 00:08:07.325 align:middle line:84% now, the question is, what's the right level? 00:08:07.325 --> 00:08:09.950 align:middle line:84% How do we think about what the right level of corporate tax is? 00:08:09.950 --> 00:08:11.700 align:middle line:84% Well, that essentially is going to go back 00:08:11.700 --> 00:08:13.690 align:middle line:84% to how we think about optimal tax. 00:08:13.690 --> 00:08:16.490 align:middle line:84% From an efficiency perspective, it's 00:08:16.490 --> 00:08:19.010 align:middle line:84% going to depend on what's the efficiency 00:08:19.010 --> 00:08:23.107 align:middle line:90% cost of reducing investment. 00:08:23.107 --> 00:08:24.690 align:middle line:84% From an equity perspective, it's going 00:08:24.690 --> 00:08:26.732 align:middle line:84% to be the fact that corporate taxes are generally 00:08:26.732 --> 00:08:28.118 align:middle line:90% paid by wealthier people. 00:08:28.118 --> 00:08:30.410 align:middle line:84% So it'll be an equity efficiency trade-off with cutting 00:08:30.410 --> 00:08:31.890 align:middle line:90% corporate taxation. 00:08:31.890 --> 00:08:35.110 align:middle line:84% What I got to last time was there's an extra wrinkle. 00:08:35.110 --> 00:08:37.850 align:middle line:84% And this is subtle, but, it's important to recognize, 00:08:37.850 --> 00:08:41.980 align:middle line:84% which is when I introduce an alpha today, that 00:08:41.980 --> 00:08:43.730 align:middle line:84% rewards all future investment, but doesn't 00:08:43.730 --> 00:08:47.470 align:middle line:84% do any good to the people who had old investments. 00:08:47.470 --> 00:08:50.080 align:middle line:90% When I cut tau, everybody wins. 00:08:50.080 --> 00:08:52.040 align:middle line:90% So it's more expensive. 00:08:52.040 --> 00:08:55.880 align:middle line:84% For the same boom in investment, it's more expensive to cut tau 00:08:55.880 --> 00:08:57.120 align:middle line:90% than to introduce an alpha. 00:08:57.120 --> 00:09:00.400 align:middle line:84% For the same budget cost, if I have a budget-neutral cut 00:09:00.400 --> 00:09:01.900 align:middle line:84% in tau in the structure of alpha, 00:09:01.900 --> 00:09:04.080 align:middle line:84% I get a much bigger bang for the buck for the alpha 00:09:04.080 --> 00:09:05.997 align:middle line:84% because that promotes forward-going investment 00:09:05.997 --> 00:09:08.480 align:middle line:84% and doesn't reward all the investment made in the past. 00:09:08.480 --> 00:09:09.880 align:middle line:90% OK? 00:09:09.880 --> 00:09:11.280 align:middle line:90% Questions about that? 00:09:11.280 --> 00:09:12.000 align:middle line:90% Yeah. 00:09:12.000 --> 00:09:14.440 align:middle line:84% AUDIENCE: With a negative effective tax rate, 00:09:14.440 --> 00:09:16.880 align:middle line:84% that means the government is literally paying you? 00:09:16.880 --> 00:09:19.380 align:middle line:84% JON GRUBER: Subsidizing investment, 00:09:19.380 --> 00:09:21.160 align:middle line:90% which it's not implausible. 00:09:21.160 --> 00:09:23.380 align:middle line:84% Investment yields growth and jobs. 00:09:23.380 --> 00:09:25.737 align:middle line:84% And it's not crazy, you'd have a subsidy to investment. 00:09:25.737 --> 00:09:27.820 align:middle line:84% AUDIENCE: But is this off of each marginal dollar, 00:09:27.820 --> 00:09:28.762 align:middle line:90% like each more-- 00:09:28.762 --> 00:09:30.220 align:middle line:84% JON GRUBER: Each additional dollar, 00:09:30.220 --> 00:09:32.000 align:middle line:84% you're actually going to-- literally, 00:09:32.000 --> 00:09:33.560 align:middle line:84% you'll make more money from investing 00:09:33.560 --> 00:09:36.400 align:middle line:90% with taxes than without it. 00:09:36.400 --> 00:09:37.700 align:middle line:90% OK, great. 00:09:37.700 --> 00:09:40.507 align:middle line:84% So trying again, I think that's clearly what's in the book. 00:09:40.507 --> 00:09:42.340 align:middle line:84% And I'm going to change it the next edition. 00:09:42.340 --> 00:09:46.640 align:middle line:84% OK, now that gets even harder when we recognize that companies 00:09:46.640 --> 00:09:48.190 align:middle line:84% don't exist just in the US, but exist 00:09:48.190 --> 00:09:49.315 align:middle line:90% in the international world. 00:09:49.315 --> 00:09:52.830 align:middle line:84% In particular, many firms are multinational firms. 00:09:52.830 --> 00:09:54.630 align:middle line:84% And they have subsidiaries abroad, 00:09:54.630 --> 00:09:56.270 align:middle line:84% which are parts of their business 00:09:56.270 --> 00:10:00.430 align:middle line:90% which are headquartered abroad. 00:10:00.430 --> 00:10:01.790 align:middle line:90% OK? 00:10:01.790 --> 00:10:04.450 align:middle line:90% And this complicates taxes. 00:10:04.450 --> 00:10:08.030 align:middle line:84% So General Electric in 2010 had worldwide profits 00:10:08.030 --> 00:10:14.390 align:middle line:84% of $14.2 billion, of which $5.1 billion came from the US. 00:10:14.390 --> 00:10:17.870 align:middle line:84% OK? $14.1 billion, $5 billion in the US. 00:10:17.870 --> 00:10:21.630 align:middle line:84% Total US taxes paid, negative $2 billion. 00:10:21.630 --> 00:10:23.350 align:middle line:90% They got a rebate in the US. 00:10:23.350 --> 00:10:24.690 align:middle line:90% How the hell was that possible? 00:10:24.690 --> 00:10:27.110 align:middle line:84% Well, let's now talk about international taxation. 00:10:27.110 --> 00:10:29.440 align:middle line:84% When we talk about international taxation, 00:10:29.440 --> 00:10:31.190 align:middle line:84% there are fundamentally two different ways 00:10:31.190 --> 00:10:33.270 align:middle line:84% you can tax international companies. 00:10:33.270 --> 00:10:35.510 align:middle line:84% There's what's called a territorial system 00:10:35.510 --> 00:10:37.270 align:middle line:90% and a global system. 00:10:37.270 --> 00:10:40.070 align:middle line:84% A territorial system is a system where literally you're 00:10:40.070 --> 00:10:42.990 align:middle line:84% just taxed on what you make in that country. 00:10:42.990 --> 00:10:45.970 align:middle line:84% So literally, whatever you make in that country, 00:10:45.970 --> 00:10:47.770 align:middle line:84% you pay tax on it in that country. 00:10:47.770 --> 00:10:50.430 align:middle line:84% What you make in another country you pay tax in that country. 00:10:50.430 --> 00:10:52.470 align:middle line:84% A global system is one where you're 00:10:52.470 --> 00:10:55.710 align:middle line:84% taxed based on where your headquarters is, basically. 00:10:55.710 --> 00:10:59.270 align:middle line:84% So essentially, if a multinational company-- if GE 00:10:59.270 --> 00:11:04.070 align:middle line:84% makes money around the world, it's taxed in the US. 00:11:04.070 --> 00:11:11.950 align:middle line:84% Now basically, what is the big issue with these systems? 00:11:11.950 --> 00:11:13.870 align:middle line:84% The big issue with these systems is 00:11:13.870 --> 00:11:16.090 align:middle line:84% that when you produce in many countries, 00:11:16.090 --> 00:11:19.930 align:middle line:84% it is hard to figure out where profit comes from. 00:11:19.930 --> 00:11:21.430 align:middle line:84% And in particular, we have a problem 00:11:21.430 --> 00:11:23.930 align:middle line:84% of what's called transfer pricing. 00:11:23.930 --> 00:11:28.017 align:middle line:90% 00:11:28.017 --> 00:11:30.350 align:middle line:84% This is for our friend in the back who likes all the fun 00:11:30.350 --> 00:11:31.558 align:middle line:90% tricks you can do with taxes. 00:11:31.558 --> 00:11:34.070 align:middle line:84% This will be another fun one for you. 00:11:34.070 --> 00:11:39.670 align:middle line:84% OK, so imagine that France has a 40% tax on corporate profits. 00:11:39.670 --> 00:11:50.260 align:middle line:84% So imagine in France the tax is 40% and in the US it's 21%. 00:11:50.260 --> 00:11:51.900 align:middle line:90% OK? 00:11:51.900 --> 00:11:55.780 align:middle line:84% Now, imagine further that an American company 00:11:55.780 --> 00:11:59.540 align:middle line:84% is a French subsidiary that manufactures microchips 00:11:59.540 --> 00:12:01.260 align:middle line:90% at a cost of $100 each. 00:12:01.260 --> 00:12:06.820 align:middle line:84% So the manufacturing cost is $100 and it's in France. 00:12:06.820 --> 00:12:10.060 align:middle line:84% They make it in France and it costs $100. 00:12:10.060 --> 00:12:14.980 align:middle line:84% They then transfer those microchips to the US, 00:12:14.980 --> 00:12:17.060 align:middle line:90% where in the US-- 00:12:17.060 --> 00:12:20.620 align:middle line:84% the manufacturing costs, and then the remaining costs 00:12:20.620 --> 00:12:23.465 align:middle line:90% are another $500. 00:12:23.465 --> 00:12:24.840 align:middle line:84% You put the chip in the computer, 00:12:24.840 --> 00:12:26.900 align:middle line:84% you put the computer together, et cetera. 00:12:26.900 --> 00:12:31.940 align:middle line:84% And then after that, you sell for $1,000. 00:12:31.940 --> 00:12:36.620 align:middle line:84% So you've put $100 of cost in i France, $500 in the US, 00:12:36.620 --> 00:12:39.700 align:middle line:84% and you sell for $1,000 for $400 profit. 00:12:39.700 --> 00:12:46.770 align:middle line:84% Now, let's say the question is, who does the profit belong to? 00:12:46.770 --> 00:12:48.010 align:middle line:90% It's not obvious. 00:12:48.010 --> 00:12:52.050 align:middle line:84% So the US company could say that the profit all 00:12:52.050 --> 00:12:53.910 align:middle line:84% is due to what was produced in France. 00:12:53.910 --> 00:12:56.970 align:middle line:84% It wouldn't exist without the original manufacturing 00:12:56.970 --> 00:12:58.030 align:middle line:90% costs on the chip. 00:12:58.030 --> 00:13:01.090 align:middle line:90% 00:13:01.090 --> 00:13:03.130 align:middle line:90% Let's call this the chip cost. 00:13:03.130 --> 00:13:05.930 align:middle line:84% The chip cost, and this is the rest. 00:13:05.930 --> 00:13:07.230 align:middle line:90% The chip costs $100. 00:13:07.230 --> 00:13:09.688 align:middle line:84% Look, we wouldn't have earned this profit without the chip. 00:13:09.688 --> 00:13:15.010 align:middle line:84% So we're going to say that we are going to assume 00:13:15.010 --> 00:13:16.190 align:middle line:90% the profits were in France. 00:13:16.190 --> 00:13:20.142 align:middle line:84% So we're going to say that chip was actually worth $500. 00:13:20.142 --> 00:13:22.850 align:middle line:84% It only cost $100 to produce it, but I wouldn't have had the $400 00:13:22.850 --> 00:13:23.910 align:middle line:90% profit without it. 00:13:23.910 --> 00:13:28.450 align:middle line:84% So I'm going to claim a $500 expense in France, 00:13:28.450 --> 00:13:29.490 align:middle line:90% because why not? 00:13:29.490 --> 00:13:30.630 align:middle line:90% I can do that. 00:13:30.630 --> 00:13:33.130 align:middle line:84% OK, I'm going to claim a $500 expense in France. 00:13:33.130 --> 00:13:40.330 align:middle line:84% That means that the French company would pay $160 in taxes. 00:13:40.330 --> 00:13:43.960 align:middle line:84% So in this world, the French company would pay taxes on $400. 00:13:43.960 --> 00:13:47.240 align:middle line:90% A 40%, that's $160 in taxes. 00:13:47.240 --> 00:13:52.480 align:middle line:84% And the American company would have no profits. 00:13:52.480 --> 00:13:54.480 align:middle line:90% And so they'd pay no tax. 00:13:54.480 --> 00:13:57.720 align:middle line:84% So you'd pay $160 in tax because you 00:13:57.720 --> 00:14:01.400 align:middle line:84% would have $400 in profits located in France. 00:14:01.400 --> 00:14:04.240 align:middle line:90% OK, questions about that? 00:14:04.240 --> 00:14:05.680 align:middle line:90% Let's do the other extreme. 00:14:05.680 --> 00:14:08.500 align:middle line:84% Let's imagine this company said, no, chips are chips, whatever. 00:14:08.500 --> 00:14:11.320 align:middle line:84% It wouldn't exist without good old USA production putting 00:14:11.320 --> 00:14:12.300 align:middle line:90% the thing together. 00:14:12.300 --> 00:14:15.040 align:middle line:84% So all the profits are earned in the US. 00:14:15.040 --> 00:14:18.160 align:middle line:84% Now, if all the profits are earned in the US, 00:14:18.160 --> 00:14:21.720 align:middle line:84% then that means there's $400 in profits in the US. 00:14:21.720 --> 00:14:25.600 align:middle line:90% What do we pay in taxes? $81. 00:14:25.600 --> 00:14:28.600 align:middle line:84% So basically, we can cut our taxes in half 00:14:28.600 --> 00:14:32.020 align:middle line:84% by claiming the profits are due to the production in the US, 00:14:32.020 --> 00:14:32.840 align:middle line:90% not France. 00:14:32.840 --> 00:14:34.360 align:middle line:90% Well, who's to say? 00:14:34.360 --> 00:14:36.800 align:middle line:84% The answer is, tax lawyers are to say, 00:14:36.800 --> 00:14:39.240 align:middle line:84% and you know my feeling on lawyers. 00:14:39.240 --> 00:14:39.760 align:middle line:90% OK? 00:14:39.760 --> 00:14:43.790 align:middle line:84% Lovely people, just it's a lot of work to basically figure out 00:14:43.790 --> 00:14:46.710 align:middle line:84% how to make the profits land in the place 00:14:46.710 --> 00:14:49.310 align:middle line:84% where it gets you the best tax deal. 00:14:49.310 --> 00:14:56.053 align:middle line:84% As a result, you basically have this problem of transfer pricing 00:14:56.053 --> 00:14:57.970 align:middle line:84% that it's hard to know where the profits land. 00:14:57.970 --> 00:14:59.412 align:middle line:84% Now, tax authorities aren't dumb. 00:14:59.412 --> 00:15:00.870 align:middle line:84% They know about this, and they have 00:15:00.870 --> 00:15:03.475 align:middle line:84% what's called arm's length transaction laws, where 00:15:03.475 --> 00:15:05.350 align:middle line:84% you couldn't actually send the French company 00:15:05.350 --> 00:15:08.025 align:middle line:84% $500 for the chip, because nobody pays $500 for a chip. 00:15:08.025 --> 00:15:09.650 align:middle line:84% So they'd say, look, you can't do that, 00:15:09.650 --> 00:15:12.650 align:middle line:84% but you could send them-- or you couldn't put it all in the US. 00:15:12.650 --> 00:15:14.310 align:middle line:84% And more importantly, you couldn't put it all in the US 00:15:14.310 --> 00:15:15.990 align:middle line:84% and say, look, you got to attribute some of the profit 00:15:15.990 --> 00:15:16.490 align:middle line:90% to the chip. 00:15:16.490 --> 00:15:19.032 align:middle line:84% You could contribute a small share of the profit to the chip. 00:15:19.032 --> 00:15:20.190 align:middle line:90% It's hard to know how much. 00:15:20.190 --> 00:15:23.310 align:middle line:84% And remember, when you have this important thing about tax 00:15:23.310 --> 00:15:25.990 align:middle line:84% enforcement we'll talk about this lecture and next lecture, 00:15:25.990 --> 00:15:27.750 align:middle line:84% you have underpaid government tax 00:15:27.750 --> 00:15:30.135 align:middle line:84% lawyers fighting highly paid people whose job it 00:15:30.135 --> 00:15:31.010 align:middle line:90% is to minimize taxes. 00:15:31.010 --> 00:15:33.390 align:middle line:84% That's something the government is always going to lose. 00:15:33.390 --> 00:15:35.910 align:middle line:84% There's a challenge there to try to fight that battle. 00:15:35.910 --> 00:15:40.050 align:middle line:84% So basically that is an example-- 00:15:40.050 --> 00:15:42.460 align:middle line:84% so an example is GlaxoSmithKline, the drug 00:15:42.460 --> 00:15:45.800 align:middle line:90% company, produces Zantac. 00:15:45.800 --> 00:15:47.780 align:middle line:90% You've all heard of Zantac. 00:15:47.780 --> 00:15:51.100 align:middle line:84% And they produce it in many countries. 00:15:51.100 --> 00:15:54.740 align:middle line:84% And at this time, the US was a much higher taxed country 00:15:54.740 --> 00:15:55.780 align:middle line:90% than the UK. 00:15:55.780 --> 00:15:58.900 align:middle line:84% So they shifted profits to the UK. 00:15:58.900 --> 00:16:05.380 align:middle line:84% And the government basically eventually found 00:16:05.380 --> 00:16:08.620 align:middle line:84% that they'd underpaid about $5.2 billion 00:16:08.620 --> 00:16:11.040 align:middle line:84% in taxes by misstating the profits attributed to the UK, 00:16:11.040 --> 00:16:13.140 align:middle line:84% and eventually sued and won on that. 00:16:13.140 --> 00:16:16.980 align:middle line:84% Now, that is a good example of the government figuring this 00:16:16.980 --> 00:16:17.580 align:middle line:90% out. 00:16:17.580 --> 00:16:18.880 align:middle line:84% I have great examples in the book. 00:16:18.880 --> 00:16:19.720 align:middle line:84% I don't have time to go through them. 00:16:19.720 --> 00:16:20.160 align:middle line:90% It's so much fun. 00:16:20.160 --> 00:16:22.540 align:middle line:84% But let's talk about the most fun one, which is Apple. 00:16:22.540 --> 00:16:33.180 align:middle line:84% In 2011, Apple made 70% of its $34.2 billion in pre-tax profits 00:16:33.180 --> 00:16:39.370 align:middle line:84% abroad and paid a tax rate of 2.2% on those. 00:16:39.370 --> 00:16:42.210 align:middle line:84% And basically they're saying-- there were $74 billion 00:16:42.210 --> 00:16:44.250 align:middle line:90% they made in profits abroad. 00:16:44.250 --> 00:16:50.450 align:middle line:84% They said that basically between 2009 and 2012, only $74 billion 00:16:50.450 --> 00:16:53.490 align:middle line:84% in profits that were taxed abroad that theoretically 00:16:53.490 --> 00:16:55.010 align:middle line:90% could have been taxed at home. 00:16:55.010 --> 00:16:56.167 align:middle line:90% How did they do this? 00:16:56.167 --> 00:16:58.250 align:middle line:84% Well, they're very creative because they're Apple. 00:16:58.250 --> 00:16:59.750 align:middle line:90% OK, what do they do? 00:16:59.750 --> 00:17:01.290 align:middle line:90% They go to Ireland. 00:17:01.290 --> 00:17:03.650 align:middle line:84% Ireland has essentially no corporate tax rate. 00:17:03.650 --> 00:17:05.569 align:middle line:84% They're what we call a tax haven. 00:17:05.569 --> 00:17:08.290 align:middle line:84% They try to encourage activity there by having no tax rate. 00:17:08.290 --> 00:17:11.891 align:middle line:84% So basically, Apple made $34 billion in 2011. 00:17:11.891 --> 00:17:13.849 align:middle line:84% The numbers aren't important, just the concept. 