Naked Economics (9 page)

The challenge of transferring money from rich to poor is not just on the taxation side. Government benefits create perverse incentives, too. Generous unemployment benefits diminish the incentive to find work. Welfare policy, prior to reform in 1996, offered cash payments only to unemployed single women with children, which implicitly punished poor women who were married or employed—two things that the government generally does not try to discourage.

This is not to suggest that all government benefits go to poor people. They don’t. The largest federal entitlement programs are Social Security and Medicare, which go to all Americans, even the very rich. By providing guaranteed benefits in old age, both programs may discourage personal savings. Indeed, this is the subject of a longsimmering debate. Some economists argue that government old-age benefits cause us to save less (thereby lowering the national savings rate) because we need to set aside less money for retirement. Others argue that Social Security and Medicare do not reduce our personal savings; they merely allow us to pass along more money to our children and grandchildren. Empirical studies have not found a clear answer one way or the other. This is not merely an esoteric squabble among academics. As we shall explore later in the book, a low savings rate can limit the pool of capital available to make the kinds of investments that allow us to improve our standard of living.

None of this should be interpreted as a blanket argument against taxes or government programs. Rather, economists spend much more time than politicians thinking about what kind of taxes we should collect and how we should structure government benefits. For example, both a gasoline tax and an income tax generate revenue. Yet they create profoundly different incentives. The income tax will discourage some people from working, which is a bad thing. The gasoline tax will discourage some people from driving, which can be a good thing. Indeed, “green taxes” collect revenue by taxing activities that are detrimental to the environment and “sin taxes” do the same thing for the likes of cigarettes, alcohol, and gambling.

In general, economists tend to favor taxes that are broad, simple, and fair. A simple tax is easily understood and collected; a fair tax implies only that two similar individuals, such as two people with the same income, will pay similar taxes; a broad tax means that revenue is raised by imposing a small tax on a very large group rather than imposing a large tax on a very small group. A broad tax is harder to evade because fewer activities are exempted, and, since the tax rate is lower, there is less incentive to evade it anyway. We should not, for example, impose a large tax on the sale of red sports cars. The tax could be avoided, easily and legally, by buying another color—
in which case everybody is made worse off.
The government collects no revenue and sports car enthusiasts do not get to drive their favorite color car. This phenomenon, whereby taxes make individuals worse off without making anyone else better off, is referred to as “deadweight loss.”

It would be preferable to tax all sports cars, or even all cars, because more revenue could be raised with a much smaller tax. Then again, a gasoline tax collects revenue from drivers, just as a tax on new cars does, but it also provides an incentive to conserve fuel. Those who drive more pay more. So now we’re raising a great deal of revenue with a tiny tax and doing a little something for the environment, too. Many economists would go yet one step further: We should tax the use of all kinds of carbon-based fuels, such as coal, oil, and gasoline. Such a tax would raise revenue from a broad base while creating an incentive to conserve nonrenewable resources and curtail the CO
₂
emissions that cause global warming.

Sadly, this thought process does not lead us to the optimal tax. We have merely swapped one problem for another. A tax on red sports cars would be paid only by the rich. A carbon tax would be paid by rich and poor alike, but it would probably cost the poor a larger fraction of their income. Taxes that fall more heavily on the poor than the rich, so-called regressive taxes, often offend our sense of justice. (Progressive taxes, such as the income tax, fall more heavily on the rich than the poor.) Here, as elsewhere, economics does not give us a “right answer”—only an analytical framework for thinking about important questions. Indeed the most efficient tax of all—one that is perfectly broad, simple, and fair (in the narrow, tax-related sense of the word)—is a lump-sum tax, which is imposed uniformly on every individual in a jurisdiction. Former British Prime Minister Margaret Thatcher actually tried it in 1989 with the community charge, or “poll tax.” What happened? Britons rioted in the streets at the prospect of every adult paying the same tax for local community services regardless of income or property wealth (though there were some reductions for students, the poor, and the unemployed). Obviously good economics is not always good politics.

