The $2 trillion hole in the U.S. economy

No, it's not hole in the banking system. It's the incremental $2T worth of GDP our education system could provide. McKinsey & Company released an very interesting report detailing the economic impact of the various education gaps between the U.S. and other countries and within the U.S. itself.

McKinsey quantifies the effects on GDP from closing various achievement gaps:

• Closing the racial gap between black and white students generates $310-525B in GDP
• Closing the low-income to high-income gap is worth $400-670B
• Bringing the worst-performing states up to the levels of high-performing states is $425-700B

Closing these gaps (note that they are not additive - the total impact of closing all three would less than the sum of the three) could generate a substantial boost to GDP -- enough to easily offset losses from the current economic slowdown for example. If the U.S. was solely able to address these gaps, it would be a tremendous accomplishment.

What factors then contribute to the achievement gap? First, it should be noted that the data show the gap almost indisputably exists. The Department of Education tests students from across the nation through the National Assessment of Educational Progress. Scores in core subjects including math and reading show substantial gaps between white and black students.

Studies show a range of factors could contribute to this gap, from funding differences to cultural differences to parent involvement. Regardless, something needs to be done to address that gap.

But what happened to that $2 trillion mentioned in the headline? That is the gap between the U.S. and other nations (actually, McKinsey estimates the gap at between $1.3-2.3%). Despite high per-pupil spending, the U.S. consistently lags OECD countries in education performance.

Both gaps -- within the U.S. system and compared to other nations -- scream for meaningful education reform. With the price tag attached to the outcome (somewhere between one and three trillion dollars), the U.S. needs to make wise investment decisions to capture this potential GDP. This is an important frame of reference. Expenditures on education, wisely structured, need not be considered spending, but rather investment. In this case, an investment in future GDP growth, lower incarceration rates, fewer health problems, and the resulting benefit to society through GDP growth, improved tax revenues and lower public expenditures.

A key question is what separates investment from spending. Investments should be based on the expenditures that are expected to have a return of that capital in the future. Not all expenditures would qualify. Consider one easy example: if teachers received substantial increases in pay, it would likely entice more qualified applicants to the field. However, many existing qualified applicants would simply be paid more. In the latter category, the teachers benefit more than students do. Investments in education should be structured to avoid windfalls to any group of participants (teachers, administrators, contractors and suppliers, etc.) that would not deliver commensurate returns. This would argue, for instance, not simply increasing teacher wages, but changing the way teachers are paid to incentivize better teaching and attracting teachers who believe they would do such a good job they could earn substantial bonuses. It is not that higher teaching pay wouldn't improve outcomes -- it is just that that same money could improve outcomes even more if structured wisely.

Thus, items like performance pay, charter schools, and directed spending on specific programs (like early childhood development) would be viewed more favorably through this investment lens. They may not work, and educators need to play an important role in designing them, but with $2 trillion at stake every year, the time has come for the U.S. to start considering how to invest in schools, not simply fund them.

Iowa's Stimulus Plan - Same-Sex Marriage

In an Iowa Supreme Court ruling Varnum v. Brien on April 3, 2009, the State effectively legalized same-sex marriage in the State of Iowa. On April 27, 2009 Iowa joins the likes of Massachusetts and Connecticut and soon to be joined by Vermont as the only states in the US that allow same-sex marriages. Several states, California, Colorado, Maryland, New Hampshire, New Jersey, New Mexico, and Washington recognize civil unions between same-sex partners, each providing varying degrees of benefits to the partners. In Iowa, Massachusetts, and Connecticut, same-sex couples are offered the same rights as opposite-sex couples at both

the state and federal level.

The Economics Policy Review will not make any arguments for or against same-sex marriage based on economic impact or based on morality or religious beliefs. The article serves merely to assess the potential impact on the state of Iowa with same-sex marriages beginning later this month.

