issue: Regulatory Reform

Spur Digital Manufacturing in America

Posted on by The Progressive Policy Institute
This piece is part of our Building American Resilience Series.

Resilience is the ability to react quickly to unexpected events. Market economies are inherently resilient because they are decentralized. But by outsourcing too much production to the rest of the world, the U.S. has traded much of its flexibility and resilience for somewhat lower short-run prices. Moreover, we’ve reduced our ability to deal with new sources of unexpected events, including climate change, pandemics, and wars.

Our inability to produce enough N95 masks for healthcare workers, months into the pandemic, is both astonishing and instructive. N95 masks are classic examples of what might be called “middle-tech”—the masks themselves are individually cheap to produce and have no moving parts or electronic components, but the machines to make the masks, including the special non-woven fabric that filters out tiny particles, are precise pieces of equipment that are expensive, time-consuming to build and mainly come from overseas. A resilient manufacturing sector has to have the know-how and the capabilities to build more machines if needed—and it may be that we no longer have enough of the suppliers with the necessary know-how and capabilities to increase our productive capacity in a crisis.

Government statistics clearly show our eroding manufacturing base. Twelve out of nineteen major manufacturing industries shrunk between 2007 and 2019. Over the same stretch, the non-oil goods trade deficit grew by 60% to record levels, showing the gap between what we produce and what we need, and how unprepared we are to deal with potential shocks.

That’s why we propose a “National Resilience Council” to lead a national push to stimulate local production, shorten supply chains, create high-wage factory jobs and make our manufacturing sector more resilient in crises. We have to harness our strength in tech to transform manufacturing for the 21st century. To be honest, we can’t and shouldn’t fight this battle on China’s ground of giant factories supported by government subsidies.

Instead, a resilient manufacturing recovery requires the fostering of flexible, local, distributed manufacturing—relatively small efficient factories that are spread around the country, using new technology, knitted together by manufacturing platforms that digitally route orders to the nearest or best supplier.

The National Resilience Council would be tasked with identifying those industries and capabilities that are strategic, in the sense of improving the ability of the economy to deal with shocks like pandemics, wars, and climate changes. These areas are likely to be underinvested by private sector companies, who quite naturally don’t have an incentive to tackle these sorts of large-scale risks. For example, no single company has an incentive to invest in improving N95 mask technology so that it is easier to scale up production, but the US government does. Or to harken back to an important historic example, the Defense Department’s original motivation for funding the research that led to packet switching and the Internet was to create a decentralized network that would be more survivable in case of nuclear attack.

Shorter, simpler supply chains also help with sustainable production. Long and complicated supply chains require more air and water transportation, generating more greenhouse gases. International shipping alone, especially container ships, accounts for about 2 percent of all carbon dioxide emissions, about the same as Germany. Beyond that, the more links in the supply chain, the more difficult it is for end producers to get a full picture of their carbon emissions.

Our initiative has four parts:

• First, we should double the National Science Foundation’s roughly $8 billion budget, with more of an emphasis on manufacturing-related areas such as materials sciences. That would still put it well below the roughly$40 billion going to the National Institutes for Health.

Such a doubling has been a consistent bi-partisan goal in the past, yet the U.S. has consistently fallen short. For the past two decades more than two-thirds of U.S. private and public R&D spending has gone to infotech and biosciences, while other areas of science and technology have received much less attention. It’s time to make up the shortfall.

• Second, the government can shore up the nation’s supplier base by providing $200 million in low-cost loans and grants to help small and medium manufacturers test and adopt new production technologies, including digital advances such as robotics and additive manufacturing. Even in a low-interest rate environment, capital is relatively scarce for companies that are too small to tap the bond market.

A somewhat similar initiative to provide loan guarantees for investment in innovative manufacturing technologies, authorized under the America COMPETES Act and supervised by the Commerce Department, never got off the ground because of excessively restrictive terms. Under our proposal, the loans and grants to small and medium companies would be tied to improving the resilience of the manufacturing base.

• Third, the National Resilience Council should sponsor a Manufacturing Regulatory Improvement Commission, along the lines that PPI has suggested in the past. We have no desire to roll back essential environmental and occupational health regulations. But we do want to consider whether rules governing manufacturing have become so restrictive as to unnecessarily force out jobs.

• Fourth, the federal government should take the lead to create a common “language” so that product designers, manufacturers, and suppliers can more easily work together online, just like DARPA helped create the basic structure of the Internet in the late 1960s. Just as a young person can write an app, put it online, and find users around the world, it should be possible to create a design for a new product and easily find potential local manufacturers.

The first two parts of our “National Resilience Council” initiative, which were laid out in our 2019 policy brief, “Jumpstart a New Generation of Manufacturing Entrepreneurs”, find echoes in Joe Biden’s excellent plan for boosting U.S. manufacturing. Key elements that we support include his proposals for bringing back critical supply chains to America, boosting worker training, increasing R&D investment, building up the Manufacturing Extension Partnership, and providing capital for small and medium manufacturers.

Biden’s “Buy America” initiative is understandable, given the stunning size of the trade deficit. But in the long run, improving resilience is more about improving America’s manufacturing capabilities than it is about restricting trade. Globalization and the development of new sources of supply, like India, can be a plus for resilience as long as we keep investing at home.

Moreover, one key word is essentially missing from Biden’s plan: Digital. His proposals make no mention of digital manufacturing, cloud computing, 3D printing, or all the other technologies that have the potential to create new business models for America’s factory sector.

The key is connectivity. Twenty-five years ago the rise of the Internet connected computers and made all sorts of new businesses possible, creating millions of jobs. Now it’s time to make even the smallest factory in Ohio or Michigan part of a larger manufacturing network that can compete on a level playing field with larger foreign competitors.

Some manufacturing networks or “platforms”, with names like Xometry and Fictiv, are already starting to sprout. Such platforms can make it easier for buyers to find domestic suppliers who have the necessary capabilities, and then to shift producers quickly when shocks hit or when it becomes necessary to lower carbon emissions. Such platforms can also give manufacturing startups access to immediate markets, make it easier for entrepreneurs to create well-paying factory jobs.

But this transformation of manufacturing is not happening fast enough to help American workers. The government has an important role to play leading the way to the Internet of Goods.

Building American Resilience: A Roadmap for Recovery After COVID-19

Posted on by The Progressive Policy Institute

For Americans and much of the world, 2020 has been an annus horribilis. Following its outbreak in China late last year, the coronavirus has spread quickly across the main international travel and trade routes. To contain the pandemic, nations have been forced to order mass quarantines, freezing economic activity and social life. It likely will take decades to calculate the full human, economic and psychic costs of this still-unfolding global calamity.

Few countries have been spared the ravages of Covid-19, but no country has been hit harder than the United States. At this writing, coronavirus has killed more than 156,000 Americans, and infected more than 4.6 million. And with the pandemic spreading rapidly across the South, West and Midwest – 39 states report sharp increases in infections – the end is nowhere in sight.

Stay-at-home orders and social distancing have put the world’s biggest economy on life support. After shrinking by 5 percent in the first quarter of 2020, U.S. output plunged by nearly 10 percent in the second quarter. Since March, more than 42 million Americans have filed for unemployment and nearly 20 million are still out of work. As many as 40- percent of the virus-related layoffs could become permanent, according to a University of Chicago study.

Many small businesses have gone under, and millions more are treading water. “Data from credit-card processors suggest that roughly 30 percent of small businesses have shut down during the pandemic,” reports The Atlantic. And many large companies in sectors hit directly by social distancing – travel and tourism, restaurants and hotels, and brick and mortar retail – have announced layoffs and permanent workforce reductions.

The federal government has borrowed and spent prodigiously to combat the virus, put money in peoples’ pockets and keep the economy from cratering. Congress so far has passed three major relief bills and is wrestling over the scope of a fourth. Washington has spent $3 trillion and could be headed toward a staggering annual deficit of $5 trillion or more, the largest since World War II. Amid this unprecedented public health and economic crisis, an old American dilemma – racial injustice – has reared its head. The unconscionable killing of George Floyd, Breonna Taylor and other black Americans by police has triggered widespread public outrage and protests.

THE CRISIS IN U.S. DEMOCRACY

Intensifying all three of these traumatic shocks is a catastrophic failure of national leadership. In past crises, leaders of extraordinary skill and character have arisen to steer our republic through the storm. Not this time. President Donald Trump has run the ship of state aground.

As the coronavirus first appeared, he sought refuge in denial and dissembling. When that did nothing to halt the spread of the virus, he passed the buck to governors and refused to mobilize the full powers of the federal government to supply tests, masks and ventilators, and to help the states set up rigorous contact tracing systems. Learning nothing from his early blunders, Trump has continued to dismiss the severity of the virus, tout phony cures, and demand premature openings of the economy and schools.

Trump’s incompetence cost our country precious weeks when the federal government should have been taking vigorous action to contain the pandemic. The delay was deadly: Had we started social distancing and locking down on March 1 rather than March 14, 54,000 fewer Americans would have died, according to disease modelers at Columbia University.

Elections really do matter. If the United States had elected leaders as capable as those in Germany, South Korea and Japan, many fewer Americans would be getting sick and dying today. And with contact tracing, masks and selective social distancing, we could keep more of our economy up and running.

As demonstrations against police brutality and racial discrimination flare up around the country, Trump again has displayed a perverse talent for inciting social rancor and pitting Americans against each other. He has smeared protesters as “domestic terrorists” and, over the protests of Mayors and Governors, dispatched unbadged federal security guards to put down the phantom threat of mass anarchy in the streets.

Finally, with a crucial national election approaching, Trump is trying to deny Americans the right to vote safely at home. He’s falsely crying fraud to undermine public confidence in the legitimacy of our electoral system, even to the point of issuing a preposterous call to postpone the vote.

No wonder America’s nerves are frayed. At this fateful moment of intersecting crises – threatening our health, prosperity and cultural cohesion – our country is saddled with a dishonest, incompetent and malicious demagogue who specializes in creating chaos rather than solving problems. Here and abroad, the impression is growing that America is becoming a failed state.

DON’T COUNT AMERICA OUT

But that’s wrong. For all our dilemmas, America remains a resourceful and dynamic country capable of swift course corrections. Beneath our fractious politics lies a bedrock of shared belief in liberty, equality and democracy. We also draw strength from a diverse and inventive citizenry jealous of its freedoms. Time and again, this country has shown it can bounce back from adversity stronger than before. Now we have to reinvent ourselves again.

Fortunately, there is a national election this fall. The American people can fire a sham president and his cowed GOP lackeys and replace them with genuine leaders who can unite us and make our democracy work.

But new leaders also need a new vision.
The United States has received a series of extraordinary shocks in this still-young century: the dot-com bust, 9/11, the great recession and financial meltdown of 2007-8, and now coronavirus, a hobbled economy and civil strife over endemic racism.

We’ve learned the hard way that our country needs stronger economic and social shock absorbers. Our challenge isn’t just to recover from the present crisis, but to build a better, more equitable democracy that will be more resilient against future shocks no one can foresee.

Americans have made enormous sacrifices to save lives and keep our health system and economy from collapsing. Many have stood by helplessly as friends and relatives have died lonely deaths in isolation. The psychological toll also has been heavy: Research by The Society for Human Resource Management finds that one in four workers report feeling either hopeless or depressed. If U.S. leaders don’t emerge from this painful period resolved to build a more just and resilient society, this suffering and sacrifice will have been in vain.

CONFRONTING ENTRENCHED INEQUITIES

The fight against Covid-19 has not been borne equally by all Americans. Health care and emergency workers and those in “essential” industries (such as meatpacking and grocery stores) have been exposed to higher risks of falling ill. The chief victims of Covid-19, by far, are older Americans. Thus far, 43 percent of deaths have been linked to nursing homes.

The pandemic also has taken a severe toll on low-income and minority communities, where many suffer from health problems associated with poverty and discrimination. African-Americans are dying from Covid-19 at a rate nearly twice as large as their share of the population. At this writing, blacks (13 percent of the U.S. population) account for 24 percent of all deaths.

The economic pain inflicted by the pandemic also has been unevenly distributed.

