Category Archives: fiscal

What do Rick Perry and pro sports teams have in common?

They use the same shady economic methodology to promote their policies.

If you follow the news, you’re familiar with “IMPLAN”, albeit indirectly. It’s the software package underlying the studies that pro sports teams, among others clamoring for public favors, use to claim that each new stadium will generate several gazillion dollars for the local economy—supposedly justifying a massive public outlay. Here’s a study using IMPLAN to justify a new Sacramento Kings stadium; here’s another that looks at the proposed Santa Clara stadium for the 49ers and another that attempts to justify a new stadium for the A’s. There are studies looking at the impact of the Mavericks’ American Airlines Center, the Packers’ Lambeau Field, and Oriole Park. And, of course, there are countless others: whenever someone wants to make preposterous claims about the benefits of his pet project, he’ll inevitably turn to IMPLAN or a similar package.

Artist's rendition of the new 49ers stadium proposed for Santa Clara, whose economic impact has been studied using the same highly reliable methodology now applied by Rick Perry's campaign.

There’s an obvious element of pseudoscience to these studies. They use “input-output” models that painstakingly track the path of spending through the economy—a worthy goal, though perhaps an overambitious one. But they fail entirely to model the supply side of the economy, effectively assuming that there is unlimited capacity, and that each additional dollar of “spending” (magically generated by the new stadium) will become an additional dollar of economic activity—even more, in fact, after you account for the multiplier.

Strangely enough, Rick Perry’s campaign is using the same model to analyze his tax plan, in a context where it makes even less sense.

As James Pethokoukis explains, the Rick Perry presidential campaign has contracted with John Dunham and Associates to run a revenue analysis of Perry’s new tax plan. The impact of the plan depends on your choice of baseline policy: it raises $4.7 trillion less than the CBO baseline for 2014-2020 under conventional, static scoring, and $1.7 trillion less under “dynamic scoring”.  Relative to the CBO’s more arguably realistic alternate baseline, the plan does better. But regardless of your preferred baseline, it’s clear that the plausibility of Dunham’s “dynamic scoring” model is key: it provides an additional $3 trillion over only 6 years!

It’s troubling, then, to learn that the Perry campaign’s idea of “dynamic scoring” bears absolutely no relation to what most economists mean by the term. In fact, the Dunham model more closely resembles the shady estimates for the 49ers stadium than any accepted methodology in public finance.

The idea behind dynamic scoring—as economists generally understand the concept—is that we should account for how the incentives created by the tax system affect the economy, and how those effects might feed back into revenue. A income tax cut, for instance, might lead to higher taxable income and a new stream of tax revenue—though certainly not by enough to fully offset the initial revenue loss, as Art Laffer once claimed. In theory, capital tax cuts may to even larger offsetting movements in revenue, though still not enough to recover the loss completely. Greg Mankiw and Matthew Weinzierl provide a short guide here.

Dynamic scoring is controversial: many Democrats believe that in practice it’s a gimmick that obscures the revenue losses from tax cuts. But in principle, it’s hard to deny that dynamic scoring would be the ideal way to evaluate the effects of tax policy: taxes do have real effects, and those effects eventually find their way back into the tax base. The challenge is that the relevant magnitudes are extremely uncertain, and it’s hard to calibrate a model that realistically accounts for the effects of new policy. Moreover, if the overall effect on revenue is negative, to be complete you need a model of how other tax and spending policies will eventually adjust to close the additional deficit—a very difficult task indeed, one that practitioners usually ignore. Some proceed nevertheless; some think it’s better to avoid the issue until we have more accurate models.

But none of this matters to the Perry analysis, because it’s completely unrelated. It doesn’t look at the effect of taxes on incentives at all. Instead, it simply feeds the increased personal income from tax cuts into the IMPLAN model and churns out the same kinds of estimates we typically see for sports stadiums. If you think I’m kidding, read the document:

In order to better understand the effects of the Perry tax proposal on the national economy, a dynamic scoring exercise was conducted by JDA. JDA used an input-output model of the US economy to estimate the true revenue effect of personal income tax proposals, including the feedback effects of taxes on national income.

