Death Elasticity and Taxes

The following is an excerpt from an article I originally wrote in June 2008.  Today, with the Bush tax cuts set to expire, the insights of this article are more important than ever.

Moving on to a different area in human predictability, Gerald Prante of the Tax Foundation recommended a white paper that examines how people adjust major life decisions—including death itself—in response to tax incentives. Kopczuk and Slemrod’s 2001 paper, “Dying to Save Taxes: Evidence from Estate Tax Returns on the Death Elasticity,” is a fascinating look at these timing decisions.

In an article I penned for the March 2007 issue of the HS Dent Forecast, “Voting for Fertility,” I commented that government pro-natal policies were not likely to work. No government has enough money to convince reluctant adults to become parents unless they were already strongly considering it. Even Russia’s generous $10,000 “baby bonuses” do little to compensate parents for the money, time, and loss of freedom that children bring. Likewise, it is not likely that many couples would permanently forgo marriage to avoid the marriage penalty on their yearly 1040 or that a significant number of healthy people would commit suicide to escape the estate tax. Continue reading “Death Elasticity and Taxes”

The Post-American World

Book Review of Fareed Zakaria’s The Post-American World

Fareed Zakaria, Editor of Newsweek International and host of CNN’s Fareed Zakaria, has emerged in recent years as one of America’s best minds in current events and world politics. His recent book, The Post-American World, touches on several issues near and dear to our research. The gloomy title aside (this book got quite a bit of notoriety when then-candidate Barrack Obama was seen reading it during his campaign), Zakaria is actually rather optimistic about the economic prospects of the United States. He does discuss the role of demographics in America’s position in the world, which is a good start.

As this book has already been reviewed by countless others, we will steer clear of the sections most often reviewed, which are generally foreign policy related and compare the United States today with the British Empire last century.  We’ll start instead with Mr. Zakaria’s commentary on the US health and pension system, which echoes our own work on the subject:

Consider the automobile industry. For a century after 1894, most of the cars manufactured in North America were made in Michigan. Since 2004, Michigan has been replaced by Ontario, Canada. The reason is simple: healthcare. In America, car manufacturers have to pay $6,500 in medical and insurance costs for every worker. If they move a plant to Canada, which has a government-run health care system, the cost to the manufacturer is around $800 per worker. In 2006, General Motors paid $5.2 billion in medical and insurance bills for active and retired workers. That adds $1,500 to the cost of every GM car sold. For Toyota, which has fewer American retirees and many more foreign workers, that cost is $186 per car. This is not necessarily an advertisement for the Canadian health care system, but it does make clear that the costs of the American healthcare system have risen to a point that there is a significant competitive disadvantage to hiring American workers.

Zakaria also makes the point that tying healthcare to employment tends to tie people to their jobs and lesson their ability to leave lest they lose their health insurance. It also tends to make them fear free trade and globalization. The result is that the American economy is less dynamic and productive that it would have been under a more fluid labor market.

Moving on, Zakaria also refers to demographics as America’s “secret weapon,” at least vis-à-vis Europe and East Asia:

All in all, Europe presents the best short-term challenge to the United States in the economic realm.

But Europe has one crucial disadvantage. Or, to put more accurately, the United States has one crucial advantage over Europe and most of the developed world. The United States is demographically vibrant. Nicholas Eberstadt, a scholar at the American Enterprise Institute, estimates that the U.S. population will increase by 65 million by 2030, while Europe’s will remain “virtually stagnant.” Europe, Eberstadt notes, “will by that time have twice as many seniors as older than 65 than children under 15, with drastic implications for future aging. (Fewer children now means fewer workers later.) In the United States, by contrast, children will continue to outnumber the elderly…. Some of these demographic problems could be ameliorated if older Europeans chose to work more, but so far they do not, and trends like these rarely reverse.”

This goes to show that, with demographics, it’s all relative. The United States does indeed have a better long-term demographic prognosis than Europe or East Asia. But that doesn’t mean that the prognosis is good. “Less bad” doesn’t mean good.

