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I’m guessing many of you are familiar with the trolley problem:
The problem is interesting because there is an objectively “right” answer- absent specific circumstances, one dead person is better than five dead people- but psychology, philosophy, ethics, etc. bring in a whole host of other considerations having to do with intention, fate, and so on. Such considerations result in a problem without a correct answer, and these considerations can’t (and probably shouldn’t) be ignored in a society of human beings and not robots.
Because of this unexpected complexity, the trolley problem has spawned a number of extensions, ranging from the even more nerdy…
…to the snarky and political:
There’s even what I will call the economist version, which incorporates opportunity cost/cost of effort as well as a few other factors…
In any case, we seem to be pretty familiar with the “clear efficient answer under some basic assumptions, but fairness and ethical considerations make things complicated” concept. So allow me to present a more accurate economic version of the trolley problem:
You are currently looking at a crisis area. The status quo is that there is a large shortage of Uber drivers to get people out of the area. Do you 1. Do nothing, or 2. Implement surge pricing?
I think this is a situation that we’ve seen before a number of times. Allow me to explain the similarities to the trolley problem:
“Clear Efficient Answer Under Some Basic Assumptions”
Surge pricing is the obvious answer here, under two assumptions: first, that surge pricing gets more drivers to the area, and second, that how much a person is willing to pay for an Uber is an accurate proxy for how important it is to them. Under these assumptions, shortages are smaller (or nonexistent) under surge pricing than they would be otherwise, and cars go to those who need/want them the most. (In case you’re curious, the first assumption seems to have empirical support even though surge pricing doesn’t appear to always get more drivers on the road overall.)
“But Fairness and Ethical Considerations Make Things Complicated”
I can’t really tell you what’s fair- that’s kind of the deal with value judgments- so I will instead report some common themes that I’ve come across. One is that people should have at least a chance to get an item at the “regular” price, and some people view random rationing as more ethical than price-based rationing when extenuating circumstances are present. (I wonder how this would change if pricing were framed as regular prices and discounts rather than surge pricing.) Another is that willingness to pay is a better proxy for wealth than need/want, in which case surge pricing unfairly rations items to rich people. (This may be true in cases of extreme income inequality, but shouldn’t be the case in a market with more uniformly distributed resources, so this view is somewhat of a fact/opinion hybrid.) Yet another that hadn’t even occurred to me (thanks Internet!) is that it’s unethical to use the promise of money to get largely low-income individuals (the Uber drivers) to take on risk of bodily harm, especially when said risk is incurred during the service of higher-income individuals. (See last point, and note that this is the same logic used to justify outlawing kidney donations and such.) Yet another is what Russ Roberts says. You’ll notice that all of the fairness arguments presented except the last one are against surge pricing.
My point in bringing this up isn’t to have a discussion on fairness or convince you of anything in this regard- like I said, you’re more than welcome to subscribe to one of these viewpoints or come up with your own. My point, instead, is to highlight the role that economics can play in conversations about what is best for society. To that end, here are a few points to keep in mind:
I guess I could do something similar for economists:
Okay? Great- now let’s go have some thoughtful policy discussions.
Technically, “constant returns to scale” describes a production process where you get exactly twice as much stuff out if you put twice as much stuff in. Economists often argue that at least constant returns to scale should be achievable since, worst case scenario, you could just build a second identical factory next to the first one. As such, I want economic instructors to start using this as their example of constant returns to scale.
Alternatively, you could examine the economics of chocolate more directly. Mmmmmmmmm…
Technically, I’m cheating with the “causal Friday” title, since, while regressions do identify associations that exist when controlling for other variables, these associations aren’t always of the causal variety. (This is particularly true when not all relevant factors can be controlled for.) But I choose to not be too persnickety because I think the comic is funny and wanted to share it.
Okay, you should have known better than to believe that I was going to avoid “too persnickety.” Personally, I won’t decide whether I am suspicious of the linear regression until someone tells me whether the slope is statistically significant. Also, if there are multiple explanatory variables that affect an outcome, a scatter plot that only looks at one of them at a time will generally looks like a mess even when all of the variables are individually important. In related news, this is a good opportunity to talk about the distinction between estimated effects (i.e. regression coefficients) and R-squared. (Don’t stop reading if you aren’t super into econometrics, I promise to make this make sense.)
