Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards (with Vladimir Mukharlyamov)

January 16, 2025

Accepted, The Journal of Financial Economics

 This paper provides empirical evidence of a well-known theoretical concern that market failures in two-sided markets are hard to identify and correct. We study the reactions of banks, merchants, and consumers to Dodd-Frank’s Durbin Amendment that lowered interchange fees on debit card transactions. Banks recouped a significant portion of their losses by charging consumers for products that they previously provided for free on the subsidized side of the two-sided market. The accelerated adoption of credit cards with higher interchange fees likely diminished—if not eliminated—merchants’ savings. These effects impede the regulation’s stated objective of enhancing consumers’ welfare through lower retail prices.

Presentations: AFA, NBER SI Household Finance,  Booth Conference on Financial Regulation*, NYU Stern Women in Finance, Philadelphia Federal Reserve Consumer Finance Conference, Consumer Financial Protection Bureau, Society for Empirical Legal Studies (Theodore Eisenberg Prize), Brookings Institute

Tax Reform Project: Seeking Experts’ Ideas for a Better Tax Code (with Lawrence H. Summers, Fred T. Goldberg, and Leslie B. Samuels)

February 5, 2024

Tax Notes Federal 182 (2024): 1027-1029.

There is broad agreement on both sides of the political aisle that today, our tax system is not working the way it should. The upcoming 2025 tax debate will come at a time when the Congressional Budget Office’s latest long-term budget outlook suggests that the nation’s fiscal balance is teetering dangerously out of control, with the annual deficit as a share of GDP projected to nearly double to 10 percent by 2053. Debt as a share of GDP is on track to reach never-before-seen heights at over 180 percent of GDP by 2053. We are heading toward uncharted fiscal territory, which suggests the need for both creative revenue solutions as well as innovative ideas for improving the tax system. This is where the Tax Reform Project (TRP) comes in.  Our broad objective is to provide a forum for ideas that could (relatively) easily be implemented in today’s code, drawing on insights from practitioners, academics, and other experts.

What Private Equity Does Differently: Evidence from Life Insurance (with Divya Kirti)

July 14, 2023

The Review of Financial Studies 37.1 (2024): 201-230.

This paper studies how private equity creates value and its consequences for consumer welfare in the insurance industry, where PE investments grew tenfold following the financial crisis. PE firms add value through regulatory and tax arbitrage that increases profits relative to their non-PE counterparts. Crucially, the impact on consumer welfare is nuanced: in the short run, consumers benefit from more favorably priced products. But the arbitrage strategy also exposes them to more risk, as annual expected losses scaled by capital buffers rise by 50 percentage points. This creates the possibility of consumer harm in the event of a downturn.

Presentations: NYU/Penn Law & Finance Conference, IMF Annual Conference*, European Financial Association*

The Coming Fiscal Cliff: A Blueprint for Tax Reform in 2025 (with Kim Clausing)

September 27, 2023

The Hamilton Project 14 (2023).

At the end of 2025, almost all of the individual, estate, and pass-through provisions of the Tax Cuts and Jobs Act (TCJA) will expire. This looming expiration creates an important opportunity to improve tax policy along multiple dimensions at the same time that TCJA provisions are evaluated for possible extension. In this paper, we suggest four key principles to guide tax policy choices in 2025: first, reforms should raise revenue on net, improving fiscal sustainability; second, reforms should respond to persistent inequalities by increasing the progressivity of the tax code; third, reforms should work to reduce tax-based inefficiencies in the code, and finally, reforms should address global collective action problems such as climate change and tax competition. Using these principles as a guide, we then evaluate possible TCJA extensions and consider a menu of revenue-raising reforms that together have the potential to raise about $3.5 trillion over the coming decade, while improving the progressivity and efficiency of the tax system.

Presentations: Brookings, NYU Law and Economics Seminar, Columbia Tax Policy Colloquium, Northwestern Tax Policy Colloquium 

Rethinking How We Score Capital Gains Tax Reform (with Lawrence Summers, Owen Zidar, and Eric Zwick)

June, 2022

Tax Policy and the Economy 36.1 (2022): 1-33.

We argue the revenue potential from increasing tax rates on capital gains may be substantially greater than previously understood. First, many prior studies focus primarily on short-run taxpayer responses, and so miss revenue from gains that are deferred when rates change. Second, the rise of pass-throughs and index funds has shifted the composition of capital gains in recent years, such that the share of gains that are highly elastic to the tax rate has likely declined. If some components are less elastic, then their elasticity should get more weight when scoring big changes because they will comprise more of the remaining tax base. Third, closer parity to income rates would provide a backstop to rest of tax system. Fourth, additional base-broadening reforms, like eliminating stepped-up basis, making charitable giving a realization event, reforming donor advised funds, and limiting opportunity zones to places with the highest poverty rates, will decrease the elasticity of the tax base to rate changes. Overall, we do not think the prevailing assumption of many in the scorekeeping community—that raising rates to top ordinary income levels would raise little revenue—is warranted. A crude calculation illustrates that raising capital gains rates to ordinary income levels could raise hundreds of billions more revenue over a decade than other leading estimates suggest.

