The Becker-Posner Blog

Market Failure Compared to Government Failure -Becker

When an industry in the private sector is not performing efficiently or effectively, there is said to be “market failure”. The recommendation by economists and others typically is then for government actions to combat such failure, such as taxes to help reduce pollution. The diagnosis of market failure may be accurate, but the call for government involvement may be naïve and inappropriate.

The reason is that actual governments do not necessarily do what economists and others want them to do because there is “government failure” as well as market failure. Before recommending government actions to correct market failures, one should consider whether actual government policies would worsen rather than improve private sector outcomes. Since many factors often make for considerable government failure, considering such failure is crucial and not just a theoretical fine point.

Consider, for example, that consumers are sometimes ignorant of the qualities and other aspects of the products they buy. However, before advocating various forms of government protection of consumers, we should recognize that voters are far more ignorant of political candidates then consumers are of what they buy. The reason is that consumers directly suffer if they make bad choices out of ignorance, while individual voters have negligible influence over political outcomes. Hence voters have little incentive to be informed about different candidates and their positions, and the consequences of the mistakes they make are largely borne by others.

Monopolies do arise in the private sector, as when Microsoft had monopoly power over personal computer operating systems, when IBM still earlier had monopoly power over computers, or when manufacturers form cartels to raise their prices by restricting production. Yet, monopoly also occurs in the political sector, and it is far more pervasive there. An industry that contains only two firms is considered a duopoly that is presumed to raise prices above competitive levels, but the political process is dominated in democratic countries by duopolies, such as the Democratic and Republican parties. In addition, when government companies receive monopoly positions, such as the US Postal Service or national oil companies in many countries, they generally succeed in either keeping out or greatly delaying the entrance of private competitors. By contrast, private monopolistic positions are usually temporary, as seen in the eroding over time of IBM’s and Microsoft’s dominant positions in the computer industry.

Government actions sometimes not only fail to overcome market failure but rather worsen the failure. Fannie Mae and Freddie Mac were formed as quasi-governmental institutions to help encourage mortgages in the residential housing market because of a belief that the private sector was not providing enough mortgages, especially to lower income families. Yet, as documented in detail in Reckless Endangerment by Gretchen Morgenson and Joshua Rosner, these two companies used their privileged positions to take excessive risks, and to insure large numbers of mortgage loans that should never have been made.

European regulators have attacked Microsoft, Google, General Electric, Intel, and other (mainly American) companies because of various alleged anti-competitive policies. In these cases, and in many antitrust cases brought by American regulators, such as the recent objection to the merger of AT&T and T-Mobile, the motivation seems to be to protect the competitors of these companies or to protect jobs rather than to improve outcomes to consumers.

Many countries subsidize various alternative forms of energy, such as wind, solar, biofuels, and electric batteries, because of the substantial pollution from using coal, oil, and other fossil fuels. Often, however, the choices of what to heavily subsidize are made on political rather than economic criteria. For example, for years hydrogen cars were politically the most promising substitute for gasoline driven cars; then hydrogen fell out of favor and electric cars became the political darlings. Since governments have seldom succeeded in picking technological winners, I suspect they will be wrong again in these attempts to steer the development of cost-effective alternatives to the internal combustion gasoline engine. Another example is the scandal about the heavy American government financial support to the solar panel company Solyndra that recently failed.

How does one approach policy once it is recognized that government failure is substantial, and often much worse than market failure? As a general rule I believe the presumption should be in favor of government actions only when market failures are quite large and persistent. So clearly governments should have the dominant role in the military and police areas, in the judiciary, in protecting against massive pollution, and in providing a safety net for its least fortunate members (private charities are important but do not do enough). On the other hand, when market failures are relatively small and likely to be temporary, as in monopoly situations or in exploiting consumer ignorance, government involvement should be minimal, as in minimalist anti-trust policies, and in allowing consumers generally to make their own decisions.

The intermediate cases are the most difficult: when market failures may be significant, and yet government alternatives are not attractive. This may be decided on a case-by-case basis, but I believe the usual rule should then be to let the market operate. This belief is based on the conclusion that, on the whole, government failure is far more pervasive, damaging, and less self-correcting, than is market failure. Others may reach different conclusions, but these are the problems that a relevant welfare analysis should focus on. Simply concluding that in particular instances markets are not working perfectly is a misleading and incorrect basis for supporting active and sizable government involvement.

The Nirvana Fallacy Revisited—Posner

I recall hearing when I first came to the University of Chicago in 1969 the expression “Nirvana Fallacy,” used to describe the belief then dominant in the economics profession that market failures could and should be rectified by government intervention, assumed to be apolitical and effectively costless. The belief was unsound; government failure is commonplace, partly because of politics, partly because of the intrinsic difficulty of many of the tasks that are given to government to perform. 

The opponents of the Nirvana Fallacy did not deny the existence of market failures; they just wanted the costs to be balanced against the cost of government intervention. But as the years went by there was a growing tendency among conservatives to regard markets as Nirvana—as self-regulating—and thus to deny the need for government regulation. Alan Greenspan, when he was chairman of the Federal Reserve Board, was a spokesman for this position. It became particularly influential during the administration of the second President Bush, with seriously adverse consequences. The deregulation of the banking industry, which had begun under President Carter and been completed during Clinton’s second term, coupled with extraordinarily lax regulation of the nonbank banks (such as Goldman Sachs, Merrill Lynch, and Lehman Brothers) by the Securities and Exchange Commission (which had the principal regulatory authority over the nonbank banks) under the last chairman appointed by Bush, lax regulation of insurance companies (such as AIG) by state insurance commissioners, lax regulation of Fannie Mae and Freddie Mac by the Federal Housing Finance Agency, and lax enforcement by the Federal Reserve Board and the other bank regulatory agencies of the remaining regulations of commercial banks, were major causes (along with the lax monetary policy of the Federal Reserve in the early 2000s and misleading statements by successive Fed chairmen) of the financial crisis of September 2008 and the ensuing economic downturn—the most serious since the Great Depression. 

