The extraordinary congressional reaction to the recent increase in retail gasoline prices, though distressing to economists, is not surprising. Since the latter part of last year, the average retail gasoline price has risen from slightly over $2 a gallon to $3 a gallon, largely as a result of increases in the price of crude oil. The rapidity of the increase in gasoline prices has made it difficult for many consumers to adjust by altering the amount of their driving; demand tends to be inelastic in the short run. Suppose you drive 10,000 miles a year and have a modest income, say $40,000. You probably buy about 500 gallons of gasoline. If the price per gallon rises by $1 and you are able to reduce the amount you drive by only 10 percent and so buy 450 gallons, your total expenditure on gasoline will rise from $1,000 (500 x $2) to $1,350 (450 x $3), an increase equal to almost 1 percent of your income. For people of modest income, such an increase in expense is palpable. The fact that in inflation-adjusted dollars the price of gasoline is roughly the same as it was in 1949 and much lower than it was in 1982, or that retail gasoline prices are twice as high in the United Kingdom (and several other European countries) as in the United States, is no consolation to these people. Moreover, because people buy gasoline frequently, they are very conscious of changes in its price. And there is so much publicity about oil and so close an identification of the Bush Administration with the oil industry that people are primed to think of gasoline prices as having a special economic and political significance, and to suspect that increases in such prices are a result of malign influences.
In fact the cause of the price spike is primarily, as I said, the increase in crude oil prices, and that increase is in turn primarily the result of rapid growth in demand for oil by China (now the world's second-largest consumer of oil) and India, a growth that has outpaced supply. The notion that this represents a crisis--that the world is running out of oil--is ridiculous. In the short run, with demand rising faster than supply, price rises steeply, producing "obscene" profits since roughly the same quantity is being sold at higher prices. In the longer run, consumption falls as consumers search out substitutes; supply rises as previously uneconomical sources of oil become economical; and so profits fall back to a normal level.
One of the principal measures being mulled by Congress to respond to the pseudo-crisis--a $100 income-tax rebate to all federal taxpayers even if they don't own cars or other vehicles and have incomes of $150,000 ($219,000 in the case of a couple filing a joint return)--has the virtue of simplicity and, since it does not affect the price of gasoline, will not discourage, at least directly, efforts by consumers to economize, though if people think it signals that the government will help them pay for gasoline, they will have less incentive to reduce the amount of driving or switch to more fuel-efficient cars or to public transportation. As a measure for alleviating hardship, the $100 rebate is absurd because it is at once trivial in amount and not limited to low-income taxpayers. Other proposals being considered by Congress would if adopted reduce the price of gasoline, as by cutting gasoline taxes. Such measures would have worse effects on demand and prices: by increasing demand, they would drive prices back up.
But allowing more drilling, which is also proposed, would increase supply, though not immediately. On the demand side, requiring that new vehicles have better gas mileage is similar to hiking gasoline taxes, by making cars more expensive. But the effects are delayed, and it is a measure inferior to a tax because it prescribes one method of adjusting to higher gasoline prices rather than allowing consumers to choose how best to adjust. Many consumers would prefer to drive less (substitute public transportation, telecommute, car-pool, move closer to work, etc.) than to buy a more expensive car that gets better gas mileage.
From the broad national standpoint, we should welcome high gasoline prices because it is in the national interest to reduce our consumption of gasoline, and high prices will do that, dramatically so in the long run when more substitution is possible. The burning of gasoline in vehicles creates pollution and emits carbon dioxide that contributes significantly to global warming; and curtailing driving in order to reduce the consumption of gasoline would alleviate traffic congestion. Furthermore, a large part of the world's oil supply comes from nations such as Venezuela, Nigeria, Iraq, Iran, Saudi Arabia, and Russia that are actually or potentially unstable, hostile to the United States, or both, and it would be prudent to reduce our dependence on such suppliers. And in fact output has fallen recently in the first four nations in the list, which has contributed to the price spike.
But the best way to keep gasoline prices high may be through heavy taxes, which might actually reduce the cost of oil and hence the incomes of the oil-exporting nations (which is in the U.S. national interest to the extent that those nations are indeed hostile, as Iran notably is). If, by increasing the price of gasoline, taxes reduce consumption, the price of oil will decline because the average cost of oil increases with the quantity produced. Just as an increase in demand will cause higher-cost oil to be produced--oil that would not have been economical to produce when the market price was lower--so a reduction in demand will cause that higher-cost oil to be withdrawn from the market and so the average price of oil will fall. In effect, income of the producing nations will be transferred to the consuming nations in the form of gasoline taxes imposed by those nations.
As Becker points out in this comment, higher taxes will dampen the incentive of oil companies to invest in exploring for and developing new sources of oil, since their net revenue from selling oil produced from such sources will be reduced. However, I am unenthusiastic about creating incentives for producing more oil, because of my concern about global warming. (See my book Catastrophe: Risk and Response [Oxford University Press, 2004].) Stiff taxes will put pressure on the energy industry to achieve technological breakthroughs (such as sequestration of carbon dioxide) that will greatly reduce the use of fossil fuels.
