Ronald Coase tribute

As I am a former University of Chicago Law School professor, who overlapped with Ronald Coase during my eight-year stay there, I was asked a couple of years ago if I would like to join a group of people who would be writing short tributes to Coase, for a volume to be published by the U of C Law School, via the Coase-Sandor Institute for Law and Economics.  Now that the volume has come out, here is my little snippet.

The Coase Theorem and the Two Fundamental Theorems of Welfare Economics

                                                                                                Daniel Shaviro*

Both the Coase Theorem and the two Fundamental Theorems of Welfare Economics are well-known.  Less widely recognized, however, is their close intellectual relationship, which helps us to understand the nature of one of Ronald Coase’s main contributions.

The First Fundamental Theorem of Welfare Economics holds that a competitive equilibrium, where supply equals demand, maximizes social efficiency.[1]  The Second Fundamental Theorem of Welfare Economics holds that society can attain any efficient outcome by suitably redistributing resources among individuals and allowing them to freely trade.[2]

Two different ways of stating the Coase Theorem help to make clear its relationship to each of these propositions.  First, suppose we state it as follows: “When there are well-defined property rights and costless bargaining, the negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.”[3]  This is basically the First Fundamental Theorem, supplemented by the point that all a market requires is well-defined property rights that can cheaply be transferred.

Now suppose we state it as follows: “The efficient solution to an externality does not depend on which party is assigned the property rights, so long as someone is assigned those rights.”[4]  This is basically the Second Fundamental Theorem, again with the added point that distributable “resources” can include property rights with respect to the creation of externalities.

The two Fundamental Theorems of Welfare Economics predate the Coase Theorem by many decades,[5] and surely were well-known to the “room full of skeptical Chicago economists – including future Nobel laureates Milton Friedman and George Stigler”[6] who debated it with Coase on that famous evening when he first presented his reasoning.  What, then, was actually novel about the Coase Theorem?

The answer, I believe, lies in its extending the Welfare Theorems’ range of application.  Rather than applying just to readily observable markets for consumer goods in the field of organized economic production, they can apply wherever their basic underlying assumptions hold.[7]  Coase understood that the right either to engage in or to block polluting activity could be just like ownership of a widget.  And a “market” could be understood as any setting where people have well-defined property rights that they can transfer through low-cost transactions.[8]

Coase was thus a prominent early mover in one of the major developments of the last fifty-odd years in law and related social sciences: the steady expansion of the realm of neoclassical economic reasoning. To be sure, even before Coase, pollution was well-understood to involve “economic activity” that called for an “economic analysis” of government policy responses.  Later decades would see economists ranging considerably further out of their ancestral realm of studying organized economic production.  Consider, for example, Gary Becker’s Treatise on the Family,[9] applying neoclassical economic reasoning to study of the household, or Richard Posner’s The Economics of Justice,[10] taking “an economic approach to issues – including the meaning of justice, the origin of the state, primitive law, retribution, the right of privacy, defamation, racial discrimination, and affirmative action – that are not generally considered economic.”[11]  But Coase was an early mover, important not just for how he advanced the economic analysis of externalities, but also as a pioneer and harbinger of economic reasoning’s broader future.

---

* Wayne Perry Professor of Taxation, NYU Law School.

[1] See, e.g., Jonathan Gruber, Public Finance and Public Policy 50 (4^th ed. 2013).

[2] Id. at 53.

[3] Id. at 130.

[4] Id. at 131.

[5] They were first set forth by Pareto in 1894.  See John S. Chipman, The Fundamental Theorems of Welfare Economics (2002), available on-line at http://www.econ.umn.edu/~jchipman/econ4960/ftwe2_all.pdf .

[6] Sarah Galer, Ronald Coase Still Stirs Debate at 101 (2012), available on-line at http://www.uchicago.edu/features/20120423_coase/.

[7] For example, “[t]o establish the First Theorem, we need to sketch a general equilibrium model of an economy.  Assume all individuals are price takers: none is big enough, or motivated enough, to act like a monopolist.  Assume each individual chooses his consumption bundle to maximize his utility, subject to his budget constraint.  Assume each firm chooses its production vector, or input-output vector, to maximize its profits subject to some production constraint.  Note the presumption of [rationally pursued] self-interest.  An individual cares only about his own utility, which depends on his own consumption.  A firm cares only about its profits.”  Allan M. Feldman, Welfare Economics, in John Eatwell, Murray Milgate, and Peter Newman (eds.), The New Palgrave Dictionary of Economics, 4: 889 (1987).

