Tag Archives: tax rates

What the Mortgage Interest Deduction can Teach us About Government Failure

Is it hypocritical for a business or a politician to publicly oppose a government program only to turn around and ask for a share in it? Stephen Koff of the Cleveland Plain Dealer posed this question to me a few weeks ago. Likening it to the mortgage interest deduction, I said I didn’t think so.

I oppose the mortgage interest deduction. It pads the pockets of housing-industry special interests. It puts pressure on marginal tax rates to rise in order to make up for the lost revenue. And it likely has little impact on the incidence of home ownership since the value of the deduction is capitalized into the price of homes. (Even if it worked as intended and didn’t end up being capitalized into the value of home prices, it would be a regressive privilege for relatively wealthy home-mortgagers). For all these reasons, I—like most economists—oppose the mortgage interest deduction.

But come April 15, I take the deduction. And though I can’t say for certain, I suspect the same is true of most economists. Why?

The main reason is that not taking the deduction would have approximately zero impact on the problems I mentioned. Those problems only go away if the whole policy goes away. So, I do what I can to expose its faults when I talk to journalists but I don’t forgo it myself.

Whether or not you find this hypocritical, it is an empirical fact that lots of people see things this way. More importantly, this phenomenon is at the heart of the public choice critique of government failure. It explains why bad policy exists.  

Consider pork-barrel spending, as modeled in the prisoner’s dilemma (economists should skip the next two paragraphs). Imagine a community of two constituents. And imagine that each has the choice of two options: take pork or abstain from pork. Taking pork yields a private benefit of $10 for the taker. But because there are deadweight losses associated with taxation, $10 in pork will cost the community $12 in taxes and unrealized economic gain. If this cost is split evenly between the two constituents, and Constituent A is the only one who takes it, then he obtains $4 = $10 – 0.5*$12 (his gain, minus his share of the cost). Constituent B, however, only gets the cost of A’s pork: -$6 = -0.5*$12. The situation is reversed if B takes and A abstains. If both take, then each pays -$2 = $10 – 0.5*24 (the value of the pork minus the cost of paying for two peoples’ shares). Lastly, if both abstain, neither is taxed and neither obtains a benefit. The table below shows these outcomes. The first number indicates Constituent A’s payoff, while the second indicates Constituent B’s.

Player B
Abstain Take Pork
Player A Abstain 0.0 0.0 -6.0 4.0
Take Pork 4.0 -6.0 -2.0 -2.0


Irrespective of what Constituent B does, it always makes sense for Constituent A to take the pork. If B abstains, then A should take it because he gets $4.00 instead of $0. And if B takes, then A should also take because losing $2.00 is better than losing $6.00. Similarly, it is always in B’s interest to take. So the “equilibrium” of the game is for both A and B to take pork and for them both to be worse off than if neither took.

The point of the exercise is to show that the incentives of the system lead people to a socially suboptimal outcome. If they could somehow change the entire system—say by prohibiting taxes that fund special interests instead of general welfare—then they could get to the optimal outcome. But without changing the incentives of all players, it makes little sense for any one person to act against his or her interest.

MSNBC has lately taken to airing commercials that highlight federal funding for parochial projects. The commercials are apparently supposed to convince people that the federal government should fund all sorts of local project. As a one-time resident of Arizona I’m sure I benefited from the electricity generated at Hoover Dam. And whenever pork-barrel projects are considered, you can generally count on the local constituents who benefit from them to support them. But that doesn’t mean that the residents of the 48 states other than Arizona and Nevada should have had to pay for the Dam. In fact, the simple model of the prisoner’s dilemma teaches us that the incentives of such a system can lead to suboptimal outcomes.

I take the mortgage interest deduction. And the problem is that I—like every other homeowner—am incentivized to do so, even though the total costs outweigh the total benefits.

Do Taxes Affect Economic Growth?

