Pigovian Prices

by Levi Russell

An interesting exchange occurred last month between two economists/bloggers. Stephen Gordon, an economics professor at Université Laval in Canada, wrote a column on the concept of a carbon tax price. In it, he argues:

As the Conservatives should really know by now, market-based approaches to reducing GHG emissions are more efficient than regulations. It’s better to let households and firms make their own priorities in response to price signals instead of having them imposed by the government. And the extra upside of market-based approaches like carbon taxes or cap-and-trade is that some of the costs of the policy are transformed into government revenues that can be used to compensate vulnerable groups or even to reduce other taxes.

So it seems that Professor Gordon equates a price with a tax. Hoover Institution economist David Henderson responded, taking Gordon to task for his apparent confusion of a price with a tax.

But carbon already has a price, or, more exactly, multiple prices. Natural gas has a price; oil has a price; coal has a price. And their prices are related to the valuable carbon component of those fuels because it’s carbon that makes those fuels valuable. Just as there’s no such thing as a free lunch, carbon is not free.

So why does Professor Gordon claim that taxing carbon means “putting a price on carbon?”

I can only speculate because I don’t know him, but here’s what I’m willing to bet dollars to doughnuts on: he calls a tax a price in order to lull the reader into thinking that it’s not a tax. Later in the piece he admits that it’s a tax but in his first mention, which sets the stage, he doesn’t.

Gordon later responded:

A market price is what a consumer has to pay in order to purchase a good or service. In contrast, a tax is, er, what a consumer has to pay in order to purchase a good or service.

This is one of those cases of a distinction without a difference. Unless you’re the sort of person who reads the fine print on the pumps at the gas station, you probably don’t know what the market price of gasoline is, and even if you do, you probably don’t care — at least as far as it affects how much gasoline you buy. What really matters is the total you have to pay. So when the focus is on how carbon taxes work to reduce greenhouse gas emissions — as mine was — then there’s not much point in using up column space to make the price-tax distinction. (Although if you want to play this game, think of a carbon tax as the price governments charge for degrading a communally owned resource.)

It's interesting to note here that neither Henderson nor Gordon are getting at the fundamental difference between prices and taxes. Prices, to one degree or another, transmit information about the relative scarcity of resources. If the price of a good rises, consumers of the good are incentivized to use it more frugally while producers are incentivized to produce more of it. It doesn't really matter whether the initial cause of the price rise was a reduction in supply or an increase in demand; what matters is the incentive the price change has on behavior.

One might be tempted to argue that a tax can be used to correct market prices when they don't reflect all relevant information. Indeed, this is the Pigovian paradigm that has existed in the profession for nearly 100 years. However, there have been significant challenges to this paradigm that are, in my mind, not fully appreciated. Though Henderson doesn't make this point in his final response to Gordon, I think it gets to the heart of the matter. Perhaps a tax on carbon is a sensible policy, but to simply assume that governments can get that price right ignores the reality that information and incentive problems present in markets are not absent from governments.

The Academic Literature on State Tax Cuts

by Levi Russell

State fiscal policy continues to be a popular issue. Some are criticizing right-leaning state governments for lowering taxes with the intention of boosting growth. These commentators point out that growth in these states has not skyrocketed. Others are criticizing left-leaning states for funding issues with their public pensions and financial problems associated with Affordable Care Act co-ops. These other commentators point out that these financial issues are not easy to solve and that a more conservative spending approach is probably warranted.

So, being an economist, I thought I'd look at the academic literature on the effects of state-level taxation on economic growth. I pulled the 5 most recent articles I could find on the subject from Google Scholar and looked at the results. Of the 5 articles (of which one examined Canadian provinces) I read, 4 showed a negative effect of state taxation on growth. One showed no effect on own-state growth, and a positive effect from other states' tax increases. I may have missed some other important analysis on this subject, but it seems to me that we can (at least provisionally) conclude that 1) it's not likely that lower taxes are harming growth at the state level and that 2) it's probably a good idea to find ways to fix over-spending rather than increase taxes.

