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.

Externalising the Internality

In my standard classroom account, a smelly person on the bus next to you isn't imposing an externality, or at least not one that can be relevant for policy. You're both in a contract with the bus company through purchase of the ticket. If the bus company reckoned it would earn more money by restricting bus access to those suitably groomed, they could do so. That they don't means that the losses from doing so exceed the gains - the costs in hassles for the bus drivers and increased time at the stop exceed the costs of lost custom among those who don't like that particular negative lottery ticket. The bus company has an encompassing interest in getting that decision right; they're residual claimant on the surplus.*

But that account is wrong when the bus company can be sued for discrimination. The law can externalise internalities by mucking about with exclusion rights.

L.A. Weekly tells the story of a homeless man who sued MTA for violating his civil rights; they wouldn't let him on the bus because of his appearance. And, from the context of the rest of the story, likely because of his odour. MTA settled for $200,000 in January 2011. In a Coasean world, the bus company could just start paying him not to take the bus. But free entry into the "being unpleasant and not taking the bus" industry would probably make that rather cost-prohibitive.

The rest of the story is well worth reading. Nowell, the man excluded from the bus, used a good chunk of his settlement to take a one-year lease in an apartment building. But because his neighbours were pretty insistent that he take a bath, he consequently refused to take one. So after several months of legal fights, he was evicted. Nobody comes out of the story smelling minty fresh.  The story concludes:

"When I moved in, they made such a huge issue right from the start," he [Nowell] says.

If he cleaned up, they would think he did it because of them.

"It might be a childish way to react, but it also has to do with self-respect. Call it pride, or whatever you want. If they'd just left me alone, let me catch my breath. By them making an issue out of it, none of it happened. Everything went wrong."

Nowell admits there are patterns he's become locked into. "Enough people tell you you're a certain way, a bum, you think, 'I must be that.'  When you're at the bottom of the barrel, everyone feels like they have the right to tell you what to do, where to do it and when. It becomes a reflex action to dig your feet in and say no," he says. 

SB Properties kept his six months' prepaid rent plus double deposit. Now it is going after him for attorney's fees. Nowell estimates he paid his attorney $30,000. He isn't sure. He hasn't been counting the money too closely, except to note that he has less than a quarter of the original settlement left. He is spending much of the rest to appeal the jury verdict.

"Why did they allow me to sign the lease and immediately turn around and spend the next eight months trying to remove me?" he asks, unable to move on.

By the time SB got him out, it was August. The irony — and in this case there are many — is that his lease had only four months left.

Asked if he believes Nowell would have cleaned up on his own, had he just been left alone, SB Properties general manager Yaniv Abiner pauses for a long time, then finally says, "What do you think?"

Nowell, meanwhile, is on the hunt for a new place to live, noting wryly, "A roommate situation isn't going to work for me."

Yesterday, he explains over the phone, he went to see a unit in a downtown artists loft building, hoping that artists would be more understanding. The woman who owned it was waiting out front. She said no the minute she laid eyes on him, adding that he ought to try a halfway house for people on welfare. "I'm not the stereotype you think I am," he admonished her.

He did not wear the new pants. "I'm looking at them right now, in fact," he says.

It has been some time since he last took a bath.

Fixing homelessness seems a bit harder than giving somebody enough money for rent.



* Similarly, Christchurch's Red Bus must reckon that the costs of letting professionals onto the bus with a takeaway cup of coffee exceed the cost of lost custom among my cohort.

Externalities: A Primer

It is far too easy to come away from a lazy version of Econ 101 thinking that, because externalities are pervasive, the range of meliorative government policy is very broad indeed. It's hard to think of any part of life that doesn't involve external costs of one sort or another.

When you get past Econ 101, you start getting all the caveats. The range of externalities that actually generate inefficiencies is pretty small relative to the universe of externalities. And, even those that can potentially be fixed by policy aren't necessarily best handled by policy. Private solutions to some kinds of externality problems do emerge; layering policy on top of private solutions can make things worse than leaving things alone.

Let's start by walking through a narrative version of Buchanan and Stubblebine's seminal work. And, we'll start by separating out two very different kinds of ways that other peoples' behaviour can affect you.

Suppose that you and I both attend a house auction. I show up wearing a t-shirt that is so offensive that you feel physically ill.* In fact, you would have been willing to pay me $100 to have worn a different t-shirt this morning. I would have been willing to have changed shirt for any payment greater than $20. Despite your nausea, you are able to bid on the house. But, because I'm bidding against you, you wind up paying $10,000 more than you otherwise would have.

My bidding against you at auction imposes a cost on you, but one that does not change the efficient outcome. The house goes to the person who values it most: you. And while you have to pay more for it, the seller receives more for it: my action has caused a transfer from you to the seller. When we model things more formally, these effects run through your budget constraint rather than your utility function. You have less money with which to do things, but we have no reason to expect that anybody is choosing the wrong mix of goods given their budgets. We call these budget-affecting externalities "pecuniary externalities". When economists say, "Oh, but that's only pecuniary", that means that it's something that we don't really need to worry about if what we care about is efficiency. We only care about externalities because they induce resource misallocation; pecuniary externalities don't do that. There might be other justice-based reasons for worrying about pecuniary effects, but to the extent that we do, we generally conclude that those kinds of concerns are really best handled by just giving money to poor people.

