Tax Carbon, Not Work

Tax This

Not This . . . .

CNN is reporting that several Republicans are calling on Congress to adopt a so-called "carbon tax," coupled with a reduction in taxes on income.  (One might call this plan "Tax and Cut.")  The list of advocates includes former University of Chicago economist and one-time Secretary of State George Shultz, now at the Hoover Institution.  Under the proposal, the national government would levy (additional) taxes on coal, natural gas, and gasoline, presumably calculated to reflect the environmental and health harms resulting from the use of these fuels.    These calls by Schultz and others follow similar proposals by other free market conservatives, including renowned supply-side economist Arthur Laffer, to adopt a revenue-neutral carbon tax.

Proponents of such a carbon tax generally focus on two benefits.

1) First, such taxes force individuals and firms that employ carbon-emitting fuels to take account of or "internalize" the full cost of their activities.  That is, the"carbon tax" functions as a classic "Pigouvian Tax."    While individuals dispute the full extent of these costs, there is no doubt that such costs exists, whether in the form of asthma-inducing smog, global warming, and/or mercury, a byproduct of coal-fired power generation.

2) Second,  the corresponding reduction in income or payroll taxes would ensure that individuals capture a larger share of their individual productivity.   This, in turn, would produce two benefits, one static and one dynamic.  First, knowing that they would retain a larger share of their earnings, individuals would supply more labor to the market, thereby increasing the nation's economic output in the short run.  Second,  individuals would also invest more in improving their own economic productivity, knowing that they would, in the future, capture a greater share of such gains.  The result would be a better-educated and more skilled workforce, more potential output and thus greater economic growth (and a lower price level) in the long run.

These are certainly laudable objectives and, taken together, would by themselves justify the imposition of  a carbon tax coupled with a reduction in tax on labor.   There are, however, two additional benefits that make the case for a carbon tax even stronger. 

3) Third, imposition of such a tax would presumably eliminate the need for much "command and control" environmental regulation.  Such regulation requires firms to employ particular pollution control technologies, even when other technologies would be more cost-effective, thereby reducing economic welfare.   If, however, firms must pay the true cost of their activities, such regulation is redundant and counter-productive; firms will themselves take cost-justified steps to maximize the net social benefits of their activities.  Such steps might include purchasing pollution control equipment, changing the composition of output, and/or inventing new ways to reduce their carbon footprint.  Moreover, firms that produce such equipment would also be free to innovate, producing what they believe to be cost-justified equipment, instead of producing whatever the government happens to mandate.

4)  Fourth, such a tax would eliminate the perceived need (by some) for the national government to encourage the emergence of so-called "green" technologies and industries by distributing state largesse to favored firms or, in extreme cases, bailing out entire industries.   As previously explained on this blog, the national government is poorly suited to predicting which companies and/or technologies will in fact be cost-beneficial and thus a worthy investment of scare capital.  Moreover, once the government takes on this responsibility, private businesses will invest scarce resources in attempting to influence political decision makers, in a rational effort to steer taxpayer largesse their way.  The result will at best be inefficient allocations of scarce capital and at worst outright corruption.  The recent ill-advised bailout of the auto industry provides a classic example of such inefficiency.   As previously explained on this blog, President Obama justified the bailout in part as a means of insuring that General Motors and Chrysler produced more "green" automobiles.  The result has been a heavily-subsidized Chevrolet Volt, with a sticker price over $40,000, that no one wishes to purchase.  By contrast other companies, including Ford, are producing popular high-mileage automobiles in response to market demand.   Society thrives when the decentralized market, not a distant central government, allocates scarce capital.

More than half a century ago F.A. Hayek described the price system as a "marvel" that allows economic actors to rely upon local knowledge and thus coordinates the plans and activities of millions of unrelated individuals, esuring an allocation of economic resources that generates far more economic welfare than any planned society could ever imagine.  However, as Hayek and others would later emphasize, a well-functioning price system and decentralized allocation of resources requires society to create and enforce property rights, thereby ensuring that market prices accurately reflect the  actual costs and benefits of economic activity and thus send appropriate signals to economic actors.  By forcing individuals and firms to internalize the full costs of their actions, and reducing the penalty on labor, a scheme of "Tax and Cut" could harness and improve the already-marvelous price system, improve environmental outcomes and  increase economic welfare for all.

John F. Kennedy, Radical Supply-Sider?

In an August 2, 2010 Op-Ed "Soak the Rich Catch-22" published in the Wall Street Jounal, Arthur Laffer argues that a tax increase on the wealthy will reduce the tax revenue received from such individuals and, other things being equal, increase the federal budget deficit. The Op-ed follows a May WSJ column by Laffer on tax policy in various states, entitled "Soak the Rich, Lose the Rich." Laffer argues that the wealthy, which he defines as individuals in the top 1 percent of the income distribution, can more readily take those steps necessary to alter their activities and income so as to avoid the incidence of income taxes.

As Laffer puts it:

"The highest tax bracket income earners, when compared with people in lower tax brackets, are far more capable of changing their taxable income by hiring lawyers, accountants, deferred income specialists and the like. They can change the location, timing, composition and volume of income to avoid taxation."