Here are the articles I read. If I missed an important, recent paper, please link to it in the comments below!

Another look at tax policy and state economic growth: The long-run and short-run of it, Economics Letters, 2015, Bebonchu Atems (one of my former graduate school colleagues)

The Determinants of U.S. State Economic Growth: A Less Extreme Bounds Analysis, Economic Inquiry, 2008, W. Robert Reed

The Impact of Tax Cuts on Economic Growth: Evidence from the Canadian Provinces, National Tax Journal, 2012, Ergete Ferede and Bev Dahlby

Redistribution at the State and Local Level: Consequences for Economic Growth, Public Finance Review, 2010, Howard Chernick

The Robust Relationship between Taxes and U.S. State Income Growth, National Tax Journal, 2008, W. Robert Reed

More Mercatus Center Research on State Tax Reform

by Levi Russell

In a previous post I shared a comparison of the results of tax reform in Utah and Kansas. That comparison was part of a broader analysis of reform efforts in 5 states: Kansas, Michigan, North Carolina, Rhode Island, and Utah. The report provides a detailed analysis of reform efforts and draws some general conclusions about how reform should be implemented.

The  authors generally report good news for the states in terms of government fiscal health. Kansas is an exception. Here's one of the "common trends" identified in the report:

The most effective tax reforms seem to be those that both lower the rates of taxation and simultaneously broaden the scope of activities that are taxed. Such reforms improve the efficiency, convenience, and transparency of a tax system.

 This is the opposite of what Kansas has done. Unlike North Carolina, Kansas politicians failed to couple the tax reform effort with orderly spending cuts. Further, as the report notes, Kansas narrowed its tax base in a distortionary way:

Kansas also made the decision to exempt “pass-through” profits from corporate taxation; that is, business income that is taxed on individual business owners’ tax returns. While this lowers the tax burden on businesses, it creates distortions in the way business owners choose to classify their operations. Moreover, it is inequitable because it disproportionately benefits high earners and creates an unfair playing field among businesses.

There has certainly been a lot of media coverage of Kansas' state government budget information. Another Mercatus paper compares state government fiscal situation data from all 50 states and Puerto Rico in 2014. Kansas is 27th of the 51 states/territories examined. This doesn't sound consistent with the dominant narrative in the media.

How has the reform effort affected the private economies in these states? Below is a graph of private GDP indices for the five states listed above, the US as a whole, and two other states that are, to put it mildly, in big trouble fiscally: California and Illinois. It's tough to draw any general conclusions. Michigan, Utah and California are all doing quite well relative to the US as a whole. Michigan and Utah have had significant tax and spending reductions; California hasn't. Illinois, Kansas, North Carolina, and Rhode Island are all lagging relative to the US as a whole. Kansas and Illinois had pretty flat growth from 2012 to early 2014, but have picked up recently. Kansas in particular seems to be catching up to the US as a whole. North Carolina has been catching up at a feverish pace.


Quantity Index for Real Private State GDP - BEA

click image to enlarge

Yet another Mercatus paper provides a short review of the literature on the relationship between state tax policy and the economic health of the state. Here's the relevant paragraph:

Research finds that higher state taxes are generally associated with lower economic performance. There is somewhat weaker evidence that state and local taxes can significantly reduce income growth within a state, particularly when the revenues raised are devoted to transfer payments. More recent research corroborates this finding in relation to net investment and employment. However, when additional tax revenue is used to improve the quality of public goods and services, economic growth may increase. When looking at business activity more broadly, more comprehensive reviews of the literature find higher taxes to be associated with less economic growth. They also find this relationship to be stronger within metropolitan areas than across metropolitan areas, which means that local taxes have a larger effect on economic growth when it is less costly for firms and taxpayers to relocate to avoid the tax.

A Case Study of State Tax Reform Efforts

by Levi Russell

Adam Millsap of the Mercatus Center has a new case study on state tax reform. I have not yet read the study, but his Forbes column has some good stuff in it. I reproduce the sections on Utah and Kansas below.