Meanwhile, not all benefits are created equal either. One of the biggest poverty-fighting tools in recent years has been the earned income tax credit (EITC), an idea that economists have pushed for decades because it creates a far better set of incentives than traditional social welfare programs. Most social programs offer benefits to individuals who are not working. The EITC does just the opposite; it uses the income tax system to subsidize low-wage workers so that their total income is raised above the poverty line. A worker who earns $11,000 and is supporting a family of four might get an additional $8,000 through the EITC and matching state programs. The idea was to “make work pay.” Indeed, the system provides a powerful incentive for individuals to get into the labor force, where it is hoped they can learn skills and advance to higher-paying jobs. Of course, the program has an obvious problem, too. Unlike welfare, the EITC does not help individuals who cannot find work at all; in reality, those are the folks who are likely to be most desperate.

When I applied to graduate school many years ago, I wrote an essay expressing my puzzlement at how a country that could put a man on the moon could still have people sleeping on the streets. Part of that problem is political will; we could take a lot of people off the streets tomorrow if we made it a national priority. But I have also come to realize that NASA had it easy. Rockets conform to the unchanging laws of physics. We know where the moon will be at a given time; we know precisely how fast a spacecraft will enter or exit the earth’s orbit. If we get the equations right, the rocket will land where it is supposed to—always. Human beings are more complex than that. A recovering drug addict does not behave as predictably as a rocket in orbit. We don’t have a formula for persuading a sixteen-year-old not to drop out of school. But we do have a powerful tool: We know that people seek to make themselves better off, however they may define that. Our best hope for improving the human condition is to understand why we act the way we do and then plan accordingly. Programs, organizations, and systems work better when they get the incentives right. It is like rowing downstream.

T
he first car I ever owned was a Honda Civic. I loved the car, but I sold it with a lot of good miles left in it. Why? Two reasons: (1) It didn’t have a cup holder; and (2) my wife was pregnant, and I had become fearful that our whole family would get flattened by a Chevy Suburban. I could have gotten beyond the cup holder problem. But putting a car seat in a vehicle that weighed a quarter as much as the average SUV was not an option. So we bought a Ford Explorer and became part of the problem for all of those people still driving Honda Civics.
^*

The point is this: My decision to buy and drive an SUV affects everyone else on the road, yet none of those people has a say in my decision. I do not have to compensate all the owners of Honda Civics for the fact that I am putting their lives slightly more at risk. Nor do I have to compensate asthmatic children who will be made worse off by the exhaust I generate as I cruise around the city getting nine miles to the gallon. And I have never mailed off a check to people living on small Pacific islands who may someday find their entire countries underwater because my CO
₂
emissions are melting the polar ice caps. Yet these are real costs associated with driving a less fuel-efficient car.

My decision to buy a Ford Explorer causes what economists refer to as an externality, which means that the private costs of my behavior are different from the social costs. When my wife and I went to the Bert Weinman Ford Dealership and the salesman, Angel, asked, “What is it going to take for me to put you in this car?,” we tallied up the costs of driving an Explorer rather than a Civic: more gas, more expensive insurance, higher car payments. There was nothing on our tally sheet about asthmatic children, melting polar ice caps, or pregnant women driving Mini Coopers. Are these costs associated with driving an Explorer? Yes. Do we have to pay them? No. Therefore, they did not figure into our decision (other than as a vague sense of guilt as we contemplated telling our environmentally conscious relatives who live in Boulder, Colorado, and flush the toilet only once a day in order to conserve water).

When an externality—the gap between the private cost and the social cost of some behavior—is large, individuals have an incentive to do things that make them better off at the expense of others. The market, left alone, will do nothing to fix this problem. In fact, the market “fails” in the sense that it encourages individuals and firms to cut corners in ways that make society worse off as a result. If this concept were really as dry as most economics textbooks make it seem, then a movie like
Michael Clayton
would not have made millions at the box office. After all, that film is about a simple externality: A large agribusiness company stands accused of producing a pesticide that is seeping into local water supplies and poisoning families.
There is no market solution in this case; the market is the problem.
The polluting company maximizes profits by selling a product that causes cancer in innocent victims. Farmers who are unaware of (or indifferent to) the pollution will actually reward the company by buying more of its product, which will be cheaper or more effective than what can be produced by competitors that invest in making their products nontoxic. The only redress in this film example (like
Erin Brockovich
and
A Civil Action
before it) was through a nonmarket, government-supported mechanism: the courts. And, of course, George Clooney looks good making sure justice is done (as Julia Roberts and John Travolta did before him).