00:17:13.849 --> 00:17:17.050 align:middle line:84% Made $34 billion in 2011 and reported 00:17:17.050 --> 00:17:20.130 align:middle line:84% that its Japanese subsidiary-- even though Japan is where 00:17:20.130 --> 00:17:21.510 align:middle line:90% they sell a ton of their stuff. 00:17:21.510 --> 00:17:23.760 align:middle line:84% If you've been in Japan, there's a lot of Apple stuff. 00:17:23.760 --> 00:17:26.550 align:middle line:84% They only made $150 million in Japan, 00:17:26.550 --> 00:17:28.490 align:middle line:84% even though it's one of their biggest markets. 00:17:28.490 --> 00:17:31.170 align:middle line:84% Instead, they reported $22 billion 00:17:31.170 --> 00:17:32.810 align:middle line:84% in income in Ireland, which would 00:17:32.810 --> 00:17:35.250 align:middle line:84% be like six iPhones per person in Ireland. 00:17:35.250 --> 00:17:38.510 align:middle line:90% Now, they've gone further. 00:17:38.510 --> 00:17:43.710 align:middle line:84% They now have AOI, Apple Operations International. 00:17:43.710 --> 00:17:46.493 align:middle line:84% It owns all of Apple's offshore production. 00:17:46.493 --> 00:17:48.410 align:middle line:84% AOI is a holding company that owns all Apple's 00:17:48.410 --> 00:17:49.730 align:middle line:90% offshore production. 00:17:49.730 --> 00:17:55.890 align:middle line:84% But AOI has no physical presence and no employees 00:17:55.890 --> 00:17:57.730 align:middle line:90% except for one Irish employee. 00:17:57.730 --> 00:18:02.950 align:middle line:84% Because it's not managed or controlled in Ireland, 00:18:02.950 --> 00:18:05.050 align:middle line:84% Ireland does not recognize it as tax residency. 00:18:05.050 --> 00:18:06.830 align:middle line:84% Because it's not incorporated in the US, 00:18:06.830 --> 00:18:09.870 align:middle line:84% the US doesn't recognize tax residency. 00:18:09.870 --> 00:18:12.450 align:middle line:84% So basically, they created this thing that exists in limbo 00:18:12.450 --> 00:18:14.650 align:middle line:90% and paid no tax. 00:18:14.650 --> 00:18:19.475 align:middle line:84% Eventually they got caught and they got paid a little bit, 00:18:19.475 --> 00:18:21.350 align:middle line:84% but nothing as much as they should have owed. 00:18:21.350 --> 00:18:22.130 align:middle line:90% Yeah. 00:18:22.130 --> 00:18:24.495 align:middle line:84% AUDIENCE: How can you create a corporation-- 00:18:24.495 --> 00:18:25.870 align:middle line:84% JON GRUBER: I'm not a tax lawyer. 00:18:25.870 --> 00:18:27.610 align:middle line:90% I'm not a tax lawyer. 00:18:27.610 --> 00:18:29.070 align:middle line:90% Don't try to figure it out. 00:18:29.070 --> 00:18:31.690 align:middle line:84% No matter what you figure out, they're smarter than you are. 00:18:31.690 --> 00:18:32.210 align:middle line:90% AUDIENCE: It doesn't exist? 00:18:32.210 --> 00:18:33.630 align:middle line:90% JON GRUBER: It doesn't exist. 00:18:33.630 --> 00:18:35.930 align:middle line:84% That's the point, is that basically there's all-- 00:18:35.930 --> 00:18:37.880 align:middle line:84% international taxation is incredibly hard 00:18:37.880 --> 00:18:40.582 align:middle line:84% because it's hard to talk about where money comes from when 00:18:40.582 --> 00:18:42.040 align:middle line:84% you're selling things and producing 00:18:42.040 --> 00:18:43.800 align:middle line:90% things in different countries. 00:18:43.800 --> 00:18:47.720 align:middle line:84% So now, with that in mind, what are the relevant policy issues? 00:18:47.720 --> 00:18:51.400 align:middle line:84% Well, a big policy issue is basically, 00:18:51.400 --> 00:18:55.620 align:middle line:84% should we have our global system-- in fact, 00:18:55.620 --> 00:18:58.240 align:middle line:90% the US was virtually alone. 00:18:58.240 --> 00:19:03.200 align:middle line:84% Before the Trump tax cuts 2017, the US had a global tax system. 00:19:03.200 --> 00:19:04.490 align:middle line:90% What that meant was-- 00:19:04.490 --> 00:19:05.740 align:middle line:90% and by the way, we were alone. 00:19:05.740 --> 00:19:07.420 align:middle line:84% Every other country in the world had a territorial tax. 00:19:07.420 --> 00:19:09.740 align:middle line:84% Every other major country had a territorial tax system. 00:19:09.740 --> 00:19:11.440 align:middle line:84% You're taxed on what you made there. 00:19:11.440 --> 00:19:13.520 align:middle line:90% The US had a global system. 00:19:13.520 --> 00:19:15.970 align:middle line:84% Now, if you have a true global system 00:19:15.970 --> 00:19:17.720 align:middle line:84% and people are taxed on where they produce 00:19:17.720 --> 00:19:19.500 align:middle line:84% and taxed in the US, that would be double taxation. 00:19:19.500 --> 00:19:20.060 align:middle line:90% That's unfair. 00:19:20.060 --> 00:19:21.960 align:middle line:84% So what we did is we offered what was called a foreign tax 00:19:21.960 --> 00:19:22.698 align:middle line:90% credit. 00:19:22.698 --> 00:19:24.240 align:middle line:84% So the way it works is we said, look, 00:19:24.240 --> 00:19:25.700 align:middle line:90% you're selling shit in France. 00:19:25.700 --> 00:19:27.040 align:middle line:90% You're paying tax to France. 00:19:27.040 --> 00:19:28.623 align:middle line:84% We're going to give you credit for all 00:19:28.623 --> 00:19:29.800 align:middle line:90% the tax you pay in France. 00:19:29.800 --> 00:19:31.967 align:middle line:84% Anything that's left over, you'll owe the US. 00:19:31.967 --> 00:19:33.800 align:middle line:84% So basically say, whatever profits you made, 00:19:33.800 --> 00:19:35.100 align:middle line:90% we'll level the US tax on it. 00:19:35.100 --> 00:19:37.150 align:middle line:84% But we'll give you credit for all the tax 00:19:37.150 --> 00:19:38.437 align:middle line:90% you paid to other countries. 00:19:38.437 --> 00:19:40.270 align:middle line:84% And we're going to have a global system that 00:19:40.270 --> 00:19:42.230 align:middle line:90% doesn't invoke double taxation. 00:19:42.230 --> 00:19:47.670 align:middle line:84% The problem is they only know what you made in other countries 00:19:47.670 --> 00:19:49.830 align:middle line:84% when you bring it back to the US. 00:19:49.830 --> 00:19:52.137 align:middle line:84% So you make a bunch of money in other countries. 00:19:52.137 --> 00:19:53.970 align:middle line:84% You just report it to those tax authorities. 00:19:53.970 --> 00:19:56.110 align:middle line:84% But the US company has no reason to know about it 00:19:56.110 --> 00:19:57.710 align:middle line:90% until you bring it back. 00:19:57.710 --> 00:20:01.390 align:middle line:84% So what that meant, there was a huge lock-in incentive 00:20:01.390 --> 00:20:04.310 align:middle line:84% to leave your money in other countries. 00:20:04.310 --> 00:20:06.250 align:middle line:84% Because basically, as long as it was there, 00:20:06.250 --> 00:20:09.543 align:middle line:84% you weren't paying that extra US tax from bringing it back. 00:20:09.543 --> 00:20:12.210 align:middle line:84% So there's this huge likelihood of capital gains lock-in effect. 00:20:12.210 --> 00:20:14.230 align:middle line:84% It was an international lock-in effect. 00:20:14.230 --> 00:20:21.350 align:middle line:84% So basically, if you take the $74 billion in profits 00:20:21.350 --> 00:20:24.450 align:middle line:84% that Apple avoided through low foreign taxation, 00:20:24.450 --> 00:20:27.070 align:middle line:84% if they brought it back to the US, it would have taxed it. 00:20:27.070 --> 00:20:29.668 align:middle line:84% They only paid a 2.2% tax rate on that $74 billion. 00:20:29.668 --> 00:20:31.710 align:middle line:84% We would have said, we're going to take the rest. 00:20:31.710 --> 00:20:33.407 align:middle line:90% Our rate at that point was 35%. 00:20:33.407 --> 00:20:35.240 align:middle line:84% We'll take another third of that, thank you. 00:20:35.240 --> 00:20:36.260 align:middle line:84% That would have been a nice chunk of change 00:20:36.260 --> 00:20:37.280 align:middle line:90% for the US Treasury. 00:20:37.280 --> 00:20:40.200 align:middle line:84% Instead, they just left it abroad, so we never saw it, 00:20:40.200 --> 00:20:42.180 align:middle line:90% so we never taxed it. 00:20:42.180 --> 00:20:47.740 align:middle line:84% So many people have argued that basically, we 00:20:47.740 --> 00:20:50.340 align:middle line:84% essentially already have a territorial system. 00:20:50.340 --> 00:20:52.673 align:middle line:84% That basically, yeah, in theory we have a global system. 00:20:52.673 --> 00:20:55.340 align:middle line:84% But at the end of the day, since no one brings their money back. 00:20:55.340 --> 00:20:57.000 align:middle line:84% We don't really have a global system. 00:20:57.000 --> 00:20:59.020 align:middle line:84% We have a territorial system, which is basically 00:20:59.020 --> 00:21:00.180 align:middle line:84% we should just essentially give up 00:21:00.180 --> 00:21:02.263 align:middle line:84% on trying to tax the money made in other countries 00:21:02.263 --> 00:21:04.100 align:middle line:84% because they're not bringing it back anyway. 00:21:04.100 --> 00:21:05.380 align:middle line:90% Yeah. 00:21:05.380 --> 00:21:08.380 align:middle line:84% AUDIENCE: Is that holding overseas but not reporting back 00:21:08.380 --> 00:21:09.625 align:middle line:90% to the US government illegal? 00:21:09.625 --> 00:21:11.000 align:middle line:84% JON GRUBER: No, it's not illegal. 00:21:11.000 --> 00:21:11.920 align:middle line:90% It's totally legal. 00:21:11.920 --> 00:21:13.610 align:middle line:84% And more than that-- it's totally legal-- more than 00:21:13.610 --> 00:21:14.460 align:middle line:90% that, it's bizarre. 00:21:14.460 --> 00:21:19.443 align:middle line:84% So a big argument you heard for changing our tax system 00:21:19.443 --> 00:21:21.360 align:middle line:84% was there was all this money they held abroad, 00:21:21.360 --> 00:21:24.443 align:middle line:84% and they'd bring it back to the US and create all these jobs. 00:21:24.443 --> 00:21:26.360 align:middle line:84% Paul Krugman was very good at explaining this. 00:21:26.360 --> 00:21:27.040 align:middle line:90% Let's be clear. 00:21:27.040 --> 00:21:28.780 align:middle line:84% It was literally in the same bank. 00:21:28.780 --> 00:21:29.980 align:middle line:90% It was in a bank. 00:21:29.980 --> 00:21:32.120 align:middle line:84% On one side was called Apple foreign profits. 00:21:32.120 --> 00:21:33.975 align:middle line:84% Another side was called Apple US profits. 00:21:33.975 --> 00:21:35.850 align:middle line:84% When they brought it back, all they had to do 00:21:35.850 --> 00:21:37.590 align:middle line:90% was change the account number. 00:21:37.590 --> 00:21:39.990 align:middle line:84% It wasn't like they were bringing new money into America. 00:21:39.990 --> 00:21:41.407 align:middle line:84% It's just money sitting in a bank. 00:21:41.407 --> 00:21:42.690 align:middle line:90% It's which label was on it. 00:21:42.690 --> 00:21:45.112 align:middle line:84% Now you could say, well, maybe if they bring it back, 00:21:45.112 --> 00:21:47.070 align:middle line:84% then they've got to spend it in the US somehow. 00:21:47.070 --> 00:21:47.470 align:middle line:90% But they don't. 00:21:47.470 --> 00:21:49.178 align:middle line:84% They can just still leave it in the bank. 00:21:49.178 --> 00:21:49.770 align:middle line:90% Yeah. 00:21:49.770 --> 00:21:51.090 align:middle line:84% AUDIENCE: Does the lock-in prevent them 00:21:51.090 --> 00:21:53.210 align:middle line:84% from spending it in the US without paying money? 00:21:53.210 --> 00:21:54.130 align:middle line:90% Or is it-- 00:21:54.130 --> 00:21:55.550 align:middle line:84% JON GRUBER: Well, they can spend whatever they want in the US. 00:21:55.550 --> 00:21:57.930 align:middle line:84% So what they do is they take loans in the US to do stuff 00:21:57.930 --> 00:22:00.370 align:middle line:84% and they pay the loans back with money 00:22:00.370 --> 00:22:03.050 align:middle line:90% from their foreign accounts. 00:22:03.050 --> 00:22:07.030 align:middle line:84% So basically, the bottom line is people are saying, 00:22:07.030 --> 00:22:11.810 align:middle line:84% look, there was this lock-in and we should reduce it. 00:22:11.810 --> 00:22:13.670 align:middle line:84% And basically, we actually tried that. 00:22:13.670 --> 00:22:17.390 align:middle line:84% So in 2004, in the American Jobs Creation Act-- 00:22:17.390 --> 00:22:19.410 align:middle line:90% you got to love these names-- 00:22:19.410 --> 00:22:22.820 align:middle line:84% they actually essentially had a one-year tax holiday. 00:22:22.820 --> 00:22:25.070 align:middle line:84% They said, we know you guys got all this money abroad. 00:22:25.070 --> 00:22:25.653 align:middle line:90% Bring it back. 00:22:25.653 --> 00:22:29.450 align:middle line:84% This year, you only pay 5% in taxes instead of the 35%. 00:22:29.450 --> 00:22:33.200 align:middle line:84% And over the next few years, US companies 00:22:33.200 --> 00:22:37.040 align:middle line:90% repatriated $312 billion. 00:22:37.040 --> 00:22:40.718 align:middle line:84% And what they found was it created zero jobs, because it 00:22:40.718 --> 00:22:43.260 align:middle line:84% wasn't about-- they were just literally relabeling the money. 00:22:43.260 --> 00:22:44.780 align:middle line:84% They're like, OK, we don't have to keep holding it there. 00:22:44.780 --> 00:22:46.280 align:middle line:84% We can come bring it back to the US. 00:22:46.280 --> 00:22:47.018 align:middle line:90% Yeah. 00:22:47.018 --> 00:22:49.560 align:middle line:84% AUDIENCE: When we talked about lock-in with the capital gains 00:22:49.560 --> 00:22:52.680 align:middle line:84% tax that had negative impacts, does this lock-in 00:22:52.680 --> 00:22:53.780 align:middle line:90% have any negative impacts? 00:22:53.780 --> 00:22:54.960 align:middle line:90% JON GRUBER: Not really. 00:22:54.960 --> 00:22:57.760 align:middle line:84% I mean, that's the point of this argument, 00:22:57.760 --> 00:22:59.740 align:middle line:90% because it's just funny money. 00:22:59.740 --> 00:23:01.860 align:middle line:90% Now, in theory, it could. 00:23:01.860 --> 00:23:03.360 align:middle line:84% Remember I said capital is strangely 00:23:03.360 --> 00:23:04.760 align:middle line:90% immobile internationally? 00:23:04.760 --> 00:23:08.200 align:middle line:84% You could imagine a world where capital that's labeled US 00:23:08.200 --> 00:23:10.517 align:middle line:84% could actually change people's investment decisions. 00:23:10.517 --> 00:23:11.100 align:middle line:90% It's possible. 00:23:11.100 --> 00:23:12.100 align:middle line:90% In theory, it shouldn't. 00:23:12.100 --> 00:23:13.058 align:middle line:90% It's possible it could. 00:23:13.058 --> 00:23:14.840 align:middle line:84% But the tax holiday suggested it didn't. 00:23:14.840 --> 00:23:17.320 align:middle line:84% Suggested basically nothing changed when they did that. 00:23:17.320 --> 00:23:23.680 align:middle line:84% So basically, we have this tension 00:23:23.680 --> 00:23:27.342 align:middle line:84% of the fact they're keeping this money abroad. 00:23:27.342 --> 00:23:28.800 align:middle line:84% And we also have this other tension 00:23:28.800 --> 00:23:31.160 align:middle line:84% I talked about before, which is it's really not great to have 00:23:31.160 --> 00:23:32.460 align:middle line:90% tax provisions that don't work. 00:23:32.460 --> 00:23:35.475 align:middle line:84% It's undercuts the morality of the tax code 00:23:35.475 --> 00:23:37.100 align:middle line:84% to have tax provisions that don't work. 00:23:37.100 --> 00:23:39.412 align:middle line:84% And so for a long time, many economists said, look, 00:23:39.412 --> 00:23:41.120 align:middle line:84% we should just have a territorial system. 00:23:41.120 --> 00:23:42.880 align:middle line:84% And then the Trump tax cuts, we did. 00:23:42.880 --> 00:23:45.880 align:middle line:84% We moved to a territorial tax system. 00:23:45.880 --> 00:23:50.120 align:middle line:84% Now, at the same time, what the Trump tax cuts did 00:23:50.120 --> 00:23:52.045 align:middle line:84% were fundamentally three large things. 00:23:52.045 --> 00:23:53.920 align:middle line:84% The first was they cut the corporate tax rate 00:23:53.920 --> 00:23:56.480 align:middle line:90% from 35% to 21%. 00:23:56.480 --> 00:23:59.495 align:middle line:84% And second, we moved to a territorial system. 00:23:59.495 --> 00:24:02.120 align:middle line:84% So essentially, we became much more competitive internationally 00:24:02.120 --> 00:24:05.040 align:middle line:90% in terms of corporate taxation. 00:24:05.040 --> 00:24:07.120 align:middle line:84% Much more competitive internationally. 00:24:07.120 --> 00:24:10.400 align:middle line:84% Now, they did do a couple of things 00:24:10.400 --> 00:24:14.160 align:middle line:84% to try to reduce the-- because some people were repatriating 00:24:14.160 --> 00:24:14.660 align:middle line:90% money. 00:24:14.660 --> 00:24:17.740 align:middle line:84% So it is a money loser to go to a purely territorial system. 00:24:17.740 --> 00:24:20.600 align:middle line:84% You are giving up on the money people actually did bring back. 00:24:20.600 --> 00:24:25.440 align:middle line:84% So they did a couple of things to try to address that. 00:24:25.440 --> 00:24:29.698 align:middle line:84% So for example, they actually imposed a one-time tax. 00:24:29.698 --> 00:24:31.990 align:middle line:84% They basically estimated how much money you had abroad, 00:24:31.990 --> 00:24:34.697 align:middle line:84% and did a one-time what's called deemed repatriation tax. 00:24:34.697 --> 00:24:36.530 align:middle line:84% We know how much money you guys have abroad. 00:24:36.530 --> 00:24:37.650 align:middle line:90% We're going to tax you on that. 00:24:37.650 --> 00:24:40.150 align:middle line:84% We're going to have a new tax that didn't exist before, just 00:24:40.150 --> 00:24:42.650 align:middle line:84% grab some of that from you to try to make up for it. 00:24:42.650 --> 00:24:46.830 align:middle line:84% But the bottom line is, it's not really-- 00:24:46.830 --> 00:24:49.650 align:middle line:84% the bottom line is, I think if you poll economists, 00:24:49.650 --> 00:24:53.790 align:middle line:84% I think they're fairly generally positive on the corporate tax 00:24:53.790 --> 00:24:55.630 align:middle line:90% side of the Trump tax cuts. 00:24:55.630 --> 00:24:58.190 align:middle line:84% Our rate probably was too high internationally to compete. 