Don't "Plan" The Colorado River or Why Property Still Works

Bound For Los Angeles? 

Had a Better Idea

Yesterday's Los Angeles Times reported that "[w]ater demand in the Colorado River Basin will greatly outstrip supply in coming decades as a result of drought, climate change and population growth."  The story is based on a recent study by the U.S. Department of the Interior, which concludes that demand for the river's water will exceed supply by 3.2 million acre-feet per year in 2060.  According to the story, 3.2 million acre-feet is more than five times the current annual consumption of water by Los Angeles and its citizens.  The story concludes by discussing various possible responses to such a shortage.  Such responses include conservation, recycling, desalinization, building a pipeline from the Missouri River to Southern California, or towing icebergs from the Arctic Ocean to Southern California.  Interior Secretary Ken Salazar admonished all those who rely on water from the Colorado to "plan for this together."  

With due respect to Secretary Salazar, little or no planning is necessary.   Such a "shortage" is the natural and predictable result of the failure to establish property rights in a resource, a failure that results in below-market prices and thus artificially high demand and overuse by those, including agribusinesses, who do not internalize the full social cost of using the resource.  As one leading scholar has explained: "[w]ell-defined and defended property rights encourage greater resources stewardship and sustainable utilization."  See Jonathan Adler, Water Rights, Markets and Changing Ecological Conditions, 42 Environmental Law Review 93 (2012).  Thus, a well-functioning market for water from the Colorado River and elsewhere would result in prices that reflect the actual social cost of that water and thus a more efficient allocation of this precious resource.

At first glance it seems more difficult to establish property rights in water than in other items such as automobiles, I-Phones or candy bars.  After all, it's one thing to own a pickup truck; quite another to own a river.  And yet, auctioning off the Colorado River might be just the solution to this purported "shortage."  Such an auction would create a single owner of all the water in the river, and this owner would then charge a market price for the water in question, a price that would bring demand and supply into equilibrium and thus eliminate any artificial shortage.  In such a market, consumers would only purchase water when their personal value for the water equaled its true social cost.  Moreover, such consumers would have incentives to conserve water in any number of ways.  For instance, farmers might choose to plant crops that are less water-intensive, even if such crops are slightly less valuable.  Fewer citizens would purchase swimming pools, and some would forgo grass lawns for the sort of faux desert landscapes, complete with rocks, cacti and palm trees, already popular in the Southwest.

Without any planning whatsoever, then, the creation of property rights in the Colorado's water would encourage conservation and result in a more efficient allocation of this scarce resource.  As F.A. Hayek explained more than six decades ago, the price system is a "marvel" that transmits information about the value of competing uses of particular resources to various market participants.  Thus, different possible purchasers of water need know nothing about how or why other purchasers might use water, as the market price will reflect values that other market participants place on that use.  See F.A. Hayek, The Use of Knowledge in Society, 35 American Econ. Rev. 519 (1945).   Moreover, as Hayek explained in subsequent work, the creation and enforcement of well-defined property rights is a necessary condition for a well-functioning price system.   See F.A. Hayek, Free Enterprise and Competitive Order in Individualism and Economic Order, 110-16 (1948) (explaining that well-functioning competitive order depends upon properly-designed “legal framework” of contract, property, tort, and business law).  Thus, granting the Colorado's water to a single owner would facilitate the operation of a well-functioning price system and thus help optimize the allocation of water resources. 

 
Some might object that this hypothetical single owner of the Colorado River would reduce output below the socially optimal level and charge monopoly prices for the river's water.  There are, however, there distinct reasons that this possibility is less problematic than it might first seem.

First, even if such a single owner did reduce water output below the socially optimal level, such a (negative) deviation from the optimal output of water may do less social harm than the current regime, under which firms and individuals consume too much water, thereby resulting in artificial shortages.  All institutions are imperfect; as Ronald Coase explained over two decades ago, society must choose between various imperfect institutional arrangements.  Perhaps granting a monopoly over the Colorado's water would be the least imperfect means of allocating this resource.

Second, any claim that a monopolist will produce well below the optimal level of output assumes that the river's single owner will change the same price per gallon to all purchasers, that is, will not engage in price discrimination.  If, however, the firm does engage in price discrimination, albeit imperfect discrimination, it will be able to set output closer to the socially optimal level.  While such a firm would earn excessive profits, a properly-run and competitive auction would force the firm to pay the expected value of such profits to the national government, which could use these proceeds to reduce taxes or take other steps that would mitigate the distributional consequences of such monopoly pricing.

Third and finally, any claim of monopoly is likely overstated.  After all, the Colorado river is not the only source of water for many of the firms and individuals that currently draw water from it.  Indeed, one suspects that the current and artificially low price for the Colorado's water has discouraged firms and individuals from seeking out alternate sources.  Thus, creation of a single owner of the Colorado's water, by increasing prices closer to market levels, may actually spur users to identify competing sources of water.  If a single owner really did end up with meaningful monopoly power, the national government could consider allocating particular shares of the river's output to several sellers, who could then compete to sell the water to purchasers.

Don't look for the national government to sell off the Colorado River any time soon.  The proposal may have additional downsides not discussed here.  Moreover, the national government may have to pay just compensation to individuals who currently possess property rights to particular amounts of water under state law, for instance.  Finally, political pressure from those who benefit from the current system would prevent the sort of major reform suggested here.  Still, imagining such a radical, property-based solution could be the first step toward meaningful reform that would eliminate artificial shortages and thus obviate the need for schemes like towing icebergs to Los Angeles.

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.

Will President Obama Have to Soak the Middle Class?

Both men knew "where the money is."

