Not the right answer

Greg Mankiw comments on Obama's plan for a "Windfall Profits Tax" on oil companies. He says that it's not really a Pigouvian tax:

"...a windfall profits tax on domestic companies discourages domestic production, but has it has no effect on domestic consumption. By contrast, a Pigovian tax at the gas pump reduces domestic consumption but has no effect on domestic production."

He also notes that since this tax will only apply to domestic oil companies (the US government does not have authority to directly tax Saudi Aramco or Russia's Gasprom), it will only serve to push consumers away from domestic oil and towards foreign oil imports. Think of it as a negative-tariff that will increase consumption of foreign oil.

Obama's proposal also includes a $1,000 tax rebate to help consumers pay for gasoline. It's a very strange plan. The problem: high gas prices. The solution: tax domestic producers (which will cut the supply) and give a tax rebate to consumers (which will increase demand). Doesn't sound like it will work, does it? Of course it's not just Obama. McCain has come up with plenty of his own bad ideas to solve the energy crisis.

Energy politics are far from rational, but the current political debate highlights American policymakers' unwillingness to admit that the US can't directly control the price of oil. But maybe that's a good thing. If US politicians could determine the price of oil, gas would cost $0.50 per gallon, Americans would drive even more than they do, and we'd be that much closer to beach-resorts in Greenland.

Gas prices and global warming: what to tax?

Recently, Congress voted down a bill that would impose a Windfall Profits Tax (WPT) on the oil industry. Big Oil, awash in cash as the price of crude oil continues to rise, has seen its profits skyrocket. To put this into context, consider the following piece of trivia: if Exxon Mobil were its own country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank's economic rankings. Take that Swaziland!!

Of course, Big Oil's windfall earnings come at a time when the economy is slowing and many Americans, particularly in rural areas, are struggling with the price of gas. Senate Majority Leader Harry Reid recently summed up the dichotomy:

"Today, Republicans will have a simple choice: Will they continue to stand with [President] Bush, [Vice President] Cheney, and the modern-day oil barons? Or will they join us on the side of struggling American families who deserve better?"

So would a WPT work? It depends on your goals, but probably no. For people concerned about the price of gas, this is clearly a bad idea. The reasoning is similar to that used during the "gas-tax holiday" saga a few weeks ago. Paul Krugman explains it best:

"It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount. The McCain gas tax plan is a giveaway to oil companies, disguised as a gift to consumers."

With regard to the WPT, we can use this argument in reverse. Any tax on the oil companies will (at least in part) be passed onto consumers. The problem goes further, though. High prices and profits create an incentive to increase supply. As the price of oil increased between 2003 and 2006, oil companies increased their spending on improving existing oil fields and new field discovery by 43% and 67%, respectively. By taxing oil company profits, you dampen the incentive to invest in future production, thus decreasing future supply.

But what if, like many of us, your real concern is decreasing gasoline usage as part of a larger anti-global warming strategy? Isn't the WPT a Pigouvian tax? Well, sort of. Certainly the oil industry produces a great deal of carbon emissions. Thus taxing them may reduce their production (though it probably won't, for the reason mentioned above), which would reduce carbon emissions.

My real concern with the WPT, however, is that it sends the wrong message to the public. The public maintains many erroneous beliefs about economic policy, and opinions on gas prices are no different. According to a recent Gallup Poll, the American public cites "price gouging" as the biggest reason why the price of gasoline has increased in the past few years. While "supply and demand" did place second, other important factors like "the increased price of crude oil" (which would seem obvious) and "the decline in the value of the dollar" come in close to last. The price gouging explanation has emotional appeal, but doesn't make much sense empirically. If price gouging were a factor, why would the price of gas go up and down? And why would the worldwide price of gas go up, rather than simply the price of gas in the US?

