May 19, 2022

Economic View: Pigovian Taxes May Offer Economic Hope

NO one enjoys paying taxes — and no politician relishes raising them. Yet some taxes actually make us better off, even apart from the revenue they provide for public services.

Taxes on activities with harmful side effects are a case in point. Strongly favored even by many conservative Republican economists, these levies are known as Pigovian taxes, after the British economist Arthur C. Pigou, who advocated them in his 1920 book, “The Economics of Welfare.” In today’s deeply polarized political climate, they offer one of the few realistic hopes for progress.

To see how Pigovian taxes work, consider a driver checking out the offerings at his local auto dealership. He is trying to decide between two vehicles, one weighing 6,000 pounds and the other, 4,000 pounds. After comparing sticker prices, mileage estimates and other features, he views the choice as roughly a tossup. But because he has a slight preference for the larger vehicle, he buys it. His decision, however, could be viewed as a bad choice for society as a whole, because of the side effects. The laws of physics tell us that heavier vehicles tend to cause more damage in crashes. They also spew more emissions into the air and cause more wear and tear on roads.

By providing an incentive to take those external costs into account, taxing vehicles by weight would make the total economic pie larger. Those who don’t really need heavier vehicles could buy lighter ones and pay less tax. Others could pay the extra tax as fair compensation for their heavier vehicles’ negative side effects.

But the mere fact that Pigovian taxes produce greater benefits than costs doesn’t make them an easy sell politically. Like other changes in public policy, a Pigovian tax produces winners and losers. And it’s an iron law of politics that prospective losers lobby harder to block change than prospective winners do for its adoption. That asymmetry creates a powerful status-quo bias that makes even broadly beneficial policy changes hard to achieve.

Yet, in principle, any change that makes the economic pie larger makes it possible for everyone to enjoy a bigger slice than before. The practical challenge is to slice the larger pie so that everyone comes out ahead. A first step toward a vehicle-weight tax would be to make it revenue-neutral — for example, by returning its revenue in the form of lump-sum rebates to each buyer. That would soften the blow, while preserving the incentive to buy lighter vehicles.

For example, if the tax were 20 cents a pound, a 6,000-pound vehicle would be taxed at $1,200, as opposed to $800 for a 4,000-pound one. If an equal number of vehicles of each weight were sold, all buyers would get a $1,000 rebate when the total tax income was redistributed. The buyer in our example would thus be making a net payment of $200 because of the tax, but his total outlay would have been $400 lower if he’d bought the smaller vehicle instead.

Although revenue neutrality would help, buyers who really need large vehicles might feel aggrieved. Paradoxically, the key to mollifying them is to propose Pigovian taxes not just on vehicle weight but also on a swath of other activities that cause undue harm to others. We could drivers tax contributing to traffic congestion, for example, on the grounds that entering a crowded roadway causes delays to others. We could tax noise, carbon emissions and other specific forms of air and water pollution. Although some people would end up as losers under any single one of these measures, virtually everyone would come out ahead under a broad suite of Pigovian taxes.

That’s because adopting a large number of them is like repeated flips of a coin whose odds are stacked heavily in your favor. If someone offered a chance to flip a coin that paid $10 for heads and lost $1 for tails, would you take it? It’s an attractive gamble, obviously, but if there is only a single flip, there’s a 50 percent chance that you’ll be a loser. After many flips, however, you’d almost certainly be a net winner.

Likewise, any single Pigovian tax is an attractive gamble for the average taxpayer, who would get a rebate equal to the amount she’d paid in tax and would benefit from the resulting reduction in harm. Under a collection of such taxes, the odds of being a net winner go up sharply. Only the minuscule minority who cause much more than average amounts of harm in almost every category might end up paying more total tax than before. And even those few would still be net winners, because of the corresponding reductions in harm.

A BROAD slate of Pigovian taxes would thus meet the challenge of how to divide the larger pie so everyone comes out ahead. And because the prospect of a continued divided government makes short-run legislative progress unlikely on other fronts, why not pick this low-hanging fruit right now?

The case for Pigovian taxes isn’t easily reduced to bumper-sticker slogans. Still, the basic ideas are not complicated, and President Obama has the biggest megaphone on the planet. It should be easy for him to persuade rational voters to embrace policies that would make virtually everyone better off.