Let’s say an economist is trying to model how much coffee I drink. (In reality, this is not necessary- the regression would just have a really big constant term, but go with me here.) Unfortunately, the only data available to use as an explanatory variable is income. Obviously, there are a lot more factors that affect my coffee consumption than just my income, so it shouldn’t surprise you that if I were to plot coffee consumption as a function of income (where each data point is a month of time, let’s say) I would get something that looks like the scatter plot above.
Let’s say that I’m measuring my income in hundreds of dollars and the estimated slope of the regression line is 0.01. This means that, on average, each hundred dollar increase in income is associated with 0.01 more coffees per month. If the numbers show that this estimate is statistically significant, then it’s pretty unlikely that this association exists in the data by random chance. Let’s also say that the R-squared of the regression is 0.06, like in the picture. This means that changes in my income only explain 6 percent of the variation in my coffee consumption.
My point is that these two conclusions aren’t in conflict with one another- it’s entirely possible for a relationship to both be statistically significant and for it to explain only a small fraction of what is going on. (This happens a lot in finance, actually, and an R-squared of 0.06 wouldn’t generally be seen as a red flag just because there is so much unexplainable noise in the data.) Sure, the result would be more impressive with a higher R-squared, but it’s largely a matter of personal judgment whether explaining, say, 6 percent of a phenomenon is worth talking about. (Not gonna lie- some economics journals vote no on this question.)
That said, I do recommend watching out for a red flag of a slightly different sort- one of the conditions in order for a regression to be valid is that your explanatory variables are uncorrelated with all the relevant stuff that you aren’t controlling for (your error term, in technical terms). In the case of my coffee regression, my result is valid only if my income isn’t correlated with whatever else could be causing variation in my coffee consumption (hours worked, for example). I can tell you personally that that is a lot of stuff.
I’m now tempted to perform a neural net analysis of my coffee consumption in order to see if I could get Rexthor out of it.
— Justin Sandefur (@JustinSandefur) August 25, 2016
Well played, sir. =P
Tired of the disposition effect yet? This one’s short, I promise- just shows how the incentives for tax-motivated selling of losing stocks change over the year and cloud the disposition effect test statistics.
As usual, you can see the whole behavioral economics playlist here in case you want to catch up or need a review.
So here’s a decent and concise overview of the latest issue to be taking over the internet:
|Have a peanut allergy? Chance are you’re about to spend a lot more on EpiPens
by Emma Hinchliffe
Over the past few weeks, EpiPens have slowly overtaken the news. So what is going on with them exactly?
I feel like we’ve talked about this before as it relates to this guy, who apparently has some feelings about economists:
@jodiecongirl lol economics professors lmao
— Martin Shkreli (@MartinShkreli) July 22, 2016
I don’t think he understands that economists are one of the groups likely most sympathetic to his ideals of profit maximization. Anyway, the general narrative is “company buys product, decides to make money from product, raises price of product,” and I would like to proceed by addressing one of Senator Sanders’ specific points:
There's no reason an EpiPen, which costs Mylan just a few dollars to make, should cost families more than $600. https://t.co/rVWUlMxD0Q
— Bernie Sanders (@SenSanders) August 18, 2016
This is where I point out that just because someone doesn’t like the reason doesn’t mean that the reason doesn’t exist. (As you’ll see in a bit, however, I pretty much agree with the spirit of what Sanders is saying.) In this case, the reason is some combination of inelastic demand and monopoly power– if consumers aren’t price sensitive (in this case because the product is a necessity) and they don’t perceive substitutes as being available (in this case one technically exists but often isn’t viewed as an acceptable substitute, so forgive me for not opining on the evils of patent protection at the moment), a producer can increase profit by increasing price. Sure, it will usually lose some customers, but the additional profit from customers that remain will more than make up for it. (In fact, the Lerner Index shows that markup over cost is inversely related to price elasticity of demand.)
Now, Bernie’s a smart guy, so I’m pretty sure that he knows this. He probably also knows that, even when producers are always maximizing profit, not all price increases are a result of cost increases. They could be the result of cost increases, but they also could be the result of an increase in demand for the product, at least in the short run. (That said, individuals do tend to view the former as fair and the latter as unfair.) In this case, there does seem to be an increase in demand for EpiPens over time, but what has more likely transpired is that the producer has shifted its values over time to focus more on pure profit maximization and less on keeping prices “fair.”
