The Unseen Costs of Taxation and Regulation

On a EconLog post about E-Verify, commentor “Jay” writes:

I’m confused, if [E-Verify] poorly enforced and therefore only sparsely followed by employers, how does it raise hiring costs?

Jay’s question is an excellent one, and one that gets down into one of the main reasons we have deadweight loss (DWL) stemming from taxes and regulation.  Taxes and regulations change behavior (if they didn’t, we’d only have a transfer of wealth from consumers/producers to the government and there would be no DWL).  The obvious way they change behavior is when people adopt less efficient use of resources (in the case of E-Verify, hiring a worker who may be less productive over a worker who would be more productive because the first worker will pass E-Verify and the second worker won’t).

But evasion of those taxes and regulations are also a cost.  For example, if an employer hires someone who would not pass E-Verify, and as such goes to lengths to ensure his hiring is not caught (paying him under-the-table, hiding him of INS come looking, that sort of thing), these are all extra costs being paid.  Costs of time, or money, or effort that would otherwise have been spent doing something productive (and that’s not even counting the government’s cost of enforcement!).

These costs, while unseen, are very real.  Employers face evasion costs just like anyone else, and will make decisions based upon them, even if they never show up explicitly as some budget item or in an official government report.  These costs will change their actions, and we are all worse off for it.

The Doctrine of Scarcity

Two brothers, Charles and Joseph, are sitting at home reading the news.  The following is a conversation between the two:

Charles: Joe, did you see the nation of Zimbabwe is facing a terrible drought?

Joseph: Are they?  What fabulous luck for them!

C: Luck?  How is this luck?

J: My dear brother, have you no capacity to reason?  The drought is a blessing for the farmers of Zimbabwe!  First, since it makes the supply of food more dear, the prices rise.  The farmers get more money!  This, they can spend on employing more workers (since the land is now less fertile) toiling all day to get the wheat out of the ground.  The demand for workers will increase their wages, making the Zimbabwean worker better off.  Surely, only good times can follow!  This is just Economics 101!

C: Perhaps, Joe, but this is only because there is less food.  Perhaps, in nominal terms, workers earn more, but they can buy less with their money.  Are they not worse off?

J: My dear brother, have you learned nothing?  Their increased pay will make them richer!  What they can’t spend on food, they’ll surely spend on other things!  That’ll further increase demand for workers, raising wages even higher!

C: But that doesn’t solve the initial problem, Joe.  There is still less food to go around.  Sure, they may have more money, but that doesn’t calm an angry belly.  Would it not be better for the rains to come and have the fields of Zimbabwe overflow with grains?

J: And have the price of food plummet?  Have the workers no longer needed (since the fields are now more productive) be unemployed?  Why, think of the chaos of having all those people unemployed!  You would undo the Zimbabwean worker with your mana from Heaven!

C: Perhaps there would initially be people who no longer need work in the fields, but they’d have more full bellies.  Since they are freed up from the labor, they could do other things (maybe make clothing?).

J: You are simply a theorist!  No, brother, it is far better for the people of Zimbabwe to have drought, to drive up prices, use more resources for less output.  Indeed, it is in scarcity, not abundance, that true wealth lies!

C: But you live with less-

J: So?  The workers have work!  That is all they need!  They have a sense of purpose, a sense of living!  What more could a person want?

C: Food, shelter, clothing, leisure…

J: Bah!  More of your theorizing!  The true strength of an economy is the number of jobs it has!

C: But what good are those jobs if you can’t buy anything?

J: Better than having lots to buy and not enough farm jobs.

C: But there are other kinds of jobs.  They can do something else.

J: “Something else!”  More theorizing!  Such an unsatisfying answer.

C: But true nonetheless.

(The conversation continued in this manner for some time).

Joe’s comments may seem weird to our ears, and yet it is the common claim of those who practice the doctrine of scarcity commonly known as “protectionism.”  Since scarcity, and not “protection” or “abundance”, is the foundation for “protectionism” I propose calling these people “scarcitists.”

The scarcitists have a weird idea that it is from scarcity that wealth arises, not abundance.   It is as if the best thing to happen to Man was to be cast from the Garden of Eden.  It is as if Hell, and not Heaven, is our goal.  Scarcisim is a strange doctrine.

A Tale of Two Roads

Commenting on this blog post at Carpe Diem, commentator (and friend of the blog) Walt Greenway says:

If people trade and not countries, should we condone theft from the Chinese people [in the form of subsidies on exported goods] just because we get a good deal in the U.S.?

Here is my response:

There are two issues here:

1) The question before us is whether or not trade with China (who subsidizes their stuff) harms us, Americans. That is an emphatic “no.”

2) As an economist, I advocate free trade for all. Were the Chinese government (or were I a Chinese citizen) to ask me what the best course to take would be, I’d argue for liberalizing trade. But I am not a consultant for the Chinese government nor a Chinese citizen. I am an American. I can only affect US barriers, not Chinese barriers. Therefore, I will content myself with reducing half of the trade barriers if I cannot reduce them all.

