Friday, May 30, 2008

Taxes and subsidies

Global warming raises a critical policy question: how do we discourage carbon-spewing energy sources (coal, petroleum, and natural gas) while encouraging clean ones (wind and solar)? Some propose taxes on pollutants, while others propose subsidies for the cleaner sources, and many advocate a combination of both.

Which does an economic analysis support? The standard framework yields a surprisingly simple conclusion: it is better to tax, not subsidize.

To see why, consider why we have energy taxes and subsidies in the first place: to account for some costs or benefits not captured in the market price. With coal, this is obvious. The damage from its carbon emissions isn't included in the standard price, and to achieve an efficient outcome we have to impose a tax.

But, you might ask, if we're trying to encourage a switch from fossil fuels to clean sources of energy, what's the difference between a tax and a subsidy? They both seem to accomplish the same aim: making fossil fuels relatively more expensive, and alternative sources more economical. In a sense, this is true. Either taxes and subsidies can create a socially optimal pattern of substitution between different energy sources; as long as the relative prices are properly set, consumers seeking to consume a certain amount of energy will allocate their consumption correctly. If the only two available sources of power in an area are coal and wind, and the cost of coal pollution is 5 cents a kilowatt, either a 5-cent tax on coal or a 5-cent subsidy for wind power will prod consumers to choose the appropriate source.

The problem is that subsidies lead to a unnaturally high amount of total energy consumption. Say that the cost of producing wind power is 7 cents a kilowatt. A 5-cent subsidy will cause the price to dip to 2 cents, leading consumption to skyrocket. Such an increase isn't justified by any cost-benefit analysis; after all, the fact that coal pollutes doesn't change the absolute cost of wind power. Consumers may be making the right choice between coal and wind, but there's no reason to start consuming a higher total amount of power.

The optimal pollution abatement policy, then, is simply to levy a tax that tracks the damage caused by pollution. Subsidies distort the system, making a source of energy cheaper in an absolute sense than the market indicates it should be.

At least... this is all what a "first-best" economic analysis would indicate. There is one way that some carefully targeted subsidies may be appropriate: to encourage innovation.

The process of innovation is rife with positive spillovers. If one company develops a cheaper way to manufacture solar cells, ultimately other companies in the industry will learn about it. Even when inventors are granted temporary patent rights, their innovations will ultimately spread throughout the industry, and many critical developments can't be patented at all.

At the same time, innovation often goes hand-in-hand with production. Particularly when the goal is to cut manufacturing costs, "learning by doing" is one of the main ways that firms improve themselves. The laptop I'm using to type this post isn't the result of a fifty-year project specifically to produce laptops; instead, it's the culmination of several decades of computer manufacturing, where existing companies continually improved their products.

This poses a serious problem for the development of alternative energy. Unlike computers, which commanded a serious (and rapidly expanding) market from the start, solar cells are only useful in idiosyncratic settings -- for instance, in very remote areas, where the costs of electricity transmission make on-site generation the only plausible option. Worse, this isn't a market with a clear, continuous path of expansion. It's highly dependent on certain "barrier" values: until photovoltaic cells are cheap enough to make them an economical way to power Phoenix, Arizona (as consistently sunny a place you're going to find), they simply will not be viable on a large scale.

Even if a firm recognizes all of this, and sees the tremendous importance of reaching the barrier values, it might not want to make any particularly large investment in R&D, because the fruits of its research will diffuse to its competitors too. Thus the market undervalues research, and since the low level of current production prevents most "learning-by-doing," the industry develops far slower than its pressing societal importance would indicate.

One way to lift the industry out of this low-development trap is to administer a subsidy, to help firms break through the mass-market barrier and begin the process of widespread innovation. In theory, such a subsidy compensates manufacturers for the advances they bring to the entire industry: if they make improvements as part of the production process, and the ideas thus generated spread to other firms, it's efficient to encourage them to produce more.

This argument is dangerous, though, because it's a kind of economic black magic. You can justify almost any subsidy along the same lines, and advocates of heavy government involvement in the economy have successfully done so in the past. The political process introduces its own set of pitfalls and inefficiencies, and it's imperative that we avoid offering an excess of special breaks, lest they attract vested interests and lead to unforeseen consequences.

That said, I do think that the unusual economics of alternative energy may provide a special case. Hardly any other markets have such dramatic barriers to expansion, and a moderate program of subsidies is inexpensive compared to the potential rewards. We'll need a revolution in energy technology to confront global warming, making a kick-start to the dreary pace of development eminently sensible.


