UtilityMinimization

An interesting problem found in public finance is called the tragedy of the commons, which states that resources (land, housing, clean air) will be overused in terms of economic efficiency. One of the first to introduce the idea was Garrett Hardin in his 1968 article “The Tragedy of the Commons”. As you may remember from our discussion on externalities, when someone or something does not bear the full cost of their actions, there will be too much of that action—with too much defined as more than the socially optimal level. The tragedy of the commons is a natural extension of this idea.

Let us take a common-pool resource. A classic example is the Grand Banks, an extensive area of shoals in the western Atlantic Ocean off southeast Newfoundland, Canada. The mingling of the cold Labrador Current and the warmer Gulf Stream and the shallowness of the water make the area a major source of fish. A feature of the Grand Banks is that it is very large and there are no fences (it’s the ocean). What this means is that for all practical purposes, the Grand Banks exhibit a feature that defines a common-pool resource: nobody owns it, and nobody can profitably own it (the reasons could be practical as in the Grand Banks, or, perhaps, cultural, like common property among many Native American tribes). When this is true, an interesting thing happens.

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In our last discussion we talk about a particular type of market failure called externalities, which were loosely defined as an action who full cost or benefit is not reflected in the market price. The implication of which is that since the person doing the bad thing is not paying the cost to society of their bad actions, there is too much of this bad action. Conversely, since a person only gets the private benefits of their good actions, there is an under provision of good acts, and society misses out on the optimal level of a socially good action. As we aid earlier, in order to arrive at the socially optimal level, we need to figure out a scheme to internalize the external costs or benefits. Most of the solutions centered around regulation, taxation, or other forms of government intervention. A very smart man by the name of Ronald Coase came up with a scheme that, with two small assumptions, changed how everyone thought about externalities and the case for government intervention. Oh, and it also won him the Nobel Prize.
What Coase proposed had an immense effect on public policy. He said that government intervention is not necessary in order to achieve the economically optimal outcome. Rather, all we need is property rights. Let’s walk through his argument. First, he sets down two conditions: 1) The cost of bargaining is zero (or at least low), and 2) Owners of a resource can identify the source of damage to their property and can use legal methods to stop that damage. Coase said that if these two things are true, then in order to arrive at a socially optimal outcome, we only need to assign the rights to the resource to someone. It does not matter to whom we assign the rights as long as we assign the rights to someone. This powerful, but simple, statement stunned his colleagues at the University of Chicago, which included many current and future Nobel Prize winners. They called him into a meeting and twenty of them grilled him for two hours. At the end of the two hours, they all walked out changed men (economically speaking).

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Externalities are one of the most fascinating subjects in public policy and economics. Technically, economists define an externality as an action by one party that affects another party in a manner that is not accounted for by the market. Blah, blah, blah, blah, blah. What this really means is that one someone does something, they don’t have to pay for ALL the consequences, good or bad. The implications are huge. Because one person is not paying for all their actions, part of the costs or benefits are external to the market. Because of this, there are whole sections of the economy where society is not getting enough of some things and too much of others. Externalities provide a prime example of when markets can fail, and why government intervention is warranted. Let’s start with a common example given in every Econ 101 class—pollution.

When ACME Electricity Company generates power, they burn coal to heat water, to create steam, to move turbines, which creates electricity to power my laptop, so I can write this entry. These are all really good things (New Yorkers will certainly remember what happens when there is no electricity, as during last summer’s blackout), and I like them so much, I pay for them—to the tune of $70 per month, or so. This is all an economic wash as far as overall welfare is concerned. I pay $70, and I get $70 worth of electricity. ACME spends $70 generating electricity, and they give up that much power to me. In addition, if generating electricity gets more expensive, I pay more, and if it gets cheaper, I pay less or ACME gets higher profits. The point is that the market accounts for all the good and bad parts of this transaction through the price of electricity. Something else happens, however, when ACME burns the coal to make me some more electricity, they release black smoke into the atmosphere. This black smoke kills off some of the cherry blossoms that grow in Prospect Park that my friend Ian really likes to look at. Let’s carefully look at the implications of this: some transaction that I have entered into has created a lower level of welfare for Ian, and, this is the point, I don’t pay for Ian’s lessened lifestyle.

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Why is the property tax so hated? A recent USA Today article stated, “Property taxes are taking center-stage in the debate over taxes. Many homeowners are grumbling about skyrocketing tax bills, which are driven by higher home prices. And many state legislatures are looking for new ways to tame the most unpopular of all taxes.” The ‘most unpopular of all taxes’ seems a strong sentiment towards a tax that, could, in theory, exactly what we want in a tax. Americans pay three major types of taxes, a consumption tax (in the form of a general sales tax), an income tax, and a wealth tax (in the form of a property tax). Why might we like a wealth tax, at least in theory? The answer might lie in the idea of tax progressivity.

Simply stated, a progressive tax is a tax where people with higher incomes pay higher taxes. Unfortunately, there are different ways to interpret this. One way is to say that as a person’s income increases, they pay a higher share of their income in taxes. For example, our income tax attempts to be a progressive tax system under this definition. People with higher incomes pay a higher rate than people with lower incomes, and if we get the rates correct, wealthier people will pay a higher share of their income towards taxes. Progressivity can also be measured as wealthier people pay a greater share of the overall tax bill. A flat income tax is progressive under this system—the number of dollars paid into the system is greater for a wealthy person than for a poor person. Note, that a flat tax is neither progressive nor regressive under the first definition because everybody pays the same share of his or her income. However we choose to measure it, it is clear that most Americans are comfortable with a progressive tax system.

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Since we’ve all (presumably) paid our taxes by now, I thought I’d write about tax arbitrage, a method of using deductions and tax free investments to make an unlimited amount money. Unfortunately the IRS made it illegal years ago, but there is always a chance you won’t get caught. Here is how it works.

Let’s say our consumer, MacGyver, is in the 36% tax bracket. Now also suppose Mac can borrow money from a bank at a rate of 15%. Interest costs, if the money was borrowed for certain allowed purposes, is tax deductible. These certain things are educational loans, home mortgages, and certain financial assets. Of particular interest to us are tax-exempt state and local bonds. If MacGyver can deduct the interest he on a loan he uses to buy bonds with, he can make a lot of money.

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