Most economists did not understand the inherent instability of financial markets (which derives from the basic financial model of borrowing short term and lending long term, which can induce runs, especially when, as in the case of the nonbank banks, the short-term capital—often overnight—is not insured), the vulnerability of housing markets (in which the banking industry was heavily involved) to bubbles, or the potential macroeconomic consequences of a failure of those markets, which made deregulation a riskier policy than in industries such as air and surface transportation, electrical distribution, natural-gas production, oil pipelines, and communications. Because of the potential for catastrophic market failure, regulation should have been much tighter than it was. 

Of course more than mistakes by economists were involved; the pressure of the banking industry for deregulation and light enforcement of the remaining regulations was intense, because the bankers wanted to be allowed to take more risk so that the expected return would be greater. Whether there would have been more resistance if the economics profession had opposed the industry is an academic question. 

Regulation had got a worse name than it deserved because of a tendency to conflate it with other, more questionable government activities—the actual operation of economic enterprises (the Post Office, air traffic control, toll roads, TVA), all of which would be more efficiently operated as private firms, and a variety of unjustifiable subsidies, such as the provision of medical insurance to affluent old people, or the deductibility from federal income tax of interest on home mortgages. Government-run businesses and most government subsidies displace more efficient private activity, but regulation is essential and cannot be outsourced. Not that there isn’t excessive regulation; but some—notably of financial markets—is indispensable. 

Another potential confusion is between comprehensive economic regulation of specific industries and the regulation of safety and health and of workplace discrimination, cutting across industries. Public utility and common carrier regulation, illustrated by the regulation of telephone companies and railroads before the deregulation movement, was notably inefficient, tending to protect not consumers but instead sellers, by shoring up the sellers’ cartels or monopoly. Banking regulation was of that character before the deregulation movement—limitations on the grant of banking charters, on branch banking, and on the payment of interest on demand deposits were examples of regulatory policies that reduced competition in banking. This was not an entirely undesirable effect because the more competitive banking is, the riskier it is—and the risks are macroeconomic (in contrast, if the airline industry, say, went bankrupt, the consequences for the rest of the economy would be trivial).  But the traditional regulation of banking was too restrictive and was rightly dismantled—only the deregulation of banking (and related financial institutions) went too far. 

The deregulation movement that focused on comprehensive regulation of specific industries coincided with a movement in the opposite direction—toward greater regulation—with regard to safety, health, pollution, and discrimination. Many of these regulations have no economic justification; they are paternalistic, as in the case of seatbelt laws—or if justified, are justified only because of the existence of other unjustified government interventions, such as subsidies for the medical expenses of people injured because they don’t fasten their seatbelts. 

But the fact that there is a great deal of unsound or questionable regulation is not a good argument for leaving all economic activity to the Darwinian processes of the market. Competition forces businesses to ignore external costs and benefits (that is, costs and benefits not borne by the creator of them). If either sort of externality is great enough, there is a strong case for regulation, provided the benefits of regulation can be shown to be highly likely to exceed the costs.

Obama’s Jobs Speech—Posner

The President’s “Jobs” speech to a joint session of Congress on September 8 was notably forceful and, I am guessing, politically adroit. It may help to save at least one job—his own. But the question I want to address is, assuming that all his recommendations were enacted by Congress, would they do enough for the economy to justify their estimated (doubtless underestimated) cost of almost $450 billion? 

The principal recommendations and their estimated cost are as follows: cut in payroll taxes, both the share paid for by the employee and the share paid for by the employer ($240 billion); extension of unemployment benefits ($49 billion); subsidies for construction and related projects (highways, airports, school renovation, low-interest loans for private projects (“infrastructure bank”)) ($90 billion); aid to state and local governments ($35 billion); financial assistance to homeowners to refinance their mortgages ($15 billion); tax credits for employers who hire persons who have been unemployed for at least six months ($8 billion). The aim would be to spend most of the $450 billion between now and the end of 2012. The cost would be recouped by a combination of unspecified spending cuts and unspecified tax increases for upper-income taxpayers—but not immediately, since the aim is to inject money into the depressed economy in order to increase private spending in the hope that this will stimulate production and so employment, in a virtuous circle. So initially the cost of the jobds program would be defrayed by the Treasury with borrowed money, and thus would add to the national debt except insofar as the program caused an immediate rise in incomes and hence in federal tax collections. 

I can set to one side three of the components of the program: extension of unemployment benefits, tax credits for employers who hire the unemployed, and financial assistance in refinancing home mortgages—the estimated cost of these three programs is $72 billion. They are losers. Extending unemployment benefits, while it will increase the income of the recipients, and in that respect have an effect similar that a tax credit or refund could be expected to have on people who pay income taxes, will actually reduce the hiring of the unemployed by reducing the cost to them of remaining unemployed; generally, the intensity of job search by unemployed persons surges when unemployment benefits are about to run out, and that date will be postponed for the recipient of the extended benefits. 

Tax credits for hiring the unemployed are likely to have no net effect on unemployment at all, because there is no labor shortage. Employers have all the employees they want to have, which is why there is such a rate of un- and underemployment and discouraged workers; employers lured by the tax credit to hire an unemployed worker are likely to lay off one of their existing employees to make room for the new employee. And finally, financial assistance in refinancing home mortgages has been tried, and is a proven failure because of restrictions in mortgage instruments on refinancing and the poor credit of the homeowners who need refinancing the most. 

