The Answer Is Transaction Costs

Motives and Morals of Taxes, and an Homage to Bob Barker

• Michael Munger • Season 1 • Episode 17

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There are three reasons to impose taxes, it seems:
1. To discourage behavior "we" don't like
2. To raise revenue for things "we" want 
3.  To achieve a pattern of social justice in the distribution of resources
What does transaction cost analysis have to tell us about all this?
And Bob Barker, and the 99 cent price point.
Have you even read Marx?
And a new letter.
NOTE: This is the last of the regular episodes of Season 1. With the start of the new academic year, TAITC will move to once per month, with longer episodes coming out the last Tuesday of each month. 
APOLOGY: I said "Meltzer and Richards" with an "S", twice. That's wrong. It's just "Richard," no "S."


Links to Resources:

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger of Duke University, the knower of important things Taxes, don't tax. You, don't tax me. Tax that man behind the tree. Also, pricing points and a new twedge, plus this week's letter and more Straight out of Creedmore. This is Tidy C. I thought they'd talk about it in a system where there were no transaction costs. It's an imaginary system. There are always transaction costs when it is costly to transact, institutions matter and it is costly to transact. Last week's letter was on taxes, rk wrote. I'd like to have you expound upon a topic of a recent Tidy C, one of the strongest economic arguments and you might touch on moral, ethical and practical arguments as well for taxing richer people at a higher tax rate. Well, thanks, rk.

Speaker 1:

In March 1932, the magazine Colliers Weekly ran an article titled Tax Everyone but Me and it contained this passage. At the end of the year and again at the opening of 1932, the hotel rooms and lobbies of Washington were crowded and swarming with citizens who had come to play, in paraphrased adult form, an old game of their childhood Congress, congress, don't tax me. Tax that fellow behind the tree. Well, if that sounds like a bunch of people standing in line to try to get benefits and if that sounds like transactions cost to you, that's right. Look, taxes have two purposes Reduce the amount of the thing being taxed or increase the revenue. That and I'm making quote marks we all agree we need to spend on good things. So reduce the amount of things that being taxed is the first purpose. Second purpose is revenue. Now, seriously, that distinction is important. We tax things if we want revenue, in which case we'd prefer not to affect the amount of the thing being done because that introduces distortions. Or we tax things we want to go away, things we hate, and we don't care if there's any revenue at all because we don't like the thing being taxed. People often get confused, but these are quite separate and distinct functions.

Speaker 1:

Now let's think about taxes in terms of fairness. One example is a head tax. Everyone pays the same amount. There's less distortion, we all exist. It's unlikely that you're going to commit suicide to avoid paying a relatively small head tax and we all use services. So a head tax is fair in the sense that we all pay the same amount.

Speaker 1:

Or a sales tax, A tax on consumption If you spend more, you pay more. That's true also of user fees, like gasoline taxes. Gasoline taxes are correlated with the mileage that you drive and the weight of the vehicle. So the more intensively you use the road, the more you pay. A carbon tax would be like that, also proportional to use.

Speaker 1:

Now, third, an income tax or wealth tax. It's proportionate to the thing being taxed. But do we want less income or wealth, or are we using that tax to raise revenue? A while back I talked about TAH, the dumb security dog. Now it's not much more expensive to protect a big house in a nice car than it is to protect a small house in an old car. So there must be a third reason to tax.

Speaker 1:

In addition to wanting less of the thing and wanting more revenue, we're also concerned with relative fairness. To put it simply, should the wealthy pay more, even though it does not cost more, to provide the wealthy the services that are being promised in exchange for the tax? There's three ways to think about tax systems and who's paying. What Regressive systems are where the poor pay a higher proportion of their income, for example, proportional systems or flat tax. Everyone is paying the same proportion of their income. Progressive taxes are taxes where the wealthy pay a higher proportion of their income. They're not just paying more, of course the wealthy are going to pay more. That's true under a flat tax. In a progressive tax, wealthy pay a higher proportion of their income. Now, usually we're concerned about equality before the law.

Speaker 1:

Giving T the state discretion means that there are enormous rent seeking contests to gain control of the unit that exercises discretion. If you can gain control of the Supreme Court, the President or the Congress, you can control the way that that discretion about who to tax is going to be exercised. And that's what all those people in the lobby of the hotel in 1932, as described by Collier magazine, were trying to do. They were trying to annex the discretion that was available to Congress in order not to tax them but to tax that man behind the tree. It's probably better not to have discretion.

