Moody's Negative Outlook on U.S. Local Government Debt

A few days ago, Moody's Investors Service announced that its outlook for the entire U.S. local government tax-backed and related ratings sector is negative. This is newsworthy not only for municipal bond investors but also for anyone following the U.S. recession. It marks the first time that Moody's issued an outlook on this entire sector, although it has issued ratings on the sector since 1914.

Moody's Investors Service is one of the leading issuers of credit ratings. Investors use these ratings to gauge the risks of investing in debt assets. So, one might conclude that the analysts at Moody's are remarkably pessimistic about the impact that recessionary economic conditions will have on the ability of local governments in the U.S. to meet their debt obligations. This means that the risk of defaults on these debts has risen.

However, Moody's hedged its announcement by mentioning that credit pressures will vary significantly across locales due to differences in economic conditions, property assessment methods, and authority to raise revenue. The varying economic conditions can largely be explained by localities' exposure to industries hit particularly hard by the recession. These include real estate development, auto manufacturing, financial services, tourism, gaming, and general manufacturing. Differences in property tax systems will play a major role. Moody's report shows evidence that about 72% of local government tax revenue comes from property taxes. The bursting of the housing market bubble will bring declines in property tax revenue for most local governments because of falling home values.

Several of these governments might have the authority to increase property, sales, or income tax rates to raise revenue. Whether the elected officials running these localities are willing to do this is an open question. Moody's points out that taxpayers are worried about their own financial conditions and are highly resistant to increases in local taxes. Raising taxes in this environment will be unusually difficult for locally elected officials.

Cutting spending during the economic crisis will not be an attractive option either. In part, this is because many of these governments may face service mandates that prevent them from reducing service-related expenditures. An example of a service mandate is that a state government may mandate that local governments provide health services for the poor. Moody's analysts also reported that the demand for improved government services will make it that much more difficult for these governments to sustain healthy finances. Local officials may find that it is more palatable to default on their bonds rather than raise taxes or cut spending.

The credit crunch is also having a direct impact on local government finance. Moody's report states that access to credit will be more expensive for these governments than it had been in recent years. Moody's negative outlook announcement surely caused investors to demand greater yields on the municipal bonds trading in the credit markets. The company also warned that some localities are in such dire straits that they may be completely shut out of the credit markets.

Yet, the situation ought to be tenable for numerous governments. For instance, some well-managed localities increased their reserves during the boom years and were prudent with the funds generated during the real estate bubble. A simple example from portfolio theory can help show why investors may still be willing to buy the bonds of a cross-section of municipalities.

Suppose that a bond investor purchases three one-year bonds with different expected returns and probabilities of default. For simplicity, we'll assume that the investor is risk-neutral and the bonds pay nothing in the event of default. Bond A has a 25% probability of default this year but pays a coupon of 15% if it avoids default. Bond B has a 50% probability of default this year but pays a coupon of 20% if it avoids default. Bond C has a 75% probability of default this year but pays a coupon of 30% if it avoids default. Let's also assume that all the bonds have a face value of $100 each.

What is the investor's expected payoff from investing in this portfolio? It is


(0.75 × $115) + (0.5 × $120) + (0.25 × $130) =

$86.25 + $60 + $32.50 = $178.75


So, on average, an investor would be willing to pay less than 60% of face value on these bonds to make a positive expected return.

This example was purposefully simple, but from it you can see the advantage of diversification and the problem of gauging risk. If the probabilities of default end up being higher than estimated, the investor might lose money but will only lose all his money in the rare case that all bond issuers default. Yet, if the probabilities of default are lower than estimated, the investor might earn a high rate of return.

Discussion Questions

1. How does the bond portfolio example relate to the impact that mortgage-backed securities had on financial institutions? What must have happened to their default rates for them to become known as "toxic assets"?

2. If you had a large sum of money that you had to use for investment purposes, would you put together a portfolio of U.S. local government debt? If yes, why? If not, explain what your preferred investment would be.

3. Besides an economic recovery, what changes, if any, do you think are needed for local governments to avoid defaults in the future? How feasible are your proposed changes?