The lockdown, in fact, has exposed a new class divide in America. On one side are office workers, mostly college-educated, well-paid and digitally enabled, who have been able to keep working from home, and to have food and other goods delivered to them. On the other side are low-paid service, hospitality and retail workers, who can’t work remotely. Young workers, immigrants and Hispanic workers have been hit hardest by Covid-19 job losses.

Minority-owned businesses, often smaller and more precarious, have been damaged disproportionately by the pandemic. The National Bureau of Economic Research reports that, between February and April, there was a 41 percent decrease in black business owners and a 31 percent decrease in Latinx business owners, compared to an overall decline of 22 percent.

The pandemic also has exposed serious weaknesses in our private economy. Because of offshoring and long supply chains, for example, U.S. factories were unable to supply masks, gowns, gloves and ventilators in a timely way to health care workers desperately battling the virus.

Key public sector systems, long starved of investment and entangled in red tape, also have failed to respond nimbly to the crisis. Archaic computer systems in state Unemployment Insurance offices crashed as applications surged. The Center for Disease Control and Prevention, our front-line agency against pandemics, not only sent out flawed coronavirus tests, but also allowed bureaucratic inertia to delay the production of reliable tests by private laboratories.

Tens of millions of young children and older students have lost months of early learning and classroom instruction as schools of all kinds have closed. Some K-12 school systems used virtual learning to mitigate the loss, but many either did not have that capacity or chose not to use it to avoid discriminating against low-income families without computers or internet access.

Through the free and reduced price lunch and breakfast programs, public schools also play a critical role in feeding needy children. While some schools improvised “grab and go” programs to provide meals to kids, 80 percent report serving fewer meals, and only 22 percent offered meals two days a week. School closings thus have contributed to an upsurge in hunger in poor communities, even as they interrupt all childrens’ education.

A BOLD BLUEPRINT FOR RECOVERY AND RESILIENCE

In contrast to Trump’s “let’s get back to the way things were” message, progressive leaders should offer voters this fall an ambitious vision for America’s economic and social reconstruction. In this report, PPI presents a blueprint for speeding recovery and building a more resilient society. It tackles long-festering social inequities and bolsters the capacities of business and government to perform their vital missions during future pandemics or other national emergencies. Applying what we have learned during the Covid-19 crisis, our scholars and policy experts offer radically pragmatic ideas for change:

• Spur digital manufacturing in America and shorten supply chains for essential goods.

• Launch a “national reemployment” drive to get everyone back to work as soon as conditions allow, and to make work pay.

• Drive down the exorbitant cost of medical care so that we can invest more in healthy communities.

• Create well-paid production jobs and fight climate change by making America number one in electric vehicles.

• Make the social safety net more resilient.

• Forge a new economic security bargain with gig workers.

• Install a “fiscal switch” that allows Washington to automatically stimulate during economic downturns and shrink its debts during expansions.

• Give birth to two million new businesses to replace those that have gone under during the pandemic shutdown.

• Invest in resilient cities and metro regions.

• Fix America’s broken financing model for higher education. • Create a more nimble and accountable K-12 school system.

• Democratize capital ownership and expand national service.

• Replace outdated U.S. immigration laws with a “demand-driven” policy that welcomes more willing workers.

• Make our electoral democracy more resilient by ensuring that every citizen can vote at home.

Find each report of our series, Building American Resilience, below:

 

INTRODUCTION: BUILDING AMERICAN RESILIENCE

Will Marshall

SPUR DIGITAL MANUFACTURING IN AMERICA 

Michael Mandel

GET EVERYONE BACK TO WORK – AND MAKE WORK PAY 

Will Marshall

INVEST IN A HEALTHIER AMERICA 

Arielle Kane

MAKE AMERICA #1 IN ELECTRIC VEHICLES

Paul Bledsoe

WEAVE A STRONGER SAFETY NET POST-COVID 

Crystal Swann

MAKE THE GIG ECONOMY MORE RESILIENT

Alec Stapp, Michael Mandel

CREATE A “FISCAL SWITCH” TO MAKE OUR ECONOMY MORERESILIENT AGAINST RECESSIONS

Ben Ritz

CREATE TWO MILLION NEW BUSINESSES

Dane Stangler

INVEST IN METRO RECOVERY AND RESILIENCE

Crystal Swann

FIX HIGHER ED’S BROKEN MODEL

Paul Weinstein, Jr.

CREATE MORE INNOVATION SCHOOLS

David Osborne

DEMOCRATIZE CAPITAL OWNERSHIP 

Jason Gold

SHIFT TO “DEMAND DRIVEN” IMMIGRATION

Dane Stangler

MAKE ELECTORAL DEMOCRACY MORE RESILIENT

Colin Mortimer

A vision for independent workers

Posted on by The Progressive Policy Institute

A slice of bread is good, but a whole loaf is better. In the spring, Senator Mike Braun of Indiana introduced the Helping Gig Economy Workers Act to shield digital companies from lawsuits on worker classification when providing protective equipment during the coronavirus pandemic. This legal “safe harbor” for such digital companies could find its way into the Republican stimulus package under consideration in Congress.

But independent workers around the country, including freelancers and sole proprietors, need much more than protective equipment. They need access to a universal baseline level of benefits, paid for by the companies they work with, without losing the work flexibility they value. They need a new regulatory framework that is suited for the 21st century labor market rather than the 20th century labor market. Reaching these goals requires legislation, but it is very different from what Braun is proposing.

First, it is important to realize that while independent contractors receive tax deductions with expenses like vehicle miles, the tax system penalizes independent workers who provide their own benefits. Most independent workers must pay Social Security and Medicare taxes on the money they contribute to their retirement accounts. By contrast, the contribution of employers to their employee retirement accounts is exempt from these taxes, subject to certain rules. Indeed, this tax exemption can be worth thousands of dollars for middle income workers. Similar problems also arise with health insurance coverage for independent workers.

Second, the companies that do business with independent workers are not able to provide benefits because then the Internal Revenue Service would classify the workers as employees, leading to the loss of flexibility and control over their hours and who they can work for. Such a shift with status would likely reduce the number of available jobs. Those remaining workers would have fixed schedules, capped hours, and inability to work with more than one company. It is obvious that these tax and regulatory barriers weaken the labor market position of independent workers since benefits are more expensive and difficult for them to receive.

Read more here.

Credit Rating Agencies: Sending A Clear Signal

Posted on by The Progressive Policy Institute

INTRODUCTION 

The Covid-19 pandemic has sent the global economy and financial markets into an unprecedented crisis. The path of the downturn and recovery is difficult to discern. Some companies and nations are likely to survive and prosper, while others will struggle indefinitely.

In this context, bond markets will be looking to rating agencies to objectively assess the changing prospects of bond issuers, both private and public. Even the Federal Reserve is counting on the rating agencies—the Fed’s own rules for which bonds it can purchase under the new Primary Market Corporate Credit Facility explicitly reference the ratings produced by major nationally recognized statistical rating organizations (“NRSRO”).1 

Can the credit rating agencies be trusted to do a good job analyzing the credit prospects of borrowers in the downturn? Will the resulting rating actions balance the needs of investors, issuers, and the financial markets? Will ratings downgrades unnecessarily make the economic and financial situation worse? 

Before the virus struck, two independent advisory committees at the SEC in the United States were in the process of examining the business and compensation models of credit rating agencies such as Moody’s Investors Service and S&P Global. The issue was whether their “issuer pays” business model gives them an incentive to inflate the initial ratings of corporate bonds and other securities, or an incentive to slow-walk necessary ratings downgrades in tough times. Several meetings were held at the SEC in 2019 and 2020 to discuss alternative compensation models that might not have the same conflicts of interest.

But despite these criticisms, the strengths of the current model of fixed income credit ratings— built around transparency and reputation—are often overlooked.

The market for ratings for fixed income securities has developed a set of incentives and institutions that consistently produce strong signals that are useful for market participants, even in uncertain times.

This paper examines the pluses and minuses of the “issuer pays” model of credit ratings. The current model helps solve two information problems simultaneously. First, it’s hard for financial intermediaries such as mutual funds and life insurance companies to assess all the different bonds that they might invest in. Second, it’s difficult for individuals who trust their money to these financial intermediaries to monitor the soundness of their portfolios. Well-understood ratings by an independent rater address both problems.

We compare the issuer-pays to alternative models, such as “investor pays” and government-sponsored ratings. We conclude that despite potential conflict of interest problems, the “issuer pays” produces a stronger and less biased signal for market participants. We look back at the 2008-2009 financial crisis and see that ratings were inversely correlated with 10-year default frequencies even in the disrupted residential mortgage-backed securities (RMB) and collateralized debt obligation (CDO) markets, just as they should be.

We also address the knotty question of “procyclicality”—whether the rating agencies are too lenient in good times and then compensate by being too tough when the credit market turns down. We look at the recent evidence and suggest that there’s no reason to believe that the alternative business models do a better job than the “issuer pays” model in generating useful information in downturns. 

We then set the business model and practices of the credit rating agencies in a broader context. In every part of the economy, the Information Age has made an exponentially increasing amount of data available to everyone. The difficult problem is extracting useful signals from the noise, especially when some market participants are actively taking advantage of opportunities to manipulate data, or to create false signals. 

The credit ratings market, based on the issuer pays model, seems to have a way to consistently produce high quality and more accurate ratings that give strong and useful signals to market participants. Another benefit of independent credit rating agencies is that they set a global language – a global standard of comparison. This is especially important at times of stress, like now, when credit facilities need to be set up quickly. 

Finally, we ask the important policy question of whether the “issuer pays” model provides any useful lessons for other areas of the economy struggling with extracting signal from noise, such as journalism and safety certification of new products. 

BACKGROUND 

Why do credit rating agencies exist? Whose interests do they serve? Bond issuers, from small companies to giants, sell a wide variety of fixed income securities. These are mostly bought by financial institutions such as banks, mutual funds, and insurance companies, who are functioning as financial intermediaries. For example, the 2019 financial accounts report from the Federal Reserve shows that out of the $14 trillion in corporate bonds, only $937 billion are held directly by U.S. households and nonprofits.2 That’s less than 7 percent. Households invest in corporate bonds indirectly, through financial intermediaries. They own shares in bond mutual funds, which in turn own corporate bonds. Or they have paid for life insurance, and the life insurance companies invest in turn in corporate bonds.

Here is a schematic diagram that shows the flow of money supporting the fixed income markets. The role of the credit rating agencies is to help solve not one but two information problems. First, financial intermediaries like mutual funds and life insurance companies want to have some way of assessing the riskiness of the bonds they are buying from the issuers.

Obviously they do their own analysis. But it’s also helpful to have an independent source of ratings, since the issuer has an incentive to minimize potential risks.

In theory, financial intermediaries could do without the ratings agencies, if they are willing to put enough money into analyzing every bond. However, fully shifting the bond riskiness assessment to the financial intermediaries wouldn’t solve and might even worsen the second information problem: The financial intermediaries buying the bonds have an incentive to understate the riskiness of their portfolio for households, other investors and regulators. Moreover, households and regulators generally do not have the resources to independently assess the riskiness of the portfolios of the financial intermediaries. Most households and retail investors, of course, are not direct users of credit ratings. But indirectly ratings provide guardrails for financial intermediaries such as life insurance companies, guiding which bonds they can invest in and reassuring buyers of life insurance policies that their money will be safe.

In effect, the ratings do double duty. They are used by the bond buyers to assess the riskiness of the bonds. In addition, they are used by households and regulators to assess the riskiness of the portfolios of the financial intermediaries as well. Any alternative to the current business model has to take into account both uses. (Figure 2).

HOW THE RATING PROCESS WORKS

Under the current model, the issuer of a bond pays the rating agency or agencies for the initial rating of a security, as well as ongoing ratings. Different rating agencies use different lettering schemes, but there is widespread agreement about what counts as investment grade bonds and what counts as speculative grade.

More precisely, the rating is an assessment that the bond can withstand a particular level of economic stress. For example, S&P lays out a chart that says that a AAA-rated bond can withstand a downturn on the level of the 1929 Great Depression.3

Unfortunately, no one, including the credit rating agencies, can forecast how deep the pandemic-related economic downturn can go.