[8] Coase’s notion of transaction cost can be viewed as underlying the existence of a well-functioning market.

[9] Gary S. Becker, A Treatise on the Family (1981).

[10] Richard A. Posner, The Economics of Justice (1981).

[11] Id. at 1.

NYU Tax Policy Colloquium - another cancellation due to winter weather!

Tomorrow's Tax Policy Colloquium sessions, featuring my colleague David Kamin's paper "In Good Times and Bad: Designing Legislation That Responds to Fiscal Uncertainty," has been cancelled due to the blizzard that is already hitting NYC and thereabouts.

We also had a session cancelled last year due to a winter storm, and a second session was hampered because the author understandably wanted to head back to the airport early - in the middle of the 4 pm session - before yet another another storm might have trapped her in NYC for up to 48 hours.  And we also had a cancellation due to the weather a couple of years before that.

In the first 15-plus years of the NYU Tax Policy Colloquium, we not only never had a weather-based cancellation, but it was never even close.  There may have been about two storms during that whole period that would have been a problem had they hit on the wrong day of the week.

Then there are the two hurricanes we had in NYC in recent years, one of which knocked out electrical power in downtown Manhattan for 6 whole days.  The other one might have done similar damage, except that luckily it peaked at low tide, rather than high tide.

Anecdotal though this may be, I certainly get the impression that climate change is starting to have a personal impact here.

NYU Tax Policy Colloquium, week 1: paper by Brigitte Madrian

Yesterday we had the first session of the 2015 NYU Tax Policy Colloquium.  This is the 20^th time (in 20 straight spring semesters) that I have done the colloquium.  This year, I am happy to be co-leading it with Alan Viard.  (The full roster of people I’ve co-led it with in the past, ranked by how many weeks or years they’ve done it, except that the last two are tied, is David Bradford, Alan Auerbach, Mihir Desai, Bill Gale, Rosanne Altshuler, and Kevin Hassett.)

One sign of institutional health, I suppose, is that we can’t accommodate all of the students who want to enroll.  Luckily from an overall institutional standpoint, the law school ties my hands so that I can’t act in accordance with what would otherwise be my revealed preference of just letting everyone in.  (The problem is that the feel of the class changes for the worse if the class size grows too great.)

Although lots of other tax policy colloquia around the country have followed in our wake – maybe 20 or more, although they may not all be operating at present or in a given year – we still have a unique format, in which the author doesn’t present the paper, but rather a lead commentator focuses the conversation on a couple of main topics, one at a time.  We consult with each other first, then with the author, and then we run the show at 4 pm.

Not having the author present is admittedly a tradeoff.  I personally find the conventional twenty minute presentation upfront to be boring – including, and indeed especially, when I am the author and presenter at someone else’s session – if I have already read the paper carefully (or wrote it).  And not having the presentation induces the audience either to (1) invest more in reading it in advance or (2) not to come.  The key, for it to be a positive strategy, is that there must be enough people out there who choose option (1) rather than option (2).

For me, the tiebreaker against the author presentation is that, if you do that and then follow it up with your own commentary, the audience is just going to be sitting around forever before it gets to participate.  I don’t find that to be either fun or interesting, whether I’m in the audience or at the front.  So in my view, not shared by everyone who runs a tax policy colloquium, skipping the author presentation verges on being a necessary cost of leading and initially directing the discussion, rather than just asking for audience questions.

Anyway, on to yesterday’s session.  The author was Brigitte Madrian, presenting “Does Front-Loading Taxation Increase Savings?  Evidence from Roth 401(k) Introductions.”

While I thought it was a really good session, I don’t comment here about the content of a given session, because that would be inconsistent with our policy that they are off the record.  So here are some thoughts about the paper and the issues it raises, mainly based on expanding my notes for the session (I was in the lead this week).

The paper reports on the findings of a study of 11 firms that initially had just “pre-tax” retirement saving plans under Internal Revenue Code section 401(k), but then added Roth options.

To illustrate how these two types of section 401(k) plans work, suppose that my marginal tax rate is 35 percent at all times.  Suppose I contribute $100 to a pre-tax plan, and withdraw it after retirement once the money has doubled to $200.  I get to deduct the $100 contribution, generating a $35 reduction in my current year tax liability.  Thus, the cost to me is only $65.  Then, when I withdraw the money, it is taxable at 35%, so I end up with $130.