What is left in the jobs bill are the payroll tax cuts, the financial assistance to state and local government, and the construction subsidies. 

Whether the cut is in the employee’s share of the payroll tax, in the employer’s share, or (as in Obama’s proposal) in both, is of no economic consequence. Payroll taxes are a labor cost to the employer in either event; he either pays the government directly, or he pays a higher wage because the employee’s share of the payroll tax makes the employee’s net wage lower than it would be if the tax were lower. Reducing labor costs should increase the demand for labor, but probably not when the reduction is temporary, as it is likely to be. Reducing labor costs makes labor cheaper relative to capital as an input into production, but a company is unlikely to change the labor-capital proportions in its mode of production in response to a short-term fall in labor costs. Nor will he hire more workers just because they will settle for a lower pre-tax wage, if he has all the workers he needs. Still, presumably the benefits of the payroll tax reduction will be divided between workers and business in some proportion and the result should be some increase in consumer spending and business investment, but it may be small, as the tendency of business and consumers alike is to save rather than spend a high proportion of transitory (windfall) income. This tendency is likely to be especially pronounced at present, because the collapse of the housing bubble and the accompanying fall in stock prices increased the amount of debt in family budgets and thus spurred an increase in the savings rate. 

The effect on stimulus of the save/spend division is exacerbated in the case of the financial assistance to the states and local governments. They have been busy laying off workers in response to mounting deficits in state and local government government, but it doesn’t follow that they will use the $35 billion that President Obama wants to give them to hire back these workers, rather than, for example, pay down debt, which have no, or very little, immediate effect on consumption or business spending. 

That leaves construction. The $90 billion earmarked for construction projects is the most promising part of the Obama plan. Unemployment in construction and related trades is very high, and when the government finances construction projects the contractors have to go out and hire workers to do the projects; the effect on employment is immediate, and a fall in unemployment both boosts incomes and consumption and creates greater optimism about economic prospects. Increased consumption, and increased confidence about the future, have positive psychological effects on the propensity of consumers and businessmen to consumer and invest, respectively. This is an essential insight of Keynes: uncertainty about the future tends to make consumers and businessmen alike freeze; in his famous phrase it dampens people’s “animal spirits.” 

The problem with government-financed construction projects as a method of stimulating employment and the good things that come with higher employment is delay, which we saw with the original (February 2009) $787 billion stimulus program, a significant portion of which was earmarked for construction and related projects. Modern American government is smothered in red tape, and the result was long delay in beginning the projects. The danger of such delay is that the public spending will be deferred to a future period in which the economy is growing, in which event the public projects will be competing for capital with private ones, in which event interest rates will rise, which will slow down the recovery. 

Belatedly the Administration has recognized the problem: the President promised in his speech to cut the red tape that might impede the projects he wishes to finance. Good luck! The Administration is not noted for good management. Putting Vice President Biden in charge of the original stimulus program, rather than an experienced manager, was a serious mistake, but perhaps the Administration has learned from its mistakes and really will cut the red tape that might otherwise smother the most promising part of the President’s new program.

A Second Stimulus Package? Becker

The recovery from the Great Recession has been slow and unsteady. Two years after unemployment peaked at 10.1%, it still remains over 9%, in contrast to the under 5% in 2007. GDP has grown very slowly during the past year, and is now more than 10% below its potential level. President Obama is rightly concerned about the large number of Americans who are unemployed, especially the longer term unemployed-those who have been without jobs for over six months. How successful will his proposed American Jobs Act be in getting the economy moving forward at a much faster clip?

Boiled down to its essentials, the proposed Jobs Act is a second stimulus package since most of the spending is supposed to take place soon (before the end of 2012), while it will be financed over the next ten years in ways that are unclear.  At an estimated approximately $450 billion, this package is much smaller than the first stimulus package in 2009 that cost about $800 billion. The proposed structure is better than the first one since it relies more on tax cuts and direct subsidies to households: about 2/3 of the proposed spending comes from a temporary cut in (payroll) taxes and increases in benefits to the long term unemployed.

I am less negative on the extension of unemployment benefits than is Posner. I agree it will encourage some of the longer term unemployed to stop searching for jobs since they could then receive these extended benefits. On the other hand, an extension helps insure workers against long-term unemployment, which is the most difficult form of unemployment to finance out of own savings and borrowing. In an economy with a very slow recovery, extending unemployment benefits tailored to long-term unemployment may be sensible, although it is not an easy call.

The cut in payroll taxes is supposed to have two positive effects on the economy. It would temporarily reduce the cost of labor to companies and thereby encourage them to hire more workers, and it would increase the spending of workers through increasing their take home pay. Such temporary cuts in wage costs to employers will increase employment only a little, and it will be mainly for low skilled low wage jobs that can be easily eliminated after the cuts expire. Since spending by households responds much more to their long term income prospects than to short run changes in their incomes, households would tend to save rather than spend most of their higher incomes due to a temporary cut in social security taxes. Therefore, the employment bang for the buck will be small per dollar of tax cut.

Further lowering, and possibly reversing the sign, of any positive stimulus to the economy from a temporary tax cut and extension of unemployment benefits is that they must eventually be paid for: either through future higher taxes, lower government spending, or greater inflation (the inflation “tax” in the language of economists). These effects may not be fully anticipated, but surely businessmen and households who are making long-term investments will pay attention to future taxes and future government spending as well as to their present levels.