The CRS has a new report by Thomas Hungerford that has attracted some attention. It seems to suggest that taxes do not affect economic growth. To be precise, it seems to suggest that the top marginal tax rates of two taxes in particular—the personal income tax rate and the capital gains tax rate—have little statistically significant effect on economic growth.

A few comments:

First, as William McBride of the Tax Foundation notes in an excellent post, the study only examines two taxes.

The largest tax on investment is the corporate income tax, but the CRS report ignores corporate rates, even though other studies have found corporate taxes to be the most economically damaging.

Second, Will also rightly notes that the study focuses exclusively on the statutory rates of these two taxes, ignoring their actual incidence.

Because Congress has larded up the tax code with piles of credits, exemptions, and deductions, statutory rates often have little relationship to the rates people actually pay (just ask GE). For that, we need an estimate of effective marginal tax rates. As it turns out, many (most?) researchers who study taxes in the U.S. do attempt to get at this. Barro and Redlick’s piece is one example. It employs a tax model which accounts for the “complexity of the federal individual income tax due to the alternative minimum tax, the earned-income tax credit (EITC), phase-outs of exemptions and deductions, and so on.” Using this measure, Barro and Redlick find taxes do have “significantly negative effects on GDP.”

Third, the piece makes no attempt to account for reverse-causality (what economists call endogeneity).

Put simply, tax rates do not change randomly. If they did, that’d be great for researchers because randomization is the gold standard of the scientific method. But because policy makers are not so keen to let economists experiment with the national economy, tax rates don’t change randomly. Instead, governments tend to change rates in response to changing economic conditions; they cut taxes when the economy is weak and they raise taxes when the economy is strong. This makes disentangling cause and effect quite difficult.

Imagine we studied new drug treatments this way. Instead of large scale controlled experiments with randomized treatments and placebos, what if we only had one patient, and we only gave her a treatment when her condition worsened? If, after the treatment, her condition deteriorated further, would we conclude that the drug did her in? A simple statistical test would say so: drug applied, condition worsened. But such a test would ignore the fact that she only got the drug because she was sick to begin with! The point is that it’d be irresponsible to conclude anything from such a small sample and without trying to control for reverse-causality.

That’s why economists go to great lengths to mimic the conditions of a controlled, randomized experiment. In the case of tax studies, the best example of this is the study by Christina and David Romer. They painstakingly combed the archives of presidential speeches and government documents to identify tax changes that came about for reasons other than the condition of the economy. They found that these sorts of plausibly exogenous tax changes had quite significant macroeconomic effects. In their words:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Fourth, I also take issue with the way the report characterizes some of the existing literature. For example, Hungerford writes that:

There is substantial evidence…to suggest that labor supply responses to wages and tax changes are small for both men and women.

This is only true if the question is whether people who already have jobs change their labor supply in response to tax changes. Increasingly, however, the literature has identified another margin that matters: lifetime decisions about schooling, fertility, and work experience. If taxes affect these things, then they still affect labor supply, even if they don’t seem to affect short-term decisions about how much labor to supply. As Michael Keane’s recent piece illustrates, taxes have a very pronounced effect along this margin, especially among women.

The CRS report is interesting. And its results should be added to the body of literature on taxes. But it is hardly reason to throw out decades of other research which suggests taxes do harm growth:


“The last thing we can do is go back to the same failed policies that got us into this mess in the first place.”

I’ve heard this a great deal lately. I suspect I’ll hear it even more over the next three months. Whatever could it mean? Presumably, the speaker is worried about the sorts of micro and macro policies that were pursued in the years prior to the Great Recession:

  • Perhaps he thinks it was bad policy for federal spending as a share of GDP to leap from 18.2 percent in 2001 to 25.2 percent in 2009 (this was the largest such increase in ANY 8 year period since WWII).
  • Or perhaps he thinks it was bad that net federal debt went from 32.5 percent of GDP in 2001 to 54.1 percent of GDP in 2009 (a post WWII high).
  • Or maybe the speaker thinks it was ill advised for the Bush Administration to be far more aggressive than its predecessors in pursuing discretionary, Keynesian-style countercycle fiscal policy. There were no fewer than four such measures during the Bush years: cash rebates in 2001, investment incentives known as “bonus depreciation” in early 2002, tax rebates in 2003, and of course, the 2008 stimulus bill which included more rebates.
  • Perhaps the speaker thinks it was a bad idea for the Bush Administration to impose 30 percent tariffs on imported steel.
  • Or maybe he thinks it was bad for the Bush Administration to introduce (an unfunded) Medicare prescription drug benefit, the first major entitlement program since the Great Society.
  • Perhaps he thinks it was bad for the Bush Administration to reintroduce industrial policy by signing the Energy Policy Act of 2005, creating the Department of Energy loan program that ramped-up the government’s adventures in venture capitalism.
  • Perhaps the speaker thinks that in the years leading up to the crisis, monetary policy became unhinged from a restrained, rules-based approach?
  • Or perhaps the speaker thinks that the government sponsored enterprises, Fannie Mae and Freddie Mac, systematically encouraged over-leveraging in the housing industry?
  • Or maybe that capital requirements encouraged investors to load up on mortgage-backed securities.
  • Or maybe he thinks that, once the crisis hit, the Bush Administration shouldn’t have undertaken the most comprehensive and far-reaching bailout of private industry in U.S. history, one that resulted in the federal government buying stake in or bailing out hundreds of financial firms.
  • It must be that the speaker was worried that in aggregate these policies had seriously undermined the economic freedom of the U.S., as evidenced by the precipitous fall in measured economic freedom from 2001 to 2009:

If this is what the speaker was getting at, then I couldn’t agree more! Hopefully, he’s proposing ideas to reverse course: spending reductions to bring spending in line with taxation, entitlement reform to put the nation’s budget on a sustainable course, tax reform to close loopholes and reduce rates such as the corporate tax rate, financial reforms to finally end too big to fail, regulatory reforms to reduce distortions in the marketplace, health care reforms so that market forces can actually operate in that industry, and other economic reforms to restore a level playing field in American business.

….Or, maybe the speaker is just focusing on one policy that marginally moved the nation in a market direction, the temporary reduction of all personal income tax rates, including the top marginal rate from 39.6 percent to (gasp!) 35 percent. And maybe the speaker is hoping that no one will notice that on just about every other policy dimension, the previous administration was anything but laissez faire.

Trickle-Down Economics: Does Anyone Actually Believe In It?

I have heard a lot about “trickle-down economics” lately. The President has taken to using it in speeches. And pundits have increasingly invoked the idea. Back in February, I was asked about the term when I testified before a House committee and had to confess that I have never met an economist who has advocated anything close to “trickle down” economics.

The words “trickle down” imply that if you redistribute money to the wealthy, they will spend it (say, by hiring workers or by buying products) and it will somehow find its way into the hands of the poor. To the extent that any economists endorse such a notion, they are emphatically not free market economists.

This is not to say that there is no case for low taxation. There is a strong theoretical case for low taxation (so long as it is accompanied by low spending!). And it is backed by good empirical evidence.

But the case for low taxation is not—as the phrase “trickle down” implies—based on the idea that we should give money to a wealthy person so she can spend it. Instead, it is based on the idea that if we take money away from either a rich or a poor person when they engage in some activity, they will tend to engage in less of that activity.

If we tax work, people will tend to work less. If we tax consumption, people will tend to consume less. If we tax saving, people will tend to save less. The idea is rooted in basic microeconomics. Taxing labor, for example, makes leisure less expensive. So people choose more leisure. This is called the substitution effect.*

All this theory is well and good, but is there any evidence to back it up? Yes. Michael Keane offers a nice survey of labor supply and taxation studies in the December issue of the Journal of Economic Literature. He identifies at least two major patterns in the evidence:

  1. Women are more responsive to taxes than men (most economists think men are relatively unresponsive to labor taxes, especially in the short run).
  2. People—particularly women—are more responsive to taxes when they consider whether to work than they are when they consider how much to work. In the average study, the long-run elasticity for female labor is 3.6. This means that if a tax hike reduces after tax wages by 10 percent, female labor force participation tends to fall by about 36 percent. As Keane puts it, this is a “very large” effect.