Under Roth, my contributions are not deductible, but the withdrawals are not taxable.  Thus, it turns out to be exactly identical – again, assuming my marginal tax rate is the same at all times, and ignoring various statutory differences between the two types of plan – so long as my nominal contribution – matching my “true” after-tax cost under the pre-tax option - is $65.  Once again, I have $65 less in my pocket up front, but end up with $130 in retirement once the money has doubled.

Suppose that, under a switch to Roth, I still nominally contributed $100, and thus ended up with $200.  I would then have changed the amount of consumption that I am actually from the present to the future.  Absent more to the story, it would violate consistent rational choice for me to contribute the same nominal $100 under pre-tax as under Roth, given that, in the rational choice model, I am aiming for a particular consumption flow, and wouldn’t change this merely due to form if my true opportunity set was the same in both cases.

Anyway, the paper finds evidence that people didn’t reduce their nominal contributions by reason of the firms’ adding Roth to pre-tax employer retirement plans.  The apparent violation of consistent rational choice (unless otherwise explainable) might come as a surprise if not for twenty years of excellent empirical research into retirement savings behavior, much of it by Madrian herself, that finds even greater violations of consistent rational choice regarding even simpler decisions, such as whether or not to save for retirement.  (I discuss this evidence and its broader implications in a recent paper that you can find here.)

I proffered two discussion topics: the paper’s empirical analysis, and the broader policy implications.

1) Empirics.

The paper is based on studies of 11 firms that added a Roth option between 2006 and 2010.  As one would expect given the skill of the researchers, it is normalized for age, salary level, and gender.  It compares people who were hired just before the Roth option was added, to those who were hired 12 months later (and thus at the same time of year) when the Roth option was available.

Suppose marginal tax rates are entirely fixed, even for the future, will be the same for each individual all times, and that there are no relevant differences between the actually available pre-tax and Roth style 401(k) plans.  Then any individual who contributes $X under pre-tax should contribute $X(1 – t) under Roth, where t is that individual’s marginal tax rate.

To know how much employee contributions should drop when a Roth option is made available, we have to know how much they utilize it.  E.g., suppose everyone’s marginal tax rate is 35%, and that given everyone’s hypothesized complete indifference they are simply told which type of plan they were in.  Then contributions should drop by 35% if everyone is put in Roth, 17.5% if it’s half-Roth and half-pretax, and zero if no one uses Roth.

The paper shows that only about 15% of the money that employees were contributing ended up in Roth plans after the option was introduced.  Hence, if we posit that everyone has a marginal tax rate at all times of 33.3%, the expected drop in pretax contributions would only be 5%.

This alone might be small enough for one to worry about losing it amid the statistical noise.  (The authors had only limited data, and published to get the ball rolling in terms of academic study of the issue – they not only acknowledge the need for further research, but very likely will be doing some of that further research themselves.)

Now let’s add the fact that pretax and Roth plans are not entirely identical in practice.  For example, Roth is better if you expect your tax rate at retirement to be higher than it is at the time of contribution.  Optionality – pretax versus Roth – inherently makes retirement saving through the employer plans more attractive (although admittedly this might lead not just to increased true saving via substitution effects, but also reduced true saving via income effects).

Anyway, the bottom line is that one can’t be sure the “rational adjustment” effect would actually show up here in the data.  So while I believe the result, this reflects my priors, as much or more than what we learn from the study.

One bit in support of independently crediting the paper’s finding was that pretax contribution rates did not discernibly differ as between firms which had different levels of Roth utilization.  I would guess the authors’ reason for not highlighting this potentially very helpful point more (although they do mention it) was that the amount of data involved was admittedly limited.

They did apparently find, although not reported in this paper, that peculiar behavior around 2008, when the financial crisis hit and (obviously) may have strongly affected people’s thinking, does not appear to have a measurable effect.

2) Policy implications

(a) Zero long-term budgetary cost – or zero “unintended” long-term budgetary cost? – The paper concludes: “These results raise the possibility that governments may be able to increase after-tax private savings while holding the present value of taxes collected roughly constant by making savings non-deductible up front but tax exempt in retirement, rather than vice versa.”

Just as a quibble, if people make (in real terms) more use of Roth than pre-tax 401(k) plans, because their fixed nominal contributions are equivalent to making what are actually greater tax-adjusted contributions, implies that there might be a positive long-term budgetary cost.  To be sure, this is an “intended” budgetary effect if we think of policymakers as wanting to encourage greater utilization of the retirement savings provisions.