On Income Caps and the Market System

Yesterday morning on a local radio station, a few callers discussed a silly idea. The question posed to listeners was this: "Should there be a law against anyone earning over $1 million per year?" One caller talked about the celebrity Kim Kardashian, and how it is not right that she earns so much money. That is absurd. The market is rewarding Kim because of her looks, her connections, and because in recent years her public persona has been well-managed. If companies want to pay her ridiculous amounts of money for her various "talents" because people enjoy being entertained by her, then so be it. It might not be fair, but neither is life. On the bright side, we have a progressive income tax system that will tax such extravagant incomes at higher rates than the rates faced by ordinary Americans. A much better idea would be to raise marginal income tax rates on the highest tax brackets to help limit our budget deficits and get a fair amount of tax revenue from those whom our market system has allowed to earn enormous amounts of income in our nation.

Yet, how could economists ridicule a ban on excessive income when they support President Obama's limits on executive pay for firms that seek government assistance? The reason is that such firms were mismanaged, and as a result, they got pummeled by the market, forcing them to sheepishly seek government bailout funds. In this situation, executive salary caps are a brilliant proposal. If the firms do not like the caps, they could try getting bailed out by the market, but they will find that the market will most likely not come to their rescue. The market system will allow the firms to go bankrupt because of their poor performance. That is what the market system does to firms that perform poorly. Obama's limit is set at "only" $500,000 per year and lasts until the bailout funds are fully repaid by the firm.



The argument against the salary caps proposed by Obama is that these firms will lose good executives because they can be paid more elsewhere. But is this necessarily a problem? There are undoubtedly many capable people with better understanding of risk management and liquidity who would be happy to work for these firms for $500,000 per year. If the firms find that they cannot retain the best executives, then they will find themselves with a greater incentive to refund the taxpayer money that much sooner. If the executives who are running these firms want to earn more than $500,000 per year, they will have to get their firms back in shape and earn enough profit to repay the bailout money. An argument can be made that shareholders can oust poorly performing executives and limit executive pay by changing a corporation's board of directors. This argument is a diversion, as can be seen in an article named Shareholder Power from the Christian Science Monitor.

Let the Kim Kardashians of the financial sector go seek out new firms to mismanage!

Discussion Questions

1. Do you agree with this author's viewpoint about bans on enormous salaries? How about his viewpoint on Obama's executive pay cap plan? Is there inconsistency in his views? Is there inconsistency in yours?

2. How do you feel about America's progressive income tax system? If you were in control of the federal government, what would you do to change it, if anything?

3. What do you think about the concept that government should stay out of the free enterprise system? Do you believe that government involvement has made the global financial crisis worse, or has it helped moderate its severity?

4. Suppose that the U.S. did enact a law against anyone earning over $1 million per year. What would the corporate CEOs, celebrities, athletes, and other top earners do in response? Would they leave the country? What other complications might arise from such a law?

Bovine Intervention

A couple of weeks ago, economist Greg Mankiw pointed to an interesting story about so-called cow tax proposals in Europe. The taxes would apply to farmers and ranchers, based on the number of animals they raise—the more cattle in your herd, the larger the tax bill. Thus far, lawmakers in Ireland and Denmark have struck such measures down. The defeated Irish proposal put the tax at €13 for each dairy cow and the Danes were considering a tax as high as €80 per cow.

Why tax livestock? In a word, flatulence. (In two, enteric fermentation.) Cows belch and otherwise discharge their way to about 14% of the world's methane emissions. Like carbon dioxide, methane is a greenhouse gas. Although methane accounts for a relatively small share of all greenhouse gas emissions, it is alarmingly effective at preventing heat from escaping the planet. Compared to carbon dioxide, a little bit of methane goes a long way toward raising the potential for climate change. Reducing methane emissions would help Denmark and Ireland meet their EU climate policy commitments.

Raising livestock generates a negative externality: the costs of methane emissions are born by the general public rather than those directly involved in the production and consumption of meat and dairy. The emissions cause the marginal social cost of producing a pound of beef to exceed the marginal private cost.