In my view, both of these patterns make sense. Historically, women have been more likely than men to work at home and so higher taxes seem more relevant for them than for men (as more women work outside the home and as more men stay home, I’d expect this gender difference to narrow). It also makes sense that taxes have a larger effect on the decision to work at all than on the decision to work a certain number of hours. Most of us can’t tell our employers that we want to work 30 hours a week rather than 40. But we can tell our employer that we don’t want to work at all. And evidently a lot of people—particularly women—do tell their employers this when taxes are high.

So far, I’ve only discussed how taxes affect labor supply. But they may also depress consumption and investment. What is the overall effect on the economy?

One of the best recent studies is that by President Obama’s former economic advisor, Christina Romer and her husband, macroeconomist David Romer. The Romers set out to understand the effect of taxation on an economy. But they knew that there was a major problem: taxes are not randomly increased or decreased. Instead, politicians tend to keep taxes low when the economy is in recession and raise them when the economy is booming. This makes it very difficult to disentangle cause and effect. So the Romers painstakingly analyzed decades of presidential speeches and government documents to identify exogenous tax changes (i.e., changes that were undertaken for reasons other than the condition of the economy). They then compared the performance of the economy following such exogenous changes. They concluded that exogenous tax increases are “highly contractionary.” As they put it in the conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Now here is the irony: As I note above, few if any economists advocate redistributing resources to the wealthy in the hopes that they will trickle down to the rest of us. But over the objection of economists—particularly free market economists—policy makers do this all the time. Think of President Bush’s TARP. Or President Obama’s decision to extend TARP to the auto companies. Or his excursions into venture capital. In each case, money was actually transferred from taxpayers to the (mostly) wealthy managers and shareholders of private firms.

If words mean anything, each of these policies—and not, say, an across the board reduction in marginal income tax rates—should be labeled “trickle-down economics.” But in politics, words often mean nothing.


*  You might be thinking that the income effect offsets this: By taxing income, you not only make leisure less expensive, you also make people feel poorer. In response to feeling poorer, they may feel that they need to work harder to make up for the loss income. This works for an individual, but as economists James Gwartney and Richard Stroup long ago explained in the American Economic Review, it does not work for society as a whole. This is because governments do something with the money they collect in taxes. And the income effect of spending government revenue makes people work less. So at the economy-wide level, the income effect from spending offsets the income effect from taxing. All you have left is the substitution effect and that unambiguously reduces labor supply.


New Research on Freedom and Entrepreneurship

Here are a few findings from my recent paper with Joshua Hall and John Pulito titled “Freedom and Entrepreneurship: New Evidence from the 50 States”

  • Humans are entrepreneurial by nature. We desire to improve our material well-being, which drives us to innovate, often through new business creation. Despite the ever-present tendency toward entrepreneurship, public policy can have a significant impact on the incentives for entrepreneurial activity. Economists often call these incentives the “rules of the game.”
  • When making the decision to take on a new business, entrepreneurs must weigh the risks against the potential payout. Policy makers have the power to raise the cost of starting a new business by raising taxes or increasing regulatory costs, and they have the power to lower the cost by pursuing stable and consistent public policy initiatives consistent with economic freedom, such as low, broad-based taxes and prudent regulation.
  • Previous research has demonstrated that “rules of the game” favoring lower taxes and limited regulation—as measured by economic freedom indices—encourage entrepreneurship. Studies have found similar results both in comparisons across the states and in comparisons across countries. “Freedom and Entrepreneurship: New Evidence from the 50 States” uses an index of freedom, the Mercatus Center at George Mason University’s Freedom in the 50 States by Will Ruger and Jason Sorens. The study confirms earlier results: economic freedom permits higher levels of entrepreneurship, as measured by the creation of new businesses.
  • Freedom in the 50 States includes measures of both economic and personal freedom. Personal freedom had not previously been studied as a factor in the entrepreneurship level, and this study found that it did not in fact have a significant impact on business creation. Only economic freedom appears to have a positive impact on entrepreneurship, although personal freedom is of course important for other reasons.
  • This additional evidence that economic freedom is correlated with entrepreneurship should encourage policy makers to pursue changes that increase their states’ economic freedom. The evidence suggests that by increasing economic freedom, policy makers have significant power to improve their states’ climate for new business creation. For example, if policy makers in Ohio— which currently ranks 32nd in the Freedom in the 50 States’ Economic Freedom index—increased the state’s ranking to the level of Nevada, which ranks 23rd, Ohio residents could expect to see a 33 percent increase in new business creation. Lower tax rates, lower regulatory burdens, and lower barriers to trade can all encourage citizens to pursue their drive toward entrepreneurship.

