Thursday, April 16, 2015

Banking at the IRS

A while ago in two blog posts here and here I suggested many ways other than currency to get a zero interest rate if the government tries to lower rates below zero. Buy gift cards, subway cards, stamps;  prepay bills, rent, mortgage and especially taxes -- the IRS will happily take your money now and you can credit it against future tax payments; have your bank make out a big certified check in your name, and sit on it, don't cash incoming checks. Start a company that takes money and invests in all these things (as well as currency).

Chris and Miles Kimball have an interesting essay exploring these ideas "However low interest rates might go, the IRS will never act like a bank." Their central point: sure that's how things work now. But with substantial negative interest rates, all of these contracts can change. It's technically possible in each case for people and businesses to charge pre-payment penalties amounting to a negative nominal rate.

Reply: Sure, in principle. Nominal claims can all be dated, and positive or negative interest charged between all dates.

But this did not happen in the US and does not happen in other countries for positive inflation and high nominal rates,  despite symmetric incentives, and at rates much higher than the contemplated 3-5% or so negative rates.  Yes,  with large nominal rates there is pressure to pay faster,  inventory cash-management to reduce people's holdings of depreciating nominal claims, but this pervasive indexation of nominal payments did not break out. The IRS did not offer interest for early payment.

More deeply, what they're describing is a tiny step away from perfect price indexing. If all nominal payments are perfectly indexed to the nominal interest rate, accrued daily, then it's a tiny change to index all prices themselves to the CPI, accrued daily. If "how much you owe me," say to rent a house, is legally, contractually, and mechanically determined as a value times e^rt, and changes day by day, then e^(pi t) is just as easy.

So, price stickiness itself would (should!) disappear under this scenario.

Price stickiness has always been a bit of a puzzle for economists. As the Kimballs speculate how easy it is to index payments to negative interest rates, so economists speculate how easy it is to index payments to inflation. Yet it seems not to happen.

So this point of view strikes me as a bit of a catch-22 for its advocates, who generally are of the frame of mind that prices and nominal contracts are sticky and that’s why negative nominal rates are a good idea to "stimulate demand" in the first place.  If we can have negative nominal rates and change all these legal and contractual zero-rate promises to allow it, then prices won't be sticky any more!   Conversely, I should be cheering, as it amounts to a broad push to unstick prices. That has long seemed to me the natural policy response to the view that sticky prices are the root of all our troubles. It would allow negative rates, but eliminate their need as well.

Alas, the world seems remarkably resistant to time-indexing all payments.


16 comments:

  1. Indexation of payments to inflation doesn't happen often, but Robert Shiller has written extensively on the case of Chile - where it did happen. He has also advocated doing it in the US. I think it's great that he presses for monetary innovation, and suggests some possibilities, but inflation simply isn't the salient risk to consider in advanced economies like ours. I'm more convinced of the need to index payments to help with balance sheet issues, as advocated by people like Amir Sufi.

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  2. John,

    From the article you reference:

    "In confronting the question of whether to IRS in particular can be used as if it were a government bank offering a zero interest rate, it helps to be a US tax lawyer used to dealing with complex tax questions, as Chris is. There are two key points:"

    "1.The tax code actually has several interest rates, including an overpayment rate, an underpayment rate, and zero. The non-zero rates are a function of Federal short-term borrowing rates and while it has never happened, there is no obvious reason that they could not be negative."

    "2.The IRS is not a bank with in-and-out privileges. Paying taxes is easy. Getting money back is possible but complicated and uncertain as to time and interest rate."

    "Underpayment and overpayment rates are defined as the “Federal short-term rate” rounded plus an adjustment (3 percentage points in general, but more or less in specific circumstances, including 0.5 percentage point for large corporate overpayments and 5 percentage points for large corporate underpayments). The Federal short-term rate is determined month by month, and is defined by statute as:"

    "The rate determined by the Secretary based on the average market yield (during any 1-month period selected by the Secretary and ending in the calendar month in which the determination is made) on outstanding marketable obligations of the United States with remaining periods to maturity of 3 years or less."

    Funny that the Treasury uses market yields instead of auction rates. If the market interest rate is negative and the Treasury assesses a negative interest rate on late payments does that mean I get extra money back if I file my taxes late?