Consider a more banal example, but one that raises the ire of most city dwellers: people who don’t pick up after their dogs. In a perfect world, we would all carry pooper scoopers because we derive utility from behaving responsibly. But we don’t live in a perfect world. From the narrow perspective of some individual dog walkers, it’s easier (“less costly” in economist speak) to ignore Fido’s unsightly pile and walk blithely on. (For those who think this is a trivial example, an average of 650 people a year break bones or are hospitalized in Paris after slipping in dog waste, according to the
New York Times.
)
¹
The pooper-scooper decision can be modeled like any other economic decision; a dog owner weighs the costs and benefits of behaving responsibly and then scoops or does not scoop. But who speaks for the woman running to catch the bus the next morning who makes one misstep and is suddenly having a very bad day? No one, which is why most cities have laws requiring pet owners to pick up after their animals.

Thankfully there is a broader point: One crucial role for government in a market economy is dealing with externalities—those cases in which individuals or firms engage in private behavior that has broader social consequences. I noted in Chapter 1 that all market transactions are voluntary exchanges that make the involved parties better off. That’s still true, but note the word “involved” that has left me some wiggle room. The problem is that all of the individuals
affected
by a market transaction may not be sitting at the table when the deal is struck. My former neighbor Stuart, with whom we shared an adjoining wall, was an avid bongo drum player. I’m sure that both he and the music shop owner were both pleased when he purchased a new set of bongos. (Based on the noise involved, he may even have purchased some kind of high-tech amplifier.)
But I was not happy about that transaction.

Externalities are at the root of all kinds of policy issues, from the mundane to those that literally threaten the planet:

The Economist
has suggested somewhat peevishly that families traveling with small children on airplanes should be required to fly at the back of the plane so that other passengers might enjoy a “child-free zone.” An editorial in the magazine noted, “Children, just like cigarettes or mobile phones, clearly impose a negative externality on people who are near them. Anybody who has suffered a 12-hour flight with a bawling baby in the row immediately ahead or a bored youngster viciously kicking their seat from behind, will grasp this as quickly as they would love to grasp the youngster’s neck. Here is a clear case of market failure: parents do not bear the full costs (indeed young babies travel free), so they are too ready to take their noisy brats with them. Where is the invisible hand when it is needed to administer a good smack?”
²


Mobile phone use is under stricter scrutiny, both in public places, such as restaurants and commuter trains, where the behavior is fabulously annoying, but also in vehicles, where it has been linked to a higher rate of accidents. Texting is the second-most dangerous thing you can do while driving a car, next to driving drunk.


In Chicago, Mayor Richard Daley attempted to impose a 1-cent tax on every $2 of take-out food purchases, arguing that the “litter tax” would reimburse the city for the costs of picking up litter, much of which consists of discarded fast-food containers. The mayor’s economics were sound—litter is a classic externality—but a judge ruled the ordinance unconstitutional because it was “vague and lacking in uniformity” in the way it dealt with different kinds of fast-food containers. Now there is talk at the federal level of a junk food tax (or a soda tax) to deal with a different kind of food-related externality: obesity. The health care costs associated with obesity are now roughly as high as those related to smoking. Society picks up at least some of the tab for those bills through the costs of government health programs and higher insurance premiums—giving me a reason to care whether you have a Big Mac for lunch or not.


Global warming is one of the most difficult international challenges in large part because firms that emit large amounts of greenhouse gases pay only a small share of the cost of those emissions. Indeed, even the countries in which they reside do not bear the full cost of the pollution. A steel plant in Pennsylvania emits CO
₂
that may one day cause a flood in Bangladesh. (Meanwhile, acid rain caused by U.S. emissions is already killing Canadian forests.) The same thing is true in all kinds of factories around the world. Any solution to global warming will have to raise the cost of emitting greenhouse gases in a way that is binding upon all of the earth’s polluters—not the easiest of tasks.

It is worth noting that there can be positive externalities as well; an individual’s behavior can have a positive impact on society for which he or she is not fully compensated. I once had an office window that looked out across the Chicago River at the Wrigley Building and the Tribune Tower, two of the most beautiful buildings in a city renowned for its architecture. On a clear day, the view of the skyline, and of these two buildings in particular, was positively inspiring. But I spent five years in that office without paying for the utility that I derived from this wonderful architecture. I didn’t mail a check to the Tribune Company every time I glanced out the window. Or, in the realm of economic development, a business may invest in a downtrodden neighborhood in a way that attracts other kinds of investment. Yet this business is not compensated for anchoring what may become an economic revitalization, which is why local governments often offer subsidies for such investment.