The somewhat uncomfortable reality is that, unless I’m interpreting price-gouging laws wayyyyyy too narrowly, the producer is within its rights to increase the price of its output, regardless of whether or not its costs have changed. (I feel like this point gets lost since companies often pay lip service to government to try to justify price changes in order to try to avoid future increases in regulation.) In fact, there’s even somewhat of an expectation coming from investors and capital markets that companies act so as to maximize profit. (While investors do seem to be increasing their emphasis on fairness and good corporate citizenship, the notion of a fiduciary responsibility to shareholders does still exist.)
I’m not saying that this outcome is right, either from an ethical or an efficiency standpoint, just that it shouldn’t be surprising. Again, the uncomfortable reality is that we rely on companies being “nice” as far as necessities are concerned in many cases, and recently we’ve gotten smacked with examples that show how fragile that trust can be. I’m also not saying that regulation is easy- how do you decide whether a product is truly a necessity? How do you decide whether a market is sufficiently competitive so as to solve its own problems? How do you regulate price or remove barriers to entry without destroying the incentives to innovate or keep costs down? (Economists have some models for regulating natural monopolies such as this, but they’re not perfect solutions.) I do think, however, that it’s a little unfair for policymakers to resort to shaming companies that are operating within the legal framework that they created because they kicked the regulatory can down the road (but, ironically yet likely justifiably, regulated enough to create the problem in the first place) rather than addressing what is an easily foreseeable issue from an economic standpoint.
Last time, we discussed the main result that shows evidence for the disposition effect- i.e. the bias toward selling winning stocks and against selling losing stocks. What I didn’t tell you at the time was that the calculation suffers from somewhat of an econometric problem, so I make up for my oversimplification and discuss that here.
As usual, you can see the whole behavioral economics playlist here in case you want to catch up or need a review.
So the internet seems pretty much obsessed with this story right about now…
|Ramen is displacing tobacco as most popular US prison currency, study finds
by Mazin Sidahmed
Cost-cutting measures by private facilities have led to subpar food quality and fewer meals, making noodles a commodity that trades well above its value
|Source: The Guardian|
The headline, taken at face value, isn’t particularly surprising to economists- we are quick to point out that a pretty wide variety of items can count as “money”, provided that they perform a few functions:
By this characterization, sure, ramen could serve as money- I guess ramen packs aren’t so large as to be too cumbersome to be traded, you could quote “prices” of other items in terms of packs of ramen (and measure your wealth in packs of ramen, I suppose, though that sounds a little sad), and ramen isn’t particularly perishable so it could make a decent store of value. If you think about it, basically any non-perishable commodity could be used as money in this way, it’s just a matter of changing your “base currency” to the good in question. For example, let’s say that the “price” of a pack of cigarettes is 3 packs of ramen- this means that 3 packs of ramen can be traded for one pack of cigarettes. (Note that prices are really just terms of trade.) I could have just as easily quoted the price of a pack of ramen as 1/3 of a pack of cigarettes- nothing has changed except I’m in an universe where the cigarettes are the base currency, i.e. money. (This framing shift happens all the time in foreign exchange, since a nominal exchange rate is just the price of one currency in terms of another currency.) I used this example because, historically speaking, cigarettes are commonly used as currency in prison situations, as the article points out.
When economists talk about money, we are careful to distinguish between commodity money- i.e. money with intrinsic value- and fiat money, which isn’t useful in and of itself. Clearly, ramen falls under the heading of commodity money, since, if you are anything like me, you get utility from eating ramen. (Technically I am referring to the restaurant version, but just go with me here.) Interestingly, it’s precisely this feature that causes me to question a. whether ramen is actually being used as money is typically used, and b. whether, if true, such use would even be a good idea.
The article above states that “the decline in quality and quantity of food available in prisons due to cost-cutting has made ramen noodles a valuable commodity.” I completely buy this statement, but “valuable commodity” and “money” are not synonymous. The article does go on to mention that ramen does often get traded for other goods and services, and the “prices” imply that there is some sort of arbitrage opportunity for those who can acquire ramen at the commissary price of 59 cents and then trade for other goods rather than acquire the other goods directly. The “money” argument kind of breaks down, however, when the article clarifies that people do in fact want to eat the ramen- I suppose you can technically eat a dollar bill if you wanted to, and you see situations where people use pennies decoratively rather than as a medium of exchange, but it seems like the opportunity cost of forgone consumption is pretty low when it comes to traditional currency, and you don’t see a lot of traditional currency being diverted for consumption purposes. Ramen, on the other hand, has a high opportunity cost of forgone consumption, literally speaking…and a prisoner decreases the the money supply every time he or she gets hungry! I’m not convinced that that is how money is supposed to work- just imagine the hunger-related swings in interest rates that could result. (At least when money is used to buy food, the food gets consumed whereas the money just gets transferred.) Even if the prison economy isn’t sophisticated enough to support a market for loans, eating the ramen currency is going to result in deflation, since there’s going to be less ramen currency to go around to conduct other economic transactions. (In other words, ramen purchasing power will increase because there is less of it available for purposes of exchange.) This isn’t great, since stable prices are thought to be a desirable feature in an economy.