But the nausea that I imposed on you with my careful choice of t-shirt is a real external cost. It's easy to imagine that you'd be willing to pay some amount to change the state of the world - that means it's potentially Pareto-relevant. A Pareto-efficient outcome is one where it's impossible to make anybody better off without making somebody else worse off at the same time; a Pareto-improving move is on that makes at least one person better off while making nobody worse off. A Pareto-relevant externality is one where a Pareto-improving move is available: the total willingness to pay to change the outcome, aggregated across all the people affected, is enough to generate a change in the outcome. You suffered costs of $100; I would have been willing to accept $20 to avoid imposing those costs. Eighty dollars worth of value was forgone by my having worn the wrong shirt. So the externality was Pareto-relevant: had I chosen a different shirt, the gains to you would have outweighed the losses to me. We call externalities of this sort technological: they affect others directly through their utility functions rather than indirectly through the budget constraint.

We expect technological externalities may induce inefficient outcomes. The real costs that I impose on you through your utility function are not factored into my decisions and so I can wind up choosing the wrong consumption bundle. But, again, not necessarily. If it would have cost me $100 to change shirt, and the burden on you was only $20, the efficient result is that I wear the t-shirt. The externality was only potentially Pareto-relevant, not actually Pareto-relevant.

Eli Dourado's Mercatus Working Paper on cybersecurity walks nicely through the difference between inframarginal externalities and marginal externalities, along with a host of policy and private solutions to externality problems. David Friedman's treatment is excellent; he also cautions in Law's Order of problems that can arise when we couple Coasean solutions to externality problems with tax-based approaches [see Chapter 4 in particular].

What about externalities that affect you through the tax system? Edgar Browning calls these "Fiscal externalities". They would count as pecuniary by the Buchanan and Stubblebine definition, but they also are effects that operate outside the market process. David Roberts worries about these when weighing the case for taxes on sugary drinks. In the presence of a public health system, any decision you make that affects your health also has effects on others through the tax system. To what extent is it efficient to worry about them?

First, imagine the limiting case in which nobody's behaviour changes as consequence of health care costs being borne by others: everyone behaves as though they had private insurance that charged actuarially fair premiums. In that limit case, every health cost borne through the tax system is only a transfer. It's a transfer from richer and healthier people to poorer and less healthy people, and it's a transfer from risk-averse to risk-preferring people, but it has no efficiency consequence. There is no simple efficiency case for worrying about it, though you could build complicated cases around the cost of raising money via taxes versus the costs of abating health care costs via other mechanisms.

Now, let's take the more realistic case where individual behaviour is at least somewhat responsive to that somebody else is paying for your hospital care and that your premiums do not vary with your costs. There's reasonable evidence for this: Jon Klick and Thomas Stratmann show that when state governments mandated that private insurance plans cover substance abuse treatment, people increased their alcohol consumption by an amount equivalent to about "48 extra beers per person per year".

What are the policy implications? Let's recall first that the cost imposed by the behavioural change is likely to be small if consumption changes are small relative to the total amount that would otherwise have been consumed: average per capita beer consumption in the US is 78 litres according to Wikipedia. Imagine that we had no public health insurance but instead we gave a lump sum of cash to everybody and required that they use it to purchase health insurance; insurers could charge what they liked. How much would we really expect anybody to cut back on their consumption of sugary drinks? People bear very direct personal costs of being in poor health; the monetized value of that will not be trivial even relative to expensive insurance premiums. In other words, the effect may mostly be inframarginal. I refrain from engaging in extreme mountain biking even though ACC would cover all of my health costs: I really don't like pain and injury. I would pay multiples of the cost to the health system of a broken arm to avoid breaking my arm.


So any policy seeking to internalise the external costs of individual health-affecting decisions ought to focus on the incremental costs caused by the extrernalisation of those costs through the public health system, not the aggregate burden of related diseases. Browning, in the piece above-linked, shows that the set of taxes and subsidies that would be necessary to nudge everyone back to what they would have been doing if the health system didn't distort behaviour winds up replicating the insurance premiums individuals would have been paying under private insurance but at very high administrative cost. Private insurers can set premiums based on individually specific characteristics; governments are more typically constrained to using linear tax schedules. But for things like sugary drinks, health costs are likely exponential in consumption, not linear; for alcohol, it's a J-curve with health benefits from moderate consumption and costs from excess consumption. Your insurer might decide only to increase your premiums if you're a heavy drinker; governments are restricted to linear taxes on alcohol that overcharge moderate drinkers and undercharge heavy drinkers.

Setting excise taxes to try to internalise the largely pecuniary effects of consumption decisions can induce technological externalities by causing some would-be moderate consumers to consume too little.