00:24:58.190 --> 00:24:59.430 align:middle line:90% We brought it down. 00:24:59.430 --> 00:25:02.550 align:middle line:84% We probably aren't losing that much going from global 00:25:02.550 --> 00:25:03.250 align:middle line:90% to territorial. 00:25:03.250 --> 00:25:06.410 align:middle line:90% We're losing some money. 00:25:06.410 --> 00:25:07.570 align:middle line:90% It's going to rich people. 00:25:07.570 --> 00:25:09.577 align:middle line:90% But it's not nearly-- 00:25:09.577 --> 00:25:11.910 align:middle line:84% it probably is also increasing efficiency and increasing 00:25:11.910 --> 00:25:14.030 align:middle line:90% investment in the US. 00:25:14.030 --> 00:25:17.390 align:middle line:84% The problem was the following, which is, let's come back 00:25:17.390 --> 00:25:19.550 align:middle line:90% to our concept of tax wedges. 00:25:19.550 --> 00:25:23.110 align:middle line:84% Remember, there was a tax wedge between investing in the US 00:25:23.110 --> 00:25:24.610 align:middle line:90% and investing internationally. 00:25:24.610 --> 00:25:27.250 align:middle line:84% Because you invested in the US, you paid 35%, internationally, 00:25:27.250 --> 00:25:29.180 align:middle line:90% you paid more like low 20s. 00:25:29.180 --> 00:25:32.700 align:middle line:84% So that was a tax wedge that reduced investment in the US. 00:25:32.700 --> 00:25:35.320 align:middle line:84% We addressed that by taking our rate down to 21%. 00:25:35.320 --> 00:25:38.500 align:middle line:84% The problem is in doing so, it created a new tax wedge, which 00:25:38.500 --> 00:25:41.020 align:middle line:84% is remember, you can do activity in the corporate sector 00:25:41.020 --> 00:25:42.860 align:middle line:90% or the non-corporate sector. 00:25:42.860 --> 00:25:45.460 align:middle line:84% In the non-corporate sector, most people are rich. 00:25:45.460 --> 00:25:47.520 align:middle line:84% They pay the top marginal individual rate, 00:25:47.520 --> 00:25:49.700 align:middle line:90% which is about 39%. 00:25:49.700 --> 00:25:52.935 align:middle line:84% So before the tax reform, we had pretty flat incentives 00:25:52.935 --> 00:25:53.560 align:middle line:90% in two sectors. 00:25:53.560 --> 00:25:57.540 align:middle line:84% It was 35% for corporations, 39% for non-corporations. 00:25:57.540 --> 00:25:59.180 align:middle line:84% Now all of a sudden, you've got 39% 00:25:59.180 --> 00:26:02.460 align:middle line:84% for non-corporations, 21% for corporations. 00:26:02.460 --> 00:26:05.620 align:middle line:90% So you've created a new wedge. 00:26:05.620 --> 00:26:07.220 align:middle line:90% So what do you do about that? 00:26:07.220 --> 00:26:10.780 align:middle line:84% Well, what Trump tax bill did was essentially 00:26:10.780 --> 00:26:14.060 align:middle line:84% give a huge tax break to non-corporate entities. 00:26:14.060 --> 00:26:16.040 align:middle line:84% Basically, all these non-corporate entities, 00:26:16.040 --> 00:26:17.665 align:middle line:84% your doctor's offices, your car washes, 00:26:17.665 --> 00:26:19.100 align:middle line:84% all that, they all got a huge tax 00:26:19.100 --> 00:26:21.800 align:middle line:84% break to bring those rates in line with each other. 00:26:21.800 --> 00:26:23.460 align:middle line:90% And that was a terrible idea. 00:26:23.460 --> 00:26:25.220 align:middle line:84% That cost us a huge amount of money 00:26:25.220 --> 00:26:28.890 align:middle line:84% and basically just gave a bunch of money to rich guys. 00:26:28.890 --> 00:26:30.510 align:middle line:84% I mean, these are largely rich people. 00:26:30.510 --> 00:26:32.870 align:middle line:84% Actually, if you look at a lot of the most wealthy-- 00:26:32.870 --> 00:26:34.910 align:middle line:84% a lot of the top 1%, you think of them 00:26:34.910 --> 00:26:36.670 align:middle line:84% as investment bankers and athletes. 00:26:36.670 --> 00:26:39.270 align:middle line:90% They're auto chain owners. 00:26:39.270 --> 00:26:40.618 align:middle line:90% They're laundromat chain owners. 00:26:40.618 --> 00:26:42.410 align:middle line:84% A lot of the richest Americans are actually 00:26:42.410 --> 00:26:43.930 align:middle line:90% people owning small businesses. 00:26:43.930 --> 00:26:46.450 align:middle line:84% And they just got a huge tax break. 00:26:46.450 --> 00:26:49.170 align:middle line:90% And it's not clear entirely why. 00:26:49.170 --> 00:26:51.850 align:middle line:84% It's not clear entirely why we care so much if they're 00:26:51.850 --> 00:26:53.367 align:middle line:90% corporate or non-corporate. 00:26:53.367 --> 00:26:55.450 align:middle line:84% And certainly the amount of money that was spent-- 00:26:55.450 --> 00:26:59.090 align:middle line:84% it was $500 billion was spent to end this tax wedge-- it's not 00:26:59.090 --> 00:27:00.050 align:middle line:90% really clear why. 00:27:00.050 --> 00:27:00.770 align:middle line:90% Yeah. 00:27:00.770 --> 00:27:02.645 align:middle line:84% AUDIENCE: Is the difference between those two 00:27:02.645 --> 00:27:04.530 align:middle line:84% types of entities whether they're 00:27:04.530 --> 00:27:05.890 align:middle line:90% publicly or privately held? 00:27:05.890 --> 00:27:07.865 align:middle line:84% JON GRUBER: No, the difference is whether-- 00:27:07.865 --> 00:27:08.490 align:middle line:90% I'm sorry, yes. 00:27:08.490 --> 00:27:10.573 align:middle line:84% Yes, the difference is publicly or privately held. 00:27:10.573 --> 00:27:11.930 align:middle line:90% Yes. 00:27:11.930 --> 00:27:13.270 align:middle line:90% No, no, no. 00:27:13.270 --> 00:27:15.810 align:middle line:84% It's not public or privately held. 00:27:15.810 --> 00:27:18.250 align:middle line:84% Basically, there's different types of corporations. 00:27:18.250 --> 00:27:20.330 align:middle line:84% There's what's called C corps and S corps. 00:27:20.330 --> 00:27:22.537 align:middle line:84% And you're now exceeding my level of expertise. 00:27:22.537 --> 00:27:23.870 align:middle line:90% AUDIENCE: That's the difference? 00:27:23.870 --> 00:27:26.260 align:middle line:90% JON GRUBER: Yeah. 00:27:26.260 --> 00:27:30.240 align:middle line:84% So basically, it's an interesting point 00:27:30.240 --> 00:27:32.600 align:middle line:84% that essentially, there's tax wedges floating 00:27:32.600 --> 00:27:34.320 align:middle line:90% all over the place. 00:27:34.320 --> 00:27:38.182 align:middle line:84% And fixing them fixes some problems but creates others. 00:27:38.182 --> 00:27:40.640 align:middle line:84% And with each case, in the case of fixing the corporate tax 00:27:40.640 --> 00:27:43.972 align:middle line:84% wedge from other countries, that was probably a good policy move. 00:27:43.972 --> 00:27:46.180 align:middle line:84% Fixing this other tax wedge was incredibly expensive. 00:27:46.180 --> 00:27:47.340 align:middle line:90% It's not clear what good it did. 00:27:47.340 --> 00:27:49.060 align:middle line:84% That was probably an inefficient use of money. 00:27:49.060 --> 00:27:49.560 align:middle line:90% Yeah. 00:27:49.560 --> 00:27:53.760 align:middle line:84% AUDIENCE: Do non-corporate businesses still 00:27:53.760 --> 00:27:55.747 align:middle line:90% have limited liability? 00:27:55.747 --> 00:27:57.580 align:middle line:84% JON GRUBER: There's sort of a middle ground. 00:27:57.580 --> 00:28:00.640 align:middle line:84% So there's non-corporate non-corporate. 00:28:00.640 --> 00:28:03.200 align:middle line:84% That's kind of like your partnership 00:28:03.200 --> 00:28:04.882 align:middle line:90% or a self-employed person. 00:28:04.882 --> 00:28:06.340 align:middle line:84% Those what's called S corporations, 00:28:06.340 --> 00:28:09.000 align:middle line:84% which are essentially small corporations that still have 00:28:09.000 --> 00:28:11.220 align:middle line:84% limited liability, but they don't have, 00:28:11.220 --> 00:28:12.700 align:middle line:84% for example, a board of directors. 00:28:12.700 --> 00:28:16.680 align:middle line:84% They don't have a lot of things that public companies do. 00:28:16.680 --> 00:28:19.840 align:middle line:84% Let me see if I have a better definition in here 00:28:19.840 --> 00:28:23.870 align:middle line:90% of S corps versus C corps. 00:28:23.870 --> 00:28:24.730 align:middle line:90% One second. 00:28:24.730 --> 00:28:28.283 align:middle line:90% 00:28:28.283 --> 00:28:29.950 align:middle line:84% The major difference between these two-- 00:28:29.950 --> 00:28:32.430 align:middle line:90% they're really pretty similar. 00:28:32.430 --> 00:28:34.430 align:middle line:84% Actually, here's the only meaningful difference. 00:28:34.430 --> 00:28:37.470 align:middle line:84% S corps pay individual tax, C corps pay corporate tax. 00:28:37.470 --> 00:28:39.220 align:middle line:84% So essentially the point-- here is the way 00:28:39.220 --> 00:28:41.678 align:middle line:84% to think about it-- this is a better way to think about it. 00:28:41.678 --> 00:28:43.030 align:middle line:90% They're essentially the same. 00:28:43.030 --> 00:28:46.015 align:middle line:84% It's just before, you did it based on, I don't know, 00:28:46.015 --> 00:28:47.390 align:middle line:84% what was more convenient for you. 00:28:47.390 --> 00:28:49.307 align:middle line:84% Now you'd be like, gee, I want to be a C corp, 00:28:49.307 --> 00:28:50.770 align:middle line:90% because that pays a lower tax. 00:28:50.770 --> 00:28:51.770 align:middle line:84% And people were worried about that. 00:28:51.770 --> 00:28:53.970 align:middle line:84% But it's not actually clear why that's a distortion, 00:28:53.970 --> 00:28:55.150 align:middle line:84% whether they're S corp or C corp. It's just 00:28:55.150 --> 00:28:56.170 align:middle line:90% two different labels. 00:28:56.170 --> 00:28:58.670 align:middle line:84% And yet we're spending $500 billion 00:28:58.670 --> 00:29:01.090 align:middle line:84% to equalize the playing field between those labels. 00:29:01.090 --> 00:29:03.310 align:middle line:90% That's the interesting question. 00:29:03.310 --> 00:29:04.230 align:middle line:90% OK? 00:29:04.230 --> 00:29:05.870 align:middle line:90% Questions about that? 00:29:05.870 --> 00:29:06.550 align:middle line:90% OK. 00:29:06.550 --> 00:29:08.590 align:middle line:84% Now we're going to teach you everything 00:29:08.590 --> 00:29:14.990 align:middle line:84% you need to know about corporate finance in 15 minutes. 00:29:14.990 --> 00:29:16.703 align:middle line:90% You can save all your course-- 00:29:16.703 --> 00:29:17.370 align:middle line:90% I'm just joking. 00:29:17.370 --> 00:29:20.070 align:middle line:84% But let's talk about corporate finance. 00:29:20.070 --> 00:29:24.120 align:middle line:84% Let's think about how taxes affect firms' investment-- 00:29:24.120 --> 00:29:26.920 align:middle line:84% how taxes affect how firms finance their investments. 00:29:26.920 --> 00:29:30.020 align:middle line:84% Now we're going from whether a firm invests to how 00:29:30.020 --> 00:29:31.240 align:middle line:90% they finance that investment. 00:29:31.240 --> 00:29:34.500 align:middle line:90% So go to figure 24-5. 00:29:34.500 --> 00:29:37.100 align:middle line:90% 00:29:37.100 --> 00:29:39.460 align:middle line:84% Let's say that there's a firm that 00:29:39.460 --> 00:29:41.940 align:middle line:90% is going to make an investment. 00:29:41.940 --> 00:29:43.920 align:middle line:84% They're going to finance an investment. 00:29:43.920 --> 00:29:45.080 align:middle line:84% They're not going to use their retained earnings. 00:29:45.080 --> 00:29:46.705 align:middle line:84% They're going to finance an investment. 00:29:46.705 --> 00:29:49.540 align:middle line:84% Actually, go back for a second to figure 24-1 to start. 00:29:49.540 --> 00:29:53.780 align:middle line:84% Remember, figure 24-1, if you want to finance an investment, 00:29:53.780 --> 00:29:56.680 align:middle line:84% the bottom arrow is you could use your retained earnings. 00:29:56.680 --> 00:29:57.680 align:middle line:90% We'll come back to that. 00:29:57.680 --> 00:29:58.640 align:middle line:90% Leave that aside for now. 00:29:58.640 --> 00:30:00.040 align:middle line:84% Imagine you have retained earnings. 00:30:00.040 --> 00:30:01.100 align:middle line:84% You need to finance that investment 00:30:01.100 --> 00:30:02.620 align:middle line:90% by raising the money somehow. 00:30:02.620 --> 00:30:07.320 align:middle line:90% Now go back to figure 24-5. 00:30:07.320 --> 00:30:08.820 align:middle line:84% What you do with that money is going 00:30:08.820 --> 00:30:10.480 align:middle line:90% to depend on how you finance it. 00:30:10.480 --> 00:30:13.300 align:middle line:84% For example, when you earn $1, let's say 00:30:13.300 --> 00:30:15.900 align:middle line:90% you finance that by borrowing. 00:30:15.900 --> 00:30:17.860 align:middle line:90% So that's the upper branch. 00:30:17.860 --> 00:30:20.660 align:middle line:84% You're then going to say, if you earn $1 00:30:20.660 --> 00:30:22.143 align:middle line:90% and that's money that you owe-- 00:30:22.143 --> 00:30:24.560 align:middle line:84% if you earn $1 that you owe to the people who finance you, 00:30:24.560 --> 00:30:26.500 align:middle line:84% you give that dollar to the bondholders, 00:30:26.500 --> 00:30:31.020 align:middle line:84% and they will pay income tax on that. 00:30:31.020 --> 00:30:36.620 align:middle line:84% But if you earn $1 and you have equity holders-- 00:30:36.620 --> 00:30:39.360 align:middle line:84% oh, and by the way, there's no corporate tax paid on it. 00:30:39.360 --> 00:30:40.340 align:middle line:90% Why? 00:30:40.340 --> 00:30:42.780 align:middle line:90% Because interest is deductible. 00:30:42.780 --> 00:30:45.860 align:middle line:84% So if you earn $1 and you're paying it to bondholders, 00:30:45.860 --> 00:30:48.440 align:middle line:84% you can deduct from your taxes that interest payment. 00:30:48.440 --> 00:30:51.360 align:middle line:90% So on net it cancels out. 00:30:51.360 --> 00:30:53.660 align:middle line:84% But if you earn $1 and it goes to stockholders, 00:30:53.660 --> 00:30:54.920 align:middle line:90% you do pay corporate tax. 00:30:54.920 --> 00:30:59.420 align:middle line:84% The first step is you pay a corporate tax amount. 00:30:59.420 --> 00:31:01.960 align:middle line:84% Then the next step is you pay it out to your stockholders. 00:31:01.960 --> 00:31:03.980 align:middle line:84% But there's two ways you can do that. 00:31:03.980 --> 00:31:07.460 align:middle line:84% One way is you can pay them a dividend, in which case 00:31:07.460 --> 00:31:11.620 align:middle line:84% they're taxed again at the dividend tax rate. 00:31:11.620 --> 00:31:13.645 align:middle line:84% The other way is you can put it into your stock 00:31:13.645 --> 00:31:15.020 align:middle line:84% and let it go up, and then people 00:31:15.020 --> 00:31:17.062 align:middle line:84% can sell it and get a capital gain, in which case 00:31:17.062 --> 00:31:19.140 align:middle line:84% they're taxed again at the capital gains rate. 00:31:19.140 --> 00:31:21.030 align:middle line:84% So if you pay out money to equity holders, 00:31:21.030 --> 00:31:22.270 align:middle line:90% there's double taxation. 00:31:22.270 --> 00:31:24.270 align:middle line:84% This is why many people don't like the corporate tax system. 00:31:24.270 --> 00:31:26.250 align:middle line:84% They say, well look, it features double taxation. 00:31:26.250 --> 00:31:28.292 align:middle line:84% Because you're taxed once at the corporate level, 00:31:28.292 --> 00:31:30.730 align:middle line:84% taxed again at the individual level when that's paid out. 00:31:30.730 --> 00:31:34.410 align:middle line:84% And that level of taxation depends on how it's paid out. 00:31:34.410 --> 00:31:37.410 align:middle line:84% Now, if you look at this chart, it 00:31:37.410 --> 00:31:41.570 align:middle line:84% raises the two fundamental mysteries of corporate finance. 00:31:41.570 --> 00:31:46.010 align:middle line:84% The first mystery is, why do firms ever use equity? 00:31:46.010 --> 00:31:48.310 align:middle line:90% Debt is massively tax favored. 00:31:48.310 --> 00:31:52.050 align:middle line:84% When you pay out debt, you don't have to pay the corporate tax. 00:31:52.050 --> 00:31:53.650 align:middle line:90% When you pay in equity, you do. 00:31:53.650 --> 00:31:56.090 align:middle line:90% Corporate tax used to be 35%. 00:31:56.090 --> 00:31:57.850 align:middle line:90% That's a big difference. 00:31:57.850 --> 00:31:59.390 align:middle line:90% Why do firms not all debt? 00:31:59.390 --> 00:32:01.730 align:middle line:84% And so there's a large literature on that. 00:32:01.730 --> 00:32:06.330 align:middle line:84% And the fundamental answer comes down to the key distinction 00:32:06.330 --> 00:32:10.870 align:middle line:84% between debt and equity, which is debt requires fixed payments, 00:32:10.870 --> 00:32:12.450 align:middle line:90% equity does not. 00:32:12.450 --> 00:32:15.410 align:middle line:84% When you take a loan, you have to pay it back. 00:32:15.410 --> 00:32:17.325 align:middle line:84% When you issue stock, you don't do anything. 00:32:17.325 --> 00:32:18.700 align:middle line:84% You don't have to pay a dividend. 00:32:18.700 --> 00:32:19.950 align:middle line:90% It doesn't even have to go up. 00:32:19.950 --> 00:32:23.080 align:middle line:84% I mean, you want it to, but it doesn't have to. 00:32:23.080 --> 00:32:25.080 align:middle line:90% So think of it this way. 00:32:25.080 --> 00:32:28.840 align:middle line:84% Imagine that I gave you two choices for a grading 00:32:28.840 --> 00:32:30.640 align:middle line:90% scheme for this course. 00:32:30.640 --> 00:32:31.400 align:middle line:90% OK? 00:32:31.400 --> 00:32:35.360 align:middle line:84% In one choice, you do a problem set every week. 00:32:35.360 --> 00:32:39.280 align:middle line:84% And if you ever fail one problem set, you fail the course. 00:32:39.280 --> 00:32:41.053 align:middle line:84% In another choice, I'm going to average 00:32:41.053 --> 00:32:42.220 align:middle line:90% all your problem set grades. 00:32:42.220 --> 00:32:45.420 align:middle line:84% And at the end, I'll rate you based on average how 00:32:45.420 --> 00:32:47.440 align:middle line:90% your problem set grades did. 00:32:47.440 --> 00:32:50.663 align:middle line:84% Unless you're risk loving, you prefer the second. 00:32:50.663 --> 00:32:52.080 align:middle line:84% Well, the problem is, debt is kind 00:32:52.080 --> 00:32:54.413 align:middle line:84% of like the first and equity is kind of like the second. 00:32:54.413 --> 00:32:56.520 align:middle line:84% Not exactly, but it's a similar feature. 