Most of the remainder of the president’s jobs plan is the $90 billion that will help finance infrastructure projects. While many infrastructure projects in the US might well have high benefit/cost ratios, it is doubtful whether these will be the projects selected by the political process. The president was well aware of this in his speech when he said he wanted “no more bridges to nowhere”, but I see no reason why this time will be different than much of America’s recent history on federal-supported infrastructure projects.

This recovery has been so slow in good part because small and large businesses are reluctant to hire workers for the long term and to invest in durable physical capital since they are concerned over the uncertainty and level of the long-term taxing, regulatory, and fiscal situation of the United States. The president partly addressed these concerns by calling for passage of the stalled free trade acts with Panama, Colombia, and South Korea, supporting patent reform, and advocating lower taxes on corporations. At the same time, however, he also raised concerns about the future economic environment by his proposed sizable increase in federal spending that would further weaken the fiscal position of the federal government.

The net effect on the short and long term health of the economy will depend on whether Congress supports those aspects that will improve the environment faced by households and businesses rather than the more prominent proposals that are likely to further weaken the economy.

In Trouble Once Again: What to do About US Post Office? Becker

 

The United States postal system has a distinguished history since mail delivery is part of the Constitution, and Benjamin Franklin was the first Postmaster General. But during the past half century it has faced one financial crisis after another. Changing communication technologies may be the underlying source of its difficulties, but the postal system has also been hampered by regulations, and by its own inefficiencies. The solution: completely privatize the postal system, and allow other carriers to make daily mail deliveries using business and residential mailboxes. There are now enough actual and potential competitors, including the Internet, to make delivery of mail a highly competitive industry.

After running up billions of dollars in losses subsidized by the federal government from 1942-71, the postal service was made a quasi-independent non-profit enterprise (the United States Postal Service, or USPS) that no longer receives any direct government subsidy. Financially, USPS held its own until 2007, but since then cumulative losses have amounted to about $20 billion, and it is expected to lose another $8 billion this fiscal year. Obviously, this cannot continue much longer without a resumption of government subsidies, so this is an excellent time to consider major changes in the postal service and the economic environment in which it operates.

The most important factor behind its worsening financial fortunes is the sizable drop during recent years in the total volume of mail delivered. First class mail alone, although protected by a legal monopoly, fell by about 30% from 1998-2008, and has continued to fall rapidly during the past 3 years. The Great Recession is responsible for part of the decline in mail deliveries in recent years, but most of the fall has been due to the growing use of the Internet to pay bills, and to deliver newspapers, magazines, and books. The recession will end, but Internet use will only get more widespread, so the challenges facing USPS will continue to grow.

Defenders of the postal service correctly point out that part of its troubles is due to regulations that significantly raise its costs of operation. These include the requirements to deliver first class and some other mail 6 days a week at uniform prices to about 150 million residences, mailboxes, and businesses, including very remote locations that are costly to serve. Most mail prices can only be raised according to a formula fixed in 2006, and the USPS is restricted from entering new businesses.

The postal system would like to reduce costs by eliminating regular delivery of mail on Saturday, and by closing about 10% of it’s over 30,000 post offices. It would also like greater freedom in setting prices of first class and other mail delivery. The postal system should be given these and other requests to operate more freely. Regular Saturday delivery of mail is an expensive luxury that is no longer needed, and the cost of operating post offices in remote areas cannot be justified, especially given the growing use of the Internet to pay bills and receive news and advertising.

 However, greater freedom for the USPS should be part of a sweeping reform of the environment in which the postal service operates. Certain major advantages given to the USPS should also be removed. The post office has had a monopoly for over 100 years on the daily delivery of first class letters and other mail, a monopoly that includes exclusive access to customer mailboxes. Eliminating this monopoly, and allowing the postal service to operate as a private for-profit company, would force the USPS to try to compete more fully against Fed Ex, UPS, and perhaps new companies that would enter the mail business.

Competition would do wonders for mail delivery in the United States since it would make the USPS improve its operations if it wants to survive against competitors. We have seen how the 1971 law that required the postal service to be financially self-sufficient forced the postal service to eliminate losses. It did this by cutting costs through large reductions in the number of postal workers, and by closing many small and uneconomical post offices.

Nevertheless, the efficiency of the postal service still lags far behind that of Fed Ex and UPS. Part of this lag is due to regulatory restrictions, but some is due to its own mismanagement. As in prior discussions on our blog I refer again to the small town on Cape Cod where I have a summer home. Since its population expands 8-10 times during the summer, first class and other mail rises enormously during the summer. Fed Ex adjusts to this peak load problem in many ways, including renting trucks from Enterprise rental, delivering packages during longer hours, and shifting some employees from other locations. The local post office, by contrast, hardly adjusts at all. It has exactly the same hours as during the low volume winter months, which includes closing from 12-1 on weekdays, and only being open until noon on Saturdays. Since there is no mail delivery in this small town, most residents have mailboxes at the post office. Even though these boxes are in a separate room, which could be kept open when there is no other mail service, this room is closed too at about the same times when other mail service at the post office is closed.

Government enterprises, even quasi-independent ones like the USPS, are notoriously inefficient because of political and regulatory inefficiencies (see my op- ed of September 2 in Wall Street Journal on “government failure”). Sometimes, as with the military, there is no good substitute for a government enterprise. Fortunately, that is not the case with mail delivery since competition could be easily introduced by taking away the legal monopoly given to the USPS, eliminating the many restrictions imposed politically on its operations, and forcing it to operate like a for-profit company.

These changes will not be easy politically, although New Zealand and many European countries have either privatized or greatly liberalized their postal systems. But radical changes in competition and the regulatory environment are the only way to improve efficiency in mail delivery while trying to meet the major challenges posed by the Internet.

