Simple Truths

One of the useful things about theories and laws–in the sense of scientific method–is that they provide some very simple insight into the way things are. They are not based on wishful thinking or faith. Hypotheses grow up to be theories only with rigorous testing by many many great minds who consistently recreate similar truths in similar circumstances.

Once the theory becomes established, it can be used for many purposes and insights. In economics, we use these things for predictions and policy insights. We know that a given outcome will–with extremely high probability–recur given the same circumstances. There are laws of demand and supply. There are theories on elasticities of supply and demand given prices or income. We have a fairly good catalog of theories that we teach and we make doctoral students reprove over and over again so they too, can establish that insight and make predictions.

Established theories are basically things that are ‘no brainers’ in any field. One such set of theories in economics deals with taxes and subsidies. You tax something, you see less of that thing because it adds cost and dampens both supply and demand for the taxed thing. You subsidize it, you get more demand and more supply because it lowers the cost. As a matter of theory, when you really subsidize something, you generally end up warping the incentives for production and consumption of that good so badly that not only does that market become pretty dysfunctional, but it tends to spread to other markets because it transfers scarce resources–better put to other uses– from some markets to the subsidized market.

In some cases, we purposely warp a market with taxes for policy purposes. This is the case with so-called sin taxes. There is a reason that cigarettes are taxed to the point that the pricing point of a pack of cigarettes approaches the cost of a CD of music or a ticket to a movie. That’s because the government wants to discourage entry to the market to teen smokers. Prices (after tax) of cigarettes typically rival things teens do. These include going to movies or buying music. It forces the teen who might become a smoker into a choice and hopefully, a good one that includes not smoking. In this case, the disincentive is the policy choice. We often subsidize things too like public transportation or public education. This is because we’d see less of them and less public benefit if they were priced to the market or priced to the cost of producing the good. When you study microeconomics which is the study of individual choices within individual markets, you study externalities.

Generally speaking, a good policy will subsidize a good or service with positive externalities and tax a good or service with bad externalities. We usually call these “spill over” costs or benefits because the cost or the benefit of the activity spills over to the public. If a business can’t realize the benefit in terms of profit, the business won’t provide the service or good. If the business can pass the cost of an activity or service on to the public, it will.

Subsidies should only go to places where there are positive spillovers. Taxes should be applied to places where there are negative spillovers. It is not considered a good idea for taxpayers to subsidize harmful activities in economic theory. We have finally lowered our subsidies to the tobacco industry because it’s good policy. The taxpayer shouldn’t be incentivizing a public health issue that they will have to pay for on both ends. First, in the subsidy to the business, and second to the costs of tremendous health problems created by the users. People who benefit neither from growing tobacco, making cigarettes or smoking, shouldn’t be asked to pay all the spill over costs that come from that activity.

This is why subsidies to Oil Companies baffle many of us.

There’s a really good article today in the NYT on the billions of dollars provided by the U.S. Taxpayer to Oil Companies. My students will be reading this shortly, believe me, because it’s a great example of really bad public policy. Among the things that the article mentions is that the drilling rig, The Deepwater Horizon, “was flying the flag of the Marshall Islands. Registering there allowed the rig’s owner to significantly reduce its American taxes”. Transocean basically shopped corporate ownership to several countries to avoid tax liability. But wait, it gets worse.

At the same time, BP was reaping sizable tax benefits from leasing the rig. According to a letter sent in June to the Senate Finance Committee, the company used a tax break for the oil industry to write off 70 percent of the rent for Deepwater Horizon — a deduction of more than $225,000 a day since the lease began.

With federal officials now considering a new tax on petroleum production to pay for the cleanup, the industry is fighting the measure, warning that it will lead to job losses and higher gasoline prices, as well as an increased dependence on foreign oil.

But an examination of the American tax code indicates that oil production is among the most heavily subsidized businesses, with tax breaks available at virtually every stage of the exploration and extraction process.

According to the most recent study by the Congressional Budget Office, released in 2005, capital investments like oil field leases and drilling equipment are taxed at an effective rate of 9 percent, significantly lower than the overall rate of 25 percent for businesses in general and lower than virtually any other industry.

And for many small and midsize oil companies, the tax on capital investments is so low that it is more than eliminated by var-ious credits. These companies’ returns on those investments are often higher after taxes than before.