Speaker 1:

From a transaction cost perspective, you're better off just having a fixed rule rather than having a constant contest to decide who pays this year. Now, if we charge a head tax, head taxes are equal amounts, so we take the spending and we divide by N and that's your tax bill. You've all done this at a restaurant. Let's just split the bill, says someone. Now. It is an obvious low transaction cost solution to the problem, rather than negotiate or argue over who pays what. But if someone ordered a couple of expensive drinks or dessert and you didn't order those things, it's not fair, since the amounts of the spending may benefit us in different ways.

Speaker 1:

Just to divide the total cost by N or so, many people would say A flat tax. Suppose that everyone pays an equal proportion. Well, if I order twice as much food at the restaurant or I drink twice as much, I should pay twice as much. So I'm going to pay according to how much I use. It's not clear that this applies to taxes, but if I have twice the income, I pay twice as much tax. If I have 10 times as much income, I pay 10 times as much tax.

Speaker 1:

Now the question is, when you look at the American tax system, are the wealthy paying their fair share? Well, if there's a proportional tax and if there are standard deductions for the first 10,000 or so, for example, then the poor are going to pay very little. The middle class are going to pay 10% if that's the flat tax rate, and the wealthy will also pay 10%, but the wealthy pay far more. In fact, much of the total tax bill is going to be paid disproportionately by the wealthy. Now, is that fair? Remember, in a democracy we decide by majority rule or the median voter, the middle voter. If there are some people who have little income and receive public assistance and some very wealthy people, the median income will be much less than the average income. There was a famous paper by Meltzer and Richards in 1981 called A Rational Theory of the Size of Government, where they pointed out that wealth is likely to be concentrated in relatively few hands in most societies. And then in a democracy, it is likely that the median voter is going to prefer redistributive taxation, which puts an upward bias on the size of governments in democracies. So if you ask the median voter, they'll say don't tax, you, don't tax me. Go and tax the wealthy. If you're interested in the problem of the median voter, but you've never heard about it, you might go and read the Munger and Munger book Choosing in Groups, published in 2015 by Cambridge University Press. I'll put a link up to it in the show notes, as well as a link to the Meltzer and Richards paper, which is a very important paper in the history of political economy.

Speaker 1:

So the question is why are we taxing the wealthy? Why do we want to tax the wealthy more? Just saying that the median voter wants to do that because she can is not a very good argument. What's the ethical argument? Are we taxing the wealthy because we want them to have less wealth, because we want less income inequality? That is, we don't like it. Or are we taxing the wealthy because, to paraphrase the famous bank robber Willie Sutton, that's where the money is and we can get more revenue? Now let's be clear. Wealthy people already pay most of the taxes. In the US, the top 1% of income earners pay more than 40% of the total revenue of the federal income tax. The top 10% of income earners pay 75%. Let me say that again the top 10% of income earners pay 75% three-quarters of all the income tax revenue raised by the United States, our government, the income tax at least, is funded mostly by the top 10%. Now, is that the fair share of the top 10%? Should it be more or less, and how would we decide? Remember we have already established that voting empowers the median, and the median voter will always think that someone else the wealthy, the man behind the tree, the man on the 14th tee should pay more.

Speaker 1:

Politics is one gigantic transaction cost problem, because if we use anything other than a fixed rule, we invite a carnival of rent-seeking and special pleading. Now I've spent quite a bit of time in Chile and I often talk about the Chilean political system as an example, because I think it's interesting. The Chilean tax system is very simple. They charge a maximum marginal rate of 40% on what they call the second category tax, which is their name for income tax, and there's essentially no deductions. You can do your taxes on a postcard. It takes about a minute. Your income 40%, check against employer withholding, pay or receive the difference, and you're done.