Unfortunately, a population ignorant of economics and suspicious of the Administration's motives probably cannot be brought to understand the social benefits of high gasoline prices and heavy gasoline taxes.
The causes of the sharp increase in gasoline prices during past year and a half are clear. The main ones are the rise in the price of oil to over $70 a barrel, and the lack of unused capacity in oil refineries that makes it difficult to increase gasoline production. Since refineries pollute and are generally unpleasant to have in one's neighborhood (the NIMBY, or Not in My Back Yard, mentality), political opposition prevented any new refineries from being built in the United States since the 1970's. We are reaping the consequences of that opposition.
Gasoline prices have risen by about $1 during the past year to almost $3 a gallon. This is a very large increase over a short period of time, but it should be put in perspective. Spending on gasoline by the average household has risen from about 2% of its total consumer spending to a still low 3%-it reached over 41/2% of personal consumption spending in 1981. The real cost of gasoline, adjusted for changes in the price level, is less than in 1981. Since a typical family has a higher real income than it did 25 years ago, the burden of high gas prices is easier to bear now than at that earlier time. The higher price will pinch for families who commute long distances to work in their SUV's, but the price of gasoline does not have a major effect on the many poor families who take public transportation to work.
Most of the other economic consequences of higher gas prices are beneficial to a world concerned about an over-dependence on Middle East oil producers. They induce consumers to drive less and to shift toward more fuel-efficient cars. They encourage politicians to worry about why American refineries have not been built for over 30 years, and to remove some of the regulatory obstacles. High oil and gas prices encourage the hunt for additional sources of oil in shale and tar pits, and give researchers greater incentive to search harder for alternatives to the gasoline-powered internal combustion engine, such as electric powered engines, fuel cells, ethanol, and other alternatives.
On the other hand, many potential political consequences of high gas prices are worrisome and even scary. As Posner indicates, the proposed $100 rebate to taxpayers would help many well-to-do families, and have a minor effect on families that have been hard hit by the rise in gas prices. Perhaps even worse are the proposals to investigate whether oil companies have conspired to raise gasoline and oil prices. No one mentioned any oil conspiracy when real gasoline and oil prices declined significantly during the 1980's and 1990's. Stagnation in the number of American oil refineries, the havoc caused by Katrina to refineries in the Gulf, rapidly growing world energy demand, and disruptions in the world supply of oil during the past year are sufficient to explain high gas prices without any conspiracy theory.
I doubt if "excess" profits tax on oil producers will be introduced, but even the suggestion to do that is disturbing. It is related to, although different from, the oil "windfall" profits tax in effect during most of the 1980's. Profits of oil producers are volatile, and were depressed during the 1980's and '90‚Äô' when oil prices fell a lot. Higher profits encourage greater investments in looking for new oil reserves, while governmental restrictions on profits discourage the search for new oil sources that are crucial to controlling oil prices in the longer run.
I do believe Congress should roll back the some $2 billion in tax breaks given to oil companies last year. They never should have been given in the first place, but these benefits mainly reflect the political power of the oil industry, a power that is at least temporarily in retreat. One of several better ways to encourage oil production in North America is to open the Northern Alaskan region to oil production; President Bush has proposed that once again.
The advisability of raising taxes on gasoline, supported by Posner, is not so clear, even aside from the political impossibility of increasing taxes when gas prices are high. One disadvantage of higher taxes is that they partly offset the incentives provided by high gasoline and oil prices to invest in new sources of oil, such as shale, that reduces dependence on Middle Eastern oil.
Federal, state, and local governments of the U.S. combine to impose taxes on gasoline of about 60 cents per gallon. Studies by Resources for the Future suggest that this is more than adequate to cover all effects of pollution, aside perhaps from some larger estimates of the effects of gasoline consumption on greenhouse warming. The purpose of gasoline taxes is to cut consumption by raising gasoline prices to consumers, but the $1 increase in gasoline prices during the past year has cut gas consumption. These higher prices, if they stay, will cut gasoline usage much further as consumers have more time to adjust their behavior. If the optimal tax on gasoline was $1 when gasoline sold for $2, the effective tax is now $1.60: the 60 cents imposed by governments and the $1 increase due to market forces. So, if anything, this argument suggests that gasoline taxes be reduced rather than increased while prices are so high.
I am not usually as diligent as Posner, so I need not apologize too much. But I regret that other commitments kept me from replying to the comments on several weeks' postings. I will discuss taxes and inequality now, and on one or two more of the past discussions tomorrow or Tuesday.
My estimate of the total cost is crude, but it is not that different from several others, and is much lower than say the Tax Foundation estimates. Some commentators went wrong in not appreciating that tax compliance costs, as most costs, are highly skewed. As I pointed out, many people fill out the short form and spend relatively little time. I adjusted for that by lowering the number of hours for me-which I believe understates my annual hours- by 50 per cent.
I did indicate that various tax complications encourage inefficient behavior to take advantage of special treatments. I also indicated that lobbying led to many of the special deductions and provisions. But that does not mean that an economy with restrictions on campaign contributions will have a simpler tax system since groups that spend a relatively large amount of time or money lobbying, even if much less money than under an uncontrolled system, will exert greater influence.