The dynamic analysis used in this model was based on tax savings (or tax increases) for various income groups in each of the 7 years between 2014 and 2020. These savings were run through the IMPLAN input-output model as increases to income for each group and the resulting change in GDP was fed back through the model for subsequent years. This led to higher GDP growth estimates for each year beginning with 2014 (see Table 6). Based on this analysis, GDP is expected to grow faster than forecast by the CBO, reaching $26.5 trillion by FY 2020 – a 16 percent increase.

Needless to say, this description is a little hazy, but it’s pretty clear what’s going on: they look at tax savings as increases in “income” to each group and feed them through the IMPLAN input-output model, which vastly multiplies the initial impulse and leaves us with an utterly implausible estimate for improvement in GDP. (Sixteen percent? Are they kidding?) There’s no recognition that long-run output is determined by supply constraints, not demand; in fact, this is a completely demand-side analysis trying to pass itself off as supply-side dynamic scoring. Rather bizarre for a Republican candidate, particularly one as hostile to demand-side policy as Rick Perry!

Now, to be clear, there is a place for demand modeling and multipliers like those in the IMPLAN model: when we’re in a demand-constrained recession and monetary policy has reached its limits, tax cuts may provide economic stimulus by boosting aggregate demand, not just improving supply-side incentives. (Though there’s a debate about that.) But this is explicitly a short-to-medium term phenomenon, one that only matters (if at all) in a zero lower bound recession. No one—not even the most fanatical Keynesian—claims that such multipliers provide a foundation for long-term analysis of public finance. And certainly no one is crazy enough to think that the demand-side effects of a tax cut can boost GDP by sixteen percent, as the Perry analysis claims.

In fact, this model makes even less sense in the context of federal tax policy than in its usual, already dubious applications. When we’re looking at a stadium, at least we’re confining ourselves to a particular region: consumers flocking to a stadium can’t boost the productive capacity of the US economy as a whole, but they might encourage labor and capital to relocate around the stadium, delivering economic expansion to the region in question. But this doesn’t apply to the US as a whole: we only have so much labor and capital. Granted, if the model looked at the supply side of Perry’s plan, it might demonstrate how improved incentives lead to an expansion in labor and capital supply, thus increasing potential economic output. That is, however, what the model explicitly does not do: it ignores supply considerations completely, instead assuming that supply constraints are irrelevant and that the income from tax cuts will forever ripple throughout the economy and prompt a demand-led expansion that would put the Clinton era to shame.

I never thought I’d see the day when I had to lecture a Republican presidential candidate on the importance of supply-side analysis, or the dangers of overexuberant demand-side logic. Apparently that day has come!

The truth, of course, is that neither Rick Perry nor his staff have any idea of the analysis behind their numbers. Instead, they hired a consulting firm that specializes in using IMPLAN to create exaggerated estimates for the effect of particular industries (“Meat! Responsible for 5 trillion jobs!”) in order to please its lobbyist clients. The firm evidently knows nothing about tax analysis; it has no credentialed public finance economists on its staff and no experience in analyzing tax policy. When asked to conduct a study, it turned to the only game it knew: IMPLAN, which just happens to be a absurd way to analyze national fiscal policy.

But hey—cut them some slack! It’s not like they’re evaluating the key economic proposal from a major presidential candidate or anything.
 


Update. Lifted from the comment section, from economics professor and sports researcher Donald Coffin:

Nice to see a good take-down of the IMPLAN modelling approach. Those of us who do sports economics and urban economics seriously are almost constantly having to push back against those kinds of studies. The single most disturbing aspect of the IMPLAN model for local economic analysis is the wildly unreasonable values that have for multiplier effects (compared, for example, with the BEA’s Regional Input-Output Modeling System). IMPLAN is exactly what you describe it as, a “model” designed to generate large impact numbers to please a client who wants to lobby someone.