The proposed taxes are an attempt to force farmers and ranchers to internalize the heretofore external costs of the methane emissions, bringing the private costs of raising livestock closer inline with the social costs. The tax would raise the costs of producing meat and dairy, reduce the supply of such products, and, consequently, lower methane emissions.

While a tax based on the number of cattle in a herd would undoubtedly reduce farming-related green house gas emissions, it would do so in rather blunt fashion. To see why, consider two ranchers. The first uses specialized cattle feed to reduce the methane emissions of his herd. The second sticks to traditional methods with the typically methane-intensive results. The cow tax, however, is levied equally on each head of cattle, failing to account for the methane reduction efforts of the first rancher.

While the cow tax provides an incentive to cut back on cattle, it doesn't encourage ranchers to adopt any of the promising technologies devised to reduce methane discharge from individual cows. Ideally, climate change policies should focus on the amount of methane emitted rather than the number of cows.

Discussion Questions

1. Can you think of policies to incentivize the adoption of methane-reducing technologies in farming and ranching?

2. Governments in Europe and the United States heavily subsidize the farming and ranching sectors of their economies. How would the removal of such subsidies impact methane emissions in Europe and the U.S.? What about methane emissions from less developed countries?

Ireland's Plastic Bag Tax

In an important scene from the 1999 movie American Beauty, two characters—Jane and Ricky—watch footage of a plastic bag dancing in the wind. That there's beauty all over the place, even in garbage, seems to overwhelm Ricky: "Sometimes there's so much beauty in the world, I feel like I can't take it, like my heart's going to cave in."

Unlike Ricky, Dubliners have to live without the heartbreaking splendor of airborne garbage. Plastic bags nearly disappeared from Ireland's cities after the government began taxing them in 2002. The tax, 33 cents per bag, was enough motivation for most shoppers to replace plastic bags with reusable cloth bags. Ireland's experience illustrates a basic principle of taxation: if you want less of something--like the not-so-biodegradable, sewer-clogging plastic bag--tax it. Read Elisabeth Rosenthal's New York Times article to learn more about Ireland's bag tax.

Discussion Questions

1. There's nothing like a green tax to bring out our inner-environmentalists. As Rosenthal points out, after the tax passed, plastic bag use became socially unacceptable in Ireland. In what way does the tax lower the barrier to adopting a disapproving attitude toward plastic bag use?

2. Ohio issues yellow and red license plates to drivers convicted of drunk driving (apparently, Ohio officials didn't give much thought to tourists from the great state of New Mexico). Can you think of other situations or even laws that are governed largely by the threat of disapproval from others?

3. How is the Irish government's campaign against plastic bags similar to government campaigns against tobacco? In what ways do cigarette and plastic bag taxes increase efficiency for society as a whole?

4. Taxing bad behavior can be good, but implementation and enforcement are issues. It'd be relatively easy to cut down on paper waste from ATM receipts because the fee can be collected electronically at the site of the transaction. Why does a plastic bag tax that works remarkably well in the digitized supermarkets of Ireland run into implementation problems among the vendors and mom and pop shops in China?

Labels: Taxes, Incentives, Market Failure, Externalities, Environment

Should the Government Tax Consumption or Income?

Robert Frank devoted his most recent New York Times column to the idea of shifting taxes from income to consumption. It’s not a new idea, and it’s one that many economists of various political stripes agree on.

Right now, the amount of tax you pay is based on your income. The more you earn, the more you pay in taxes on each additional dollar earned—the “marginal income tax rate.” One important argument against the income tax is that it penalizes savings. Consider an unmarried taxpayer—let’s call her Sally—who is in the 25% tax bracket. (For an individual, that means earning between about $30,000 and $70,000 per year.)

Now suppose that Sally gets a $10,000 raise. She faces a marginal tax rate of 25%, so that $10,000 raise is really a $7,500 raise at most. If she saves that money at 6% interest, the additional income will also be taxed at 25%, bringing it down to about 4.5% per year—barely more than inflation. It would take her eight years to earn enough interest to get her bank account back to the initial “raise” of $10,000.