As it heads into 1929 territory, it’s possible that some top-rated corporate bonds may default. Even under less stressful circumstances, the rating agencies cannot predict how the global economy or financial markets will perform.

Moreover, we can reasonably expect sectorspecific shocks that affect bonds in one sector differentially. For example, the current coronavirus crisis has the potential to cause significant downgrades of bonds issued by travel companies such as airlines and hotels. Meanwhile residential mortgage-backed bonds got hit hard during the 2008-09 financial crisis.

Given the unpredictability of the financial markets and the economy, the rating agencies can reasonably be expected to assess relative riskiness within a sector.

Table 2 is based on the performance summaries that the credit rating agencies are required to supply to the SEC annually. We looked at the tenyear period starting with 2006, the year before the financial crisis started, and focused on the performance of ratings issued for the RMB and CDO markets. These are two of the sectors that were disrupted the most in the 2008-09 financial crisis. We combined the data for Moody’s and S&P Global.4,5

We see that for these two important sectors, the rating on a security in 2006 is inversely correlated with the frequency of defaults 10 years later. The higher the initial rating, the lower the frequency of defaults.

THE FINANCIAL CRISIS OF 2008-09

Under the current model, the issuer of a bond pays the rating agency or agencies for the initial rating of a security, as well as ongoing ratings. Different rating agencies use different lettering schemes, but there is widespread agreement about what counts as investment grade bonds and what counts as speculative grade.6

In response, the Dodd-Frank Act of 2010 called for the SEC to study alternatives to the “issuer pays” business model, as well as other regulatory reforms. In addition, the Department of Justice, in combination with some state attorneys general, launched lawsuits accusing S&P and Moody’s, in particular, of defrauding investors.

The lawsuit against S&P was settled in 2015, focusing on a small number of incidents where internal procedures weren’t followed.7 A similar lawsuit against Moody’s was settled in 2017, with the rating agency agreeing to do a better job following its published rating procedures.8 In neither case was there sufficient evidence for a finding of fraud.

POTENTIAL BIAS

The obvious bias in the issuer pays model is that the ratings agencies compete to offer issuers better ratings. To put it another way, an issuer can engage in “ratings shopping” by choosing to pay the agency that offers the higher rating.

But study after study has shown much less evidence of rating shopping than one might expect. Most bond buyers only want to invest in securities that are rated by multiple agencies. That means rating agencies are under less pressure to boost ratings.

It is true that among single-rated securities or tranches, there is evidence that bond issuers are choosing the agency that offers the higher rating, as one might expect. One study found that for mortgage backed securities, “outside of AAA, realized losses were much higher on single-rated tranches than on those with multiple ratings, and yields predict future losses for single-rated tranches but not for multi-rated ones.”9

However, it turns out that bond buyers are not stupid. When they see a single-rated security, they are less likely to trust the rating than if it has been rated by multiple rating agencies. One 2019 study found that “bonds with upwardbiased ratings are more likely to be downgraded and default, but investors account for this bias and demand higher yields when buying these bonds.”10

In other words, the combination of the rating and the number of raters—both publicly observable pieces of data—produces useful information for participants in the bond market. In other words, the bias is partly self-correcting.

MITIGATING THE BIAS

Still, it is clear that credit rating agencies face conflicts of interests, much like other participants in financial markets. Accounting auditors face pressure to give good grades to their clients. Investment banks face pressure to overstate the potential of the initial public offerings that they help bring to market. And even regulators face conflicts of interest, since a typical career path often leads out of government to the regulated industry.

Like these other institutions, internal controls at the rating agencies can help mitigate the bias towards higher ratings. That includes internal separation of sales and analysis, so that the people assigning a rating to a bond are not in direct contact with the issuer of the bond. In addition to internal controls, credit rating agencies are heavily regulated around the world. That includes annual exams in the U.S. by a regulator who has significant authority to take action if any violations occur—including revoking a credit rating agency’s license to operate.

Even with these internal controls, though, the real mitigating institutions are transparency and reputation.

Transparency

The agencies assess the creditworthiness of the bonds according to published and detailed methodologies.11 In fact, there is literally nowhere else in the private sector that gives this level of transparency into the intellectual property of an organization, or that so rigorously documents their internal methodology for making decisions (imagine a newspaper committing itself publicly for how it chooses stories or does reporting, including reporting on advertisers). From the perspective of users of the ratings, the public nature of the ratings methodologies is essential. On transparency, one of the key benefits of an issuer-pays system is the fact that allows ratings to be released publicly – meaning they’re scrutinized every day by all corners of the market, the media, and academia. The ratings agencies cannot be judged on the performance of the ratings they issue, because of the uncertain effects of future events. But they can be judged on whether they follow their published methodologies.

Reputation

The other institution that mitigates bias is the need to preserve reputation. Credit rating agencies know that credit booms always end in a recession or credit crisis. The exact nature of the crisis can’t be predicted—the concept of a global pandemic, even if acknowledged within the realm of possibility, was part of very few reasonable scenarios. But when the crisis comes, credit rating agencies can be sure that their rating decisions will be challenged ex poste.

Their initial rating decisions will be criticized for being excessively sanguine. Their ratings downgrades will be attacked for either being too slow (leading to investors being misled) or too rapid (potentially undermining the economic viability of a bond issuer). All of their internal decision-making processes will be scrutinized and investigated.

This sort of intense scrutiny is only reasonable. Rating agencies do all of their work out in the open. They issue public ratings, and the performance of the ratings is visible as well. It’s not possible to investigate all of the bond issuers, so the ratings agencies are a proxy. They are an easy target, and that’s a good thing.

One can think of this as a long-term equilibrium where the rating agencies make good profits during the boom periods assigning ratings.

During the downturn it’s revealed how well their ratings performed. In addition, after the inevitable investigations, the rating agencies can expect that their internal rating process will be revealed as well. They therefore have a strong incentive not to cut corners and preserve their reputation so that they can survive the investigations of the downturns.

Indeed, issuers will not use the ratings if investors don’t trust in their independence and the strength of the models. In fact, demand for the use of certain credit rating agencies comes from the performance of their ratings over time and the ongoing judgment of investors.

ALTERNATIVE COMPENSATION MODELS

Is there a better way? Dodd-Frank charged the SEC with examining alternative business models for ratings agencies, since issuer pays has an obvious conflict of interest. Meeting in late 2019 and early 2020, the SEC’s Fixed Income Market Structure Advisory Committee looked at the question, in the words of SEC Chairman Jay Clayton: “Are there alternative payment models that would better align the interests of rating agencies with investors?”12

Economists, regulators, and financial market participants have suggested a variety of alternative compensation models designed to reduce conflicts of interest while still maintaining the critical function of the ratings agencies. A 2012 report from the GAO identified seven possibilities, though several had never been tried in the real world. At the end of the day, the only plausible alternatives are some form of “investor pays” and random assignment.

Investor Pays

One option is to require the investor to pay for ratings, like a subscriber fee. More precisely, it’s better to say that “financial intermediaries pay” since financial intermediaries such as mutual funds, pensions, and life insurance companies own the majority of fixed income securities.

The shift to “financial intermediaries pay” removes one conflict of interest, at the cost of creating two more. On the one hand, at the time of issue, it’s better for the bond buyer if the rating is cautious, so that the bond will be priced lower and pays a higher yield. On the other hand, financial intermediaries prefer that the rating agencies are slow to downgrade, to make their portfolios look better to final investors and regulators.

It’s also true that there are fewer financial intermediaries than bond issuers. Moreover, financial intermediaries tend to have the resources to do their own analysis if needed. They are therefore less dependent on the rating agencies, and have less need for the information.

In the end, there is no compelling case that the “investor pays” model is superior to the “issuer pays” model. Moreover, it’s hard to see how an “investor pays” model would work without strict government rules.

Random assignment

The critics who worry about issuers shopping for ratings keep coming back to the same solution: Random assignment of rating agencies to new bond offerings. When an issuer wanted to have a bond rated, they would apply to a central organization that would randomly assign a credit rating agency off of a list of approved agencies. The agency would then get paid for its work at a fixed rate.

In effect, the “random assignment” compensation model turns credit ratings into a government-run utility using “fixed price” contractors. As with all government-run utilities, there would be pluses and minuses.

On the one hand, random assignment reduces or eliminates the ability of issuers to shop for better ratings, which is the intention. That means rating agencies would not have an incentive to artificially boost ratings.

But as in the case of “investor pays,” eliminating one problem creates two new problems. First, under the random assignment compensation model, rating agencies have no incentive to put effort into producing high quality ratings, since they get picked randomly even if they do just an average job. Credit rating agencies would be investing the money in innovation. As a result, the random assignment approach may produce ratings that are less biased but also less accurate. Moreover, there might be an incentive to set ratings artificially low to avoid downgrades.

The second and related problem is deciding which rating agencies are on the approved rotation list—which ones are eligible, and which ones need to be removed for bad performance. That requires a government “gatekeeper” to assess the short-term and long-term performance of each agency and which ones are “good enough” to be on the list.

There are two approaches to assessing performance of rating agencies. One is to look at measurable outcomes—for example, the frequency of defaults and large downgrades. These must be measured over an entire credit cycle, so it’s tough to see how they can be applied in the short run. Moreover, any “objective” measure will be gamed by new rating agencies that want to get on the list.

The other approach is to set up a standard that is based on minimum capabilities. That is, the government gatekeeper would add to the list any rating agency that has enough licensed analysts and published methodologies. The result is that more competition is likely to lead to worse quality ratings.

There’s one final important point. One of the biggest and most politically fraught rating decisions is how to assess sovereign debt, and in particular the debt offerings of the U.S. government. With the government as the gatekeeper for the random assignment list, there’s likely to be pressure on rating agencies not to downgrade government debt even if appropriate. The conclusion is that the shift to a random assignment system is likely to produce new unknown biases in ratings.

PROCYCLICALITY

One charge levelled against the current “issuer pays” model is that it leads to “procyclicality.” If ratings were procyclical, that would mean that the rating agencies go too easy on issuers in good times, and then are forced to be tough and downgrade bonds in bad times. In this way, say the critics, ratings procyclicality can end up making the booms bigger and the downturns worse.

However, the evidence for ratings procyclicality is, to put it mildly, mixed. A July 2020 report from the SEC observed that “ratings downgrades are generally lagging indicators of cost of debt capital. Moreover, consider the issue of whether rating agencies have been giving “too high” ratings to corporate borrowers in recent years. In a February 2020 report, the OECD directly addressed that question, comparing the pattern of ratings by one credit rating agency in 2017 with 2007. The report found that at the same rating level, borrowers in 2017 had a higher level of debt relative to various measures of cash flow and earnings.

By itself, that result suggests that credit rate standards had gotten easier in 2017 compared to 2007. However, the report then admits that low interest rates made it easier for corporate borrowers to cover their debt payments in 2017 compared to 2007, providing evidence that credit standards had not gotten easier.

In truth, the procyclicality argument is a bit of a red herring. When the credit cycle turns down, credit rating agencies are stuck no matter what they do. If they are conservative and cautious about downgrading bonds, they are accused of protecting their issuers. If they downgrade aggressively, they are accused of making the recession worse. The cries are especially loud when sovereign debt issued by governments is downgraded, since such a move has a broad effect on the ability of governments to raise money.

Moreover, there’s no evidence that the alternative compensation models would do any better. Under the “investor pays” model, the rating agencies will come under strong pressure from investors to not downgrade the bonds in their portfolios in downturns, making ratings untrustworthy at precisely the moment they are needed the most. And as we point out in the previous section, under the “random assignment” model, any rating agency that downgraded the government might find itself out of the rotation in the future.

OTHER APPLICATIONS OF ISSUER PAYS

For all their flaws, independent credit ratings agencies, paid by issuers, produce a strong and useful signal in a noisy information environment. It isn’t perfect, but the ratings perform well, and users are able to adjust for potential conflicts of interest. The combination of transparency and reputation seem to create sufficient incentives to make it worthwhile for the credit rating agencies to take their job seriously and produce information that issuers, financial intermediaries, and households and regulators can’t do without.