Many have regard Iowa as a recession resistant state due to the high reliance on agriculture, low consumer debt, and less dramatic real estate impact. Iowa reported an unemployment rate of 4.9% verse 8.1% for the US as a whole. Despite this, the potential impact on state budgets for major legislation cannot be ignored. The Williams Institute at UCLA provides in depth analysis of same-sex partnerships on state budgets. Following the initial district court hearing on Varnum v. Brien, the Williams Institute published The Impact on Iowa's Budget of Allowing Same-Sex Couples to Marry in April 2008. The study estimated a $5.3 million per year net benefit of same-sex marriage. The study moves step by step through the relevant categories of fiscal impact, income tax, inheritance tax, public assistance, sales from increased tourism, administrative fees, and employee benefits.

The study was published prior to Connecticut legalizing same-sex marriage on November 12, 2008. Additionally, Massachusetts does not allow out-of-state couples to wed, thus eliminating any precedent for tourism revenues. According to the 2005 American Community Survey there were 5,833 same-sex couples in Iowa; extrapolating the 2000 and 2005 data forward at a compound annual growth rate of 9.8%, there is an estimated 7,714 same-sex couples in Iowa at 2008 year-end. Using similar extrapolation, the neighboring states would have 120,728 same-sex couples to draw on for marriages and thus tourism dollars. See Chart below:


The Williams Institute assumes 50% of Iowa's same-sex partnerships and 25% of neighboring, using similar data, 34,039 couples would wed over the next three years; of which, 3,857 would be Iowa residents.

Using the fiscal impact categories above, the Williams Institute assumes inheritance tax (decrease in revenue) and income tax (increase in revenue) effective net. The assumptions seem fairly valid. The study assumes that many same-sex couples are DINKs (double income no kids), thus in a joint filing, Iowa's progressive tax structure would increase the effective tax rate on a large majority of couples, generating an additional $700 per couple. Despite a detailed discussion, it is difficult to reproduce the Williams Institute calculations. The following assumptions will be used: 50% marriage rate and a similar break-down of 85% have an increase in taxes, 5% no impact, and 10%, using 5,833 couples in 2005 and 7,714 couples in 2008E. There is a net income tax increase of $1.7mm with the 2005 population and $2.2mm using the 2007 estimated population.

The inheritance tax requires a number of difficult assumptions to forecast, average death rate, wealth of deceased, etc. The Williams Institute uses a probability distribution of wealth, charity assumptions, and gifts to children to estimate the annual impact is a decrease in revenue of $1.5mm or roughly equivalent to the $1.7mm increase in revenue.

The tourism impact could be the most substantial for Iowa relative to its peers. While Connecticut, Massachusetts, and Vermont (Fall 2008) are the only states with legalized same-sex marriages, many of their neighbors have variations that would limit the population draw; additionally, Massachusetts does not allow out of state marriages. Effectively, Vermont and Connecticut are competing for New York, Pennsylvania, Rhode Island, and Delaware marriages. New Jersey, Maine, and Maryland have a variation of civil unions. Iowa will have a virtual monopoly on same-sex marriages to its neighboring states and a population of over 120,000 couples.

The Williams Institute estimate the increased sales tax based on two groups, in-state and out-of-state. The in-state marriages assume an average opposite sex wedding costs $23,000, but same-sex couples due to lack of family support and social stigmas would spend only 25% on their weddings and out-of-state couples would spend 10%, resulting in $5,750 and $2,300 per wedding respectively. As a result, in the first three years following legalization, it can be assumed that in-state couples will spend $5.5 million and out-of-state couples will spend roughly $140 million on weddings. With the State of Iowa's 5% sales tax rate, the state would yield an additional $7.2 million in sales tax or $2.4 million per year. This neglects the benefits of increased employment or the broader multiplier implied by the increased spending. It can be reasonably concluded that the State will benefit considerably beyond the Williams Institute's roughly $2.0 million in sales tax.

