Tuesday, April 24, 2007

Taxing Traffic

In a bold speech delivered on Earth Day, New York City Mayor Michael Bloomberg proposed broad changes to improve the environment in the city. A centerpiece of this proposal, sure to be controversial, is an attempt to deal with traffic problems by imposing congestion charges on drivers who enter Manhattan. By charging motorists, the mayor aims to reduce pollution and relieve driving difficulties in the city. The plan would result in payments of up to $8 per day for drivers ($21 for trucks) who enter the busiest sections of the city—what the report calls the “Manhattan Central Business District.” The revenues generated by the fees would be used to fund transportation programs throughout the city, including road improvements, expansion of public transit, promotion of cycling, and increased enforcement of traffic laws.

While Bloomberg’s proposal is innovative, New York is not the first city to consider such fees. Congestion charges have been in place since 2003 in London; and Stockholm, Singapore, and Toronto (among others) employ similar types of fees. The results in London have been fairly dramatic: the number of automobiles in the city decreased by more than 30%, traffic delays declined by 20%–30%, and average road speeds increased by nearly 20%. Opponents of the London plan—and there were many—argued that it would “strangle retailers,” but the feared drop in sales has not materialized.

City traffic imposes dual externalities on residents and commuters—there is the pollution produced by the vehicles in the area, but there is also the effect of traffic itself on drivers. Each driver represents only a small proportion of the actual traffic, but when all of the drivers are added in, the impact can be dramatic, slowing commute times substantially. Congestion charges represent a direct application of what is referred to as a corrective tax—forcing drivers to internalize the external costs that they impose on other drivers. For example, if the average commuter’s opportunity cost is $16 per hour, and the presence of an additional motorist increases the driving time of all other drivers by a total of 30 minutes each day, then the proposed charge of $8 per day could be interpreted as an appropriate tax.

Discussion Questions

1. How would drivers who pay the fees benefit from this program?

2. Beyond the expected benefits of reduced pollution and traffic congestion resulting from the congestion charges, are there other effects that could result from the imposition of these fees?

3. How would the benefits and costs of such a program be distributed?

Harold Elder is a professor of economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's master's and Ph.D. programs.

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Friday, April 20, 2007

Harvey's Milk

On June 9, new rules governing organic dairy farming will take effect. The Harvey rule—so named for the Maine blueberry farmer whose lawsuit prompted the change—will increase the cost of converting a conventional dairy operation to an organic one. Under the old rules, obtaining the organic designation required nine months of feeding cows a blend of 80% organic and 20% conventional feed, followed by three months of 100% organic feed. The Harvey rule requires farmers to feed cows 100% organic feed for the entire conversion year. In essence, the new rule makes the conversion process "more" organic.

The expectation of a more expensive transition, combined with relatively high organic-milk prices, caused many farmers to "go organic" under the old rules last spring in order to avoid the Harvey rules. As a result, the supply of organic milk should increase this spring as more organic farms enter the market. Read Andrew Martin's article in the New York Times to learn more about the Harvey rule's impact on the market for organic dairy.

Discussion Questions

1. Even with surging organic-milk supply, the article argues that
…consumers probably will not see lower prices. Several manufacturers and retailers said they did not plan to reduce prices, in part because the oversupply would be quickly absorbed by increasing demand.
The graph above illustrates the scenario where rising demand for organic milk neutralizes the price effect of an increase in supply. Do you think this is a likely scenario? In the absence of sufficiently strong demand, do you think organic dairy manufacturers and retailers have the market power to keep prices from falling?

2. How will the increase in the supply of organic milk affect the market for products like organic yogurt and cheese, for which organic milk is an input? As more and more dairy farmers go organic, how will the reduction in the number of conventional dairy farmers affect the price of conventional milk?

3. According to the article:
The challenge of making a dairy farm organic is that the farmer’s costs rise during the conversion year, but they are not yet offset by the higher income from selling organic milk. The high cost of feed corn is a big factor; corn farmers see few incentives to go organic because they can make so much money selling their crops to make ethanol.
How will the rising number of organic dairy farmers and the imposition of the Harvey rule affect the incentives faced by corn farmers when deciding whether to go organic? Conversely, how might further growth in the ethanol industry affect incentives for dairy farmers to go organic?

4. Governments often announce new legislation well before it takes effect—sometimes with unintended consequences. For example, the federal government might announce that it intends to impose land-development restrictions in areas inhabited by endangered species. Developers will face an incentive to initiate development before the costly rules take effect—potentially ruining the habitats the legislation was intended to save. Did the sizable lag between the Harvey rule's announcement and its imposition in any way compromise its intent?

Click here for another Aplia perspective on organic foods and resource allocation.

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Monday, April 16, 2007

Inflation, Taxes, and Saving

What's so bad about inflation? Economists typically break the discussion of inflation costs into two categories: the costs of low, predictable inflation and the costs of high, unpredictable inflation.

Economies with high, unpredictable inflation tend to experience slower growth rates. With unpredictable inflation, borrowers and lenders cannot be sure what the real interest rate will turn out to be over the course of a loan. This uncertainty makes people less likely to lend their money (for example, by buying bonds), which in turn leads to less investment and a slower rate of long-term economic growth.