I do have to comment on the issue of efficiency and special interests. That the political system responds to more powerful interest groups is clear enough. That may define the efficiency of the political system-given the lobbying- but the power of various special interests may still reduce the efficiency of the economy. Many of the special tax provisions obviously make the economy less efficient, even if the political system is responding efficiently to the demands of various interests.
Casey Mulligan and I have an article in the Journal of Law and Economics where we argue, and present some evidence, that a simpler less complicated tax system tends to lead to greater taxes. So perhaps tax complexities help to keep down total taxes. But one still has to count as harmful the cost in efficiency produced by tax complexity and other tax complications.
On the wholly different subject of Raymond Aron, I greatly admire the various articles and books of his that I read, but I did not read the book mentioned. Aron pointed out the weaknesses and horrors of communism while most French intellectuals were great admirers of say the Soviet Union.
THE GROWTH IN EARNINGS INEQUALITY
There are many studies of the causes of the rise in earnings inequality- see for example papers by Kevin M. Murphy (my colleague) or Lawrence Katz of Harvard. These studies suggest, they do not definitively prove, that globalization and especially new technologies are the most important factors. Illegal and legal immigration played a role in keeping down the earnings of the less skilled, but it is not the dominant factor. As readers of this blog know, I strongly support increased legal immigration, especially of skilled immigrants. That would tend to lower earnings differences by skill, but not by a lot.
Signaling and credentialism are not causing the rise in earnings inequality by education. Whatever the effects of such considerations, they were as important to college earnings in the 1970's as at present. Indeed, partly for this reason, the signaling interpretation of the earnings premium to college education has been in retreat as earnings differentials rise, and knowledge becomes more and more important in an economy.
Some of you deny that college education teaches much. This is obviously false when considering learning by students of engineering, physics, modern finance, or many other specialties in various areas. But college education also helps students process information more effectively since they get so much practice doing this through readings and exams. In the information and knowledge age, the ability to process information efficiently is increasingly valued not only in the labor market, but also in obtaining good information about health, using the Internet more effectively, etc.
To be sure, not everyone can profit from a college education or from finishing high school. But that does not mean that the numbers going on to college or graduating high school is the efficient or optimal number. The quality of k-12 schools and encouragement from family and friends to continue education can make a big difference. Some people remarkably rise above terrible circumstances, but sometimes sufficiently gifted boys and girls cannot, and that is what society should be working on.
Some of you discussed more general questions about justice, capitalisms' effects on inequality, inequality in access to health (which incidentally has gone down, not up), and what are attractive statistical measures of inequality. These are all very interesting questions, but go far beyond my focus on the rise in earnings inequality. Earnings inequality is clearly the most important determinant of overall income inequality-for example, far more important than inequality in inheritances- so a concentration on earnings is getting at the main source of the change in overall inequality
I have been terribly remiss in responding to comments these past few weeks. Let me try to make limited amend:
National Cultures: One comment helps to dispel the mystery of French productivity, by pointing out that regulation has shrunk the service sector in France relative to the rest of the economy, and service sectors tend to have the lowest productivity because they are so labor-intensive.
Lobbying: Three good comments bearing on the puzzle that the expenditures on lobbying seem very small relative to the potential gains. One, which help to solve the puzzle, is that huge contributions would be too conspicuous, and thus boomerang--it would be obvious to the politicians' constituents that some group or industry was trying to buy favorable legislation. Another comment, which also helps to solve the puzzle, is that much less than the entire federal budget is in play in any given year: quite apart from entitlements, which consume a large part of the federal budget but are not subject to fundamental change from year to year, much of the federal budget is committed and cannot be altered by lobbying. Lobbyists work at the margin. The third comment, which cuts the other way, is that there are huge potential rents from legislative changes that do not affect the federal budget, such as a law making environmental regulations more or less stringent.
Tax Simplification: Taxes must not be viewed as mere revenue generators. They are also means of regulation, for example of externalities. I would like to see heavy taxes on carbon dioxide emissions. But regulatory taxes are generally not part of income tax, where the tax-preparation expenses that were the focus of Becker's and my posts are mainly incurred.
Equality: I had emphasized product improvements as a source of real though not pecuniary increases in income that have helped to reconcile people to the fact that, for many of them, their money incomes have not risen in recent years. One comment points out insightfully that if income is defined in terms of the services that are yielded by the products (and services) that we buy, it is much more equal than if it is defined in money terms. The comment compares a Camry to a Lexus. The Lexus is a better car, but it costs three times as much and is it three times better? No. The 18-year-old Macallan (a single-malt Scotch) costs about twice as much as the 12-year-old, but the difference in taste is very slight. This seems a general characteristic of luxury goods. This is the sense in which people of widely different incomes can all consider themselves middle-class without being delusional.
Income inequality widened, particularly between urban and rural households after China began its rapid rate of economic development in 1980. At the same time, the fraction of Chinese men, women, and children who live on less than $2 a day--the World Bank's definition of poverty--greatly fell. Few would argue that the poor in China did not become much better off due to the rapid economic development, even though the gap between their incomes and those of the middle and richer classes widened by a lot. A similar conclusion would apply to India as the explosion in its general economic development during the past 20 years widened the gap between rich and poor, but raised the income levels of the very poor.
