Tim Harford The Undercover Economist

Articles published in November, 2015

The pillars of tax wisdom

‘The Budget bears not even a passing resemblance to how we economists were taught that taxes should work’

I sometimes feel that seeing the world through the eyes of an economist is like seeing the world through the ears of a bat. We notice a lot that others miss, and we miss a lot that others notice.

The annual rituals of the chancellor’s Budget, and next week’s Autumn Statement — focal points of the British political calendar — are good examples. Tax thresholds are nudged up and down, allowances introduced and withdrawn, and much attention is given to the tax on a pint of beer. None of this performance bears even a passing resemblance to how we economists were taught that taxes should work.

So how would the Budget look if designed by economists? Economists’ ideas about taxation are based on three pillars. The first, developed by Cambridge economist Arthur Pigou in 1920, is that we should tax things that have unpleasant spillover effects on bystanders — “externalities”. The classic example is to tax activities that produce pollution. A few Pigouvian taxes exist in the UK but they are patchy: the tax on petrol is implausibly high, for example, while that on domestic fuel is strangely low.

The second pillar was erected in 1927 by another Cambridge man, Frank Ramsey, shortly before his death at the age of 26. Ramsey showed that taxes should be focused on products that aren’t very responsive to price. This is because a tax on a price-sensitive good will simply destroy demand. The consumer won’t buy the good, the retailer can’t sell the good, and the taxman doesn’t collect any tax. Everyone loses out.

Ramsey’s ideas, too, are patchily implemented. Basic foodstuffs such as rice and bread might look like excellent candidates for high taxes in the pages of a learned journal but less so on the front page of a newspaper.

The third pillar was unveiled in 1971 by James Mirrlees — now a Nobel laureate — who tried to figure out what could be said about optimal income taxation. One of his conclusions, surprising to him as much as anyone else, was that an optimal income tax might impose flat or even falling marginal tax rates.

This counter-intuitive idea requires us to see the difference between the marginal rate of tax — the headline rate, paid on each extra pound earned — and the average rate of tax that an individual pays. The two can be very different: if everyone pays a marginal tax rate at 50 per cent, with a £10,000 allowance, then someone with an income of £10,000 pays no tax; an income of £20,000 will attract a 25 per cent average rate; an income of £1m will attract a 49.5 per cent average rate. Yet while the tax burden is progressive, everyone must give half of any extra earnings to the taxman.

Why did Mirrlees argue that the best marginal rate might be falling or flat, as in the example above? The answer is that high marginal rates on top incomes are almost a pure discouragement for the rich to earn money. But high marginal rates on lower incomes will raise money from lots of people, without discouraging work. If you earn £40,000 and the chancellor raises income tax in the £20K to £30K band, that should encourage you to work harder.

This isn’t conclusive proof that marginal tax rates should fall rather than rise — there are lots of other factors at play — but it was a surprising and powerful argument, and one of the few that politicians did seem to absorb.

These three pillars have been standing for a while. So what’s new in the economics of taxation?

. . .

One answer: better data. The next generation of economists, people such as Raj Chetty and Amy Finkelstein, are drawing on data that the likes of Pigou and Ramsey could hardly have imagined. As a result they are able to blend ideas from mainstream economic theory with the psychological insights beloved of behavioural economists. It’s a pragmatic approach, depending on the problem at hand and what the data tell us.

A few years ago, Finkelstein looked at what happens when tollbooths offer electronic toll collection, allowing drivers to breeze through without fiddling for change. She found persuasive evidence that the electronic toll weighed less heavily in people’s minds — they forgot exactly what the price was and began to ignore it. Toll collectors, quite rationally, respond by raising the toll.

More recently, Chetty and co-authors tried to estimate whether the earned income tax credit (EITC) in the United States, a work-related subsidy paid to parents, encouraged people to work more. With a truly mind-boggling dataset boasting 78 million taxpayers and 1.1 billion income statements, they found that the EITC can work very well — if people know about it. In areas with lots of claimants, new parents tended to be well-informed and to respond to the EITC. In other areas, the EITC was not widely understood, and it was less effective.

Perhaps this new data-driven, psychologically realistic approach to tax will win political support. After all, Finkelstein discovered a tax that works best when concealed, while Chetty found a benefit payment that works best when widely trumpeted. Boasting about the good news and hiding the bad? That is the kind of economic theory that any politician can love.

Written for and first published at ft.com.

Nothing to fear but fear itself?

