Friday 18 September 2009

Transitional gains traps

I'm wrong about this, but I don't know why I'm wrong. I know that I'm wrong
  1. Because it's never been done and
  2. Because Tullock says there is no solution
But I don't know why I'm wrong. Maybe you can help me out.

Tullock in 1976 wrote about the Transitional Gains Trap. Suppose that the government puts in place a regulation that confers rents on a few companies. So each of those companies earns an extra $1 million per year, now and forever. The value of the new rental stream has to be capitalized into the price of the fixed asset that draws the rent. And so New York City taxicab medallions, which give their owners the right to run a vehicle as a taxicab, sell for about $750,000. The link is from the homepage of a firm that provides loans to help folks buy taxicab medallions. And in Canada's ridiculous dairy quota management system, the right to milk a cow costs about $25,000. The value of the rent gets capitalized into the asset that's in fixed supply: the permit to run the cab, the right to milk a cow, the land that's eligible for tobacco growing, and so on.

After that capitalization has taken place, the person benefiting from the rental flow is again earning only a normal rate of return on his investment. All of his gain was transitional: the rent-seeker gets a one-off increase in capital value, but no ongoing benefits. Of course, over time, ownership changes; the new owners never enjoyed the transitional gain and earn only a normal rate of return.

Tullock says that, as consequence, reform is well-neigh impossible. While the folks getting the rent are not made better off by it, getting rid of it would impose massive capital losses on them; they'll then lobby up to the expected value of the capital loss to prevent it. And, he says further that there's no way out of it.

The solution seems remarkably simple in principle; since it's not been done, I must be wrong.

For New York Taxis, the City of New York stumps up to buy out all existing medallion holders at a price equal to the average selling price in the quarter prior to folks started talking about a buy-out. They finance this rather large purchase ($750K times about 13,500 licenses = $10 billion) by a bond issue. They then put in place a specific sales tax on taxi rides that leaves the post-change price lower than the prices charged under the medallion system but nevertheless is sufficient to pay off the bond because of reduced deadweight losses and increased numbers of cab rides. The tax expires when the bonds are fully paid off.

The scheme compensates the losers from the change by a tax on the beneficiaries. In the absence of companies that exist solely to facilitate medallion sales, it would be Pareto efficient; instead, it's likely only Kaldor-Hicks. We could imagine some compensation to Medallion Financial Group, though, that would still make the whole thing Pareto.

In the Canadian dairy case, it would be much more complicated because of the way that the Canadian system runs cross-subsidies from "industrial" milk to consumer fluid milk: the tax would have to be on the portions of milk sales that currently earn a premium. Otherwise, it would be similar but would cost a lot more -- best guess, around $25 billion. 978,000 cows * $25,000 per permit.

Think about those numbers. The capitalized value of the rents conferred by the Canadian dairy system and the New York City taxicab system together amount roughly to thirty percent of New Zealand GDP. Ugh.

Ok, so why am I wrong? It looks Pareto to me. What am I missing?


  1. Donald Wittman, please stop hacking Crampton's blog. ;-)

  2. More seriously, why wouldn't the explanation be roughly equivalent to why shirking employees don't announce to their bosses that they are shirking but that since they'd be willing to work harder for more pay, they should effect the Pareto improvement? Voters don't really have rational expectations with full Bayesian updating about taxicab medallions. They would be against such a plan, but if you explained to them why exactly this would be Pareto improving, they would also prefer to just confiscate the rent.

  3. @Ryan1: Ha1
    @Ryan2: I can buy arguments that voters wouldn't support the change. But Tullock was saying, if I read him right, that we can't even imagine a way of doing it leaving aside voter irrationalities.

    A better argument emailed by loyal reader Mark is that the area of rent would have to be the same size as the area of tax so nobody's made better off. I can imagine that under three conditions:
    1) The number of taxicabs is at or above the number that would be chosen by a profit-maximizing monopolist
    2) There is no x-inefficiency in taxicab provision under the current medallion system
    3) The government's bond rate is no lower than the discount rate used in rent capitalization.

    If the first one fails - the licensing board could well have fewer medallions out than the number that would maximize aggregate rents since current medallion holders would suffer if the number were expanded - then total tax take could be higher than the value of capitalized rents.

    If the second one fails, then the supply curve shifts down in the more efficient cost structure, and again prices can be below current prices for an adequate tax take.