I make this observation in reaction to the great concern expressed by politicians and many others in the United States over the rather substantial increase during the past 25 years in earnings inequality among Americans. The China and India examples illustrate that whether rising inequality is considered good or bad depends on how it came about. I believe that the foundation of the growth in earnings inequality of Americans has mainly been beneficial and desirable.
The basic facts are these. There has been a general trend toward rising gaps between the earnings of more and less skilled persons. With regard to education, real earnings (that is, earnings adjusted for changes in consumer prices) earnings of high school dropouts did not change much. Earnings of high school graduates grew somewhat more rapidly, so that the gap between dropout and graduate earnings expanded over time.
The main action came in the earnings of college graduates and those with postgraduate education. They both increased at a rapid pace, with the earnings of persons with MBA's, law degrees, and other advanced education growing the most rapidly. All these trends produced a widening of earnings inequality by education level, particularly between those with college education and persons with lesser education. I should also note that while an upward trend in the earnings gap by education is found for both men and women, and for African Americans and whites, the earnings of college educated women and African Americans increased more rapidly than did those of white males. As a result, inequality by sex and race, particularly among college educated persons, narrowed by a lot.
As the education earnings gap increased, a larger fraction of high school graduates went on to get a college education. This trend toward greater higher education is found among all racial and ethnic groups, and for both men and women, but it is particularly important for women. The growth in the number of women going to and completing college has been so rapid that many more women than men are now enrolled as college students. Women have also shifted toward higher earnings fields, such as business, law, and medicine, and away from traditional occupations of women, such as K-12 teachers and nurses. The greater education achievement of women compared to men is particularly prominent among blacks and Latinos.
The widening earnings gap is mainly due to a growth in the demand for educated and other skilled persons. That the demand for skilled persons has grown rapidly is not surprising, given developments in computers and the Internet, and advances in biotechnology. Also, globalization increased the demand for products and services from the U.S. and other developed nations produced by college educated and other highly skilled employees. Globalization also encouraged a shift to importing products using relatively low-skilled labor from China and other low wage countries instead of producing them domestically.
Rates of return on college education shot up during the past several decades due to the increased demand for persons with greater knowledge and skills. These higher rates of return induced a larger fraction of high school graduates to get a college education, and increasingly to continue with postgraduate education.
Some of you might question whether rates of return on higher education did increase since tuition grew rapidly during the past twenty-five years. However, increases in tuition were mainly induced by the greater return to college education. Pablo Pena in a PHD dissertation in progress at the University of Chicago argues convincingly that tuition rose in part because students want to invest more in the quality of their education. Increased spending per student by colleges is partly financed by higher tuition levels.
This brings me finally to the punch line. Should not an increase in earnings inequality due primarily to higher rates of return on education and other skills be considered a favorable rather than unfavorable development? Higher rates of return on capital are a sign of greater productivity in the economy, and that inference is fully applicable to human capital as well as to physical capital. The initial impact of higher returns to human capital is wider inequality in earnings (just as the initial effect of higher returns on physical capital is widen income inequality), but that impact becomes more muted and may be reversed over time as young men and women invest more in their human capital.
I conclude that the forces raising earnings inequality in the United States is on the whole beneficial because they were reflected higher returns to investments in education and other human capital. Yet this is not a ground for complacency, for the responses so far to these higher returns is disturbingly limited. Why have not more high school graduates gone on for college education when the benefits are so apparent? And why did the fraction of American youth who drop out of high school, especially African American and Hispanic males, remain quite constant at about 25 per cent of all high school students?
The answer to both questions lies partly in the breakdown of the American family, and the resulting low skill levels acquired by children in broken families. Cognitive skills tend to get developed at very early ages, while my colleague, James Heckman, has shown that non-cognitive skills, such as study habits, getting to appointments on time, and attitudes toward work, get fixed at later, although still relatively young, ages. High school dropouts certainly appear to be seriously deficient in the non-cognitive skills that would enable them to take advantage of the higher rates of return to greater investments in education and other human capital.
So instead of lamenting the increased earnings gap by education, attention should focus on how to raise the fraction of American youth who complete high school, and then go on for a college education. These pose tough challenges since the solutions are not cheap or easy. But it would be a disaster if the focus were on the earnings inequality itself. For that would lead to attempts to raise taxes and other penalties on higher earnings due to greater skills, which could greatly reduce the productivity of the world's leading economy by discouraging investments in human capital.
Becker explains the rising income inequality in the United States persuasively; I would add only that as society becomes more competitive and more meritocratic, income inequality is likely to rise simply as a consequence of the underlying inequality--which is very great--between people that is due to differences in IQ, energy, health, social skills, character, ambition, physical attractiveness, talent, and luck. Public policies designed to reduce income inequality, such as highly progressive income taxation and middle-class subsidies, are likely to reduce the aggregate wealth of society, and therefore should not be adopted unless rising income inequality is a social problem.