Some activities have both positive and negative externalities. Cigarettes kill people who smoke them; that is old news. Responsible adults are free to smoke or not smoke as they choose. But cigarette smoke can also harm those who happen to be lingering nearby, which is why most office buildings consider smoking to be slightly less acceptable than running through the halls naked. Meanwhile, all fifty states filed suit against the tobacco industry (and subsequently accepted large settlements) on the grounds that smokers generate extra health care costs that must be borne by state governments. In other words, my taxes go to remove part of some smoker’s lung. (Private insurance companies do not have this problem; they simply recoup the extra cost of insuring smokers by charging them higher premiums.)

At the same time, smokers do provide a benefit to the rest of us. They die young. According to the American Lung Association, the average smoker dies seven years earlier than the average nonsmoker, which means that smokers pay into Social Security and private pension funds for all of their working lives but then don’t stick around very long to collect the benefits. Nonsmokers, on average, get more back relative to what they paid in. The good folks at Philip Morris have even quantified this benefit for us. In 2001, they released a report on the Czech Republic (just as parliament was considering raising cigarette taxes) showing that premature deaths from smoking save the Czech government roughly $28 million a year in pension and old-age housing benefits. The net benefit of smoking to the government, including taxes and subtracting public health costs, was reckoned to be $148 million.
³

How does a market economy deal with externalities? Sometimes the government regulates the affected activity. The federal government issues thousands of pages of regulations every year on everything from groundwater contamination to poultry inspection. The states have their own regulatory structures; California, for example, has a strict set of emissions standards for automobiles. Local governments have zoning laws that forbid private property owners from impinging on their neighbors by constructing buildings that may be unsafe, inappropriate for the neighborhood, or simply ugly. The island of Nantucket allows only a few select colors of exterior paint lest irresponsible property owners use neon colors that would destroy the quaint character of the island. I live in a historic neighborhood in which every external change to our homes—from the color of new windows to the size of a flower box—must be approved by an architecture committee.

There is another approach to dealing with externalities that tends to be favored in some cases by economists: taxing the offending behavior rather than banning it. I’ve conceded that my Ford Explorer was a menace to society. As Cornell economist Robert Frank noted in an op-ed for the
New York Times,
we are locked in an SUV arms race. “Any family can only choose the size of its own vehicle. It cannot dictate what others buy. Any family that unilaterally bought a smaller vehicle might thus put itself at risk by unilaterally disarming,” he wrote.
⁴
Should the Hummer be banned? Should Detroit be ordered to manufacture safer, more fuel-efficient cars?

Economists, including Mr. Frank, would argue not. The primary problem with SUVs—and all vehicles, for that matter—is that they are too cheap to drive. The private cost of driving a Hummer to the grocery store is obviously far lower than the social cost.
So raise the private cost.
As Mr. Frank writes, “The only practical remedy, given the undeniable fact that driving bulky, polluting vehicles causes damage to others, is to give ourselves an incentive to take this damage into account when deciding what vehicles to buy.” If the real cost to society of having an Explorer on the road is 75 cents a mile instead of the 50 cents a mile that it costs the vehicle’s owner to operate the vehicle, then tack on a tax that equates the two. This might be accomplished with a gas tax, or an emissions tax, or a weight tax, or some combination thereof. The result will make driving a Hummer to the grocery store a lot less attractive.

But now we have entered strange terrain. Is it appropriate to allow some drivers to pay for the privilege of driving a vehicle so bulky that it might run over a Mini Cooper without even spilling the sixty-four-ounce drink in the monster cup holder? Yes, for the same reason that most of us eat ice cream even though it causes heart disease. We weigh the health costs of Starbucks Almond Fudge against that divine, creamy taste and decide to have a pint every once in a while. We don’t quit ice cream entirely, nor do we have it with every meal. Economics tells us that the environment requires the same kinds of trade-offs as everything else in life. We should raise the cost of driving an SUV (or any vehicle) to reflect its true social cost and then let individual drivers decide if it still makes sense to commute forty-five miles to work in a Chevy Tahoe.