Advertisements

22 Comments

Filed under fiscal, policy

The uselessness of helicopter drops

I’ve received some skeptical feedback on my last post about how money is just another form of debt, particularly its implications for the effectiveness of a “helicopter drop”. This topic deserves more attention: for reasons I don’t understand, some very smart observers regard the helicopter drop as one of monetary policy’s most potent tools.

What’s wrong with these claims? First, let’s be precise: there are two ways to do a helicopter drop.

Option one: the Treasury and Fed coordinate. The Treasury uses bonds to raise money for a tax rebate, while the Fed immediately buys those bonds. This is just a fiscal transfer plus an open-market operation. Is either component particularly effective? Certainly the open-market operation doesn’t do much: in the current environment, exchanging reserves for short-maturity T-bills is meaningless. Trading reserves for longer-maturity Treasury securities, as in QE2, probably has a minor effect, but the Treasury could achieve the same effect by issuing short-maturity debt itself. Adding the Fed to the picture accomplishes nothing.

The case for this type of helicopter drop, then, is really no different from the case for traditional fiscal transfers during a recession—the Fed’s participation is irrelevant and unnecessary.

To be fair, depending on the Fed’s long-term objectives, there may be a monetary side to the policy. As Gauti Eggertsson once argued, a large debt load can serve as a useful commitment device to generate expectations of future inflation. If the Fed cares about the government’s overall budget, it may be tempted to tolerate inflation to eat away at the real value of the debt—and if everyone expects more inflation, the liquidity trap becomes less severe.

But there are also plenty of caveats. First, since you need a fiscal transfer large enough to materially affect the government’s long-term budget, the scope of the transfer must be enormous. When the long-term budget picture is already so questionable, it’s far from clear that this is a wise choice. Second, there’s little evidence that the Fed sets policy with the Treasury’s debt problems in mind. In practice, the Fed seems dedicated to pursuing its interpretation of the statutory mandate for price stability and full employment. No one at an FOMC meeting has ever suggested inflating away the debt, or even anything close.

And regardless, the Fed’s direct participation still doesn’t matter: trading T-bills for reserves when the policy is enacted has nothing to do with the longer-term decision to tolerate a higher level of inflation.

In the alternative kind of helicopter drop, the Treasury doesn’t issue any new debt: instead, the Fed somehow directly distributes money to households without obtaining any assets in return. This creates a hole in the Fed’s balance sheet, which has traditionally held assets (Treasuries, MBS, etc.) to back its liabilities (money). What happens then? If the hole is small enough, very little: the Fed will simply recapitalize using the profits it otherwise remits to the Treasury. Over time, Treasury will need to issue slightly more debt (since it’s receiving less money from the Fed), and in effect the transfer will turn out to be debt-financed. This is really no different from the first scenario.

What if the hole is large enough that it’s not clear the Fed can patch it using profits—in other words, if there’s a risk that the Fed is actually insolvent? This is murkier territory. First, it’s not clear that the Fed can ever really go broke: as Tyler Cowen points out, it always has the option to print a bunch of money and buy something valuable. Printing a few trillion and stocking up on equities (or even high-yield debt) will probably do the trick. Alternatively, in a crisis it can run to Congress. Both these possibilities seem far more likely than the notion that an undercapitalized Fed will somehow be forced to allow higher inflation.

In any case, a direct helicopter drop by the Fed only affects the future path of monetary policy if it puts the Fed’s balance sheet in peril. Otherwise, there’s no reason to think that the FOMC will make decisions any differently. (If it’s not externally constrained, why stop targeting its mandate?) And this is a very dangerous game to play: if you deliberately sabotage the central bank, it’s hard to know what will happen.