    If the third one fails, then the government's access to cheaper capital lets it make the deal work. I don't like this one though because it's often used to justify all kinds of nonsense and is likely false anyway.

  4. Is #1 necessary? A profit-maximizing monopolist still creates deadweight loss -- even supposing no X-inefficiency, they'd prefer to be paid their entire rent in lump-sum and then expand to the competitive level. It seems to me that this is the problem that rent-seeking arguments are pointing to. Otherwise this seems akin to the argument that "political failure" just means "Pareto optimal where the social welfare functional only weights the median voter" (an argument I would say doesn't pass the laugh test, except that I often find I'm the only one laughing).

  5. The problem more is ensuring that you can collect enough in taxes to pay off the bond issue.

  6. An obvious empirical refutation of Tullock, that didn't even require side payments, was the overnight removal of all government support for agriculture in New Zealalnd in 1984.

    I think there were three things in that case that are not dreamt of in Tullock's philosophy:

    1. the perception of a crisis gave the government an opportunity to ignore lobbying and gain public support for "making the difficult decisions";

    2. The first-past-the-post, uni-cameral legislature (sigh of nostalgia), heavily reduces the importance of rent-seeking lobbying relative to the US context; and

    3. The fact that so many farmers had recently purchased with a bank mortgage meant that the capital loss would not be borne by farmers, but by banks, who were sufficiently diversified to make it less worth the effort to lobby hard. (Then head of the Bankers' Association, Max Bradford, however, did appeal for a return to agricultural subsidies for "humnaitarian reason"!)

  7. No sidepayments? I'd thought that the farmers wanted, and got, reduced/eliminated tariffs on farm machinery.

  8. The effect of the tarrif removal was pretty small compared to the removal of subsidies (which is why farm prices still fell heavily).

    Also, I may be wrong, but my recollection is that the tarrif reductions came later, not a side payment. Once Federated Farmers saw the writing on the wall, they stopped campaigning for government support and instead for freeing up of the rest of the economy, including tariff redcutions.

  9. I'll defer to the guy who was actually here when it happened.

  10. Also, Sir Roger Douglas ended equivalent taxi restrictions in New Zealand without compensation, I'm pretty sure.

  11. Seamus Hogan is completely wrong - I did not and never would "appeal for a return to agicultural subsidies". What I did argue for and the banks and Federated Farmers agreed to, was a financial rescue scheme for viable farmers to enable them to weather the crisis at that time.

    Max Bradford

  12. Max. Fair Cop. I should not have said "return to agricultural subsidies" and I apologise for that. But correct me if I am wrong, but my memory was that you did call for some form of taxpayer funded assistance, and that your call (at least as it was reported in the media) was couched in terms of the welfare of farmers. Now, it was never in the farmers' or the banks' interests to force viable farmers off the land to be replaced by less skilled ones, so the banks had an incentive to restructure or forgive debt. To the extent, then, that the farmers most in trouble were those with large mortgages, government assistance would have been a direct transfer to the banks. My interpretation at the time was that as a spokesmen for the banks, you were fulfilling the duties of your role, and that your invoking of the welfare of farmers was a lobbying technique that I would have used in the same position but not one grounded in economic theory.

    In terms of the transitional gain trap that Eric was writing about, my point was simply that because the banks were possibly more exposed than farmers to the effect of the policy change, the costs were more diversified and the incentive to lobby hard for assistance was less.

  13. What the farmers wanted - and got - was the watersiders union smashed

    The only moral solution is for a reforming government to cancel all of these rents overnight. Not advertising intentions prevents lobbying.

    Of course, it is easier cancelling large amounts of rents and entitlements in one fell swoop rather than going piecemeal - Ruth Richardson is the example here. If you're outlawing rent control, terminating medicare & medicaid and prohibiting unemployment benefits - and treating trades unions as racketeering - then abolishing rents is much much easier.

    Yeah the US has a broken legislature - although the problem is really the mass enfranchisement of the unproductive, something clearly against the express design of the founding fathers - but at least the cops are armed, so any protest or unrest can be dealt with quickly and efficiently.

  14. Note that when a new tax on taxi rides is introduced many people will substitute away from taxis. The substitution effect is more pronounced the more elastic the demand for the trapped good or service is. Of course, elasticity of demand is one major component in determining which regulations will effectively generate rents. We are back in a trap, it would seem.

  15. @Juris: Note that the tax is set to keep the price to consumers no higher than it was under the monopoly regime; monopoly rents are converted to tax revenue.