In the broader sense, one gets a sense that the current “issuer pays” credit rating system is actually a pretty decent way of solving a difficult problem that occurs across the economy—certifying the quality of products and services. An independent third party is paid by the producer or manufacturer of the product or service to do the certification (“issuer pays”). One key is that the payment has to be large enough that the certifying organization has an incentive to maintain their reputation.

Certification of electric equipment

Indeed, the “issuer pays” model turns out to be applicable to other areas of the economy where information is important. For example, certification of electrical equipment and other products for safety is an area that is increasingly important these days. The top U.S. “certification agency” is UL LLC, an organization founded in 1894 as the Underwriters’ Electrical Bureau, and operated until 2012 as the non-profit Underwriters Laboratory.13

UL’s business model is to charge companies with new products to get certification for meeting safety standards, typically promulgated by Underwriters Laboratory, in order to get the UL certification. There are other certification organizations in the United States, such as Intertek Testing Services NA, Inc., based in Illinois. But UL is the leader.

For many products, there’s no legal requirement to have a UL certification, but many larger retailers won’t sell the product without. Certification for products used in the workplace is mandated by OSHA, which publishes a list of approved testing laboratories.14 In addition, the government sometimes mandates that particular products cannot be sold in the United States without UL certification. That was true in 2016 for hover boards, for example, when the CPSC banned any hover board that didn’t have a UL certification.15

As with credit rating agencies, issues regularly arise about the objectivity of UL certification.16 Moreover, as UL has extended its work to certify a wider variety of products, questions have arisen about its capabilities. Nevertheless, the “issuer pays” model in product safety certification seems to be functioning well.

Indeed, the European Union, which on the surface uses a “self-certification” model, seems to be heading towards “issuer pays.” The selfcertification model uses the CE mark, which means that the manufacturer or retailer is taking responsibility that the product meets EU standards.17 But in many product areas the company must also get the approval of what’s known as a “notified body,” which is the equivalent of a certifying authority.18

Unfortunately, the European system has been criticized for being too lax.19 Gradually they have been moving closer to a pure “issuer pays” model, with more products requiring certification by notified bodies.

Rating of journalist organizations

One area where third-party rating is just getting started is the news business. Companies such as Facebook and Twitter have been criticized for allowing too much ”fake news” on their platform—low quality news sources that spread misinformation. On the other hand, if they start exercising too much control, they are accused of censorship and monopoly power.

The obvious solution is for the platforms to use an independent third party. Indeed, we’ve started to see a rise of for-profit companies that rate the reliability of news sources. The leading one so far is NewsGuard Technologies, founded in 2018 by Steven Brill and Gordon Crovitz, formerly publisher of the Wall Street Journal. NewsGuard ranks news sources on nine different criteria, such as “avoids deceptive headlines” and “does not repeatedly publish false content.” 20

The demand for journalistic ratings comes in part from the threat of government regulation. European countries, in particular, have passed laws to control “fake news.”21 Companies such as Facebook, Google, Microsoft, Mozilla, and Twitter have signed onto the European Commission’s voluntary Code of Practice on Disinformation, which commits them to take certain steps to control fake news.22

So far, the NewsGuard business model is “user pays.” As the company says, “NewsGuard’s revenue comes from Internet Service Providers, browsers, search engines and social platforms paying to use NewsGuard’s ratings.” For example, Microsoft is paying a licensing fee to NewsGuard to incorporate the ratings into Microsoft’s Edge browser.23 In addition, individuals can subscribe to the service for a small monthly fee. It’s not clear how many other platforms are paying, especially since the ratings are publicly available.

Over time, platforms may gravitate towards only featuring news sources that get satisfactory grades from at least two independent raters. That opens the possibility of an “issuer pays” model where news sites pay a fee to get rated, perhaps proportional to their web traffic. This has the advantage that the ratings are public and available to everyone.

CONCLUSION

Since the 2008-2009 financial crisis, critics have worried about the biases built into the “issuer pays” compensation model for credit ratings agencies. Now that the Covid-19 crisis has placed the credit markets under great stress, these questions are once again coming to the fore. But as we show in this report, nobody has been able to come up an alternative compensation model that is clearly better. There’s no reason to believe that the issuer pays compensation model will get in the way of the necessary effective and independent third party assessment of default probabilities under extreme uncertainty.

Indeed, in the Information Age, the “issuer pays” approach for credit ratings may serve as a good model for other parts of the economy, because it generates a clear signal. We identified another sector, product certification, where “issuer pays” is the dominant model despite its inherent biases. We also consider whether the “issuer pays” model could be applied to certify the quality of journalist organizations, an exceptionally important problem that has been difficult to solve.

Regulatory Improvement for Independent Workers: A New Vision

Posted on by The Progressive Policy Institute

One of the biggest productivity advances in recent years has been the use of platforms to connect buyers and sellers at lower cost. Platforms offer less rigid contractual arrangements, expanded earnings opportunities for workers and access to essential goods and services for underserved communities. Overall, platforms generate win-win economic activity which benefits everyone. 

The flexibility of platforms will play a critical role in helping the U.S. labor market recover more quickly from the Covid recession. In most economic recoveries, companies have been apprehensive about making the commitment to hire given lingering economic uncertainty. That has typically made employment a lagging indicator in recoveries. By contrast, platforms will make it easier for workers to scale up hours worked gradually as the economy expands, which will boost consumer spending and demand, which will in turn boost employment. 

The big question, though, is how to regulate platforms in a way that preserves the flexible nature of the work and the benefits to our economy at large, while continuing to protect both workers and consumers. The Progressive Policy Institute believes strongly in the importance of regulation for a well-functioning market economy. Yet we have long advocated for “regulatory improvement” as essential for accelerating growth and job creation.

Regulatory improvement is very different from deregulation. Too many sectors of the economy have overlapping and contradictory layers of regulation that get in the way of productivity gains and rising incomes. At the same time, there may be parts of the economy where new rules are necessary. In this case, platform businesses need to step up and provide a baseline level of benefits to their workers.

The labor market, in particular, is struggling with a 20th century regulatory framework imposed on a 21st century economic structure. The first 1099 was issued in 1918 and the first W-2 in 1944. To this day the labor market is artificially divided into “employees” and “independent workers”, including freelancers, sole proprietors and other self-employed workers. The dividing line is quite complicated and, in some cases, almost impossible to understand, with different federal and state agencies following different rules for establishing the dividing line. This patchwork of conflicting regulations creates enormous business uncertainty, reducing the incentive to create new work opportunities.

In the current regulatory framework, workers classified as “employees” are subject to a completely different regulatory regime than independent workers, including rules for scheduling and hours worked, working conditions, minimum wages and who pays Social Security and Medicare taxes. Employees are subject to employers’ control in every aspect of how they do the job, which for many low-income workers means shift work tied to a single company, which sets the exact hours. Employees typically get certain benefits, such as workers compensation and unemployment insurance, which are generally paid for by payroll taxes, and possibly access to other benefits, such as group life insurance, defined contribution retirement plans, and employer-sponsored health insurance or health savings accounts (HSAs).

Independent workers have a unique flexibility that employees do not enjoy at all. In the same survey, 51% of respondents said there is no amount of money where they would definitely take a traditional job. Part of the explanation may be that independent contractors simply aren’t able to work under the terms of normal employment; in fact, 46% say they could not have a traditional job due to personal circumstances (e.g., health or caregiving duties).

But in exchange, independent workers, almost by definition, are not allowed to get benefits from the companies that they do business with. As an IRS publication states:

Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.

Unfortunately, the current tax system systematically penalizes independent workers who try to provide their own benefits and companies that want to help these workers maintain flexibility while accruing appropriate benefits or protections. For example, as we explain below, most independent workers have to pay FICA taxes on the money they contribute to their tax-deferred Individual Retirement Accounts (IRA), Simplified Employee Pensions (SEP) or solo 401k accounts. By comparison, the contribution of employers to employee retirement accounts is exempt from both employer and employee FICA taxes. This saving can be worth thousands of dollars. The same or similar problems show up with other benefits as well. 

This puts independent workers into a catch-22 situation. The companies that they do business with can’t provide benefits because that would turn them into employees, an outcome that the overwhelming majority of these workers do not want. But independent workers providing benefits for themselves incur a much bigger tax burden than they would face as an employee. 

There are two solutions to this problem for independent workers. One is to double down on the historical dichotomy between employees and independent workers and make the distinction even more rigid. This “Procrustean Bed” solution is best exemplified by which imposes rigid tests on who can be classified as an independent contractor. Basically, it forces companies to turn many of their independent contractors into employees, which would lead to the loss of these workers’ flexibility and control over their hours and who they can work for. In the gig economy space, this would almost certainly mean set schedules and the inability to work on more than one platform. Minimum wage rules and other employment regulations would lead to reduced service at certain times of day or in certain geographical areas.

The other alternative is to improve the position of independent workers by creating a new regulatory regime that extends them important new benefits, while still allowing the flexibility that self-employed workers choose. 

This new regulatory regime would have several important features. 

  • It would straighten out the tax treatment of benefits so that independent workers are on a level playing field with employees.
  • It would require a baseline level of benefits and protections for independent workers, including a cafeteria style plan with a menu of options for workers to choose what makes the most sense for them.
  • It would have a uniform national standard for determining who is an independent worker. One possibility is that companies would have no control over hours of work, and no non-compete agreements. 

A separate and important question is whether the new regulatory regime would be opt-in or mandatory. We lean towards opt-in, as discussed below.

The Structure of Benefits 

What benefits are U.S. employers actually paying to their employees? Table 1 below summarizes the distribution of benefits for full-time and part-time workers for the 2018-2019 period, based on BLS data. Note that part-time workers get a significantly small share of their compensation in benefits compared to full-time workers. Moreover, almost half of the benefit “package” for part-time employees comes through the legally mandated “benefits” such as employer tax payments for Social Security and Medicare, much of which independent workers already pay on their own. 

In general there are two problems with independent workers providing their own benefits. First, as we will see, the tax laws are written in such a way as to be biased against independent workers compared to employees, especially when the independent workers file on Schedule C. Second, if the businesses hiring the independent workers try to provide benefits, that’s taken as prima facie evidence that the independent workers are really employees, which the overwhelming majority of self-employed workers typically do not desire to be. 

Example 1: Retirement Savings

We already mentioned that the current tax system systematically penalizes independent workers who try to provide their own benefits. Let’s begin with retirement. Suppose that an employer wants to contribute $1000 to an employee retirement plan such as a 401k. That employer contribution is deductible from the employer’s business income and does not incur Social Security or Medicare Taxes for either the employer or the employee, as long as certain rules are met. 

Now suppose a company gives that $1000 to an independent worker who is filing as a Schedule C sole proprietor or single-person LLC. They deposit the $1000 in their IRA, SEP, or solo 401k account as a tax-deferred retirement contribution. The independent worker gets to deduct this contribution from their federal income tax (line 15 or line 19 on schedule 1). 

However, the independent worker has to pay both the employee and employer FICA tax, minus the net impact of the deductibility of the employer share (Schedule SE and line 14 on schedule

1). So, for example, if the independent worker’s marginal federal income tax rate is 22%, they end up paying a bit under 13% on the $1000, rather than 0%.

In other words, the independent worker is penalized on the retirement savings side. And the company can’t offer to bring the independent worker into the company’s plan without classifying the worker as an employee. 

Example 2: Healthcare Benefits

 A similar disparity holds in the case of healthcare benefits. If an employer contributes $1000 to a health insurance plan for their employee, that contribution is deductible from the employer’s business income and exempt from both employer and employee FICA taxes (within limits). And the contribution does not count towards the employee’s taxable income. 

That same $1000, paid directly to the independent worker, can also be used to finance health insurance. In many circumstances, that spending on self-employed health insurance can be deducted from taxable income (Line 16 on schedule 1). However, the independent worker still must pay employer and employee FICA taxes on that $1000, minus the deductibility of the employer share. As before, if the independent worker’s marginal federal income tax rate is 22%, they end up paying just under 13% on the $1000, rather than 0%. 