Presentations: NBER TPE, National Tax Association

Dynamic Regulation

July, 2021

Southern California Law Review 94.5 (2021): 1005-1082.

There is widespread consensus that the Great Recession did not have to be as Great as it was: Had regulators acted earlier, its consequences would have been less severe. Two explanations are typically offered for early inaction. The first is that crises occur unexpectedly, so there is little time to respond aggressively. The second is that even regulators who suspected a downturn was imminent lacked the legal authority to intervene. This Article disputes these myths. First, empirical evidence demonstrates that there was over a year between the first tremors in financial markets and the crash. Second, legal analysis illustrates that regulators had at their disposal significant authority to bolster banks. In fact, they used this authority with respect to small banks, but not large, systemically important firms.

There is an alternative explanation for the tepid initial response to the crisis. Regulators’ default is inaction until regulatory measures of bank health signal distress. These measures are slow to update—in many cases, the day before banks failed, their regulatory capital measures suggested no cause for concern. In the absence of significant change, regulators will inevitably be fire-fighting future financial crises ex-post; rather than successfully policing financial markets ex-ante. The next crisis can be prevented. But to do so will require an overhaul of the financial regulatory regime. This Article proposes a way forward. It advocates for automating aggressive action when financial markets indicate that distress is likely. Such reform will finally make costly bank failures a relic of the past.

Presentations: Duke Law & Economics Seminar, Michigan Law & Economics Seminar, Georgetown Law & Economics Seminar

Tax Reform for Progressivity: A Pragmatic Approach (with Lawrence H. Summers and Joe Kupferberg)

January 28, 2020

Chapter in Tackling the Tax Code: Efficient and Equitable Ways to Raise Revenue, Hamilton Project (2020).

Trends in demographics, national security, economic inequality, and the public debt suggest an urgent need for progressive approaches to raising additional revenue. We propose a suite of tax reforms targeted at improving tax compliance, rationalizing the taxation of corporate profits earned domestically and abroad, eliminating preferential treatment of capital gains, and closing tax loopholes and shelters of which wealthy individuals disproportionately avail themselves. We estimate that these proposals have the potential to raise over $4 trillion in the coming decade. These proposals are comparable on the basis of both potential revenue raised and progressivity with newer and more radical proposals, like wealth taxation and mark-to-market reforms, that have been the focus of much recent attention. Importantly, our agenda is likely to enhance rather than reduce efficiency, is far less costly in terms of political capital, and hews more closely to basic notions of fairness than alternative approaches.

Presentations: Brookings Institution (video), National Tax Association, Penn-Wharton Budget Model

CBO Recognizes, but Understates, Potential of Tax Compliance Efforts (with Lawrence H. Summers)

July 20, 2020

 Tax Notes Federal 168 (2020): 443-449.

In a July 2020 report, the Congressional Budget Office estimated that modest investments in the IRS would generate somewhere between $60 and $100 billion in additional revenue over a decade. This is qualitatively correct. But quantitatively, the revenue potential is much more significant than the CBO report suggests. We highlight five reasons for the CBO’s underestimation: 1) the scale of the investment in the IRS contemplated is modest and far short of sufficient even to return the IRS budget to 2011 levels; 2) the CBO contemplates a limited range of interventions, excluding entirely progress on information reporting and technological advancements; 3) the estimates assume rapidly diminishing returns to marginal increases in investment; 4) the estimates leave out the effect of increased enforcement on taxpayer decision-making; and 5) the use of the 10-year window means that the long-run benefits of increased enforcement are excluded. We discuss these issues, present an alternative calculation, and conclude that a commitment to restoring tax compliance efforts to historical levels could generate over $1 trillion in the next decade.

Making Consumer Finance Work

October, 2019

Columbia Law Review 119.6 (2019): 1519-1596.

The financial crisis exposed major fault lines in banking and financial markets more broadly. Policymakers responded with far- reaching regulation that created a new agency—the Consumer Financial Protection Bureau—and 19changed the structure and function of these markets.

Consumer advocates cheered reforms as welfare enhancing, while the financial sector declared that consumers would be harmed by interventions. With a decade of data now available, this Article examines the successes and failures of the consumer finance reform agenda. Specifically, it marshals data from every zip code and bank in the United States to test the efficacy of three of the most significant postcrisis reforms: in the debit, credit, and overdraft markets.

The results are surprising. Despite cosmetic similarities, these reforms had very different outcomes. Two (changes in the credit and overdraft markets) increase consumer welfare, while the other (in the debit market) decreases it. These findings run counter to prior work by prominent legal scholars and encourage reevaluation of our (mis)conceptions about the efficacy of regulation.

The evidence leads to several insights for regulatory design. First, banks regularly levy hidden fees on consumers, obscuring the true cost of financial products. Regulators should restrict such practices. Second, consumer finance markets are regressive: Low-income customers often pay higher prices than their higher-income counterparts. Regulators should address this inequity. Finally, banks tend to discourage regulation by promising their costs will be passed through to consumers. Regulators should not be overly swayed by their dire warnings.