The Williams Institute highlights the large area for potential impact is a reduction in state incurred expenses as a result of same-sex marriage. The Williams Institute estimates the level of assistance given to same-sex couples and likewise the savings by applying data from the lower of the 1999 Iowa Census on same-sex verse opposite-sex couples assistance levels to the estimated same-sex couple population. According to their data, same-sex couples receive $9.5 million in public assistance which would be reduced to $2.8 million when partners become eligible on their spouses benefit plans.

On balance, same-sex marriage should provide economic benefits to all current and future states considering the initiative. Iowa presents an interesting circumstance due to the virtual monopoly on same-sex marriages in the Midwestern corridor. Prior legalizations either of competition from surrounding states or do not allow out-of-state marriages. Whether the impact is $1.0 million or $100 million annually, the opponents can rest assured, they will not be paying for a lifestyle to which they are in opposition.

Turning the FDIC into AIG

It looks like Sheila Bair is trying to turn the FDIC into AIG, minus the bonus scandal. The government's latest plan to aid ailing banks, the Public-Private Investment Program, relies heavily on the FDIC to ensure adequate capital is available. Specifically, the FDIC will insure debt backing 85% of the loans made through the PPIP. While the FDIC plans to charge for this insurance, no shortage of evidence exists that the government systematically under-charges for insurance.

This under-charged amount is a subsidy, as it allows the insured parties to be shielded from risks they would otherwise have to pay for. If a private investor with FDIC guarantees never has to use the guarantee, the insurance looks great. This is not unlike a car insurer that would look very profitable if no cars ever got in an accident. But, if the FDIC guarantee is used, the government will take tremendous losses. In this way, the FDIC guarantee is a gamble... no one knows whether it will be used or not. AIG made this exact same gamble (the FDIC program is exactly a credit default swap on the assets in the program), and lost big. And now the entity that insures our deposits is making that same bet, with an uncertain outcome.

What is certain is that this guarantee contains a subsidy, by precisely the amount that the insurance is underpriced. This subsidy will be split between the banks and investors participating in the program. By delivering this subsidy in a relatively obscured manner (this subsidy doesn't require writing an actual check to banks), the Treasury has managed to skirt Congress's need to approve funding for the program. Clever, unless the FDIC loses on its gamble. Then, the FDIC will have to cover potentially enourmous losses from the PPIP, surely enough to swamp the already struggling fund. No one expects the FDIC to go bankrupt, as such a failure would wreck havoc on the financial markets and cause mass panic. Instead, the taxpayers would have to bail out the FDIC, just as we have bailed out AIG.

Ms. Bair has already commented that she does not expect there to be any losses from the program. As the NY Times points out, that sounds shockingly like another executive's declaration:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

The executive who uttered this line? None other than AIG's Joseph J. Cassano.

Re: A tax by any other name

Last month the review proposed taxing health care benefits as one potential solution for stemming spiraling health care costs. The general argument was that health care benefits, because they are not taxed, offer employees a compensation solution that is dollar-for-dollar more beneficial than additional salary raises. Companies increase benefits to retain key workers, and health insurance companies bid up their rates to capture most of that surplus, raising the cost throughout the entire system. The only "brake" in place today is Medicare. The government sets reimbursement rates (usually below profitability levels for most health care providers), which acts like a tether, preventing private insurers from getting too far away from the arbitrary cost floor.

While the system hasn't worked well, it has functioned. Individuals have reasonable flexibility to choose between health care providers, and those who can't afford it opt into Medicare. The oft-mentioned "coverage gap" is a huge problem, but the fact remains that EVERY one in the country has access to basic and emergency care. This system is inequitable, highly inefficient, and unsustainable without serious revision.

But the proposal by Congress to create a government run health care plan that will compete with private insurers is not a revision of the current system. It is a demolition charge set at the base of the building. In a best-case scenario (the public option sets reimbursement rates at the median of competing plans'), it will recalibrate the arbitrary cost floor and raise prices throughout the system. In the worst-case scenario (the public option undercuts all competitors), it will create a flight to cost, crowding out private insurers and leaving the government in charge of health care in this country.

