Does it make sense to subsidize biofuels?

Ina relatively short time, biofuels have become remarkably popular, especially as an additive to regular petroleum based fuel. This is at least in part due to massive subsidies from the US to fuel and corn producers. As biofuels compete with food, this has lead to major price increases for corn and sugar, with adverse consequences for importing countries. This begs the question: is it actually a good idea to subsidize biofuels? I mentioned previously that it is preferable to tax other energy products rather than subsidize alternative energies (1, 2), but let us revisit this issue.

Subhayu Bandyopadhyay, Sumon Bhaumik and Howard Wall use a general equilibrium trade model and confirm that if there is a Pigovian tax on conventional fuels, subsidies are not needed. But if the Pigovian tax is not available or too low (as is the case in the US), then a subsidy for biofuels makes sense, But if the country in question is large, there are other implications through increased worldwide demand for food. In that case, a food exporter wants to subsidize biofuels and tax conventional fuels. A food importing country would only want to subsidize biofuels if the pollution reduction effect is large enough.

Hector Nuñez, Hayri Önal, Madhu Khanna, Xiaoguang Chen and Haixiao Huang look more specifically at the interaction of policies in the US and Brazil, the two largest producers of biofuels. Indeed, the US imposes a special tariff on the importation of biofuels, in particular the more advanced sugarcane based one from Brazil. Brazil is also the largest producer and exporter of beef. The paper uses a multi-country, multi-good model, unfortunately with a partial equilibrium, but it takes into account possible crop rotations and different categories of land. It concludes that eliminating the tariffs would significantly reduce biofuel production in the US, with the latter importing biofuels from Brazil and exporting corn. While this reduces producer welfare compared to the status quo, it increases consumer welfare. Given the political system in the US, guess what will happen.

Risk-free rate tax deductions

The Norwegian shareholder tax is rather peculiar in that it allows the deduction of risk-free interest income, thus only taxing the risky portion of capital income. This is rather counter-intuitive, as one usually wants to encourage risk-taking in the form of venture capital or plain entrepreneurship. But the idea in Norway was that this would make financing of firms neutral with respect to the source of funds.

Jan Södersten and Tobias Lindhe argue this line of reasoning is not appropriate for an open economy like Norway and 56% foreign ownership. Indeed, one needs to understand as well who is investing. Indeed, taxes are capitalized differently by different people. Indeed, for an economy that is so open, returns are largely determined on international markets, What is then determinant for Norway is the after-tax return, and this is where new distortion enter the picture: large firms are financed on international markets, and the after-tax rate is set abroad. Small firms that finance themselves domestically have provide similar after-tax returns, but domestic investors face different tax rules than their foreign counterparts. This is where new distortions can enter, and severe under-investment in domestic firms could be the consequence. But for a rather closed economy, this seems a good idea, especially as it is a neat way to prevent under-reporting of income.

Higher local sale tax leads to more local retail activity

Many US states are currently tempted to increase sales taxes in order to overcome revenue short falls. While they should really be thinking about introducing a value-added tax instead, in the short run it is useful to study what the consequences of such a tax increase would be, not just on revenue, but also on economic activity and its composition.

Daria Burnes, David Neumark and Michelle White study the impact of higher sales taxes on retail employment at the local level. You think that higher taxes lead retailers to flee, but one should not forget that local authorities have other tools, in particular zoning. They find that in fact that locations with higher sales taxes have more retail employment, and that is because authorities than make greater efforts to attract big retail outlets. The downside is that manufacturing employment is getting crowded out by these efforts.

The role of independent fiscal watchdogs

As discussed a few days ago, politicians have a rational tendency to lie. One remedy against this is to improve information. One area where political lies hurt the most is when politicians distort (or blatantly ignore) the consequences of their actions or policy proposals. The starkest recent examples come from the second Bush Administration with the Iraq war ("it pays for itself with Iraqi oil") and the prescription-drug plan for the elderly. How do you improve the information of the public in this regard? And you may also want to inform politicians as well as they may be ignorant or easily influenced (many are lawyers after all, and certainly not economists who can gain their own insights). Finally, you want to redress short-sighted politicians and find a way to commit them to long-term policies and outcomes. One way is to institute some fiscal watchdogs. There are plenty of think tanks willing to take this role, but they usually have some vested interests in the debate and rely on funds from interest groups to function. The fiscal watchdog thus needs to be independently funded.