If the inflation rate is low and stable, it imposes fewer economic costs. As prices rise, one dollar will purchase fewer and fewer goods and services over time. This slow erosion of purchasing power encourages people to invest their savings in interest-bearing accounts, keep more of their money in the bank and less in currency, and generally spend more time managing their assets than they would in the absence of inflation; but savings rates are pretty much unaffected… right?

Not quite. Even if inflation is relatively tame, it can still have some major consequences on savings rates because of the way investment gains are taxed. In a recent Slate column, Henry Blodget argues that the design of the tax system in the United States discourages saving—in part because portions of the tax code do not attempt to correct for distortions caused by inflation. Read Blodget's article to find out more about the tax treatment of savings and the tax distortions from inflation.

Discussion Questions

1. According to Blodget, what non–tax-related factors explain the negative U.S. personal savings rate in 2005 and 2006?

2. Suppose you purchase a $1,000 T-bill that offers a 4% nominal rate of return. The inflation rate is 3% per year and you're in the 15% tax bracket.
  • What is the before-tax nominal return on your T-bill in the first year?
  • As Blodget notes, the U.S. government treats the return on your T-bill as income and assesses a 15% tax on the nominal return from your T-bill. How much tax would you pay on your nominal return from the T-bill?
  • By how much does inflation erode the purchasing power of your nominal return?
  • What is the after-tax, inflation-adjusted return on your T-bill in the first year?
3. What are the differences between taxes on gains from stocks and taxes on gains from holding T-bills? Suppose you purchase a share of stock that immediately doubles in value. What tax event will you trigger in the event that you sell the share of stock at its new, higher price?

4. How does low, predictable inflation distort savings decisions when the government taxes the nominal gains on savings vehicles such as stocks and bonds?

5. What are Blodget's suggestions for making the tax system less hostile to saving? How does he suggest taxing the capital gains from the sale of stocks? How would he treat the interest earned on T-bills? Can you think of other changes to the tax system that would encourage rather than discourage saving?

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Saturday, April 14, 2007

Subprime Primer

Subprime mortgage lenders make home loans to "subprime" borrowers—people who don't have the income, wealth, or credit history to qualify for the traditional lending terms offered to prime borrowers. The recent housing slump pushed multiple subprime lenders into bankruptcy as a rising number of subprime borrowers failed to make their mortgage payments. As subprime lenders go belly-up and subprime borrowers fall on hard times, lawmakers have been quick to find signs of fraud and abuse, and quicker to propose new regulations for the subprime market. Events in the subprime market offer a glimpse of several issues behind the housing market correction in the United States. A recent New Yorker column by James Surowiecki explains the subprime fiasco.

Surowiecki suggests that focusing solely on "predatory lending" practices does not suffice to explain the trouble in subprime markets. He notes that lawmakers cannot consider instances of lender fraud and abuse without also considering the "overambition and overconfidence of borrowers." For example, borrowers who expected sharp increases in home prices used the easy credit offered by subprime lenders to make speculative purchases—buying a home with the intention of selling quickly and for a substantial profit. Other borrowers were enticed by low introductory interest rates and placed too much confidence in the ability of their future selves to pay the mortgage when the low rates expired and higher, adjustable interest rates kicked in.

University of Chicago economist Austan Goolsbee calls for restraint in the regulatory backlash against subprime lending in his New York Times column. Goolsbee focuses on a research paper by three economists: Kristopher Gerardi and Paul Willen from the Federal Reserve Bank of Boston and Harvey Rosen of Princeton. The paper suggests that innovations in the market for home loans, including subprime lending, offer more upside than down. According to the authors, a government crackdown on subprime lending could reduce homeownership opportunities among young people, minorities, and people without a lot of money for a down payment.

Discussion Questions

1. What's a "liar" loan? How did borrowers use such loans to make speculative gambles in the housing market?

2. What's a 2/28 loan? In what ways do consumers tend to "overvalue present gains at the expense of future costs," as Surowiecki suggests? (Think about decisions on whether to consume today or save for the future, or whether to study for an exam or attend a party.)

3. According to Surowiecki, what percentage of subprime borrowers were living in their homes and making monthly mortgage payments at the time the article was written? What does this suggest about the wisdom of an outright ban on "exotic" subprime lending products like the 2/28's?

4. In what way do subprime loans (such as 2/28's) benefit currently low-income households that expect to earn much higher income in the future? How do subprime rates reflect the fact that the expectation of higher future income is not a guarantee of higher future income?

5. What factors traditionally cause homeowners to foreclose? Do recent numbers suggest that subprime lending is the leading cause of foreclosures in the United States?

6. According to Goolsbee, what is the link between the expansion of subprime lending and the growth of homeownership among African-American and Hispanic households?

7. According to both Goolsbee and Surowiecki, the vast majority of subprime borrowers are making their mortgage payments on time. As higher, adjustable rates kick in on home loans with low introductory rates, how might the rates of delinquency (missed payments) and default (failure to pay the loan entirely) change? Suppose the housing market correction continues and home prices continue to fall. How will this affect the bets of speculative borrowers in the subprime market?

8. How would a continued housing slump affect economy-wide consumption and investment expenditures? (Recall that part of investment is residential investment—purchases of new homes and apartment buildings.)

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