Speaker 1:

Now in the US, politicians have learned that it's very beneficial to them to use transaction costs to their advantage. They jabber about very high tax rates in order to get credit from the left, but they lard on deductions, exemptions and special privileges so that no one actually pays those high rates. It has been estimated that American citizens pay $150 billion, maybe more, just on tax compliance. It's the ultimate transaction cost problem in order to pay your taxes. That's not the cost of taxes. That's the cost of paying your taxes. The problem is that almost everything you think is a cost politicians perceive as a benefit All those extra taxes, those deductions, which actually net out to nothing. That's a chance to raise campaign funds. Folks. All that extra expense on tax forms, that's an excuse to hire more bureaucrats and to create useless jobs at the big tax and accounting firms. Why would politicians care about prosperity and economic growth? They don't get any of that. But campaign contributions and taxes now those we need more of, because those help me, the politician.

Speaker 1:

The real question is how to think about the wealthy. As I asked before, are we thinking of raising revenue so that we can support the poor? Are we just straight up trying to get rid of concentrations of wealth? There's a famous song from the 1960s called Change the World by the group. 10 years after, it has the line tax the rich, feed the poor till there are no rich no more. If you've heard that song, have you ever thought about that? Shouldn't it be till there are no poor, no more? The problem is that many people on the left want to define wealth as a relative rather than absolute concept, so that means that there will always be poor people as long as there are rich people. The only way to get rid of poverty is to get rid of wealth. What they then are substituting is a concept called equality. They don't care about poverty. What they want to do is tax until there are no rich, no more. Economists tend to think of the major problem of development as being poverty, but for many folks on the left, the major problem is inequality.

Speaker 1:

In the lead-up to the 2008 election, in a democratic debate, candidate Barack Obama was asked if he would raise taxes, even if it meant reducing revenue. Now this question was asked by Charlie Gibson and some analysts have rightly in my view reacted that this was a dumb question. The so-called Laffer curve does demonstrate that for high tax rates certainly those approaching or exceeding 100%, for example cutting taxes may raise revenues, but our tax rates are nowhere near that level. So what that means is, if we raised taxes, it probably would raise revenue. But in any case, the premise of Charlie Gibson's question was suppose that raising taxes actually cut revenues. Would you still want to raise taxes? Barack Obama accepted the premise of the question and he answered quite forcefully and, I guess, to his credit, truthfully it was worth raising taxes on the very wealthy, even if revenues fell, for the purposes of fairness. It's just not fair that there are wealthy people now. This is quite clearly an argument that society should tax the wealthy to have less of that thing like pollution or other negative externalities. The 10 years after song seems to have both motivations. First, we'll tax the rich to feed the poor, that is, we'll use it for revenue. But we'll do it until there are no rich, no more, meaning that great concentrations of wealth alone Are an offense to fairness. Well, thanks again, rk, for that question.

Speaker 1:

I Should note that a great figure of transaction costs passed away this past week. Bob Barker of the price is right. The premise of the show is that you don't know what the correct price is. You see the object, but you don't know what the price is. That is, how much is this worth? I've always thought this was a great metaphor for the problems of socialism, as pointed out by Mises, hayek and others a bunch of people wasting time trying to play the price is right by Guessing it what the correct price should be, rather than using markets to generate it. So you end up with a bunch of bureaucrats guessing instead of doing something productive. But it was hilarious to watch. It was one of my father's favorite show because Bob Barker was quite a host. Further, I have to give Bob Barker credit. To win a prize you had to come as close to guessing the correct price as possible without going over. I'm thinking Bob Barker is up in heaven now being congratulated by all the fans, even though the devil, who is also a fan, is yelling. Bob had always said he wanted to live to be a hundred, but in the end the urge to win the price is right was apparently just too strong. He died at the age of 99. As close as possible, without going over. Bob, you will be missed.

Speaker 1:

This made me also think about why it is that so many prices end with 99. Many stores are going to be discounting their items and changing price tags to end in 0.99 during this coming long weekends Labor day sales, but seeing a price end in this number is so common. Shoppers hardly notice the extremely effective sales tactic. Why is it so effective? Well, the answer is transaction costs. It may seem silly to price items one cent short of a solid dollar, especially when taxes make the overall cost more than a dollar anyway. But that pricing tactic has been around for at least a century. Historians can't pinpoint who actually first tried this trick, but consumer behavior experts can definitely explain why it helps move more goods.

