Hidden costs to tax cut

Boston Herald article "Hidden Costs to Tax Cut" (October 23rd, 2010) talks about the benefits of a tax cut as if it would be a direct transfer from government coffers to consumers. However, they would potentially gain much more.

Each voter must decide if that 3 cents per dollar savings is worth more to them than what they would lose in cuts to public safety, schools, roads, senior programs, health care, libraries, housing.

Because taxes create deadweight loss, for every three cents transferred from government is more transferred to them. Indeed, it could be much more. This is depicted in a competitive constant marginal cost case graphically below (click to enlarge). However, it could be extended to a monopolistically competitive case--this would make Corrections point even more strongly, as tax incidence may sum to more than 100% for monopolies, as they transfer the loss of the tax to the consumer inefficiently, so to speak.

Put in the way the Herald is arguing it, individuals may be losing one cent of government services for every three they get back in sales tax. Additionally, they are gaining not only what they lost, but what they never bought because of the tax wedge. They gain the amount they were taxed as well as the distortion, the tax wedge, brought on by that tax.

Trading Away the Stimulus

New York Times OpEd "Trading Away the Stimulus" (September 9th, 2010) presents a foolish analysis of trade, completely neglecting the notion of opportunity cost.

Also essential is a border tax to counter foreign export rebates. In countries with value-added taxes, those levies are returned to producers when they export their goods — which allows them to lower their products’ prices in our market. In response, we can ensure fair competition in our home market by applying a tax equal to the rebate upon a product’s entry to the American market.

COnsumers in the US are made unambiguously worse off by a tax on foreign imports. We show this in a graph depicting the US market for some good both before and after a border tax meant to counter a Chinese export subsidy. An analysis of the market in the US requires that we consider the total supply of goods, both Chinese and U.S.-made. Then, the total supply in the US market is found by adding US supply and Chinese supply. It may be that, due to a Chinese government subsidy of s per unit, Chinese suppliers are able to produce every unit more cheaply than US suppliers. This means that even with the same technology, their supply curve could lie below that of US producers. We depict the equilibrium in such a market below (click here to enlarge).

If the US counteracts the Chinese subsidy of s dollars with an import tax of t=s dollars, then the Chinese supply becomes identical to US supply, and we have a new equilibrium. We depict this market below (click here to enlarge).



Now consumer surplus (the green shaded area) is smaller than before, while US producer surplus (the red shaded area) is larger. Nonetheless, because the equilibrium price is higher in this regime, and quantity is lower, we as a country are worse off than we were without the tax. The gray shaded area shows the total loss to the US from a tax that would benefit a few marginal (high cost) producers. This again gives our rule of thumb for politics: whenever a group is pushing for more taxes or regulation, it is because they and government officials they fund are "putting one over" on consumers, taking their surplus and dividing it between them.

N.Y. to Try Again to Tax Indian's Cigarette Sales

New York Times article "N.Y. to Try Again to Tax Indians' Cigarette Sales (August 31st, 2010) fails to note why a government tax program is ill-concieved.  New York is currently considering attempting to tax the cigarette sales of Indian reservations.  In an attempt not to tax reservation consumption of cigarettes, it will give vendors a lump-sum tax break.  This is the reverse of efficient taxation.

The state’s plan does make exceptions for cigarettes sold to tribal members, estimating, based on the population of an Indian reservation, what portion of the sales are made to them. Taxes are charged on the remaining packs, on the assumption that they are bought by customers who are not Indians.

In fact, this does not make reservations for tribal members.  Vendor prices should be the same for all cigarettes, sold to Indians on reservation or not.  The reason is that it appears stamps must be on all cigarette packs--there is no "dual supply" problem.  In this case, vendors will raise the price of all cigarettes by whatever the tax is (recognizing competition and constant returns to scale production) and simply take the tax cut as pure producer surplus.  The supply-and-demand equilibrium before and after is depicted below (click to enlarge).  The upper blue-to-red supply line depicts the taxed supply.  The red line depicts supply without tax.  As we can see, because of the law of one price, producers have in effect been given a lump sum transfer, which will not be reflected in their prices.

The structure of taxation will make this effectively a tax on on-reservation Indian consumption of cigarettes.

We Might Decide to Fly

New York Times editorial "We Might Decide to Fly" (June 3rd, 2010) suggests that government regulation may improve the flying experience for consumers. Perhaps, but consumer surplus will fall.

The Obama administration’s new consumer protections for beleaguered airline passengers — including higher compensation for travelers bumped from oversold flights and prominent disclosure of all service fees — are much needed.

The airline industry is widely considered competitive, so airlines do not make profit, but instead charge each consumer the cost of providing his seat on the airlplane. If the government increases this cost, by requiring them to invest resources into making sure fewer customers are bumped from flights, for example, then the airlines will have no choice but to pass this cost increase directly to consumers. As shown in the graph below, total consumer surplus--the sum of benefit that all consumers receive from flying, will decrease from the entire shaded triangle to the yellow shaded triangle.

Even if we allow for the argument that airlines have some monopoly power, regulation may harm consumers more than it helps them. This is because monopolies also pass some portion of any cost increase to consumers. The amount of this increase depends on the response of demand to price changes. Again, as depicted below, consumer surplus will decrease. This will overwhelm the gains in service to consumers, due to the mechanics of monopoly profit maximization.

The Health Care Number You Didn't Hear

Real Clear Markets article "The Health Care Number You Didn't Hear" (February 26th, 2010) makes the argument that American workers do not pay for their health care because their employers pay. This is incorrect. While the article's point is quite correct, when people don't have to pay for services they will demand more of them, its point about employers paying for health care is wrong.

American health care fuses these two systems, but with a common economic flaw: people are overinsured, paying pennies directly on every dollar of health service they receive.

The end result: for every dollar spent on health care in the United States, just 12 cents comes out of the individuals' pockets. Imagine what food costs might be if your employer paid 88% of your grocery bill or what a trip to Saks might be like if your company covered the vast majority of the costs of the shopping spree.

Were employers to pay 88% of one's grocery bill, then one would expect one's wage to go down. The incidence of this tax on employers that refunds benefits to is likely to fall almost entirely on the individual. We could similarly imagine a world in which the government takes 50% of every person's paycheck and sends it back to them. Take-home wages would go down by half (and we would get a check from the government for 50%). Equilibrium wages would not change, and employers would not be paying for anything.