It is worse than you think

by on September 11, 2007 at 6:31 am in Economics | Permalink

Here is Marty Feldstein, through some vias:

[F]inancing additional government spending by an across the board rise
in all marginal tax rates would make the cost per dollar of government
spending equal to $1.76.

These two facts – that the actual revenue is only 57 percent of
the static gain and that the deadweight loss is 76 cents per dollar of
revenue – should be central to any consideration of tax policy.  And yet
they are not.

What is talked about even less is that most government programs are, for better or worse, irreversible investments.  They don’t fade away very easily, even if they have been proven ineffective or harmful.  Do you really think that the Departments of Energy and Education have to pass a market test every year?  In fact government programs, on average, grow almost automatically.

Do you know the literature on irreversible investment and option value?  Under plausible parameter specifications, you need a benefit-cost ratio of 3 to 1 or more before it makes sense to proceed with the irreversible investment.  Otherwise it is better simply to wait.  That’s not 1.3 to 1, that’s 3 to 1.

The main argument for not waiting is simply that the political process cannot do much useful with any new information that is generated by waiting.  But viewed more broadly, that is hardly an argument for proceeding in the first place.

The bottom line: Cram all those numbers together into your noggin’ and keep them there.

john pertz September 11, 2007 at 7:15 am

Yikes, that is some pretty scary stuff. There is more dead weight loss associated with public outlays than previously thought. In light of all of the empirical evidence which is finding that most government expenditures have a benign or even harmful effect on society, why dont more people support rules for spending? I am thinking about something along the lines of what Buchanon argues?

mk September 11, 2007 at 9:17 am

A few questions about Marty Feldstein’s calculation.

1) Isn’t it possible that government is serving a role that people want served? And thus, if you removed the government program, people would want the gap filled with private giving? And if people divert their cash flow, even through a private decision, it will still affect propensity to work?
If the program still needs the same cash flow whether via government or charity, what is the difference with charity which permits no dead weight loss? I can think of a few possibilities but they seem fairly subtle. I think there must be some effect on propensity to work.

2) Isn’t much of this deadweight loss “regained” in terms of utility by people enjoying more leisure? I understand that the tax distorts incentives compared to laissez-faire, but suppose people are almost indifferent at current levels between working and leisure. In that case the picture is much more positive than Feldstein suggests.

mkayser September 11, 2007 at 9:40 am

Charitable giving is voluntary, while fund-raising is competitive

OK, the voluntary aspect I can imagine. If I control where my money goes, I get a bit more utility out of the marginal buck, thus I work a little harder for it. I think it’s very much an open, empirical question how big this effect is, however.

The competitiveness you mention would seem to be an argument about administrative efficiency, not dead weight loss. There are many interesting empirical questions here, but the question earlier was particularly about dead weight loss.

Susceptibility to abuse is another interesting point.

I would prefer that all these effects be experimentally measured. Plausibility, as we empiricists know, doesn’t guarantee it actually happens like that.

Bernard Yomtov September 11, 2007 at 10:01 am

These two facts — that the actual revenue is only 57 percent of the static gain and that the deadweight loss is 76 cents per dollar of revenue

That sounds like only one “fact” to me, stated two different ways.

M. Hodak September 11, 2007 at 10:08 am

And for dstevens who thinks “the people” are deciding on the existence, growth, or viability of government programs, you need to check your public choice premises. The point Tyler makes about public choice results versus a market tests is probably much more significant than you realize.

David J. Balan September 11, 2007 at 11:59 am

No one is proposing an across-the-board increase in marginal rates. If you want to raise taxes, the trick is to raise the ones that have the smallest deadweight loss, alongside whatever equity concens you might have. Undoing W’s tax cuts for rich folk would be a good start on both counts.

mk, the deadweight loss (if it is calculated correctly) is the loss *after* the benefit from the increase in leisure has been taken into account.

guy in the veal calf office September 11, 2007 at 12:26 pm

M Hodak- For those who don’t have the lingo down, what is the “point Tyler makes about public choice results versus a market tests” Is it basically that a contribution to a charity is not an irreversible investment, but, say, subsidies for dairy farmers has proven to be irreversible?