Lars Calmfors makes the case for independent fiscal watchdogs in a report to the Prime Minister of Finland. He forcefully argues that the rules vs. discretion problem of central banks is just as valid for fiscal authorities, if not more as political terms are typically shorter than those of central bank governors. The ideal would be to have an independent fiscal authority, but this is clearly not feasible, so an independent fiscal watchdog is the next best solution. The paper focuses on the example of the Swedish Fiscal Policy Council, but there are others. They work as long as people are willing to listen to them. One example where it does not seem to work as well as before in the United States, where the Congressional Budget Office is not viewed as being credible due to the general attitude against scientific evidence in the country, and due to partisan bickering. But beyond criticizing fiscal policy, fiscal watchdogs can help with the formulation and enforcement of fiscal rules, like the German one that forces the government to act once deficits exceed some level.

In any case, this paper is a good read for anybody who is worried about the unsustainability of fiscal practices and who wants politicians to think harder about the consequences of their actions.

Another French experiment with work hours going bad

The French have a special knack in messing with labor markets. The last spectacular failure was the law that limited almost everyone's workweek to 35 hours in the hope this would spread the total hours to more people, lead to more employment and solve a chronic unemployment problem. Well, it did not and lead to loss of productivity and ridiculed controls. And I doubt many economists were surprised. With the election of Sarkozy, this law was quickly scraped and an equally ridiculous law from the other end of the spectrum was introduced.

Pierre Cahuc and Stéphane Carcillo discuss the French policy of making overtime work tax exempt. One can really question what Sarkozy had in mind with this policy, as the adverse consequences are all too obvious. First what is overtime is easily manipulated, and suddenly many regular hours became overtime hours. Second, if the intend was to increase the total hours of work, it was bound to fail if most of the overtime is coming from workalcoholics who would work no matter what the wage is. This is why you need to tax them instead of subsidizing them. And Cahuc and Carcillo find that indeed total hours hardly changed. So what all this amounted to is a generous lump-sum subsidy to highly-skilled workalcoholics. Great.

A driving median voter reduces gas taxes

If you own a car, you are not too happy when gas taxes go up: it is more money out of you pocket, however you benefit from a reduction in congestion and lower pollution as long as this tax increase also implies a reduction in gas consumption. If you do not own a car, you would view positively the increase in gas taxes, as the state can now provide more services or reduce other taxes you may be paying. However, some goods with a high share of transportation costs may be become more expensive. Does this reasoning make sense in a political equilibrium, i.e., is the level of gas taxes determined by whether the median voter is a car driver or not?

Fay Dunkerley, Amihai Glazer and Stef Proost show that it does and figure out that in the OECD a car driving median voter leads to a gas tax that is 20% lower than a walking median voter. Of course any such estimate is fraught with endogeneity: the median voter is walking because the tax is high. To overcome this problem, the authors use a dynamic setup that takes into account when a median voter starts to drive.

How to fight tax evasion

Tax evasion is a serious problem in developing countries because of the tiny administrative capacity of authorities and the size of the informal sector. Even in more developed economies, say, the Southern European ones, tax evasion is part of daily life. Again, administrative capacity is lacking. One could even argue it is a problem in the United States seeing the tiny auditing staff of tax authorities and the complexity of the tax code. Tax auditors have thus to define priorities.

Mirco Tonin studies the rules that Italy and Bulgaria instituted. In Italy, businesses and self-employed people reporting revenues below some level are subject to higher scrutiny. The idea is thus not to go after those who declare to be big fish, but rather those who may hide it. And making it known that there is such a threshold induces people to declare more to tax authorities. In Bulgaria, authorities are after employees and firms that declare too little in social security contributions. This is also forcing them to declare more to avoid scrutiny.