During the 2003-2004 debate over the Iraqi War, the public didn't even blink while President Bush and the Republican Congress passed Medicare Part D. It was intended to neutralize political exposure on a key election issue, and by all accounts was very effective. It also constituted the largest increase in Federal entitlement spending since LBJ was in office. At the time, everyone was more focused on the billions of dollars being spent on cruise missiles for use in the next month, than on the hundreds of billions of dollars that the government was committing to spend over the next decade.

We seem to be running the risk of repeating recent history again. With the public attention captivated by the ongoing recession, everyone is focusing on the near-term costs of bailout spending measures. It would be very unfortunate if the public failed to take note of yet another long-term commitment that federal politicians seem all too willing to get us into.

Immigration Reform Redux - Part I

Wednesday morning the New York Times broke the story that the Obama administration is resuscitating immigration reform as an issue for this coming year. Most will remember that this issue captured the public attention during the 2006 midterm elections, when it was discussed largely in the context of national security. After reform legislation flamed out in the Senate, the issue went away. Now the issue is being brought up again, this time in an economic context.

There are two major forces at work here: politics and economics. The economic repercussions of immigration reform are tremendous. If successfully implemented, the U.S. could experience an economic boom mirroring those that followed previous economic booms. Alternately, it could saddle large portions with depressed wages and huge tax burdens needed to support an influx of unskilled workers. Politically, it is a land mine field. Catering to one voter group can create repercussions in other groups, and the current economic environment has made immigration a charged issue for many Americans. This two-part article takes a look at the political and economic issues underlining the immigration debate.

Political

Pundits have suggested that this recent restart of immigration reform is a pre-emptive strategic strike by the White House, who is worried that a lingering recession and a bailout-weary populace will hand them defeat in the 2010 midterm elections. The Hispanic electorate is very much up for grabs, and could provide an effective hedge against a Republican resurgence.

In the months leading up to the 2006 midterm election, political insiders on both sides of the aisle began teeing up immigration as one of the hot-button issues. For many in the Republican base, the issue was red meat, evoking powerful emotions around domestic security and cultural/economic preservation. For Democrats, the issue seemed like an opportunity to appeal to one of the fastest growing voter groups in the country. For President Bush, it provided a rare opportunity to act as bi-partisan cheerleader, and he attempted to leverage his declining political capital to push comprehensive immigration reform through Congress. The bill would have granted amnesty to existing immigrants, provided for guest worker program, but it also would have provided for increased border security and the construction of additional fences. After two tries, the bill finally went down in 2007, failing to pass cloture and reach the floor for a full vote. The breakdown of the vote highlights how this issue cuts across party and geographic lines (click here for a map).

* Author’s note: I had a front row seat to this issue. At the time I was working in local government in San Antonio, where the percentage of the population that is Hispanic is well north of 50%, the issue had particular prescience. One of the most hotly contested races in the country was the race between Democrat Ciro Rodriguez and incumbent Republican Henry Bonilla. In a close race, Rodriguez defeated Bonilla, who was the lone Mexican-American member of the House Republican caucus. Bonilla came out in support of tougher border measures, while Rodriguez supported amnesty. The race was extremely ugly, with each candidate trying to he was more Hispanic than the other. In the end, Rodriguez was able to portray his opponent as “Henry Vanilla”, an out of touch aristocrat who had lost touch with his cultural roots.

The stakes could not be higher. Hispanics represent the fastest growing part of the electorate, adding over 4 million eligible voters between 2000 and 2007. Hispanic voters now represent ~10% of the national electorate, a number that will continue to grow. The Pew Hispanic Center projects that by 2050, nearly 30% of the population will be Hispanic, and that Hispanics will constitute 60% of the total growth in U.S. population during that time period. The electoral impact will likely be lessened by the fact that most of the growth will be concentrated in areas that are already highly Hispanic, meaning that heavily Hispanic areas will become more Hispanic. Dispersion patterns have increased markedly (see graphic below), but the growth still remains concentrated in border states like California, Arizona, New Mexico and Texas, as well as in the historical immigration hubs of Chicago, New York and Miami. Nevertheless, if one party manages to emerge as the party of choice for Hispanic voters, it could set in place a congressional realignment that holds for decades, similar to the way the New Deal created a coalition of blue-collar democrats that held together for more than 50 years.