I do think that there’s an important metaphor here- the above discussion suggests that sure, ramen can technically function as money, but the fact that it’s useful in itself causes it to function suboptimally as money in a number of ways. More generally, using an item as money either takes that item out of consideration as a useful resource or causes undesirable money supply/price stability effects (or some combination of the two). In this way, fiat money is pretty efficient in that it minimizes the productive stuff diverted to count as money (mainly some fancy paper, zinc, etc. Hey, it’s not a perfect system.). By similar logic, it’s not surprising that gold was a popular form of commodity money, since the uses for gold (electronics, jewelry, tooth caps. etc.) are actually pretty limited compared to the amount of gold available in the world. (If this were not the case, we wouldn’t see so much of it in bar form.)
I guess what I’m saying is that I hope this ramen as currency thing doesn’t catch on as a larger trend, since I don’t want to have to feel as bad about eating ramen as I do about leaving dollar bills in jeans pockets when I do my laundry. (I was going to say that I didn’t want to have to decide between eating the ramen and buying stuff with it, but I suppose the tradeoff between consuming one good and consuming another exists even when money itself is not consumable.) Also, it’s thought that contractionary monetary policy can cause recessions, and I certainly don’t want my ramen consumption habits to be responsible for that.
Update: The internet is a fantastic place, so now we’re discussing how the commissary could act as a ramen central bank and I am pondering the amount of seigniorage potential present in ramen minting. For now, I’m going to go in the kitchen and whip up some counterfeit ramen.
So a little while ago I wrote about the efficiency of free trade where I went through a situation in which a country would want to start importing a good from abroad. At the end, I noted that an export situation is basically the same but with a role reversal for producers and consumers. Nonetheless, there is an objection of “yeah, but you didn’t consider exports” in the comments section…I was mainly trying to not be repetitive, but in retrospect I think I inadvertently did what so many economists (especially economics instructors, sorry about that) do- we focus on the effects of imports and then gloss over the effects of exports. This isn’t great for students etc., and it’s particularly problematic because people more generally focus on the impact of foreign competition for production much more than the impact of foreign competition for consumption. So I apologize, and I’m here to make up for my earlier oversight.
I think this bias occurs at least partly because it’s easier to find motivating examples/case studies/etc. that have to do with imported goods. (This doesn’t mean that imports are a bigger deal, just that, like I said, we tend to focus on them more, so…chicken and egg, you know?) But here’s one on a topic near and dear to my heart…and stomach, and brain probably:
|Meet the Man Bringing Coffee Back to Colombia
by Ethan Fixell
Despite the country’s reputation for fantastic coffee, it’s nearly impossible to get a good cup of joe in Colombia. The second largest coffee exporter on earth sent $2.6 billion worth of beans to other countries around the world last year, forcing locals in most Colombian cities to brew imported beans from far-off places like Vietnam.
Like before, I’m going to try to explain what’s going on here without using any graphs (even though I like them so much!). Say you’re a coffee grower in Colombia, and you live in a world where there is no trade among countries. Your only option, therefore, is to sell your coffee to people in Colombia, who might not have a lot of disposable income or might not like coffee that much or whatever. In this world, you sell your coffee (unroasted wholesale, to make the numbers make a little more realistic) for 25 cents per pound. (No, I don’t know why our Colombian transactions are denominated in USD, but let’s try to focus here.) The point is that Colombian roasters can buy your coffee pretty cheap, which is good since they can’t set too high a price for the finished product, what with Colombians not having a lot of cash and not liking coffee and whatnot.