Tonin uses a model of imperfect monitoring to figure out whether such threshold rules make sense. And yes, they improve tax revenue, as those who have higher true income declare more than the threshold, and those below become more truthful. Now all you need to do is figure out where to put the threshold to equalize marginal tax revenue and marginal auditing cost, possibly adjusted by the dead-weight cost of taxation and for observable characteristics of the tax payer.

Are consumption taxes more equitable?

There is no doubt that consumption taxes are more efficient that labor income or capital income taxes, because they do not punish activities one would like to see promoted in an economy (labor supply, investment). But they are widely regarded as unfair, as the consumption share of income is higher for poor people. Hence the implementation of exclusions for essential goods where consumption taxes exist, in order the achieve some tax progressivity.

Isabel Correia claims that switching from income taxes to consumption tax can lead to less inequality even in the absence of lump sum transfers. This is a very counterintuitive result, and this is probably the reason why it made it into the American Economic Review (Yes, I know, I am breaking a trend here). But despite my best efforts, I still do not understand how this could happens, and the article provides very little in terms of explanation. Not only is no intuition provided, but the idea of using Gorman aggregation to reduce the model to a representative agent model seems wrong in this context. If anybody has read and understood the article, please help me here.

Are military expenses good for growth?

It is obvious that federal fiscal deficits will have to be addressed sooner or later in the US, and seeing how difficult it is to raise taxes, one has to think about how to trim expenses. Of course, the biggest line item is defense, and one can ask what the consequences of cutting these military expenses could be. Critics of those cuts will point to WWII, where the military build-up has pulled the US out of the Great Depression. While I do not quite agree with this interpretation of this anecdote, it is worthwhile to study more generally the impact of military expenses.

Giorgio d’Agostino, Paul Dunne and Luca Pieroni do a literature review and note that out should not just look at the direct impact of expenses. Indeed, a military build-up is also more likely to generate conflicts, and after all a conflict is overall a waste of resources as much effort is spent blowing physical and human capital to pieces. The multiplier argument is also rather vacuous, as these funds could be used for other purposes as well with higher multipliers, in particular when you compare wars in foreign lands versus infrastructure at home. The same applies to the argument that military research has some positive impact on civilian technology (why not simply focus research on the latter?).

This clearly makes it difficult to make a case that military expenses are good for growth. Empirical work is really difficult, like so often with cross-country growth regressions, but d'Agostino, Dunne and Pieroni conclude that the evidence tends towards a negative impact. The only ones that obtain positive impacts are those that include supply-side effects, and those are of course rigged to provide a positive impact.

A balanced budget in the US constitution, really?

Europe and the United States are a story of contrasts these days. While the Obama Administration is pushing for fiscal stimuli at the cost of large deficits, Europe is severely putting the brakes on its public expenses to bring public budget back in order. This is quite ironic, as European governments have in the past used public deficits quite liberally, while the US has always been wary of deficits, and most US states in fact have balanced budget requirements. This makes the proposal that the federal government adopt a balanced budget amendment a hot topic again.

Marina Azzimonti, Marco Battaglini and Stephen Coate use a political economy model to contrast the short time costs of the debt reduction (with lower public services and higher taxes) against the long term benefits of a lower debt burden and the long term cost of higher volatility in tax rates and public services.

In such an analysis, the first order of business is to establish why the Ricardian Equivalence would fail in a quantitatively meaningful way. If it does not, then deficits do not matter as they internalized as future taxes by all agents, and a balanced budget rule has no impact. My reading of the literature is that there certainly no agreement, but overall we are not that far away form the Ricardian Equivalence. Well, let us assume it does not hold, because labor income tax is sufficiently distorting, as Azzimonti, Battaglini and Coate implicitly assume. They also calibrate the model to the US, which is quite tricky as one needs to take a stand on the utility of public goods.

This is where the paper becomes rather strange. At least at the state level, a balanced budget rule is usually thought to be challenging because income and expenses vary with the business cycles. This is not the approach taken here, whereas the fluctuations stem from changes in the taste for public goods. The authors' argument is that one needs to distinguish normal times to unusual times where the government wants to spend massively more, like wars. I do not think this is the real issue. If wars are the problem, then an amendment to the rule can be that properly declared wars can be financed with war bonds.