Passing a WPT would send a dangerous political message to Americans, reinforcing their beliefs about the price of oil. But it would also be unfair to solely blame oil suppliers for the problem of pollution. People don't use oil because the oil companies exist; oil companies exist because people demand oil. As a result, taxing oil companies, rather than everyone (individuals and businesses) that uses oil (and thus directly producing carbon emissions) would be an ineffective measure for curtailing global warming. Alternatively, a carbon tax, which would tax the emission of CO2, rather than the production and sale of oil, would be a much more effective Pigouvian tax that would actually change people's behavior and would actually help the environment. Additionally, a carbon-tax does not have to be regressive. Rather, as Jason Furman notes, the carbon tax could be paired with reductions in other taxes, such as the payroll tax, so that low and middle-income taxpayers do not see their tax bills increase. That way we tax polluting behavior and not income.

The WPT is, at best, an ineffective half-measure and is, at worst, cynical political scapegoating. If we want to take global warming seriously, we need to tax polluting behavior; you do not need to have any sympathy for the oil companies to see that. And, yes, tax breaks and other incentives for oil companies are nothing more than "Conservative Nanny State" policies, which have to stop. But don't shed any tears for the WPT. As a measure for solving climate change, it won't work; as a means of scoring political points, it probably will.

Update: More from the Pigou Club

Here is Charles Wheelan (The Naked Economist) writing about a carbon tax. He makes an additional point about Pigouvian taxes that I left out of my previous post. Referring to the consequences of the higher price of gas he writes:

"I will add, perhaps gratuitously, that the behavioral changes we're seeing now are exactly why we should have implemented a carbon tax (with offsetting income tax or payroll tax cuts) 10 years ago. Given that we have to raise revenue somehow, we ought to do it by taxing behaviors that we would prefer to discourage. An income tax discourages work; a carbon tax discourages pollution. Which one makes more sense to you?"

Taxes serve two important functions: they raise revenue for government and discourage whatever behavior is being taxed. In America, income and investments are taxed at a higher rate than consumption. At a time when we're all so concerned about public and private debt, maybe this is something we should rethink.

Also, check out Wheelan's terrific book, Naked Economics: Undressing the Dismal Science. It's the best introduction to economics out there, and one of the only ones that wont put you to sleep.

The Joy of Tax

Nobel Laureate Milton Friedman once compared governments to a teenager with their father’s credit card. As long as there is money to be spent, they will spend it. Unfortunately, the recent economic slowdown is starting to hit states’ budgets. And since individual states, unlike the federal government, cannot simply print money to make up the difference, they have to find other sources of funds.

Everyone knows that politicians don’t get elected by calling for tax increases or for cuts in spending on popular programs. So the only avenue left for state politicians in tough economic times is to find a group that the public doesn’t like (or for whom they feel no sympathy) and drudge up a moral case for taxing them. Massachusetts lawmakers, for example, have discussed taxing the Harvard University endowment. The endowment, estimated at roughly $34 billion, currently grows tax-free due to Harvard’s status as a non-profit institution. The argument, says Representative Paul Kujawski, is simple: “It's mind boggling that one entity not paying taxes has $34 billion…When people can't afford to live, how do you justify not taxing them?” Whether or not you agree with the tax, the message from Massachusetts law-makers is quite clear: times are tough, and we need tax those who have the money.

Law-makers in California are trying something similar, going after an equally well-endowed group: the porno industry. According to Representative Charles Calderon, the 25% tax on both the production and consumption of pornography will generate $665 million in tax revenue from the $4 billion per year industry. However, unlike their east-coast compatriots, the California politicians sponsoring this bill are not invoking a “rich should pay their fair share” argument; rather, they are drawing inspiration from 20^th century British economist Arthur Cecil Pigou. Pigou is best known for the “Pigouvian tax”, which is a tax designed to correct the negative by-products (externalities) of market activities. An externality is an outcome of a market activity that affects a third party not involved in the transaction. Positive externalities are things like education, which provides indirect benefits to society beyond the direct effects on the person attending school. Negative externalities are things like pollution. The emissions from the car I drive, for example, impose costs on others that I don’t pay for. As a result, there is a tendency for people to under-consume goods with positive externalities (since they don’t get the full social benefit) and over-consume goods with negative externalities (since they don’t pay the full social cost). Pigou and others have argued that the role of government is to tax goods with negative externalities (to put the individual cost in line with the social cost) and subsidize goods with positive externalities (to put the individual benefit in line with the social benefit).