Laffer also warns that those who call for higher taxes at this moment in history are repeating the mistakes of Herbert Hoover and Franklin Roosevelt, each of whom signed large income taxes into law in the early 1930s, increases that Laffer claims first precipitated and then deepened and legthened the Great Depression.

To support his claim that raising taxes on the rich will result in lower revenues, Laffer points to data showing that, after REDUCTIONS in tax rates on the rich, tax receipts from the rich rose. For instance, between 1978 and 2007 (the last year from which Laffer has data), taxes paid by the rich rose from 1.7 percent of GDP to 3.3 percent of GDP. (It should be noted that GDP rose significantly during this period. Thus, the size of the pie increased, and so did the portion of the pie that the "rich" paid in taxes.) During the same period, Laffer notes, the share of taxes paid by those individuals in th lower 95 percent of the income distribution fell, from 5.4 percent of GDP to 3.2 percent of GDP.

It should be noted that there may be alternative explanations for these data. For instance, it may be that, from 1978 until 2007, the wealthiest's pre-tax share of overall GDP rose, thus explaining the increase in tax receipts from the wealthy as a share of GDP. Note, however, that this increase in pre-tax share of GDP would reflect in increase in the productivity of the wealthy relative to other earners, an increase that Laffer might explain by the reduction in tax rates that led the wealthy to work, save and invest more than they had under prior tax rates. Others may attribute this increase in productivity to other factors or claim that productivity had nothing to do with the wealthy claiming a larger share of GDP.

Here, though, is what really caught this blogger's eye.

Laffer begins his editorial with a quote from the January, 1963 Economic Report of the President, published by John F. Kennedy.

"Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idle --- workers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in today's economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficit --- why reducing taxes is the best way open to us to increase revenues." Like the Arthur Laffers of today, President Kennedy argued that, over the longer run, cutting taxes will actually result in increased government revenues.

Now of course, President Kennedy likely did not pen the words that appeared in his economic report. That task probably fell to Walter Heller, also pictured above, who chaired President Kennedy's Council of Economic Advisors at the time. Heller was a highly respected macroeconomist from the University of Minnesota, hardly a hotbed of laissez faire. Note, however, that Heller was echoing what President Kennedy himself had said just a month earlier, in his famous speech to the Economic Club of New York. There the President made the case for an "across the board, top to bottom" reduction in income tax rates as well as corporate tax rates, as a means of stimulating the economy. At the time, the unemployment rate was 5.5 percent.

In so doing, President Kennedy sounded a lot like Professor Laffer.

"In short it is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country's own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring about a budget surplus."

It should be noted that there are a couple of possible distinctions between Professor Laffer's position, on the one hand, and that taken by President Kennedy, on the other. That is, Laffer emphasizes the ability of individuals to shift income from one place to another --- both spatially and temporally --- an ability that prevents tax increases from raising revenue. President Kennedy's emphasis was more Keynesian, that is, he claimed that tax cuts would enhance private consumption and investment, thereby enhancing aggregate demand and increasing real output, given that the economy was operating below full employment. Of course, the conventional Keynesian story includes an INCREASE in the full employment budget deficit, an increase that stimulates consumption and investment. Kennedy does not fully explain n how, given his Keynesian logic, deficits will, as he claims, turn into surpluses, except to say that such tax cuts will lead to increased prosperity and thus to a balanced budget. However, he does claim that wealthy Americans who receive a tax break will "hereby be encouraged to undetake additional efforts and enabled to invest more capital." This is pure supply-side reasoning, as such "additional efforts" and investing of "more capital" manifest themselves as shifts in the aggregate supply curve that thereby increase real output (and reduce prices). In so doing, he seems to distance himself from the traditional Keynesian approach, which assumes away such supply-side effects to focus only on the demand side. Perhaps he also had in mind the possibility that relaxed monetary policy would provide a separate source of stimulus and thereby boost GDP sufficiently to lead to a balanced budget.

One final note. True Keynesians believe that, when it comes to stimulating the economy, increased spending will, if anything, be more potent than tax cuts. After all, individuals who receive a tax cut, particularly those who are well off, may choose to save the additional income the government allows them to retain instead of spending it. The Keynesian model assumes that such savings will be completely unproductive, even if the additional savings drive down interest rates, because the economic downturn will reduce the return from private investments. (Moreover, consumers may spend the proceeds of a tax cut on imports, thus stimulating the economies of other countries.) Outright spending, by contrast, will stimulate the economy "by definition," as the government purchases goods or services directly from its citizens. Nonetheless, Keenedy's speech to the New York Economic Club rejected additional spending as a remedy for recession, arguing that "such a course would soon demoralize both our government and the economy." "If the government is to retain the confidence of the people," he continued "it must not spend more than can be justified on grounds of national need or spent with maximum efficiency." In short, President Kennedy rejected a big government spending approach to stimulating the economy.

In sum, while President Kennedy may not have been a pure, "true believing" supply sider, he did incorporate certain aspects of supply side thinking in his macroeconomic policy, as part of an overall synthesis of Keynesian and supply-side principles.