Let’s Talk Taxes

Seemingly every 2-4 years, the Federal Government starts talking tax reform.  The same talking points are repeated over and over: high tax, low tax, red tax, blue tax.  But from an economic standpoint, taxes are much more subtle.

The standard economic story of taxes is fairly simple: as the price of something goes up (in this case, the price increase is due to taxes), you get less of it.  Higher taxes on labor (income tax, payroll tax, etc) discourage labor.  Higher taxes on cigarettes discourage smoking.  Therefore, many economists argue, taxation should be as low as possible.  Therefore, tax cuts can stimulate economic growth.

However, taxation does go to support government and institutions like stable property rights (under which I am classifying law enforcement and national defense), courts, and the like.  Other economics argue these institutions encourage economic growth, so taxation should be relatively high to fund and develop these institutions.  So tax hikes can stimulate economic growth.

Both arguments are reasonable and not mutually exclusive.  There is likely some optimal level of taxation necessary to promote desirable institutional development without being a net drag on the economy.et’s say that the economy is beyond that optimal point of taxation, that the current level of taxation is too high and is a net drag on the economy.  Does it immediately follow that taxes should be cut to stimulate growth?

Let’s say that the economy is beyond that optimal point of taxation, that the current level of taxation is too high and is a net drag on the economy.  Does it immediately follow that taxes should be cut to stimulate growth?  I argue no.  If taxes are cut without regard to spending, that is taxes are cut and deficits emerge, then it won’t do much to stimulate growth.  This is because people are rational and forward-looking.  If taxes drop and deficits rise, then people will realize that, at some point, those deficits will need to be covered, either by higher taxes in the near future, or by government borrowing, which means higher taxes down the road.  People will begin to prepare for these higher taxes by saving more in the meantime knowing they’ll have a higher tax bill coming.  In short, there would be little (if any) effect on the economy from the tax cut; it’ll be no different than if there had been no cut at all.

However, if the tax cut were permanent, that is coupled with a cut in spending so that there is no deficit, then the cut would likely have a more positive effect.  Knowing (to the extent they can) that taxes won’t rise means they see their higher amount of kept income not as a temporary thing, but as a permanent change.  The tax cut would have a more stimulative effect on the economy.

When discussing taxation, it’s important to remember that deficits matter, too.  A tax cut that only generates deficits won’t have the same effect as a tax cut that does not generate deficits.

Coase, Transaction Costs, and Environmental Entreprenureship

Today’s Quote of the Day comes from pages 7-8 of Ronald Coase’s 1988 book The Firm, the Market, and the Law [emphasis added]:

Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions.  In an economic theory that assumes transaction costs are nonexistant, markets have no function to perform and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of a forest or some similar fanciful example.

Many readers of Coase (including economists!) misunderstand him.  This is evident in the improperly named Coase Theorem (it’s improper in that it’s not a theorem).  In fact, Coase is so often misunderstood, he felt compelled to write the book this quote is from to clarify his point!  Coase is often understood to say that, absent transaction costs (or sufficiently low transaction costs), externality issues (eg pollution, noise, etc) can be solved by an allocation of property rights and, regardless of their initial allocation, will result in a Pareto-efficient outcome.  This is correct, but only a partial understanding of Coase.

Much of Coase’s work (and work that spun off from him, such as with Armin Alchian, Harold Demsetz, Gordon Tullock, and many others including my own) focus on the role of the market in addressing externality issues.  Detractors from Coase argue that his insights, that markets for externalities can exist only if there are no/low transaction costs, are not applicable to the “real world,” since transaction costs abound and, therefore, government intervention is necessary.  But this argument represents a misreading of Coase.  In a purely ideal world, there would be no transaction costs, but then no market would be necessary.  As Coase says in the above quote, it is in the world of transaction costs that the market is most useful!  The existence of transaction costs gives rise to firms and other means of human collaboration, which in turn reduce transaction costs, and increase the market exchange of individuals (see The Nature of the Firm (1937) for a more in-depth conversation on this point).