Is it? That depends, I think, on average income (and hence on the wealth of society as a whole), on whether incomes are rising (at all levels), and on the particular way in which the income distribution is skewed. The higher the average income in a society, the less likely is inequality to cause envy or social unrest. The reason is that, given diminishing marginal utility of income, people who are well off do not have a strong sense of deprivation by reason of their not having an even higher income. If, moreover, their income is rising, they are more likely to derive satisfaction from a comparison of their present income to their former income than to be dissatisfied by the fact that some other people‚Äôs incomes have risen even more. In my book Frontiers of Legal Theory, ch. 3 (2001), I present empirical evidence supporting a positive correlation between political stability on the one and average, and rising, income on the other hand.
It is true that progressive taxation and other income-equalizing policies are found in rich rather than poor countries. But that is partly because poor countries lack the governmental infrastructure for administering complex policies and partly because these societies have powerful social norms of equality. Studies of peasant societies find that "black" envy is widespread in them--that is, if your neighbor has a nicer barn than yours, you'd prefer to burn it down than to exert yourself to build an equally good barn. "White" envy, in contrast, better described as emulation, promotes economic growth.
As for the way in which a society's income distribution is skewed, if, though average income is high and rising, there is a very small, very wealthy, upper class, a tiny middle class, and a huge lower class, the society is likely to be unstable. Because the majority of the population will not be well off, and the upper and middle classes small, there will be few defenders of the existing distribution.
The United States has a high average income, incomes are rising for most groups in the population--though more slowly than for the wealthiest--and most of the population is middle or upper class. It is therefore not surprising that rising income inequality has not generated noticeable social unrest or calls for return of heavy progressive taxation. Moreover, when nonpecuniary income is taken into account, there is less inequality than the income statistics suggest. In a democratic and rights-oriented society such as the United States, all citizens have a bundle of equal political rights (to the vote, to the free exercise of religion, to be free from unreasonable searches and seizures, and so forth), which are a form of income, and equal political duties, which are a form of expense. Rich people as well as ordinary and poor are prosecuted for crime, and, as in the recent spate of corporate scandals, often punished very heavily.
What is more, income statistics do not record the enormous secular improvement in the quality of products and services, and hence in the utility that purchases confer on consumers. Think only of the extraordinary improvements in the quality of automobiles, medical care, and electronic products. Americans whose income has not increased faster than the rate of inflation are nevertheless living far better than they used to live. They know this and it is one reason they are not clamoring for income redistribution.
A cultural factor that reduces the social tensions that might otherwise arise from a sharp and rising inequality of Americans' incomes is that the United States, unlike the countries of Europe, has no aristocratic tradition. There is no suite of tastes, accent, bearing, etc., that distinguishes the rich in America from the nonrich. The rich have more and better goods, but they do not act as if they were a "superior" sort of person, refined, well bred, looking down on the average Joe. The rich play golf, but so does the middle class. The middle class follows sports, but so does the upper class.
Finally, rising income inequality in the United States is due in part to increased immigration, since immigrants, legal as well as illegal, tend to work for lower wages than citizens. Immigrants do not, however, compare themselves with wealthy citizens, but rather with the much lower wages they could expect to earn in their countries of origin. Rather than immigrants envying wealthy citizens, many citizens are hostile to poor immigrants!
The "problem" of income inequality should not be confused with the problem of poverty. The first, I have argued, is, at least in the United States at present, a pseudo-problem. Poverty is a genuine social problem, because by definition it signifies a lack of the resources necessary for a decent life. It is only tenuously if at all related to income inequality, since one could have zero poverty in a society in which the gap between the income of the worst-off members of society was huge--imagine if the poorest person in America earned $100,000 a year and the wealthiest $1 billion.
The more competitive and meritocratic a society, the more intractable the problem of poverty. The reason is that in such a society the poor tend to be people who are not productive because they simply do not have the abilities that are in demand by employers. It is unlikely that everybody (other than the severely disabled) can be trained up to a level at which there is a demand for his or her labor, and so there is likely to be an irreducible amount of poverty even in a wealthy society such as ours, unless we provide generous welfare benefits--which will discourage work.
As my wife and I were recently preparing our income tax data to give to our accountant, I began my annual guess about the cost of complying in the U.S. with the Federal Tax code. But instead of just shaking my head over it, as I usually do, I made a few simple calculations that I will share with our readers. I will also offer some suggestions on how to cut down drastically compliance costs and reduce the negative effect of federal taxes on the efficiency of the economy.
We spent at least 25 hours in 2005 preparing and keeping track of our 2005 income, deductible expenses, and other data relevant for tax purposes. Our accountant spent another 6 or so hours, so together our tax filing used over 30 hours. Last year the IRS processed about 130 million tax returns. If the average filer along with any professional help together spent about 20 hours, 2.6 billion hours would have gone into complying with the 2005 tax code. This may seem huge, but the Tax Foundation put much more effort into their calculations, and finds that about 6 billion hours were spent in complying with the federal income tax code alone.
Businesses spend many more hours than most individuals do, while many filers who primarily have taxes withheld by their employers spent less time because they use the "short" tax form. Still, over half of all filers consulted accountants, lawyers, or other professionals for assistance in preparing their taxes. During the tax season, apparently over 1 million persons work professionally helping others prepare their tax returns.
