Why Taxes Trump Subsidies

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My last post explored the inefficiencies in the primary objective of the Clean Energy and Security Act bill, mainly carbon-offsetting. This post will focus on the other provisions in the bill, mainly, subsidies in the form of tax credits and business grants for those entities choosing to use clean energy technologies.

I must preface that though I am criticizing the abilities of this bill, it is a monumental legislative step in the right direction; though it must still pass in the senate. A friend of mine who does not believe in global warming has even expressed admiration for the bill and its intentions, though agrees with my assessment of its planned execution of those intentions.

The US government has long suffered from control issues. This bill provides subsidies and tax credits for those people who choose to use energy efficient technologies. To understand why this is not a great idea, we must look at the effect subsidies have on decision-making and rationality. In economics, we assume that people are rational agents acting on perfect information, among other things. If information is perfect, then prices represent the actual cost of the goods produced. By subsidizing clean energy technologies through business grants or tax credits the government is essentially creating prices that do not reflect the true social value of the good. Therefore, more is consumed of these goods than would otherwise be optimal and creates a higher social net cost without the same social net benefit that would have occurred if the prices were representative of the value of the good.

So what would be the solution? Instead of making it cheaper to consume certain energy sources, make it more expensive to consume the bad energy technologies. This may seem to achieve the same objective of having consumers substitute good energy with bad but this results in a more socially optimal solution.

Bad energy goods are labeled “bad” because they create an externality and further, this externality is not internalized in the price. This means that the cost to society of using this good is higher than the price being charged by firms because the firms are not held responsible for the negative effects the result from production and use of the good. By increasing the cost of these bad energy goods we can internalize the externality caused by the goods.

Why is this better? This gives consumers perfect information by way of prices so that they are able to choose the socially optimal level of consumption of both, or just one, good(s). The problem with subsidizing goods is that it gives signals to the consumer that the good creates a positive externality, i.e. it increases social welfare. While clean energy technologies trample less heavily on the earth, solar panels and wind turbines must still be produced by a firm using hazardous materials and non-renewable energy. One cannot argue that using such technologies reverse damage in the atmosphere, they only damage it less; therefore, they do not create a positive externality and should not be subsidized.

An Energy Bill with a Catch

Yesterday, a monumental energy bill was passed in the House. While liberals and conservatives are shouting out praise or disapproval, respectively, few have looked past party lines to gauge the real effects of the bill.

The bill is attempting to achieve one main objective which is a 17% reduction in economy-wide greenhouse gas emissions by 2020. The proposed strategy is a cap-and-trade system with large amounts of domestic and international carbon offsetting opportunities. There are provisions in the bill which will assist and mitigate the primary objective such as renewable energy requirements on utilities, energy efficiency incentives for consumers and businesses, grants for green jobs, and research and development on carbon sequestering technologies.

Though I support a bill to mitigate use of carbon-producing technologies, I cannot say with confidence that this bill will be able to achieve that. A system of cap-and-trade can be effective but is easily sabotaged with offset credits. The theory behind cap-and-trade (in this case) is that the government will set a limit on CO2 emissions that can be released into the air and then issue permits to businesses to pollute in the specified range. This provides economic incentives to businesses to reduce emissions for whom it is inexpensive to adopt cleaner air technologies. These businesses can then sell their permits to businesses that cannot easily adopt clean air technologies. So far so good. But then the offsets begin. This allows a business to pollute above their permit allowance so long as they invest in carbon offsetting activities. These carbon offsetting activities could be planting trees in Brazil to encouraging US farmers to adopt energy saving farming practices. Businesses will then invest in the offsets until the cost of offsetting reaches the cost of buying permits. The problem is that offsets reverse any intention and effect that capping has - i.e. it is the purpose of the cap to reduce emissions but offsets allow firms to pollute past the cap as long as they pay for it.