Ultimately, I agree with Scott Sumner: it’s bizarre to use a helicopter drop to create inflation expectations when you haven’t tried the much easier route of saying you want inflation. This is doubly strange when you realize that a helicopter drop only “works” if it irresponsibly endangers the Fed’s balance sheet. If you want inflation, say it. If you want to write more checks to households, tell the Treasury to do it. The “helicopter drop” is just a strange mishmash of fiscal and monetary policy that adds nothing.

17 Comments

Filed under fiscal, macro

Money is debt

It’s just another type of debt.

Following Thomas Sargent’s recent Nobel Prize, I came across this excellent excerpt from a 1989 interview:

The essential job of the Fed from a macroeconomic point of view is to manage the government’s portfolio of debts. That’s all it does. It doesn’t have the power to tax. The Fed is like a portfolio manager who manages a portfolio made up wholly of debts—it determines how much of its portfolio is in the form of money, which doesn’t cost the government any interest, how much is in the form of T-bills and how much is in 30-year bonds. The Fed continually manages this portfolio. But it doesn’t determine the size.

Exactly. The Fed can trade money for bonds, but this doesn’t change the overall level of government debt—just its composition.

This is important to understand the fallacy in common arguments for “helicopter drops”. You often hear people saying roughly the following:

The Fed has the power to create money and hand it to consumers, stimulating the economy. Normally, the problem with this policy would be inflation, but clearly the dominant risk today is deflation, not inflation—so what’s the downside?

I agree that inflation is low on the list of important risks, but this is nevertheless a deeply flawed argument. Holding more debt in the form of money now is not an inflation risk, but the money doesn’t magically disappear after a few years. It’s still out there, and it’s still on the Fed’s balance sheet. It’s still debt.

Suppose that the Fed creates $1 trillion out of thin air and sends every American an equal share. For a while, this will be fine. Assuming that the intervention doesn’t drastically change the demand for currency, the new money will be held mainly in the form of reserves. The Fed will pay 0.25% on these reserves—not a big deal. So what’s the problem?

Again, the money doesn’t go away—the Fed still has an enormous liability on its books. With so much money in circulation, the marginal investor won’t be willing to pay a premium to hold money. The federal funds rate will therefore be roughly the same as the interest rate paid on reserves, which will also be roughly equal to the rate the Treasury pays on T-bills. In other words, holding debt as money won’t be any cheaper than simply holding it in the form of short-term bonds. The government can’t escape the cost of financing its liabilities. Giving money to households via a helicopter drop is fundamentally the same as giving them money via an act of Congress, with all the usual benefits (improved aggregate demand in the short term) and costs (burdensome future taxation to pay back the debt).

Admittedly, it’s possible that the increase in debt load will cajole the Fed into pursuing easier monetary policy in the future. The more nominal debt you’re trying to finance, the more tempting it is to push down interest rates and spur inflation. (In fact, Sargent and Wallace’s famous paper deals with an extreme case of this phenomenon, where the central bank is forced to make up for the fiscal authority’s inadequacies.) If you’re trying to create expectations of future inflation, this is arguably a good thing.

But it’s not clear why a helicopter drop should provoke such a change in incentives, unless it’s of truly overwhelming magnitude. Excluding intragovernmental holdings, the public debt is currently over $10 trillion. Even a $1 trillion helicopter drop would only add 10%. Is a 10% increase in debt enough to dramatically change the Fed’s incentives in the future? It’s possible, but I’m skeptical. Historically, we’ve seen much larger swings in the government’s balance sheet, and the Fed’s response has been minimal at best.

Bottom line? Money is a form of debt. Whether an operation’s short-term financing comes from “bonds” or “money” makes no difference; the cost is the same, and the usual tradeoffs of fiscal policy remain.

18 Comments

Filed under fiscal, macro

Avoiding the word “tax”

I have a new way to balance the budget. When employees are paid, I will require their income to spend one day in an escrow account, where it will be invested in “Liberty Bills”. Liberty Bills are government-issued bonds with a daily return of negative 5%. I am confident that this simple reform will eliminate the deficit.

Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?

Maybe not. In fact, I see similar proposals all the time.

