Econofact

Tax Policy

The Capital Gains Tax and Inflation

By Daniel Bergstresser·August 13, 2018
Brandeis University

The Issue:

The United States Treasury Department is reportedly studying whether it can issue regulations that would allow taxpayers to account for inflation when calculating taxes on capital gains.

The Facts:

Taxes on capital gains are an important – and at times highly variable – source of revenue for the federal government (see chart). A capital gain (or loss) occurs when an asset – real estate, a security, a cryptocurrency, or any other asset – that was purchased for one price is later sold for a different price.
Proposals to account for inflation when calculating capital gains taxes reflect an effort to tax the increase in the real purchasing power of an asset rather than the increase in its value that only reflects overall rising prices.
A potential benefit from indexing capital gains would be enhanced incentives for savings and investment. These incentives would depend upon the change being credibly believed to be persistent.
But, any type of inflation indexation would lower tax revenue at a time of rapidly increasing budget deficits. It would also overwhelmingly benefit high-income households. Moreover, adjusting the capital gains part of the tax code for the impact of inflation without addressing real/nominal discrepancies elsewhere will open up new tax shelters for people and businesses with the resources to access them.

What this Means:

Tax policy reflects a tradeoff between raising revenue and distorting the functioning of the economy; the goal is to raise the required revenue in a way such that the damage done by economic distortions created by taxes is as low as possible. The goal of minimizing tax distortions on savings is a legitimate one, and the tax code already includes a number of ways in which capital gains enjoy preferential treatment. The ability to defer capital gains until an asset is sold is an important benefit, and tax rates on capital gains for assets held more than a year are generally lower than tax rates on other sources of income. Indexing capital gains taxes for inflation by regulatory fiat – if it were actually determined to be legal – would have significant costs and questionable additional benefits.

International Macroeconomics and Exchange Rates

Is China Weakening the Yuan to Fight U.S. Tariffs?

By Michael W. Klein·August 7, 2018
Fletcher School, Tufts University

The Issue:

The Chinese currency has declined in value against the dollar by over 7 percent since mid-May. This lowers the cost of Chinese exports to the United States and could help counteract the effect of U.S. tariffs on Chinese goods. The Trump administration has interpreted the weakening of the yuan against the dollar as an effort to undo the effects of the proposed 10 percent tariffs on Chinese goods, and has responded by threatening to raise the proposed tariff rate to 25 percent.

The Facts:

The Chinese government largely controls the value of its currency. Unlike the United States, where the value of the dollar is determined by market forces, the Chinese government exerts more active control over its currency through restricting capital flows into and out of the country, using its foreign currency reserves to intervene in the foreign exchange market, and regulating foreign currency trade.
The bilateral yuan / dollar exchange rate has depreciated since the Spring of 2018, after a run up in its value that began in the summer of 2017 (see solid black line in the chart, a fall in the value represents a weakening of the yuan against the dollar). But this movement is not restricted to the dollar; the yuan has weakened against a broad index of other currencies, which may also be a purposeful move by authorities to bolster an economy that is showing signs of softening.
The broad weakening of the yuan against many currencies is matched by a broad strengthening of the dollar against a wide range of U.S. trading partners. An index of the U.S. dollar against 61 currencies (the solid blue line in the chart) has strengthened by about 9 percent since the beginning of February 2018. The continued strength of the U.S. economy and the likelihood that the Federal Reserve will raise interest rates to keep the economy from overheating have both contributed to the dollar’s strength.

What this Means:

While a weaker yuan does soften the impact of U.S. tariffs on Chinese exports, domestic economic factors in both China and the United States are important underlying contributors to the change in the value of the dollar/yuan exchange rate. For now, the weakening of the yuan and the strengthening of the dollar are both likely to exacerbate trade tensions. Beyond the question of whether the trade war has shifted into a currency war, these currency moves make narrowing the bilateral trade deficit between the countries — one of the Trump administration's stated trade goals (despite the fact that this is a deeply flawed statistic) — more difficult and, with that, comes a greater risk of a broadening trade war.

International Trade

Threats to U.S. Agriculture from U.S. Trade Policies (UPDATED)

By Menzie Chinn·August 5, 2018
Robert M. La Follette School, University of Wisconsin-Madison

The Issue:

Sales of U.S. agricultural products abroad are responsible for 20 percent of U.S. farm income, supporting more than one million American jobs on and off the farm. The three biggest buyers of American agricultural products are China, Canada, and Mexico. Yet trade with these three countries faces heightened uncertainty.