‘It is not clear that the US economy has suffered much from terrorism, even from the enormity of 9/11’

This article was published before the November 13 terrorist attacks in Paris.

On a long-haul flight recently, I was jerked from the usual concerns over legroom and a power socket by a memory. I recalled the flight I had taken a few weeks after watching the Twin Towers of the World Trade Center collapse on television. It was an eerily quiet journey from London to Cape Town. I was in a state of mortal fear. But despite occasional grim reminders that terrorists can kill, my dread then seems foolish to me now.

Every violent death is an awful thing but there are many other ways to die a violent death, even in a rich country. Each year, one in 8,000 Americans kill themselves — and each year an American citizen has a one in 9,000 chance of dying in a motor vehicle accident, and a one in 20,000 chance of being a victim of murder or manslaughter. Even in 2001, the chance of an American being killed by a terrorist was less than one in 100,000. In more typical years the figure is one in 10 million. For Americans, terrorists are about as dangerous as lightning strikes.

These dry statistics do not diminish the anguish of those who have lost a loved one to a terrorist attack. Terrorism is no trivial thing; but losing a daughter to suicide or a son in a motorcycle accident is not trivial either, and it is something many more people must endure.

There are other costs to terrorism, deftly surveyed in Alan Krueger’s 2007 book, What Makes a Terrorist. In 2003, economists Alberto Abadie and Javier Gardeazabal published an estimate of what Eta’s terrorist campaign — which at the time had killed 800 people — might be doing to the economy of the Basque Country. Abadie and Gardeazabal estimated that the attacks had, over time, reduced the gross domestic product of the region by 10 per cent. A year later, Zvi Eckstein and Daniel Tsiddon applied a different method to a different country — Israel — but produced the same estimate of the costs: GDP down by 10 per cent because of terrorist attacks. If correct, these are very large costs. (Even the suspicion of an attack on a Russian passenger plane over Egypt — still unconfirmed as I write — is damaging the tourism industry in Sharm el-Sheikh.)

But it is less clear that the US economy has suffered much from terrorism, even from the enormity of 9/11. Official estimates were that the attack on Manhattan destroyed more than $13bn of office space and damaged almost $17bn more. Perhaps 75,000-100,000 jobs were lost in the immediate wake of the attack, particularly in travel and tourism. Yet the received wisdom — summarised in a 2005 book, Resilient City — is that New York bounced back rapidly, recovering the obvious economic losses within about a year. Rebuilding physical infrastructure took longer but in a city such as New York, buildings are demolished and replaced all the time. In the interim, people squeezed into tighter spaces, or companies rented space in suddenly empty hotels while things were sorted out. New York adapted.

This is encouraging and should not be entirely surprising. Natural disasters such as earthquakes can do far more damage, and economies recover from them, too. The classic study here is economist George Horwich’s analysis of the impact of the earthquake that devastated Kobe, Japan, in 1995. The earthquake destroyed 100,000 homes and made 300,000 people homeless. Yet 15 months after the disaster, Kobe’s manufacturing output was back to 98 per cent of pre-quake levels.

The recovery was not complete: there was no serious effort to resurrect industries that were already under pressure from foreign competition, such as the plastic shoe business. But many of the industries that were flourishing before the disaster were flourishing again in time.

Perhaps the true impact of terrorism is psychological — the clue is in the name. A few months after 9/11, a small plane flew into the Pirelli Tower in Milan. The news that this was not a terrorist attack provoked widespread relief. That relief (which I shared) is strange. The Pirelli crash killed three people; knowing that the crash was an accident does not make them any less dead. But it makes their deaths less unsettling.

. . .

There have been attempts to measure the psychological impact of terrorism. One plausible finding, from a team led by psychologist Roxane Cohen Silver, is that 60 per cent of Americans suffered some symptoms of anxiety in the weeks immediately following the 9/11 attacks — but that figure soon ebbed to 30 per cent within two months and 10 per cent within half a year. The attack seems to have had the same effect on the American psyche as it did on the New York economy: a severe but transitory impact.

Despite all the evidence that even the most grotesque acts of terrorism have a transitory effect, it remains a popular tactic. The reason for that is perhaps best summarised in Eric Frank Russell’s 1957 novel, Wasp, about a terrorist. The title refers to the tale of a tiny wasp, armed with a sting it does not even use, causing the deaths of four people. They’re in a car; the driver, agitated by the wasp, crashes and kills them all.

The terrorists’ best hope lies in provoking an overreaction. Too often, they succeed.

Written for and first published at ft.com.