Now consider a different tax system: one in which Sally’s consumption is taxed rather than her income. That is, suppose she would owe exactly $0 in taxes on any money she saves. This means she could put away the entire $10,000 raise and let it accrue interest at the full rate of 6% per year. After eight years, she would have nearly $16,000 in the bank. Such a system would clearly encourage Americans to save more money.

The fact that a consumption tax would encourage savings by not taxing saved money has earned it the nickname of the “unlimited savings allowance.”

Discussion Questions

1. If one were choosing between a pure income tax and a pure consumption tax, the former would be more likely to encourage consumption, while the latter would be more likely to encourage savings. Which of these—consumption or savings—would be more beneficial to the economy as a whole? Why?

2. Frank suggests a highly progressive consumption tax (i.e., the marginal tax rate would rise as consumption increased). He even does a thought experiment with a 100% marginal tax rate on consumption beyond a certain level. A famous tax proposal by economists Bob Hall and Alvin Rabushka would levy a “flat tax” on consumption. How would you compare these two proposals? What are the pros and cons of each?

3. Frank is famous for his belief that because people care about “keeping up with the Joneses,” consumption actually has a negative externality associated with it. If that is true, is a consumption tax in reality a kind of Pigovian tax?

4. Two of the guiding normative principles by which many people judge tax systems are the ability to pay principle (briefly, that the rich should pay more in taxes) and the benefits received principle (briefly, that if taxes are used to fund a public good, those who benefit the most from the good should pay the taxes). Does Frank’s proposal follow these principles? Why or why not?

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?

Prop 87, Rent-Seeking, and Confiscatory Taxes

A number of commentators responded to Paul Romer's post last week on California's Prop 87. Their comments raised a host of interesting issues. It's worth understanding two of them in depth: rent-seeking behavior and confiscatory taxes. Both of these are standard arguments against government taxing and spending activity.

1. Rent Seeking

On the topic of subsidies for alternative energy research, Arnold Kling wrote that "once you open up the can of worms of these taxes and subsidies, a lot of rent-seeking crawls out." In the comments to Kling's post, Charles Kruse was less politic:

When Economics Professor Romer says to his students: "Appropriate government subsidies could encourage a socially optimal level of R&D," this is both mealy-mouthed and misleading. Sure, it "could" happen. But consider how the decisions on subsidies will actually get made and the history of previous schemes--not just ethanol but the Lloyd Cutler/Jimmy Carter Synfuels Corporation and other scams. Even the worst ideas to transfer money to the political class can be dressed up with this sort of language.

Kling and Kruse are speaking of rent-seeking behavior--a problem that arises when government, rather than the market, allocates resources. Rent-seekers attempt to obtain artificial payoffs by spending money to curry the favor of elected politicians. What kinds of rent-seeking behavior might occur around Prop 87? Well, when California's government has an extra $4.1 billion burning a hole in its pocket, a lot of people will have an interest in trying to influence how that money gets spent. Firms may devote resources to getting government contracts rather than doing actual energy research. Talented young people, when choosing what career to go into, may go to work for lobbying firms rather than for firms that actually produce things. In short, society will waste resources on the allocation process that would be better used elsewhere.

Consider an example. Suppose you run a company that makes a new kind of solar energy panel. You've already raised $10 million in venture capital to conduct research. Now Prop 87 passes, and the state is looking around for someone to develop a new kind of solar chip. Getting this grant would be worth $50 million to your company. Say you could spend $2 million of your venture capital on campaign donations to elected officials, or perhaps to charities favored by those who are in charge of allocating the Prop 87 funds. If you do this, you figure, you'll increase your chances of landing a government contract by 10%--an expected payoff of $5 million. This may, from your perspective, be a good prospect. Of course, other companies will have the same incentives. Suppose they all start giving money to politicians and charities. In the end, everyone faces the same probability of getting the contract as before--but many valuable person-hours are wasted in lobbying to influence who does the work.