Click here to read the paper in its entirety.

Detroit’s Financial Future

This post originally appeared at Market Urbanism.

After flirting with Chapter 9 bankruptcy or a state takeover of its finances, Detroit has reached a deal with the state of Michigan that will allow it to remain independently managed with a requirement for state oversight. The Detroit Free Press reports:

The city has seven days to create the positions of chief financial officer and program management director and 30 days after that to make a hire from a list of three candidates from the mayor and state treasurer. Lewis said the city is compiling a list of candidates.

“We’ve got a lot of requirements that are in the agreement,” Lewis said. “We’ve got a lot of work to do (with the agreement) and then getting to the work of fixing the city. Our focus is on executing the plan and getting the resources here to execute the plan.”

Snyder reiterated that the city “shouldn’t expect” a cash bailout, adding that Detroit is one of many troubled communities in the state. But he said the state would use its resources in a variety of ways to help the city.

Snyder said the agreement assures the things that need to be done will get done, describing it as a “progressive series of steps” that first allow the mayor and the council to make the decisions, and then empowers the project manager to do so if they don’t. “This is a legal document designed to deal with situations when they don’t go right,” he said.

While bankruptcy protection offers the advantage to cities of achieving a more manageable debt load, it doesn’t come without a cost. Bankruptcy would add an additional stigma to Detroit, already known for municipal financial distress, encouraging business disinvestment.

Vallejo, CA filed for bankruptcy in 2008, and as the New York Times explains, the city is still in a difficult financial position. After bankruptcy cities have less room in their budgets to provide public services such as infrastructure, parks, and schools while their tax rates don’t fall accordingly. This contributes to further erosion of the tax base as businesses and residents leave the city.

Municipal bankruptcy is always a two-sided issue involving both revenue and debt. At The Atlantic Cities, Emily Badger covers the equation from the revenue side. While cities often both subsidize and enforce sprawl through road-building, parking requirements, and minimum lot sizes, these policies are detrimental to their property tax equations. She cites the positive example of Asheville, NC as a city that has taken advantage of denser downtown redevelopment to improve its ratio of property taxes to infrastructure costs:

Asheville has a Super Walmart about two-and-a-half miles east of downtown. Its tax value is a whopping $20 million. But it sits on 34 acres of land. This means that the Super Walmart yields about $6,500 an acre in property taxes, while that remodeled JCPenney downtown is worth $634,000 in tax revenue per acre. (Add sales tax revenue, and the downtown property is still worth more than six times as much as the Walmart per acre.)

[. . .]

All of this is also just looking at the revenue side of the ledger. Low-density development isn’t just a poor way to make property-tax revenue. It’s extremely expensive to maintain. In fact, it’s only feasible if we’re expanding development at the periphery into eternity, forever bringing in revenue from new construction that can help pay for the existing subdivisions we’ve already built.

[. . .]

“The thing is it all works fine when you have all this new growth and the new gap is met by all these new permit fees – that’s like free money,” Joe Minicozzi [of Public Interest Projects] says.