Consider the following: when Dean Baker proposes that we cancel the Treasury debt held by the Fed, he’s essentially saying (aside from the temporary accounting gimmick) that we should undertake a long-term shift in the composition of debt, from bonds to money. Why? Most observers suspect that the Fed will eventually pull back the money created through quantitative easing. To so, however, it needs to sell lots of assets—and if half of its assets disappear, this is no longer a viable option. Under Baker’s proposal, then, the Fed will be forced to leave over $1 trillion in excess reserves in the system, until it recapitalizes through profits (far in the future) or is bailed out by Congress (in which case the proposal is completely circular). Debt that would otherwise be issued by the Treasury will be left in the form of money instead.

What happens then? Quite possibly nothing. With so many reserves in the system, the premium on reserves will linger around zero—no one will sacrifice yield to hold reserves when equivalent riskless assets are available. The rate paid on reserves, the federal funds rate, and the short-term T-bill rate will all be roughly the same. In this environment, issuing debt in the form of money rather than bonds is completely useless: you can borrow at the same rate with T-bills. Monetization changes nothing.

What Baker proposes, however, is to vastly increase the burden of reserve requirements, such that there is no longer an excess supply of reserves. At this point, banks are willing to pay a premium for reserves, the Fed is able to pay interest on reserves at a rate lower than the rate on T-bills. Money becomes a cheaper form of finance than bonds, and we see a fiscal benefit.

But what’s really happening? The Fed saves money in this scenario only because the new reserve requirements force banks to carry a low-yield asset (reserves) in order to accept deposits. In other words, the Fed is taxing bank deposits. In fact, Congress could impose precisely the same tax through legislation: a statutory tax of (federal funds rate – interest on reserves)*(reserve requirement) would be equivalent.

Of course, hardly anyone* wants us to enact an ad-hoc tax on certain types of bank deposits: it’s not a very efficient way to raise money, and it’s quite possibly regressive. I can easily think of a dozen more effective ways to boost revenue. So why does anyone take this proposal seriously? As far as I can tell, it’s because a “reserve requirement” doesn’t sound like a tax. It’s not obvious that this policy is just another distortion-inducing way to gather revenue, and that it should be subject to the same cost-benefit analysis as any tax. As with many proposals for means testing, we’re so eager to escape uncomfortable fiscal tradeoffs that we invent a new, needlessly circuitous way to tax, one that’s even less efficient than the existing tax code.

I’m still fond of Liberty Bills myself.


*As I mentioned in my last post, there are serious proposals for taxing “liquidity creation”, but properly implementing these proposals would produce a policy so different from today’s reserve requirements that it’s a stretch to use the same name.

6 Comments

Filed under fiscal, macro

The optimal taxation of Manhattanites

Matthew Yglesias dismisses the argument that $250,000 isn’t “really rich” in Manhattan:

Allison Schrager offers what is I think my least-favorite economic argument, the regional variant of the old people who buy expensive houses aren’t rich because their houses cost so much switcheroo…

“Perhaps fairness also requires that the tax code account for the higher cost of living in some areas. The income cut-off for tax increases floated by President Obama is $250,000. That sum buys you a lot more in Fargo than it does in Manhattan. Most high earners live in expensive areas. They command such high salaries, in part, to offset their high cost of living.”

But that’s not to say that $250,000 buys “more housing” in Fargo than it does in Manhattan, it’s to say that it buys worse housing. The people in those expensive Manhattan apartments are paying for the positive amenity value. They could move to the Bronx, but they don’t want to. Similarly, Manhattan is full of restaurants that don’t exist in Fargo. There are law firms in Manhattan and law firms in Fargo, but the Manhattan law firms are better. Service professionals move to New York to peddle their services because the city features a critical mass of well-heeled clients who can pay top dollar for the best hairstylists or dentists or architects in the world. Fargo’s not like that…

I’m with Yglesias about the $250,000: that income officially makes you rich everywhere. As a practical matter, I also agree that the tax code shouldn’t account for the “cost of living”. But from a theoretical perspective, there is some basis for the idea that Manhattan should have higher federal tax brackets than the rest of the country.

