David R. Henderson favorably reviewed Ross McKitrick’s presentation (at IER’s Carbon Tax conference last summer) on the “tax interaction effect,” and then in a follow-up post David pursued Greg Mankiw’s writings on the topic.
In the comments of David’s second post, someone wrote:
If my microeconomic intuition — that taxing harmful externalities will enhance net welfare, and to a greater degree than some regulatory regime — turns out to be wrong, then I wonder what else I might be wrong about? After considering tax interaction effects, should we not be so hard on speeders? Maybe even encourage them? And what about theft, of various sorts? Keeping Coase (rather than Pigou) in mind, I sometimes think about uncompensated environmental externalities as a form of theft. I wonder if theft, generally, might turn out to be beneficial in some CGE model beyond my ability to comprehend.
OK, putting aside what seems to be sarcasm, it’s clear that this guy doesn’t really understand what the TIE [tax interaction effect] claim is. That’s not entirely his fault, because it’s a very subtle issue, and I don’t think the actual economists publishing on the topic have spelled it out in crystal-clear fashion. The more I think about it, the more “obvious” it seems to me, but it has taken me a long time to get here. At IER, I will soon have a post trying to walk through the whole thing, but because I explain it from scratch, it’s pretty long. In the present blog hit, let me summarize the key issues (as I now conceive them) in a hopefully intuitive way, for people who are familiar with the standard Pigovian framework.
(Note: Silas Barta had a great idea when he flipped the “stacking” of the taxes; his analysis clarified my own thinking on this.)
(A) Assume people are annually emitting 30 billion tons of carbon dioxide with no carbon tax. Assume the marginal/average “social cost of carbon” for current emissions is the same, at $30/ton. So if nothing is done, Earthlings are causing $900 billion annually in future negative externalities (present discounted value).
(B) With no other taxes, “optimal” thing to do according to textbook is to levy a $30/ton carbon tax, the receipts of which are distributed lump-sum back to citizens. Assume this makes people cut emissions in half, down to 15 billion tons. There is a reduction in climate change damages of $450 billion. However, the conventional economy is hurt; after all, businesses and consumers are now facing a constraint to use less carbon-intensive techniques. (If someone could magically cure climate change, the carbon tax would obviously hurt the economy, so it’s still having that effect now, even though we’re superimposing a stabler climate on top of the hurt economy.) Suppose that the harm to the conventional economy from the optimal carbon tax is $100 billion. Thus the net benefit of the carbon tax is $350 billion; this is the maximum, by the way, because we’re choosing the $30/ton tax optimally. If we had made it $31/ton, then climate change damages would be only $440 billion but economic damages would rise to $111 billion, putting the net gain at only $349 billion. Going the other way, if we had only set the carbon tax at $29/ton, then climate damages would be $461 billion while economic damages would be $90 billion, for a net gain of the carbon tax of $349 billion. So the optimal carbon tax of $30/ton–which is the “social cost of carbon”–maximizes the net benefits of a carbon tax, which makes sense.
(C) Now re-do the analysis, but this time suppose there was an income tax. We all know income taxes are distortionary. Suppose this income tax (considered by itself, without a carbon tax) caused $1 trillion in deadweight loss on the economy. We also know that if you increase the income tax rate, then the deadweight loss increases more than proportionally. So, if you are going to implement this identical income tax code, not starting from scratch, but on top of a carbon tax of $30/ton–which itself is already causing $100 billion in harm to the economy–then the marginal deadweight loss of the income tax code is $1.2 trillion, rather than the $1 trillion if there is no carbon tax. Thus, the “tax interaction effect” here is $200 billion. This is in addition to the $100 billion harm to the economy coming directly from the carbon tax. The tax interaction effect’s $200 billion harm is an indirect effect of the carbon tax, because it makes the deadweight loss from the income tax that much higher.
(D) With the above numbers, it’s still better to impose a carbon tax at $30/ton than to do nothing at all. Note that we are still returning the receipts of the carbon tax back to citizens in lump-sum checks. By imposing that tax, you reduce climate damages by $450 billion, while the economy suffers damages of $100 billion (direct hit) plus $200 billion (tax interaction effect), for a total hit to the economy of $300 billion. But $450 bn – $300 bn = $150 billion, which is the net gain of doing the original $30/ton carbon tax.