Example 3: Workers’ Compensation

Workers compensation is basically an insurance policy that covers employees for on-the-job accidents or injuries. Workers comp benefits are typically not taxable, and workers comp premiums are deductible from business income. Depending on the particular state, independent workers with no employees are usually not required to purchase workers’ comp for themselves. Such individual policies can be quite expensive, so many independent workers go without. But going without workers comp or occupational accident insurance, runs the risk of being exposed to large medical bills and a significant loss of income if workers are injured on the job. On the other hand, if the company provides worker compensation to an independent worker, that runs the risk of having them reclassified as an employee, which is not the outcome self-employed workers want. 

Example 4: Unemployment Insurance 

Under ordinary circumstances, the U.S. unemployment insurance system is a fairly small part of benefits. Depending on the year, average state and federal premiums for unemployment in the private sector amounts to between 0.5% and 0.9% of compensation. In 2018—a low-unemployment year–that came to only about $40 billion, on an annual basis. By contrast, unemployment benefits received in 2018 came to only $27 billion. Unemployment insurance premiums are deductible from business income, while unemployment benefits are subject to income taxes but not to FICA taxes. 

On the other hand, during recessions, unemployment insurance benefits received swell far out of proportion to taxes paid in, as the federal government typically appropriates more money to beef up unemployment insurance. In 2009 and 2010, for example, unemployment benefits rose to over $130 billion annually. Because of these special payments, unemployment benefits paid out over this last business cycle (2008-2019) exceeded unemployment insurance taxes paid in by more than $100 billion, none of which went to independent workers. 

However, the discussion around unemployment insurance for independent workers is different now than it would have been even six months ago. The Pandemic Unemployment Assistance (PUA) covered self-employed workers and small businesses, and showed that it was possible to provide “income insurance” for independent workers in hard times outside of the conventional unemployment insurance structure. 

So let’s focus for now on how to provide “income insurance” for independent workers in normal, non-recession circumstances. The key is that independent workers need a cushion not just against economic shocks, but personal shocks such as illness or family needs. One solution is for employers to contribute to a pot of money for the independent worker that could be used for a variety of different purposes. Like unemployment insurance premiums, the contributions to the fund should be tax-deductible.

One variant of income insurance that could apply to independent workers is income averaging for tax purposes. Because of the progressivity of the income tax code, allowing independent workers and employees to average between good years and bad years could significantly reduce the average tax bill, and cushion the effects of fluctuations. Income averaging was available to taxpayers whose income spiked up until 1986, when it was eliminated by that year’s tax reform (it is still available to farmers and fishermen). 

The Wrong Approach

The key goal is to make independent workers better off. One potential solution, as noted in the introduction, is to double down on the historical dichotomy between independent workers and employees. California, which went into effect on January 1, 2020, is the exemplar of this approach. This codifies and expands the “ABC test” which says that a worker is an employee unless they meet all of the following conditions: (A) “the individual is free from direction and control,” applicable both “under his contract for the performance of service and in fact,” (B) “the service is performed outside the usual course of business of the employer,” and (C) the “individual is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as that involved in the service performed.”

Under this extremely stringent test, some independent workers would need to be reclassified as employees. This reclassification is incompatible with business models predicated on independent workers, and as a result, many businesses have cut ties with California-based workers or shut down operations in California entirely. Under the new classification, it’s not illegal per se to allow an employee to completely decide which work opportunities to accept and to set his or her own days and hours (without any intervention from the business), but it’s certainly doesn’t fit the way employers typically operate.

As a response to this new law, California independent workers have been laid off en masse. In its news coverage of the passage of AB-5, Vox published an article with the headline “Gig workers’ win in California is a victory for workers everywhere.” Its reaction as a business, however, was quite different. A couple months later, the parent company Vox Media laid off 200 freelance writers right before the holidays (and right before the law went into effect on January 1). Deliv, a Menlo Park-based crowdsourced, crowd-shipping, same-day delivery startup, severed its relationship with 591 drivers a few months after it went into effect. 7-Eleven halted new California franchises. One estimate from the Berkeley Research Group concluded that switching the status of app-based drivers to full-time employees would reduce the number of drivers by 80 to 90 percent in California.

A Better Way

An alternative is to construct a new regulatory framework that explicitly recognizes a middle ground of independent workers who can receive benefits from the (multiple) companies they contract with. 

As we noted above, would have to address three main issues. 

  • It would straighten out the tax treatment of benefits so that independent workers are on a level playing field with employees.
  • It would require a baseline level of benefits and protections for independent workers, including a cafeteria style plan.
  • It would have a uniform national standard for determining who is an independent worker. One possibility is that companies would have no control over hours of work, and no non-compete agreements. 

A separate and important question is whether the new regulatory regime would be opt-in or mandatory. We lean towards opt-in given the wide variety of independent contractor arrangements that exist (e.g., doctors, realtors, etc.). If companies do not opt in, they would remain subject to existing legal tests for determining worker classification. 

Note that our proposal is very different from the “marketplace contractor” laws passed in states such as Florida. Such laws merely specify that certain on-demand workers are to be treated as independent contractors. However, they do not fix the federal tax laws that unfairly penalize benefits for independent workers. They also do not specify baseline levels of benefits and protections. 

Straightening out the tax code

As documented in this paper, the current tax treatment of benefits systematically favors employees over independent workers. Sole proprietors and single-member LLCs that file via Schedule C pay a substantial tax penalty for attempting to access the same benefits employees get. That needs to be fixed. For example, when a self-employed worker contributes to an SEP, that contribution should be exempt from payroll taxes. The tax fix here would be a simple one, allowing independent workers to deduct healthcare and retirement contributions from the earnings calculation for the self-employment tax. 

The companies need to step up here, too. A company should be able to contribute to an independent worker’s retirement or health accounts without triggering additional tax consequences, just as would happen for an employee. This would require a modification to current law governing benefits.

Simplifying the dividing line

The dividing line between independent workers and employees should include whether the company contributes to benefits for the independent worker. To the contrary, in this new category, once a worker reached a certain number of hours contracting with a particular company or platform, the worker would be entitled to a required set of tax-advantaged benefits —for example, portable benefits including paid leave, retirement savings accounts and contributions towards an individual’s health insurance premiums. All workers should be covered by occupational accident insurance for on-the-job injuries. On the other hand, companies would be forced to allow workers in this third category the freedom to choose their hours as well as work for other companies in the same industry. In other words, control over hours or non-compete agreements. 

Baseline level of benefits

The exact level of benefits required in the new category would have to be considered carefully. The optimal mix of benefits will create an option that is preferable to current rules for many companies and workers, creating a win-win proposition. The flexibility, in particular, will be attractive to many workers.

We note that it’s especially important to design the benefits package to help low wage workers. For example, one could imagine zero-cost banking as part of the package in order to link the unbanked to the financial system. These zero-cost bank accounts would be designed to be portable and would be subsidized by the companies with which the worker contracts. 

Companies would be required to choose, on a year by year basis, whether they treat their independent contractors under this new category. This choice would allow companies to offer benefits to independent contractors without worrying that they would be reclassified as employees at either the state or federal level, while preserving the flexibility and independence that are synonymous with independent contractor status. And independent contractors would be on a level playing field with the tax-advantaged employee benefits.

How the cafeteria style plan would work

The cafeteria plan would allow independent workers to choose from a variety of pre-tax benefits, including health insurance, paid time off, and retirement savings. These benefits would be tied to the individual, not the job, making them truly portable. Plans would be managed by a qualified benefits provider. If an independent contractor ceases work for one company, they do not lose any accrued benefits from that relationship. Companies pay the equivalent of a certain share of the worker’s earnings into a dedicated account for pre-tax benefits. There is no required match from the beneficiary – the cost is fully borne by the business and nothing comes out of workers’ pockets. The independent contractor accrues benefits in proportion to the amount of money earned on the platform.

Independent workers can choose to use these funds towards individual health insurance premiums. They can also choose to add the money toward paid leave or retirement. Individuals access the paid leave benefits by self-certifying that they have experienced a qualifying event, such as falling sick, needing to take care of a family member, or living under a state of emergency. Since there is no separation event for an independent contractor similar to an employee being laid off an employer, there needs to be a cutoff when this short-term insurance plan converts into a cash benefit. For example, at the end of the year, the unused benefit funds could be rolled into a retirement savings account.

In order to prevent a patchwork of state and local laws from developing, the new federal law needs to include preemption. This new regulatory model — in particular the social insurance component — is critical to solving market failures. To take one illustrative example, consider the negative externalities created during a pandemic. In the case of a contagious disease, one individual’s actions (such as wearing a mask) directly affect the likelihood of others getting infected. Similarly, there is a public interest in ensuring independent contractors aren’t financially pressured to work when they’re feeling sick. The government needs to create a new regulatory framework that incentivizes private sector companies to fund benefits programs such as sick leave or paid leave to reduce the recurrent negative spillovers in labor markets.

Cost

Obviously this new regulatory regime extends certain tax breaks now enjoyed by employees to independent workers as well, which incurs some hit to tax revenues. But note that the alternative solution to the independent contractor problem—redefining the dividing line so that more independent workers are reclassified as employees—also incurs a hit to tax revenues. Reclassification of independent workers as employees costs the federal government FICA tax revenues on employer contributions to healthcare and retirement plans. In addition, reclassification significantly reduces the amount of work (and therefore the amount of taxable worker pay) overall. 

Consider, for example, business payments for health insurance. As we saw earlier, for independent contractors who file a Schedule C, those health insurance payments can be typically deducted from taxable income, but not from the payroll tax base. By contrast, business payments for health insurance for employees are not subject to the payroll tax. So, legislation that forces independent workers into employee status ends up reducing payroll tax revenues, all other things being equal. This would reduce the public funds available for vital social insurance programs. 

This is not a final answer on the cost question, of course. But it does mean to get a good cost estimate, it’s necessary to compare apples to apples. Critically, businesses should incur the full cost of participating in the new framework we are proposing.

Conclusion

Independent workers face a dilemma where they cannot currently receive benefit payments from companies without risking their independent status. Meanwhile, they cannot provide benefits for themselves without being unfairly penalized by the tax code relative to employees.

Previous attempts at the state level to define a new category of “marketplace contractors” has not fixed this dilemma, because they did not address disparities in the tax treatment of benefits. Nor did they create a baseline benefit package that companies must provide. 

We suggest that it is possible to design a new regulatory regime that is a win-win proposition. It makes independent workers better off by making it easier for them to either get benefits from a company or provide the benefits for themselves, while still retaining the flexibility that is an essential attraction of independent work for most. At the same time, by allowing companies to opt into this new regulatory regime, it ensures that companies have an alternative to a patchwork of state regulations if they are willing to offer a baseline package of benefits. 

Return Free Filing Won’t Fix What’s Wrong With America’s Tax System

Posted on by The Progressive Policy Institute

Because of COVID-19 Tax Day moved this year from April to July. That means the debate over the supposed panacea to the convoluted process of filing taxes – a return-free filing system (RFF) – is now making its annual appearance, albeit four months late.

The return-free filing idea has been around for a longtime and is currently in practice in Denmark, Sweden, Spain, and the United Kingdom (among other countries), places with limited or no tradition of voluntary compliance. If the U.S. government adopted RFF, the Internal Revenue Service (IRS) would estimate your taxes by using information from a mix of sources (depending upon the system) including employers, financial institutions, other third parties, and in some cases the individual taxpayer themselves. Proponents say (in effect) let the government do your taxes and spare you the burden of hiring a tax preparer, purchasing commercial tax software, or trying to do it yourself.

That sounds alluring, but it’s important to underscore the limits of what an RFF system could achieve and what it would not. For example, an RFF would not eliminate the $1.6 trillion in tax incentives that benefit primarily wealthier taxpayers. Nor would it raise revenue to build new roads, rail, or schools; support scientific research; pay down public debts; make the tax code fairer and more progressive; or, help us close our $458 billion annual tax gap (the difference between what is owed in taxes versus what is paid).