Economically, this makes sense. Those who pollute must pay. But the goal of the bill clearly specifies a 17% decrease in greenhouse gas emissions by 2020. If the goal is a reduction, then offsets will not help. If the goal instead is to increase the cost of polluting to reduce consumption, then cap-and-trade with offsets is the right system. it might seem that in both cases the reduction in emissions is realized, but in the first system, without offsets, the amount of emissions is set and final, while the with the offsets, the amount of emissions will depend on a multitude of factors such as firm's cost structures, elasticity of demand for that firms products, elasticity of supply of that firm, etc. And this is where it becomes complicated.

Further, though I have not done the research, it seems a bit far fetched to me that planting forests in South America will offset emissions released in the US. On average, maybe this is true, but this isn't statistics where the average rules. This is our air and I want the air I breath in the US to be clean, not clean "on average."

Consuming Health Care

The Obama Administration released a report the other day claiming that Americans must start to reduce their consumption of health care in order to avoid soaring budget deficits and further damage to the economy.  In a time when the government is trying to increase consumption in every other sector, why is consumption on health care considered bad?

Insurance: Using insurance to pay for health care consumption create moral hazard and inefficiency.  Moral hazard occurs when people take greater liberties in risky behavior because they know they are protected by the insurance.  Insurance is based on a set of data based on behavioral patterns in the absence of insurance.  When these people get insurance, their behavior invariably changes because they are now responsible for less of the burden if injury should occur. 

But this doesn't only make people more risk-seeking, it also makes them medi-holics. Americans consume an enormous amount of health care services.  We go to the doctor when we have a cold, we get flu shots every year, it's over precautious.  There is a certain level of precaution that is considered optimal but we are surpassing that level and it results in inefficiency.  

I suppose the argument against this is that it's the market-determined level of health care consumption so it is not bad that we spend so much on health care.  To that I would argue that the optimal level of health care consumption can only be found when insurance is not offered.  Insurance effectively subsidizes health care costs so the level of actual consumption is higher than the optimal level; again, resulting in inefficiency.

Medicare: It is a fact that people aged 65 + spend more on health care than those under 65 and that those older people are on medicare. This means that the government's health care burden is enormous.  Medicare accounts for 14% of the federal budget and we can expect to see this number rise as the elderly population increases. Though people 65 + made up 13% of the population in 2002, they accounted for 36% of health care consumption. Further, the relative size of the aging population has increased greatly since 2002 and will continue to increase for the next 10 years.  This creates an even greater burden for the government, especially in this recessionary time, since many of these medicare recipients will drop any outside coverage and rely solely of medicare for health insurance.

Since health care expenditures are subsidized our consumption is far above the level it should be.  There is no easy solution and I think the Obama Administration is not unjustified to ask Americans to spend less on health care.  Further, since our consumption on health care is inefficient, reducing the amount spent on health care and transferring it to other sectors would not only create a more efficient economy but also a more efficient household allocation of resources.

Fast Facts

Health care consumption per person

1980: $1,106

2004: $6,280

Health care as a percentage of GDP

1980: 9%

2004: 16%

Thanks to http://www.ahrq.gov/research/ria19/expendria.pdf and http://facts.kff.org/ 

Here's a comment I posted on an interesting blog called The Catholic Atheist:

A little off topic but your post inspired me:

I've never been of faith but I've always thought of God as an imaginary number (the ones that engineers and mathematicians study). An imaginary number is basically the square root of a negative number which, after all my years of math, I still don't understand. But, some people do. Some people live in imaginary numbers, creating complex systems based on them, theorizing proofs and conjectures that assume their existence.

As an economist I only study what is real, or rather what is tangible (kinda). We don't study imaginary numbers but we do study "the invisible hand" which is just saying that there exists an unseen mechanism that allows markets to be self-regulating. So what sounds more crazy, telling someone you believe in a supreme being or that you believe in this detached hand that goes around telling us what price we should buy something at. I would say the latter sounds a great deal crazier.

Mathematicians get to represent their imaginary numbers with a small i, us economists get to represent our detached hand with arrows on a demand and supply diagram (kinda lame) and Catholics get to represent Christ with something to eat and drink. Not a shabby deal on the Catholic side.