(b) Pre-tax vs. Roth if Congress uses time-limited budget windows. – Because Congress tends to use short-term, rather than infinite horizon, budget windows, Roth saving “looks” cheaper than pre-tax in budgetary terms even if the true  long-term cost is the same.  Both Congress and particular legislators, making supposedly budget-neutral proposals, have not been shy about exploiting this point to engage in bogus “deficit reduction” or “budget neutrality.”  So it is plausible that, even if using Roth in lieu of pretax increased private saving, it might induce increased government dissaving.

(c) Other pre-tax versus Roth issues – The tax benefits for retirement saving under Roth are less truly pre-committed than those under pre-tax.  We can be confident that in, say, 2030, Congress won’t increase particular individuals’ taxes because they got deductions in 2015 from using pre-tax retirement savings plans.  But Roth exemption would effectively remain on the table in 2015 even if Congress didn’t explicitly and directly renege.  An example would be partly or fully replacing the income tax with a VAT or an X-tax (i.e., an individual-level progressive consumption tax that effectively combines a VAT with low-wage subsidies).

This difference could be either good or bad from the standpoint of evaluating Roth.  It makes the tax benefit less credible, but leaves Congress with more discretion.  (Those are basically two different ways, with seemingly opposite normative implications, of saying the same thing.)

One thing I don’t like about Roth style exemption is that it can result in effectively exempting extraordinary returns that people have a limited opportunity to generate.  E.g., Mark Zuckerberg would have done a whole lot better with Roth than pre-tax treatment for his initial investment in Facebook.  This is a real issue when you recall the evidence suggesting that, say, Romney (along with lots of other financial sector insiders) appears to have played games with the IRA contribution limits by grossly undervaluing initially contributed assets.  The answer, when using Roth-style savings rules, is to require that only true arm’s length asset purchases and contributions be permitted.

.

(d) Construing the choice set more broadly – It makes perfect sense for this paper to research pre-tax versus Roth, and then in its conclusion to spell out the main direct implication of its empirical finding.  But obviously policymakers should be thinking in broader terms than just pre-tax versus Roth.  The big items on the agenda today are Social Security, the use of “nudges” such as automatic enrollment in employer plans, and whether to continue using income tax “incentives” to encourage / increase retirement savings.

But note that income tax “incentives,” such as pretax and Roth, actually result in tax-neutral treatment of retirement saving – not in tax-favoring it – if one’s marginal tax rate is the same at all relevant times.  Thus, despite my general admiration for Raj Chetty’s work (with coauthors such as John Friedman) in this area, it makes my teeth ache a bit they describe the income tax rules (for example, here)  as providing “subsidies” for retirement saving.  This is only so (a) relative to an income tax baseline that discourages saving, or (b) when one uses a pre-tax plan and one’s marginal tax rate is lower at retirement than in the year of the contribution (which is, admittedly, likely to be a common scenario).

(e) Income tax vs. consumption tax – As discussed in my article on behavioral economics and retirement saving  a lot of evidence suggests that people have a great deal difficulty with intertemporal choice.  This has important implications for the income tax versus consumption tax policy debate that have not as yet been widely recognized.

Taxing capital gains at death

I'm pleased by the headline item in the tax proposals issued by the White House in connection with tomorrow's State of the Union address: the proposal to tax capital gains at death.

Current law, with its stepped-up basis at death, is  rightly called, by the write-up "perhaps the single largest loophole in the entire individual income tax code."  It means that asset appreciation that accrued during one's life will never be taxed.  (The possible, but today relatively limited, application of the estate tax, is quite different - it applies to value without respect to appreciation.)

Here is a simple hypothetical illustration of why this matters.  Despite my personal fondness for Apple products, I will take the late Steve Jobs as my example.  Suppose - no doubt exaggerating the actual facts, but probably in close relationship to them of Jobs, and even if not for him than for others - that he paid $1 for his initial stake of Apple stock when it was founded, and that the value of this stock appreciated to $1 billion by his death.  The income tax will never reach this enormous gain under stepped-up basis.

What about Jobs' salary from Apple?  With his famous dollar-a-year salary, this wouldn't have done anything either.  But even if Apple had paid him an arm's length salary, rather than effectively compensating him via stock and option appreciation, each dollar of salary it paid him would be includable by him yet deductible by it, leading to zero net tax revenue if their tax rates were the same (as during the long period when the top marginal rate was 35 percent for both individuals and corporations).

What about taxing Apple at the entity level?  In principle, taxing Apple at the corporate level could be a proxy for taxing Jobs as an individual, subject only to the question of whether its marginal tax rate was as high as the rate that one might have wanted to apply to him.  But Apple famously has minimized its tax liabilities through clever international tax planning.