But he must also persuade House Republicans. Getting their votes will be the real test of his celebrated rhetorical skills.

Robert H. Frank is an economics professor at the Johnson Graduate School of Management at Cornell University.

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Greek and Cyprus Credit Ratings Cut in Latest E.U. Downgrade

LONDON — In the latest downgrades to hit the euro zone, Greece had its credit rating cut by Standard Poor’s on Wednesday, while Moody’s Investors Service cut the rating for Cyprus.

S.P.’s rating for Greece, already in junk territory, was reduced two notches to CC with a negative outlook. In a statement, S.P. said that the proposed restructuring of Greek government debt as part of a second bailout was a selective default — a prospect ratings agencies had warned about when the plan was being discussed.

S.P. also said that despite the new aid package agreed on last week, there was still a good chance that Greece would default on its debt.

Under the second bailout, banks and other private investors are to contribute about €50 billion, or $72 billion, by swapping their existing debt for new bonds..

“Standard Poor’s has concluded that the proposed restructuring of Greek government debt would amount to a selective default under our rating methodology,” the agency said. “We view the proposed restructuring as a ‘distressed exchange’ because, based on public statements by European policymakers, it is likely to result in losses for commercial creditors.”

Moody’s cut Cyprus’s long-term government bond rating two levels to Baa1 — still an investment grade — from A2. It assigned a negative outlook, signaling the next move may be another downgrade, and cut its short-term ratings.

An explosion at a naval base this month badly damaged the Vasilikos power plant. That has caused outages, and Moody’s said that the shortage is likely to hurt the economy, which it now expects to stagnate this year, and expand only 1 percent next year.

Moody’s also cited the “increasingly fractious domestic political climate” and “the material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece.”

Cyprus bonds fell on Wednesday and Italian and Spanish bonds dropped as investors became increasingly concerned whether a package assembled by European leaders to help Greece’s troubled finances and restore confidence in the euro zone would be enough. The yield on Cyprus’s 10-year bond rose 0.13 percentage points to 10.043 percent.

Banks in Cyprus continue to hold “substantial” Greek debt and would be affected in the case of a sovereign debt default, Moody’s said.

Moody’s also said it was concerned about the large role the banking sector plays in the Cypriot economy. Bank assets amount to about 600 percent of gross domestic product in Cyprus, excluding foreign bank subsidiaries, it said.

The July 11 explosion that destroyed the plant and killed 13 people also rattled the government. Costas Papacostas, the defense minister, and Petros Tsalikidis, chief of the national guard, resigned amid criticism about failing to take steps that could have prevented the accident. Some 98 gunpowder containers were left stacked for more than two years in an open field near the power station.

The political friction might make it harder for the center-left government, which does not have an absolute majority in Parliament, to push through spending cuts and privatizations announced on July 1.

“This adverse development increases implementation risk to the government’s plans, many of which will require not just cross-party support but also acceptance by the trade unions,” Moody’s said.

On Tuesday, a number of parties accused the government of backtracking because they feared an angry backlash from Cyprus’s powerful labor unions, Reuters reported from Nicosia.

Cyprus, which adopted the euro on Jan. 1, 2008, is seeking to bring down a budget deficit that hit 5.3 percent of gross domestic product last year.

“The Cypriot banks have been considered safer than the Greek banks and have received a lot of the deposit outflow from Greece,” Panicos Demetriades, a professor at the University of Leicester, said, adding that the banks have large businesses in Russia. “However, the problem is that a small country like Cyprus cannot afford to support such a large banking system, if it gets into trouble.”

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Debt Ceiling Has Some Give, Until Roof Falls In

Even after Aug. 2, the deadline the Treasury Department set this week for Congress to lift the borrowing limit, the government might be able to delay a crisis, perhaps even for a few months, through extraordinary measures such as asset sales.

But with every passing week of stalemate over the debt ceiling, the risk increases that investors will start to fret that the United States will not pay its debts, and demand higher interest rates for loans to the federal government.

Should that happen, the cost could be vast and the damage difficult to reverse.

Debates over the debt ceiling are a regular feature of political life in Washington. Congress has lifted the ceiling more than once a year, on average, over the last half-century — often right before the deadline. But the debt has never been so large, and the political climate has rarely been as contentious.