If we value my 2.6 billion hours estimate conservatively at an average of about $40 per hour because higher income filers and tax preparers spend many more hours in tax preparation than lower income filers, the aggregate cost of complying would be over $100 billion. This is almost 10 per cent of the approximately $1.2 trillion that will be paid in 2005 in federal income taxes. The Tax Foundation concludes that total compliance costs for 2005 will amount to $265 billion, or over 20 per cent of federal income tax revenue.
Even with my lower estimate, compliance costs are big, despite the availability of computer software that greatly helps in tax preparation. The culprit is clearly the complicated tax code that has produced over 66,000 pages of federal tax rules. Of course, these complications are not there by accident, but are the result of pleadings and lobbying (see our discussion last week of lobbying) by special interests for favorable tax considerations. These include efforts by builders and home owners to get the government to allow deductions for interest paid on mortgages, by philanthropic organizations and universities to have charitable contributions deductible from reported income, by state and local governments to allow the deductibility of state and local income and property taxes, by industries lobbying to get accelerated depreciation on capital purchases, and special tax provisions for the oil and gas industry. They also include lobbying by financial institutions to get incomes accumulated in IRA's to be tax free, by employers and other groups that prefer the earned income tax credit over more generous welfare payments, and so on for the many pages in the tax code.
These numerous provisions not only enormously raise the direct cost of tax compliance, but cause many changes in behavior to take advantage of favorable treatments in the tax code. These alterations in behavior, like expenditures on compliance, usually make the economy less efficient, whether because many talented lawyers and accountants spend their time finding tax loopholes, or because too many and very large houses are built to take advantage of the favorable tax treatment of housing expenses, or because of many other changes in behavior.
Complications in the tax code are an excellent example of the conflict that sometimes arises between what is rational at the individual level, and what is rational to society as a whole. Each interest group lobbies to promote the interests of its members, although their interests advance usually at the expense of the interests of others. When many groups succeed in promoting their interests, losers vastly outweigh winners since each group gains from what they do, but loses from what is done to them by hundreds of other powerful interest groups.
There is no magic cure to this problem, at least none that I have encountered. Still, it is valuable to see clearly the problems and how they might be corrected because the future may provide opportunities for reform that are not presently available. A window of opportunity could arise to implement thoroughgoing changes that are not now politically feasible. One example of this kind of process is the voluntary army: a pipedream in the 1950's and 1960's became feasible in the 1970's because of the discontent over the draft during the Vietnam War.
The only way to radically reduce compliance costs is to engage in drastic surgery on the complexities of the tax code. The best approach would be to essentially eliminate all deductions, and have tax rates based just on total consumption, or as a second best alternative, just based on total income. Then compliance costs would be small because taxes owed could be calculated on a form the size of a postcard.
Such a radical simplification is often confused with a flat tax, which is a tax that is the same percent of income at all income levels. But eliminating all special deductions and benefits does not imply a flat tax, nor does a flat tax imply enormous tax simplification. In fact, most people who propose a flat tax really are proposing a progressive tax structure since they want incomes below a certain level to be free of all income taxes, and then a constant tax rate on each dollar of income about this minimum level. One could still have low compliance costs with a greater degree of progression in rates if tax rates started at zero and rose as incomes increased. Most degrees of tax progression are consistent with low compliance costs, although the more complicated the degree of tax progression, the greater the alterations in behavior that reduce an economy's efficiency.
To return to the cost of tax compliance, it is obviously excessive and socially wasteful. It is not easy to be optimistic about the prospects for tax simplification since the fundamental trend over time in the United States has been a steady increase in the complexity of the tax code. But at some future time, concern over the social waste in compliance costs that amounts to between 10 and 20 percent of total revenue produced by the income tax may galvanize American taxpayers into a revolt that, at least for a while, would result in drastic simplifications of the tax code.
An article by the economists Edward Lazear (now chairman of the Presiden's Council of Economic Advisers) and James Poterba published in The Economists‚Äô Voice last December estimates the annual costs of preparing federal tax returns at $100 billion and, like Becker, uses this high figure as the basis for arguing for simplification of the federal income tax. A difficult project that, as far as I know, has not yet been undertaken would be to estimate the actual savings from simplification. Unfortunately, they might turn out to be modest.
H&R Block obtains total revenues of almost $2 billion a year from preparing tax returns for almost 20 million taxpayers, most of rather modest means and, presumably, rather uncomplicated returns. The average expense of tax preparation to these taxpayers is thus $100. The total number of federal income tax returns filed this year will be almost 140 million. If one assumes that the bedrock expense of preparing each of these returns is $100, then a simplified income tax system would cost $14 billion. This would represent a considerable saving over the present system, but the $14 billion figure is undoubtedly a gross underestimate in two respects. First, it ignores the time cost to the taxpayer (emphasized by Becker) of obtaining, and forwarding to the tax preparer, the information needed to complete a tax return. Second, drastic simplification would impose significant social costs. There are compelling economic justifications for allowing some deductions or credits, examples being charitable contributions, expenses for the production of income, and foreign and other duplicative taxes. Computing these items often involves unavoidable complications, such as how to value charitable gifts that are made in kind rather than in cash and how to determine when business expenses are really expenses rather than disguised income. To the economically efficient deductions and credits must be added certain sacred-cow deductions and credits that aren't going away, of which the most attractive is the earned-income credit. Moreover, even if there were no deductions, there would be bound to be complications in computing tax due on nonsalary income. And some income that escapes taxation at present, such as the imputed rental income of owned housing, should be taxed in order to avoid distortions, and an attempt to do so would impose additional tax-preparation costs.