Rather, pursuing return-free filing is a way to avoid the hard choices needed to revamp our tax code to promote economic fairness and growth. It would put the burden of contesting initial tax determinations on the filers rather than on the IRS, fundamentally reversing the presumption of the tax system today. And, if truly voluntary, it is unlikely to have a significant impact on the way most Americans complete their taxes. In California, which proponents often cite as a good example of how an effective return-free filing can be implemented only about 90,000 people used “Ready Return” in any given year of that experiment (despite the some two million Californians that were annually offered the government-prepared tax returns) — putting into serious doubt the idea that a federal return-free filing system could be voluntary and actually achieve the purported national benefits it proponents claim will occur.

In fact, moving away from a voluntary tax filing system would actually worsen many of the problems that an RFF system is supposedly designed to fix — accuracy, tax evasion, and simplicity. Furthermore, were the U.S. to implement an RFF system, it would eliminate the moment of financial planning and review that is tied to the self-return process, and as the only time each year many households take stock of their finances, has an intrinsic value for American families.

Accuracy

As tax codes around the world have become more complex, many countries that are currently using RFF systems are increasingly finding it necessary to re-engage taxpayers in order to ensure accuracy. In the introduction to a 2017 report by the UK’s All-Party Parliamentary Taxation Group on Pay-As-You-Earn (PAYE), the RFF system utilized by the United Kingdom. Ian Liddell-Grainger, the Chair of this non-partisan policy committee and a Conservative Member of Parliament, noted that:

(Given) the changing nature of the workforce, a growing self-employed community and the complexity of our current system leading to significant overpayments…It is my firm belief that we need to involve the taxpayer in this process. It is them who can improve the accurate flow of information throughout the fiscal year.

The Parliamentary report found that as a result of a number of economic changes since the creation of PAYE, approximately one-third of British taxpayers were effectively filing their own taxes via a process known as Self-Assessment — negating much of the “will save the taxpayer time” rationale for a RFF system. The report cited a number of reasons for the increase in Self-Assessments, including a rising number of self-employed workers; a more mobile workforce; and an increase in tax code complexity driven in part by the growth in tax incentives.

Unfortunately for the PAYE system, these trends are likely to worsen over time given the growth in globalization and the growing mobility of the workforce.

The PAYE report also noted that error rates had been rising significantly in the United Kingdom, costing the government and taxpayers billions over the years. This counters another rationale for RFF — that no-file systems reduce the error rate and the thus help close the size of the tax gap. The parliamentary analysis points to exactly the opposite outcome in the real-world experience of their RFF in practice.

Tax Evasion

While unintended error is one major source of the tax gap, another is the intentional underreporting of income subject to tax — or tax evasion.

Some have argued that RFF systems could help reduce the tax gap because it would reduce underreporting. In a 2006 paper on return-free filing, Austan Goolsbee, former Chairman of the White House Council of Economic Advisers under President Obama, cites a 1996 General Accounting Office (GAO) report that concluded that a no-file system could help the Internal Revenue Service significantly reduce its number of “underreported” cases.

In a 2010 paper, economists Jeffrey Eisenach, Robert Litan, and Kevin Caves took a contrary view. They argued that the adoption of an RFF tax system would not have any impact on the U.S. tax gap, adding that it would

“do virtually nothing to reduce under- reporting on individual tax returns, because almost all under-reporting is associated with types of income that would make filers ineligible to use RFF in the first place.”

In fact, the authors contend that RFF might actually make the tax gap larger, since taxpayers who receive completed tax returns that understate their actual tax liabilities are not likely to challenge the IRS’s errors in their favor. Even Joseph Bankman, a longtime advocate of RFF, has explicitly acknowledged it could lead to greater opportunities for taxpayers to underpay what they owe.

In a 2017 article in Propublica, Bankman noted there were multiple ways taxpayers could benefit from an RFF system and stated that “If there’s a mistake that goes in your (the taxpayer’s) favor, maybe you don’t call attention to it.”

Supporting this argument is data on tax evasion in countries with return-free systems compared with the U.S, which relies on voluntary citizen compliance.

According to the Tax Policy Center (TPC), 36 countries permit return-free filings for some taxpayers. This is typically accomplished in one of two ways. In the pay-as-you-earn systems used in Japan, Germany, and the United Kingdom, the government calculates tax withholding to match the amount of annual taxes due. Most citizens, particularly those whose income is derived from a single employer, never even see a tax return.

Other nations like Belgium, Spain, and Denmark, use what’s called a pre-populated return. Employers report individuals’ income directly to the government, which then sends the taxpayer a pre-filled return he or she just has to verify.

In Table 1 we compare tax evasion rates in 13 countries — six that use pay-as-you-earn systems in which the government calculates withholding, six that pre-populate returns with information provided by employers, and one, the United States, where citizens file their own tax returns. (Tax evasion data was not available for all 36 countries using RFF)

The average rate of tax evasion as a percentage of GDP for the 12 countries on this list was 1.45. For those countries that have pay-as-you-earn systems, the average was 1.35. For those with a pre-populated return system, the average level was 1.71. In contrast, the level of tax evasion for the United States as a percentage of GDP was only 0.1.

While many other factors need to be taken into account when looking at what is responsible for the different levels of tax evasion by country, including trust in government, complexity of the tax code, type of taxation (income tax, sales tax, etc.), and effective rate of taxation, it is nevertheless of interest that the U.S. had a significantly lower level of tax evasion as measured by GDP than those countries that utilized either system of return free filing.

Simplicity

Proponents of return-free filing say it would greatly simplify the process of filing taxes. Goolsbee argued in 2006 that moving to a return free filing system would save taxpayers 225 million hours of tax compliance time.

However, it’s doubtful that such savings would materialize in the United States. We have a very complicated tax system. Governments at the federal, state and municipal levels all have taxing authority.

The federal tax code, moreover, is encumbered with $1.6 trillion worth of tax incentives for a vast array of activities. And because we have a large number of self- employed workers and two-income families, moving to an RFF system would still necessitate a great deal of taxpayer involvement to ensure accuracy, completeness, and fairness.

Adopting an RFF would not address the growing complexity of the U.S. tax code. In fact, if an RFF system works as its proponents argue, it would leave the status quo in effect – an inefficient tax code riddled with tax breaks that disproportionately benefit wealthy taxpayers at the expense of working class families.

As PPI has long contended, what America really needs is a comprehensive overhaul of
the tax code, not an army of government tax collectors doing your taxes for you. In addition to big changes in what we tax and restoring progressivity, radically streamlining the tax code is the right way to make our government more user-friendly and to reduce the time and money citizens spend on filing their taxes.

Financial Planning

One often overlooked benefit of America’s tradition of voluntary tax compliance is that it educates citizens about their financial condition.

Ironically, filing one’s taxes provides a window of opportunity during which Americans can review their financial history from the prior year and reassess their needs for the future — such as how much to save for retirement.

But shifting to an RFF system would eliminate or reduce that educational moment. As former Senator (and co-chairman of the National Commission on Restructuring the IRS) Bob Kerrey noted in an article for Time Magazine entitled “Beware of Simple Solutions to the Tax Code:”

“Perhaps the worst aspect of the simple return is that it reduces or eliminates
one of the most important activities that occur during the tax-filing season: individual financial review and planning. Calculating how much we owe in taxes is an unpleasant activity, but it is also central to understanding our personal financial situation and planning our financial futures — and often the only time all year that the average family looks at its finances.”

As exasperating as it can be, doing your own taxes, and understanding you family’s financial relationship with government, is more worthy of a free and self-reliant citizenry than delegating that responsibility to government tax collectors. We shouldn’t reduce taxpayer engagement in their own financial affairs simply to avoid the hard work of passing and implementing real tax reform. The impact of greater taxpayer disengagement from their own personal finances is not an inconsequential consideration as a matter of national economic policy. To the contrary, numerous analyses of the national savings rate and financial literacy underscore the need for more personal engagement in one’s financial affairs—not less.

Conclusion

Nobody enjoys paying taxes, and the U.S. tax system leaves a lot to be desired. It is overly complex, wasteful, does not raise enough revenue to cover the needs of its citizens, and tilts toward the interests of the wealthy. Moving to a return free filing tax system would not address any of those problems. If policymakers want to reduce the amount of time taxpayers spend on filing taxes, they should be not be distracted by magical panaceas, but rather aim their sights on creating a simpler, more efficient and fairer tax system that promotes economic growth and equity.

PODCAST: Should we abolish tax returns? A conversation with Sen. Bob Kerrey

Posted on by The Progressive Policy Institute

As millions of Americans rush to file their tax returns, former Senator Bob Kerrey joined the Center for New Liberalism and the Progressive Policy Institute’s Paul Weinstein and Alec Stapp to discuss whether or not the US government should adopt return-free filing for individual taxes. The participants discussed the costs and benefits of return-free filing relative to our current voluntary tax filing system, the main problems with our current tax system, and whether or not return-free filing would reduce tax evasion.

FICO rolls out new credit scoring model

Posted on by The Progressive Policy Institute

Consumers are getting turned down for all sorts of financial products, from personal and auto loans to credit cards. The Wall Street Journal, using Equifax data, reports that credit card approvals totaled 483,000 in the week ending May 10, down from 856,000 in the week ending March 22. To compare to the year prior, weekly card approvals in 2019 “rarely fell below 1.2 million,” according to The Wall Street Journal.

But as banks are tightening their lending requirements, a new tool is trying to prevent lenders from cutting off consumers’ access to credit.

Fair Isaac Corp., the data analytics company behind the FICO credit score, has just launched the FICO Resilience Index, a new scoring model designed to help lenders better assess consumers’ sensitivity to financial stress by looking at their capacity to survive financially though a downturn.

“The FICO Resilience Index, used in conjunction with a FICO Score, allows card issuers to limit access less than they otherwise would have because they can now identify borrowers who are more resilient to the economic downturn,” Sally Taylor, VP of FICO Scores, tells CNBC Select.

FICO defines resilient borrowers as “consumers that are more likely to pay as agreed in the event of a recession.”

The new scoring model ranks consumers’ resiliency on a scale of 1 to 99. The higher your score, the higher the risk you will default on your payments; the lower your score, the more likely you are to make on-time payments even when the economy experiences a downturn.

Read the full piece here.

This piece was originally published on CNBC by Elizabeth Gravier on June 29, 2020.

Economic Impacts of a Moratorium on Consumer Credit Reporting

Posted on by The Progressive Policy Institute

Two bills introduced in Congress, H.R. 6370 and S. 3508, ‘‘Disaster Protection for Workers’ Credit Act of 2020’’ would impose a moratorium on credit reporting of “adverse information” for the duration of the coronavirus crisis. Credit scores are an integral part of the consumer credit underwriting process as their power to predict the likelihood of borrower default is well-established empirically. Consequently, lenders have come to heavily rely on the integrity and information content of credit scores as a critical measure of a borrower’s creditworthiness.

Economic theory suggests that in the absence of viable mechanisms to effectively distinguish between high and low risk borrowers, lenders will ration credit. Under a credit reporting moratorium, the reliability of credit scores to distinguish between borrower risks would come into question. Lenders would respond to the proposed credit reporting moratorium by raising minimum credit score requirements and/or raising borrowing rates as a credit uncertainty premium to offset the risk they face from the moratorium. During the 2008 financial crisis, lenders raised credit score minimums on FHA loans, for example, beyond those set by the agency as a response to uncertainty over indemnification provisions that posed significant costs to lenders. And today, during the coronavirus, a number of Ginnie Mae originators have raised credit scores to blunt some of the risk they face due to requirements to pass-through mortgage payments to investors, including those in default or subject to forbearance.

Read the full piece here.

This piece was originally published on Chesapeake Risk Advisors, LLC by Clifford Rossi on June 17, 2020.

Congress Should Stabilize The American Economy – Both Now And Later

Posted on by The Progressive Policy Institute

At the end of next month, several economic support programs created by the CARES Act in March will expire. House Democrats have moved to extend and expand these supports through January 2021 with the $3 trillion HEROES Act. Senate Republicans, however, have used fiscal cost as a pretext to oppose or scale back this and other potential future stimulus measures. The stakes are high: allowing the CARES Act programs to expire would reduce the incomes of up to 30 million unemployed Americans by more than half overnight and cut off lending programs that have helped otherwise healthy businesses stay afloat during the crisis. Fortunately, there is an opportunity for lawmakers to strike a bipartisan compromise that supports our economy in a fiscally responsible way.