Pigouvian taxes have enjoyed a bit of resurgence recently. Gregory Mankiw, Harvard professor and former head of the President’s Council of Economic Advisors, has even gone so far as to create the “Pigou Club”, which includes many notable economists, policy wonks and pundits. The Pigovian tax most often cited by Mankiw is a carbon tax. According to Mankiw, a carbon tax would be the best way to get people to use less fossil fuel, and that the cost could be offset by decreases in the payroll tax. This is an idea that most economists think will work.

So how is a tax on porn a Pigouvian tax? Representative Calderon claims that the tax will help address the “secondary effects” of the porno industry, including the spread of sexually transmitted diseases and crime associated with adult venues. However a more careful look at the evidence suggests that Calderon’s assertions about the porn industry are, well, overblown.

As far as the first claim goes, while STDs do count as a social ill and public health problem, a porn tax seems like a strange way to solve it. Making porn more expensive (and just in California) will not make porn stars more likely to use protection. If anything, the tax will raise the cost of production as well as sales, encouraging studios to film more exotic and risky behaviors. And for anyone who thinks that porn encourages unsafe sex among its viewers, perhaps funding more comprehensive sex education would be a better place to start.

More interesting is the claim about crime at adult venues. While Representative Calderon (true to form as a politician) offers no empirical evidence to back up this statement, researchers have looked into this issue and found mixed evidence. A study commissioned by the city of Los Angeles (cited in the link above) found adult venues to be associated with higher rates of prostitution, robbery, assault and theft in surrounding communities. However, a study conducted by researchers at Duke University, looking at areas with adult venues with comparable control areas without them, found no evidence of “secondary effects” associated with these businesses. Further, Dr. Daniel Linz of the University of California, Santa Barbara and Dr. Bryant Paul of Indiana University, have published several papers dismissing the “secondary effects” theory, and have questioned the methodologies of studies used by law-makers to push bans and zoning restrictions. Interestingly, while they have found evidence of increased crime associated with venues that serve alcohol, they actually found this effect to be higher at establishments that did not feature adult entertainment.

If we accept, however, the dubious notion that adult venues cause more crime in the surrounding areas, this implies that a Pigouvian tax should be levied on all venues for which such a relationship holds. According to recent research from the University of Denver, this includes sporting events. The study, which looks at criminal offense data from the host communities of college football games, suggests that games days induce, “sharp increases in assaults, vandalism, arrests for disorderly conduct, and arrests for alcohol-related offenses.” The authors further note that, “…upsets are associated with the largest increases in the number of expected offenses.” So not only should sports teams (and fans) pay a tax for going to a ball game, but teams that lose a lot should pay even more. This is bad news for Los Angeles Dodgers, San Diego Padres, and San Francisco Giants, all of which currently have losing records.

So why treat sports differently from porn when there is actually more substantial evidence of the former increasing crime? It is politically difficult (if not impossible) to attack a beloved institution in a state with 5 MLB teams, 3 NFL teams, 3 NHL teams, and 4 NBA teams (one of which is currently in the Finals), not to mention all the major college and high school teams littered throughout Pacific Coast.

But what about the most practical question: will the tax work? Daniel Hamermesh doesn’t think so. This tax would affect both the demand and supply sides of the market. If the demand for adult entertainment is inelastic (as Hamermesh suggests), then the tax wont affect consumption but will generate tax revenue. The supply side, however, is a different story. Businesses tend to move to the most favorable climates, when possible. A tax on Hollywood (completely infeasible politically), might not lead to the flight of studios to other states because there are a lot of fixed costs associated with the movie industry: large sets, studios, networks of writers and actors and other service staff. The adult entertainment industry, by contrast, is much more mobile. All you really need to make a movie is two busty blonds, a hotel room, a camera and a slew of battery operated devices. The likely effect of a tax will be the exodus of the porn industry from Southern California to Western Nevada, taking 40,000 jobs with it. This could only exacerbate the current budget woes.

Real Pigouvian taxes can and do work. However, cash-strapped legislatures have a strong incentive to use Pigouvian arguments to justify taxing a politically unpopular group, particularly ones with high silicone to body fat ratios. So beware of politicians bearing Pigouvian taxes; you might just get screwed in the end.