 

Whither the Post Office and Its Universal Service Obligation? Posner

Becker is certainly correct that the U.S. Postal Service should be privatized. Although government is probably more efficient at providing some services than private enterprise is, such as the military, national security intelligence, the police, the judiciary, the central bank, and prisons, because the output of these services is so difficult to measure, there is no reason to think it any more efficient at providing postal service than it would be at providing telephone service or airline service. Its origins as a public service reflect government concern with conspiracies (and its desire therefore to be able to read letters in transit), the natural-monopoly character of postal service (multiple postal services would require duplication of delivery trucks, post offices, and sorting stations), and the desire to provide universal service at flat rates in order to improve information flow throughout the entire society (i.e., to achieve network externalities).

Later, when the telegraph and telephone were invented, it became recognized that these desiderata could be achieved without public ownership. AT&T until its breakup in the early 1980s had a de facto monopoly of telephone service, providing universal local service at flat rates subsidized by long-distance service and shielded by regulatory agencies (primarily the Federal Communications Commission) from competition by “cream skimmers” (competitors entering the service markets in which rates were kept artifically high in order to subsidize local service, especially local service in sparsely inhabited areas), but constrained in its ability to obtain monopoly profits by regulatory control of rates. 

This could have been the regime for postal service, and an important step in the direction of substituting a government-regulated for a government-owned postal service was the 1971 reform that converted the service from a Cabinet department to an independent agency that was to be self-financing (largely from the sale of stamps) rather than dependent on congressional appropriations. The universal service obligation remained, along with a legal monopoly of first- and third-class mail and of access to post boxes (as distinct from front-door mail slots), and continues to this day. 

But just as AT&T was eaten away by cream skimmers owing to liberalized regulation in the 1970s, so that by the beginning of the next decade it was ready to embrace a large measure of deregulation, so the postal service is being destroyed by competition from unregulated services, mainly email and other online services but also fax and Federal Express. Its revenues are plummeting faster than it has been able to cut costs. As a result, according to an article in today’s New York Times, “the [postal service] is so low on cash that it will not be able to make a $5.5 billion payment due this month and may have to shut down entirely this winter unless Congress takes emergency action to stabilize its finances.” The article discusses various economies, as well as congressional subsidy, that might save the postal service—but does not mention privatization as a possibility.

The postal service is hobbled in competing by its universal service obligation, which requires it to maintain post offices and fleets of delivery trucks in remote areas of  the country that generate little in the way of postal revenue, and to pick up and deliver mail six days a week. And since email, fax, and Federal Express service are available everywhere, the case for subsidizing postal service to remote areas is weak. 

The federal government could no doubt sell the postal service, just as states are busy selling turnpikes and bridges. If it sold it subject to the buyer’s assuming the universal service obligation, it would have to convey along with the postal service's physical assets its monopoly protections against cream skimming—the monopoly of first- and third-class mail and exclusive access to post boxes. But then little would have been achieved by the sale—not nothing, because the buyer would be more strongly motivated than government to seek economies, but not a lot. 

A sale without conditions would be different—the results would be radical: a large reduction in post offices and delivery trucks, and correspondingly large reductions in numbers of employees. But then what of the people living in remote areas? Email and fax are not a complete answer, because there is still a demand for letters, magazines, advertising brochures, and other items of snail mail. All these are things that can be delivered by Fed Ex or UPS, but the price for pick up and delivery in remote areas might be quite high. There is no good economic reason to subsidize people who decide to live in remote areas, but there would be political pressures to do so. 

As a practical matter, reform of the postal service should I think proceed in three stages over a period of years. In the first stage, the postal service should be allowed to charge double postage for mail to or from designated remote areas and to terminate Saturday mail service to and from those areas. In the second, the postal service should be sold to private enterprise but with the legal restrictions (universal service, in its modified form with double postage and no Saturday delivery in remote areas, and exclusive access to post boxes) intact. And in the third the legal restrictions should be removed and all postal service be open to competition.

Warren Buffett on Taxing the Wealthy More Heavily—Posner

Two weeks ago Warren Buffett made waves with a brief op-ed piece in the New York Times of August 15 entitled “Stop Coddling the Super-Rich.” In it he says that very rich people are undertaxed, but he would leave the federal income tax rates of 99.7 percent of taxpayers unchanged and only raise the tax rates of taxpayers who report more than $1 million of taxable income a year; if they report at least $10 million a year they would pay an additional surcharge. But he doesn’t say what the increased tax rates on either group should be. He also wants dividends and capital gains taxed at the same rate as ordinary income but does not say whether he thinks the uniform tax rate should be the present income tax rate (except for those earning over $1 million a year and therefore liable for the lesser or greater surcharge) or perhaps a lower rate because it have a bigger base. 

Buffett’s piece is short, and really the only thing of interest, besides the celebrity of its author, is his claim, based on his extensive personal knowledge of wealthy investors, that increasing  the taxes on the wealthy would not cause them to invest less. He may be right but he does not discuss the distinct issue of whether they would invest differently. 

The growth of the federal deficit, which is growing from a very high level at a rate of well over $1 trillion a year, cannot be arrested without more tax revenues. The alternatives are spending cuts and rapid economic growth. They are attractive to many conservatives but will not cut the mustard. The needs of government preclude the kind of drastic spending cuts that would curb the growth of the federal deficit without any need for additional federal revenues. Diehard opponents of increasing tax revenues even by closing loopholes without raising tax rates argue that the federal government is too large and can only be made smaller by reducing its income. But this argument contains two mistakes. One is to think that the federal government can finance its activities only by taxation. Not true; it can finance them with borrowed money, as proved by the Bush tax cuts, which did not lead to a reduction in the scale or spending of the federal government, but merely to an increase in borrowing. Of course, as the federal government approaches bankruptcy, the pressure to curtail federal spending is great and an increase in tax revenues would alleviate the pressure, but probably only slightly because the feasible scope for such an increase is very limited.