“The flow of revenues to oil companies is like the gusher at the bottom of the Gulf of Mexico: heavy and constant,” said Senator Robert Menendez, Democrat of New Jersey, who has worked alongside the Obama administration on a bill that would cut $20 billion in oil industry tax breaks over the next decade. “There is no reason for these corporations to shortchange the American taxpayer.”

Yes, that’s right. President Obama with his green agenda is working on a bill that CUTS $20 billlion in more tax breaks to this industry. But don’t get me started on their ethanol subsidies, it’s the same damned deal. Take food away from being used as food and use it as an additive to fossil fuels. This, too, is bad policy. (To read more on that you may want to check out this link at The Oregonian.)

THIS is what passes as “free market” capitalism these days. Tax payers pay in their tax bills for these horrendous subsidies, then they take it at the pumps too. (In the case of ethanol subsidies, we’ll also take it at the grocery store.) Republicans are much worse. They have no idea that what they are doing is not capitalism. It’s basically encouraging monopolies and monopoly profits as well as distorting resource markets.

Ethanol subsidies, oil drilling incentives, government insurance and loan guarantees for nuclear energy, natural gas subsidies: These proposals tend to have as many or more Republican advocates as Democratic advocates. Even worse, self-described free-market conservatives often rally for energy subsidies and claim it’s not a deviation from their principles.

Today, at the liberal environmentalist website Grist, blogger Dave Roberts takes to task Newt Gingrich. Roberts, with whom I often spar on the Interwebs, has a great (and depressing) argument and analysis of Gingrich’s defense of current energy subsidies and proposal for even more energy subsidies. This is the heart of the argument:

Gingrich and his acolyte defend these subsidies. Why? Says Gingrich, “a low-cost energy regime is essential to our country.”… Fossil-fuel subsidies don’t reduce costs, they shift costs. The burden is moved from energy companies to the public. The result is what we have today: energy that looks cheap because most of its costs are hidden from view.

Even during times of obscene profits (which are pretty much guaranteed by subsidies in a good where the market demand isn’t very sensitive to price changes), we still subsidize these business. Here’s the link to The Grist which basically outs Ginrich as being anything but a capitalist. This is more like the old mercantilism of the past where the king and queen choose a particular company to be blessed with a monopoly and give them some start up funds to go and rape a colony of its natural resources. Think East India Tea Company and the colonies here pre-Revolution. For years, our tax funds have gone to big oil, big finance, and big defense contractors. Lincoln warned of it. Eisenhower warned about it. Teddy Roosevelt and Sherman did something about.

So, here we are again with companies that feed at the public trough while behaving in a way that has nothing to do with public interest. This is no surprise to any economist. We know that the only things corporations are about are maximizing profits and minimizing costs any way they can. They’ll do it by abusing any resource they can, IF we let them get away with it. That’s why there is still slavery, pollution, strip mining, blood diamonds, and for all intents and purposes, wars in places that sit on oceans of oil.

Politicians are all about maximizing their chances of getting re-elected. If they can’t do that, then they maximize their wealth and their after politics career possibilities. This is where we come in. They will continue to do whatever they want to as long as our vote is no longer a check and balance on those behaviors. We have a responsibility to throw the bums out that do this to us.

So, carrots and sticks are important to economic theory and political theory. We know this. The problem is what are going to do about it?

2 Comments on “Simple Truths”

  1. Again, another great piece. I had read the NYT article this morning and posted it to my Facebook page. Glad you latched onto it too.

    Regarding subsidies, I wish you had thrown Pharma in as well. A lot of the R&D for drugs is funded through NIH – which is funded by tax dollars. That cuts Pharma’s costs to bring a drug to market, yet the consumer (taxpayer) has to pay elevated costs for the New drug. We pay for it twice. Then there are subsidies to the “meat” industry, primarily ranchers who graze their cattle on public lands and pay about $2 a head for the privilege. They fence off the water on the public lands, reserving it for their cattle, and keeping out native species, many of whom die because there is no water for them to drink. These subsidies make the price of meat so low that the demand has increased astronomically. And, on feedlots and other factory farms, the animals consume half the corn grown in the US. Between ethanol production and food for factory farmed animals, that doesn’t leave much for human consumption.

    • dakinikat says:

      Just read an article that’s posted on Naked capitalism about Pharma’s subsidies because they need to do R&D. You may want to check it out Connie!