Now let’s open up Colombia to some trade- you know, that thing that people have taken a sharp turn against for some reason:
— Carroll Doherty (@CarrollDoherty) August 18, 2016
If we’re honest with ourselves for a second, I think we can all agree that Americans have a (relatively) decent amount of disposable income and are pretty much welded (I was going to say wedded but I think the typo works better) to our coffee intake. This combination of factors leads to a higher willingness to pay for coffee, especially Colombian coffee, since we all bought into the coffee marketing of the 1980’s:
(No really, that ad is from 1983, and I have no idea why this marketing was so salient to my young self.)
As a result, let’s say that roasters in the US will pay $1 per pound for Colombian coffee. Also, let’s note that we drink a lot of coffee, so the US roasters are willing to buy as much as Colombia will sell us at that price. What are Colombian coffee growers going to do?
I feel like the article preview pretty much ruined the suspense here- if coffee growers can sell all they want to the US for $1, they aren’t going to sell to Colombia for less than $1, so the price to Colombian roasters goes from 25 cents to $1. Colombian roasters don’t buy as much Colombian coffee (demand curves do slope downward after all), and Colombian coffee drinkers get coffee imported from Vietnam rather than the stuff that it right around them. Weird, right? But is perfectly understandable from an economic standpoint.
In this scenario, Colombian coffee producers are better off because of trade and Colombian consumers are worse off. (Told you it was the reverse of the import situation.) Like with imports, trade is efficient since the producers win from trade more than consumers lose from trade. Why is this? Well, let’s think about this in a few consumer-group parts:
This combination of no change, increase, increase has to result in an overall increase in value for Colombian society. (Like the basic import analysis, however, this doesn’t address distributional concerns regarding winners and losers.)
Not gonna lie- it’s pretty perplexing to me that this dynamic doesn’t seem to call for export restrictions nearly as much as the reverse situation results in calls for import restrictions. If I had to guess, I would hypothesize that people are more inclined to think about their welfare in terms of money coming in (i.e. the producer side) rather than in money going out (i.e. the consumer side). On the other hand, people complain way too much about inflation for this explanation to be entirely satisfying, so who knows. Maybe it has to do with the fact that producers tend to be more concentrated than consumers, and more protest happens when losers are more concentrated? In any case, it *is* sort of unfair to talk about the effects of imports without considering the effects of exports, or vice versa, if for no other reason it’s difficult to include a “we want to sell you stuff without restriction but we’re going to tax the stuff you try to send to us” clause in trade agreements nowadays.
In a previous video, my class went over the empirical setup in one of the main papers about the disposition effect in stock-market behavior. Now they got to talk about the results of that analysis:
If you need a refresher, you can see the whole behavioral economics playlist here.
You know you’re an econ/math nerd if you read this and think “haha, it’s like the matching pennies game”:
But hear me out…here’s the matching pennies game, and, like the joke, the crux of the game is that there is no Nash equilibrium without randomization. To further the analogy: The matching pennies game works as it does because player 1, let’s say, “gets off” when the pennies match whereas player 2 gets off when the pennies don’t match. (This wording hopefully shows the intuition of why there is no pure-strategy Nash equilibrium, since the goals of the players are clearly mutually exclusive.) The…uh, matching fetishes game works in a similar fashion, since the guy gets off when he and his partner are in agreement, but the woman gets off when there is discord.
With some minor labeling changes, you could even make a payoff matrix for the matching fetishes game, the conclusion of which is…hm, can one randomize being turned on or not?
In my class, I try to introduce a topic and then give my students a discussion question to work through so I can make sure that everyone is catching on. This discussion question relates back to the disposition effect, or the bias towards selling winning stocks and away from losing stocks.
If you need a refresher, you can see the entire behavioral economics playlist here.
Steve Levitt, in addition to gaining fame (at least at an economist level, not a Justin Bieber level) for writing Freakonomics, has made a career teasing cause and effect out of (largely) observational data. (By “observational data,” I mean that he doesn’t explicitly run controlled experiments in a lot of cases and just looks at the world as it transpired naturally instead.) Observational data presents an interesting challenge because people usually make choices in life rather than being guided by randomness. As a result, we often end up with selection bias that makes causal interpretations difficult- for example, we can look at people with and without pets and observe that the people who have pets are happier. (This is hypothetical, but it is in keeping with everything I would like to believe about the world.) This doesn’t mean that pets make people happier, since it could just be the case that people who are already happier also tend to adopt pets. It would be better from a data analysis standpoint if people were just randomly endowed with pets (like when a cat showed up on my doorstep when I was little I suppose), but unfortunately for science purposes we live in a society where people choose whether or not to have pets, and this choice aspect kind of messes things up.