A few bottom lines study notes for the exam, as this will also now be part of the readings for my Economics & Current Policy Issues class:

• There is no market failure case for responding to pecuniary externalities. 
• While there can be a market failure case for policies addressing technological externalities, we have to be awfully careful because private markets often have already internalised them. A decent rule of thumb: if people are linked through a contractual or quasi-contractual nexus, intervening is likely a bad idea. We don't need policies to address the costs screaming babies impose on other airline passengers; the airlines are residual claimant.
• Most of the "cost to the taxpayer through the public health system" aspect of individual consumption is pecuniary rather than technological. Any policy in this area has to be very careful to address only the parts of consumption behaviour that are directly caused by the potential for public defraying of health care costs; the risks of inducing inefficiency by setting policy to address pecuniary effects are real.
• Note too that the actual burden on the health system may be pretty complicated. Smokers cost the health system more in every year that they are alive, but potentially save the health system money in the long run by dying early - and they definitely save the government money in total when we consider that smokers die before drawing too much in superannuation. It's even pretty plausible that healthy people wind up costing the health system more in total because they impose costs for a long period of time. What do we do if we find out that it's the gym rats who wind up costing everybody more because they spend ten years in a publicly funded dementia ward instead of dying of a heart attack at 67?

This is part 2 of a two-part series; in part 1, I took a more rights-based approach. And see here for prior posts on externalities.

* Only weirdos would be offended by these fine shirts, but they count in the social welfare function too. Anybody stumped for Christmas presents for Crampton can send me one of these shirts; I'm likely a medium.

Externality chains

Are there really no bright line rules separating actions with external costs from those that are properly left entirely to individual choice? David Roberts sees only shades of grey:

Take sodas, for instance: The costs of health care in the U.S. are socialized to some degree, so individual decisions to get unhealthier do affect me. I pay when rates are driven up, or when people end up in the emergency room.

So whatever the line is — between the sphere of rights and sovereign individuality on one hand and the sphere of interconnectedness and social responsibility on the other — it can’t be “actions that don’t affect others.” There are none!

Perhaps, then, the distinction is between actions that mostly affect me and those that substantially affect others. If I dump trash in a neighbor’s yard, obviously I’m violating her sovereignty and the state has a legitimate right to constrain my liberty; no one would call that “paternalism.” But the causal chain between my decision to drink a big soda and the effect on health-care costs is long, tenuous, incremental, and uncertain. Perhaps I decided to jog home after my soda! Do I get a tax credit for that? In the case of soda, the claim to individual sovereignty is more immediate, more tangible, than the long thread connecting the decision to impacts on the collective welfare.

What this reveals is that state decisions to restrict individual behavior can not be guided by a clean line between the individual and collective spheres; there is no clean line. Restrictions on individual liberty will always be judgment calls about whether negative effects on others (externalities) outweigh the presumption of sovereignty.

This dilemma is on the mind of anyone who covers climate and energy.

I'll argue for two separate bright-line rules: the first based on individual rights (but pretty influenced by economics), and the second where I ditch the rights-based argument and stick to the economics.

Let's compare Roberts' first two examples, sticking to a rights-based approach for now; the pure economics version will be a separate post.

The only mechanism by which somebody else's obesity really hurts me is when either my insurer is legally barred from charging actuarially fair premiums, or when health care is covered through generalized taxes.* Let insurers charge the obese for their actual expected risk and there is no cost on anybody else. Let the government get out of the business of providing health care and instead get into the business of giving poor people money and mandating that they buy private health insurance with it, and obesity again puts no cost on anybody else. It's perverse to tell people:

"In exchange for forcing you to be part of a public insurance scheme that you might not want, I'm going to set up an apparatus of regulations, subsidies and taxes to force you to behave in ways that reduce the costs on the system that I'm forcing you to join. You're welcome."

Roberts' long causal chain runs directly through deliberate policy choices that work to socialise the costs of individual behaviour. And if we let things run through that mechanism, there is absolutely no end to the range of behaviours that can legitimately be subject to the heavy hand of the state. Remember that STDs cost the government money too.

By contrast, carbon emissions do affect others directly and in a way that's awfully hard to handle through tort. Setting up a clean carbon tax seems the best way of minimizing aggregate rights violations: the tax is an imposition, but so too are the emissions.

When we ditch the rights-talk and stick to economics, we have to look at pecuniary, non-pecuniary, and fiscal externalities. That's likely worth a separate post since it comes up an awful lot and I'd rather like to be able to point to it on its own in future. In short, the economic case for intervening in response to external effects depends not on whether other people are bearing costs but rather on whether there are efficiency consequences.

* There can be a case where the insurer is allowed to do it but it isn't worth the insurer's time and effort. Aggregate losses in this case can't be very large - the insurer doesn't spend much time assessing your risk of paper-cuts for similar reasons. The same holds for other kinds of transactions where there are apparent effects. Airlines have tried to require that very large people purchase two seats to accommodate their girth; some countries have socialised this cost by mandating that airlines give fat people two seats for the price of one; others have banned it as discriminatory. The obese cost you money in higher airfares because the government has forced the airline to make it so.