An article last Monday in the Wall Street Journal "[w]here the tax money is" examined President Obama's purported claim that raising taxes on the wealthy will result in meaningful deficit reduction, thereby making the sort of spending reductions proposed by others, including Congressman Paul Ryan of Wisconsin, unnecessary. To this end, the article calculates the impact on federal revenue and thus the deficit of a 100 percent confiscatory tax on indivduals who earn $380,000 or more per year and finds that such a tax would raise $938 billion annually, far less than the current deficit of over $1.6 trillion. Moreover, a 100 percent tax on those individuals in the top five percent of the income distribution would yield $1.89 trillion, just enough to cover the deficit.

Note that these calculations certainly overstate the impact on the deficit of such confiscatory taxation. For one thing, the "wealthy" individuals in question already pay a sizeable portion of their income in taxes, with the result that the net increase in revenue resulting from a 100 percent tax rate would be less than the $938 billion and $1.6 trillion figures, respectively. Moreover, at least some individuals who must pay their entire salary to the government would work less, or not work at all, and thus create less income, if the government simply confiscated their income under the guise of "taxation." Such a reduction in work effort, of course, will also reduce the rate of economic growth and thus reduce the income of other citizens as well, thereby reducing tax payments from lower income groups. In short, even a 100 percent tax rate on high income earners, whether "high income" is defined as the top 1 percent or top 5 percent, defined, will still leave the United States with a very large deficit.

How, then, will the United States close its titanic budget deficit, if that is what she chooses to do? One way, of course, is to reduce spending, along the lines suggested by Congressman Ryan. If, however, the United States rejects meaningful spending reductions, the article predicts that Congress will, to quote bank robber Willie Sutton (pictured above), "go where the money is," that is, raise taxes (either directly, or by eliminating deductions) on indivduals in the middle and upper middle classes. For, as the article points out, individuals in the $50,000-$200,000 range produce more taxable income than individuals who earn over $200,000. Such an approach, it should be noted, would be consistent with the observation of nobel laureate Friedrich Hayek, also pictured above, to the effect that a chief function of high (progressive) tax rates on "the rich" is to induce individuals in the middle classes to accept rates that, while high in an absolute sense, are lower than those paid by the rich. (There is, of course, precedent for such an approach. In 1960, for instance, the top marginal federal income tax rate, levied on incomes of $400,000 and above, was 91 percent. Moreover, the marginal rate on income between $12,000 and $16,000 was 30 percent; the marginal rate on income between $24,000 and $28,000 was 43 percent, the marginal rate on incomes between $36,000 and $40,000 was 53 percent, the marginal rate on incomes between $88,000 and $100,000 was 72 percent, and so on. It short, while rates on the "rich" were quite high, so too were rates on individuals in the middle and upper-middle classes.) As Hayek put it:

"It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off."

See F.A. Hayek, "Taxation and Redistribution," in The Constitution of Liberty (1960).

Instead of simply redistributing income from rich to the middle class, such an approach would presumably also redistribute income within the middle class.

Hopefully the nation will opt for reduced spending instead of the Sutton approach.

Mark Warner Supports Vouchers !

Mark Warner (pictured on the right), Virginia's former Governor and now junior Senator, has bucked his party and voted to revive a voucher program for D.C. School Children that many Democrats in Congress apparently want to kill. The Richmond Times-Dispatch quite rightly praises Senator Warner's vote here.

The "D.C. Opportunity Scholarship Program" provides up to $7,500 for students from families with incomes less than 185 percent of the poverty standard. More than sixty private schools participate in the program, and about 1,800 children currently receive such vouchers.

The Washington Post recently opined that Congressional opponents of vouchers have "step[ed] between 1,800 D.C. Children and a good education." The Post also concludes that these opponents won't "let fairness and the interests of low income, minority children stand in the way of their politics." Translation: politics is trumping the interests of schoolchildren who lack the means to escape a substandard school system.  Here is the Post Editorial.

One commentator has estimated that Washington D.C. spends more than $24,000 per pupil on its K-12 schools.  The same commentator estimates that the average tuition at the private schools in the District to be far less.  Here are the relevant figures for the District's private schools:

Average tuition actually paid: $11,627;

Median tuition actually paid: $10,043;

Estimated average total per pupil spending: $14,534;

Estimated median total per pupil spending: $12,534

Presumably private endowments make up the difference between tuition and actual spending at these schools.

The arguments for vouchers are powerful and, I think, irrefutable. Take food stamps as an analogy. Most Americans believe that taxpayers should feed the hungry. This obviously requires the government to raise revenue and spend the proceeds. When it comes to feeding the hungry, such spending takes the form of a food voucher -- food stamps. The government need not, however, take over the grocery stores that sell the food, the farms that produce it, the factories that package it, or the trucks or trains that transport the final product from factory to the grocery store. Instead, a free society rightly depends upon the private market, based on property and free contract, to produce and distribute such goods, subject of course to valid police power regulation, e.g., state-enforced labeling requirements and health-related inspections. Redistribution to feed the hungry is one thing. Coercive state monopoly is something else entirely. Support for the former in no way justifies the latter.

If food stamps are the right answer when it comes to feeding the hungry, why not apply the same logic to educating individuals who cannot afford to send their children to private schools? This, of course, was the approach taken by the "GI Bill," which provided vouchers to returning GIs who then applied such vouchers at the private or public University of their choice. Ditto for ROTC scholarships, which recipients may spend at any school with an ROTC program, so long as the recipient meets the school's admissions standards. No one, I hope, would have argued that the federal government should have nationalized universities after World War II to ensure that returning GIs would have sufficient educational opportunities.

Perhaps that's why so many Nobel Prize winning economists, including F.A. Hayek (pictured above-left) have supported vouchers.