Allow me to elaborate in the manner of Frederic Bastiat:

There are two countries: Libertas and Protectistan.  The two build a road between one another; a road which overcomes barriers like mountains and deserts, allowing the two to trade with each other more cheaply.  For many years, both countries prosper from the trade.  One year, in a fit of madness, both erect artificial barriers (checkpoints, potholes, erroneous signs, anything to slow the flow and raise the price) along their halves of the road to keep the other from “flooding” their market.  As time moves along, the citizens of Libertas get frustrated they’re no longer once prospering the way they once did.  They hold a meeting.

One man gets up and says: “Our issues began when we erected barriers on the road to Protectistan.  First we paid for the road and then we paid for the obstructions!  That is absurd.  If we remove our barriers, we can improve our lot by making cheaper the goods we can get from Protectistan.  Let us do this post haste!”

Another man (this one from the government) stands up and says: “Do not listen to that crazy person.  We can only reduce our barriers if Protectistan lowers theirs! We have sent diplomats to Protectistan to negotiate the removal of barriers and they refused.”

The first man gets up again: “Sir, we have no control over what Protectistan does, but we do have control over what Libertas does.  Let us uphold our end and remove our barriers.  Perhaps, one day, they will see the folly of their ways, but why should we be punished just because they don’t want to remove barriers?”

The government man replies: “Do not listen to this dreamer, this theorist.  We can only prosper if our barriers are kept in balance.  Why, if we removed our barriers, all would be lost!  It would be more difficult to go than come, to export than import.  Our ruin would follow just as quickly as it has followed the cities at the mouths of the Mississippi, the Thames, the Amazon, the Yellow River, for it is easier to go downstream than upstream.”

A lady in the back responds: “The cities at the mouths are wealthier than the cities on the tributaries.”

The government man cries: “That is impossible!”

The same voice: “But it is a fact.”

The government man: “Then they have prospered against the rules!

The government man finished his oration by appealing to all manner of things: nationalism, patriotism, etc.  He spoke of murderous competition, of loss of pride.  The assembly, so moved, voted to keep the barriers in place, agreeing that it is only by paying and not receiving can profit be achieved.

Destroy the City to Save the City

Commenting on this blog post, a “Daniel DiMicco” says:

Your commentary couldn’t be more misleading and dead wrong. Rather than the picture you paint, the Steel Industry is the “canary in the coal mine”. It is the case study for the Massive trade Mercantilism and cheating that China is perpetrating on the USA’s entire Manufacturing sector. Your propaganda doesn’t pass the smell test!

Below is my response:

Daniel Dimicco:

You say that the steel industry is the “case study for the Massive [sic] trade Mercantilism [sic] and cheating that China is perpetrating on the USA’s entire Manufacturing sector.”

Presumably, this means China’s low steel prices are harmful to the American manufacturing sector.

However…what would happen to the US manufacturing sectors that are dependent on steel? Like auto-making, construction materials, and the like? They’d face higher price pressures from any resulting tariffs you demand. Assuming they can’t adjust prices, this would mean they’d need to cut adjust costs elsewhere…perhaps lay off workers, perhaps cut hours, all kinds of things. They’d be negatively impacted by your steel tariffs.

Even if they could adjust their prices, now you’re looking at the effects on the consumers of these steel products. They’d start looking for more cheap substitutes or simply cut back on the amount they purchase. This would weigh on the manufacturing sector as well (as well as the consumers).

In short, your effort to save one canary will kill off several others.

On a related note, I found a picture of protectionists celebrating a tariff hike:

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On Bananas, Fish, and Trade

Commenting on this blog post, Warren Platts writes:

If imports were stopped by a stroke of a pen, there would still be a trillion dollars of pent up demand per year from American consumers. If the demand for goods couldn’t be satisfied with imports, domestic manufacturers would take up the slack, creating jobs. Things would be more expensive, sure, but the GDP would grow a lot faster, more people would have good jobs.

Warren’s argument, while common, is incorrect.  Imports, which do satisfy demand, generate more demand for other products by virtue of the fact they are of lower economic cost.  As Warren says, if these imports were stopped, “things would be more expensive.”  This inherently means that there are not “trillions of dollars in pent up demand per year,”that American manufacturers can simply “take up the slack.”  Rather, those trillions of dollars are released by the imports and would become constrained by the forbidding of such.

By way of example, let’s say we have two countries: Bananaland and Fisherland. In autarky (that is, no trade), Bananaland can produce 50 fish or 50 bananas.  Fisherland can produce 100 bananas or 200 fish.  If each country divides their time evenly between each activity, Bananaland can produce and consume 25 bananas and 25 fish.  Fisherland can produce and consume 50 bananas and 100 fish.  In this autarky, the price of bananas in terms of fish is 1 in Bananaland and .5 in Fisherland (in other words, Bananaland needs to give up 1 fish to produce 1 banana.  Fisherland need only give up half a banana to produce 1 fish). The two countries open trade with one other and, given that both countries want to consume the same number of bananas after trade as before (an assumption made for simplicity; doesn’t change the story if we relax this), then the citizens of Bananaland agree to send 25 bananas for 37 fish (a price of .68).  To satisfy this, Bananaland stops producing fish and produces only bananas (they produce 50 bananas).  Fisherland cuts back on banana production to 25 but ramps up fish production to 150.  The day comes and the two trade.  Now, Bananaland consumes 25 bananas and 37 fish.  Fisherland consumes 50 bananas and 113 fish.  Their total economic well-being (crudely called “GDP”) is Bananaland: 62 (25+37) and Fisherland: 163 (50+113).