When wishful thinking becomes wasteful

‘The simplest explanation for lengthy disputes? That people misperceive their chances of winning’

From a purely rational perspective, costly arguments are puzzling. A divorce case that goes to court, an industrial dispute that leads to a strike, even the extreme case of a war — all these things are, to put it in the mildest possible terms, a waste.

Of course, there will always be conflicts — but logical people should resolve them quickly. Consider a simplified model of this process. Two people, Amy and Ben, are arguing over how to divide a baked Alaska, the centre of which is gradually melting. First Amy makes an offer. Ben may accept it or propose a counter-offer. Amy, in turn, may accept that or make a counter-counter-offer. Each time an offer is rejected, the delicious dessert shrinks by 10 per cent. Amy and Ben have opposing interests because each would prefer to have the entire dessert to eat alone. But they also have one thing that they can agree on: given the situation, both would be wise to shake hands on a deal promptly and start eating.

A similar logic suggests that an industrial dispute should never lead to a strike. Instead, employers and unions should see that a strike will cost them both dearly, and find some way to resolve their differences. Civil litigants should always agree a settlement before having to go through costly legal proceedings. Often, this is what happens — but not always. Why?

Economists have a few ideas. One cynical suggestion is that some people are playing a different game. Perhaps a belligerent politician or union leader would find his or her position strengthened by a strike. A general might desire a war. Lawyers might profit from urging their clients to go to court.

Another possibility is that people need to signal their willingness to fight in battle after battle. Imagine a large company is being sued by a small competitor for some transgression. If it settles out of court, other competitors will scent blood and dart in like piranhas, so it fights a costly case to scare other would-be litigants away.

But the simplest explanation is that people misperceive what is fair and also their chances of winning.

Consider that melting baked Alaska again. The obvious division is a 50/50 split, and in laboratory experiments that is usually what Amy and Ben will agree, and quickly. (The sophisticated equilibrium of this game is not quite 50/50 because Amy has the advantage of moving first, but it’s close.) But what if the disagreement was more complex? For example, what if Amy preferred the meringue topping, which was not melting, and Bob preferred the ice-cream centre, which was? This complication introduces doubt as to what the intuitive split should be. Ben may still see 50/50 as the logical split, while Amy may feel that she is in a stronger position and should get more. Each side may believe that the division that happens to suit them is objectively fairer — a self-serving bias. And indeed, in laboratory experiments players usually fail to reach a swift agreement in such circumstances.

In a more realistic setting, such as an industrial dispute or a legal case, there will typically be several ways of seeing the problem and several different settlements that could be justified as fair. When the disputants fixate on different settlements, agreement may be derailed.

To test this idea, Linda Babcock and George Loewenstein, behavioural economists at Carnegie Mellon University, once asked experimental subjects to ponder the facts of a real tort case from Texas. A motorcyclist had been injured after a collision with a car and sued the driver of that car for $100,000. The subjects were randomly given the role of the motorcyclist or the driver and asked to role-play negotiating a pretrial settlement, to proceed to court if no settlement could be agreed. The experimental pay-offs mimicked the structure of the real case, including a reward for reaching a pretrial deal.

The subjects were also asked to make a guess as to what damages the judge awarded in the real case — with a cash bonus if their guess was accurate. Despite this bonus for accuracy, the “motorcyclists” guessed that the judge had awarded almost $15,000 more than the “drivers” guessed. Their entire view of the case had been biased by their own self-interest. No wonder that plaintiffs and defendants sometimes fail to reach a settlement.

Wasteful conflicts may also occur because of wishful thinking about the outcome. Strikers may assume that an employer will soon cave in to pressure. Litigants may overrate the strength of their case and the competence of their lawyer.

A few years ago, Guy Mayraz, who is now a behavioural economist at the University of Melbourne, conducted a test of wishful thinking. He divided experimental subjects into “farmers”, who benefited from high wheat prices, and “bakers”, who profited when wheat was cheap. Then he showed them historical charts of wheat prices and asked them to make forecasts. Mayraz paid a bonus for accuracy, yet the farmers systematically predicted higher prices than the bakers. This is wishful thinking in its purest form. Whether engaged in a tough negotiation, or simply trying to predict the future, we find it hard to distinguish between what is true, and what we wish was true.

Written for and first publiched at ft.com.