To try to overcome this issue, economists tend to look really hard for sources of randomization- technically known as instrumental variables. In the pet example, whether a stray animal showed up on the doorstep might make a good instrumental variable, at least if the showing up was fairly random and people tended to keep the animals once they showed up. Using some statistical fanciness, we could compare the group of people who had animals show up versus those that didn’t and get a reasonable estimate of the causal effect of pets on happiness.
I know what you’re thinking- this is all nice in theory, but it’s not like we keep good records on stray animal on doorstep prevalence. This is true, and wouldn’t it be nice if we could actively create an instrumental variable- perhaps let a bunch of stray cats loose in a neighborhood and record what happens? (I was going to add a disclaimer to not try this, but it could actually be pretty interesting for research purposes.) How about if we could introduce a source of randomness in the easiest way possible, by flipping a coin?
Turns out that Levitt actually implemented the coin flip as instrumental variable to assess the causal effect of change on happiness:
Little is known about whether people make good choices when facing important decisions. This paper reports on a large-scale randomized field experiment in which research subjects having difficulty making a decision flipped a coin to help determine their choice. For important decisions (e.g. quitting a job or ending a relationship), those who make a change (regardless of the outcome of the coin toss) report being substantially happier two months and six months later. This correlation, however, need not reflect a causal impact. To assess causality, I use the outcome of a coin toss. Individuals who are told by the coin toss to make a change are much more likely to make a change and are happier six months later than those who were told by the coin to maintain the status quo. The results of this paper suggest that people may be excessively cautious when facing life-changing choices.
(Note that you should be able to access the article with most university email addresses, and even some alumni email addresses. Worth trying, at least.)
So let’s think this through…the outcome of a coin flip is random, so people were essentially randomized into “change” and “don’t change” groups. This randomization implies that the two groups are (at least approximately) comparable along other dimensions, leaving the change directive as the only systematic difference between the groups (and therefore the only plausible cause of any observed differences in outcomes). If everyone who was told by the coin to make a change actually did so (and vice versa), Levitt wouldn’t have even had to do anything statistically fancy and could have just compared the average levels of happiness of the two groups. Because not everyone listened to the coin (which I guess is sort of a good thing for the world more generally), he had to do the more fancy version of the math but is still able to find a statistically significant causal effect of change on happiness. Cool, huh? Now go make a change- apparently it’s good for you.
In case you’ve forgotten, the disposition effect is the bias toward selling winning stocks (or other investments I guess) and away from selling losing stocks. In the video below, I start covering one of the seminal empirical papers on the disposition effect and can’t resist fangirling out for a second in the process.
You can see the full behavioral economics playlist here.
You guys, I’m frustrated. Yes, by this:
— David Lazarus (@Davidlaz) August 11, 2016
and by this…
"I oppose it now, I'll oppose it after the election, and I'll oppose it as president." Real talk: It would be v hard for HRC to flip on TPP
— Jim Tankersley (@jimtankersley) August 11, 2016
But what I’m referring to is slightly less, well, dramatic, for starters. So allow me to describe one of my (admittedly many) pet peeves: When economists teach the concept of comparative advantage and gains from trade, it goes something like “hey, if you can pay somebody $20 an hour to clean your house and get paid $25 an hour at your regular job, you can specialize in your job and outsource your housecleaning and have $5 an hour left over! Everyone is better off!” Sounds great, right?
Well I tried it, and boy am I disappointed.* First off, I explained to my boss that I hired someone to clean my house and therefore I am able to spend 3 more hours per week at work. He seemed pleased with that, so I then reminded him to adjust my salary accordingly, and, well, that’s where things sort of went off the rails. Luckily, I’m a great negotiator, so he eventually came around to meet my demand. I started envisioning what I would do with that $5 an hour efficiency prize (mmmmm, Starbucks vanilla sweet cream cold brew, here I come), but when I looked at my online banking statement the numbers didn’t play out as I had expected- got paid for 3 extra hours of work, paid for 3 hours house cleaning and a grande cold brew ($4 and change IIRC) and I’m worse off than I was before? How is that possible?