    How long would that last if no-one filed their taxes because the Treasury was paying people (assessing a negative penalty) to file late?

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    1. "If the market interest rate is negative and the Treasury assesses a negative interest rate on late payments does that mean I get extra money back if I file my taxes late?

      How long would that last if no-one filed their taxes because the Treasury was paying people (assessing a negative penalty) to file late?"

      In addition to interest payable on unpaid taxes, the IRC imposes *penalties* for late filing of returns and late payment of taxes. Even if a return is filed on time, if the taxes are not paid when due, there is a late payment *penalty* equal to one-half of one percent per month (equivalent to 6 percent annually) up to 25 percent. This is independent of any prevailing interest rate. See, IRC Section 6651.

      It would take a heck of a negative interest rate to overcome that.

      Vivian Darkbloom

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    2. So the maximum penalty is 25%. All that you would need is a cumulative negative penalty of greater than 25% over any number of years to make it worth your while.

      Also, because the government is using market interest rates instead of auction interest rates, the government could be paying out both ends if market rates are negative and auction rates are positive courtesy of wide bid / ask spreads in the secondary markets.

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    3. "So, the maximum penalty is 25%"

      No, Frank Restly, perhaps you should also familiarize yourself with the criminal sanctions for wilful failure to pay taxes. Is, for example, 5 years in prison "worth your while"?

      http://www.irs.gov/pub/irs-utl/tax_crimes_handbook.pdf

      Viv

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    4. Viv,

      The point is that it is ludicrous for the Treasury Department to set the penalty rate for late tax payment equal to the secondary market interest rate both from a government finance perspective and a common sense approach.

      Also, the burden is on the government to prove willfullness. I am not a tax expert nor a Supreme Court attorney but it seems to me that willfulness should be extended both ways - I am willful to pay taxes as long as the IRS is willful in accepting my tax payments.

      I would argue that a positive penalty on early payment of taxes represents a lack of willfulness on the government's part to accept payment of taxes in full.

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  3. It is interesting---in high-tax modern economies that go to zero interest rates, or negative interest rates and deflation, we see gigantic bulges in cash in circulation.

    In Japan there is now cash in circulation equal to 20% of (officially reported) GDP!

    In Europe, we have seen a 66% surge in cash in circulation since 2008, and in the US a bulge of late brings cash in circulation to more than $4,200 per capita! Per capita!---and we are pikers next to Japan, where many business will not "take plastic." Well, they have had more time to adjust to deflation. (In Japan, depending on exchange rates, they keep $7000 to $8000 or so in circulation in cash dollar equivalent, per capita!)

    It seems clear that if a modern high-tax nation moves to negative interest rates and deflation, we will see even more explosion in cash in circulation, first for savings, and then, as it is easy, to avoid taxes.

    This will lead to a bifurcated economy, one aboveground, expensive and taxed and regulated, and another untaxed, unregulated and less expensive. Reported GDP may stagnant, while the underground economy grows---sounds like Japan?

    Seems like a deflationary economy will ultimately fall apart, from developing such a large untaxed underground sector as to become anarchic.

    The solution of outlawing cash, and introducing an Orwellian state on steroids, in which every transaction (and phone and e-mail) is recorded by the federal government may appeal to some,

    Maybe we should just go back to 3% inflation. It begins to seem like a small price to pay, for prosperity, sustainability and maybe even freedom.

    Another odd one: Piles of cash in circulation is associated with deflation, not inflation. You would think so much cash would lead to spending and inflation. Evidently not.

    Yes, all the cash is doing drug deals. And your evidence for that is? You saw it in a movie?



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    1. Jose Romeu RobazziApril 16, 2015 at 9:34 AM

      Mr. Cole, not all cash transactions are "under ground", one can go to Walmart and pay in cash ... McDonald's take cash as well. I get your point, and probably the under ground economy will grow,as you say, but would that be a problem per se? Is it all that bad if a society rejects paying high taxes by going to cash, untraceable transactions ? Maybe that is actually a good thing...

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    2. Mr. Robazzi: a growing underground economy does pose a threat to a stable democracy. Who pays taxes? Those who honor the rules? And only those who honor the rules?
      A deflationary society may find itself becoming somewhat anarchical.
      I also resent high taxes and regulations. But then, living standards are higher in Germany than in Mexico.