AIB Award for Radio Journalism 2015

I’ve just been told that the BBC World Service has won this year’s Association for International Broadcasting Radio Journalism award for its coverage of the Ebola outbreak in West Africa. A live special I presented with Solomon Mugera, featuring Hans Rosling and Margaret Lamunu and produced by Ruth Alexander, was singled out for praise. The World Service richly deserves the award and I’m delighted to have made a contribution.

7th of November, 2015MarginaliaComments off

The robot takeover: not so fast . . . 

‘It is one thing to imagine such a future . . . It is another to have confidence that it is approaching’

Are we nearing a dramatic moment in economic history? Before humans developed agriculture, the world population — and thus the world economy — doubled in size roughly every 250,000 years. After acquiring the power of agriculture, the world economy doubled in size roughly every 900 years. After the industrial revolution, growth accelerated again, and since the second world war the world economy has been doubling in size roughly every 15 years. These numbers have been collated by Robin Hanson, an economist at George Mason University in Virginia; they are based on educated guesses by various economic historians.

If another step change of a similar scale were to happen, the world economy would double in size between now and Christmas. That is hard to imagine but, before the industrial revolution happened, it too would have been hard to imagine. And a small band of believers, not short on imagination, look forward to an economic “singularity”. Hanson is one of them, and the computer scientist Ray Kurzweil, author of The Singularity Is Near, is perhaps the most famous.

The singularity would be a point at which, rather than humans developing new technologies, the new technologies developed themselves. They would do so at a rate far beyond our comprehension. After the singularity, our civilisation would be in the hands of cyborgs, or brains uploaded into the cloud, or genetically enhanced superbeings, or something else able to make itself smarter at a tremendous rate. The future economy might consist of rapid interactions between artificial intelligences. The idea that it might double in size every few weeks no longer seems quite so unimaginable.

But it is one thing to imagine such a future. It is another thing to have confidence that it is approaching. Many economists point out that productivity growth has been sluggish for a long time, which hardly seems to be a precursor to a transformative economic take-off. Growth in advanced economies, far from accelerating, seems to require extraordinary stimulus to prevent it from stopping altogether. Other economists are more bullish, reminding us of a basic fact about the rapid exponential growth in computing power: if it continues, then by definition growth in the future will dwarf growth in the past.

Recently, the economist William Nordhaus published a research paper that aims to adjudicate on this debate. Nordhaus proposes a series of tests that we could use to spot an imminent singularity, looking for evidence that either the productive forces of the economy, or the goods that we enjoy consuming, are being transformed by computing.

Nordhaus’s first test is on the demand side. Is it likely that singularity-prone products such as games, films and computers will eventually absorb most of our spending?

So far, the answer seems to be no. The proportion of spending on such products is falling because their price is collapsing. If this trend continues, limitless digital goods will be the intricate icing on a stodgy economic cake. Our economy will move at the pace of the slowest sectors, and we will be chained to productivity improvements in mundane products such as food, shelter and transportation. After all, we cannot eat smartphone apps.

Perhaps, instead, computing will revolutionise how we produce these mundane products. An obvious second test, then, is to ask whether US productivity is accelerating. It isn’t.

Other tests look at the importance of investment goods in the economy. If the singularity is approaching, one might expect them to become very cheap and to dominate economic output. Are the average prices of investment goods — which include computers and software but also buildings and machinery — falling relative to wages at an accelerating rate? The answer, again, is no. What about the stock of capital relative to US economic output — is it rapidly rising? No.

So far there is not much sign of a singularity in the data. But a couple of tests do point in that direction. For example, the share of US national income accruing to capital rather than labour is increasing, albeit at a modest pace. That is what one might expect as the robots march into human affairs. And within the capital stock, the share of information assets such as software and intellectual property is increasing, although it is still only 6 or 7 per cent of the total. Nordhaus argues that these two tests suggest a singularity is many decades away; his other tests all point in the wrong direction entirely.

At this point the pro-singularity crowd might complain that conventional economic statistics do a poor job of measuring some of the new products and services. A mobile phone, for example, comes bundled with dozens of free products — a flashlight, satnav, an alarm clock and much more.

All this Nordhaus acknowledges — he is, it so happens, one of the world’s leading authorities on measuring the value of goods that conventional statistics miss. He ponders various back-of-the-envelope measures — for example, the amount of time that people spend consuming digital goods such as email. But none of these efforts suggests anything transformative yet.

Perhaps this is complacency. In the movies, the robot takeover tends to be rather sudden. Perhaps cyborgs have kidnapped the real Nordhaus and are using his name to spread disinformation. It is more likely, though, that the singularity is not near.

Written for and first published at ft.com.