(E) Ah, but the $30/ton carbon tax is no longer optimal. On the margin, the carbon tax is causing more damage in the presence of the income tax, than it would in a textbook scenario with no other taxes. So if we reduce the carbon tax down to, say, $15/ton, we now achieve the optimum of a (say) $220 billion gain in welfare, from imposing the tax. This of course is lower than the $350 billion gain we achieved in (B). This makes sense too; since we have to worry about the carbon tax exacerbating the deadweight loss of the income tax, it is no longer as useful a tool, so the total social gains we can derive from it are lower than in a scenario with no tax interaction effect.
(F) Ah wait, we can actually do something better. We can use the receipts from the new carbon tax to reduce the income tax rates. In the absence of the carbon tax, reducing the rates of the income tax obviously reduce its deadweight loss; this is the “revenue recycling effect.” So now, in addition to its beneficial effects in terms of reducing emissions and hence climate change damage, the carbon tax has two other effects that cut in opposite directions: The tax interaction effect makes the income tax worse, pushing us to levy the carbon tax at less than the social cost of carbon. But the revenue recycling effect makes the income tax better, pushing us to levy the carbon tax at more than the social cost of carbon. Which effect dominates? This is an empirical question, but the intuition on this particular point (as to whether TIE <> revenue recycling) is that a carbon tax has a base smaller than a typical income tax, and so on that score you would think intuitively that raising $1 billion from a carbon tax is more harmful to the conventional economy than raising $1 billion from an income tax.
(G) In light of all the above, it is probably the case that (given our other numbers) the new carbon tax, if levied on top of the pre-existing income tax but with all carbon tax receipts being used to reduce income tax rates, will have an “optimal” rate lower than $30/ton but higher than $15/ton. Note that such a number is also higher than $0/ton. Thus, even after you’ve absorbed the standard tax interaction effect analysis: It is still true that a negative environmental externality can be fixed with a Pigovian tax, and it is still true that using carbon tax receipts to reduce other income tax rates (rather than increasing government spending, or even returning receipts back, lump sum) is “good for the economy.” However, it is NOT true that the presence of a distortionary income tax bolsters the “case for a carbon tax,” and it is really really not true that if you disregard environmental benefits, you can still get a “pro-growth” tax reform by implementing a carbon tax and reducing income taxes accordingly.
This week I’m going to talk in-depth about this with Tom Woods–and you really should be listening to all of his shows, they’re great–but let me give just a quick taste.
For people who have been following the blogosphere wonk econ debate since 2008, I think you will agree that the following is an accurate summary of part of the exchange:
KRUGMAN, DELONG, et al.: Sure the Fed’s asset purchases are a move in the right direction, but it’s not enough.
SCHIFF, MURPHY, et al.: This is insane. This is the same thing that caused the current crisis. Get ready for big price inflation. The dollar itself is at risk.
KRUGMAN, DELONG et al.: You guys are nutjobs. Deflation is the threat, not inflation. Japan here we come.
SCHIFF, MURPHY, et al.: Prices are indeed rising, just not at the grocery store (yet, and as much as we have been warning). Look at asset prices, there is a huge bubble in Treasuries and the dollar. This is setting the economy up for a huge fall, just like Greenspan did with the housing bubble.
KRUGMAN, DELONG et al.: Way to move the goalposts, liars. Monetary policy can’t be too loose, because otherwise we’d see rising consumer prices. We would actually be seeing core deflation right now, except for the fact that empirically we are not seeing it–just as our models predicted.
Long-time readers of this blog know exactly what I am talking about. Clearly when Austrians and other hard-money types argued that Bernanke was going to cause a bubble with his loose monetary policy, Krugman et al. came back and said no, this was crazy, because core CPI was modest.