00:32:56.520 --> 00:32:59.760 align:middle line:84% So basically, now add on top of that 00:32:59.760 --> 00:33:03.120 align:middle line:84% the agency problem, which is that basically 00:33:03.120 --> 00:33:05.720 align:middle line:84% if the stock goes up or down, that 00:33:05.720 --> 00:33:07.040 align:middle line:90% is annoying or not annoying. 00:33:07.040 --> 00:33:09.800 align:middle line:84% If the company goes bankrupt, I lose my job. 00:33:09.800 --> 00:33:12.240 align:middle line:84% So I really care about making sure the company doesn't 00:33:12.240 --> 00:33:13.760 align:middle line:90% go bankrupt. 00:33:13.760 --> 00:33:17.030 align:middle line:84% I really care about making sure my debt holders get paid. 00:33:17.030 --> 00:33:24.390 align:middle line:84% As a result, there is going to be a bias towards equity 00:33:24.390 --> 00:33:25.570 align:middle line:90% and away from debt. 00:33:25.570 --> 00:33:27.470 align:middle line:90% We can see this in an example. 00:33:27.470 --> 00:33:32.870 align:middle line:84% Let's go to table 24-1, the debt versus equity conflict. 00:33:32.870 --> 00:33:33.590 align:middle line:90% OK. 00:33:33.590 --> 00:33:38.350 align:middle line:84% You've got a company here that's worth $6 million. 00:33:38.350 --> 00:33:41.390 align:middle line:84% In the first case, $1 million is held by equity holders 00:33:41.390 --> 00:33:44.030 align:middle line:90% and $5 million by debt holders. 00:33:44.030 --> 00:33:46.590 align:middle line:90% Now you have an investment. 00:33:46.590 --> 00:33:49.910 align:middle line:90% It's a coin flip. 00:33:49.910 --> 00:33:52.590 align:middle line:84% The investment is a coin flip, which 00:33:52.590 --> 00:33:56.010 align:middle line:84% is that it's 50% chance to win $3 million, 00:33:56.010 --> 00:33:59.390 align:middle line:90% 50% chance lose $6 million. 00:33:59.390 --> 00:34:03.150 align:middle line:84% 50% chance win $3 million, 50% chance lose $6 million, 00:34:03.150 --> 00:34:07.230 align:middle line:84% a negative expected value project. 00:34:07.230 --> 00:34:08.230 align:middle line:90% OK? 00:34:08.230 --> 00:34:11.070 align:middle line:84% Think of this from the equity holders' perspective 00:34:11.070 --> 00:34:13.790 align:middle line:90% in the first case. 00:34:13.790 --> 00:34:20.300 align:middle line:84% If we make the investment and it hits, they get all $3 million. 00:34:20.300 --> 00:34:20.820 align:middle line:90% Why? 00:34:20.820 --> 00:34:22.699 align:middle line:84% Because we've already promised-- the debt holders 00:34:22.699 --> 00:34:23.679 align:middle line:90% can't make any extra money. 00:34:23.679 --> 00:34:24.760 align:middle line:84% They just get their interest payments. 00:34:24.760 --> 00:34:25.480 align:middle line:90% That's predetermined. 00:34:25.480 --> 00:34:27.239 align:middle line:84% The equity holders are the residual claimants. 00:34:27.239 --> 00:34:28.906 align:middle line:84% They get all the benefit from good luck. 00:34:28.906 --> 00:34:32.699 align:middle line:90% 00:34:32.699 --> 00:34:33.580 align:middle line:90% Oh, let's also say-- 00:34:33.580 --> 00:34:34.239 align:middle line:90% I'm sorry. 00:34:34.239 --> 00:34:38.940 align:middle line:84% Let's say this company also regularly pays out a dividend 00:34:38.940 --> 00:34:41.500 align:middle line:90% of $100,000 a year. 00:34:41.500 --> 00:34:43.000 align:middle line:90% And these rates are 10%. 00:34:43.000 --> 00:34:44.113 align:middle line:90% So it pays out a dividend. 00:34:44.113 --> 00:34:45.780 align:middle line:84% The stream of dividends for this company 00:34:45.780 --> 00:34:47.780 align:middle line:84% is the present value of a million dollars. 00:34:47.780 --> 00:34:50.739 align:middle line:84% So the company is going to pay out a dividend of $100,000 00:34:50.739 --> 00:34:52.139 align:middle line:90% a year. 00:34:52.139 --> 00:34:54.100 align:middle line:84% So what happens, if the company goes bankrupt, 00:34:54.100 --> 00:34:55.620 align:middle line:90% to the equity holders? 00:34:55.620 --> 00:34:58.200 align:middle line:84% Well, first of all, they lose the future stream of dividends, 00:34:58.200 --> 00:35:00.060 align:middle line:90% which is worth $1 million. 00:35:00.060 --> 00:35:01.980 align:middle line:84% Second of all, they lose their investment, 00:35:01.980 --> 00:35:03.940 align:middle line:90% which is worth $1 million. 00:35:03.940 --> 00:35:05.940 align:middle line:90% So total what do they lose? 00:35:05.940 --> 00:35:07.540 align:middle line:90% $2 million. 00:35:07.540 --> 00:35:09.740 align:middle line:90% So what do they want to do? 00:35:09.740 --> 00:35:11.153 align:middle line:90% Take the bet. 00:35:11.153 --> 00:35:13.320 align:middle line:84% Because from their perspective, it's win $3 million, 00:35:13.320 --> 00:35:15.170 align:middle line:90% lose $2 million. 00:35:15.170 --> 00:35:19.350 align:middle line:84% Now, the equity holders-- the debt holders, I'm sorry-- 00:35:19.350 --> 00:35:23.730 align:middle line:90% 00:35:23.730 --> 00:35:28.650 align:middle line:84% if the investment goes up, they get nothing. 00:35:28.650 --> 00:35:32.050 align:middle line:90% If the investment goes down-- 00:35:32.050 --> 00:35:33.270 align:middle line:90% let's see, what did I get? 00:35:33.270 --> 00:35:34.928 align:middle line:84% What are the bondholders getting? 00:35:34.928 --> 00:35:36.970 align:middle line:84% They're getting an interest payment every period. 00:35:36.970 --> 00:35:38.510 align:middle line:84% They're getting an interest payment per period of 10%. 00:35:38.510 --> 00:35:41.090 align:middle line:84% They get $500,000 a year paid back no matter what the company 00:35:41.090 --> 00:35:41.635 align:middle line:90% does. 00:35:41.635 --> 00:35:43.510 align:middle line:84% So what happens if the company goes bankrupt? 00:35:43.510 --> 00:35:46.490 align:middle line:84% They lose that future stream of $500,000 payments. 00:35:46.490 --> 00:35:47.790 align:middle line:90% That's $5 million. 00:35:47.790 --> 00:35:49.590 align:middle line:84% And they lose the $5 million investment. 00:35:49.590 --> 00:35:50.673 align:middle line:90% That's another $5 million. 00:35:50.673 --> 00:35:51.890 align:middle line:90% So they're out $10 million. 00:35:51.890 --> 00:35:54.170 align:middle line:84% So basically, bondholders are screwed. 00:35:54.170 --> 00:35:56.690 align:middle line:90% Equity holders make out. 00:35:56.690 --> 00:35:59.770 align:middle line:84% Now, flip it in the bottom panel. 00:35:59.770 --> 00:36:02.410 align:middle line:90% Now take equity holders. 00:36:02.410 --> 00:36:04.370 align:middle line:84% Imagine $5 million of the company 00:36:04.370 --> 00:36:06.530 align:middle line:84% is in the hand of equity holders and $1 million 00:36:06.530 --> 00:36:07.850 align:middle line:90% is in bond holders. 00:36:07.850 --> 00:36:11.190 align:middle line:84% Well now, if the investment hits, gain $3 million. 00:36:11.190 --> 00:36:14.540 align:middle line:84% But if it misses and the company goes bankrupt, 00:36:14.540 --> 00:36:16.680 align:middle line:90% they now lose $10 million. 00:36:16.680 --> 00:36:19.280 align:middle line:84% So they don't want to do the investment, and likewise, 00:36:19.280 --> 00:36:20.960 align:middle line:90% debt holders don't. 00:36:20.960 --> 00:36:24.000 align:middle line:84% So the bottom line is the share of the company 00:36:24.000 --> 00:36:28.400 align:middle line:84% that's in equity will affect its taste for risk. 00:36:28.400 --> 00:36:31.920 align:middle line:84% So now you're a bank looking at this table and I come to you 00:36:31.920 --> 00:36:32.673 align:middle line:90% for a loan. 00:36:32.673 --> 00:36:34.840 align:middle line:84% which firm are you going to charge a higher interest 00:36:34.840 --> 00:36:37.200 align:middle line:90% rate to? 00:36:37.200 --> 00:36:38.500 align:middle line:90% These two firms exist. 00:36:38.500 --> 00:36:40.020 align:middle line:84% They want another million dollars. 00:36:40.020 --> 00:36:41.500 align:middle line:90% They come to you for a loan. 00:36:41.500 --> 00:36:42.840 align:middle line:90% Which one's riskier? 00:36:42.840 --> 00:36:45.860 align:middle line:84% Which firm are you more worried about? 00:36:45.860 --> 00:36:46.360 align:middle line:90% Yeah. 00:36:46.360 --> 00:36:48.320 align:middle line:84% AUDIENCE: The first one, because they're 00:36:48.320 --> 00:36:49.920 align:middle line:90% more likely to take on risk. 00:36:49.920 --> 00:36:52.140 align:middle line:84% JON GRUBER: Yeah, the first one's gambler's. 00:36:52.140 --> 00:36:54.295 align:middle line:84% I just want my interest payment back. 00:36:54.295 --> 00:36:55.420 align:middle line:90% I'm not trying to get rich. 00:36:55.420 --> 00:36:57.400 align:middle line:84% I'm just trying to get my 10% a year. 00:36:57.400 --> 00:36:58.525 align:middle line:90% I don't want these cowboys. 00:36:58.525 --> 00:37:00.650 align:middle line:84% I don't want to loan to these cowboys who are going 00:37:00.650 --> 00:37:02.480 align:middle line:90% to throw it away on crazy bets. 00:37:02.480 --> 00:37:05.000 align:middle line:84% So I'm going to charge a higher interest rate. 00:37:05.000 --> 00:37:09.320 align:middle line:84% The higher is the share of the company that is in debt. 00:37:09.320 --> 00:37:11.800 align:middle line:84% What that means is there's now a trade-off. 00:37:11.800 --> 00:37:16.240 align:middle line:84% As I lever up, it gets harder to raise new money. 00:37:16.240 --> 00:37:18.280 align:middle line:84% So that's why firms aren't all debt. 00:37:18.280 --> 00:37:21.760 align:middle line:84% There's a tax advantage, but there's a leverage disadvantage. 00:37:21.760 --> 00:37:24.420 align:middle line:84% The tax advantage is you don't pay corporate tax. 00:37:24.420 --> 00:37:26.700 align:middle line:84% The leverage disadvantage is the more leverage 00:37:26.700 --> 00:37:29.480 align:middle line:84% to the firm, the riskier they are. 00:37:29.480 --> 00:37:33.600 align:middle line:84% And it'll be more expensive to raise new financing. 00:37:33.600 --> 00:37:35.180 align:middle line:84% And that's why firms aren't all debt. 00:37:35.180 --> 00:37:38.320 align:middle line:90% That's the essential trade-off. 00:37:38.320 --> 00:37:39.025 align:middle line:90% OK? 00:37:39.025 --> 00:37:39.900 align:middle line:90% Questions about that? 00:37:39.900 --> 00:37:40.400 align:middle line:90% Yeah. 00:37:40.400 --> 00:37:42.880 align:middle line:84% AUDIENCE: Why is the gain in the debt case 00:37:42.880 --> 00:37:45.305 align:middle line:84% still 0, even if they were making money on interest? 00:37:45.305 --> 00:37:46.680 align:middle line:84% JON GRUBER: Why is the gain-- oh, 00:37:46.680 --> 00:37:51.640 align:middle line:84% it's 0 to debt holders because they get their $500,000 payment 00:37:51.640 --> 00:37:52.600 align:middle line:90% no matter what. 00:37:52.600 --> 00:37:55.142 align:middle line:84% They have signed a contract that says every year I'll pay you 00:37:55.142 --> 00:37:55.960 align:middle line:90% back $500,000. 00:37:55.960 --> 00:37:57.883 align:middle line:84% So if the firm becomes worth $8 billion, 00:37:57.883 --> 00:37:59.300 align:middle line:84% they don't get anything out of it. 00:37:59.300 --> 00:38:02.120 align:middle line:84% They still get their $500,000 a year. 00:38:02.120 --> 00:38:04.160 align:middle line:84% So that's the point, is all the upside 00:38:04.160 --> 00:38:05.662 align:middle line:90% is held in equity holders. 00:38:05.662 --> 00:38:07.120 align:middle line:84% But the equity holders' downside is 00:38:07.120 --> 00:38:09.360 align:middle line:84% limited to how much the company they own. 00:38:09.360 --> 00:38:11.390 align:middle line:84% That's why the more is equity, the more 00:38:11.390 --> 00:38:12.610 align:middle line:90% risks they're going to take. 00:38:12.610 --> 00:38:13.110 align:middle line:90% Yeah. 00:38:13.110 --> 00:38:15.790 align:middle line:84% AUDIENCE: Do you know about micro strategy? 00:38:15.790 --> 00:38:18.092 align:middle line:84% JON GRUBER: I mean, there's lots of stories like this. 00:38:18.092 --> 00:38:20.050 align:middle line:84% I'm not even getting into scummy behavior here. 00:38:20.050 --> 00:38:21.230 align:middle line:90% This is just all legal. 00:38:21.230 --> 00:38:22.970 align:middle line:84% I'm not getting into Enron and stuff. 00:38:22.970 --> 00:38:24.570 align:middle line:90% This is legal stuff. 00:38:24.570 --> 00:38:25.270 align:middle line:90% Yeah. 00:38:25.270 --> 00:38:27.190 align:middle line:84% AUDIENCE: So the more debt you're in-- 00:38:27.190 --> 00:38:28.048 align:middle line:90% or the more debt-- 00:38:28.048 --> 00:38:29.590 align:middle line:84% JON GRUBER: The more highly leveraged 00:38:29.590 --> 00:38:31.093 align:middle line:84% you are, the higher share of debt. 00:38:31.093 --> 00:38:32.510 align:middle line:84% AUDIENCE: The higher share of debt 00:38:32.510 --> 00:38:34.550 align:middle line:84% the organization has, the less risk-averse 00:38:34.550 --> 00:38:39.660 align:middle line:84% it is, which makes it a less safe place to lend money? 00:38:39.660 --> 00:38:41.410 align:middle line:84% JON GRUBER: It makes it a more safe place. 00:38:41.410 --> 00:38:43.572 align:middle line:84% I'm sorry, no, the less risk-averse it is. 00:38:43.572 --> 00:38:45.030 align:middle line:84% Yes, it makes it a less safe place. 00:38:45.030 --> 00:38:46.405 align:middle line:84% AUDIENCE: It's a less safe place. 00:38:46.405 --> 00:38:47.150 align:middle line:90% JON GRUBER: Yes. 00:38:47.150 --> 00:38:48.830 align:middle line:84% AUDIENCE: And so they have to pay higher interest 00:38:48.830 --> 00:38:49.497 align:middle line:90% rates and that-- 00:38:49.497 --> 00:38:51.433 align:middle line:84% JON GRUBER: Offsets the tax benefit. 00:38:51.433 --> 00:38:52.850 align:middle line:84% AUDIENCE: Offsets the tax benefit. 00:38:52.850 --> 00:38:55.790 align:middle line:84% Does that mean that even in a perfect credit market, 00:38:55.790 --> 00:38:57.432 align:middle line:90% this would occur? 00:38:57.432 --> 00:38:59.390 align:middle line:84% JON GRUBER: Well, define perfect credit market. 00:38:59.390 --> 00:39:01.557 align:middle line:84% In a perfect information credit market, none of this 00:39:01.557 --> 00:39:04.390 align:middle line:84% is a problem, because basically I know everything 00:39:04.390 --> 00:39:05.870 align:middle line:90% before I make you the loan. 00:39:05.870 --> 00:39:08.190 align:middle line:84% So I would know that this investment is a loser 00:39:08.190 --> 00:39:10.440 align:middle line:84% and I wouldn't loan you the money for that investment. 00:39:10.440 --> 00:39:13.285 align:middle line:84% But in a realistic credit market, this is going to happen. 00:39:13.285 --> 00:39:14.660 align:middle line:84% AUDIENCE: I guess my question was 00:39:14.660 --> 00:39:20.780 align:middle line:84% like, why couldn't a company always keep on borrowing 00:39:20.780 --> 00:39:23.260 align:middle line:90% and paying off creditors? 00:39:23.260 --> 00:39:24.060 align:middle line:90% Never mind. 00:39:24.060 --> 00:39:25.680 align:middle line:84% JON GRUBER: Yeah, it's complicated. 00:39:25.680 --> 00:39:26.760 align:middle line:90% It's a hard example. 00:39:26.760 --> 00:39:28.640 align:middle line:90% But here's the intuition. 00:39:28.640 --> 00:39:31.800 align:middle line:84% The intuition is, debt is an action-forcing event. 00:39:31.800 --> 00:39:33.740 align:middle line:90% You have to pay up. 00:39:33.740 --> 00:39:35.620 align:middle line:90% Equity lets you slide. 00:39:35.620 --> 00:39:37.420 align:middle line:84% So basically, the more of your company 00:39:37.420 --> 00:39:41.780 align:middle line:84% that's equity, the freer you are to mess around and take risks 00:39:41.780 --> 00:39:43.280 align:middle line:90% that may not be healthy risks. 00:39:43.280 --> 00:39:44.947 align:middle line:84% AUDIENCE: I think I just figured it out. 00:39:44.947 --> 00:39:47.920 align:middle line:84% That point about debt having to be paid, why isn't it 00:39:47.920 --> 00:39:50.280 align:middle line:84% that a company can keep on borrowing, 00:39:50.280 --> 00:39:52.180 align:middle line:84% paying off the original creditors, borrowing? 00:39:52.180 --> 00:39:54.700 align:middle line:84% JON GRUBER: Because the new creditors will know then. 00:39:54.700 --> 00:39:56.060 align:middle line:90% The new creditors know. 00:39:56.060 --> 00:39:58.300 align:middle line:84% They're just going to-- if you keep borrowing 00:39:58.300 --> 00:40:02.420 align:middle line:84% and you lever up on debt, then basically, 00:40:02.420 --> 00:40:03.600 align:middle line:90% they'll know the total. 00:40:03.600 --> 00:40:05.140 align:middle line:84% Actually, in some sense, that's part of the problem 00:40:05.140 --> 00:40:06.682 align:middle line:84% we've run into with these corporate-- 00:40:06.682 --> 00:40:10.530 align:middle line:84% so if you look at-- what was the company recently 00:40:10.530 --> 00:40:11.590 align:middle line:90% that went bankrupt? 00:40:11.590 --> 00:40:13.130 align:middle line:84% People didn't realize how much debt 00:40:13.130 --> 00:40:14.970 align:middle line:84% they had because they were borrowing 00:40:14.970 --> 00:40:17.050 align:middle line:90% from lots of different sources. 00:40:17.050 --> 00:40:19.050 align:middle line:84% And this is basically in some sense a little bit 00:40:19.050 --> 00:40:20.330 align:middle line:90% the story of FTX. 00:40:20.330 --> 00:40:22.170 align:middle line:84% But in general, basically the point 00:40:22.170 --> 00:40:23.630 align:middle line:90% is you're absolutely right. 00:40:23.630 --> 00:40:26.842 align:middle line:84% If my new borrowers don't know about my old borrowers, 00:40:26.842 --> 00:40:29.300 align:middle line:84% then I can pay back my old borrowers with my new borrowers. 00:40:29.300 --> 00:40:30.550 align:middle line:84% New borrowers will not charge me. 00:40:30.550 --> 00:40:32.092 align:middle line:84% So this is assuming the new borrowers 00:40:32.092 --> 00:40:33.430 align:middle line:90% know what's in this table. 00:40:33.430 --> 00:40:35.962 align:middle line:84% If the new borrowers don't know this, then yeah, 00:40:35.962 --> 00:40:37.670 align:middle line:84% they won't charge a higher interest rate, 00:40:37.670 --> 00:40:39.790 align:middle line:84% and you can keep taking risks without them knowing. 