Well, let us assume this is what we want to care about. The quantitative analysis indicates that a balanced budget rule would indeed be beneficial in the long run, because it imposes lower taxes, and thus less distortions, which are more valuable than the missing public services according to the calibration. But one must point out that there are serious costs in the transition, as one starts with rather high levels of debt. But these transition costs cannot be evaluated with the present model, as it does not feature growth and thus cannot take into account the debt/GDP ratio declines naturally as an economy grows. All in all, I am not sure what we learned with this paper.

The welfare gain from age-dependent taxation

There is now a substantial body of literature that advocates for tax rates that would depend on the age of the individual. The logic is simple: the dispersion of wages increases over age, thus the scope for redistribution increases. And if you want to encourage human capital accumulation, you want to tax high incomes more when young than when old. And the uncertainty about outcomes decreases considerably with age. Finally, the source of income varies over time, with capital income taking over labor income at retirement. And, by the way, I previously reported that age-dependent taxation could allow a transition from a pay-as-you-go social security system to a fully funded one.

Spencer Bastani, Sören Blomquist and Luca Micheletto add to this literature in two ways: first they take into account within cohort heterogeneity, second they quantitatively evaluate the welfare gain from a linear age-dependent tax on income. In their overlapping-generation economy, agents face uncertainty about future outcomes and can save. They find that one does not need to tax capital, which is very useful as one does not need to worry about incentive compatibility (it is difficult to lie about one's age) when trying to reach golden rule capital accumulation. Calibrating to Sweden and the United States, they find that a nonlinear age-dependent income tax provides a welfare gain corresponding to about 2-3% respectively 2-2.5% compared to an age-independent one. That is certainly not negligible.

And how the taxes look like? The marginal labor income tax rates are decreasing. That is consistent with this model, as one tries to increase the savings rate to the golden rule level and savings should be encouraged. And the old are systematically paying higher labor income taxes than the young at the same level of income. This is because, I think, capital income taxes are then much lower, and older workers have much more capital income. I wonder how this would look like if human capital accumulation were included as well...

Mergers and tax competition

With increased mobility of labor and capital, Europe is currently struggling with tax competition that keeps taxes lower than is deemed healthy, in particular because of some small entities trying to poach on larger ones by attracting the larger tax payers. A response to this problem would be to merge fiscal authorities so as to reduce competition and thus get higher taxes and also allow a fairer distribution of the tax burden across jurisdictions. While this is not (yet) feasible at the European level (there is no talk of a European tax), there is plenty of evidence of within country mergers. What are they expected to bring?

Marie-Laure Breuillé and Skerdilajda Zanaj note that mergers have not only an impact on regional tax rates, but on local ones as well. Mergers are expected to a) reduce tax competition, b) increase tax bases and c) take into account tax externalities of cities. The impact on tax rates differs, however, by level: regional taxes increase, while local ones decrease. That seems like a trivial results, as mergers are suppose to reduce the influence of local jurisdictions. The tax changes are direct consequences of effects a) and b), but c) counteracts it, and an ambiguity may arise. But it turns out from the Nash equilibrium of the game the regions play, c) is always smaller than a) and b). The impact on welfare, though, is difficult to establish before first saying something about public goods and tax distortions. Indeed, some level of tax competition is not always bad.

Starve the beast?

The Republican strategy in the US has been since Reagan to starve the government to prevent it from growing. The master at this has been Bush Jr., who to significantly increase expenses while cutting taxes. And the new crop of parliamentarians has vowed to make these tax cuts permanent, thus forcing even further government expense cuts in the near future. While there can be much disagreement about where to cut, one could first ask whether it is a good strategy in the first place to starve the beast like this.