Furthermore, Zakaria falls into the same trap as most economists that have approached this issue. He focuses on demographics as it applies to workers. The Sizemore Investment Letter focuses instead on the demographic characteristics of consumers. As Japan has proven for nearly two decades, a country can still produce with an aging workforce, but it ceases to consume at the same pace. And in an economy dominated by consumer spending, this is a problem.

The Post-American World is full of other interesting points that deserve more space than we can offer here. We highly recommend this book for your summer reading.


Summer Reading

This set of book reviews originally appeared in the July 2008 issue of the HS Dent Forecast month and cover a wide variety of topics: financial bubbles, pension funding, healthcare, immigration, population control, and of course, age demographics. Before your next trip to the beach, make a stop by the bookstore and toss one of these in your bag.

The New Paradigm for Financial Markets
by George Soros

We will start our summer reading list with George Soros’s most recent book, The New Paradigm for Financial Markets. In the opening pages, Soros gives a good history and analysis of the 2007-2008 credit bubble and crisis using some rather sobering language:

We are in the midst of a financial crisis the likes of which has not been seen since the Great Depression of the 1930s. To be sure, it is not the prelude to another Great Depression. History does not repeat itself. The banking system will not be allowed to collapse as it did in 1932 exactly because its collapse then caused the Great Depression. At the same time, the current crisis is not comparable to the periodic crises which have afflicted particular segments of the financial system since the 1980s…. This crisis is not confined to a particular firm or a particular segment of the financial system; it has brought the entire system to the brink of a breakdown, and it is being contained only with the greatest difficulty. This will have far-reaching consequences. It is not business as usual but the end of an era.

Continue reading “Summer Reading”

Genetics, the China-Tibet Dispute, and Investment Psychology

In “Human and Economic Evolution,”  I discussed how natural selection is alive and well among humans, and used such examples as genetic resistance to malaria among Africans and high aptitudes in the maths and sciences among Ashkenazi Jews.  Today I’d like to discuss an interesting finding reported in The Economist that is relevant to the China/Tibet dispute, and I’m going to tie it into a broader discussion of the human brain and investment psychology.

Tibetans and their supporters in Western countries have long contended that the Han Chinese do not belong in Tibet.  New genetic research suggests they may be correct–to an extent.
Continue reading “Genetics, the China-Tibet Dispute, and Investment Psychology”

The Ghosts of Milton Friedman and John Maynard Keynes

I originally penned this article for the August 2007 issue of the HS Dent Forecast–nearly three years ago.  My comments on deflation and consumer spending turned out to be right on the mark.

The late Milton Friedman may be the most accomplished economist of his generation. Just as his predecessor John Maynard Keynes influenced every aspect of economic thinking and policy in the 1930s, 40s, and 50s, virtually every significant development in recent decades towards free and open markets bears Friedman’s mark. Friedman’s Chicago School provided much of the intellectual fuel for the Reagan and Thatcher Revolutions in America and Britain. Even Augusto Pinochet, the Chilean military dictator, staffed his government with “Chicago Boys” who eventually gave Chile one of the most competitive economies in the developing world. Milton Friedman was a revolutionary who truly changed the world, though this piece is not about his intellectual exploits. Rather, it explains the economist’s theories on consumer behavior and relates them to our own research. We will attempt to add demographic insights into the venerable Milton Friedman’s work and discuss the implications for the next economic season.

But First, a Word on Keynes…

Any discussion of consumption must first start with a review of John Maynard Keynes and his work. Pre-Keynes, most economic theory was focused on production, or the supply side of the equation. Consumption, driven by end-user demand, was merely an afterthought, something that just “happened” and didn’t need to be explained. This was best summarized by Say’s Law, a maxim memorized by every freshman economics student: “Supply creates its own demand.” By virtue of manufacturing something, you have created a demand for that something, since it can be traded for other goods. This could be called a “build it and they will come” strategy, to borrow a line from the movie Field of Dreams.