Cities should not be in the business of requiring the sort of development that is most expensive for them to support. However, this analysis ignores the debt side of Chapter 9, one that may be even more difficult to tackle politically. Despite the harm that poor financial management causes, local elected officials simply do not have the proper incentives to avoid it.

Politicians operate on election cycles, and during their time in office they generally seek to provide their constituents with the best possible services at the lowest tax rate. This leads them to put off payment on long term debt and liabilities using accounting gimmicks and fiscal evasion techniques to spend more on goods that residents will see in the near term.

A combination of debt and declining revenue has put Detroit in the position it’s in today. Its urban development strategy must be a part of the property tax revenue solution. Perhaps the new officials that the city hires will help with debt management, but this additional oversight is unlikely to overcome the incentives of election cycles.

Puerto Rico Secretary of State on Government Reform

On my last post about government reform in Puerto Rico, a commenter pointed out that some of the trends indicating that the territory’s government is shrinking have reversed in the past year. Indeed, the number of government employees increased from 259,000 in December 2010 to 269,000 in December 2011. Likewise, government revenues ticked up in 2010 and 2011 after decreasing in 2008 and 2009.

I wanted to learn more about the reversal of the shrinking central government, so I spoke with Puerto Rico Secretary of State Kenneth McClintock about these trends. He explained, as the commenter pointed out, that the increase in government revenue is in large part due to an excise tax on foreign corporations that went into effect in 2011. This temporary tax is being used to finance broad-based tax reform and is gradually being phased out over the next five years when it will expire in 2016. McClintock explained that a six year plan for tax reform was one of the administration’s top priorities upon Governor Luis Fortuño taking office in 2008.

Reform measures have included cutting corporate tax rates from 39 percent to 30 percent and individual tax rates by 50 percent over the six year period. McClintock said, “Beginning in year one, everybody had more money in their pockets.” These reforms include a unique trigger. If Puerto Rico doesn’t achieve a balanced budget by the end of the six-year reform period, the final tax cuts will not go through. “We wanted to show people that good things happen with fiscal discipline,” McClintock continued.

Regarding the increase in government employees, McClintock said that part of the increase was due to stimulus funds from the American Recovery and Reinvestment Act and hiring by local governments. Additionally,  a negligible number of the initial cutbacks were deemed to be unsustainable and required refilling some positions that were eliminated in the initial round of cuts. Attrition policies are still in place, so longterm cuts should still be expected.

Initially, government job cuts raised Puerto Rico’s already high unemployment rate by about 1.2 percentage points. McClintock said that while hard data is not available on the individuals laid off from government jobs, anecdotally about half of them are now employed in the private sector. The layoffs included a $1 billion severance package which provided $5,000 for each laid off employee that they could use either to go to school or as seed money for a new business.

Of course, not everyone is as optimistic about the success of the territory’s reform efforts. As a blog produced by Center for the New Economy, a Puerto Rican think tank, reports, the tax reform program is not uncontroversial:

The control and reduction of government spending has stabilized the Commonwealth’s financial position.  Unfortunately, this stabilization is not cost free.  The implementation of this contractionary fiscal policy in the middle of a four year recession may have deepened and prolonged the economic recession in Puerto Rico.  Furthermore, the government’s pro-cyclical fiscal policy has been implemented at the same time that commercial banks in the island are undergoing a de-leveraging process that has significantly reduced the availability of credit.

As the article explains, some aspects of the tax reform plan may not point toward long run stability. The territory’s budget is increasingly reliant on federal funds with $1 of every $4 spent by the central government coming from federal transfer payments. Furthermore, debt service payments are increasing as a percent of Puerto Rico’s GDP.