Second is a confusion between size of government and amount of government spending. The federal government is not too large in the sense of having too many employees or even too many functions. We need a large military, and we need regulatory agencies that are well staffed—regulatory laxity was a major contributing factor to the financial crisis of 2008 and the broader economic crisis that it triggered. What we can’t afford is not federal employees (including soldiers) but careening entitlements. But the administration of vast entitlement programs is not particularly costly. A small government can transfer immense amounts of wealth among its citizens. The problem is the entitlements themselves, not wasteful expenditures on administering them—indeed the Medicare program would probably be more efficient, and, specifically, less susceptible to fraudulent and other overbilling and approval of unnecessary or marginal medical treatments, if the Medicare administration had more staff. 

Military spending cannot be cut significantly without endangering national security. Of course there is “waste” in military spending as there is in most activities, but bureaucratic and political imperatives, as well as the inherent uncertainty of threats to national security, place limits on economizing on military spending. Most of the other discretionary spending of the federal government (that is, spending that Congress must approve every year) is likewise justifiable, including spending on domestic security, infrastructure, the environment, basic research, and disaster relief, as well as regulation. Discretionary federal spending can and will be cut if the deficit cannot be reduced by other means, but it probably cannot be cut a great deal without inflicting costs greater than the benefits. 

Anyway the real threat to the solvency of the federal government doesn’t come from military expenditures, which would be leveling off even if there were no budget crisis, or other discretionary spending, which if it cannot be greatly cut can nevertheless be kept in bounds without great hardship. The real threat to federal solvency comes from the entitlement programs—Medicare, Social Security, Medicaid, and many others—not because they are huge, though they are, and certainly not because they are costly to administer, but because their outlays are growing rapidly, especially Medicare and Social Security outlays because of the aging of the population and the rising costs of medical technology as a byproduct of technological advance. Political resistance to cutting these programs, or at least to cutting Medicare and Social Security, is fierce. The programs may be cut some despite their sacred-cow status, but not enough to reduce the rate of increase of the deficit to the rate of economic growth. 

So can economic growth be increased, then? In the near term, the combination of poor economic leadership and management by the Administration with the economic radicalism of congressional Republicans makes it unlikely that the government will do anything to stimulate growth before the 2012 Presidential election and the seating of a new Congress in January 2013. Eventually the economy may rejoin its long-term trend of an annual growth rate of GDP of a little under 3 percent; whether there is a set of economically and politically feasible policies that would increase that rate seems doubtful. 

Which leaves increased tax revenues as a seeemingly indispensable weapon against the soaring deficit. Indispensable—but not ideal. Any increase in tax revenues would be counterproductive in the present depressed state of the economy, because it would take money out of the private economy at a time when the government can finance its debt cheaply by borrowing at very low interest rates. The increase in tax revenues would have to be phased in gradually and meanwhile the deficit will be growing. 

Merely increasing marginal income tax rates, even on the millionaires and multimillionaires and billionaires, is likely to be counterproductive. Unless the percentage increase is substantial, it will not generate much revenue. And if the increase is substantial, it will induce a flight to loopholes. (Buffett would close only two of them—dividends and capital gains—and there are many more.) Only if increased rates were joined with a thoroughgoing reform of the tax system that would eliminate virtually all deductions and exemptions would the increased rates generate substantially increased revenues by preventing a flight to loopholes. The reform would have to be precise, leaving very little for regulatory adjustments by the Treasury, and represent an unshakeable congressional commitment, eliminating all uncertainty so that taxpayers would know exactly where they stood. Meaningful tax reform along these lines, though falling far short of what was, and today is much more urgently, needed, was achieved during the Reagan Administration; there is no reason, other than interest group pressures and other political forces, why it can’t be achieved today. But those pressures and forces are great.

Buffett and a Better Tax System-Becker

In my blog post last week on inequality I expressed sympathy with Warren Buffett’s concern that the share of the income paid in taxes by the very wealthy is considerably smaller than the shares paid by many middle class Americans. But I am troubled by what he proposes to do about it.

He suggests that the 12 member congressional panel set up to cut current and future federal deficits leave tax rates unchanged for 99.7 percent of taxpayers, and only raise rates on the approximately 250,000 households who make more than $1 million. Simple calculations show that a tax increase on such a small number of households, even a very large tax increase, would have a negligible effect on total tax revenue, and hence on closing the budget deficit. As we will see, there are more sensible ways to improve tax revenue.

Warren Buffett has persuaded 68 other billionaires to follow his example and promise to give at least half their wealth to charities. But why hasn’t Buffett proposed also that the very rich make large gifts to the federal government to offset what he considers ridiculously low taxes on their incomes and wealth? My guess is that he and the others who pledged to give away their wealth to charity would have little confidence in how the government would spend such gifts. Buffett, for example, is giving most of his wealth to the Gates Foundation, not to the federal government, and is relying on how this foundation will spend his vast gift. Given this reluctance to make large gifts to the federal government, why should anyone have confidence that the federal government will spend additional tax revenue in a sensible way?

Still, I agree with Buffett that the American income tax system makes no sense from an equity viewpoint, nor does it make sense from its effects on the efficiency of the American economy. Of course, it makes great sense from a political economy perspective since special treatments of all sources of income- whether it be capital gains, gifts to charities, or deductibility of interest on home mortgages- are in the tax code not by accident, but are there due to the political power of builders and home owners,ethanol producers, universities and other non-profit organizations, and other special interest groups. However, perhaps with the present concern by voters over present and future deficits, it may be possible to get serious tax reform by overcoming the political power of important interest groups.