Let’s go back to a fundamental result in the theory of optimal taxation: the Atkinson-Stiglitz Theorem. This result demonstrates that if consumption and leisure are “separable in the utility function”, the optimal tax system should rely only on income taxation. Translated into English, this means that unless someone’s consumption decisions provide extra information about her underlying earning ability—information beyond what’s signaled by the level of income itself—it’s best to avoid taxing different goods at different rates.

As I pointed out in a earlier post, this result shows why some seemingly sensible propositions are wrong: the fact that demand for gasoline is highly inelastic doesn’t singlehandedly justify a higher gas tax. But Atkinson-Stiglitz is also useful in how it fails: it tells us when differential taxation might be reasonable after all.

In particular, if a certain type of consumption makes it easier to earn a high income (conditional on particular level of a ability), then the tax code should favor that type of consumption over others. The obvious candidate here is place of residence: it’s easier to earn a high income in Manhattan than Fargo. This doesn’t quite mean that we should set taxes based on the “cost of living”—a city might be more expensive because it has better amenities, not because it offers better income opportunities. (In practice, it’s usually a little of both.) But to the extent that cost of living is a proxy for income opportunities, it can play a useful role in the tax system.

Think about it this way: discouraging productive (but expensive) urban agglomeration is one of the efficiency costs of taxation. Normally, we think about the losses from income taxation along the labor/leisure margin: if the marginal tax rate on your labor income is too high, you’ll substitute away from labor and spend more time at home. (Perhaps you’ll retire sooner, or leave the labor force if you’re a secondary earner.) But the effect on decisions about where to live is also a source of inefficiency. Maybe after moving from Fargo to Manhattan, it’ll cost $50,000 more every year to maintain the same standard of living, and you’ll earn an extra $100,000. This should be a great tradeoff, but you’ll stay in Fargo if your marginal tax rate is higher than 50%.

In fact, if we change a few labels, we can think about this problem using another famous result in public economics: Diamond and Mirrlees’s demonstration that intermediate goods should not be taxed. Living in a high-powered city, after all, is just an “intermediate good” that makes labor more productive.

Now, in the real world I don’t think the tax code should discriminate according to place of residence. First of all, we don’t have any accurate measure for the extent to which cities improve productivity; we only have cost of living, which is an incredibly indirect proxy. Second, changing the tax code along these lines invites endless political manipulation—how long before the “cost of living” is mysteriously estimated to be highest in swing states? Finally, and most importantly, the high cost of living in the most expensive urban areas owes more to regulation-induced scarcity than economic fundamentals. Given the artificial supply constraint, lower taxes for Manhattan residents would be mainly a giveaway to incumbent property owners, not a way to encourage efficient concentration of labor.

But it isn’t ridiculous to think that a properly designed tax system might want to incorporate the fundamental differences between cities. In fact, in the lens of Atkinson-Stiglitz, it’s a lot more reasonable than most of the other breaks in the tax code.

4 Comments

Filed under fiscal

Insurance against oil shocks: the best idea Bill Frist ever had

Back in 2006, there was a brief stir over the Republican majority’s plan to offer $100 rebates to offset higher prices from gasoline. It quickly became the object of almost universal derision, earning scorn from politicians and bloggers of both the left and right.

Kevin Drum, for instance:

A hundred dollar rebate! It’s bad economics, bad policy, bad optics, and the palpable stink of election-year desperation all rolled into one fetid package. But at least it’s means tested!

On the conservative side, Power Line asked “Wasn’t there a time when Republicans knew something about economics?” and proceeded to demonstrate its own ignorance of economics:

Taxes are a large part of the cost of gasoline. How about if we cut them?

Ironically, the rare proposal that managed to draw bipartisan condemnation was one of the best ideas Congress ever had.