Person September 11, 2007 at 12:40 pm

Aschkan is right and David_J._Balan is wrong. The DWL is highest for the rich: their decision to earn
additional income is much more sensitive to tax rates becausebeing rich, by definition, they don’t
*have to* work. The DWL is the loss in a) shifting to leisure instead of lower tax + work, plus b)
the would-be recipient of that work who has to find someone else.

datacharmer September 11, 2007 at 12:58 pm

To use these estimates to argue we should cut taxes would entail comparing apples and oranges – government does things that the private sector doesn’t. Saying that the dead-weight loss of a tax amounts to 80% means that instead of getting an orange for an apple you are getting 20% of an orange for an apple. How is that an argument for reducing consumption of oranges?

datacharmer September 11, 2007 at 1:04 pm

*In itself. I’m not talking about the price going from 1 to 5, I’m talking about the price staying constant at 5 all along.

Lee A. Arnold September 11, 2007 at 1:39 pm

Wouldn’t the Hayekian inference be that static analysis and deadweight loss are pretty much unrelated to reality?

Lee A. Arnold September 11, 2007 at 3:37 pm

One policy argument from bounded rationality would be that institutions are necessary. Therefore, taxes may perform the function of reducing future costs, (and not just compounding interest on the government debt, which on balance 80% of us pay to the other 20%.) And certainly there are other clear distortions, such as tax-avoidance behavior. But if you look at it dynamically, deadweight cost has a long way to go to justify much complaint. Let’s call it the “dynamic Coasian inference,” since if you go beyond the initial “transaction” of the taxation, institutions (some sorts of which, taxes are used to pay for,) perform their good functions, (if and when they do!,) by some sort of organizational innovation that decreases the costs of other transactions — transactions that are in the arena to which the institution is applied. It’s analogous to the savings from innovations in general — even the simplest hand-tools save force translation in spacetime. Up at our macroscopic level, economic transaction costs take up around 50% of the GDP, according to Coase. It could be that taxes usually show a dynamic “liveweight gain,” all things considered — which they never are. Ideas, innovations, institutions are the ways in which bounded rationality leaps its bounds. They ARE economic growth. Coase was clearly aware of the seed of this argument — he thought it would turn economics upside-down. And it is at the basis of Hayek’s spontaneous organization, of course.

Not to say that an institution can’t go wrong — much as an idea or innovation can. They are selected against in different ways, of course: markets vs. voting, and all that, and people become habituated and so on. Still, Tyler Cowen might clarify whether his phrase “most government programs” refers to the cardinal count, or to the spending amount. Because by expenditure, the two biggest programs by far are: Defense (it should be listed as Numero Uno: if you include all defense-related items from other programs, it is close to twice the regular budget figure) and of course Social Security. Put together, if we include the expanded definition of defense spending, that’s over half of the federal budget. Add Medicare, Medicaid, and debt service, and you’re over 80% of all federal spending. Surely it is no one’s contention that these are (entirely) “ineffective or harmful.” (Unless perhaps, it is a libertarian’s!)

Roger September 11, 2007 at 6:58 pm

Tyler, do you realize that these numbers were arrived at through a tax simulator, which Mr. Feldman programmed to say that for every 10% reduction in marginal tax rates, the tax base would increase by 16%?

The rest of it’s just mathematical masturbation – he made up a number for economic growth as a function of tax rates, and he’s calling the output of the simulation, based on his made-up elasticity number, a “fact.”

Garbage in, garbage out. By the way, the paper where he presents his “evidence” is riddled with typos. It’s also pay-to-read, but a little bit of Googling can find it for free.

Lee A. Arnold September 11, 2007 at 10:37 pm

Well I think it was it was Dr Johnson who said the purpose of conversation is either to instruct or entertain… But the objections remain: Innovations and institutions are functionally homologous. Neither static analysis nor benefit-cost is a substitute for sufficent reason. U.S. history has examples of government programs which have been discontinued.

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