00:40:39.790 --> 00:40:41.130 align:middle line:84% And that's sort of what happened with FTX, 00:40:41.130 --> 00:40:42.380 align:middle line:90% but in a more complicated way. 00:40:42.380 --> 00:40:44.210 align:middle line:84% AUDIENCE: So the intermediate due dates 00:40:44.210 --> 00:40:45.690 align:middle line:84% on these payments are less of the important thing, 00:40:45.690 --> 00:40:47.310 align:middle line:84% because you could borrow and give-- 00:40:47.310 --> 00:40:49.310 align:middle line:84% JON GRUBER: Well no, it's a less important thing 00:40:49.310 --> 00:40:50.102 align:middle line:90% if they don't know. 00:40:50.102 --> 00:40:51.435 align:middle line:90% But in theory, they should know. 00:40:51.435 --> 00:40:53.030 align:middle line:84% In theory, there are rating agencies, 00:40:53.030 --> 00:40:54.390 align:middle line:84% which should be keeping an eye on you and saying, 00:40:54.390 --> 00:40:55.330 align:middle line:84% hey, you're pretty levered up, you're not 00:40:55.330 --> 00:40:56.050 align:middle line:90% rated this highly anymore. 00:40:56.050 --> 00:40:57.350 align:middle line:90% We're going to downgrade you. 00:40:57.350 --> 00:40:58.790 align:middle line:84% AUDIENCE: Doesn't paying off your earlier debt 00:40:58.790 --> 00:40:59.710 align:middle line:90% lower your leverage again? 00:40:59.710 --> 00:41:02.252 align:middle line:84% JON GRUBER: No, because you've only levered up to pay it off, 00:41:02.252 --> 00:41:04.032 align:middle line:84% so your total leverage is still high. 00:41:04.032 --> 00:41:05.490 align:middle line:84% So basically, that's kind of how we 00:41:05.490 --> 00:41:07.400 align:middle line:90% think about that first puzzle. 00:41:07.400 --> 00:41:09.665 align:middle line:84% Now, there's a second puzzle, though. 00:41:09.665 --> 00:41:11.540 align:middle line:84% The first puzzle is why do firms do all that. 00:41:11.540 --> 00:41:15.840 align:middle line:84% There's a second puzzle, which is why do firms pay dividends? 00:41:15.840 --> 00:41:17.760 align:middle line:84% Remember, the capital gains tax rate 00:41:17.760 --> 00:41:20.360 align:middle line:84% is way below the dividend tax rate, 00:41:20.360 --> 00:41:24.040 align:middle line:84% because you don't have to pay it until you realize gains. 00:41:24.040 --> 00:41:27.440 align:middle line:84% You don't pay it at all if you die. 00:41:27.440 --> 00:41:30.400 align:middle line:84% And the rate is actually physically lower. 00:41:30.400 --> 00:41:33.580 align:middle line:84% So the second mystery is, why do firms pay dividends at all? 00:41:33.580 --> 00:41:34.940 align:middle line:90% Now increasingly, they're not. 00:41:34.940 --> 00:41:36.857 align:middle line:84% Dividends are much lower than they used to be. 00:41:36.857 --> 00:41:38.960 align:middle line:90% But they're still quite large. 00:41:38.960 --> 00:41:40.960 align:middle line:90% So why do firms pay dividends? 00:41:40.960 --> 00:41:46.080 align:middle line:84% Once again, the best answer is through the agency model. 00:41:46.080 --> 00:41:48.040 align:middle line:84% Well, in two aspects of the agency model. 00:41:48.040 --> 00:41:49.180 align:middle line:90% There's two answers here. 00:41:49.180 --> 00:41:55.600 align:middle line:84% There's an agency answer and a signaling answer. 00:41:55.600 --> 00:41:59.023 align:middle line:84% The agency answer is look, we want them to pay dividends 00:41:59.023 --> 00:42:00.440 align:middle line:84% because we don't want them keeping 00:42:00.440 --> 00:42:03.280 align:middle line:84% their hands on all that cash and doing stupid shit with it. 00:42:03.280 --> 00:42:14.470 align:middle line:84% So for example, one study studied 25-- in 2002, 00:42:14.470 --> 00:42:17.310 align:middle line:84% if you took the 25 largest longstanding dividend-paying 00:42:17.310 --> 00:42:21.470 align:middle line:84% companies, they currently held $160 billion in cash. 00:42:21.470 --> 00:42:24.110 align:middle line:84% If they never paid dividends, they would have had $2 trillion 00:42:24.110 --> 00:42:25.470 align:middle line:90% in cash. 00:42:25.470 --> 00:42:29.190 align:middle line:84% And cash sitting around makes people do silly things. 00:42:29.190 --> 00:42:31.110 align:middle line:84% They try to steal it, take risks, et cetera. 00:42:31.110 --> 00:42:33.152 align:middle line:84% So part of it's like, I don't trust the managers. 00:42:33.152 --> 00:42:34.825 align:middle line:84% I want to get out of their hands. 00:42:34.825 --> 00:42:36.950 align:middle line:84% The other theory of why firms pay dividends, what's 00:42:36.950 --> 00:42:38.950 align:middle line:84% called a signaling theory, which comes back to our discussion 00:42:38.950 --> 00:42:39.630 align:middle line:90% just now. 00:42:39.630 --> 00:42:41.690 align:middle line:84% It's hard to know how well a firm's doing. 00:42:41.690 --> 00:42:43.190 align:middle line:84% But if they're paying you cash, they 00:42:43.190 --> 00:42:44.830 align:middle line:90% know at least they got cash. 00:42:44.830 --> 00:42:47.190 align:middle line:84% So it's a signal the firm's OK that they're 00:42:47.190 --> 00:42:48.750 align:middle line:90% paying these dividends. 00:42:48.750 --> 00:42:49.630 align:middle line:90% OK? 00:42:49.630 --> 00:42:52.750 align:middle line:84% So that's a couple of theories for why firms pay dividends. 00:42:52.750 --> 00:42:55.390 align:middle line:84% Why is this relevant for taxation? 00:42:55.390 --> 00:42:59.910 align:middle line:84% It's relevant because one of the key debates over the last 20 00:42:59.910 --> 00:43:04.100 align:middle line:84% years and going forward is how heavily should we tax dividends? 00:43:04.100 --> 00:43:08.500 align:middle line:84% If you look at this chart, if you go back to figure 24-5, 00:43:08.500 --> 00:43:11.260 align:middle line:84% you see that ultimately, the dividend tax affects the rate 00:43:11.260 --> 00:43:12.780 align:middle line:90% of return to investment. 00:43:12.780 --> 00:43:14.880 align:middle line:84% Because ultimately, equity holders pay it. 00:43:14.880 --> 00:43:17.225 align:middle line:84% So in principle, if the dividend tax falls, 00:43:17.225 --> 00:43:19.100 align:middle line:84% that raises the return to investing in firms. 00:43:19.100 --> 00:43:21.203 align:middle line:90% That'll raise investment. 00:43:21.203 --> 00:43:23.120 align:middle line:84% So for many years, people have said-- in fact, 00:43:23.120 --> 00:43:27.180 align:middle line:84% this is why George W Bush cut massively the dividend tax rate. 00:43:27.180 --> 00:43:29.680 align:middle line:84% He cut the dividend tax rate because economists were saying, 00:43:29.680 --> 00:43:32.080 align:middle line:84% look, that is a way to lower the cost of capital. 00:43:32.080 --> 00:43:34.122 align:middle line:84% That's the way to make investment more rewarding. 00:43:34.122 --> 00:43:36.100 align:middle line:90% Let's cut the dividend tax rate. 00:43:36.100 --> 00:43:38.860 align:middle line:84% What was wrong with that argument is you 00:43:38.860 --> 00:43:41.620 align:middle line:84% should understand why firms pay dividends. 00:43:41.620 --> 00:43:43.500 align:middle line:84% And if you think about it, both the reason 00:43:43.500 --> 00:43:46.540 align:middle line:84% why firms pay dividends would say a cut in the dividend tax 00:43:46.540 --> 00:43:52.900 align:middle line:84% rate would actually want you to invest less. 00:43:52.900 --> 00:43:54.320 align:middle line:90% Think about it this way. 00:43:54.320 --> 00:43:55.300 align:middle line:90% Yeah, question. 00:43:55.300 --> 00:43:57.340 align:middle line:84% AUDIENCE: Do share buybacks do the same thing, 00:43:57.340 --> 00:43:58.820 align:middle line:90% solve the agency problem? 00:43:58.820 --> 00:44:00.862 align:middle line:84% JON GRUBER: Yeah, buybacks are a similar feature. 00:44:00.862 --> 00:44:02.487 align:middle line:84% AUDIENCE: But they're not taxed, right? 00:44:02.487 --> 00:44:03.980 align:middle line:84% So why don't they just do buybacks? 00:44:03.980 --> 00:44:05.397 align:middle line:84% JON GRUBER: Increasingly they are. 00:44:05.397 --> 00:44:07.620 align:middle line:84% But buybacks, the problem is-- right. 00:44:07.620 --> 00:44:09.240 align:middle line:84% Increasingly they're doing buybacks. 00:44:09.240 --> 00:44:12.060 align:middle line:84% The question is, why pay dividends at all? 00:44:12.060 --> 00:44:13.300 align:middle line:90% And I don't know the answer. 00:44:13.300 --> 00:44:14.940 align:middle line:84% I don't know the literature on dividends versus-- 00:44:14.940 --> 00:44:16.360 align:middle line:84% I guess you do have to take a finance course. 00:44:16.360 --> 00:44:18.610 align:middle line:84% I don't know the answer are dividends versus buybacks. 00:44:18.610 --> 00:44:24.540 align:middle line:90% 00:44:24.540 --> 00:44:27.260 align:middle line:84% In fact, both the agency and the signaling models 00:44:27.260 --> 00:44:30.260 align:middle line:84% say that a cut in the dividend tax rate 00:44:30.260 --> 00:44:32.020 align:middle line:90% will lead to less investment. 00:44:32.020 --> 00:44:34.740 align:middle line:84% That's because dividends are wasteful in these models. 00:44:34.740 --> 00:44:36.180 align:middle line:84% So basically, dividends are simply 00:44:36.180 --> 00:44:39.100 align:middle line:84% a wasteful thing you're doing to either solve the issue problem 00:44:39.100 --> 00:44:40.760 align:middle line:90% or signal, right? 00:44:40.760 --> 00:44:41.820 align:middle line:90% They're wasteful. 00:44:41.820 --> 00:44:44.060 align:middle line:84% So, if you cut the price of something wasteful 00:44:44.060 --> 00:44:46.375 align:middle line:90% you'll do more of it. 00:44:46.375 --> 00:44:47.000 align:middle line:90% You'll do more. 00:44:47.000 --> 00:44:48.560 align:middle line:84% You'll send bigger dividends because they're cheaper, 00:44:48.560 --> 00:44:49.460 align:middle line:90% et cetera. 00:44:49.460 --> 00:44:51.757 align:middle line:84% But the point is, if you're sending those dividends, 00:44:51.757 --> 00:44:53.340 align:middle line:84% what are you not doing with the money? 00:44:53.340 --> 00:44:56.340 align:middle line:84% You're not retaining it, using for investment. 00:44:56.340 --> 00:44:59.500 align:middle line:84% So actually, by cutting the dividend tax rate, 00:44:59.500 --> 00:45:02.570 align:middle line:84% you're saying send more money to your investors. 00:45:02.570 --> 00:45:05.032 align:middle line:84% That's less money you're investing. 00:45:05.032 --> 00:45:07.490 align:middle line:84% So in fact, it's not clear whether cutting the dividend tax 00:45:07.490 --> 00:45:09.090 align:middle line:84% rate will raise investment or lower investment. 00:45:09.090 --> 00:45:11.210 align:middle line:84% In the standard model, it'll raise investment, 00:45:11.210 --> 00:45:12.930 align:middle line:84% because basically there's a higher return 00:45:12.930 --> 00:45:14.810 align:middle line:90% to investing in companies. 00:45:14.810 --> 00:45:16.890 align:middle line:84% But in the alternative model, which is actually 00:45:16.890 --> 00:45:18.557 align:middle line:84% the only model consistent with the data, 00:45:18.557 --> 00:45:20.090 align:middle line:90% it could lower investment. 00:45:20.090 --> 00:45:20.823 align:middle line:90% So we don't know. 00:45:20.823 --> 00:45:22.490 align:middle line:84% And in fact, there was a wonderful study 00:45:22.490 --> 00:45:25.170 align:middle line:84% done by an economist named Danny Yagan who 00:45:25.170 --> 00:45:28.370 align:middle line:84% noted that when George Bush cut-- when there was 00:45:28.370 --> 00:45:30.370 align:middle line:84% this massive dividend tax rate cut, 00:45:30.370 --> 00:45:33.610 align:middle line:84% it was true for C corporations and not S corporations. 00:45:33.610 --> 00:45:37.130 align:middle line:84% So very similar firms, which just by how they were labeled, 00:45:37.130 --> 00:45:38.730 align:middle line:90% got a very different tax cut. 00:45:38.730 --> 00:45:40.970 align:middle line:84% So we could do a difference in difference study 00:45:40.970 --> 00:45:42.650 align:middle line:90% of how did the tax cut-- 00:45:42.650 --> 00:45:45.300 align:middle line:84% C corporations saw big tax change, big reduction 00:45:45.300 --> 00:45:46.050 align:middle line:90% in dividend taxes. 00:45:46.050 --> 00:45:47.450 align:middle line:90% S corporations didn't. 00:45:47.450 --> 00:45:51.130 align:middle line:84% Huge change, zero effect on investment. 00:45:51.130 --> 00:45:53.330 align:middle line:84% So we paid out hundreds of billions 00:45:53.330 --> 00:45:55.450 align:middle line:84% of dollars in tax breaks to rich guys 00:45:55.450 --> 00:45:57.850 align:middle line:84% and got no increase in investment for it. 00:45:57.850 --> 00:46:03.020 align:middle line:84% And that is very helpful to think about why theory matters. 00:46:03.020 --> 00:46:03.520 align:middle line:90% OK? 00:46:03.520 --> 00:46:04.650 align:middle line:84% I'm a very empirical-oriented guy. 00:46:04.650 --> 00:46:05.840 align:middle line:90% It's why theory matters. 00:46:05.840 --> 00:46:07.920 align:middle line:84% Once you understand the theory of why the hell firms pay 00:46:07.920 --> 00:46:08.920 align:middle line:84% dividends in the first place, you 00:46:08.920 --> 00:46:11.360 align:middle line:84% understand it wouldn't obviously lead to more investment. 00:46:11.360 --> 00:46:13.900 align:middle line:84% In a naive model of just, well, I look at this chart, 00:46:13.900 --> 00:46:15.180 align:middle line:90% it lowers the rate of return. 00:46:15.180 --> 00:46:17.055 align:middle line:84% But once you actually think about the theory, 00:46:17.055 --> 00:46:19.580 align:middle line:84% it's not at all obvious what it would do. 00:46:19.580 --> 00:46:21.920 align:middle line:84% And in fact, the answer is it did nothing. 00:46:21.920 --> 00:46:22.440 align:middle line:90% OK? 00:46:22.440 --> 00:46:22.940 align:middle line:90% Yeah. 00:46:22.940 --> 00:46:24.520 align:middle line:84% AUDIENCE: What can the US government 00:46:24.520 --> 00:46:27.443 align:middle line:84% do if very big corporations don't pay tax? 00:46:27.443 --> 00:46:29.360 align:middle line:84% JON GRUBER: Well, I mean, they could sue them. 00:46:29.360 --> 00:46:30.580 align:middle line:90% And they win sometimes. 00:46:30.580 --> 00:46:31.860 align:middle line:90% That was like GlaxoSmithKline. 00:46:31.860 --> 00:46:32.360 align:middle line:90% We won. 00:46:32.360 --> 00:46:34.440 align:middle line:84% We got billions of dollars in back settlements. 00:46:34.440 --> 00:46:37.040 align:middle line:84% But if they're not paying taxes legally, like Apple-- 00:46:37.040 --> 00:46:39.080 align:middle line:84% I mean, I don't know about this holy thing 00:46:39.080 --> 00:46:40.260 align:middle line:90% that lives in no country. 00:46:40.260 --> 00:46:44.760 align:middle line:84% But the previous one, where they just actually were-- 00:46:44.760 --> 00:46:46.680 align:middle line:84% basically, you sue them, and you hope 00:46:46.680 --> 00:46:49.880 align:middle line:84% that your lawyers are smarter and can keep up 00:46:49.880 --> 00:46:51.320 align:middle line:90% with their lawyers. 00:46:51.320 --> 00:46:54.360 align:middle line:90% Essentially the way it goes. 00:46:54.360 --> 00:46:58.020 align:middle line:84% So that is all I really want to say about corporate taxation. 00:46:58.020 --> 00:46:59.610 align:middle line:90% Any other questions about that? 00:46:59.610 --> 00:47:00.322 align:middle line:90% Yeah. 00:47:00.322 --> 00:47:02.030 align:middle line:84% AUDIENCE: Just to clarify, empirical data 00:47:02.030 --> 00:47:03.572 align:middle line:84% showed that there was no correlation? 00:47:03.572 --> 00:47:06.072 align:middle line:84% JON GRUBER: That there was no effect of cutting the dividend 00:47:06.072 --> 00:47:06.870 align:middle line:90% tax on investment. 00:47:06.870 --> 00:47:09.910 align:middle line:84% So basically, Bush cut the dividend tax for C corporations, 00:47:09.910 --> 00:47:11.285 align:middle line:84% didn't cut it for S corporations, 00:47:11.285 --> 00:47:13.535 align:middle line:84% and yet patterns of investments across those two types 00:47:13.535 --> 00:47:14.950 align:middle line:90% of corporations were unchanged. 00:47:14.950 --> 00:47:16.658 align:middle line:84% AUDIENCE: So it's more so just signaling? 00:47:16.658 --> 00:47:18.992 align:middle line:84% JON GRUBER: Yeah, it's more we're just dumping money out 00:47:18.992 --> 00:47:19.570 align:middle line:90% to rich guys. 00:47:19.570 --> 00:47:21.737 align:middle line:84% So essentially it's giving a tax break to rich guys. 00:47:21.737 --> 00:47:23.890 align:middle line:84% That's something they were-- it's inframarginal. 00:47:23.890 --> 00:47:25.670 align:middle line:84% So once again, we care about marginal and inframarginal 00:47:25.670 --> 00:47:26.370 align:middle line:90% effects. 00:47:26.370 --> 00:47:28.230 align:middle line:84% The marginal effect-- well, gee, can we 00:47:28.230 --> 00:47:30.570 align:middle line:84% get more investment by cutting the dividend tax rate? 00:47:30.570 --> 00:47:31.830 align:middle line:84% The inframarginal, I'm giving away money 00:47:31.830 --> 00:47:33.622 align:middle line:84% to people who are getting dividends anyway. 00:47:33.622 --> 00:47:36.510 align:middle line:84% And the answer was all inframarginal, no marginal. 00:47:36.510 --> 00:47:37.810 align:middle line:90% Now, is that good or bad? 00:47:37.810 --> 00:47:39.132 align:middle line:90% That's an equity question. 00:47:39.132 --> 00:47:41.090 align:middle line:84% But we know that the dividend holders are rich. 00:47:41.090 --> 00:47:43.830 align:middle line:84% So it's certainly bad from an equity perspective. 00:47:43.830 --> 00:47:45.430 align:middle line:90% OK? 00:47:45.430 --> 00:47:49.790 align:middle line:84% Now we're going to start the last chapter, where we tie this 00:47:49.790 --> 00:47:50.930 align:middle line:90% all together. 00:47:50.930 --> 00:47:53.270 align:middle line:84% This is very important and exciting, because once again, 00:47:53.270 --> 00:47:54.410 align:middle line:90% I like when we integrate things. 00:47:54.410 --> 00:47:56.190 align:middle line:84% We're going to really be able to tie together all the stuff we've 00:47:56.190 --> 00:47:58.597 align:middle line:84% learned in the last six chapters into one tidy package 00:47:58.597 --> 00:48:00.180 align:middle line:84% and talk about what we should actually 00:48:00.180 --> 00:48:01.462 align:middle line:90% do about taxes in the US. 00:48:01.462 --> 00:48:02.920 align:middle line:84% So please, if you can it on Friday, 00:48:02.920 --> 00:48:04.740 align:middle line:84% I really urge you to figure out a way to be there, 00:48:04.740 --> 00:48:06.240 align:middle line:84% because this is a fun discussion. 