Basically what I'm saying is that though iconoclasm is banned from most religions, it is human nature to represent what we cannot see; whether it's in math, economics, or religion.

Economic Costs of Banning Books

Banning books is nearly a universal wrong, though many countries revel in the practice. These countries generally cannot be persuaded by the current arguments against banning books such as "It's just wrong" and "It inhibits freedom of choice." So I am going to try another route: what are the economic costs and benefits to banning books. I will first focus on the benefits of banning books and their economic rewards and then move on to the easier and more accurate analysis of what happens in the economy when books are banned.

Arguments for banning books are as follows

1. Reduce externalities caused by radical thought
   
2. True paternalism

To analyze the effect of externalities on a market we can refer to the graph below. The conventional example is a factory that has a negative externality of polution. The private cost is the cost structure that the firm faces without internalizing the societal harm caused by pollution. The social cost is the cost structure that the firm would face if the firm was made responsible for the fixing, reducing, or simply compensating the harm done to society. The difference between the social cost and the private cost is the cost of the externality.

Theoretically, countries that ban books would assume that the externality caused by such books would be so large as to push the cost curve (also known as supply) high enough so as to no longer have an intersection between demand and supply as shown below.

The second argument is true paternalism which is essentially the thought that the government knows better what is good for a person than does that person. This occurs in the US in the form of inalienable rights. A popular example is the market for human kidneys. It is illegal in the US to sell your kidney even though it belongs to you. It is a form of true paternalism in which the government believes that you will be better off keeping both of your kidneys than selling one of them. In the case of banning books, the government believes that the harm you will be caused by reading certain books is too high to risk and therefore, the government bans those books to prevent any harm.

The costs of banning books are much greater and varied.

1. Increased risk of book creation (private)
   
2. Restraint of trade (social)
   
3. Reduced potential surplus value from knowledge (social)
   

There is a certain risk involved when deciding to write a book. Economists call it the costs of creativity and they are partially determined by the expected profits of the book once it is published. Expected profits are a function of the payment schedule and a the probability of attaining each payment. If a government is banning books then they are essentially reducing expected profits by the probability that the book will be banned.

Example:

Assume that to write a book there is only one cost which is fixed at $20,000 and that there is only one profit outcome at $50,000. Therefore expected revenue = (1)(50,000) = $50,000. Multiplying by 1 stands for the probability that this outcome will occur which in this case is 100%. Expected costs is fixed at $20,000 so the writer will have positive profits of $30,000 and will write the book.

Now suppose the government starts banning books and the probability that a book will be banned is 75%. Therefore, the new expected revenue = (.35)(50,000)+(.75)(0) = $17,500. In this case the writer will not pursue writing the book because the expected revenue is less than expected costs.

The second cost of banning books is restraining trade by prohibiting voluntary transactions. This is simple to analyze; when voluntary transactions are quashed the market becomes inefficient because an excess is created, in this case, we would see an excess in demand.

Books are not like other commodities in that they can foster surplus value by aiding in the creation of ideas. When books are banned, we essentially take away potential surplus value that could have otherwise existed. This reduces social welfare. It is also seen that when opportunities for surplus value to be created is taken away from society, the economy is not able to grow at an optimal level.

The Problem with the War on Drugs

There was once a time when Americans were concerned about issues other than the global economic meltdown and journal reported on sex, violence, wars, and drugs. It's the latter that I will touch upon today.

Basic economics classes, and even advanced, teach that a market looks like the diagram below with supply and demand having relatively similar slopes.
In this graph, when supply is shifted to the left (supply decreases), quantity will decrease and price will increase by roughly the same amount. Likewise, when demand is shifted left (demand decreases), both quantity and price decrease by roughly the same amount.

The graph below is what the market for illegal drugs looks like. It has a highly elastic supply curve and a highly inelastic demand curve. The demand curve is steep because of the high incidence of drug addiction which makes drug users relatively unresponsive to changes in drug prices.
In this graph, when supply or demand is decreased, price and quantity will change asymmetrically. This is essentially the problem of the war on drugs.