The Facts:

Exports of agricultural products from the United States to the rest of the world amounted to $138.4 billion in 2017, with over 40 percent of the total accounted for by Canada ($20.5 billion), Mexico ($18.6 billion), and China ($19.6 billion). In 2017, $12.4 billion alone was accounted for by soybean exports to China.
U.S. tariffs on steel and aluminum, as well as U.S. tariffs imposed directly on China, have sparked retaliation. Mexico retaliated by applying tariffs against U.S.-produced hogs and cheese, among other items. Canada has retaliated by applying tariffs primarily against manufactured products, but also against yogurt and tomato products. Soybeans are perhaps the biggest agricultural target for China. Prices for soybeans to be delivered in July plunged from $10.65/bu in early April to $8.80 at mid July -- a 17 percent decline. Exposure to agricultural trade with China varies by state (see chart).
In response to the damage inflicted on farmers by trade retaliation, the Trump administration announced a $12 billion package of farm assistance. It is unclear whether the measures will fully offset the effects of tariffs on elevated farm cost.
Renegotiation of the North American Free Trade Agreement (NAFTA) is underway, with the threat of withdrawal on the table. Withdrawal from NAFTA would cause Mexican and Canadian tariff rates on U.S. agricultural commodities to rise and export quantities would decline.

What this Means:

Policies implemented and under consideration by the Administration have sparked moves to restrict imports from the United States, putting downward pressure on prices for and quantities of several U.S. agricultural exports. The farm economy is already being affected negatively, with the largest single blow coming from the impact on U.S. soybean prices. Withdrawal from NAFTA would constitute another very heavy blow.

Editor's note: This is an updated version of a post originally published on February 1, 2018.

China

What is the Problem of Forced Technology Transfer in China?

By Lee Branstetter·August 3, 2018
Carnegie Mellon University and Peterson Institute for International Economics

The Issue:

There is bipartisan agreement regarding a problem at the core of trade issues with China: China's persistent misappropriation of foreign technology.

The Facts:

Forced technology transfer occurs when foreign multinational companies have to provide strategically significant technology to an indigenous entity they do not control in order to gain access to the Chinese market.
China uses its control over state owned enterprises or the partially closed nature of its foreign direct investment regime to force multinational firms to do in China what they would not do anywhere else.
The sheer size of the Chinese market makes it a difficult opportunity to pass up. A company that pushes back on technology transfer pressures, or decides to stay out of the Chinese market altogether, runs the risk that a rival multinational will secure the deal and gain the profits that come with access to the massive market.
The cost is not just borne by the firms that have to give away a valuable asset. Ultimately, it could hurt the most innovative firms and dampen technological innovation around the world.

What this Means:

Forced technology transfer in China is a real and harmful phenomenon. In its efforts to negotiate a more level playing field, the Trump administration has applied tariffs to a broad range of Chinese exports. This strategy runs the risk of imposing large costs on a broad swath of American industries, consumers, and investors — especially once retaliatory tariffs are taken into consideration. An alternative option would be for the U.S. government to apply very narrowly focused sanctions on the specific companies or Chinese government officials involved in these forced technology transfer deals, such that it directly alters the incentives Chinese firms and Chinese officials face. Moreover, dealing with the problem would be more effective if it were done in a multilateral way. If the United States prevents its firms from transferring technology but Europe and Japan allow their firms to go forward, then the only thing that this is likely to accomplish is that it will prejudice the profits and opportunities of U.S. firms.

Education Policy

Demographic Changes Pose Challenges for Higher Education

By Nathan Grawe·July 29, 2018
Carleton College

The Issue:

Demographics are working against colleges and universities. If the patterns that currently link demographic factors to the demand for higher education continue to hold, these trends suggest the potential for significant contraction and realignment in higher education in the next 10 to 15 years.

The Facts:

The population of the United States has shifted geographically toward the south and west in recent decades. Both the reduction in the numbers of Northeastern non-Hispanic whites and the increase in Hispanic Southwesterners represent movements away from higher education’s traditional markets.
A nation-wide reduction in fertility that coincided with the onset of the Financial Crisis further complicates the demographic challenges facing higher education. From 2008 to 2010, the total fertility rate fell 10 percent and, provisional reports for 2017 suggest that we have yet to find the bottom of the present birth dearth.
Taken together, U.S. population trends project a more than 10 percent reduction in college enrollments by the end of the 2020s. The losses will fall most heavily in the Northeast — an area with a disproportionate share of the nation’s colleges and universities (see map).
Lost enrollments among traditional-age students are expected to be greater at regional institutions (two-year colleges and four-year schools ranked outside the top 100 colleges and universities by U.S. News & World Report). By contrast, the demand for elite institutions (those ranked among the top 50 colleges and universities) is projected to remain steady through the end of the 2020s.

What this Means:

While some institutions may manage to mitigate lost enrollments (and associated fee income) through broader outreach to underserved domestic and international markets, the magnitude of the reduction in fertility is so large that most cannot rely on this strategy alone. Focusing on the challenge of increasing student retention and improving college completion rates offers a potentially fruitful approach. By re-doubling retention efforts some institutions might increase enrollments without recruiting new students. This may require reconsidering a range of practices in and out of the classroom. Institutions that cannot find ways to recruit or retain sufficient students may face retrenchment.