Bananaland, convinced their getting a bad deal following the lack of fishing in their country (remember, what was once a thriving industry) and the low prices they now pay, elect a protectionist on the grounds that he (and he alone) will “Make Bananaland Great Again!”  He promptly forbids all imports of fish from Fisherland.  They go back to their autarky ways.  Since Bananalanders now pay higher prices for their fish and more resources are devoted there than elsewhere, they can only consume 25 fish and 25 bananas.  Their GDP falls to 50!*  There was “pent up demand,” but the higher costs the various citizens now have to pay to even just consume the same amount they did before eats up that “pent up demand.”  The domestic manufacturing simply cannot supply it.

Adam Smith first explored this concept way back in 1776, and David Ricardo formalized it with the theory of Comparative Advantage.  Trade occurs for the simple reason that it provides people with better outcomes than other alternatives.  Other alternatives simply cannot provide the desired outcomes.

Update: I realized, as reading though this, I made a small math error.  It has been corrected.

*It’s worth nothing a similar decline happens to Fisherland, a nation where they can produce much higher levels than Bananaland.  Their GDP falls to 150.  Even their manufacturing cannot satisfy the “pent up demand.”

On Protectionism and Competitiveness

A common argument heard for protectionism is that it increases/enhances competitiveness of the domestic firms, that it “levels the playing field” (this argument used to be made primarily when talking about “infant” industries in a country, but more recently is used to justify actions taken against China and other “trade manipulators”).  The problem with this argument is that it is simply impossible.

Just as minimum wage cannot create new jobs, it just outlaws current jobs, so it is with protectionism.  Protectionist tariffs do not create more efficiencies and competition, they just outlaw/restrict certain efficiencies and competition.  This doesn’t make the protected firms more competitive.  In fact, it reduces the competitiveness of the protected industries!

Allow me to explain via metaphor:

In the 2016-2017 NFL season, the Cleveland Browns were the worst professional football team (as measured by the win-loss record).  “This is hardly fair,” say the Browns ownership.  “The other teams are so much better than we; we only got a single win!  This is costing us revenues from ticket sales, jersey sales, etc.  Other teams can woo big-name free agents better than we can and we need to mortgage our future by trading draft picks to get anyone good via a trade.  How can we expect to compete?”  NFL commissioner Roger Goodell agrees: “In order to increase league competitiveness, I hereby issue the following decree,” he says.  “Whenever a team is playing someone worse then them, they must bench their top players at each position.  This will allow teams like Cleveland to be more competitive!”

I do not think anyone would argue that Mr. Goodell is right in his proclamation, that hobbling better teams makes the League more competitive.  It reduces the competitiveness of the League.  It reduces the quality of the product of the League.  The Cleveland Browns are helped by this rule change, make no mistake, but only at the expense of the rest of the League and the consumers of its product (football fans).

Like much of protectionism, the argument for tariffs on the grounds of enhancing competitiveness relies on a half-truth, an economic sophism (to borrow Bastiat’s term).  It relies on the seen effect of the benefit to the protected firm(s), but does not see the unseen costs to everyone else.

No Distinction Necessary

On this excellent post by Mark Perry at Carpe Diem, commentator Scott asks:

If trade deficits “don’t matter,” why does every country in the world try to erase their own trade deficit by doing everything they can, no matter how allegedly harmful (like currency manipulation), to boost exports and thus decrease their trade deficit? Are all you guys “just right” and everyone is else is “just wrong?”

Scott’s question, if a bit snarky, is important but contains a major fallacy from which nearly all protectionism is derived: namely, he assumes that governments, not people, trade.

There’s an important distinction that’s necessary here: it’s not “every country” that is doing everything in its power to reduce trade deficits. It’s every government. Countries do not trade; individuals do (this is why it’s fallacious to argue that international trade is inherently different).

Once we remember that, the question becomes clearer: why are governments doing everything they can, no matter how allegedly harmful (like currency manipulation), to boost exports and thus decrease their trade deficit?

This question has an answer (one which won Jim Buchanan, among others, his Nobel Prize. One which Adam Smith first proposed way back in 1776): concentrated interests and defused costs. In other words, those who benefit from protectionism are concentrated (the steel industry, the auto industry, etc) whereas those who are harmed are defused (consumers). When you transfer wealth from a large group to a small group, it is easy to see the gains to the small group, but much harder to see the losses to the large group. From a simple Public Choice perspective, this makes the political choice easy: help those who it can be seen and push the costs onto those who cannot be seen.

Of course, the above analysis only holds if we assume that politicians, like other people, are rational, self-interested actors. If we assume that politicians are omnipotent, incorruptible, and pure angels, then yes the argument that protectionism is good because every government is doing it becomes more likely. However, I feel the second assumption is weaker than the first. Thus I’ll use Public Choice Theory.