While siginificant economic growth has yet to be seen coming out of the recession, economic indicators are looking better than when Governor Fortuño took office, despite about 12,500 government layoffs by the central government. Unemployment has fallen from 18 percent to under 16 percent and the Economic Activity Index reached positive territory in 2011 for the first time since early 2006. Some recent reforms will have staying power beyond Governor Fortuno’s term in office. The focus has been on improving Puerto Rico’s business climate relative to the states and neighboring countries by expanding trade and lowering taxes.

Reducing bureaucracy has also been a priority. “So far we have approved 11 of 13 reorganization plans to consolidate and eliminate agencies,” McClintock explained. He also said that many of the barriers to the renewable energy industry have been eliminated, leading the territory to become home to the largest wind and solar farms in the United States.

Puerto Rico is also pursuing an institutional change that could reduce long run spending. In August, Puerto Ricans will vote on an amendment to cut the number of legislators from 27 to 17 in the senate and 51 to 39 in the house of representatives. As research from Jowei Chen and Neil Malhotra demonstrates, state spending is likely to decrease with fewer state senators and with a higher ratio of representatives to senators.

Matt Mitchell and Nick Tuszynski covered their research in a literature review, and Matt estimates that these changes could be expected to reduce spending in Puerto Rico by about $77 per person yearly. The change to the legislature would take place ahead of the 2016 elections. McClintock said that this proposal is the result of “courageous legislators who are thinking from the people’s perspective rather than their own. It’s only natural that after cuts in the administration, people would expect cuts in the legislature as well.”

Many of the changes in Puerto Rico could be implemented in states looking to streamline government, particularly their tax reforms and triggers to provide incentives for voters to act as watchdogs to be sure that fiscal discipline is carried through.

Why Are Cell Phone Taxes So High?

Nationwide, combined federal, state, and local taxes on cell phone services average more than 16 percent. That makes a cell phone one of the highest taxed goods around. Cell phone taxes are even higher than beer taxes.


Image by Carlos Porto

My colleague, Thomas Stratmann, and I attempt to answer that question in our latest working paper. Most of the conventional rationales for above-average taxation just don’t apply: cell phones don’t have obvious negative externality characteristics, they are no longer luxury goods, and consumers are not particularly insensitive to price changes.

So why would policy makers choose to tax them so much? Part of the answer is that no single politician does choose to tax them that much. Instead, the high taxes that we pay on our cell phones are the sum of lots of little taxes imposed by several different political entities. Consider, for example, the tax bill of a typical New Yorker. It includes a federal USF fee, four state taxes, five city taxes, and a local 9-1-1 fee. Each of these is relatively small, but when you add it all up, the combined rate is over 22 percent.

We believe that this pattern of taxation is characteristic of what Columbia Law School Professor Michael Heller has called a “tragedy of the anticommons.”

In the better-known tragedy of the commons multiple parties have the right to use one resource and tend to over-use it since they fail to account for the way that their use harms others (think of the ocean; it’s owned by everyone and is over-fished). In a tragedy of the anticommons, however, multiple parties have the right to exclude others from using a resource by taxing or somehow regulating its use.

Heller points to the Rhine river as a classic example. Under the Holy Roman Empire only one party–the Empire–had the right to tax trade on the river. The government was careful, then, not to over-tax (over-exclude) trade. But once the Empire fell, multiple barons gained the right to tax trade (p. 3):

The growing gauntlet of “robber baron” tollbooths made shipping impracticable. The river continued to flow, but boatmen would no longer bother making the journey. . . . For hundreds of years, everyone suffered—even the barons. The European economic pie shrank. Wealth disappeared. Too many tolls meant too little trade.

Like the barons on the Rhine, multiple parties have the power to tax cell phones: Federal, state, county, city, and special district coffers all tax the base. In many cases, multiple taxes apply even at one level of government (e.g. five taxes levied by the city of New York).

We test the anticommons theory using variation in tax rates and taxing entities across the states. We write:

The anticommons problem has two dimensions. First, the mobile-service tax base funds numerous distinct projects at each level of government. Second, the base is taxed by numerous overlapping levels of government. We use state-level data from three years to examine the possible economic, demographic, and political factors that might explain the variation in these rates. We find that wireless tax rates increase with the number of overlapping tax bases.