2. Confiscatory Taxes

If the problem of rent-seeking behavior arises because Prop 87 gives California money to spend, the problem of confiscatory taxes arises from levying the tax in the first place. For example, on Harvard economist Greg Mankiw's blog, commenter Harsh Pencil, a contributor to the John Adams blog, writes:

Paul Romer's analysis is basically correct. In effect, there is very little
difference between this proposed tax and simply confiscating a fraction of the oil under the ground in California. (In fact, if the supply curve is vertical, there is no difference.) In many ways, such taxes are the perfect tax: no distortions.

But there is a larger issue. There is always a motive for government to confiscate sunk assets to fund things which would otherwise require distorting taxes. Just because these discovered reserves are sunk assets now, doesn't mean they always were. Do we really want to encourage citizens to worry about after-the-fact confiscations?

As Pencil says, the confiscatory tax argument might seem at first blush to fly in the face of the normal tax incidence literature, which suggests that the deadweight loss of a tax is lessened if the supply or demand curves are inelastic. However, recall that the long-run supply of oil is much more elastic than the short-run supply. Therefore, even though California can expect not to affect the amount of oil extracted from its wells over the short term through Prop 87, in the long run, the existence of Prop 87 makes drilling new oil wells in California a less profitable prospect.

Even worse, as Pencil points out, if entrepreneurs in all industries believe that California will impose an after-the-fact tax on any risky venture that goes well, the expected return from taking risks is significantly diminished. This goes well beyond the question of oil. Suppose, for example, that you could invest $1 billion in researching a vaccine for HIV/AIDS. If you succeeded, you could produce the vaccine at a cost of $1 per person. Suppose you thought that if you did succeed, the state of California would pass a law stating that it was immoral for you to charge a price above your marginal cost, and levy a tax on your profits. The fear of such a confiscatory tax could be a huge disincentive to research, and might result in the drug not being developed at all.

Discussion Questions

1. The arguments of rent-seeking and confiscatory taxation can be made against much, if not all, government taxing and spending activity. Are these arguments especially true in the case of Prop 87? Why or why not?

2. The problems highlighted here are legitimate costs associated with Prop 87. However, there are also benefits. How can you compare these costs and benefits to find out whether, on the whole, Prop 87 represents a worthwhile policy?

3. Suppose Prop 87 passes, and you are put in charge of distributing the funds to research institutions. What guidelines could you put in place to reduce rent-seeking behavior?

4. Think about the argument that confiscatory taxes decrease risk-taking activity. This argument relies on the notion of a reputation effect: in particular, that the people of California might develop a reputation for passing confiscatory taxes, which would then have an adverse effect on future entrepreneurs. Is this a credible argument? Do California voters--an ever-changing population--have the ability to commit to not passing confiscatory taxes in the future? By contrast, why would the act of passing Prop 87 make it seem more likely that similar measures would pass in the future? (Remember, the voters of California were the same ones who passed Prop 13, perhaps the most famous government-limiting initiative in U.S. history.) Would it be worse or better if the California legislature passed a confiscatory tax?

Slicker than Oil: The Debate Over California’s Proposition 87

Proposition 87, a hotly contested measure on the ballot in California, nicely illustrates the key lessons about tax incidence--who actually pays a tax. The political debate about this Proposition shows that these lessons, which are typically covered in an introductory microeconomics course, are not well understood by the voting public. Is education powerful or what? Armed with knowledge of just a few economic principles, you will be able to analyze important policy issues better than most.

To raise funds for research on and development of alternative fuels, Proposition 87 taxes oil produced in California. (Read a summary of the provisions of this act on the Secretary of State's web site.) Opponents of the tax claim that this tax will increase the price of gasoline at the pump. The following figure shows why this claim is wrong. The market for oil is global, and the price of oil is set by global supply and global demand. California produces less than 1% of all the oil produced in the world, so changes of a few percent in its output would be far too small to have a noticeable effect on global supply and demand. Taken together, all the producers in California are in the same position as a single firm in a competitive industry. They face a residual demand curve for their oil that is horizontal, or perfectly elastic, at a price equal to the world price of oil plus the cost of transporting it to California. Call this price P*.
To understand why the demand curve faced by local producers is horizontal, consider the decisions made by the typical manager of a gasoline refinery. She already has barrels of imported oil delivered to her at the price P* and could order many more at that same price. If the price of oil delivered from a local producer was more than P*, she wouldn't buy any. If it was less, she'd buy as much as she could and cut back on purchases of oil brought into the state from Alaska and the rest of the world. Local producers, understanding this, would be foolish to charge a price less than P*. They'd be leaving money on the table. Even if they did, this wouldn't reduce the price that the refinery manager would charge for gasoline. She'd happily buy all the cheap local oil she could, but still charge the same price for gasoline that other refiners, who continue to import foreign oil, are charging--the price determined by P* and the cost of refining.