First, why is one of the main alternative proposals—a cut in gas taxes—such a ridiculous idea? Since the US accounts for more than 20% of world oil consumption and the short-term supply of oil is highly inelastic (except when it’s in contango and oil is being hoarded), elementary tax incidence theory tells us that a substantial chunk of the gains from a short-term cut in taxes will go to producers, not consumers. In fact, a very short-term cut in the summer is even worse, since most of the supply is completely fixed, as refineries are already planning to produce as much as they can (which is what made Hillary Clinton’s 2008 proposal so absurd). On top of all this, gas taxes are presumably there to serve some purpose—in particular, to internalize some of the harm from congestion, accident, and pollution externalities—and that purpose doesn’t go away when the price of oil increases.

In short, cutting gas taxes in response to high prices is very bad policy. But that doesn’t mean there shouldn’t be any response from the government.

Of course, the US can’t repeal the laws of supply and demand: there’s no way to suddenly turn on the spigot and make oil cheaper in a world market where American producers will never provide more than a few percent of supply. An increase in oil prices will make Americans poorer.

But the problem isn’t just that an increase in prices makes consumers poorer. It’s that they have short-term liquidity problems: most consumers lack any cheap line of credit for when gas suddenly becomes more expensive. Instead, they have to cut other spending, even when the increase in prices isn’t expected to last forever—and that’s a very real inefficiency.

In an ideal, frictionless economic world, consumers would either buy insurance against high gas prices ahead of time or have easy access to credit, to make a sudden price change more palatable. In the real world, this doesn’t happen: the administrative costs of insurance are too high, and there are innumerable agency failures making it difficult to provide credit. When consumers are operating under these constraints, government intervention can be beneficial.

Frist’s $100 rebate proposal, though tiny, was a way to slightly ease the liquidity constraints facing consumers hit by price increases—in a sense, he wanted the government to provide insurance when the private sector could not. Of course, it wasn’t targeted to consumers who used the most oil, but that was unavoidable. Without any preexisting arrangement, the only way to provide targeted relief would be to cut the gas tax, which for all the reasons I’ve already covered would be a horrible idea.

Such relief could be made much more effective, however, if we made it part of a formal insurance system. Imagine the following: every year, taxpayers filling out their 1040s are given the option to purchase a limited amount of insurance against a surprise increase in oil prices. (The insurance is priced by government economists based on data from futures markets—in fact, the government can even take an offsetting position to negate its risk.) Naturally, anyone who is especially susceptible to an increase in prices will want to buy the most insurance—for instance, a commuter from the exurbs, or a New Englander whose house requires heating oil. This way, the government delivers targeted relief without the perverse incidence of a tax cut.

Whenever government intervenes in a market, of course, the natural question is to ask what advantage government has in providing the service. In this case, I think the answer is obvious: since the government already administers taxes, the overhead from offering oil price insurance consists of little more than an extra line on tax returns, some wire transfers (when the insurance is paid out), and maybe some checks in the mail. The government’s scale is so enormous that its cost of conducting trades to hedge the risk is minimal (and next to the size of its budget, the risk is minimal anyway). There are no regulatory barriers to navigate, and no costs to advertise the new program.

I can’t see why this has never been proposed.

In the absence of a more systematic program, however, ad-hoc insurance like Frist’s doomed “gas rebate” is a completely reasonable idea. It’s revealing that the proposal was so roundly mocked as bad policy—lawmakers and pundits relied more on the vague sense that a rebate sounded gimmicky than on any serious economic analysis. Republicans immediately pivoted to the their “real solution” (pretending that domestic supply can change world prices), while Democrats did the same (using CAFE to force consumers to buy efficient cars). And a perfectly valid proposal skidded to failure.

5 Comments

Filed under fiscal, policy

Is it better to tax goods with inelastic demand? (Atkinson-Stiglitz redux)

Not necessarily.

Bloggers across the political spectrum, from Noah Millman to Ryan Avent, have recently argued that because the demand for oil is inelastic with respect to price, a gas tax is a relatively efficient way to raise revenue. Though I support a higher gas tax, I don’t think this argument is quite right.