In sum, Jobs' income may never be taxed to any significant degree absent a tax on capital gains at death.  And note that, in this instance, we are talking about labor income that any sensible tax base - including, for example, a well-designed consumption tax - would have reached at some point.  It is not just a question of taxing "capital income."

The tax on capital gains at death really is directed at the top 0.1 percent, especially with the bells and whistles that the White House proposal adds to address political concerns about "small business" and the like.  Note also that, in at least one respect, it actually increases the efficiency of the tax system.  Lock-in, or tax-induced reluctance to sell appreciated assets even if one would otherwise like to do so, is greatly worsened by the tax-free step-up in asset basis at death.  With step-up, selling one's appreciated assets while alive means that one is not merely accelerating a tax that will be due at some point in any event, but incurring a tax liability that would simply go away if one waited.  Hence, it encourages the simple tax planning trick that Ed McCaffery has labeled "buy, borrow, die."  Without step-up, capital gains taxes can achieve a decent tradeoff between revenue raised and distortionary costs from lock-in at a higher rate than is possible today.

The White House fact sheet calls tax-free step-up the "trust fund loophole," which is fair enough although we will see whether or not it catches on.  Obviously, there is not a snowbill on the Sun-facing side of Mercury's chance that the repeal of tax-free step-up will be enacted any time soon, but, if it enters the conversation as a serious reform proposal, this could matter down the road.  And note that sincere progressive consumption tax advocates should recognize that present law's step-up undermines their vision, not just the achievement of more comprehensive income taxation.

Someone has attacked my work!

It was unprovoked, and not on the merits.  Here is the evidence.

The attacker was sharp-clawed Sylvester, the individual on the lower step in this picture.  

From this picture alone, it should be obvious that serene Gary, unlike the crazed Sylvester, would never do such a thing.

Stanford talk on behavioral economics and retirement saving

This past Tuesday, I flew to Stanford Law School for a one-day visit, and presented my paper "Multiple Myopias, Multiple Selves, and the Under-Saving Problem" at Joe Bankman's and Dan Kessler's tax policy colloquium.

My slides, revised from when I presented the paper at the National Tax Association annual meeting last November, are available in pdf form here.

Although I struggled a bit writing this paper, some have told me that it makes a couple of reasonably new contributions to the literature on behavioral economics and retirement saving.  One is to connect the issue about retirement savings "incentives" in the income tax to the fundamental tax reform debate.  For example, I note that if we take the Chetty et al point that "subsidies don't work" in increasing retirement saving, the underlying claim is highly relevant to the relative merits of income and consumption taxation.  The case for income taxation is potentially strengthened if people are relatively oblivious to the deferred taxation of saving.

Second, I talk about the labor supply issues raised by, say, reducing under-savers' take-home pay via "nudges" that cause them to enroll in employer retirement savings plans.  These are at least conceptually important, as they are part of understanding how people make decisions, even if short-term labor supply responsiveness is generally low for the relevant population.

I'm aware of no empirical work on this issue.  As the paper notes, under some of the explanations for under-saving one would expect to have offsetting substitution and income effects, making the research problem more complicated than it would otherwise be (though surely not impossible to address).

I also haven't seen anything discussing the labor supply issues from a theoretical standpoint, with the exception of this article by Louis Kaplow, which helped to inform my own thinking.

The article will be appearing in the Connecticut Law Review sometime this year, as the focus of a symposium issue that will also have three or more papers commenting on it.

One of the questions I was asked at the Stanford session was: What sort of responses have you gotten to the article?  I answered: I've gotten some nice feedback from commenters, and from a few other people to whom I sent it.  But other than that, it was exactly the same as what almost always happens when you post or publish something.  Out it goes, you don't hear much back, and you just go on to your next project, whatever it might be.

2015 NYU Tax Policy Colloquium

We start up in less than two weeks, on January 20 at 4 pm.

Our first two papers, by Brigitte Madrian of the Harvard Kennedy School and David Kamin of NYU are now available through our website. Madrian's paper, "Does Front-Loading Taxation Increase Savings?  Evidence from Roth 401(k) Introductions," is available here.  Kamin's paper, In Good Times and Bad: Designing Legislation That Responds to Fiscal Uncertainty, is available here.

Both should be good sessions and, as we like to do from one week to the next in the colloquium, on wholly different topics.

Both will be followed small-group dinners.  Interested attendees can sign up in advance, and can also get on the regular weekly mailing list for the papers, by contacting me off-line.