Tax maximisation, smoking, and the Stalin Gap

If my lifestyle and leisure choices lead me to remit less to the government in taxes than I would have under alternative scenarios, have I imposed an externality on the State?

James Meanwell asks:

Eric, care to weigh in on a debate I'm having about this elsewhere? Specifically, does loss of tax revenue as a result of lower productivity (e.g. due to smoking, eating too much) count as an externality? I've argued that the government would have to be spending efficiently, which is unlikely, for the loss of revenue to count as an externality and so it probably doesn't (count). Not sure if that's right, but the notion (i.e. loss-of-revenue-due-to-lower-productivity-as-externality) seems odd to me.

I started replying to his comment, but reckoned it deserved its own post.

Let's start with the big picture and work down to details.

Consider two people, alike in relevant ways at age 10 and equal in earnings potential, but with different utility functions. So they make different choices.

Mr. A decides that the rat race isn't for him and decides instead to take a part-time job at 20 hours per week instead of 40. Were he to have worked a full time job, his earnings would have doubled and, because of progressive taxation, his tax payments would have more than doubled. But he's not on welfare; he just can transform relatively little income into a fair bit of happiness because he really likes leisure.

Mr. B does not enjoy sitting idle; he consumes his leisure by smoking while working a full-time job. Associated health issues reduce his productivity and, as consequence, he earns a quarter less than he otherwise would; his tax payments are then perhaps a third lower than they otherwise could have been. Other sources have a lower wage penalty for smoking; we'll stick with a big one for present purposes.

If Mr. B's lower tax payments because of his choice to smoke are of policy consequence, then so too are Mr. A's lower tax payments because of his choices. Indeed, we could say that Mr. A is far worse than Mr. B: while Mr. B pays, in New Zealand, about three times as much in tobacco excise as he'll cost the public health system and is so kind as to die before costing the superannuation system very much, Mr A pays zero tax on his leisure and will earn two-thirds of the national average wage in his retirement despite having contributed relatively little to the superannuation system.

If we need to use policy to nudge Mr. B into smoking less, because of reduced tax earnings, then we also need to nudge Mr. A into working harder. And when nudges don't work in tobacco and start becoming shoves, we need to start shoving Mr. A as well.

Mancur Olson argued that Stalinist Russia had the world's most effective extractive tax regime. Workers were effectively compelled to work by near complete inframarginal taxation combined with very low taxation at the margin. If Stalin had had the ability to solve the Socialist Calculation Problem, he could have done slightly better, leaving each worker with an individualised menu of two choices: starvation, or a personalised bundle of very hard work and some goods leaving the worker epsilon better off than under starvation. I suppose that we could consider any deviation from that level of work as a harm imposed on the state. But it's only Stalin who'd really want to push there.

The Okun Gap is the difference between potential and realised GDP due to excess unemployment. I'll call the Stalin Gap the difference between an individual's potential maximal tax payments and his actual tax payments based on his choice to consume leisure over labour - partially because he would choose some leisure even in the absence of taxes, partially because too high of income tax rates yields substitution to leisure.

Most of us could earn more, and consequently submit higher tax payments, by choosing more labour and less leisure. But we'd be less happy.

So that's the big picture: the world in which the smoker's lower income tax payments (ignoring his much much higher excise tax payments) are sufficient basis for taking away his leisure is one where we want to penalize people for taking holidays or failing to work as many hours as they otherwise could: closing the Stalin Gap. Unless we say that leisure via time off relaxing is, by assumption, good, while leisure via smoking is bad - but that remains question-begging.

Smaller picture: is this even an externality?


Short answer: likely, but likely very small, and that small portion mostly because of how the tax system treats poor people.

All right. An individual chooses between smoking, leisure and labour. In a world with private health care and no taxation, the individual optimally balances health harms from smoking against enjoyment of smoking - he earns less because he smokes, but that's just part of the full cost of tobacco that he enters into his optimisation. All you behavioural guys who want to complain about whether he can be rational or informed on this can shut up for the moment - we're trying to figure out whether he's imposing an externality on the government once we move to a tax regime, so the behavioural stuff is entirely beside the point.