Maryland’s New Budget Proposal

Maryland’s fiscal challenges did not occur over night and, in fact, the state has been running structural deficits for the past several years. The Governor’s recent proposal to balance the state’s budget consists of two major components: (1) having the state share the costs of the teachers’ pension system with county level governments and (2) modifying the state’s tax code.

Cost Sharing:

As the system currently stands, local governments in Maryland determine teacher salaries but the state, however, picks up the entire cost of teacher pensions. The Governor’s proposal would essentially split these costs – the state would continue to pay for a portion of the teachers’ pension costs but county governments would also pick up a portion of the cost. Although some consider this to be an extreme reform, the principle behind the reform is really not that severe.

When the average family in the U.S. makes their budget for the week or the month they must include everything they spend money on – groceries, gas, health insurance, and etc. Governor O’Malley is essentially asking county governments to do the same. He is asking units of local government to budget for what they spend money on, which includes teacher pensions.

This proposal is definitely a step in the right direction. Splitting the cost of pensions with the county governments introduces more transparency and accountability into the teachers’ pension system. More importantly, cost-sharing introduces a better sense of fiscal discipline for county level budgeting.

Tax Code:

The second component of the Governor’s proposal consists of modifying the state’s tax code – increasing the tobacco tax, getting rid of tax loopholes in the mining industry, implementing a tax on internet sales, and changing the tax structure for high income earners. There seems to be some confusion on this final point. To be clear, as I understand it, this is not an increase in the tax rate but rather it’s a decrease in the number of tax exemptions for high income earners.

Some of these ideas are certainly better than others, but what’s important about these tax reforms is that Governor O’Malley is seemingly trying to introduce neutrality into the tax code. If this is in fact what he is trying to do, then it’s a step in the right direction. State’s that introduce neutrality and generality in their tax code by getting rid of tax loopholes, reducing the number of exemptions, and broadening their tax base have been able to lower tax rates while increasing revenues.

Taking Reform a Step Further:

The Governor is taking Maryland in the right direction by introducing structural reform into the state’s budgeting process. This budget proposal, however, is only one of many steps that need to be taken. If Maryland really wants to get its fiscal house in order it needs to continue focusing on institutional reform. One reform, for example, that the Governor should consider is implementing an effective spending limit – specifically, one that ties spending growth to the sum of population growth and inflation.

For more on this topic, watch my recent interview with Fox-5 news:

Gov. O’Malley Outlines $311 Million in New Revenue for Maryland: MyFoxDC.com

Economists Agree – Illegality Increases the Street Price of Drugs

The University of Chicago’s Booth School of Business launched a website earlier this year titled The Initiative on Global Markets. The purpose of this website is to explore the extent to which economists agree or disagree on some of the major debates in the public policy arena. Specifically, 40 economists respond to a policy related question each week and their answers are then posted on the website.

In describing the process behind choosing the panel, the website states:

our panel was chosen to include distinguished experts with a keen interest in public policy from the major areas of economics, to be geographically diverse, and to include Democrats, Republicans and Independents as well as older and younger scholars. The panel members are all senior faculty at the most elite research universities in the United States.

This week’s question was

All else equal, making drugs illegal raises street prices for those drugs because suppliers require extra compensation for the risk of incarceration and other punishments.

93 percent of the economists on the panel either agreed or strongly agreed with this statement. Berkeley Economist Aaron Edline commented that “Illegality leads to high prices and crime.”  MIT economist Richard Schmalensee said that the answer to this question is “Basic micro” and that “Illegality also rules out some efficient forms of production & distribution.”

Other topics the questions have covered include treasury holdings, federal tax rates, voucher programs in the education system, exchange rates, stock prices, “buying American,” and healthcare.

Overall, I think this website provides a unique opportunity see where top economists stand on some important policy issues. It will be interesting to follow their answers to these weekly questions.