Expanding the idea of markets, firms, and transaction costs to environmental issues, we see the rise of “enviropreneurs” (to use the phrasing of PERC), that is people who seek out and find ways to mitigate these transaction costs in order to achieve desired environmental ends; in short, a market process of environmental concerns (for a detailed look at many different kinds of enviropreneurs, see Free Market Environmentalism for the Next Generation, especially Chapter 9).  The fact transaction costs exist is not a detriment to free market environmentalism, like the detractors of Coase argue, but rather what allows it to come about!

Like Coase (and Buchanan and many others) before me, I realize the market is not a panacea.  There may be conditions for government to get involved (namely where involvement by the firm or an individual are too costly).  But the work of Coase (and Alchian and Demsetz and Buchanan and Tullock and Anderson and many others) show us that the mere existence of an externality and transaction costs is not enough to justify intervention.

Unintended Consequences of Protectionism: The Jones Act and Highway Congestion

In 1920, the US government passed the Jones Act, an act requiring all sea shipping between US ports be done on ships that were built, crewed, flagged, and owned by Americans.  The act is a clearly protectionist measure designed to protect domestic shipping from foreign competition (although there is also a national defense argument for it).  The idea is that a cheaper foreign shipping company could not undercut US shippers on domestic trade routes.  If I were to ship something via ocean from Miami to Boston, I’d have to do it on US built, crewed, flagged, and owned ships.

The Jones Act, to the extent it is binding, raises the cost of ocean shipping in the US (if this were not the case, say it were already cheaper to ship on US ships than foreign ones, then the Jones Act would not be binding).  When the relative price of something rises, it encourages the use of substitutes.  The main substitutes for domestic shipping are trucking and railroad (and air to a lesser extent).  With the rise of ocean shipping costs from the Jones Act, transporters would turn to trucking and rail.  Furthermore, since trucks take up a lot of room on the highways and freeways, it is likely the marginal increase in trucking from the Jones Act increases congestion on the highways.  In short, the unintentional result of the Jones Act is to increase traffic congestion (and, potentially, traffic accidents as well).

Some interesting thoughts for further research:

  1. Do trucking and rail companies lobby in support of the Jones Act (bootlegger and Baptist)?
  2. Has the Jones Act had a measurable impact on the level of traffic (this is an empirical question that would be extremely hard to answer because of the age of the Act)?

Taxation Is Not Necessarily Theft: A Rejoinder to Libertarians and Anarchists

Taxation, by its nature, is not necessarily theft.  Likewise, taking something and not giving something in return is not necessarily theft, either.  The circumstances are what matter.

By way of example: two men meet on the street.  One is selling apples.  The other man has money.  They agree to an exchange: one man gets $5, the other gets a bushel of apples.  The two go on their merry way, happy as can be.  No theft here.

A similar circumstance: two men meet on the street.  One is selling apples.  The other man has money.  While the apple seller is distracted, the other man takes an apple and leaves no money.  Now, a theft has occurred.

What is the difference between the two stories above?  In the first, there is consent between the two parties.  In the second, there is no consent.  Consent is what makes an action theft or voluntary.  There would be no argument whatsoever on this point.  So, the question becomes, can one never consent to taxation?  Is taxation inherently non-consensual?

The answer to that question is “no.”  Taxation is not inherently non-consensual.  It can be agreed upon; it can be consented to.  Let’s say a group of people get together and decide to pool their resources for some public good (let’s say, common defense).  Depending on the structure of their arrangement, they all agree to provide some annual contribution to this goal.  This is, in essence, taxation.  Furthermore, it is consensual taxation.

But if taxation can be consensual, doesn’t the use of (or threat of) force for compliance necessarily mean that taxation isn’t consensual?  Isn’t that evidence against my thesis?  Again, not necessarily.  Yes, the thief may use force to get what he wants, but even consensual agreements may carry a threat of force.  Contracts contain provisions in case one person reneges on his deal.  These are voluntary agreements that contain elements of force if certain conditions are not upheld.  So, the existence of force is not in and of itself a sign that the agreement is involuntary.