All this is not to suggest that tax simplification is not a good idea and would not produce genuine cost savings, though probably only in the 10 percent range. Two measures that would tend to produce savings without simplification would be, first, not allowing tax-preparation fees to be deducted from income tax and reducing marginal tax rates, since the higher those rates, the greater the benefit of efforts to find tax loopholes and hence the more cost that will be incurred in such efforts.
Because the potential benefits from tax simplification are likely to be modest, perhaps greater political effort should be devoted to trying to make the tax system more efficient in the sense of maximizing the ratio of tax revenue to the distorting effects of taxation on the allocation of resources. An ideal tax is a tax on a good or service or activity that is inelastic (Adam Smith's example was a tax on salt). Such a tax will not induce many people to substitute some other good or service or activity for the taxed one, and such substitution both is inefficient and reduces the revenue collected by the tax.
In the wake of the Jack Abramoff scandal, measures are under consideration in Congress to restrict lobbying more than at present by requiring more lobbyists to register (and thus provide more information on lobbying activities to the interested public), by requiring more public disclosure of existing lobbyists‚Äô activities, and by forbidding lobbyists to buy meals for members of Congress. Citizens‚Äô groups want much tighter restrictions on lobbying than anything Congress is contemplating, arguing that lobbying skews government policy. Extensive restrictions have been placed on contributions to political campaigns, which are analogous to lobbying. Republicans, who used to oppose efforts to restrict campaign contributions by PACs (political action committees), are now seeking to place restrictions on a type of PAC called a ‚Äú527,‚Äù which can accept unlimited contributions to engage in political advocacy, provided the 527 avoids supporting a candidate explicitly. The Democrats, who were in the forefront of advocating limits on PACs, are opposing limits on 527s, which are primarily liberal.
Lobbyists provide information to members of Congress and other officials, and campaign contributions are used to sponsor political advertising, efforts to register voters thought likely to support the candidate on whose behalf the efforts are made, and other political activities, most of which are broadly informational in the sense of seeking to familiarize the electorate with the candidate and his program. Hence restricting lobbying and campaign contributions is likely to reduce the flow of information to government officials and to voters, and this might seem a substantial interference with the political marketplace.
The main concerns about lobbying and campaign contributions are first that they are wasteful and second that they are a form of quasi-bribery and distort legislation and policy. They are indeed wasteful in an arms-race sense: if one candidate (or industry) spends heavily on advertising, his competitors have to do likewise lest they be drowned out; the incremental information furnished the official or the voter may be slight. This is less of a problem with lobbying than with campaign contributions. Members of Congress and their staffs are spread very thin and would find it difficult to function without the information provided by lobbyists. Most voters, in contrast, have very little interest in political information, even in hard-fought presidential campaigns, in part because they know that their vote isn't going to swing the election.
As for the distorting effect of lobbying on policy, it probably is slight. Of course there are many examples of special-interest legislation that reduce overall social welfare, but there would be much special-interest legislation without any lobbying, since in a democratic society legislators have to be attentive to the preferences of influential constituents. Much such legislation is, moreover, quite inconsequential from an overall social-welfare standpoint. Liberal activists denounce "corporate subsidies," many of which consist simply of tax breaks. The usual effect of giving a tax break is merely to shift the incidence of taxation--if one taxpayer pays less in taxes, another will pay more--with uncertain and perhaps often trivial effects on resource allocation. Most economists consider taxation of corporations inefficient because its effect is to tax investors twice, so tax breaks for corporations probably increase social welfare.
The aggregate effects of lobbying, moreover, may be rather trivial. This is suggested by the fact that annual expenses on lobbying Congress are only about $1.5 billion, even though the total federal budget is more than $2.5 trillion, and the regulatory powers of Congress place much of our $12 trillion economy under congressional sway as well. There are two possible inferences to be drawn from the disparity between the amount spent on lobbying and the total economic rents that Congress could confer on lobbyists' clients. One is that the marginal cost of influencing a member of Congress by a given amount rises very steeply. Perhaps the first nice meal you buy him increases by .001 the probability of his supporting your pet rent-seeking project but you would have to buy him 10 nice meals to increase the probability of his supporting you by another .001, and so on. The second and complementary possibility is that most members of Congress are not bribable, and that all that most lobbyists get for their efforts is access that enables them to furnish information useful to the member. There is (returning to the previous point) only so much that one can spend on generating information; moreover, and because information is relatively cheap to obtain and communicate to a small number of people, even relatively unorganized and impecunious groups who oppose a proposed project can provide offsetting information to the members of Congress. The lobbying market should therefore be competitive.