Michael Kumhof, Douglas Laxton and Daniel Leigh use an elaborate model to come to the conclusion that this is a good strategy if government expenses are useless. But if they provide a public good, then it is not. That seems like a very trivial result, and one that can explain the disagreement between the left and the right in the United States. But there is more to the paper. It shows that for this strategy to be welfare enhancing, cuts need to be done very quickly, and cut services must have little impact, and the taxes that are reduced must be very distortionary. It is very unlikely that all three conditions can be satisfied.

Should human capital be taxed?

There is a long standing and quite robust result in the literature, originating with Christophe Chamley and Ken Judd, that physical capital should not be taxed. Larry Jones, Rodolfo Manuelli and Peter Rossi extend this reasoning to human capital. These are very strong results that are not borne by the data, thus either the models are missing something, or economists still have a lot of convincing to do.

Christoph Braun challenges the last result on a technicality. Jones, Manuelli and Rossi assumed that human capital exhibits constant returns to scale in its production function, that is, a doubling of current human capital doubles ceteribus paribus future human capital. Braun take the opposite extreme: current human capital has no impact on future human capital, as the latter is only dependent on the time dedicated to education. The first assumption was very convenient, because it made human capital disappear from key equations, but this also drives the no-tax result. The latter makes it simpler than an intermediate assumption (decreasing returns to scale), but give a very different result from the original paper: in particular, the return to human capital does not vanish from the taxation equation and thus should be taxed. However, the accumulation of human capital is encouraged through the tax deductibility of tuition. And in the end, physical capital is still not taxed.

How to raise government revenue: tax bling bling, but subsidize hip hop?

Lost in the debate on how governments could be raising much needed revenue in our difficult times is that there are some goods that are just begging to be taxed: diamond goods. These goods are valued solely because they are expensive. The money spent on these goods is independent of their price. Thus taxing them all the way to infinity makes them even more attractive, as very little of the diamond good needs to be produced for the same satisfaction. Thus, everybody should agree diamond goods must be taxed heavily: the buyers because of the prestige of the high sticker price, the others for the tax revenue.

Per Engström adds a little nuance to this argument. Suppose there is a strong complement to the diamond good, like hip hop music is a strong complement to bling bling. As the diamond good constitutes a free lunch for the social planner, the latter would want to subsidize it. But that beats the purpose of taxation. However, one can subsidize the complement, which encourages the consumption of the diamond good.

Engström mentions other pairs of goods. Entry to the Sex and the City should be free and designer shoes should be taxed to the hilt. The same for James Bond movies and champagne. Any other examples?

Bubbles with collateral and infinite credit

Rational bubbles occur when people believe that prices will increase into the infinite future, which makes that they invest in more assets and prices really increase. But equilibrium models have difficulties replicating such phenomena because this increased wealth also induces, at some point, people to consume more, and then the budget constraint bites and halts the bubble. So how could one still get a rational bubble? By relaxing the budget constraint.

This is what Christopher Reicher does in a way that is reminiscent of the US before the crisis: through the provision of unlimited credit, which is possible if real estate is used as collateral. This sounds rather intuitive, as long as lenders are willing to go along. What is more interesting is that the model shows that there are monetary and fiscal policies that can prevent bubbles from happening. One is to apply the fiscal theory of the price level to credit markets, that is, to make sure the price level instantaneously responds to land prices to deflate the debt. If this is difficult to implement, and it would, another way to deflate a bubble is the make sure the returns of assets are lower by increasing interest rates of bonds, which makes them more interesting than real estate. Of course, one could also tax away the bubble. And one has first to recognize that there is a bubble.

How can very small economies survive?

I find very small countries fascinating. They are link small scale representations of the economies we usually study, to a scale that would correspond to an experiment we would want to perform. But these very small countries are not perfect replicas of the larger ones. Because of their size, they are less diversified, need more per capita overhead for governing, their capital accounts are more vulnerable, but they can play very well with tax competition.

Patrice Pieretti, Skerdilajda Zanaj and Benteng Zou, fittingly based in Luxembourg, set up a linear, small open economy where government set tax rates (and thus productivity enhancing public amenities) and household firms locate à la Hotelling around the country border. The result is that there are three possible paths, as so often in dynamic systems: the economy either collapses, explodes or finds its way towards a steady-state along a saddle path.