Speaker 1:

Ending a price in 99 is based on a theory that we read from left to right and at least in English American culture that's certainly true. That's why shoppers are more likely to buy a product for 499 than an identical product for $5. And the difference is not the difference that you would expect from a one penny difference in price. You don't see the same difference with 5 or 501. There's a big difference between 499 and $5. The reason is, if you just look quickly you have the mental impression that it costs 4 rather than 5. It takes you cognitively a lot more energy to think about it. Now I think most of us have come around to this some, but subconsciously if it starts with a 4, that just seems a lot cheaper than something starts with a 5, because we read from left to right and first number to the left of the decimal has outsized importance. Additionally, just the 99 alone seems to make an item appear to be on sale because it was priced carefully.

Speaker 1:

Price conscious customers have become conditioned to believe they're getting a good deal if they buy something with a price ending in 99, even if the markdown is minimal or non-existent. In fact, there are some studies that appear to show that a number ending in 99, even if it is larger may result in more sales. That is, I'm more likely to buy something at $22.99 than I am at $22. Now, that's one of those things where you might say studies show and there may be other explanations. But it is interesting how much we seem to pay attention to the fact that someone else might be having a sale. For instance, the clothing stores JCrew and Ralph Lauren typically price regular merchandise in whole dollar amounts and they stick 99 cents endings on discounted items. It's as if there was a big sale sign if they end in 99. So these retailers purposely avoid ending their regular prices in.99 so that consumers won't associate those items with cheap deals. Stores that are trying to project an image of selling underpriced goods will make it a point to end all their items tags regularly and discounted alike in.99. I'm getting a message from beyond. Wow, it's an answer to the question of why stores use 99 cent prices instead of whole dollars. My name is Bob Parker and the answer is transaction costs. Well, thanks, bob, and thanks very much for having given so many of us so much joy for so long. Whoa, that sound means it's time for the twedge.

Speaker 1:

Two economists were sitting around at their favorite nudist colony arguing about socialism. After a while they stood up to go to lunch, but one economist wanted to continue the argument. She said have you even read Marx? The other said of course, but I think it's just these darned wicker chairs. This week's letter is about effective altruism.

Speaker 1:

One issue that your thoughts on transaction cost have helped me make some progress on is Peter Singer's argument in his infamous paper Famine, affluence and Morality. To recall that argument, the centerpiece is a story where Singer, walking past a shallow pond, sees a child drowning in that pond. The intuitive judgment is that Singer or anyone else in this situation ought to and that's morally speaking, ought to wade into the pond to rescue the child from drowning. The argument continues by claiming there's no morally relevant differences between a case where a child is drowning in a pond and you can see it, and the suffering and death of people in other parts of the world, suffering and death we know of, at least in the abstract, but maybe can't see and are in some position to alleviate or prevent. The argument concludes that each of us who has resources and knowledge of the situation in other parts of the world is morally obliged to sacrifice as much as we have to ameliorate that situation up to the margin of sacrificing something morally comparable to the suffering and death we aim to alleviate.

Speaker 1:

In a key passage, singer claims that, from the moral point of view, the development of the world into a global village has made an important, though still unrecognized, difference to our moral situation. Expert observers and supervisors sent out by famine relief organizations or permanently stationed in famine-prone areas can direct our aid almost as effectively as we could get it to someone in our own block or, implicitly, to the child drowning in the pond right in front of us. This passage has always bothered me as being too glib, too easy, but meditating on transaction cost has yielded some conceptual resources to better say what might bother me about the passage. Singer seems to ignore the difference in transaction cost encountered by someone rescuing a child from drowning in a pond and someone donating to what claims to be a Bengali famine relief charity. To my mind, the differences in transaction cost is substantial, but what remains unclear to me is whether the difference in transaction costs make much more difference. I can see how the development of the effective altruist movement, as well as services like GuideStar and Charity Navigator, constitute efforts to reduce the transaction cost of charity.

Speaker 1:

I'm curious to hear your thoughts on this matter. With Best Wishes, aa. Well, thanks for listening. This episode is the last of the first season of TidyC. I won't have time to do a weekly show once classes start, so I'll be doing a slightly longer version with a short interview once a month, the last Tuesday of each month from now through April, and then I'll start up the once a week version again the first Tuesday in May and for the rest of that summer. So I'll be starting up Academic Year Session 1 on Tuesday, september 26,. Four weeks from now We'll work on the puzzle of effective altruism. Have another hilarious twedge and more next month on TidyC.