It’s true that the deadweight loss from a tax (a standard measure of inefficiency) is intimately connected to the supply and demand of the good being taxed. If either supply or demand is inelastic with respect to price, the deadweight loss will be low. But when designing a tax system, the deadweight loss isn’t the only relevant consideration.

To see why, let’s consider a silly example. Imagine a tax with the lowest deadweight loss imaginable: a tax on breathing, levied at a rate of $10 every day that you take a breath. The demand elasticity here is exactly zero—no one (I hope) is going to stop breathing for an entire day just to avoid paying the tax. This is a wonderfully efficient tax: it has zero deadweight loss.

In fact, this is effectively a lump-sum tax, a tax demanded equally of every individual. Since lump-sum taxes are a perfectly efficient way to collect money, anyone thinking about how to minimize deadweight loss will always raise revenue exclusively through lump-sum taxes. But this is a cheat: obviously we don’t observe lump-sum taxes in practice, even though at the margin it would be possible to implement them. (If the government demanded that everyone coughed up an additional $50, almost everyone could manage to do it.)

The reason why the government doesn’t do this, of course, is distributional: we care about the poor, and it wouldn’t be fair to ask them to pay exactly the same dollar amount as the rich. This is important for even the most conservative fiscal policy proposals—many of them suggest flat taxes, but never a regressive lump sum. And one we realize that this is a key issue, it’s critical for our understanding of optimal taxation, far beyond the observation that lump sum taxes are a bad idea.

A famous result in public finance, the Atkinson-Stiglitz theorem on the optimality of direct taxation, captures this intuition in a striking way. Atkinson and Stiglitz show that if the utility function is weakly separable between consumption of various goods and labor (intuitively, the amount you work has nothing to do with your consumption choices, except insofar as working more gives you more money to spend), then no consumption taxes are needed to attain the optimum. You don’t levy higher taxes on gas than soy milk because soy milk has a higher elasticity; you just determine the optimal tax schedule on income and then stay away.

Why is this? Well, the reason we don’t levy lump-sum taxes is that we’re concerned about distribution. But it’s also a story about information: if we knew exactly what each person was capable of making, we could assign everyone personalized lump-sum taxes, and achieve our distributional goals without distorting any incentives. (“Matt, the government has calculated that you are easily capable of making $1 million a year over the next 10 years; therefore you must pay $300,000 in tax every year, regardless of your actual income.”) Of course, we don’t have this information, and we’re forced to use income as a proxy for ability to pay instead. But then we reach the Atkinson-Stiglitz result: if your exact consumption decisions don’t add any information about this ability, they shouldn’t be part of the tax. Unless gasoline consumption indicates that you have high hidden earnings potential, it shouldn’t be subject to any special charges.

Mapping this result onto the real world is tough, since “income taxes” in practice include taxes on saving (i.e. capital income), rather than the original income itself. Unless propensity to save or access to savings vehicles offer additional information about underlying earning ability, the Atkinson-Stiglitz results suggest that taxes on capital income should be zero, and that our current regime is inefficient. In this context, it might be efficient to raise gas taxes if they’re replacing taxes on capital gains. But it would be even more efficient to replace capital gains taxes with taxes on regular income*, or implement a progressive consumption tax. It’s tough to imagine a world where hiking gas taxes is the fiscally optimal thing to do, or even the second best.

Of course, this isn’t to say that gas taxes aren’t a good idea. If they’re correcting an externality, gas taxes are absolutely appropriate. They’re just hard to justify on fiscal grounds alone.


*Since people with lots of capital tend to be rich, and they acquired that capital under the assumption that it would be taxed, in practice a sudden implementation of this change would represent a windfall gain for the rich. But this could be counteracted either through an explicit one-time expropriation of capital or an implicit expropriation through an increase in consumption taxes.

15 Comments

Filed under fiscal