00:48:06.240 --> 00:48:06.990 align:middle line:90% We'll start today. 00:48:06.990 --> 00:48:08.260 align:middle line:90% We'll continue on Friday. 00:48:08.260 --> 00:48:09.540 align:middle line:90% OK? 00:48:09.540 --> 00:48:12.220 align:middle line:84% So I want to talk I want to start 00:48:12.220 --> 00:48:15.600 align:middle line:84% with a story of a guy named Herman Cain. 00:48:15.600 --> 00:48:17.500 align:middle line:84% Any of you guys know who Herman Cain is? 00:48:17.500 --> 00:48:19.820 align:middle line:84% Herman Cain founded Godfather's Pizza, 00:48:19.820 --> 00:48:24.580 align:middle line:84% and he ran for president in 2012. 00:48:24.580 --> 00:48:27.480 align:middle line:90% And he was a silly character. 00:48:27.480 --> 00:48:30.402 align:middle line:84% But his big platform was 9-9-9, he called it. 00:48:30.402 --> 00:48:32.860 align:middle line:84% He said, we're going to get rid of all this complicated tax 00:48:32.860 --> 00:48:35.120 align:middle line:90% system, have a flat tax. 00:48:35.120 --> 00:48:36.880 align:middle line:90% It was a 9-9-9 plan-- 00:48:36.880 --> 00:48:42.560 align:middle line:84% 9% corporate tax, 9% income tax, 9% sales tax. 00:48:42.560 --> 00:48:43.760 align:middle line:90% Everything else is gone. 00:48:43.760 --> 00:48:46.672 align:middle line:84% None of this million pages of tax forms, 00:48:46.672 --> 00:48:48.880 align:middle line:84% none of this conflict, none of this-- all that stuff. 00:48:48.880 --> 00:48:49.622 align:middle line:90% Just a flat tax. 00:48:49.622 --> 00:48:51.080 align:middle line:84% It was actually incredibly popular. 00:48:51.080 --> 00:48:53.650 align:middle line:90% It got pretty far on just 9-9-9. 00:48:53.650 --> 00:48:54.400 align:middle line:90% He got pretty far. 00:48:54.400 --> 00:48:55.900 align:middle line:84% And actually, there's a long history 00:48:55.900 --> 00:48:58.410 align:middle line:84% of people proposing that we just scrap our current tax 00:48:58.410 --> 00:49:00.530 align:middle line:90% system with a flat tax system. 00:49:00.530 --> 00:49:03.950 align:middle line:84% Now, we actually got fairly close at one point. 00:49:03.950 --> 00:49:06.290 align:middle line:84% The holy moment, the golden moment for public finance 00:49:06.290 --> 00:49:09.210 align:middle line:84% economists and tax policy was in 1986 00:49:09.210 --> 00:49:10.730 align:middle line:90% under a Republican president. 00:49:10.730 --> 00:49:12.770 align:middle line:84% Republican and Democratic senators 00:49:12.770 --> 00:49:15.970 align:middle line:84% locked themselves in a hangar at an Air Force base 00:49:15.970 --> 00:49:17.818 align:middle line:84% until they hammered out a tax deal. 00:49:17.818 --> 00:49:19.610 align:middle line:84% And the fundamental feature of the tax deal 00:49:19.610 --> 00:49:23.290 align:middle line:84% was to massively overhaul the individual tax system. 00:49:23.290 --> 00:49:28.930 align:middle line:84% Before 1986, there used to be 15 tax brackets, with rates 00:49:28.930 --> 00:49:32.290 align:middle line:90% ranging from 11% to 50%. 00:49:32.290 --> 00:49:35.770 align:middle line:84% There was also all sorts of loopholes 00:49:35.770 --> 00:49:38.250 align:middle line:84% in the tax system, all sorts of violations of Haig-Simons 00:49:38.250 --> 00:49:39.690 align:middle line:90% all over the place. 00:49:39.690 --> 00:49:44.210 align:middle line:84% In 1986, they said, we're going to take these 15 brackets 00:49:44.210 --> 00:49:45.770 align:middle line:90% and make them three brackets-- 00:49:45.770 --> 00:49:49.010 align:middle line:90% 15%, 28%, and 33%. 00:49:49.010 --> 00:49:51.290 align:middle line:84% Capital gains are now regular income. 00:49:51.290 --> 00:49:53.070 align:middle line:90% No more IRA deductions. 00:49:53.070 --> 00:49:55.680 align:middle line:84% We are going to go to Haig-Simons with a much flatter 00:49:55.680 --> 00:49:56.760 align:middle line:90% tax system. 00:49:56.760 --> 00:49:58.480 align:middle line:90% And economists cheered. 00:49:58.480 --> 00:49:59.760 align:middle line:90% This is what we want. 00:49:59.760 --> 00:50:01.680 align:middle line:84% Basically, a flat, broad tax system 00:50:01.680 --> 00:50:04.660 align:middle line:84% is the most efficient way to collect taxes. 00:50:04.660 --> 00:50:07.100 align:middle line:90% Now you lowered the top rate. 00:50:07.100 --> 00:50:11.180 align:middle line:84% So you could dispute whether the top rate should be 33% or 50%. 00:50:11.180 --> 00:50:13.720 align:middle line:84% But it was a much more efficient tax system. 00:50:13.720 --> 00:50:15.800 align:middle line:90% However, it did not last. 00:50:15.800 --> 00:50:18.340 align:middle line:84% Starting in 1993 and then again in 1997, 00:50:18.340 --> 00:50:21.460 align:middle line:84% then again in 2001, 2003, 2012, 2017, 00:50:21.460 --> 00:50:23.060 align:middle line:90% we kept messing up the system. 00:50:23.060 --> 00:50:26.200 align:middle line:84% So now we have our more complicated system again. 00:50:26.200 --> 00:50:30.040 align:middle line:84% So basically the question is, what 00:50:30.040 --> 00:50:33.160 align:middle line:84% is the advantage of a simpler, flatter system 00:50:33.160 --> 00:50:34.820 align:middle line:90% and can we get back there? 00:50:34.820 --> 00:50:36.700 align:middle line:84% What are the barriers to getting back there? 00:50:36.700 --> 00:50:38.220 align:middle line:84% I'm going to argue there are advantages. 00:50:38.220 --> 00:50:40.053 align:middle line:84% What are the barriers to getting back there? 00:50:40.053 --> 00:50:42.400 align:middle line:84% And there's really advantages in three areas. 00:50:42.400 --> 00:50:44.200 align:middle line:84% There's three fundamental reasons 00:50:44.200 --> 00:50:47.720 align:middle line:84% why a simpler, flatter tax system helps. 00:50:47.720 --> 00:50:50.640 align:middle line:90% The first reason is tax evasion. 00:50:50.640 --> 00:50:54.880 align:middle line:84% We've so far talked about tax avoidance, doing legal things-- 00:50:54.880 --> 00:50:57.400 align:middle line:84% at least borderline legal things. 00:50:57.400 --> 00:50:59.480 align:middle line:84% There's also straight tax evasion, literally just 00:50:59.480 --> 00:51:01.880 align:middle line:84% cheating-- just not reporting your income. 00:51:01.880 --> 00:51:07.280 align:middle line:84% Now, there's lots of fun examples of this. 00:51:07.280 --> 00:51:10.063 align:middle line:84% So the CEO of Brockman Incorporated-- 00:51:10.063 --> 00:51:11.980 align:middle line:84% I'm sorry, Reynolds and Reynolds Incorporated. 00:51:11.980 --> 00:51:15.200 align:middle line:90% They make tinfoil and stuff. 00:51:15.200 --> 00:51:18.040 align:middle line:84% He hid over 20 years of capital gains income 00:51:18.040 --> 00:51:20.920 align:middle line:84% through secret bank accounts, managing the largest tax fraud 00:51:20.920 --> 00:51:23.960 align:middle line:84% case ever for a US citizen in 2020. 00:51:23.960 --> 00:51:25.940 align:middle line:84% He backdated records and used code words 00:51:25.940 --> 00:51:27.440 align:middle line:84% to conceal the movement of his money 00:51:27.440 --> 00:51:29.565 align:middle line:84% to entities in the foreign jurisdictions of Bermuda 00:51:29.565 --> 00:51:31.400 align:middle line:90% and Nevis. 00:51:31.400 --> 00:51:34.320 align:middle line:84% And then he and his co-conspirators 00:51:34.320 --> 00:51:36.680 align:middle line:84% settled for the Justice Department with $130 million 00:51:36.680 --> 00:51:37.660 align:middle line:90% in back taxes. 00:51:37.660 --> 00:51:40.120 align:middle line:84% But it wasn't nearly as much as he'd stolen. 00:51:40.120 --> 00:51:42.780 align:middle line:84% Now, the rich are not the only ones who cheat on taxes. 00:51:42.780 --> 00:51:46.240 align:middle line:90% 00:51:46.240 --> 00:51:49.580 align:middle line:84% We have something called-- in the US tax system, 00:51:49.580 --> 00:51:53.358 align:middle line:84% there used to be deductions for the number of children you have. 00:51:53.358 --> 00:51:54.650 align:middle line:90% Now we have a child tax credit. 00:51:54.650 --> 00:51:58.550 align:middle line:84% It used to be a deduction for each of your number of children. 00:51:58.550 --> 00:52:01.590 align:middle line:84% Before 1986, you just listed how many children you had. 00:52:01.590 --> 00:52:03.370 align:middle line:84% Starting in 1986, as part of the tax form, 00:52:03.370 --> 00:52:05.710 align:middle line:84% you had to list the kids' Social Security numbers. 00:52:05.710 --> 00:52:11.990 align:middle line:84% When they did that, 6 million kids in America disappeared. 00:52:11.990 --> 00:52:17.270 align:middle line:84% My favorite example, actually, internationally is Greece. 00:52:17.270 --> 00:52:18.890 align:middle line:84% Other countries have a hard time. 00:52:18.890 --> 00:52:21.190 align:middle line:84% Other countries, much more of the economic transactions 00:52:21.190 --> 00:52:22.330 align:middle line:90% are done under the table. 00:52:22.330 --> 00:52:24.370 align:middle line:84% So it's hard to measure income and wealth and tax it. 00:52:24.370 --> 00:52:25.787 align:middle line:84% So they tried to do clever things. 00:52:25.787 --> 00:52:27.250 align:middle line:84% Remember the window tax in England? 00:52:27.250 --> 00:52:29.158 align:middle line:90% Well, Greece had a pool tax. 00:52:29.158 --> 00:52:30.950 align:middle line:84% They noticed that people with private pools 00:52:30.950 --> 00:52:33.310 align:middle line:84% are more likely to be wealthy than people 00:52:33.310 --> 00:52:34.910 align:middle line:90% without private pools. 00:52:34.910 --> 00:52:36.910 align:middle line:84% So what they did is they'd literally 00:52:36.910 --> 00:52:38.910 align:middle line:84% fly helicopters over and find out who had a pool 00:52:38.910 --> 00:52:40.310 align:middle line:90% and tax them more. 00:52:40.310 --> 00:52:43.350 align:middle line:90% Well, people got wise to this. 00:52:43.350 --> 00:52:45.910 align:middle line:84% Basically, people developed pool covers 00:52:45.910 --> 00:52:48.990 align:middle line:84% that could fool the tracking, could fool Google Earth. 00:52:48.990 --> 00:52:52.180 align:middle line:84% So in the wealthy suburb of Kifisia, 00:52:52.180 --> 00:52:56.980 align:middle line:84% there were estimated 324 people reported having a pool. 00:52:56.980 --> 00:53:02.320 align:middle line:84% The true number of pools is estimated 17,000 pools. 00:53:02.320 --> 00:53:05.660 align:middle line:84% So 324 out of 17,000 pools were found and reported. 00:53:05.660 --> 00:53:08.540 align:middle line:84% So basically, there's a lot of people do a lot of stuff 00:53:08.540 --> 00:53:11.140 align:middle line:90% to avoid paying taxes. 00:53:11.140 --> 00:53:12.403 align:middle line:90% Why do they do that? 00:53:12.403 --> 00:53:13.820 align:middle line:84% Well basically, as always, they're 00:53:13.820 --> 00:53:15.278 align:middle line:84% trading off the costs and benefits. 00:53:15.278 --> 00:53:18.940 align:middle line:84% So let's go to the first figure in chapter 25, which is 00:53:18.940 --> 00:53:21.500 align:middle line:90% a model of optimal tax evasion. 00:53:21.500 --> 00:53:24.060 align:middle line:84% Remember, we model everything, from love to marriage 00:53:24.060 --> 00:53:25.380 align:middle line:90% to tax evasion. 00:53:25.380 --> 00:53:28.070 align:middle line:84% And we always do it trading off costs and benefits. 00:53:28.070 --> 00:53:29.820 align:middle line:84% So let's think about the cost and benefits 00:53:29.820 --> 00:53:31.040 align:middle line:90% of cheating on taxes. 00:53:31.040 --> 00:53:33.060 align:middle line:90% Well, let's imagine a model. 00:53:33.060 --> 00:53:36.100 align:middle line:84% What is the benefit of cheating on taxes? 00:53:36.100 --> 00:53:39.660 align:middle line:84% Well, for every dollar of tax you cheat, you save tau cents. 00:53:39.660 --> 00:53:42.140 align:middle line:84% So the marginal benefit is a flat line 00:53:42.140 --> 00:53:43.520 align:middle line:90% at the marginal tax rate. 00:53:43.520 --> 00:53:47.570 align:middle line:84% So let's start with the marginal tax rate of 50%. 00:53:47.570 --> 00:53:49.320 align:middle line:84% Let's say there's a 50% marginal tax rate. 00:53:49.320 --> 00:53:52.350 align:middle line:84% The marginal benefit MB1 is just a flat line at $0.50. 00:53:52.350 --> 00:53:54.330 align:middle line:90% That's the marginal benefit. 00:53:54.330 --> 00:53:56.290 align:middle line:90% What's the marginal cost? 00:53:56.290 --> 00:54:01.810 align:middle line:84% The marginal cost is going to be essentially the penalty 00:54:01.810 --> 00:54:04.050 align:middle line:90% you pay if you get caught. 00:54:04.050 --> 00:54:08.970 align:middle line:84% So if the idea is that basically both the odds of getting caught 00:54:08.970 --> 00:54:12.730 align:middle line:84% and how heavily you're penalized rise with how much you cheat, 00:54:12.730 --> 00:54:15.988 align:middle line:84% you have an upward-sloping marginal cost curve. 00:54:15.988 --> 00:54:17.530 align:middle line:84% So if you cheat a little bit, there's 00:54:17.530 --> 00:54:21.033 align:middle line:84% no cost, because they're going to ignore you. 00:54:21.033 --> 00:54:23.450 align:middle line:84% But as you cheat a lot, the odds you get caught get higher 00:54:23.450 --> 00:54:25.250 align:middle line:84% and the amount you have to pay gets higher, 00:54:25.250 --> 00:54:27.770 align:middle line:84% so marginal cost is going to rise. 00:54:27.770 --> 00:54:31.672 align:middle line:84% Now, basically what that means is 00:54:31.672 --> 00:54:33.130 align:middle line:84% what will determine how much-- that 00:54:33.130 --> 00:54:35.330 align:middle line:84% means there'll be an optimal amount of cheating. 00:54:35.330 --> 00:54:37.970 align:middle line:84% The optimal amount of cheating is where marginal benefits 00:54:37.970 --> 00:54:39.330 align:middle line:90% equal marginal costs. 00:54:39.330 --> 00:54:42.930 align:middle line:84% So in this example, people evade an amount 00:54:42.930 --> 00:54:47.250 align:middle line:84% which is where the expected damage from being caught 00:54:47.250 --> 00:54:49.440 align:middle line:90% equals the benefit of cheating. 00:54:49.440 --> 00:54:50.300 align:middle line:90% What does that mean? 00:54:50.300 --> 00:54:52.080 align:middle line:84% That means that two things fundamentally 00:54:52.080 --> 00:54:54.680 align:middle line:90% determine how much you cheat. 00:54:54.680 --> 00:54:57.560 align:middle line:84% The first is the penalties and odds of getting caught. 00:54:57.560 --> 00:54:58.920 align:middle line:90% That's the MC curve. 00:54:58.920 --> 00:55:02.620 align:middle line:84% So if you increase penalties or increase surveillance of taxes, 00:55:02.620 --> 00:55:04.200 align:middle line:90% that will raise marginal costs. 00:55:04.200 --> 00:55:06.060 align:middle line:90% That will induce less cheating. 00:55:06.060 --> 00:55:06.560 align:middle line:90% OK? 00:55:06.560 --> 00:55:09.160 align:middle line:90% You move from E1 to E2. 00:55:09.160 --> 00:55:11.263 align:middle line:84% Because once again, it's a cost-benefit analysis. 00:55:11.263 --> 00:55:12.680 align:middle line:84% On the other hand, if the tax rate 00:55:12.680 --> 00:55:15.420 align:middle line:84% goes up for a given set of penalties, 00:55:15.420 --> 00:55:16.800 align:middle line:90% that increases cheating. 00:55:16.800 --> 00:55:19.520 align:middle line:84% Because the costs are fixed, the benefits have now risen. 00:55:19.520 --> 00:55:24.680 align:middle line:84% So what that means is another reason besides Haig-Simons 00:55:24.680 --> 00:55:28.400 align:middle line:84% why we like low tax rates is it reduces the incentive to cheat. 00:55:28.400 --> 00:55:31.000 align:middle line:84% The higher the tax rate, the more incentive 00:55:31.000 --> 00:55:33.520 align:middle line:90% there is to cheat. 00:55:33.520 --> 00:55:37.040 align:middle line:84% Now, in fact, in the US, we estimate 00:55:37.040 --> 00:55:44.120 align:middle line:84% that currently about $630 billion-- about 3% of GDP 00:55:44.120 --> 00:55:45.100 align:middle line:90% is our tax gap. 00:55:45.100 --> 00:55:47.040 align:middle line:84% That is, there's $630 billion not 00:55:47.040 --> 00:55:49.630 align:middle line:84% being paid in taxes that should be paid in taxes. 00:55:49.630 --> 00:55:52.530 align:middle line:84% That's pretty similar to other developed countries. 00:55:52.530 --> 00:55:55.310 align:middle line:90% Sweden is about 10%. 00:55:55.310 --> 00:55:57.810 align:middle line:84% But developing countries don't do very well in this measure. 00:55:57.810 --> 00:56:01.630 align:middle line:90% Pakistan has a tax cap of 70%. 00:56:01.630 --> 00:56:06.630 align:middle line:84% A recent study in other developing countries 00:56:06.630 --> 00:56:08.310 align:middle line:90% have this sort of thing. 00:56:08.310 --> 00:56:11.050 align:middle line:90% In Greece, the tax cap is 90%. 00:56:11.050 --> 00:56:13.048 align:middle line:84% And there's actually a fun story of why, 00:56:13.048 --> 00:56:15.590 align:middle line:84% which is that basically-- it's a great historical perspective 00:56:15.590 --> 00:56:18.990 align:middle line:84% on this, which is basically, for a long time, 00:56:18.990 --> 00:56:20.530 align:middle line:84% Greece was occupied by the Ottomans. 00:56:20.530 --> 00:56:21.750 align:middle line:90% They hated Turks. 00:56:21.750 --> 00:56:25.210 align:middle line:84% And basically, the Ottomans tried to tax them. 00:56:25.210 --> 00:56:27.990 align:middle line:84% So a view of patriotism was to avoid paying taxes. 00:56:27.990 --> 00:56:29.310 align:middle line:90% And it sort of stuck. 00:56:29.310 --> 00:56:31.600 align:middle line:84% This is kind of like Daron's work on institutions, 00:56:31.600 --> 00:56:33.350 align:middle line:84% that once things become a nation's culture 00:56:33.350 --> 00:56:34.682 align:middle line:90% and institutions, they stick. 00:56:34.682 --> 00:56:36.390 align:middle line:84% So Greece has a long and valuable history 00:56:36.390 --> 00:56:40.390 align:middle line:84% of not paying taxes that result in a 90% tax gap. 00:56:40.390 --> 00:56:43.130 align:middle line:90% Now, what can we-- question. 