Read the full article here.

WEBINAR: How to Address Regulations Suspended During the COVID 19 Crisis

Posted on by The Progressive Policy Institute

Attempting to mitigate the spread of COVID-19, policymakers at the federal, state, & local levels are suspending or rescinding laws and regulations that hinder timely, sensible responses to the pandemic. The temporary departure from these rules is causing many to question the need to reinstate them post-crisis.

A diverse cross-section of scholars has written on why this is an important time to evaluate whether or not some of these regulations are really beneficial and how policymakers can best make these assessments. This co-sponsored webinar will provide viewers with a grounded, non-partisan approach for doing so.

The Mercatus Center published a policy brief, part of the COVID-19 Response series, that proposes an approach called a Fresh Start Initiative.

The Progressive Policy Institute has consistently proposed an approach to regulations that could foster more growth coming out of the pandemic while still protecting people and the environment.

The Mercatus Center is the world’s premier university source for market-oriented ideas—bridging the gap between academic ideas and real-world problems. As a university-based research center, Mercatus advances knowledge about how markets work to improve people’s lives by training graduate students, conducting research, and applying economics to find solutions for society’s most pressing problems.

The Progressive Policy Institute is a catalyst for policy innovation and political reform based in Washington, D.C. Its mission is to create radically pragmatic ideas for moving America beyond ideological and partisan deadlock.

Today, PPI is developing fresh proposals for stimulating U.S. economic innovation and growth; equipping all Americans with the skills and assets that social mobility in the knowledge economy requires; modernizing an overly bureaucratic and centralized public sector; and defending liberal democracy in a dangerous world.

Please contact mercatusoutreach@mercatus.gmu.edu or info@ppionline.org if you would like to speak with the scholars or would like to learn more about the issue.

Blog: Finally, It’s the Right Time for Infrastructure Week

Posted on by The Progressive Policy Institute

As Congress passes its historic multi-trillion spending package, people across the country, as well as investors in our beleaguered financial markets, will breathe a sigh of relief. But the truth is, this “Phase 3” response to the pandemic-induced economic shutdown may just be the beginning of what we need to avert a savage recession or even depression.

Some experts, including St. Louis Federal Reserve President James Bullard warned that the nation’s GDP could fall by upwards of 50 percent in the second quarter alone. The first numbers showcasing the fallout dropped this week, with historic unemployment claims more than doubling economist’s worst fears at 3.3 million for the week.

Although it’s called a “stimulus” bill, the package is actually aimed at several urgent goals: Expanding the nation’s medical capacity to fight the contagion and treat its victims, putting money in Americans’ pockets and keeping businesses small and large from going under.

That’s essential, but we also need more of the traditional kind of stimulus intended to juice the economy. What comes next is for Congress and the Trump administration to address real stimulus- actions that use policy to activate increased economic activity.

For that -there is no better, more popular and bipartisan use of taxpayer funds than upgrading the nation’s transportation, communications and other infrastructure. And now, with unemployment spiking, it’s the right time to act at last on all those calls we hear every year during “Infrastructure Week” for a massive surge in public investment in our economy’s backbone.

Infrastructure Week has become a bad joke in Washington. It comes with great fanfare, wins praise from a bipartisan chorus of lawmakers and labor as well as business leaders — and then passes without anything changing. Perhaps now, with interest rates at nearly zero and lawmakers committed to spending whatever it takes to keep our economy afloat, infrastructure’s moment has finally come. And we should think big- upwards of one trillion dollars big.

Why? Because infrastructure investment yields the biggest bang for your buck when you have a higher jobless rate. The reason is what economists call the “multiplier effect,” which is basically a measure of how big a boost in economic output we get from each dollar spent. Creating new jobs and putting unemployed people back to work produces the strongest multiplier effect.

For example, take these estimates of multiplier effects from an economic scenario from S&P Global in 2016 on infrastructure investment (full disclosure- I was a co-author of the paper with Chief U.S. Economist Dr. Beth Ann Bovino):

“…an additional $150 billion in spending (spread evenly over eight quarters) would be fully returned to the economy within the first two years… and at least $189.5 billion to GDP in just the first few years. Additionally, this injection of funds would create roughly 307,000 infrastructure-related jobs in the first two years. Aside from the near-term boost, the country’s productive capacity and output would also likely increase once the infrastructure is built and absorbed into the economy-which means the investment would likely add jobs long after the initial effects have subsided…”

So what can numbers like this tell us about what would happen if we invest today, under the extraordinary circumstances of escalating unemployment? Well, in general, we can reasonably expect the unemployment rate to soon be higher than the 4.9% rate when the paper was written (October 2016), and general economic conditions to be softer. So those GDP returns and job estimates (proportional to the amount invested) could be on the lower end from what we might expect looking forward.

In a low unemployment scenario, which was the reality until the coronavirus hit, there’s too little slack in labor markets to generate high multiplier effects. In this scenario, you have lower overall output because you are essentially moving workers to infrastructure jobs from other jobs, as opposed to creating brand new ones and moving workers from unemployed to being employed.

Some immediate logistical problems come with quick action; for instance, can we even invest now at a time when most folks are forbidden from going to work? The answer is obviously no, but with a caveat. Infrastructure projects tend to have very long, multi-year lifecycles, with planning from engineers, environmental impact studies and permit bottlenecks, before the first shovel can even hit the ground. Additionally, it will take a long time- perhaps years- to work off the significant economic damage that is coming our way.

With even some of the longer estimates for how long it will take for life to return to “normal” running over 3 months, passing a trillion-dollar investment package soon still makes sense.

When looking for economic silver linings in a time of dour forecasts, and multiple trillion-dollar spending barely raises an eyebrow, it seems as good a time as any for a legitimate “Infrastructure Week”.

Blog: Policymakers Should Look to Accelerate the Spread of the App Economy

Posted on by The Progressive Policy Institute

The failure of the app intended to collect results from the Democratic caucuses in Iowa wasn’t the best advertisement for the App Economy. But we have to remember that apps play a central role in the economy.

As part of a global project measuring the size of the App Economy, we estimated the U.S. App Economy to have 2.246 million App Economy jobs as of April 2019. That’s an increase of 30 percent from our December 2016 estimate of 1.729 million jobs.

Many of them are at large corporations in tech hubs like the Bay Area, New York City, or Austin. But App Economy jobs aren’t exclusive to the tech sector or major cities. In fact, a growing number have seeped into smaller metro to rural areas, the physical industries, as well as startups.

For instance, as of February 2020, small IT firm Four Nodes was hiring a mobile application developer with experience in Android in Camden, Delaware. Kent Displays, which makes e-writing displays, was looking for a mobile app developer in Kent, Ohio. Federal Home Loan Bank of Des Moines was searching for a lead IT service desk analyst with knowledge of Android and iOS in Des Moines, Iowa. Television broadcasting company CBS was seeking a frontend engineer with experience in iOS and or Android development in Louisville, Kentucky.

In terms of App developing companies, Little Rock-based Apptegy is an education technology startup that allows administrators to tailor how they market their school. Leawood, Kansas-based Farmobile allows farmers to collect and share data with agronomists and other farmers. And Fargo, North Dakota-based WalkWise uses a walker attachment to track fitness data and send alerts using its mobile app.

Indeed, the ability to code from anywhere coupled with apps’ integration with the physical world (which accounts for roughly 80 percent of the economy) has democratized opportunity in these areas for businesses and consumers alike. And the Internet of Things, which will enable individuals and companies to use mobile apps to interact with physical objects and processes such as their home, cars, equipment, and warehouses, only promises to increase the interaction between apps and the physical world.

Here are some examples of App Economy jobs in the physical industries: as of February 2020, agricultural merchandiser Tractor Supply Company was hiring a mobile apps IT architect in Brentwood, Tennessee. Medical device company Medtronic was looking for a senior software quality engineer with experience in iOS and Android in Chanhassen, Minnesota. Manufacturing company IDEX was searching for a QA test engineer with knowledge of iOS or Android in Huntsville, Alabama. As of January 2020, ecommerce company SupplyHouse.com was seeking a senior Android developer in Melville, New York.

From this perspective, apps play a critical role in spreading the information revolution beyond the traditional metro hubs and tech sector. They serve as an important means to unlocking growth for smaller metro and rural areas, the physical industries, and startups.

Low-Income Borrowers and the Auto Loan Market

Posted on by The Progressive Policy Institute

Executive Summary

Some are concerned that subprime auto loans – which offer higher interest loans to riskier borrowers – pose a threat to the stability of the global economy in much the same way that the subprime mortgage market contributed to the Great Recession. Democratic presidential candidate Elizabeth Warren, in particular, has raised the warning flags as part of her campaign. But these worries are ill-founded and based on misleading data and faulty analogies.

In particular:

  • Auto loans account for a relatively small percentage of the increase in nonfinancial debt over the past five years;
  • Americans are spending less of their budgets on car purchases today, including finance charges, than they were before the recession;
  • Low-income households saw motor vehicle purchases and finance charges fall from 8.5 percent of household budgets in 2000 to 4.9 percent in 2018;
  • Over the past five years, the share of new auto loans going to low-credit borrowers has remained relatively constant. There are no signs that low-credit borrowers are either being frozen out of the market or becoming too large a share of loans;
  • Newly delinquent auto loans, as a percentage of current balances, have been falling over the past two years; and
  • Subprime auto loans differ significantly from subprime mortgages in key respects that make them less likely to pose a serious threat to financial stability

Risk-based pricing of auto loans appears to be working so far, keeping low-income borrowers in the market without driving up delinquencies or to low-income consumers, while not posing the same risk that the subprime mortgage market.

Introduction

To purchase a vehicle, Americans with low or non-existent credit scores often use auto loans with higher interest rates than loans to prime borrowers. Some market watchers have indicated concern about “subprime” auto-loan trends and the potential for a crisis similar to the subprime mortgage crisis that heralded the last recession.

The subprime mortgages and the related mortgage-backed bonds remain the classic case of a poorly executed financial innovation. The initial impetus behind the idea was a good one. Housing is a key element of middle-class wealth, so expanding the system of mortgage finance to help lower-income households buy homes seemed like a positive. However, the subprime mortgages and bonds were designed in such a way that they assumed rising housing prices. When housing prices started to fall, the subprime mortgage system collapsed and contributed to the financial crisis.

Will subprime auto loans create the same problems? In a recent essay, Democratic presidential candidate Senator Elizabeth Warren raised the warning flag:

Auto loan debt is the highest it has ever been since we started tracking it nearly 20 years ago, and a record 7 million Americans are behind on their auto loans — many of which have similar abusive characteristics as pre-crash subprime mortgages1 .

Warren is not alone in her worries. In late 2016, for example, the Office of the Comptroller of the Currency warned that auto-lending risk was increasing and that banks (and other investors in securitized assets) did not have sufficient risk-management policies in place. Fed Governor Lael Brainard pointed to subprime auto lending as an area of concern in a May 2017 speech, while analysts worried about “deep subprime” auto loans2. Some groups used the term “predatory” auto lending.3

But these concerns are misplaced. As we will show later in this paper, the statistic cited by Senator Warren does not reflect the current state of the auto loan market, as it includes old loans from much weaker economic times. Perhaps most fundamental to understanding the problem with drawing a parallel between the mortgage crisis and today is the fact that subprime mortgages and subprime auto loans are very different products.

Naturally, lower-income households with low credit scores or limited credit history may have fewer financial resources and be inherently riskier borrowers. Moreover, the fact that motor vehicles depreciate over time means that the collateral for the loan becomes less valuable.

Nevertheless, the ability to own a car and, therefore, access credit is crucial for this population. Risk-based pricing charges low- rated borrowers higher interest rates, but in return, offers them the opportunity to borrow money to buy a vehicle that might otherwise be financially inaccessible.

For many lower-income households, their vehicle is the single biggest asset they own.