But do we really learn something from this exercise? The entities here are really P.O. box firms that can move from one country to the next on a whim, except that each firm takes a worker with it. What if there are moving costs? Concave production? People who stay in the country when capital leaves? I bet you would easily find multiple, stable equilibria, some with low taxes, low returns and ovecrowding, some with high taxes, high returns and high amenities. And now things become really interesting and more realistic.

Energy taxes and employment

It seems quite obvious that the United States will have to increase energy taxes, first because energy prices need to better reflect the negative externalities they exert on the economy (pollution, wars, congestion, etc.), and second because the government will need to raise revenue from somewhere. So it is of particular interest to verify what consequence this would have, for example on labor markets. If the cost of an input increases, and it is cheaper elsewhere (or if not, the gap with elsewhere is reduced), one should expect labor demand to be reduced. But how much?

Olivier Deschenes does such an empirical exercise by exploiting the cross-state variation in energy prices and finds a price elasticity of 0.15. Given that the electricity prices are supposed to rise by 4%, a reduction in employment of 0.6% or 460,000 people is inferred. Unfortunately, these estimates cannot be relied on for several reasons. First, estimates are based on employment differences across states due to energy price differences. Imagine that electricity prices increase in Michigan, and this drives some jobs to Wisconsin. This is what this elasticity measures. But when electricity prices increases in all states, cross-state movements of jobs should not happen. They may move abroad, but this is not measured with this procedure, which certainly overestimates the correct elasticity.

Second, these are reduced form estimates that give us very little understanding how various agents in the economy would react to those price changes, especially if they are larger that the one observed in the data. One needs here some structural model to understand what would happen, a model that would, for example, include the industrial structure of each state. Computable general equilibrium (CGE) models have been used extensively for similar exercises, and should be much more reliable than this reduced form (Lucas Critique anyone?). Third, if you do not increase energy prices, it is quite obvious that some other tax will have to increase. An obvious candidate is labor income tax. Now that is certainly going to reduce employment as well, and possibly more than the 0.6% from above. In other words, the energy tax can very well be a lesser evil (on top of reducing pollution).

Some press will pick up this paper and rail against energy taxes. That is most unfortunate.

Globalization and the size of the public sector

To finance public goods, taxes need to be levied. But with globalization and international tax competition, the ability of governments to levy taxes is curtailed. Indeed, raising taxes may increase the cost of labor compared to other locations, and outsourcing takes over. The same reasoning applies to other taxes, which become more distortionary with globalization. Of course, it is never bad to put some pressure on governments to keep taxes as low as possible and thus remain efficient, but one may hit a feasibility constraint here.

Torben Andersen and Allan Sørensen think we should not worry too much, though. First, one consequence of globalization is that increased trade leads to a lower cost of goods. This decreases the marginal cost of public funds. Second, there is not necessarily a race to the bottom among tax authorities because terms of trade work to counteract the after-tax disadvantage of higher taxes, apparently for a wide set of parameter values. In other words, gains from trade and general equilibrium effects can absorb the increased distortions from taxes.

The impact of taxing plastic bags

In many countries, the movement towards charging for plastic bags appears to be a major annoyance for consumers used to free bags (and double-bagging). In most cases, retailers are forced to charge for the bags, in some few cases, they are taxed on them: Ireland, Denmark, South Africa and Botswana. Yes, Botswana, where retailers are free to pass on the tax to customers, and most do. Botswana also imposed that bags cannot be too thin, which avoids single use and wasteful double-bagging.

Johane Dikgang and Martine Visser study the consequences of these plastic bag taxes in Botswana find a very large response: the number of bags used halved within 18 months, with half of this change happening within the first weeks. Interestingly, the sharpest reduction happened at the bottom end retailers, and also at the top end retailers. While at the bottom a bag became a measurable share of the shopping bill, and hence could easily be saved, that is certainly not the case at the top end, where prices are higher and quantities shopped in a trip a larger. I wonder whether, in the case of high-income households, it was not so much the price of the bag that mattered, but rather that it signaled that bags are bad and one should reduce their consumption.