But what happens when supply doesn’t create its own demand. What happens – as in the Great Depression and in 1990s Japan – there is not sufficient demand to absorb a plentiful supply?

During the Great Depression in the US and UK, consumers stopped consuming, virtually snapping their wallets shut for more than a decade. This lead Keynes to his study of consumer behavior, which is best summarized by his Consumption Function (also required memorization by freshmen econ students), seen below in Figure 1.

Figure 1: Consumption Function

In a nutshell, Keynes’s formula says that people spend a constant percentage of their current incomes, once basic necessities are taken care of. So, Joe Sixpack cashes his paycheck every two weeks and spends, say, 75% of that paycheck each and every pay period of his life. When he gets a raise and his check rises, he spends 75% of the now higher amount. When times are hard and he takes a pay cut, he instantly cuts his spending down to 75% of the new, smaller, amount. Joe’s spending is completely flexible and based solely on his current income.

Of course, any non-economist would know this to be patently false, both for individuals and for entire societies. To start, most consumption in the modern economy is not really “discretionary.” Most significant expenditures – everything from the home mortgage to piano lessons for your daughter – are paid on some kind of monthly payment plan. Even though piano lessons can be stopped at any time, they generally aren’t. Likewise, your cable TV plan does not get upgraded to the deluxe, high-definition package one month and then get cut to basic cable or – gasp! – rabbit ears the next. Your cable bill is stable and changes only slightly over time.

Most expenses are very slow to change when income changes. One of the major benefits of the modern credit-driven economy is that it can provide for lifestyle stability. If money is a little tight this month, your family’s lifestyle does not have to radically change, at least not immediately. This is the primary reason that consumer spending is so resilient despite economic calamity and why economists have been consistently wrong in their forecasting of recessions. We’ll return to this theme shortly.

Keynes also fails to note that spending and saving habits are affected by level of wealth and – most importantly to our research – age and stage of life. We’ll give credit to Keynes for being the first person to approach consumption scientifically, but it is obvious that his model was incomplete and not reflective of the real world.

Many of these deficiencies were addressed by the economists Modigliani, Brumberg, and Ando in the 1950s and 60s in what became known as the Life Cycle Hypothesis (Figure 2). These economists graphically displayed what every household intuitively knows. People follow a life cycle of earning and spending. In early career, our incomes are low relative to our expenses, often forcing us to take out large debts for homes, cars, appliances, etc. In middle age, we earn enough money to meet all of our current expenses, plus save for retirement. And naturally, in retirement our income falls and we slowly spend down our savings.

Figure 2: Life Cycle

This model, though more advanced than Keynes’s, is still problematic. Notice that income makes a curve while consumption makes a straight line. This chart is suggesting that our consumer spending increases in a mild, linear fashion from birth until death. Of course, the foundation of HS Dent demographic research is that this is absolutely false. Spending follows a curve much like that of income, though on a different timeline. Consider Figure 3, what we will call the “HS Dent Modified Life Cycle.”

In this case, the income line has the same basic shape as in Figure 2, though the consumption line has been transformed into a curve.

Figure 3: HS Dent Modified Life Cycle Hypothesis

This familiar chart is the basis for the Spending Wave. We know, based on data from the US Bureau of Labor Statistics, that consumer spending is largely a function of age. We spend increasingly more raising our families until our late 40s, after which time we pare down our spending and save for retirement.

The Permanent Income Hypothesis

In 1957, Milton Friedman made his own modifications to the Consumption Function and to the Life Cycle Hypothesis, dubbed the Permanent Income Hypothesis. Friedman’s idea was this: people base their consumer spending on what they consider their “permanent” income, or their average income over time. They do this in an attempt to maintain a relatively constant standard of living, even though their incomes may vary wildly over time. This goes a long way to explaining why Americans love consumer debt as much as they do. It’s ok to spend more that you make today, because your salary will be high enough after that next promotion to pay it all back. [Note: this was true of American attitudes in 2007; it’s far from true today, as deleveraging is the rule of the day.]