At the same time, the influx and political ascendancy of a new electoral group will put a strain on the parties’ existing relationships with other voting groups. Southern Republicans and Midwestern Democrats, representing largely white populations, are already seeing the effects of cultural resistance to an emerging hispanic social identity that contrasts sharply with the dominant cultural identity of white America. This cultural clash is further heightened by a persistant language gap. In urban areas, African-Americans find themselves increasingly competing with hispanic immigrants for low paying jobs, and are resentful of the perceived downward pressure on wages. This is a familiar pattern in the U.S., where the strongest resistance to new immigrant classes usually comes from those groups at the bottom of the economic structure, who are forced to compete with these new entrangs for jobs.

Navigating this shift can be tricky. Richard Nixon’s so-called “Southern Strategy” was a highly effective response to the Democrat’s successful capture of the black vote in the 1960’s. While the Democrats gained near unanimous support from the black electorate, in doing so it lost a huge chunk of white voters. Over time, Democratic dependency on the urban black vote tied it to a variety of fiscal and social positions that alienated voters in western states, paving the way for the famous Red/Blue state construct that brought Republicans into a decade of power. The emergance of Barack Obama helped break that cycle, but if Democrats attempt to reconstruct the Black/Democrat relationship with the Hispanic electorate, they could re-create the same problem for themselves again.

On Monday, the Review will post the second half of this issue, focusing on the economic issues underpinning the immigration debate.

Carried Interest - Levin's Proposal

In a follow-up to a post in December, on April 3, 2009 a new proposal hit the House floor for the treatment of carried interest, the proposal would result in a significant tax hike for the ever unpopular hedge fund and private equity fund managers. Representative Sandy Levin (D-MI) reintroduced a new version of the carried interest reform bill originally introduced in 110th Congress on a message of fairness.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money. They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%."

The full bill, "To amend the Internal Revenue Code of 1986 to provide for the treatment of partnership interests held by partners providing services" (HR 1935), has not been received by the Government Publishing Office (GPO); however, it appears the entire carried interest will taxed an ordinary income rate of 35%. The prior Economic Policy Review, posting "Carried Interest - Long-Term Capital Gains or Ordinary Income", highlighted multiple options for taxing carried interest, concluding the a hybrid taxation policy would be a good comprise, for example treating the carried interest basis as a non-recourse loan from limited partners.

Rep. Levin marches through various "Myth" vs. "Fact" scenarios, many of which were presented in the prior post. One such "Myth" surrounds the impact of the change on union and state pensions. In the past, many investment professionals would have disregarded the change in taxation as immaterial, arguing incentive compensation fees would increase correspondingly. The current macroeconomic environment is not doing the investment professionals any favors and unfortunately for all but a select few, fees are more likely to decrease than increase. Levin is correct, it is "questionable" if the change in taxation will have any impact on "mom and pop."

While carried interest probably does not have enough "sweat equity" characteristics to be considered in the same light as that of pure entrepreneur, it does not have the same feel as pure incentive compensation either. All too often in the wake of a crisis, politicians over-react and the pendulum swings far past neutral. It probably is not a coincidence that Rep Levin is from the economical troubled state of Michigan, where many affiliated indirectly and directly with the auto companies (UAW pensioners) will be some of the most impacted voters from the current crisis. The bill is in its infancy, but similar legislation was included in Obama's budget, and investment professionals are far from in the good graces of Capital Hill. As such, one can reasonably assume that some change to the current tax policy will be enacted. Here's to hoping congress acts in manner that is truly "fair" and not just popular.