The real question, the one we should be discussing and thinking on, is “what constitutes consent?”  If governments “derive their just powers from the consent of the governed,” what constitutes consent?  At what point does government “become destructive to these ends”?*  Yes, this is the interesting question and one I will not be discussing in this post.

*A quick aside on this point: using the same logic as above, it can be shown that merely being in a minority, losing an election, or not having things go your way in politics is not necessarily a sign of oppression or malfunctioning government.

Some Links

Scott Sumner points us to some good news on trade for the world.  His conclusion is excellent:

Unfortunately, one major country stands on the sidelines pouting while the rest of the world moves toward ever freer trade. Sad.

JMM: So much for making America great again…

Mike Munger reviews Nancy MacLean’s smear-job new book on James Buchanan and Public Choice

John McGinnis discusses what happens when government moves beyond its core functions.

Mike Rappaport on law and legislation

Mark Perry celebrates Thomas Sowell’s 87th birthday

What Does Protectionism Protect?

What does protectionism protect?

Some claim that it protects jobs, but that’s not true.  By raising the price of the “protected” good, it reduces quantity demanded, thus reducing the need for labor and other inputs in that particular industry.  Plus, by increasing the price of the protected good, it reduces demand from other areas of the economy just to pay for the new price, costing jobs and inputs into those areas as well (eg, if you have $100 and a suit jacket costs you $50, you have $50 to spend on a night out.  If, due to tariffs, the price raises to $100, you now have nothing to spend on a night out if you buy the suit jacket).

Some claim protectionism protects industries/firms; helps them grow.  That’s not true, either.  As Mercatus Center scholar Dan Griswold reminds us: “Protected industries tend be lazy about innovation and customer service because they are shielded from normal market competition – think the U.S. Postal Service.”  Protectionism tends to weaken the protected industries, not strengthens them (this, in turn, could lead to perpetual calls for protection by the industry.  A good example of this is the US sugar industry.  The subsidies and tariffs it receives were only supposed to be temporary, while the new American nation got on her feet.  Almost 300 years later, they’re still around).

Some claim protectionism protects the economy, it “makes us great” by encouraging exports and reducing imports.  This isn’t true either.  As Dartmouth College professor Douglas Irwin reminds us: “a tax [tariff] on imports is equivalent to a tax on exports. Any restraint on imports also acts, in effect, as a restraint on exports.”  Whether you measure economic gain in the number of exports or the total volume of trade, tariffs reduce both, so it can’t encourage economic growth.

So what, then, does protectionism protect?  Nothing, so far as I can tell.  All it does is reduce the number of goods a society can enjoy by increasing prices.  This is why I call protectionism by its proper name: scarcityism.

What-ifs and Whatnot

Two friends are sitting by a pool on a hot day.  One of the friends, Joe, casually says to Smith (the other): “Smith, it sure is a hot day today.  I hope the sun doesn’t dry up all the water!”

“Don’t be stupid!” says Smith.  “The sun doesn’t cause water to evaporate.  It causes the water level to go higher!”

Joe looks at his friend perplexed.  Smith continues:

“It’s real simple.  The sun hits the water, water gets warmer and starts to evaporate, right?  So the pool master comes out and adds more water to the pool.  On net, the water rises!  Ergo, the sun causes a higher water level!”

Joe, still confused, says “No, that’s not true.  The effect of the sun is to evaporate the water.  The pool master coming in is serendipitous; it’s a ‘what-if’.”

Smith laughs.  “Oh Joe.  Don’t be so dogmatic in your thinking!  Always insisting that the sun causes evaporation!  But I have clearly proven that wrong.  These chemists who constantly insist evaporation occurs because of the sun are just ideologues.”

Joe, rolling his eyes, goes back to his book.


And so it is with minimum wage, too.  Minimum wage advocates love to construct all kinds of “what-ifs” to explain why minimum wage has no effect (or even a positive effect) on employment.  But by doing this, they hide the effect of minimum wage behind all sorts of stories and claim, then, they have turned theory on its head.  But constructing what-ifs are easy.  Any storyteller can do it.  But what-ifs and serendipity make poor bases for public policy.