Success in Utah

Of the five states studied, Utah’s 2006 reform appears to have been the most successful. The income tax was simplified from six brackets to one and many deductions were eliminated, which made it less distortionary and easier to understand. The study also notes that Utah was able to improve the efficiency of its tax system without experiencing severe drops in revenue.

According to the study, Utah’s tax reform was successful because its supporters were able to identify key stakeholders and include them in the reform process. This ensured that any reform that reached the governor’s desk had broad support. The study also points out that Utah has had a relatively high level of economic freedom for many years. This is a sign that the institutions and cultural attitude required for comprehensive tax reform were in place.

Problems in Kansas

Contrary to Utah’s experience, Kansas’ 2012 tax reform was more problematic. While the number of tax brackets was reduced from three to two and several tax credits were eliminated in order to broaden the base, Kansas’ reform also created a major distortion by exempting some business income from taxation.

This reform has allowed some businesses to avoid income taxes altogether which encourages others to mimic that behavior in order to minimize their tax own tax burden. One such example is University of Kansas basketball coach Bill Self, who is primarily paid through his business entity that is exempt from state income taxes. The distortion in Kansas’ tax code incentivizes this behavior.

Another problem with Kansas’ tax reform is that the decline in tax revenue due to the reform was not matched by a similar decline in spending. This has resulted in budget deficits. In Utah and the other cases studied tax reform was accompanied by reductions in state spending, which is crucial for maintaining a balanced budget.

Taxes as Social Engineering

Cornell economist Robert Frank recently appeared on probably the best economics podcast on the web, EconTalk. Frank was there to discuss his recent book on the role of luck in successful folks' lives. The conversation was interesting and Frank certainly has a unique perspective. He makes some clever observations but I wasn't convinced of his conclusions. I encourage Farmer Hayek readers to listen to the podcast and check out the comments here and here for some good counterpoints to Frank's positions if you're interested.

Instead of taking Frank's comments head on, I want to discuss what seems like a background assumption he makes. Frank's overall point is that since luck (specifically good luck) plays an under-appreciated role in our success, we should favor higher taxes on the wealthy. This would provide additional funds to beleaguered governments which he asserts are low on funds for infrastructure. More importantly, though, it would ensure that the wealthy would spend less money on things that don't make "anybody any happier."

Frank provides almost nothing in terms of evidence of his claims other than his own personal experiences (see the comments linked above), but even assuming he's correct about the particular facts he lays out, there's a more fundamental problem. It might very well be that declining quality of public infrastructure has more to do with simple mismanagement of resources, rather than a lack of tax revenue. Hayek's work implies that government planners are less effective at directing resources than decentralized owners of "several property" because the former simply can't gather the necessary information to plan efficiently. (see here, page 85) Much of the information necessary for an orderly economy is tacit and ever-changing such that any amount of computing power is insufficient to create the sort of plan Frank seems to believe we need.

To be clear, it's not that markets are perfect, simply that they are more likely to be better than centralized decision makers at allocating scarce resources. The knowledge required to do so is dispersed and tacit, As Hayek puts it:

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.

I can't resist a couple of final points. Though Frank disputes it, it's pretty clear that taxes on the wealthy do affect their choice of location (here and here). Frank uses a Rawlsian ethic that is quite common in business ethics courses. However, it's not altogether obvious that Rawls' ideas can be used to justify the policies Frank favors.

How Progressive is the Tax Code?

The federal tax code has been a big topic of discussion this election cycle. A lot of this discussion has been driven by the increased focus on income inequality. Whatever your views on this subject, I think it's useful to look at the way the tax burden is distributed across income groups. In this post, I'll present data from the Congressional Budget Office (CBO), which you can download here.

The charts below were created using three data series: market income, transfers, and federal taxes. Each series runs from 1979 to 2011 (unfortunately, 2011 is the most recent year for which this data is available) and is broken down into quintiles by market income. The top 1% is also split out into its own category. Every data point is a household average for the group. The data set linked above breaks the top quintile into a few more groups if you're interested in that.