Well, in that context, here’s the latest from Krugman regarding Larry Summers’ talk at the IMF meetings:
How do you know that monetary policy is too loose? The textbook answer is that excessively expansionary monetary policy shows up in rising inflation; stable inflation means money is neither too loose nor too tight. This answer has, however, come under challenge from both sides. One side — the side I’m on…says that at low inflation rates this rule breaks down: the Phillips curve isn’t vertical, even in the long run, at low inflation (perhaps thanks to downward nominal wage rigidity), so stable inflation at a low level is consistent with an economy operating well below potential.
But there’s a critique from the other side…namely, the notion that if asset prices are rising, and that this might signal a bubble, it’s time to tighten, even if inflation is low or falling.
As Simon Wren-Lewis points out, the Swedish Riksbank has gone all in on this doctrine…
The Riksbank raised rates sharply even though inflation was below target and falling, and has only partially reversed the move even though the country is now flirting with Japanese-style deflation. Why? Because it fears a housing bubble.
This kind of fits the H.L. Mencken definition of Puritanism: “The haunting fear that someone, somewhere, may be happy.” But here’s the thing: if we really are in the Summers/Krugman/Hansen world of secular stagnation, things like this are going to happen all the time. The underlying deficiency of demand will call for pedal-to-the-medal monetary policy as a norm. But bubbles will happen — and central bankers, always looking for reasons to snatch away punch bowls, will use them as excuses to tighten. [Bold added.]
I’m being dead serious: Hasn’t Krugman just confirmed what the Austrians and other “goldbugs” have been saying for the last five years? We now all agree that if we continue to use “textbook” monetary policy to fight recessions, we will simply give the US a string of never-ending bubbles.
The only disagreement we now have, is the best way to get out of this cycle. Krugman and Summers think it’s a combination of raising the average (price) inflation rate, boosting government spending, and lowering the national savings rate, whereas Austrians and other hard-money types think it involves smaller government and in particular a return of money and banking back to the private sector.
But make no mistake: Krugman’s admission above is a humongous concession, even though he doesn’t realize it. This is even more monumental than when he accidentally threw in the towel on the “potential GDP” discussion. I wonder if Christina Romer will pull him aside on this “secular stagnation” stuff too?
Krugman’s IT Expertise Is Now Non-Zero, and Cancer Patients With Canceled Policies Need to Stop Whining
OK, I just created an Obamacare account for myself…I went all the way through the process at healthcare.gov, stopping before the final step of actually applying…And the answer is that it was no problem at all, with no delays.
…[T]he visible parts of the process bear no resemblance to the horror stories of a few weeks ago.
Why did I carry out this little exercise? Well, I scanned the comments on today’s column and noticed a lot of people reporting having successfully enrolled in Obamacare — not at one of the well-functioning state exchanges, but at the supposedly disastrous healthcare.gov. Just anecdotes, I know — but anecdotes suggesting that the system is no longer the black hole of yore.
In short, it’s looking increasingly likely that the story from here on is going to be one of steadily better news — of growing enrollment in the federal as well as state exchanges, of people discovering either that their insurance has gotten better and cheaper or that they can afford insurance for the first time. [Bold added.]
Glad we got that settled. Oh, and he also shows the true Conscience of a Liberal when he adds: “Bit by bit these stories will percolate into the news media, replacing the sob stories about cancelled policies.”
Look, I have not personally hired Magnum, P.I. to investigate all of these “sob stories,” but at least one of them involves a man suffering from cancer, who allegedly had insurance covering his treatment, then lost it under ObamaCare, and now can’t afford to get new insurance, so he’s going to “let nature take its course.” If this story is true–or if there exists one such person in all of America–then we can quite legitimately say that ObamaCare killed such people.
Note, there are progressives “debunking” such anecdotes–which is remarkable in and of itself. Can you imagine having to run around, explaining why people dying from cancer are a bunch of shysters? (Also note, the people at Fox News etc. are using this people for politics too, duh.)
I truly have had my eyes opened by this debacle. I knew communists used to endorse the slogan, “You can’t make an omelet without breaking some eggs,” but it’s good to see Yglesias, Krugman, and other “progressives” saying the modern equivalent in reference to actual Americans losing their health insurance because of their pet program.