We must first identify the objective of the war on drugs, which I believe to be decreasing drug consumption in the US (rather than simply increasing the price of drugs). The US has chosen to accomplish this by attacking the supply of drugs. Money is spent checking for drugs smuggled in through ports and the borders, and helping fight drug wars in Mexico. The US government seems set on curtailing the supply of drugs in the US with the intended result of reducing consumption. Unfortunately, the market doesn't allow for such policies to work.

Take the market for drugs shown above. As the US tries to reduce supply, the supply curve will shift left and we will get the resulting graph. Notice that the blue-shaded area is much larger than the brown-shaded area. When you attack a market on the supply side with an elastic supply and inelastic demand, price increases dramatically with a very little drop in quantity. This is essentially what is happening in the US.
If, instead, the US were trying to reduce the demand for drugs, we would get a situation such as the graph below. Quantity and price would both decrease, but quantity would decrease many more times the decrease in price. As identified above, this is the supposed objective of the war on drugs.

So why doesn't the government do this? Well, it could be that it is harder to reduce demand than supply such that a dollar spent will decrease supply by 10 units but only decrease demand by 1 unit, and therefore we would see an inefficient use of money.

The government has implemented some measures to deter drug use such as increasing penalties for persons caught with drugs but it is hard to say if these penalties are working. Since people are risk-averse (even those that use drugs), an increase in the penalty will not deter drug use as effectively as an increase in the probability of getting caught. To increase the probability, the government must hire many more law enforcement agents, which is an expensive process. Though, putting stoners in jail or prison can't be too cost effective either.

The Issue of Property Rights

Development economics is a hot topic right now. It seems to baffle everyone, even economist, why some countries fail and some succeed, and why some countries can do either quicker than some. There are many theories out there, all credible in some respect, that try to ascertain one common solution to the problem. It's hard to believe that one solution could fix all developing countries but there is a theory of property rights which goes a long way to identify and solve the problem of development.

Hernando De Soto, a Peruvian economist, tries to explain why poor countries are poor and rich countries rich. His theory centers around the legal system employed in those countries and more specifically, property rights.

A major assumption of economics, which is never discussed in economics classes, is that proper legal institutions must exist. For instance, if I wanted an apple from the store I might just take it without paying for it. If there were no legal institutions that provide incentives against theft, what is stopping me from stealing? It is basically impossible to have a functioning market without the correct legal incentives. De Soto brings this to the forefront in The Mystery of Capital in which he discusses the abominable state of legal rights in developing countries versus those in countries that are considered developed.

In developing countries it is not unusual for people to have houses and land. They build houses and cultivate crops on this land, just like in developed countries. But when it comes time to use that land for collateral for a loan, no matter the size, it is nearly impossible. Though many people occupy land in developing countries, very few have the legal paperwork showing that they own the land. It has been passed down through family generation after generation before deeds were issued or it was given to them during a land-reallocation project but the government was too busy to issue deeds. De Soto calls this "dead capital."

Dead capital is "stuff" that can't be used to generate surplus value. This stuff is normally land, houses, tractors, anything of value that is not legally beholden to anybody; in the legal framework, it is essentially community property. One of the big failures of communism is that there are no property rights and therefore, every thing is community property. When things are not owned, you cannot use them for personal gain; in this case, you cannot put them up as collateral.

The solution to this dead capital is to create a system of property rights that allow people in developing countries to use their things for more than just production. But creating a legal framework is difficult and has taken thousands and thousands of years in developing countries. Europe tested legal and political systems for years before settling on one and then refining it. The US lucked out in the our legal system was implanted by European powers but during early American history, property rights were rare the further west one moved.

The moral is, there may not be one cure for developing countries but before any economic solution can be tried and implemented, these countries must first create the correct framework for a market to function on. Without the correct legal foundations no amount of money, aid, or miracle cures can work.