Some optimal level of smoking will be found above. What happens when we add taxation and government? The smoker will bear fewer of the wage costs of smoking because the government takes a portion of his earnings and so he should optimally smoke more. But again, the same is true of the individual's choice to consume other forms of leisure in the presence of income taxation. Recall that in economics, we don't care about externalities because of pecuniary effects like "the government gets less in tax". We care about them rather because they distort choices: people move from taxed labour to untaxed leisure in the presence of income taxation. The incremental increase in smoking when the returns to labour drop under a taxation regime can be viewed as a distortion. But, again, think of anything that helps increase the marginal utility of leisure. In a world with taxes and government, people choose more days off playing cheap but excellent video games relative to the zero-tax world. What then is the productivity cost of video games? Or of any other kind of leisure? It's hard for me to see any productivity externality of smoking that is different in kind from any other labour-leisure distortion generated by taxation. And it would take some number crunching to show that the technological portion of any effect* here isn't already over-internalised by current levels of tobacco excise.

Gordon Tullock reminded us in 1998 that government produces externalities as well as solving some externality problems. The vast bulk of reduced income taxation accruing to government due to smoking could only be remedied by imposing harms on smokers that are larger than the potential gains to government. Now, if you want to assume that smokers are irrational and hurting themselves by their choice to smoke, you can do that, but you don't really need the effects on income taxation to make the case.

Recall that smoking is concentrated among poorer cohorts and that marginal tax rates, though not average tax rates, are very high for the poor. If the deadweight costs of high marginal tax rates are making poor people smoke more than they otherwise would because the personal income losses are low, they're probably also screwing up a whole lot of other choices that are of greater consequence as well. If you're going to worry about it, start by trying to fix the tax schedule and abatement rates for the various income-contingent benefits so that the effective marginal tax rates facing poor families are not insanely high.

The Ministry for Social Development noted that 35% of beneficiaries (people receiving benefits other than just Working for Families, NZ's EITC) in paid work in 2008 enjoyed effective marginal tax rates higher than 75%, with some non-beneficiary low income families enduring abatement of the minimum family tax credit facing EMTRs over 100%. MSD concluded dryly, "Work incentives are very low for such families".

Effective marginal tax rates in excess of 75% are very likely to induce all sorts of very real distortions in behaviour; I expect the decision to smoke incrementally more because of reduced returns to wages is pretty trivial in this mess.



* Again, we don't care about externalities that are pecuniary. Imagine that the smoker smokes exactly as much under a tax regime as under a no-tax regime. The government earns less than it would were the smoker a non-smoker, but this is purely pecuniary: the gain to the government by forcing him to quit would be overmatched by the losses experienced by the smoker. The only portion that can matter for welfare is the excess smoking induced by the lower return to labour under the tax regime. And that's unlikely to be large relative to the amount of smoking that's invariant to income tax rates.

What is wrong with housing anyway? (Warning: wonkish)

This is a post I have been meaning to write for some time, but the current spur is the Treasury briefing for the incoming minister. It is mostly very good, but included in it is the canard about over-investment in housing. This is a refrain we hear repeatedly, usually in phrases like “New Zealanders love affair with housing”, but I think the theoretical and empirical basis for the assertion of overinvestment is weak at best.

The main issue is one of tax-induced distortions. With owner-occupied housing, the purchase of a house is an investment, which generates an inputed rent that the owner pays to himself. The payment of this imputed rent is not subject to GST, nor is the rental income subject to income tax. There is also the issue of whether the absence of a capital gains tax is a further distortion, but I have discussed that issue here, here, here, and here. In this post, I want to explain why I don’t find it obvious that there is a distortion due to the lack of tax on inputed payments of a homeowner to himself. In part, this is a response to comments by Phil Meguire in the first of the capital gains posts.

To start with, let’s get an obvious point out of the way. Housing is a good thing, and nicer housing is better than worse housing, holding all else the same: If non-neutral taxes induce more investment in housing and less in other forms of investment than a neutral system, there is a cost, but it is the difference between the value of the flow of goods that would have been produced and the value of the flow of services produced by the housing, a difference which is not necessarily significant. I suspect that some of those decrying our love affair with housing are making the mistake of thinking that just because the purchase of housing services is a non-market transaction it doesn’t contribute to economic well-being. Similarly, it is irrelevant if the alternative investment would increase labour productivity, increase exports, etc. productivity and exports are just means to increasing the value of the goods the economy can consume; so is building houses. (Surprisingly, Greg Mankiw appears to make this mistake here, but to be fair we can attribute this to the need for simplification in an op-ed article, and his basic point—that the U.S. should get rid of the crazy mortgage-interest deduction—is sound.)