Republicans and some Democrats insist that an increase in the debt ceiling must be accompanied by concrete limits on future spending, entangling an issue that requires urgent attention with a debate unlikely to be resolved before the 2012 elections.

Vice President Joseph R. Biden Jr. and lawmakers are scheduled to begin discussions on the national debt on Thursday at Blair House in Washington.

“When I talk to investors, their general reaction is they’ve seen this movie before. They expect that Congress will increase the debt ceiling,” said Mary Miller, assistant Treasury secretary for financial markets. “But I’m concerned because the stakes are higher here and the amount of time we can buy with extraordinary measures is smaller.”

The debt ceiling basically is the limit on the national credit card, the maximum amount that can be owed at any one time. The government hits the limit with some regularity because federal spending vastly exceeds revenue. Over the years, Congress, which controls federal spending, has always raised the limit.

When the current limit is reached on May 16, after the Treasury completes its latest round of borrowing, the government will need to find $125 billion a month to pay its bills.

The Treasury estimates that it can avoid a crisis until early August with few if any lasting consequences by spending about $100 billion in cash that it keeps on deposit with the Federal Reserve, the nation’s central bank, and by temporarily suspending $232 billion in special-purpose borrowing programs so it can instead borrow money to finance general operations.

The Treasury secretary, Timothy F. Geithner, warned Congress in April that once those resources were exhausted, the government would have to default.

“A broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds,” he wrote.

A range of experts, including the Federal Reserve chairman, Ben S. Bernanke; former Treasury officials from both political parties; and economists from across the ideological spectrum, warn that missing payments would be catastrophic. In particular, they say, investors would view Treasury debt as risky and Washington would be forced to pay higher interest rates.

The government plans to borrow $405 billion during the second half of 2011. If rates rose even a tenth of a percentage point, the added cost on those borrowings would be $405 million a year.

Many Republicans dismiss these warnings. They argue that the government could maintain the confidence of investors by prioritizing interest payments. There is ample revenue to make those payments, and the Republicans — also backed by economists and financial experts — say investors would not punish the government for failing to fulfill other financial obligations.

“I think the important thing to do would be to make it clear to markets that the government is not going to default on its debt,” said Senator Patrick Toomey, Republican of Pennsylvania, whose bill assigns priority to interest payments. “It would be easy, I think, to make it clear to the markets that they don’t have to worry about this.”

Treasury officials respond that the failure to pay any obligations would set off a crisis.

“What participant in the market would want to buy our debt as we are defaulting on other obligations?” asked Ms. Miller. “I think the markets would be completely spooked.”

Prioritizing interest payments would also require cutting spending immediately by much more than either party has ever proposed. The Congressional Research Service reported in February that the government would need to stop all discretionary spending and reduce payments under programs like Social Security.

So far, investors have shown no signs of concern. Moreover, the market reaction to past standoffs suggests that investors have learned over time to ignore the theatrics in Washington.

Investors demanded risk premiums of as much as half a percentage point during a heated confrontation in 1995 and 1996 between House Republicans and the Clinton administration. They demanded smaller risk premiums during standoffs in 2002 and 2003, according to research by Pu Liu, a finance professor at the University of Arkansas. But during more recent standoffs in 2005 and 2006, Professor Liu found no evidence of any risk premium.

Investors, he wrote, have taken to treating Washington “like the boy that cried wolf.”

Of course, investors were more sanguine about risk in 2006 than they are now. But even if markets do remain calm, the cost of a standoff will rise sharply when Treasury exhausts its current measures around Aug. 2.

Then the government could stave off default for a time by selling assets at fire sale prices. The United States owns about $402 billion in gold at Monday’s prices and about $81 billion in oil. It holds a portfolio of loans estimated to total $923 billion by September, including more than $100 billion in mortgage-backed securities it is selling slowly to investors, and more than $400 billion in college student loans.

Administration officials, however, say such a move would amount to a modest grace period bought at extravagant and wasteful expense. It would not change the fundamental need for Congress to raise the debt ceiling.

A more likely approach would borrow a page from the Clinton administration, which threatened in early 1996 to suspend Social Security payments for a month.

Congress immediately passed special legislation permitting the government to borrow the necessary money without counting it against the debt ceiling for one month. One day shy of a month later, Congress permanently raised the ceiling.

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