Dammit, I forgot about taxes- in fairness, if my econ textbook has taught me anything, it is to ignore tax considerations when doing comparative advantage analyses. Hopefully by now you’ve identified the two logistical points that insert frictions into this specialization and gains from trade thing:
The first point, well, that’s one’s pretty hard to address (not everyone can have an Uber driver lifestyle I suppose), but it seems like there should be some benefits to thinking about the tax issue here. If my $25 is taxable income, the government collects tax on my $25 but doesn’t collect tax on me cleaning my own house. (Don’t go getting any ideas, government.) If my house cleaner payments were somehow not taxed, the government would lose revenue on my $20 per hour payment but would collect revenue from the person cleaning my house. Granted, this is probably a bit of a loss for the government, since the house cleaner probably pays a lower tax rate then I do, but the government would probably really like that two people are employed rather than one. (If there is slack in the labor market, it need not be the case that I pulled the house cleaner away from some other job.)
Yeah, so this doesn’t happen, and I am stuck cleaning my own house.** You’ve probably gotten out the world’s smallest violin for me at this point, perhaps because many people find there to be something unseemly about hiring people to do stuff that you don’t want to do, like cleaning the house. Economically, I guess the lack of tax abatement isn’t a huge deal, since if people are paid a fixed salary or don’t have flexibility in hours it’s not the tax issue that’s the main impediment to outsourcing one’s house cleaning on the grounds of economic efficiency anyway.
BUT…let’s pretend for a second that I had used childcare rather than cleaning in the above example. Childcare is an importantly different animal, in large part because did you know that kids exist like 24 hours a day? It’s crazy. (Also, if they’re really small you can’t leave them at home by themselves, which is kind of inconvenient.) Because of this, the tradeoff between work and child care is often more binary than in the house cleaning example- in other words, people are generally deciding between working at all and taking care of their kids, or at least deciding between part-time and full-time employment. Because of this feature, it’s a more logistically reasonable candidate for exploiting gains from trade- for example, a potential worker who could pay $10,000 per year for child care (yeah, I know I’m being optimistic compared to many real cases) could leverage trade as long as she could get a job that pays more than $10,000…after taxes. (Yes, I know her taxes as a single person wouldn’t be high, but if she has a partner her marginal tax rate on the $10,000 could be quite high.)
One obvious potential solution to alleviate inefficiency in this situation would be to make child care tax deductible- as noted above, the impact to the government’s bottom line is likely small due to those who wouldn’t have paid for child care without the deduction. On the down side, the government *would* lose revenue from households who were purchasing child care even though it wasn’t tax deductible. Also, there’s that pesky thing we talked about a couple of days ago where tax deductions don’t help lower income households in the ways that we might expect (not to mention that households only get the money back at tax time, which doesn’t help households with short-term cash flow concerns).
Now, I never thought I would say this, but Trump’s team of Steves (now with more female non-economists!) is kind of onto something:
|We now know more about Trump’s proposal to subsidize child care
by Josh Barro
Donald Trump’s proposal to make child-care expenses deductible from tax became a little less vague on Thursday — and significantly more expensive.
|Source: Business Insider|
The relevant points are as follows:
1. The deduction would be “above the line.” That means it would appear before Line 37 on the Form 1040, and therefore the deduction would come out of your income before calculating adjusted gross income. Here’s why it matters where on the form the deduction goes: You can take “above the line” deductions on top of the standard deduction, without itemizing your other deductions. As a result, more taxpayers could take advantage of this deduction, including taxpayers who don’t make enough money to itemize. (Itemizing is generally for people who pay a significant amount of mortgage interest and/or state and local tax.)
2. The deduction would apply against one-half of payroll tax, not just income tax. Clinton and others have pointed out that a new income-tax deduction would be of no value to low-income parents who don’t make enough money to pay income tax. Making the deduction also applicable against the employee-paid half of payroll tax would provide some savings to anybody with labor income. The benefit wouldn’t be huge — it would equal 7.65% of the amount deducted — but that’s not nothing.
The article itself still criticizes the plan on the grounds that higher-income households get a larger discount, which is true, but you guys, this could actually get pretty close to a situation where comparative advantage and gains from trade work in the way that the textbook tells me that they do. Now we just need to have clear objectives and dig into the nerdy details of every other policy in order to satisfy…..HAHAHAHAHAHAHAHA, yeah, I know. I’ll instead direct you to the part where Trump confuses his employees with his hotel guests.
* I’m kidding- I’m not, it’s great (though I have an atypical work situation), but just go with me here.
** Still nope.
Know what the disposition effect is? Well you do now…
Next time we’ll look at one of the seminal disposition effect papers and learn how we can test for it in a sample of data.