From a efficiency perspective, the ideal tax system would replace all income taxes with a flat percentage tax on total consumption of each household, as in a flat inclusive value added tax (VAT). A tax on consumption instead of income has the advantage that it would avoid the double taxation of saving. The present income tax structure first taxes incomes, and then another tax is imposed on the income earned from any of the original income that is saved (although some savings, like in IRAs, may avoid any taxation until they are spent after retirement). A tax on consumption also avoids the double taxation of corporate income. Under the present system corporate income is taxed, and then taxed again when dividends are paid or capital gains realized. A consumption tax also eliminates the complicated calculations about depreciation on capital that are necessary to arrive at the taxable net incomes of businesses.

Of course, the consumption tax rate would have to be pretty high if it were to replace all income taxes. I would guess that a VAT on all consumption of no more than 25% would be adequate to raise the revenue needed to balance the budget, even without the desirable reductions in federal spending. Since the economy would become more efficient with such a tax, real income would expand, perhaps by a lot, which would lower the burden of a consumption tax.

Two objections are commonly raised to replacing all income taxes with a flat consumption tax. One is that it is unfair for the poor to pay the same tax percent on their small amounts consumed as the rich pay on their greater consumption. One way to introduce progressivity into a consumption tax is to impose a lower tax rate on goods more heavily consumed by low-income households, such as bread, cheap apartments, over the counter drugs, and the like. A less arbitrary way is for the government to give monetary transfers to poor households. Households that qualify for such transfers would report their incomes and savings, with consumption measured by the difference between incomes and savings. It is easier for most families to know what their income and savings are than to keep track of their consumption.

Many small government advocates agree that a flat VAT type tax is efficient, and that is what bothers them. For they are concerned that opposition to raising the tax rate of a flat VAT tax would be weak precisely because the tax is efficient. The more efficient a tax, the smaller the cost to taxpayers from higher rates, and so the more willing they are to accept higher taxes. Casey Mulligan and I develop the theory behind these concerns, and also provide evidence that efficient taxes, such as the VAT, may start low but rise over time (see our paper, “Deadweight Costs and the Size of Government” in the Journal of Law & Economics, 2003). Although some other studies have not found such strong empirical effects of efficient taxes, the argument about the greater incentive to raise tax rates from efficient taxes makes a great deal of common sense as well.

Still, no tax system is ever going to be perfect. Taking everything into account, reliance on a flat tax on aggregate consumption rather than income taxes with different tax rates and various exemptions seems to be a worthy goal to strive for. I say “strive for” since the interest groups that have favorable treatment from the tax code will not meekly go away, but will have to be fought constantly to have real hope of meaningful tax reform.

 

Deserving and Undeserving Inequality–Becker

 

During the past 25 years, inequality in the world has greatly declined mainly because of the rapid growth in incomes in large poorer nations, especially China, India, and Brazil. This led to enormous declines in worldwide poverty as hundreds of millions of families were pulled above poverty thresholds, such as having to live on $1 or $2 dollars a day. At the same time, however, inequality between families grew rapidly within many countries, especially the United States and other Anglo-Saxon countries, China, and India. Although attitudes to inequality differ across cultures and countries (see, for example Alesina, Di Tella, and MacCulloch, “Inequality and Happiness: are Europeans and Americans different?”), in every society these attitudes depend on whether the inequality is considered to improve efficiency and to be deserving – the difference between “good” and “bad” inequality.

The great majority of people in different cultures do not object to someone who has made lots of money when they have superior abilities and talents, and they work hard at producing what are considered useful goods or services. Actors like Tom Hanks or Jennifer Aniston earn millions of dollars per film, yet they are admired as stars rather than condemned for being millionaires because films are a popular form of entertainment. Bill Gates, Steve Jobs, and others who became billionaires by creating innovative companies that provide highly valuable goods and services to millions of individuals are widely admired as the business equivalents of rock stars rather than attacked for their great wealth. Leading transplant and other doctors who become successful and very wealthy through extensive education and superior skills are recognized for their valuable contributions to extending the lives of very sick individuals, and few object to their high earnings.

On the other hand, when hedge fund managers become rich by using arbitrage activities to narrow the spreads in interest rates and other prices between different regions (most hedge funds do not only engage in arbitrage) they produce useful services, but the value of what they do is not so apparent as the businessmen who make successful products. It is still harder for many to understand the usefulness of “speculators” who do well financially by successfully shorting shares of companies or commodities, such as oil, because they believe correctly that their prices will fall in the future. Their activities add value by smoothing out the prices of these shares and commodities over time, but few people like individuals who bring bad news, or who profit from anticipating bad news.

Other forms of behavior are objectionable because they both add to inequality and lower economic efficiency. These are the most dangerous sources of inequality, and they create negative attitudes toward the wealthy, and even at times social unrest. One illustration is the arbitrary use of government power to give or take away wealth. Some individuals become very wealthy because of the political favors they receive, while others lose much of their wealth because of unjust governmental treatment. Examples include Carlos Slim and the Russian oligarchs who gained big economic advantages by receiving monopoly positions in industries like telecommunications when they were privatized, and the officials of Fannie Mae and Freddie Mac who became wealthy by using their political connections to acquire a dominant position in the US residential mortgage market. A highly publicized recent example is the Indian businessmen who obtained special privileges in telecommunications and other industries because of corrupt government officials.