Keynes’s model, remember, assumed that people spent a constant proportion of their current incomes, i.e. each paycheck. Friedman assumes that people are forward-looking and base consumption decisions today on income expectations for tomorrow. Changes in current income, if perceived to be temporary, have little effect on spending. Friedman correctly realized that a family’s standard of living is “sticky.” When dad’s bonus check is a little disappointing one year, the family does not instantly eschew Neiman Marcus in favor of Wal-Mart. Whether for pride, concern for their children, or simple inertia, Americans are slow to ratchet down their lifestyles. Consider the case of the past six years [2001-2007]. America has suffered one of its worst bear markets in history in the wake of the dot-com bust. We had the most horrific terrorist attack arguably in world history on September 11, 2001. We’ve had two wars and a commodity boom that has seen the price of oil more than triple. Yet in spite of it all, Americans never stopped spending money [during the 2001-2007 period].  Keynes might have despaired that this behavior was irrational, but under Friedman’s model there is nothing irrational about it at all. American consumers are simply optimists who, seeing better times in the future, decide to enjoy the benefits of consumption today.

The Other Side of the Coin

Interestingly, none of these theories go into much detail on consumption as a function of age and what this implies in an aging society. Keynes’s model does not incorporate time at all, and Life Cycle theorists and Milton Friedman both assume that consumption rises in a linear fashion from birth to death. Keynes’s model may be the least dangerous in this sense, as nothing is as destructive to a forecasting model as linear thinking and extrapolation. The tendency to project current conditions into infinity leads to booms and busts. Remember the dot-com boom? It seems ridiculous now, but professional investors implicitly assumed that growth rates that were far in excess of historical norms would continue indefinitely into the future: “Our website is attracting 100,000 new eyeballs per day….”

Milton Friedman was an optimist and a true believer in the market system, and these are some of his most memorable and endearing qualities. They are what allowed the man to spread his views so effectively and radically change the world for the better. It is only natural, in Friedman’s optimistic mind, for consumer spending to march upward more or less continuously with only mild setbacks here and there. But we know that this is not true. People do indeed increase their spending for most of their lives, but once they hit their 50s they spend less on virtually everything.

Friedman is partially right, of course. A person’s income and expectation of future income clearly affects the level of consumption today. A janitor is not likely to buy a Porche, because at no time in his life will his income justify such a purchase. But how many Porches (or boats, or expensive clothes, or Rolex watches) do you see 70-year-old men buying?

These are luxury goods, of course. What about more mundane items? How many washing machines, sofas, or coffee machines does a 70-year-old man buy? Common sense would tell you that the answer is “not very many.” Is the reason, as Friedman’s hypothesis would suggest, because an elderly man realizes that his future income with which to pay for these items is modest? Or might it be for the more obvious reason that the man has already accumulated more than enough of these things in his 70 years?


Demographic trends suggest a decade-long lull in consumer spending starting around 2009 or 2010 as the Baby Boomers begin to spend less and save more for retirement. This will be a repeat, almost twenty years later, of the same scenario that Japan faced during the 1990s. When US consumer spending begins to falter, there will no doubt be plenty of economists attempting to explain the phenomenon by using some variation of Friedman’s permanent income hypothesis: “Americans are spending less money today because they see dark economic times ahead with declining incomes and standards of living….”

Then, any and every policy under the sun will be recommended on how to “fix” the problem. No doubt, Keynes’s Depression-era work will also be resurrected, and phrases like “liquidity trap” will become popular again in economic circles. [Note: Real world events followed this part of the forecast like a movie script.]

None of these ideas are likely to make much difference in spurring demand. They certainly didn’t in Japan, and there was no lack of trying. Japan eventually recovered to an extent, as the US will too. But the recovery in demand was a result of changes in demographic trends, not a policy miracle.