Monday, September 24, 2012

Kim Clausing on signaling, tax return disclosure, and toads



Kim Clausing of Reed College, with whom I recently co-authored an article on international taxation, has a short. op-ed style piece on what we should make of Romney's tax return non-disclosure, drawing on an analogy to the behavior of toads, as explicated by the signaling literature. (As it happens, I am a huge herptilophile and would rank toads among my favorite creatures even if they didn't eat noxious pests such as mosquitoes.)

I am happy to present Kim's piece here as a rare guest entry, as follows:



Romney’s Tax Returns and The Economics of Signaling : Why Small Toads Still Croak

by Kimberly Clausing, Reed College

Presidential candidates may well be like rival toads competing for mates.

When toads compete for mates, they face important strategic decisions regarding whether to fight over mates or continue searching. Wanting to take on smaller rivals and avoid larger ones, toads gauge the wisdom of fighting each other in part by hearing each others’ croaks. Deep croaks belong to larger toads since toad vocal cord length is associated with toad size. This raises a puzzle, though, for one might think larger toads would croak and smaller toads would stay quiet, yet most toads tend to croak, whether or not their voice is deep.

The economics of signaling can help explain this puzzle. As soon as the largest toads croak, that gives the next largest toads an incentive to croak since otherwise they’d be assumed to be the average size of the remaining pool of toads. Once somewhat large toads croak, medium sized toads have an incentive to croak lest they be assumed smallish, and the situation unravels until nearly all toads are croaking.

This situation is a useful example of the full disclosure principle at work. As long as some individuals benefit from revealing beneficial characteristics of themselves, others are forced to disclose their less stellar characteristics, lest they be assumed to be a representative member of the remaining pool. Such models of signaling have been used to understand features of labor market search and hiring procedures.

However, for signals to be effective and provide reliable information, they must be costly to fake. That’s why a college degree is a useful way of demonstrating job qualifications, and a croak is a useful way to tell the size of a toad. It is also why people do not rely too much on what a Presidential candidate says they are going to do as a guide to what policies they will actually pursue. Talk of tax cuts is cheap, after all, while Medicare and Social Security are expensive, and there is a budget to be balanced, eventually.

One useful way to gauge a candidate’s stance on tax policy might be to look at their tax returns. These returns demonstrate a host of useful information: How much does the candidate earn, and how might that affect their attitude toward taxes? What is the composition of the candidates income? Is it mostly labor income or mostly capital gains and dividends? How were the candidates finances structured: Did they pay what was due? Did they engage in elaborate schemes to reduce their tax burden? Did they comply with the law?

Candidates for office have long shared many years of tax returns in order to allay citizen concerns and curiosity regarding these questions. Indeed, Candidate Romney’s own father was a pioneer in the practice of releasing many years of tax returns, and Romney asked his Vice-Presidential short-list for ten years of returns. Yet Mitt Romney steadfastly refuses to provide the public with more than two years of tax returns.

How are we to understand this refusal? Does Romney think that his tax returns are so bad that disclosure is really worse than nondisclosure, even knowing that the public must be assuming that there is something unpleasant in there? Analysts have already discussed all sorts of unsavory possibilities, including taking advantage of tax amnesties for fraudulent non-disclosure of offshore income, that Romney actually paid zero income taxes in 2009, or that he engaged in very aggressive tax sheltering. Of course, without the returns, it is impossible to say which theory is correct, or whether some other theory is true, or what the true reason for the nondisclosure may be.

However, there are some hints that come from both the economic theory of signaling and the behavior of toads in the animal kingdom. If Romney is a rational strategist, surely he would release the returns unless he thought there was something in there that was genuinely worse than what we are already assuming. In the case of animal behavior, that would make Romney an awfully small toad.

1 comment:

Calvin Brock said...

As noted in earlier posts, I am a bit reluctant to use the effective tax rate number in discussing Romney's tax returns because of what it leaves out, namely losses and deductions that may have significantly reduced his adjusted gross income in some years. Matawan income Tax Preparation