While vehicles do not appreciate in value as homes do, vehicles are income-producing assets in the sense that they are often essential for commuting to work, especially in non-urban areas. As one report noted, “Owning a car is the price of admission to the economy and society in much of America.”4

 In this paper, we analyze the auto loan market, paying particular attention to auto loans made to low-income Americans and to people with bad credit. We find that:

  • Auto loans account for a relatively small percentage of the increase in nonfinancial debt over the past five years;
  • Americans are spending less of their budgets on car purchases today, including finance charges, than they were before the recession;
  • Low-income households saw motor vehicle purchases and finance charges fall from 8.5 percent of household budgets in 2000 to 4.9 percent in 2018;
  • Over the past five years, the share of new auto loans going to low-credit borrowers has remained relatively constant. There are no signs that low-credit borrowers are either being frozen out of the market or becoming too large a share of loans;
  • Newly delinquent auto loans, as a percentage of current balances, have been falling over the past two years; and
  • Subprime auto loans differ significantly from subprime mortgages in key respects that make them less likely to pose a serious threat to financial stability.

Risk-based pricing of auto loans appears to be working so far, keeping low-income borrowers in the market without driving up delinquencies or threatening the financial system. We conclude that the subprime auto loan market is beneficial to low-income consumers, while not posing the same risk that the subprime mortgage market did before the financial crisis. While it will be instructive to observe subprime auto loan trends going forward, current trends do not indicate significant instability concerns in this market.

Recent Patterns in Debt Accumulation

Recent patterns in debt accumulation are very different from those that preceded the financial crisis and Great Recession. Non-mortgage consumer credit – including auto loans, credit cards, and student debt – has risen by $900 billion over the past five years, according to Federal Reserve data. While that figure sounds substantial, that increase amounts to less than 9 percent of the total increase in domestic nonfinancial debt – that is, all debt except borrowing by financial institutions. The rise in consumer borrowing is dwarfed by the increase in business debt ($4.1 trillion) and federal debt ($4.2 trillion) over the same period. Those two categories together account for 82 percent of the increase in domestic nonfinancial debt (Table 1). The leading contributors to business debt growth are mortgages and corporate bonds.

Indeed, businesses have taken the greatest advantage of low-interest rates. Nonfinancial corporations have almost doubled their outstanding corporate bonds since the end of 2007 when the last recession started. Meanwhile, household debt has risen by only 10 percent.

Taking home mortgages into account, households have only accounted for 19 percent of the increase in domestic nonfinancial debt since 2014. By contrast, in the five years leading up to the Great Recession, households accounted for 48 percent of the debt increase. In other words, the financial boom in the pre-recession years was heavily driven by household borrowing, while households have only contributed a small portion to the current debt increase.

A skeptic could argue that, given derivatives and financial engineering, it’s possible for a relatively small portion of the debt market to drive an outsize increase in risk for the whole system. Indeed, that’s what happened ahead of the 2008 financial crisis. In May 2007, then-Chairman of the Federal Reserve Ben Bernanke famously said, “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”5 At the time, the value of subprime mortgages was about $1.3 trillion, which was only 10 percent of the mortgage market and an even smaller share of total borrowing. Bernanke and other policymakers figured that the problems in subprime mortgages could be easily contained.

What Bernanke and others failed to reckon with, however, was how the subprime mortgages had been designed to make sense only in a rising real estate market. Subprime mortgages were constructed effectively to subsidize interest rates with the possibility of appreciation. These financial instruments would offer low upfront rates that enabled lower-income borrowers to qualify. When the teaser rates eventually reset to much higher levels, the assumption was that the borrower could refinance into a new mortgage.

Moreover, the subprime mortgages were then securitized and used to build complicated financial derivative products. And when the subprime mortgages failed because of declining home prices, so did the derivatives. In other words, problems in a relatively small financial sector could be amplified and have a much larger effect on the rest of the economy.

Despite this concern, there is evidence to suggest that subprime auto lending is not a substantial risk to the broader economy. Auto loans are only 7.4% of household debt, which is the 40-year historical average.6 Moreover, the auto asset-backed securities (ABS) market is likewise dwarfed by the mortgage-backed securities (MBS) market. As of the second quarter of 2019, there was a mere $264 billion in auto-related securities, which included only $55 billion in subprime auto securities. By comparison, the amount of outstanding mortgage-related securities came to almost $10 trillion.7

Further, subprime auto loans don’t work the same way that subprime mortgage loans did in the pre-crisis era. Cars and trucks depreciate steadily over time, so the value of the collateral diminishes. That means lenders can’t afford to offer teaser rates, or excessive levels of negative equity, to buyers with low credit scores. They must charge higher rates, properly pricing risk. As one article put it, “the very nature of a real estate loan is very different from an auto loan. Real estate is an investment that typically appreciates over time. During the bubble years, consumers and lenders falsely believed appreciation would bail them out from poor judgment. Vehicles, on the other hand, depreciate. There is no false hope of higher values in the future to bail out a borrower or a lender.”8

The Auto Market

Despite the relatively small role that consumer debt is playing in the current debt expansion, some people can’t shake the idea that Americans are over-spending and over-borrowing to maintain a particular lifestyle. Consider this quote from an April 2019 piece from Business Insider:

The fact that America’s top-selling vehicle — a Ford truck with a price starting at nearly $30,000 – and many like it cost nearly half the median household income hasn’t stopped people from buying them and hasn’t stopped lenders from facilitating loans.9

Over the past five years, the price of new motor vehicles has risen by only 1.1 percent, according to estimates by the Bureau of Economic Analysis (BEA).10 By contrast, the overall price level of consumer goods and services have risen by 6.7 percent over the same stretch.11 In other words, the relative price of new motor vehicles has fallen over this period.

Not surprisingly, the share of consumer spending on new and used vehicles has fallen as well. In 2000, 5.4 percent of consumer spending went to purchases and leases of new and used vehicles. Today, that share is down to 3.6 percent (Figure 1).12

The BLS Consumer Expenditure Survey tells the same story. In 2000, motor vehicle purchases and finance charges amounted to 9.7 percent of household outlays. As of 2018, the last year for which full data is available, the share of vehicle purchases and finance charges fell to only 6.7 percent of household outlays.13 In part, this decline may represent a lengthening of the term of auto loans.14 (These figures would not be changed much by including automobile lease-related payments, which amount to about 10 percent of automobile purchase-related payments in 2018.)

The State of the Low-Income Auto Market

It’s not surprising that lower-rated borrowers pay more for their auto loans. Table 2 below shows interest rates for a 36-month new car loan at different credit rates for December 2015, which was close to the bottom of the credit cycle, and August 2019 (Table 2).

We can see that rates have risen for all credit-rating levels, but more so for the low-rated borrowers.

This risk-based pricing means that low-rated borrowers are not frozen out of the auto loan market. That’s good news, since, in many parts of the country, a car or truck is a necessity, even for low-income households. There is little or no public transit outside of densely populated urban areas, and ride-sharing services are not viable alternatives in many places. So, it is unsurprising that the share of low-income (the bottom quintile) households with a vehicle hold steady at 66 percent in both 2000 and 2018.

At the same time, low-income households saw motor-vehicle purchase and finance taking a smaller share of their budgets. In the bottom quintile of pre-tax income, motor vehicle purchases and finance charges fell from 8.5 percent of household budgets in 2000 to 4.9 percent in 2018 (Figure 2), a drop of almost four percentage points.15

Similar data from the New York Fed’s Household Debt and Credit Report confirm that low-income households are not being uniquely stressed financially by automobile borrowing. Figure 3 shows the share of all auto loan originations that are going to low-rated borrowers (with a Riskscore of less than 620). Before the financial crisis, about 30 percent of new auto loans were going to low-rate borrowers, a startlingly high percentage. That share fell to 20 percent after the crisis and shows no signs of rising (Figure 3).16

The biggest piece of negative news has come from the New York Federal Reserve’s well-publicized finding in February 2019:

…(T)here were over 7 million Americans with auto loans that were 90 or more days delinquent at the end of 2018. That is more than a million more troubled borrowers than there had been at the end of 2010 when the overall delinquency rates were at their worst since auto loans are now more prevalent.18

This startling number, while impressive, simply doesn’t mean what it seems to suggest. This figure includes anyone who still has an old, bad auto loan on their credit record, even if the loan was made and written off years earlier.19 In fact, even after the lender writes off the loan, the loan servicer could continue to report the account to the credit bureaus.

The recent economic history of the United States helps to explain this figure. The number of nonfarm jobs did not return to pre-recession levels until 2014, while the employment-population ratio for Americans with a high school diploma but no college did not bottom out until 2015. As a result, today’s subprime borrowers are carrying around bad loans from the days when the labor market for less-educated workers was still struggling.

Indeed, in an August 2019 blog item, New York Fed economists recommend that anyone interested in the current performance of debt should look at the transition into delinquency- that is, a chart such as Figure 4.20 And by that measure, auto loans are doing far better than in the pre-recession years.

Conclusion

In the event of a recession or a significant economic slowdown, auto loan delinquencies will predictably rise. Subprime auto borrowers, who are more likely to have fewer resources, will be likely to fall behind in their payments when times turn bad.

Nevertheless, a careful look at the data does not suggest that either the origination of subprime auto loans or the exposure of the broader macroeconomy to the auto loan market is a cause for concern. In particular, the subprime auto-loan market looks nothing like the mortgage market before the Great Recession.

Newly delinquent auto loans, as a percentage of current balances, have been falling over the past two years, and the fact that a record number of Americans have a bad auto loan on their credit record is a testimony to economic history more than current loan practices and economic conditions, particularly given the rapid rise in total car sales during this period.

Indeed, risk-based pricing in the auto loan market appears to be supplying a steady flow of credit to low-rated borrowers without imposing excess stress on the financial system.

About the Authors

Michael Mandel is Chief Economic Strategist of the Progressive Policy Institute.

Douglas Holtz-Eakin is President of the American Action Forum.

Thomas Wade is Director of Financial Services Policy of the American Action Forum.

 

Mandel for RealClearPolicy: “Do Subprime Auto Loans Threaten the U.S. Economy?”

Posted on by The Progressive Policy Institute

With partisan divisions as deep as ever, both sides can agree on one thing: Everybody wants to avoid another financial crisis. And forecasters have recently identified subprime auto loans as an existential threat to the economy.

The headlines are eye-catching and scary: “A $45,000 Loan for a $27,000 Ride: More Borrowers Are Going Underwater on Car Loans,” “Underwater: Consumers Are Treating Cars A Lot Like Houses During The Subprime Mortgage Crisis,” and more of the same. But is it true? Are subprime auto loans the new financial cancer threatening households and the economy, much like the subprime mortgage crisis did in 2007?

No.

Worries about subprime auto loans — which offer higher interest loans to riskier borrowers — are ill-founded and based on misleading data and faulty analogies, our new research finds.

Read the full op-ed here.

Ritz for Forbes: “New CBO Report Projects $13 Trillion Deficit Over 10 Years”

Posted on by The Progressive Policy Institute

Projections published today by the non-partisan Congressional Budget Office confirm that the federal government is on course to spend $1 trillion more than it raises in revenue in Fiscal Year 2020. Trillion-dollar deficits continue as far as the eye can see, with CBO estimating a 10-year deficit of over $13 trillion.

Legislative changes since August have increased projected deficits by more than $500 billion, according to CBO. More than 90 percent of the increase comes from a package of irresponsible tax cuts added to a year-end spending agreement passed in December. But most of the change was offset by a decline in the projected interest rates and other technical changes, leaving 10-year deficit forecasts “only” $160 billion more than they were in August 2019.

What’s driving these deficits? Primarily the growth in federal health-care and retirement programs caused by our ageing population. Federal spending on Social Security, Medicare, and other health programs is projected to grow from 11 percent of gross domestic product today to 14 percent in 2030. All other non-interest spending, meanwhile, is projected to shrink as a percentage of GDP. Revenue won’t keep up with these costs, in large part because the Trump administration keeps charging tax cuts upon tax cuts to the national credit card. If anything, CBO’s projections are overly optimistic because the agency is required to assume most of these tax cuts expire in 2025 as they are scheduled to under current law.

Read the full piece here.