Arbitrary taking of property through eminent domain and other government power without proper compensation is a major source of discontent. Chinese farmers objected, and some even rioted, when governments took their land to build infrastructure or factories. Governments in the United States sometimes use eminent domain powers to take the land and housing of families in order to build public and private redevelopment projects. In these and related examples, people object partly to the forced transfers of property to governments, and partly to inadequate compensation to small property owners, at least inadequate in the eyes of those losing their properties and their neighbors.

Since earnings is the biggest contributor to income for the great majority of families, the considerable inequality in earnings has been extensively dissected. During the past several decades, technological advances that favored highly skilled workers raised the earnings of college graduates by a lot relative to those with lesser education in the United States, Great Britain, China, India, and many other countries. This sharply higher relative earnings of the more educated has been accepted for the most part since it contributes to greater productivity. Criticized are the various obstacles that prevent able boys and girls from acquiring a college education, such as broken and poor families, and inadequate schools. These obstacles lead to bad and inefficient inequality that sometimes causes frustration and discontent among those affected.

Attractive public policies encourage the good earnings inequality and attack the bad inequality through laws, taxes and subsidies, and in other ways. For example, charter schools, vouchers, merit pay for good teachers, Head Start programs, and student loans help more able students from disadvantaged backgrounds enter and finish college.

Public policies can also help overcome inefficient sources of inequality in other types of income, although these policies often run into powerful political opposition. Privatization and other sales of government properties should be auctioned off, not given away to favored businessmen. Governments should be allowed to use eminent domain and similar laws to take property from individuals only in sharply constrained circumstances with very high benefit/cost ratios. Regulations should be based on rules rather than discretion, so that the regulators cannot easily get “captured” by the industries they are regulating, including capture through corruption of government officials.

I agree with the argument by Warren Buffet in a recent New York Times op-ed piece that it is neither fair nor efficient for highly wealthy individuals like himself to be paying a smaller fraction of their incomes in taxes than middle income and many lower income persons. However, the way that inequity is corrected can make an enormous difference to economic efficiency as well as to the degree of inequality. The best way to reduce these inequities is to substitute for the present tax mess an inclusive equal percentage tax on all incomes, where the income base would be greatly widened by eliminating deductions on mortgage interest payments, restraining the tax-deductibility of charitable contributions, and eliminating special subsidies, such as the generous ones to ethanol producers. With a flat broad equal percent tax on all incomes, capital gains and other sources of income that currently have special tax treatment should then be taxed at the same flat rate as earnings and other incomes.

Income Inequality and Envy—Posner

The position one occupies in the distribution of income and health is largely a matter of luck—the luck of the genes, the social and economic standing of one’s parents, accidents of upbringing, the match between one’s abilities and demand for particular goods and services, and so forth—though there is an element of choice, since people are motivated by nonpecuniary as well as pecuniary factors. But that is more a matter of some people who could earn high incomes choosing a career less remunerative but more productive of nonpecuniary income. A person who lacks the ingredients of financial success can “choose” to become rich but won’t get anywhere. 

Utilitarians believe that, other things being equal, income equality maximizes utility because of the diminishing value of income—an extra $100 confers more utility on a beggar than on a millionaire. So utilitarians are apt to condone inequality only if it increases average incomes substantially—which doubtless it does, within limits at any rate, at least in a society not riven by envy. (In highly envious cultures, a person may start a fire that will destroy both his and his neighbor’s barn, provided his neighbor’s barn is worth than his and is not insured.) 

Hence Becker properly emphasizes the importance of distinguishing between economic inequality that promotes, and economic inequality that retards, the creation of social wealth. And in a commercial society such as that of the United States, a political-economic system that allows able people to make and keep large fortunes produces powerful incentives to create wealth. I call the wealth they create “social” because it benefits other than just the creator of the wealth. Successful producers of goods and services create consumer surplus and pay a disproportionate share of taxes. 

That is not to say that the income of wealthy people is carefully proportioned to their contribution to social wealth. A person who wins a fortune in a lottery does not increase the size of the economic pie, but merely gets a big slice for himself. But lotteries are an effective method of tax collection (they are voluntary taxes), and windfalls are an essential element of the method and therefore have a legitimate social function. 

These points are not familiar to the general public, so it is a puzzle why there is so little envy in our society. There is of course local envy—envy of a neighbor or coworker who one thinks has enjoyed undeserved good fortune—but that is different from envy of the rich as a class. Inequality has grown significantly in recent decades and has been magnified and dramatized by the continuing economic crisis; high un- and underemployment coexists with widely publicized lavish partying by billionaires. One reason for the lack of envy is that the only inequality that is noticed is inequality between middle and upper class people—the poor are invisible—and the middle class is well off by international and historical standards. Another reason is that there is already a good deal of redistribution of income and wealth through the entitlements programs, and further redistribution, involving significantly heavier taxes, is generally opposed, as no one knows whom the burden of the heavier taxes will actually fall on. Still another factor is the domination of campaign financing by the wealthy, which discourages legislators from left as well as right from waging “class warfare.” Also, America is a classless society in the sense that the wealthy do not flaunt a superiority of culture or manners (think of the vulgarity of a Donald Trump); they do not, typically, attend the very best prep schools and colleges; they are not, for the most part, rentiers, living off inherited wealth; they are not considered “better” than other people; they just have more money. And America remains an open society. Children of privilege have advantages, but the talented who start with no advantages face no obstacles to rising. 

Equality of opportunity, a salient American cultural characteristic, actually guarantees inequality of income, because an opportunity is just a chance. Equality of opportunity is related to individualism and competitiveness, which are also American traits, related to the diverse origins of its large population. Ties of community are loose, and altruism outside the family circle limited. 

Inequality could reach a point at which a relatively small group controlled such a large fraction of the nation’s wealth that a political movement could rally support for dispossessing them of their wealth. At present, however, such a movement does not exist.