Hey let me add my two cents–everyone else is.
A year or two ago I actually spent about a week really diving into this issue. I wanted to see if I thought a reasonable person could adequately assess the evidence without becoming a “buff.” I decided at the end of this inquiry–in which I focused on the work of Josiah Thompson but also relied on Gerald Posner to make sure I wasn’t missing any obvious problems–that I personally could state, with a high degree of confidence, that the official Warren Report was clearly nonsense.
Note: My tentative conclusion was based on the logistical and forensic evidence. I wasn’t speculating as to who really did orchestrate the assassination, I was merely saying that I was quite confident it couldn’t have been a lone shooter from the book depository.
Naturally, given that that was my conclusion, and that the US government was clearly trying to suppress the truth, plus the other evidence seeming to suggest that the Secret Service deliberately left Kennedy vulnerable, my hunch was that it was indeed an “inside job.” But I hadn’t done enough research to say that extension with confidence. What I was confident about saying, was that there was more than one shooter. (At some point, I will write all this up more carefully so you can see how I reached that conclusion.)
Within the last year or so, I stumbled across the only alternate, non-”conspiracy” explanation that makes any sense to me: I read someone who claimed that it really was Oswald acting alone, but that in the panic a Secret Service guy jumped up on the back of the presidential car, and when he was pulling his gun he accidentally shot Kennedy. Naturally, after the fact the government didn’t want this horribly awkward fact being made public, and hence the “cover up.”
Note, I’m not endorsing this theory, but it’s theoretically possible, in light of my earlier study. But people who say, “Nah, all the bullets came from Oswald’s gun,” I think are demonstrably wrong.
This offhand remark by Krugman is really amazing:
Terrific piece in the WaPo on how Kentucky’s rural poor are being helped by Kynect, the state’s version of Obamacare, which has had a picture-perfect rollout.
This is why we need health reform.
To my misfortune, I accidentally read some of the comments, which which full of scorn verging on hatred for the “moochers” getting access to decent medical care for the first time. What can you say? I assume that these people root for President Snow against Katniss, too.
In case you don’t get it, he’s referring to the latest Hunger Games movie, which is simply phenomenal, by the way. (But, you need to have watched the first movie to appreciate it.)
Krugman’s attitude reminds me of a time when I was a professor at Hillsdale College and we had a “CCA” (Center for Constructive Alternatives) week devoted to “War on Film.” At some point, Michael Medved–who was one of the prominent visitors to the college for this event–said that the great thing about Star Wars was that it didn’t involve feelings of guilt or moral ambiguity; it was a simple story of heroic rebels fighting against an Evil Empire. I can’t remember his exact words, but he was contrasting this sort of feel-good illustration of what America stood for, as opposed to movies like Platoon that made us question whether we were really the good guys in the world.
(I was able to find thetext of Medved’s main speech. Unfortunately if you look at this, you’ll think I’m getting mixed up, because the only reference to Star Wars I can see is Oliver Stone making the opposite point. But I assure you, Medved at some point said words to the effect of what I described above, perhaps in a panel Q&A.)
At the end of the week, the faculty from Hillsdale who were assigned to that particular CCA gave summary talks, and that included me. I think I pulled it off in a way that was not too “shocking” given the context, but I had a train of thought where I mentioned that the US government almost spent as much on its military as the rest of planet Earth combined (right now it’s “only” 39% but it was higher back then), that it had military bases in x countries and occupation troops in y countries, that it had a vast intelligence network with which it was hunting down a ragtag group hiding from its obviously superior firepower, and concluded with, “So look, the analogy’s not great either way, but if you’re going to invoke Star Wars, then George W. Bush is the Emperor and Dick Cheney is Darth Vader.”
Anyway, my point with Krugman and with Medved isn’t to say that their policy prescriptions (Krugman regarding domestic health insurance, Medved regarding foreign policy) are good or bad. My modest point here is that it is simply inadmissible to point to popular movies where a plucky hero(ine) is standing up to an oppressive State, and to identify the US federal government in our day and age with the plucky hero(ine). That just doesn’t make any sense.