Campaign financing presents graver issues than lobbying does because a member of Congress cannot be reelected unless he spends a substantial amount of money on his campaign, and the people who contribute that money, many of them anyway, expect something in return. Even so, the effect can be exaggerated. If both parties have roughly equal levels of financial support, a candidate doesn't have to change his political stripes in order to raise money; and donors who share his political views will not be asking him for something he doesn't want to give them.
In the 2004 presidential and congressional elections, total campaign expenditures were approximately $3 billion, a figure that reformers consider shockingly high. It is actually low relative to the stakes in choosing a President and a Congress; it is four one-thousands of the GDP.
I am not a Pollyanna when it comes to evaluating the U.S. government. I believe that it may well be quite incompetent to deal with the problems that the nation is facing in an era of profound global political insecurity interacting with the breakneck pace of technological change. But government incompetence is better illustrated by the congressional reaction to the Abramoff scandal than by Congress's failure to enact "meaningful" campaign and lobbying reforms. An intelligent legislature, learning of a scandal, would first want to determine the likely frequency and consequences of such scandals and the adequacy of existing law to limit their recurrence. This inquiry would quickly reveal that Abramoff had pleaded guilty to criminal activity along with two congressional aides, that other members of Congress were under criminal investigation, and that an immensely powerful member (Tom DeLay) had been forced by the scandal to resign from Congress. The inquiry would further reveal that the scandal was actually an artifact of a surpassingly foolish law, namely the Indian casino law, which by conferring enormous rents randomly on Indian tribes had generated rampant rent-seeking, frequently shading into bribery. (Becker and I blogged about the law on January 9 of this year.) What the inquiry would not reveal would be a good reason for amending the lobbying laws.
The fundamental feature of the political process in any democratic society is that voters have only a weak self-interest to be informed on political questions that will come before candidates running for office, or on the details of the positions taken by these candidates. The simple explanation for this well known "rational ignorance" is that whether any voter supports or opposes particular candidates has a negligible influence over the outcomes of elections when hundreds of thousands, and even many millions, are voting.
Lobbying activities and campaign contributions try to fill this void by either directly trying to influence legislators, governors, and presidents, or by trying to persuade voters to support particular positions. They persuade by providing information and misinformation, and by changing attitudes and beliefs. They sometimes also try to influence elected officials by bribing them with gifts, money, and favors, and also by making campaign contributions that candidates can spend to try to help get elected.
The ignorance of voters implies that many different ways will be used to persuade them to vote in particular ways. Given the powerful and extensive role of government in society and the economy, one might expect that a large number of hours and many dollars would be spent influencing voters and officials. Yet as Posner indicates, what is remarkable is not how much is spent on lobbying and campaign contributions, but how little. Yes, the $3 billion spent in the 2004 presidential and congressional elections is a lot of money in an absolute sense, but it is peanuts compared to the Federal government's expenditures on different programs of over $2 trillion. It is also small relative to the thousands of regulations that directly and in many indirect ways affect business actions and personal decisions.
Posner tries to explain why lobbying and campaign spending is small relative to the important issues at stake. As he indicates, for many reasons the influence of additional spending on outcomes favorable to those doing the spending may be rather small. It remains somewhat puzzling, however, why this additional influence is so small.
Whatever the explanation, it is not clear to me why we should want to restrict spending and lobbying, aside from punishment for outright bribes, and for other forms of malfeasance by officials and contributors. Perhaps we do want to restrict how soon members of say Congress could work as lobbyists after they leave office. According to one study of a few years ago, over 40 per cent of a sample of members of Congress who left government to be active in the private sector eventually registered as lobbyists. Yet ex-legislators may be socially as well as privately helpful as lobbyists since they are familiar with the workings of the legislative process and have good personal contacts.
If as I (and Posner) believe) the essence of democracy is competition in the political process, that competitive process should include persuading and influencing activities. That is, competition in the market to influence political outcomes by persuading voters and legislators is the only effective way to produce checks and balances on points of view that reach voters and officials.
To be sure, the degree of competition is not perfect in lobbying or campaign contribution since some groups are able to collect much more money to spend than are other groups that have an equally vested interest in political decisions. But there are many other ways to influence votes and decisions. Newspapers also influence opinions, and a free press demands no controls over how much newspapers can spend trying to influence the opinions of readers on political issues. The Internet has thousands of bloggers and others who try to influence political opinion. They too are unregulated in order to provide competition in the expression of opinion. Many organizations, such as those with retird persons, encourage members to spend their time on influencing how official vote on particular issues. The use of time for political purposes is essentially also unregulated.
So why should legislation single out explicit lobbying and explicit campaign contributions, and neglect all the other ways of influencing political outcomes? Lobbying and contributing to campaigns are only one major source of persuasive and influence efforts in the vast competitive market that tries to influence political decisions.
Another way to make my point that there is excessive attention in the US to lobbying and campaign spending is to compare political outcomes here with those in Europe or Japan. All the data indicate that much more is spent on campaigning and lobbying in the US than in either of these other places. Yet it is not obvious that either Europe or Japan has better political outcomes, measured either by the quality of legislation, or by the response to public opinion. Indeed, I believe their outcomes are worse, or at least no better. That would suggest that the United States is excessively concerned about the relatively small level of resources that is spent on explicit lobbying and campaigning.