The next point to note is that the optimal tax rate on owner-occupied housing has to be considered in the context of an existing distortion: With an income tax, saving is subject to double taxation. If I choose to work today in order to buy consumption goods today, there is a difference between the value of what I produce and the value of what I consume, because of an income tax. But if I choose to work today in order to buy consumption goods in the future, there is an even bigger distortion between the value of what I produce and the value of what I consume, because the value of my work is taxed twice, once on my labour income and again when the interest income is taxed. We then have a classic second-best Ramsey taxation problem. The theoretical optimal tax on the return from investing in owner occupied saving will be somewhere between having no taxation on the saving (so as not to distort the decision between consumption today and investment in housing), and the full double-taxation rate applying to other forms of saving (so as not to distort the decision between investment in housing and other investment). So if normal investment returns are taxed at, say, 33%, the optimal housing tax will be positive but less than 33%.

And finally, here is the point that is overlooked in all the commentary on housing investment that I have seen. The flow of services from owner-occupied housing is currently subject to a tax. In other words, this graph, taken from the Treasury’s briefing to the incoming-minister, is wrong.

To see why, consider how a value-added tax like the GST works. Businesses charge GST on their sales, but deduct from their net tax liability the GST they have paid on purchases of goods and services. Expenditure on investment therefore reduces their tax liability, which is what makes the GST ultimately a tax on consumption and not investment income. When consumers buys a new house, they are making an investment, the return for which is the flow of housing services they will receive over time. The inputed payments they make to themselves are not subject to the GST, but unlike other business investment, the initial house purchase is, which has the same effect. (And, as I noted in an earlier post, the existence of a GST pushes up the prices of second-hand goods by the rate of the tax, so the argument is no different for owners who purchase an existing rather than newly built house.)

This is another example of the beauty of pure value-added taxes. By shifting in part from an income tax to a value-added tax, the rate of double taxation on delayed consumption is reduced. At the same time, the effective rate of taxation on the consumption of owner-occupied housing is increased from zero. We end up with a system where the tax rate on owner occupied housing is somewhere between 0 and the rate applying to other investment, just as Ramsey tax theory would stipulate. Whether it is higher or lower than the optimal rate is a difficult empirical question to which I don’t know the answer. But I have not seen any of “New Zealander’s love-affair with housing” commentators seek to address it. Furthermore, given that there are no simple methods of increasing the tax rate on owner-occupied housing that don’t bring their own problems (we have no mortgage-interest deduction to get rid of, for instance), I find it hard to believe that we have an over-investment problem that is worth solving.

The economics of optimal taxation applied to sport

It is now confirmed that Carl Hayman has signed with a French Club, and so will not be available to play for the All Blacks in next year’s world cup. This is obviously a big blow to the All Blacks. It is also unfortunate for rugby that international rugby, the showpiece of the sport, will continue to be without one of its genuine superstars.

Three common reactions to this are all wrong:

1. Hayman should have put national pride ahead of financial return.
2. The NZRFU should have matched the offer from Toulon.
3. The NZRFU should abandon its rule about not selecting foreign-based players.

The first of these is ridiculous: Who among the rest of us base our personal employment decisions on considerations of the national good? The second would create an incentive for more players to leave in order to be enticed back. The third would have a similar effect on incentives, at a huge long-term cost to the base of the game in New Zealand. But a variant on it is worth considering.

This is where optimal tax theory comes in. The basic idea of this literature, see here, here, and here, is that there is no benefit from levying tax on income-generating activity if that tax will lead people to not undertake that activity, so taxes should ideally only be levied on activity that will take place even with the tax. The trouble is to find observable things that are correlated with tax-insensitive behaviour and not with tax-sensitive behaviour that still leave a progressive tax system. One example from the literature is that an optimal tax system has lower tax rates at higher incomes that at lower ones. (The vast majority of people will choose to continue to earn the first $10,000 of income; they may not choose to continue to earn the millionth dollar.)

The rugby analogy is that the NZRFU would be happy to select players from overseas who would be overseas whether they were allowed to be selected or not but also want to commit to not selecting players for whom that rule would be decisive in keeping them playing in New Zealand. So what they need is a rule that allows some players thought likely to be infra-marginal to be selected for the All Blacks if playing overseas while not others.

Fortunately, such a rule is possible. The vast majority of players who have gone overseas have not done so until they have played around 8 seasons of Super rugby (Hayman, himself played 8 seasons for the Highlanders), and typically, I would guess, the majority of high-profile players who can leave do so after that time. So the NZRFU should institute a policy that to be eligible for selection in the All Blacks, you must either be based in New Zealand or have played at least 8 seasons of super rugby. Indeed, once this rule were in place it might keep some players who now would leave before completing 8 seasons, as they would have the incentive to earn perpetual eligibility.