Presentations: University of Pennsylvania Law, University of Virginia Law, Northwestern Law & Economics Seminar, Texas Law & Economics Seminar, Stanford Behavioral Law Workshop, Berkeley Law and Economics Seminar

Shrinking the Tax Gap: Approaches and Revenue Potential (with Lawrence H. Summers)

November 18, 2019

 Tax Notes Federal 165 (2019): 1099-1112.

Between 2020 and 2029, the IRS will fail to collect nearly $7.5 trillion of taxes it is due. It is not possible to calculate with precision how much of this “tax gap” could be collected. This paper offers a naïve approach. The analysis suggests that with feasible changes in policy, the IRS could aspire to shrink the tax gap by around 15 percent in the next decade—generating over $1 trillion in additional revenue by performing more audits (especially of high-income earners), increasing information reporting requirements, and investing in information technology. These investments will increase efficiency and are likely to be very progressive.

Related: VoxEU April 2020

Understanding Bank Risk through Market Measures (with Lawrence H. Summers)

September 10, 2016

Brookings Papers on Economic Activity 2016.2 (2016): 57-127.

Since the financial crisis, there have been major changes in the regulation of large banks directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress-testing has sought to further assure safety by raising levels of capital and reducing risk-taking. Standard financial theories predict that such changes would lead to substantial declines in financial market measures of risk. For major banks in the United States and around the world and for midsized banks in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, price–earnings ratios, and preferred stock yields. To our surprise, we find that financial market information does not bear out the predictions of financial theory. Measures of volatility and risk premiums today are no lower and perhaps somewhat higher than they were prior to the financial crisis. We examine a number of possible explanations for our findings. While financial markets underestimated risk prior to the crisis and regulatory measures of capital are flawed, we believe that the most important explanation for our findings is the dramatic decline in the franchise value of major banks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly from the precrisis period to the current period for most major banks. As a consequence, banks are more vulnerable to adverse shocks. We argue for taking a dynamic view of capital that recognizes future profits as a source of capital, and urge approaches to financial regulation supervision that will reliably force rapid capital replenishment in difficult times—something that did not take place in the United States in 2008 and is not taking place in Europe today.

What’s in Your Wallet (and What Should the Law Do About it?)

March, 2020

Chicago Law Review 87.2 (2020): 553-594.

In traditional markets, firms can charge prices that are significantly elevated relative to their costs only if there is a market failure. However, this is not true in a two-sided market (like Amazon, Uber, and Mastercard), where firms often subsidize one side of the market and generate revenue from the other. This means consideration of one side of the market in isolation is problematic. The Court embraced this view in Ohio v. American Express, requiring that anticompetitive harm on one side of a two-sided market be weighed against benefits on the other side.

Legal scholars denounce this decision, which, practically, will make it much more difficult to wield antitrust as a tool to rein in two-sided markets. This inability is concerning as two-sided markets are growing in importance. Furthermore, the pricing structures used by platforms can be regressive, with those least well-off subsidizing their affluent and financially-sophisticated counterparts.

In this Article, I argue that consumer protection, rather than antitrust, is best suited to tame two-sided markets. Consumer protection authority allows for intervention on the grounds that platform users create unavoidable externalities for all consumers. The Consumer Financial Protection Bureau (“CFPB”) has broad power to curtail “unfair, abusive, and deceptive practices.” This authority can be used to restrict practices that decrease consumer welfare, like the anti-steering rules at issue in Ohio v. American Express.

Presentations: Chicago Antitrust Symposium, UPenn Faculty Workshop

Stressing the Stress Tests (with Til Schuermann)

January 15, 2025

Spring 2023 saw Silicon Valley Bank, Signature Bank, and First Republic experience failure due to predictable rate hikes by the Federal Reserve. Despite the clear success of stress testing as a crisis and peacetime risk management and capital adequacy tool, the series of bank failures and resultant turmoil in the banking system revealed flaws in the stress testing regime that today governs the regulatory capital regime. It’s clear from these recent events that the current stress testing system is ill-suited to mitigate risk associated with the banking system, especially when looking at smaller regional banks that aren’t subjugated to annual stress testing. Stress testing as a regulatory tool is also exposed to significant legal risks following recent Supreme Court jurisprudence that draws into question the viability of the status quo.

Today, regulators and other interested parties must change tacks to craft a stress testing regime that is fit for purpose. This Article seeks to inform that debate by laying out key features of a successful stress testing program against which we assess the current regime in the US. Based on this analysis, wemakefourspecificrecommendations:1) using multiple scenarios to allow exploration of a wider set of risks; 2) disclosing(stressed) fair value for the assessment of all securities held on banks’ balance sheets; 3) stress testing of funding and liquidity risk; and 4)subjecting more banks to the stress tests. Taken together, these reforms would usefully improve the dynamism of the financial regulatory regime.

Presentations: Yale Law School, Columbia Law Banking Conference, Yale Program on Financial Stability Conference