Altogether, the appropriate policy incorporates both the ideas in this post. To account for the effects of pollution, we should impose taxes equal to the estimated harm. Then, specifically to encourage innovation, we should craft a reasonable package of subsidies for technologies that are struggling to enter the market.

Nonsense on monetary economics

Now that I've been stuck at O'Hare airport for the better part of the day, I've decided to abandon any sense of restraint, and turn this blog into a repository for all the gripes I've built up over the year.

Next up: How the fuck does Ron Paul get away with his nonsense on monetary economics?

In some ways, my question is silly: Ron Paul is a fringe candidate whose relative reasonableness on foreign policy overcame a jumbled and unattractive set of social and economic positions. Journalists, who already tend to shy away from "complicated" economic issues, didn't see any pressing need to investigate Paul's obsession with the gold standard, because even the vast majority of his supporters didn't care.

It's still painful, however, to see a national figure spout such tripe unpunished. From a July 2006 essay by Paul:
"All government spending represents a tax. The inflation tax, while largely ignored, hurts middle-class and low-income Americans the most. Simply put, printing money to pay for federal spending dilutes the value of the dollar, which causes higher prices for goods and services. Inflation may be an indirect tax, but it is very real – the individuals who suffer most from cost of living increases certainly pay a 'tax.'"
Except, of course, that "printing money" is a trivially insignificant piece of the federal government's revenue. Take a look at the size of the monetary base, the sum of currency in circulation and banks' federal reserve deposits. First of all, the entire monetary base is less than $900 billion, which is in turn less than the amount of federal outlays in a single year. In other words, if all the dollars in circulation were printed by the Federal Reserve in one year to pay for government expenses, they still wouldn't be enough. (In the real world, of course, such a dramatic seignorage policy would instantaneously turn a country into Zimbabwe.)

Obviously, the Federal Reserve isn't doing this; if you actually want to get an idea of the magnitude of revenue from "printing money," you should look at the increase in the size of the monetary base, also apparent from the chart linked above. You'll see that a given year only has an increase of around $20 billion. That's less than the feds spend on NASA.

In other words, when Paul claims that the government is secretly funding its operations by printing huge amounts of money, leaving the common people to suffer the effects of an "inflation tax," he is being a demagogic dimwit. Not terribly unusual for a Congressman, but still plenty irritating.


Can't we have more coverage of the fact that Hillary's attempt to seat the Florida and Michigan delegates is one of the most grotesque pieces of political dishonesty in memory?

Last year, she explicitly asserted that Michigan's sanctioned primary "wouldn't count for anything." She signed a pledge to avoid campaigning in Florida and Michigan, and her organization stated: “We believe Iowa, New Hampshire, Nevada and South Carolina play a unique and special role in the nominating process."

Then, finding herself with a handy stash of votes in the elections she promised "wouldn't count," she reversed herself and suddenly became outraged at the "disenfranchisement" of Florida and Michigan voters. She liked the situation to Zimbabwe and the Jim Crow.

All for a policy that top advisor Harold Ickes accepted when he was part of the rules committee that suspended the delegates, that campaign chairman Terry McAuliffe gleefully brandished when he was DNC chair in 2004, and that Clinton herself endorsed until the very moment it was politically convenient to change positions.

Look: although I think that Clinton is an inferior choice in almost every meaningful sense, I understand that some of you support her. But you have to acknowledge that her shenanigans on this issue are breathtakingly mendacious.

Are you scared yet?

I might have been surprised that the candidate who prides himself on experience and a "grown-up" understanding of foreign policy proved to be clueless about our own troop levels in Iraq, falsely claiming a return to "pre-surge levels."

I might have been surprised, had this not been the same candidate who confused Sunni and Shia, made contradictory and uninformed claims about al-Sadr's influence, repeatedly used the myth that al Qaeda is our primary enemy in Iraq as a political bludgeon, cited public ignorance as justification for misrepresenting the political structure of Iran, addressed the "make it 100" fiasco by fantasizing about a long-term occupation where "Americans are not being injured or harmed or wounded or killed," and casually remarked that he would expel Russia from the G8.

For anyone paying attention, John McCain is carefully and methodically demonstrating why he needs to be kept as far away from executive power as possible.

Thursday, May 15, 2008

Better blurb writers needed

Currently in the "personal tech" section of the main page of

"Taking Control of Repairing Your Computer: While personal computers rival the brain’s neural complexity, you do not need to be a neurosurgeon to fix one." (boldface added)

Ah, our paper of record...