What happens if the state of California imposes a tax of T% on the oil produced by the local producers? The figure shows that the price of oil purchased by the refineries is still equal to P*. Local producers receive (1 - T) times P* per barrel of oil. Because they face a horizontal demand curve, they bear the full cost of the tax. They can't pass the tax increase on to consumers.

As the figure shows, local production of oil will fall by a small amount after the tax is imposed, which means that imports of oil will go up. The amount of this reduction depends on the elasticity of the supply curve. As usual, the supply response grows larger over time. Initially, there should be very little supply response, but over time, wells will be retired from service sooner and fewer new wells will be drilled.

What might the size of this impact be? One estimate cited by opponents of Proposition 87 is that local production will fall by an average of about 3.4% or about 22,000 barrels per day over the first 10 years of the life of the tax. Oil produced in California meets only 37% of consumption there. The balance is supplied by oil imported to California from Alaska and the rest of the world. This means that imports of oil into the state would increase by about 1.8%. A gradual increase in imports of this magnitude would be too small to have any perceptible effect on the world price of oil or the transportation costs of oil to California.

The local producers do understand the economics of tax incidence. Chris Hall, an oil producer based in Torrance, CA, was quoted in the San Diego Union-Tribune as saying of the tax that “I can't pass it on…I'm a price taker and not a price maker. I don't determine the market.” Understandably, these producers have raised a lot of funds to support a campaign to oppose the imposition of this new tax. The tax would raise up to $4 billion before it expires, so for oil producers as a group, it makes sense to spend millions of dollars to defeat the tax. What is interesting about the campaign ads that they support is their repeated claim that the tax will raise the price of gasoline. No doubt, their campaign consultants have found that raising this irrelevant issue is the most effective way to get people to vote against this proposition.

Reasonable people can differ about whether Proposition 87 is a good idea. See the web page, by one well-known economist who studies energy, Severin Borenstein, for an even-handed discussion of its plusses and minuses. Or read this critique by Greg Mankiw. Ironically, he is opposed to the proposed tax because it will not increase gasoline prices and therefore will not encourage conservation. This kind of discussion clarifies the issues and helps people understand the underlying economic principles.

The other kind of political discussion, the kind that goes on between battling pundits or in the back and forth of campaign ads, sways some voters because they don't have the benefit of an introductory course in economics. They don't understand something that you do: a tax on a small subset of firms in a competitive industry will not affect the price paid by consumers.

1. Greg Mankiw correctly points out that the tax in Prop 87 is not a Pigovian tax--that is, a tax on oil for the purpose of reducing oil consumption to socially optimal levels. However, the revenues from Prop 87 are intended to subsidize the research and development of alternative energy. Because the marginal private benefit of R&D is less than the marginal social benefit, the market does not allocate enough resources to R&D on alternative fuels. Appropriate government subsidies could encourage a socially optimal level of R&D. Does this mean Prop 87 is in fact a Pigovian subsidy? Should Mankiw and the other members of his Pigou Club support such a policy? (Thomas Friedman and Al Gore, both of whom Mankiw counts among the membership of the Pigou club, already do. Other members of the Pigou club are encouraged to comment…)

2. Would a Pigovian tax on gasoline consumption be a better way to fund research on and development of alternative fuels? Why or why not?

3. How useful is it to enact public policy through ballot measures? On the one hand, polls show that the public isn’t well informed as to the economic consequences of Prop 87 and other ballot measures. On the other hand, the policies developed by legislators are also imperfect. Some people argue that elected officials face few political incentives to tackle long-term problems like global warming. Is Prop 87 an example of “direct democracy” achieving something the legislative process could not? Or is it an example of why setting public policy is best left up to the legislature?