Last thing: I worked at Hillsdale for three years, and I still have colleagues there, so if you have negative opinions about their views on foreign policy please remain civil.
David R. Henderson has an interesting post on the problems with using GDP as a criterion of economic goodness. Now let me be clear (as Obama would say): I fully agree with the general theme of his post, especially the examples of cheap or even free things offered on the Internet and hence not showing up in conventional GDP measures.
However, I think there is a slight problem in the specific example David uses to motivate the discussion:
Picture this: The U.S. government finally sells the Postal Service. As with other functions moved from the government to the private sector, the privatized post office does what the government did for about half the cost. So, with prices correspondingly lower, people spend roughly half as much as before on mail–which frees them to spend the difference on other desirable things. Because the Postal Service costs over $40 billion a year, the saving is $20 billion. By any reasonable measure, the average person in the U.S. is better off. In fact, the per capita increase in well-being is approximately $20 billion divided by 260 million citizens, or about $80 apiece.
But how does this change show up in gross domestic product? It doesn’t. The government’s contribution to GDP is measured not by how much value it creates but by how much it costs. So the $40 billion spent by the Postal Service counted as a $40 billion contribution to GDP. Cutting that in half through privatization may shift $20 billion from public to private hands but still adds up–under the conventions of national income accounting–to the same $40 billion. So the net effect on GDP of a $20 billion increase in economic well-being is precisely $0.00.
I don’t think that’s the whole story. Someone who wanted to defend the orthodox approach would say:
This critique conflates nominal with real GDP. When the BEA announces growth estimates, it refers to real GDP; that’s what we’re trying to promote.
Suppose an economy initially has total expenditures on final goods and services of $1 trillion, and the CPI is 100. Then a bunch of the firms have eureka moments and figure out how to massively cut their prices, without reducing their output. Their customers then (we suppose) take the savings and increase their spending elsewhere, so that total expenditures is still exactly $1 trillion. But the CPI has fallen by 50%, meaning real GDP has doubled.
Again, I’m not saying that GDP is a great way to gauge economic output, especially since government expenditures are counted as “output” on equal footing with private investment. All I’m saying is that one of David’s particular examples might overstate how bad a criterion it is.
On that great intellectual forum known as Facebook, there is an argument over methodological individualism. (I’m not naming names since, what happens on Facebook…) Someone argued that if the standard Austrian position is that it doesn’t make sense to say, “The US government bombed Germany,” then such a person can’t stop the reduction at the individual. Why not push it to the neurons inside the individual’s nervous system?
To that, my neurons replied:
It’s not that I’m saying…that an action has to be performed by a heart, lungs, brain, and skin, but that it makes no sense to say it can be performed by “US Govermernt” or “a neuron.” Rather, I’m saying an action is performed by an individual agent who has goals and reason. I’m not mapping an action to a certain collection of body parts, I’m linking it to an actor. And neither the US government nor a neuron is an actor, given the rest of our knowledge.
I have made this point before, and been denounced by atheists and theists alike: This really is the best possible world. Yes, “free will” is involved in understanding why, but when the atheist critic says, “If your God is so good, why does He allow suffering?” it is correct to say, “Because it’s better that there is suffering.”
No, I don’t know exactly how that “works,” but that’s what the answer has to be, in my mind, or else you really can’t say that God is good and omnipotent. The atheist has a compelling point, and I think Pangloss has the appropriate answer.
My pastor at church today said as much (though I don’t know if he’d endorse the way I phrased it above) when he said something like (I’m paraphrasing slightly):
“It’s not that God made creation, it was good, then there was the Fall, and He had to turn to Plan B. No, He’s God, He never lost control for a moment. God made all of creation, and that was good and illustrated His glory, but only through the Fall, Redemption of Christ, and the coming re-creation when Christ returns, will God fully demonstrate His glory. The re-creation will be more glorious than the initial creation.”
Then he went on to say (I really like this guy, by the way) that he doesn’t understand how that can be, and it doesn’t make sense, but: “It’s the truth.”