00:56:43.130 --> 00:56:45.790 align:middle line:84% AUDIENCE: What's the average-- in terms 00:56:45.790 --> 00:56:50.067 align:middle line:84% of dollars, what's the average that you can get away with? 00:56:50.067 --> 00:56:51.150 align:middle line:90% JON GRUBER: This guy, man. 00:56:51.150 --> 00:56:54.190 align:middle line:84% Am I going to go to jail for even teaching you? 00:56:54.190 --> 00:56:56.930 align:middle line:84% So basically, I do not know that answer. 00:56:56.930 --> 00:56:59.190 align:middle line:84% And if I did, I would not tell you. 00:56:59.190 --> 00:57:03.530 align:middle line:84% But basically, here is the interesting evidence on it. 00:57:03.530 --> 00:57:09.910 align:middle line:84% So there's actually some really good evidence, 00:57:09.910 --> 00:57:12.670 align:middle line:84% which is that basically, there's an incredibly 00:57:12.670 --> 00:57:16.890 align:middle line:90% high rate of return on this. 00:57:16.890 --> 00:57:20.630 align:middle line:84% And there's a really cool new study by my colleague Nathan 00:57:20.630 --> 00:57:22.650 align:middle line:90% Hendren. 00:57:22.650 --> 00:57:25.690 align:middle line:84% So the IRS randomly audits people. 00:57:25.690 --> 00:57:28.310 align:middle line:84% So there's actually data on how much people cheat. 00:57:28.310 --> 00:57:29.730 align:middle line:90% So that deters cheating a bit. 00:57:29.730 --> 00:57:31.870 align:middle line:84% But it's sufficiently random that it 00:57:31.870 --> 00:57:33.790 align:middle line:84% doesn't deter cheating that much, because it's 00:57:33.790 --> 00:57:35.090 align:middle line:90% odd you'll get audited. 00:57:35.090 --> 00:57:35.708 align:middle line:90% But they do. 00:57:35.708 --> 00:57:37.750 align:middle line:84% And they make that data available to researchers, 00:57:37.750 --> 00:57:41.990 align:middle line:84% if you go through 18 secret doors and stuff like that. 00:57:41.990 --> 00:57:44.940 align:middle line:90% So they use this to assess. 00:57:44.940 --> 00:57:49.180 align:middle line:84% And they used variation in the enforcement IRS 00:57:49.180 --> 00:57:52.340 align:middle line:84% spent on trying to go after people to assess what 00:57:52.340 --> 00:57:55.740 align:middle line:84% is the marginal return to a dollar of IRS spending 00:57:55.740 --> 00:57:57.420 align:middle line:90% to try to get people? 00:57:57.420 --> 00:57:59.920 align:middle line:84% So each dollar of IRS spending to try to collect taxes, 00:57:59.920 --> 00:58:01.380 align:middle line:90% what do you get back in taxes? 00:58:01.380 --> 00:58:06.020 align:middle line:84% What they found is on average, you get about $3 00:58:06.020 --> 00:58:08.680 align:middle line:84% of revenues for every $1 of enforcement payment. 00:58:08.680 --> 00:58:11.060 align:middle line:84% So it's a massive increasing rate of return. 00:58:11.060 --> 00:58:15.080 align:middle line:84% So already we're massively underinvesting in collection. 00:58:15.080 --> 00:58:16.320 align:middle line:90% Here's a striking fact. 00:58:16.320 --> 00:58:18.620 align:middle line:84% There's a huge income profile, which 00:58:18.620 --> 00:58:20.793 align:middle line:84% is the rich are the ones who cheat. 00:58:20.793 --> 00:58:22.460 align:middle line:84% And why are the rich the ones who cheat? 00:58:22.460 --> 00:58:26.080 align:middle line:84% Because it's hard to cheat if you're just a working Joe. 00:58:26.080 --> 00:58:29.260 align:middle line:84% Because remember, your income is just reported right to the IRS. 00:58:29.260 --> 00:58:31.460 align:middle line:84% Let's say your income is just from your job. 00:58:31.460 --> 00:58:32.652 align:middle line:90% How are you going to cheat? 00:58:32.652 --> 00:58:34.360 align:middle line:84% They're just going to report your income. 00:58:34.360 --> 00:58:36.660 align:middle line:84% Now, you could lie about how you give to charity. 00:58:36.660 --> 00:58:40.420 align:middle line:84% But that's not a first order way to cheat. 00:58:40.420 --> 00:58:42.895 align:middle line:84% So at the bottom of the income distribution, 00:58:42.895 --> 00:58:45.270 align:middle line:84% the return to enforcement is closer to dollar for dollar. 00:58:45.270 --> 00:58:47.103 align:middle line:84% There's still some gain, but it's not a lot. 00:58:47.103 --> 00:58:50.170 align:middle line:84% At the top, it's $12 to $15 for every $1 00:58:50.170 --> 00:58:52.650 align:middle line:90% you spend on enforcement. 00:58:52.650 --> 00:58:56.370 align:middle line:84% So there is an unbelievable rate of return to this activity. 00:58:56.370 --> 00:58:59.150 align:middle line:84% However, it is very hard to get investments in the IRS. 00:58:59.150 --> 00:59:02.770 align:middle line:84% And I saw this firsthand when I arrived at Treasury in 1997. 00:59:02.770 --> 00:59:06.490 align:middle line:84% In 1997, they had a huge set of hearings about abuses 00:59:06.490 --> 00:59:10.570 align:middle line:90% at the IRS, our tax authority-- 00:59:10.570 --> 00:59:13.130 align:middle line:90% about abuses at the IRS. 00:59:13.130 --> 00:59:18.495 align:middle line:84% And basically what happened was they had all sorts of people 00:59:18.495 --> 00:59:20.870 align:middle line:84% testify about how the IRS had made their lives miserable. 00:59:20.870 --> 00:59:23.210 align:middle line:84% So a New York priest spoke of being hounded by the IRS 00:59:23.210 --> 00:59:25.290 align:middle line:90% to pay taxes he didn't owe. 00:59:25.290 --> 00:59:27.730 align:middle line:84% They found one man who committed suicide after a battle 00:59:27.730 --> 00:59:28.548 align:middle line:90% with the IRS. 00:59:28.548 --> 00:59:30.590 align:middle line:84% People came with bags over their head to testify. 00:59:30.590 --> 00:59:31.730 align:middle line:90% It was a big deal. 00:59:31.730 --> 00:59:33.630 align:middle line:84% And the IRS was massively overhauled. 00:59:33.630 --> 00:59:36.730 align:middle line:84% And they massively cut back the IRS tax enforcement 00:59:36.730 --> 00:59:38.370 align:middle line:90% because of these. 00:59:38.370 --> 00:59:41.610 align:middle line:84% And basically we've learned two things since then. 00:59:41.610 --> 00:59:43.960 align:middle line:84% Every single one of them were lying, 00:59:43.960 --> 00:59:45.640 align:middle line:84% that every single one of those cases 00:59:45.640 --> 00:59:48.795 align:middle line:84% actually legitimately owed the taxes that they were found, 00:59:48.795 --> 00:59:50.420 align:middle line:84% and they were just trying to avoid tax. 00:59:50.420 --> 00:59:52.378 align:middle line:84% And the IRS caught them and was punishing them. 00:59:52.378 --> 00:59:55.400 align:middle line:90% So that was the first. 00:59:55.400 --> 01:00:00.240 align:middle line:84% So there was no systematic abuse of any of the things. 01:00:00.240 --> 01:00:02.960 align:middle line:84% And a year later, they set up a watchdog agency 01:00:02.960 --> 01:00:06.580 align:middle line:84% to investigate every complaint of harassment by an IRS agent. 01:00:06.580 --> 01:00:09.460 align:middle line:84% They investigated 830 complaints. 01:00:09.460 --> 01:00:11.080 align:middle line:90% Zero were found to have merit. 01:00:11.080 --> 01:00:13.080 align:middle line:90% So first of all, it was all BS. 01:00:13.080 --> 01:00:15.500 align:middle line:84% Second of all, by cutting the staff, 01:00:15.500 --> 01:00:19.280 align:middle line:84% we saw massive erosion in tax payment in the US. 01:00:19.280 --> 01:00:24.960 align:middle line:84% So basically, the IRS staff fell by 22% 01:00:24.960 --> 01:00:27.400 align:middle line:90% and the audit rate fell by 40%. 01:00:27.400 --> 01:00:31.530 align:middle line:84% So essentially, because of this public hearing, 01:00:31.530 --> 01:00:32.780 align:middle line:90% we massively cut back the IRS. 01:00:32.780 --> 01:00:35.140 align:middle line:84% And that is why we have these incredible opportunities. 01:00:35.140 --> 01:00:37.280 align:middle line:84% And in fact, the Inflation Reduction Act 01:00:37.280 --> 01:00:40.480 align:middle line:84% was actually the first major investment in tax enforcement 01:00:40.480 --> 01:00:42.125 align:middle line:90% in US in a long time. 01:00:42.125 --> 01:00:44.750 align:middle line:84% This Reduction Act included tons of spending, which is actually 01:00:44.750 --> 01:00:46.070 align:middle line:90% a massive money raiser. 01:00:46.070 --> 01:00:48.430 align:middle line:84% So the Inflation Reduction Act was mostly 01:00:48.430 --> 01:00:50.098 align:middle line:90% focused on climate spending. 01:00:50.098 --> 01:00:51.890 align:middle line:84% How did they pay for that climate spending? 01:00:51.890 --> 01:00:54.630 align:middle line:84% Largely by collecting more taxes that people owed. 01:00:54.630 --> 01:00:56.170 align:middle line:90% But here's what's striking. 01:00:56.170 --> 01:00:58.770 align:middle line:84% Once again, sounds so simple when I say it, 01:00:58.770 --> 01:01:01.390 align:middle line:84% but there's a large political constituency against IRS 01:01:01.390 --> 01:01:02.550 align:middle line:90% enforcement. 01:01:02.550 --> 01:01:04.180 align:middle line:84% It's actually incredibly controversial. 01:01:04.180 --> 01:01:06.430 align:middle line:84% It would not be surprising if the Trump administration 01:01:06.430 --> 01:01:07.910 align:middle line:90% cut back this funding. 01:01:07.910 --> 01:01:09.530 align:middle line:90% That is insane. 01:01:09.530 --> 01:01:10.030 align:middle line:90% OK? 01:01:10.030 --> 01:01:11.630 align:middle line:90% Let's be patently clear. 01:01:11.630 --> 01:01:14.350 align:middle line:84% The money they collect is largely-- 01:01:14.350 --> 01:01:19.350 align:middle line:84% think about why tax enforcement is the best possible policy, OK? 01:01:19.350 --> 01:01:22.230 align:middle line:84% Tax enforcement that returns more than it-- assuming we're 01:01:22.230 --> 01:01:23.110 align:middle line:90% not harassing people. 01:01:23.110 --> 01:01:24.415 align:middle line:90% Let's leave that aside. 01:01:24.415 --> 01:01:25.790 align:middle line:84% Tax enforcement that returns more 01:01:25.790 --> 01:01:27.470 align:middle line:84% than you collect as a rate of return, 01:01:27.470 --> 01:01:28.530 align:middle line:90% why is it a great policy? 01:01:28.530 --> 01:01:29.947 align:middle line:84% First of all, it's a positive rate 01:01:29.947 --> 01:01:31.230 align:middle line:90% of return government activity. 01:01:31.230 --> 01:01:33.610 align:middle line:84% Second of all, it increases tax efficiency. 01:01:33.610 --> 01:01:35.130 align:middle line:84% Why does it increase tax efficiency? 01:01:35.130 --> 01:01:37.470 align:middle line:84% Because you broaden the tax base and people 01:01:37.470 --> 01:01:39.510 align:middle line:84% don't spend their time trying to cheat. 01:01:39.510 --> 01:01:41.180 align:middle line:84% Third of all, it increases equity 01:01:41.180 --> 01:01:43.260 align:middle line:84% because it's the rich guys who cheat. 01:01:43.260 --> 01:01:45.013 align:middle line:84% So basically, there is no argument 01:01:45.013 --> 01:01:46.680 align:middle line:84% against increasing enforcement spending, 01:01:46.680 --> 01:01:48.940 align:middle line:84% especially at the top of the income scale. 01:01:48.940 --> 01:01:52.440 align:middle line:84% But somehow people kind think the IRS is some bad guy. 01:01:52.440 --> 01:01:54.152 align:middle line:84% And so it's hard to get that through. 01:01:54.152 --> 01:01:55.360 align:middle line:90% So that's been controversial. 01:01:55.360 --> 01:01:55.900 align:middle line:90% Yeah. 01:01:55.900 --> 01:01:59.920 align:middle line:84% AUDIENCE: Why did the trials have any lasting effect? 01:01:59.920 --> 01:02:02.060 align:middle line:84% I can't imagine it was because the government had-- 01:02:02.060 --> 01:02:04.140 align:middle line:84% JON GRUBER: It's because people hate-- 01:02:04.140 --> 01:02:07.580 align:middle line:84% so in some sense, there's actually an industry set up 01:02:07.580 --> 01:02:09.260 align:middle line:90% around people hating taxes. 01:02:09.260 --> 01:02:10.667 align:middle line:90% Let me explain what that means. 01:02:10.667 --> 01:02:12.500 align:middle line:84% I'll actually come back to that in a minute. 01:02:12.500 --> 01:02:13.958 align:middle line:84% But the bottom line is, many people 01:02:13.958 --> 01:02:16.520 align:middle line:84% have an incentive to get the government people to hate taxes. 01:02:16.520 --> 01:02:18.440 align:middle line:84% There's a large set of people who make people hate tax. 01:02:18.440 --> 01:02:20.980 align:middle line:84% And I'll come to more reasons why people legitimately 01:02:20.980 --> 01:02:22.180 align:middle line:90% do hate taxes. 01:02:22.180 --> 01:02:25.305 align:middle line:84% And this just fed that argument and led to change. 01:02:25.305 --> 01:02:26.680 align:middle line:84% Why does any hearing do anything? 01:02:26.680 --> 01:02:27.880 align:middle line:90% It's public outrage. 01:02:27.880 --> 01:02:28.380 align:middle line:90% Yeah. 01:02:28.380 --> 01:02:30.960 align:middle line:84% AUDIENCE: If someone cheated like a long time ago, 01:02:30.960 --> 01:02:35.245 align:middle line:84% is there a time frame in which you have [INAUDIBLE]? 01:02:35.245 --> 01:02:37.620 align:middle line:84% JON GRUBER: I do not know what the statute of limitations 01:02:37.620 --> 01:02:38.750 align:middle line:90% is, actually, legitimately. 01:02:38.750 --> 01:02:39.708 align:middle line:90% I'd tell you if I knew. 01:02:39.708 --> 01:02:40.930 align:middle line:90% I don't know. 01:02:40.930 --> 01:02:44.990 align:middle line:90% OK, so that's one argument. 01:02:44.990 --> 01:02:46.630 align:middle line:90% Can we actually do a thing? 01:02:46.630 --> 01:02:49.070 align:middle line:84% Can we start a collection for this guy's bail? 01:02:49.070 --> 01:02:51.450 align:middle line:90% Can we start a collection? 01:02:51.450 --> 01:02:54.010 align:middle line:90% OK. 01:02:54.010 --> 01:02:56.230 align:middle line:84% So I said three arguments for a flatter tax system. 01:02:56.230 --> 01:02:57.930 align:middle line:90% First is less cheating. 01:02:57.930 --> 01:03:00.230 align:middle line:90% The second is simplicity. 01:03:00.230 --> 01:03:01.870 align:middle line:84% The tax code comes to-- the question 01:03:01.870 --> 01:03:03.870 align:middle line:84% was asked here about why did the hearing matter. 01:03:03.870 --> 01:03:06.850 align:middle line:84% The tax code is super ugly and confusing. 01:03:06.850 --> 01:03:11.850 align:middle line:84% So if you look at page 25-2, this shows the number of pages 01:03:11.850 --> 01:03:13.530 align:middle line:90% in the individual tax return. 01:03:13.530 --> 01:03:16.470 align:middle line:84% So when you go to pay taxes, in 1960, 01:03:16.470 --> 01:03:18.570 align:middle line:84% you got a document with 16 pages. 01:03:18.570 --> 01:03:21.770 align:middle line:84% In 2017, you got a document with 217 pages. 01:03:21.770 --> 01:03:23.770 align:middle line:90% 217 pages. 01:03:23.770 --> 01:03:28.010 align:middle line:84% So the estimate is the average simple 01:03:28.010 --> 01:03:33.730 align:middle line:84% basic Joe filing taxes spends about $260 01:03:33.730 --> 01:03:36.930 align:middle line:84% in forgone time filing those taxes. 01:03:36.930 --> 01:03:39.730 align:middle line:84% One study estimated that in 2000, taxpayers 01:03:39.730 --> 01:03:43.010 align:middle line:84% spent 3.2 billion hours, an average 01:03:43.010 --> 01:03:45.550 align:middle line:90% of 26 hours per tax filer. 01:03:45.550 --> 01:03:50.790 align:middle line:84% It's like having 1.5 million government employees in the US, 01:03:50.790 --> 01:03:52.010 align:middle line:90% if you think of it that way. 01:03:52.010 --> 01:03:53.995 align:middle line:84% If you think about it, that's a pain. 01:03:53.995 --> 01:03:54.870 align:middle line:90% People don't like it. 01:03:54.870 --> 01:03:56.578 align:middle line:84% That's part of why they don't like taxes. 01:03:56.578 --> 01:03:58.630 align:middle line:90% It's super annoying. 01:03:58.630 --> 01:04:01.390 align:middle line:84% And a simpler tax code would simplify that. 01:04:01.390 --> 01:04:03.610 align:middle line:84% Basically, one of the appeal-- when 01:04:03.610 --> 01:04:05.700 align:middle line:84% people talk about why a flat tax they like it, 01:04:05.700 --> 01:04:06.950 align:middle line:90% it's the flatness people like. 01:04:06.950 --> 01:04:08.950 align:middle line:84% But the idea is, you're going to have to pay taxes on a postcard. 01:04:08.950 --> 01:04:10.408 align:middle line:84% We're going to send you a postcard. 01:04:10.408 --> 01:04:14.170 align:middle line:84% It's just going to say, fill in your income, fill in your sales, 01:04:14.170 --> 01:04:15.190 align:middle line:90% fill in whatever. 01:04:15.190 --> 01:04:16.750 align:middle line:90% And boom, you send it back. 01:04:16.750 --> 01:04:19.250 align:middle line:84% None of these complicated provisions, none of that stuff. 01:04:19.250 --> 01:04:19.890 align:middle line:90% OK? 01:04:19.890 --> 01:04:22.110 align:middle line:90% Very appealing for many reasons. 01:04:22.110 --> 01:04:26.470 align:middle line:84% However, we have to recognize that simplicity comes at a cost. 01:04:26.470 --> 01:04:28.330 align:middle line:90% And let's take a simple example. 01:04:28.330 --> 01:04:32.170 align:middle line:84% I've been harping on the fact that we should include 01:04:32.170 --> 01:04:34.850 align:middle line:84% in your income your employer contribution to your health 01:04:34.850 --> 01:04:35.770 align:middle line:90% insurance. 01:04:35.770 --> 01:04:37.980 align:middle line:84% That would be good for both equity and efficiency. 01:04:37.980 --> 01:04:39.583 align:middle line:84% But it would be bad for simplicity, 01:04:39.583 --> 01:04:42.000 align:middle line:84% because then you'd have this complicated thing of figuring 01:04:42.000 --> 01:04:43.580 align:middle line:84% out how much is your health insurance worth? 01:04:43.580 --> 01:04:44.747 align:middle line:90% How do I put it in my taxes? 01:04:44.747 --> 01:04:46.840 align:middle line:84% It's doable, but it's a complication. 01:04:46.840 --> 01:04:49.240 align:middle line:84% The point is, there's a trade-off. 01:04:49.240 --> 01:04:51.600 align:middle line:84% The simplest tax system is probably not optimal. 01:04:51.600 --> 01:04:54.840 align:middle line:84% The question is, could we make the tax system a lot simpler? 