Wednesday, March 31, 2004

"One small step for robots..." and the deadweight cost of taxation

This month's New York Review of Books features a great article by physicist Steven Weinberg that argues NASA is wasting its money on manned missions and should try something else. He points out that our manned space program, though justified on military and scientific grounds, does remarkably little science and produces no known military benefit at ludicrous expense. (Most of what astronauts do in space could be done by robots for a small fraction of the cost.) The "manned mission to mars" folks should take note. But towards the end of the article, Weinberg veers off into economics and makes a wrong turn, writing:

"My training is in physics, so I hesitate to make pronouncements about economics; but it seems obvious to me that for the government to spend a dollar on public goods affects total economic activity and employment in just about the same way as for government to cut taxes by a dollar that will then be spent on private goods. The chief difference is in the kind of goods produced by the economy—public or private." [emphasis added]

This is a common intuition, but it's not true. One thing being ignored is a factor known to economists as the "deadweight cost of taxation". The essence of the problem is that taxes cost the taxpayers significantly more than the value collected, and therefore even quite well-directed spending can produce a net loss for the economy as compared with simply lowering taxes.

Consider a simple sales transaction. I want to buy an apple and am willing to pay as much as $1.10 for it. (By "am willing to pay" I mean that I would be indifferent between having $1.10 and having an apple, but at any price less than that I'd feel like it was worth making the trade.) You have apples to sell and are willing to sell them for as little as $1. We meet in the marketplace and after some negotiation I agree to purchase the apple for $1.05. Since I was willing to pay a nickel more than that, I am richer by a nickel for having made the trade; the "consumer surplus" for this trade is 5 cents. Since you were willing to accept a nickel less than the agreed amount, you also are richer by a nickel for having made the trade; the "producer surplus" for this trade is 5 cents.

The economy as a whole is better off for this trade having occurred; resources (an apple) have moved to where they were more highly valued. The economy as a whole is "richer" by the ten cents worth of value that came from this trade, and the immediate benefit that flows from this is distributed as: 5 cents to you, 5 cents to me.

That was without any taxes.

Now let's add taxes to the picture. Let us imagine apple-sellers are required to pay a 5 percent sales tax. You and I still meet in the market, and you sell me the apple for $1.02 plus tax = $1.07 total. We still made the trade and the economy still benefited by ten cents from the transaction, but the breakdown on where the benefit went is: 3 cents to me, 2 cents to you, and 5 cents to the government. Assuming the government spends the money as well as you or I would, it's still consistent with Weinberg's intuition. Compared to the no-tax scenario I am 2 cents poorer and you are 3 cents poorer than we would have been, but the government is 5 cents richer so there's no value destroyed. So far, so good.

But suppose taxes are increased such that apple-sellers now have to pay a 15% sales tax. What happens?

With any tax over 10% there is no possible price for which the seller and buyer both benefit from this trade. Therefore the trade doesn't happen. I keep my money and you keep your apple because - given taxes - you can't afford to legally sell the apple at a price that I am willing to pay. So the economy fails to achieve the 10 cent efficiency improvement from the apple going to the person who most values it.

Compared to the situation where there were no taxes, I am 5 cents poorer, you are 5 cents poorer, and there is no offsetting benefit. Since the trade doesn't occur, we don't even pay taxes on it, so there's no gain in taxes to offset this ten cent loss. That is a deadweight loss. There are other losses as well. Costs from people hiring tax attorneys and restructuring their affairs to avoid taxes. Costs from trying and imprisoning tax offenders. Costs related to administering the tax system. Costs of opportunities foregone, businesses bankrupted, sales lost, inventions proven uneconomic due to an unfavorable tax climate rather than any inherent flaw. Even costs spent lobbying to benefit from tax changes (aka "rent seeking").

The higher taxes are, the worse are these costs. So yes, it really is better for the government to cut taxes in most cases. Because they'd have to spend $1.40 to do as much good with spending as cutting taxes by a dollar does.

["It has been estimated that the dead-weight costs of the federal government’s raising an additional dollar equal 39 cents."]