Tax Carbon, Not Income

Charles Wheelan--Yahoo! Finance columnist, author of Naked Economics: Undressing the Dismal Science, and public policy lecturer at Chicago's Harris School--has a knack for user-friendly explanations of economic ideas.

The Naked Economist has a modest policy proposal for Presidential hopefuls, Democrat or Republican: Tax carbon, not income. Wheelan proposes a revenue neutral tax policy: Increase taxes on carbon-based energy, like gas and coal, reduce income and payroll taxes, and engineer the changes in such a way that government tax revenues remain the same. Americans might balk at paying even higher prices at the pump, but under Wheelan's proposal they'd write smaller checks to the IRS. Wheelan makes the case for revenue neutral energy tax reform in his latest Yahoo! Finance column.

1. How would the carbon tax change our behavior--the cars and appliances we buy, our driving habits, the way and extent to which we heat or cool our homes? According to Wheelan, what are some environmental and geo-political benefits of the carbon tax? How do payroll and income tax cuts affect our incentive to work?

2. Negative externalities occur when we do stuff that's bad for other people without compensating them for the inconvenience. To what extent would a carbon tax reduce negative externalities associated with fossil fuel consumption?

3. A tax is regressive when the share of your income devoted to the tax declines as your income rises. Since lower-income households tend to spend a greater share of their income on energy than higher-income households, the carbon tax would be regressive. How could policymakers reduce the regressive impact of the carbon tax when cutting income and payroll tax rates?

4. How would our long-term response to carbon taxes present problems for the revenue neutrality of Wheelan's proposal? (In econ jargon: how does the price elasticity of demand for carbon- based energy change as time passes?)

China's Chopstick Tax

Planning on buying an SUV or golf accessories in China? Probably not, but in the unlikely event that you are: buy soon. The Chinese government hopes to encourage environmental conservation and curb conspicuous consumption with a slew of new tax hikes on April 1st. An article in The New York Times outlines the new proposals, including taxes on disposable wooden chopsticks and luxury watches.

A tax offers government several opportunities. Taxes raise government revenue, discourage certain activities, and give people an incentive to adopt alternatives to the taxed behavior. Consider an emissions tax. By taxing steel mill emissions a government could raise some revenue, discourage pollution-intensive steel production, and simultaneously give steel mills an incentive to adopt cleaner technology.

1. What types of conservation does the Chinese government hope to encourage by taxing wooden chopsticks and vehicles with large engines?

2. As China increases taxes on vehicles with engines over 2 liters, it is decreasing taxes on vehicles with engines of 1 to 1.5 liters. How will the tax affect foreign automakers that primarily sell big engines in China?

3. Chinese automakers produce relatively small vehicles compared to their foreign counterparts. How will the tax affect the demand for small-engine vehicles?

China plans to tax several luxury items, including watches, golf accessories, and yachts. Consumption of luxury goods tends to be highly price sensitive. In econ jargon, the price elasticity of demand for luxury goods is highly elastic--small price changes induce relatively large changes in quantity demanded. By raising the price of a luxury item with a tax, government can expect a relatively large drop in sales of the item.

Take America's disastrous yacht tax of 1990. Uncle Sam's tax effectively increased high-end yacht prices. Wealthy Americans responded to the tax by substituting away from yachts toward other status symbols like jets, sports cars, horses, handbags, and helicopters. Yacht sales dropped and the tax fell far short of government revenue projections. Employment in the yacht industry went the way of free falling yacht sales--not exactly the intended consequence of the tax.

4. Do you think China's luxury taxes will raise lots of government revenue?

5. China faces a bit of an image problem at the moment. The Communist Party resides over free market prosperity in urban centers even as the heavily state-controlled countryside languishes in poverty. The result is a growing income gap between rural and urban Chinese, made visible by images of luxurious urban prosperity and rural destitution. Might the Communist Party be more interested in discouraging conspicuous consumption than raising revenue?

Topics: Tax