01:04:54.840 --> 01:04:59.600 align:middle line:84% Could we make the tax system a lot simpler than we do? 01:04:59.600 --> 01:05:06.280 align:middle line:84% And would that make taxpayers feel better about paying taxes? 01:05:06.280 --> 01:05:07.860 align:middle line:90% Now, here's another thing. 01:05:07.860 --> 01:05:10.880 align:middle line:84% We talk about the politics of taxation. 01:05:10.880 --> 01:05:14.320 align:middle line:84% What other countries do is they make taxes much easier, which 01:05:14.320 --> 01:05:17.208 align:middle line:90% is they pre-fill your tax form. 01:05:17.208 --> 01:05:19.500 align:middle line:84% So in Scandinavian countries, you get a form that says, 01:05:19.500 --> 01:05:20.918 align:middle line:90% here's what we think you owe. 01:05:20.918 --> 01:05:21.460 align:middle line:90% Check it out. 01:05:21.460 --> 01:05:23.753 align:middle line:90% If it's right, sign it. 01:05:23.753 --> 01:05:25.420 align:middle line:84% And for most people, that's pretty easy. 01:05:25.420 --> 01:05:28.260 align:middle line:84% Like I said, most people have fairly simple tax forms. 01:05:28.260 --> 01:05:30.760 align:middle line:84% It still takes 26 hours to do it because you have to read 01:05:30.760 --> 01:05:31.580 align:middle line:90% through the documentation. 01:05:31.580 --> 01:05:32.247 align:middle line:90% You're confused. 01:05:32.247 --> 01:05:35.390 align:middle line:84% But actually, the truth is, it's super easy. 01:05:35.390 --> 01:05:38.638 align:middle line:84% So why don't we do that in the US? 01:05:38.638 --> 01:05:39.930 align:middle line:90% Why don't we do that in the US? 01:05:39.930 --> 01:05:41.458 align:middle line:90% Who's stopping that? 01:05:41.458 --> 01:05:42.250 align:middle line:90% AUDIENCE: Turbotax. 01:05:42.250 --> 01:05:43.390 align:middle line:84% JON GRUBER: TurboTax and H&R Block 01:05:43.390 --> 01:05:45.950 align:middle line:84% are stopping that because they would go out of business. 01:05:45.950 --> 01:05:48.110 align:middle line:84% So basically, there's actually been many bills 01:05:48.110 --> 01:05:49.710 align:middle line:84% to simplify how we pay taxes in the US 01:05:49.710 --> 01:05:51.710 align:middle line:84% that are blocked by the industries that have now 01:05:51.710 --> 01:05:53.790 align:middle line:84% made money off a complicated tax system. 01:05:53.790 --> 01:05:57.630 align:middle line:84% So once again, the complications we talked about in chapter 9 01:05:57.630 --> 01:05:59.070 align:middle line:90% rear their heads again. 01:05:59.070 --> 01:06:02.590 align:middle line:84% So that's the second argument for why 01:06:02.590 --> 01:06:03.970 align:middle line:90% we want flatter, simpler taxes. 01:06:03.970 --> 01:06:04.830 align:middle line:90% Yeah. 01:06:04.830 --> 01:06:06.270 align:middle line:84% AUDIENCE: What are their arguments 01:06:06.270 --> 01:06:09.230 align:middle line:90% for why this shouldn't happen? 01:06:09.230 --> 01:06:10.990 align:middle line:90% JON GRUBER: I don't know. 01:06:10.990 --> 01:06:12.810 align:middle line:84% I think they do it all behind the scenes. 01:06:12.810 --> 01:06:13.890 align:middle line:84% They're not out there advertising, 01:06:13.890 --> 01:06:15.530 align:middle line:84% we should have a complicated tax system. 01:06:15.530 --> 01:06:17.447 align:middle line:84% They do it all-- they just give a lot of money 01:06:17.447 --> 01:06:20.230 align:middle line:90% to politicians who oppose it. 01:06:20.230 --> 01:06:20.870 align:middle line:90% OK? 01:06:20.870 --> 01:06:22.910 align:middle line:90% So that's the second argument. 01:06:22.910 --> 01:06:26.250 align:middle line:84% The third argument is where the economics gets most interesting, 01:06:26.250 --> 01:06:30.550 align:middle line:84% which is that a simpler, flatter tax system would be much more 01:06:30.550 --> 01:06:31.910 align:middle line:90% efficient. 01:06:31.910 --> 01:06:34.700 align:middle line:84% And here we come to, in some sense-- 01:06:34.700 --> 01:06:36.360 align:middle line:84% I hate to say it, but in some sense, 01:06:36.360 --> 01:06:40.155 align:middle line:84% while chapters 21 and 22 and 23 were 01:06:40.155 --> 01:06:42.280 align:middle line:84% kind of fun and interesting, at the end of the day, 01:06:42.280 --> 01:06:43.980 align:middle line:84% it's not clear how much they matter. 01:06:43.980 --> 01:06:46.063 align:middle line:84% Because at the end of the day, what really matters 01:06:46.063 --> 01:06:48.958 align:middle line:84% is when you raise taxes, how much money do you get? 01:06:48.958 --> 01:06:50.500 align:middle line:84% And we can think about how it affects 01:06:50.500 --> 01:06:51.440 align:middle line:90% labor supply and savings. 01:06:51.440 --> 01:06:52.480 align:middle line:90% That's kind of interesting. 01:06:52.480 --> 01:06:53.960 align:middle line:84% But ultimately for public efficiency, 01:06:53.960 --> 01:06:55.520 align:middle line:84% we just want to know how much money you get. 01:06:55.520 --> 01:06:57.312 align:middle line:84% Well, how much money you get when you raise 01:06:57.312 --> 01:07:00.080 align:middle line:84% taxes is going to be a function of five things. 01:07:00.080 --> 01:07:03.860 align:middle line:90% 01:07:03.860 --> 01:07:08.140 align:middle line:84% The first is what we might call the direct effect, which 01:07:08.140 --> 01:07:12.840 align:middle line:84% is if I earned $100 and you raise my tax rate by 10%, 01:07:12.840 --> 01:07:15.300 align:middle line:90% you get $10. 01:07:15.300 --> 01:07:16.400 align:middle line:90% That's the first effect. 01:07:16.400 --> 01:07:17.500 align:middle line:90% That's the easy part. 01:07:17.500 --> 01:07:21.660 align:middle line:84% But there's actually four indirect effects 01:07:21.660 --> 01:07:23.340 align:middle line:90% that offset that-- 01:07:23.340 --> 01:07:26.020 align:middle line:84% four types of indirect effects that offset that. 01:07:26.020 --> 01:07:30.580 align:middle line:84% The first is what we call the gross income effect, which 01:07:30.580 --> 01:07:33.490 align:middle line:84% is what we call the Laffer curve, which is basically, 01:07:33.490 --> 01:07:35.890 align:middle line:84% when you tax me more, I might work less hard. 01:07:35.890 --> 01:07:37.322 align:middle line:90% I might save less. 01:07:37.322 --> 01:07:39.530 align:middle line:84% Now basically, our understanding of chapter 21 and 22 01:07:39.530 --> 01:07:42.155 align:middle line:84% suggests that it's not going to be very big, because remember, 01:07:42.155 --> 01:07:44.030 align:middle line:84% we said overall labor supply is very elastic. 01:07:44.030 --> 01:07:46.370 align:middle line:84% We don't have any evidence on how elastic savings is. 01:07:46.370 --> 01:07:47.670 align:middle line:90% But that's the first effect. 01:07:47.670 --> 01:07:50.210 align:middle line:84% It's going to turn out to be the least important. 01:07:50.210 --> 01:07:55.290 align:middle line:84% The second effect is the reporting effect, 01:07:55.290 --> 01:07:59.850 align:middle line:84% which is when you change the tax rate, that 01:07:59.850 --> 01:08:02.210 align:middle line:84% creates incentives for me to change the way I 01:08:02.210 --> 01:08:05.170 align:middle line:90% report and classify my income. 01:08:05.170 --> 01:08:07.963 align:middle line:84% It really should be called a classification effect. 01:08:07.963 --> 01:08:09.630 align:middle line:84% Let's call this a classification effect. 01:08:09.630 --> 01:08:12.850 align:middle line:90% That's a better name for it. 01:08:12.850 --> 01:08:14.352 align:middle line:90% The classification effect. 01:08:14.352 --> 01:08:15.810 align:middle line:84% Hey, Paul, can you send me an email 01:08:15.810 --> 01:08:18.290 align:middle line:90% to change that in the book? 01:08:18.290 --> 01:08:21.850 align:middle line:84% So basically what that means is-- so here's a simple example. 01:08:21.850 --> 01:08:25.170 align:middle line:84% Suppose your employer says, look, here's your choice. 01:08:25.170 --> 01:08:29.490 align:middle line:84% I can give you $5,000 raise or $5,000 in health insurance. 01:08:29.490 --> 01:08:34.359 align:middle line:84% And let's say that health insurance is worth $3,000 to you 01:08:34.359 --> 01:08:35.340 align:middle line:90% because you're healthy. 01:08:35.340 --> 01:08:37.548 align:middle line:84% So your employer is paying $5,000 or $5,000 in health 01:08:37.548 --> 01:08:38.680 align:middle line:90% insurance. 01:08:38.680 --> 01:08:43.399 align:middle line:84% If your tax rate is 25%, you say, well, the $5,000 raise, 01:08:43.399 --> 01:08:45.840 align:middle line:90% I take home $3,750. 01:08:45.840 --> 01:08:47.460 align:middle line:90% The insurance is worth $3,000. 01:08:47.460 --> 01:08:48.720 align:middle line:90% I'll take the raise. 01:08:48.720 --> 01:08:51.180 align:middle line:84% If your tax rate is 50%, you say, well, 01:08:51.180 --> 01:08:52.920 align:middle line:84% now I'll take the health insurance. 01:08:52.920 --> 01:08:55.560 align:middle line:84% So by raising tax rates, we've suddenly taken money out 01:08:55.560 --> 01:08:56.920 align:middle line:90% of the tax system. 01:08:56.920 --> 01:09:00.279 align:middle line:84% Suddenly we have money that was taxable to nontaxable. 01:09:00.279 --> 01:09:02.020 align:middle line:84% So that's the classification effect. 01:09:02.020 --> 01:09:03.960 align:middle line:84% Essentially, we've created an incentive 01:09:03.960 --> 01:09:06.140 align:middle line:84% to reclassify money in nontaxable ways. 01:09:06.140 --> 01:09:06.740 align:middle line:90% Totally legal. 01:09:06.740 --> 01:09:08.200 align:middle line:90% All of it is legal so far. 01:09:08.200 --> 01:09:14.439 align:middle line:84% The third is the income exclusion effect. 01:09:14.439 --> 01:09:15.740 align:middle line:90% The income exclusion effect. 01:09:15.740 --> 01:09:18.880 align:middle line:84% The income exclusion effect, which is it 01:09:18.880 --> 01:09:21.240 align:middle line:84% causes you to take advantage of all the tax breaks. 01:09:21.240 --> 01:09:22.640 align:middle line:84% Basically, the higher tax rate is 01:09:22.640 --> 01:09:24.265 align:middle line:84% the more you're going to take advantage 01:09:24.265 --> 01:09:26.680 align:middle line:84% of tax breaks, charitable giving, mortgage deduction, et 01:09:26.680 --> 01:09:27.180 align:middle line:90% cetera. 01:09:27.180 --> 01:09:30.470 align:middle line:84% Basically you take those the more the higher tax rate is. 01:09:30.470 --> 01:09:35.689 align:middle line:84% And then finally we have the compliance effect, 01:09:35.689 --> 01:09:39.590 align:middle line:84% which is people cheat more when the tax rate is higher. 01:09:39.590 --> 01:09:42.470 align:middle line:84% So all of these offset the direct effect. 01:09:42.470 --> 01:09:44.670 align:middle line:84% The point is, all these indirect effects 01:09:44.670 --> 01:09:48.310 align:middle line:84% mean that you will raise less than you think from taxation. 01:09:48.310 --> 01:09:50.510 align:middle line:84% So let's do an example to illustrate this. 01:09:50.510 --> 01:09:51.550 align:middle line:90% OK? 01:09:51.550 --> 01:09:56.890 align:middle line:84% Let's take Nala here in figure 25-4. 01:09:56.890 --> 01:09:59.550 align:middle line:90% 01:09:59.550 --> 01:10:04.430 align:middle line:90% Nala has wage income of $45,000. 01:10:04.430 --> 01:10:06.690 align:middle line:90% She has a job with $45,000. 01:10:06.690 --> 01:10:10.190 align:middle line:84% She also on the weekends mows lawns and makes $5,000. 01:10:10.190 --> 01:10:13.350 align:middle line:84% So she has a total income of $50,000. 01:10:13.350 --> 01:10:18.630 align:middle line:84% And let's say there's a 10% tax rate. 01:10:18.630 --> 01:10:22.500 align:middle line:90% So we raise $5,000 on her. 01:10:22.500 --> 01:10:28.230 align:middle line:84% Now let's say we raise the tax rate from 10% to 20%. 01:10:28.230 --> 01:10:30.990 align:middle line:84% And let's say Nala responds in four ways. 01:10:30.990 --> 01:10:33.990 align:middle line:84% First of all, she stops mowing lawns. 01:10:33.990 --> 01:10:36.630 align:middle line:84% So $5,000 goes away, because she doesn't want to do it 01:10:36.630 --> 01:10:38.630 align:middle line:84% if she's only paying 80% of the money. 01:10:38.630 --> 01:10:40.110 align:middle line:84% Second of all, she decides to start 01:10:40.110 --> 01:10:41.670 align:middle line:90% taking health care at her job. 01:10:41.670 --> 01:10:44.150 align:middle line:84% So $2,500 of the money goes away. 01:10:44.150 --> 01:10:46.410 align:middle line:84% Third of all, she decides to start giving to charity, 01:10:46.410 --> 01:10:47.910 align:middle line:90% so another $2,500 goes away. 01:10:47.910 --> 01:10:52.190 align:middle line:84% By the time you're done, her reported income is only $35,000. 01:10:52.190 --> 01:10:55.670 align:middle line:84% So you've doubled taxes, but you've only increased tax 01:10:55.670 --> 01:11:00.350 align:middle line:84% revenues by 40%, from $5,000 to $7,000. 01:11:00.350 --> 01:11:02.510 align:middle line:84% This is essentially the implications 01:11:02.510 --> 01:11:07.670 align:middle line:84% of the general point that the tax base is elastic. 01:11:07.670 --> 01:11:13.830 align:middle line:84% And fundamentally what we care about is what is DB D tau. 01:11:13.830 --> 01:11:16.990 align:middle line:84% How does the tax base respond to taxation 01:11:16.990 --> 01:11:20.710 align:middle line:84% is going to determine the ultimate efficiency of taxes. 01:11:20.710 --> 01:11:24.430 align:middle line:84% Ultimately, in the extreme case, if Nala literally 01:11:24.430 --> 01:11:27.240 align:middle line:84% stopped doing anything, when the tax rate went up, 01:11:27.240 --> 01:11:28.340 align:middle line:90% you would raise no money. 01:11:28.340 --> 01:11:30.632 align:middle line:84% That's what we call the wrong side of the Laffer curve. 01:11:30.632 --> 01:11:33.740 align:middle line:84% But it's not-- or if she suddenly started reporting 01:11:33.740 --> 01:11:36.840 align:middle line:84% health insurance of $40,000, you collect no money. 01:11:36.840 --> 01:11:38.540 align:middle line:84% That's not what Laffer spoke of, which 01:11:38.540 --> 01:11:41.400 align:middle line:84% is people working less hard, but it's the same effect. 01:11:41.400 --> 01:11:45.580 align:middle line:84% Which is these indirect effects poke holes in the tax base. 01:11:45.580 --> 01:11:50.240 align:middle line:84% And as a result, what that means is that when you raise taxes, 01:11:50.240 --> 01:11:52.080 align:middle line:84% you don't raise as much money as you think, 01:11:52.080 --> 01:11:54.500 align:middle line:84% because there's these offsetting indirect effects. 01:11:54.500 --> 01:11:57.540 align:middle line:90% Questions about that? 01:11:57.540 --> 01:12:02.660 align:middle line:84% So what that means is that this is essentially 01:12:02.660 --> 01:12:06.220 align:middle line:84% a way to quantify the Haig-Simons point. 01:12:06.220 --> 01:12:08.240 align:middle line:84% Well, no, scratch that statement. 01:12:08.240 --> 01:12:12.233 align:middle line:84% This is a way to quantify the deadweight loss of taxation. 01:12:12.233 --> 01:12:13.900 align:middle line:84% We talked about deadweight loss in terms 01:12:13.900 --> 01:12:15.360 align:middle line:84% of reducing labor supply or reducing savings. 01:12:15.360 --> 01:12:17.312 align:middle line:84% But ultimately the deadweight loss is really, 01:12:17.312 --> 01:12:19.020 align:middle line:84% how much less money do you raise than you 01:12:19.020 --> 01:12:20.900 align:middle line:90% think you were going to raise? 01:12:20.900 --> 01:12:23.127 align:middle line:84% It's something that economists are now-- 01:12:23.127 --> 01:12:24.960 align:middle line:84% economists' thinking has changed about this. 01:12:24.960 --> 01:12:26.877 align:middle line:84% We've moved from talking about deadweight loss 01:12:26.877 --> 01:12:29.570 align:middle line:84% to talking about what we call a fiscal externality, which 01:12:29.570 --> 01:12:33.130 align:middle line:84% is how much does it cost the government to do an action? 01:12:33.130 --> 01:12:34.130 align:middle line:90% Here we raise taxes. 01:12:34.130 --> 01:12:35.797 align:middle line:84% The fiscal externality is, how much less 01:12:35.797 --> 01:12:37.990 align:middle line:84% are we raising because of these various activities? 01:12:37.990 --> 01:12:40.090 align:middle line:84% These various activities are creating externality 01:12:40.090 --> 01:12:42.710 align:middle line:84% on the budget, which instead of raising $5,000, 01:12:42.710 --> 01:12:43.990 align:middle line:90% we're raising $2,000. 01:12:43.990 --> 01:12:46.210 align:middle line:84% That's a negative $3,000 externality from these 01:12:46.210 --> 01:12:47.170 align:middle line:90% activities. 01:12:47.170 --> 01:12:48.938 align:middle line:84% So move to thinking about it that way. 01:12:48.938 --> 01:12:50.730 align:middle line:84% And that is actually quite a nice framework 01:12:50.730 --> 01:12:51.930 align:middle line:90% because it's a lot simpler. 01:12:51.930 --> 01:12:54.210 align:middle line:84% We just ask ultimately, the efficiency of a tax system 01:12:54.210 --> 01:12:56.870 align:middle line:84% is ultimately determined by the fiscal externality. 01:12:56.870 --> 01:13:01.238 align:middle line:84% How much less do we raise than if people just didn't respond? 01:13:01.238 --> 01:13:03.530 align:middle line:84% And that's kind of the way we're thinking about it now. 01:13:03.530 --> 01:13:04.050 align:middle line:90% OK? 01:13:04.050 --> 01:13:04.690 align:middle line:90% Yeah. 01:13:04.690 --> 01:13:06.648 align:middle line:84% AUDIENCE: What is the baseline for this always? 01:13:06.648 --> 01:13:08.130 align:middle line:90% Is it the current tax system? 01:13:08.130 --> 01:13:09.597 align:middle line:90% JON GRUBER: Great question. 01:13:09.597 --> 01:13:10.930 align:middle line:90% Actually, let's start with that. 01:13:10.930 --> 01:13:12.930 align:middle line:84% I'm going to stop now because I want 01:13:12.930 --> 01:13:16.450 align:middle line:84% to riff for about 10 minutes and I don't want to break it up. 01:13:16.450 --> 01:13:18.930 align:middle line:84% So basically, let's come to that next time 01:13:18.930 --> 01:13:21.600 align:middle line:84% and bring that question back next time. 01:13:21.600 --> 01:13:25.000 align:middle line:90%