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    3. Jose Romeu RobazziApril 17, 2015 at 1:29 PM

      Mr. Cole, I don't disagree with you that Germans enjoy a welthier life than Mexicans or Brazilians. What I meant as a good thing is that society is effectively sending a message by demanding more cash. And that may well be that taxation is reaching a level that society is barely tolerating ...

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  4. John, you can't get out that easily. Your previous posts outlined a number of specific arbitrage opportunities that customers could earn at the expense of institutions that issue 0% nominal liabilities as nominal rates plunge into negative territory. The Kimballs' point (and mine here) is that because these liability-issuing institutions effectively lose money by taking the losing side of the trade, it is uncontroversial that they would quickly plug these arbitrage opportunities.

    Your argument is that they won't plug them because in the symmetrical case of positive inflation and high nominal rates, nominal liabilities were not indexed. The IRS, for instance, did not offer interest for earlier payment.

    But the sort of arbitrage opportunities plaguing issuers at negative rates simply don't exist in your hypothetical. Nor will the liability-purchasing public choose to subject themselves to the money-losing obverse side of the trade. For instance, since the IRS refuses to pay interest on earlier payment, the public will simply choose not to pay early. No one earns arbitrage profits, no one gives up arbitrage losses. Since a retailer that issues coupons doesn't pay interest, the public will not take up their coupons. Since cheques don't pay interest, the public will either cease to accept them or will deposit them at the bank within the hour.

    So I don't buy your effort to draw symmetry here. It seems to me that you're trying to change the topic to indexing when its actually about arbitrage. If you can explain why the IRS and corporations would allow themselves to adopt the losing side of an arbitrage trade as rates fall into negative territory, then I'll buy into your skepticism.

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  5. I have to also point out that cash currency formation at the zero interest rate bound is a feature, not a bug.

    If banks no longer offer interest, then they no longer compensate for counterparty risk, let alone all the cost of predatory fees. It makes wonderful sense to shift liquidity needs into cash currency under these conditions.

    The nominal economy has a lot of nexus with cash currency -- it circulates. Excess reserves sitting in banks have almost no nexus with economic activity.

    What the world needs is a lot more currency: nominal GDP would benefit far more from an additional $1 trillion of currency being demanded into existence than an additional $1 trillion of excess reserves sitting in banks.

    Bottom line, currency formation is very desirable at the ZLB: it's a boon to the nominal economy. It's how base money circulates at the ZLB! Near-zero rates suggest that nominal growth is too slow and that more base money is needed in the economy. Currency formation is how this takes place.

    More circulation, higher NGDP. This is the entire point of currency, no? To circulate!

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    1. No that is not the point of currency. You and I can stand in a room a pass a $50 bill back and forth until we both die from old age. Have we accomplished anything?

      The point of currency is to facilitate the exchange of goods. It allows to apple farmer to trade his apples for and automobile even though he may never meet an autoworker.

      It's the goods that you want to circulate. Currency is a means to that end.

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  6. Gift cards and prepayment are hardly equivalent to bank accounts. Anyway, the point of negative rates is not to enable deflation. Episodes of negative rates ought to be rare and brief, but if not, it's better to reduce the profitability of gift cards than to wreck the economy!

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  7. Indexed prices may work for small part of the society that is able to calculate nominal prices real-time. No regulator would ever allow giving indexed prices to the public without exact nominal prices. So, every shop, service... would have to calculate and change prices daily.

    One of the biggest failures of the economic theory lately, in my opinion, is insistence on rational expectations, while ignoring that majority of people have no or little math skills, no or little economic knowledge and skills, no will or time to become economists and very little rationality when assessing options, especially long-term options.

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  8. John,

    "...Yes, with large nominal rates there is pressure to pay faster, inventory cash-management to reduce people's holdings of depreciating nominal claims, but this pervasive indexation of nominal payments did not break out. The IRS did not offer interest for early payment..."

    A little history is in order. The first central bank of the United States was created in 1791. The 16th Amendment (enabling Congress to levy an income tax) was not ratified until 1913.

    The IRS did not offer interest for early payment because a method was already in place for the U. S. government to cover expenditures in excess of tax income - borrow from the Bank of the United States at interest. Later the Federal Reserve was created and was precluded from lending directly to Federal government.

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