I got a few comments of note on my last post regarding tax deductions versus tax credits. First, from Tumblr:
and from Facebook:
Technically speaking, neither of them are wrong I suppose (though I didn’t confirm the average tax rate calculation in the first comment), but the second guy is right that some additional review and clarification is probably helpful for some people.
So allow me to start with a story that, if my household is at all representative, a number of you will be able to relate to. When I was younger (let’s say like ten or so), my grandfather explained that he needed to find some tax deductions because otherwise he’d end up in a higher tax bracket (his words, not mine). The implication from his complaint was that staying in a lower tax bracket would make him better off on net, and this seemed strange. (He later clarified, still but somewhat less incorrectly, that he just didn’t want the government taking 80% of his marginal dollar, so his main error was in not realizing that it wasn’t 1962.) Now I know that tax codes are a little silly sometimes, but even 10-year-old me was suspicious that they were so stupid as to create incentives to throw money away.
I was right to be suspicious, of course- that’s not how tax brackets work. But one thing I’ve noticed is that a lot of people have similar mistaken beliefs about how taxes are calculated. So let’s do a quick refresher- if this isn’t new to you, just forward to that friend you know we all have instead…
First, let’s take a look at some marginal tax rates (assuming you’re single, but you can see the complete set of numbers here):
Let’s say you make $50,000 per year (or, if you want to be super picky, have $50,000 in adjusted gross income or whatever, since this is the amount that you actually pay taxes on). To find out how much you will pay in federal taxes, what you DON’T do is look up $50,000 in the table above, get a 25% tax rate, and multiply 25% by $50,000. If this were how things worked, then yeah, a guy making $38,000 would in fact want to burn $351 of income, for example. (If you don’t believe me, you can calculate and confirm that taking away 15% from $37,649 results in a bigger number than taking 25% away from $38,000.)
What you *do* do, instead, is more sensical but more arithmetically complicated. Again, let’s say you make $50,000 per year. Your federal tax calculation would look like this:
I’ll be honest with you, I didn’t particularly like working though that, but it is what it is, and we have calculators and Excel (and tax prep software) and such to help. Besides, no one has to do this very often, at least not for decision-making purposes. For example, let’s say I offer you $1,000 to do some research for me. You can look at the tax table and immediately know that your tax rate on this incremental income will be 25% (since you were already earning $50,000, remember), leaving you with $750 in compensation after federal income taxes. Note that it didn’t matter that your average tax rate on the original $50,000 of income was $8,271.25 / $50,000 = 16.5%, since it’s only the marginal (i.e. applied to the last dollar) tax rate of 25% that is relevant to an extra dollar of income. (This would of course get more complicated if the incremental income spanned different tax brackets, but the logic is still the same.)
The same principle holds in reverse for tax deductions- if you make $50,000 and have a $100 tax-deductible expenditure (ignore the standard deduction for now), your taxable income decreases by $100 and your taxes owed decrease by $25, in effect giving you a discount on your expenditure equal to your marginal tax rate. Note again that it was only this last tax bracket, or your marginal tax rate, that was relevant in calculating the effect of the tax deduction.
So yeah…with a progressive tax system- i.e. one with larger tax rates for higher income brackets- your marginal tax rate will be higher than your average tax rate, as you can see from the example above. (They will be the same, however, for individuals with income in the lowest tax bracket only.) So, while you mainly want to keep your marginal tax rate in mind for decision-making purposes, I guess it could make you feel better to calculate your average tax rate and be reminded that the federal government isn’t taking all of your money in income taxes. That’s FICA’s job, after all…
I’ve been doing my taxes myself for a while now, and, thankfully, I am not old enough to have had to file any complicated returns before the advent of online tax preparation systems. That said, tax calculations are complicated enough that there were a number of things that caught me by surprise. For example, I remember my inner monologue that first time…
H&R Block: Would you like to take the standard deduction, itemize your deductions, or calculate both to see which is better?
Me: Why wouldn’t I want to figure out what is optimal? Duh…
H&R Block: *asks for tax deduction info*
Me: *enters tax deduction info*
H&R Block: Based on what you’ve entered, you should take the standard deduction?
Me: WTF is the standard deduction and why did it make all of my charitable giving (like, all $100 of it, people) irrelevant?
By now, my older and wiser self knows what the deal is…most basically, I now get that the tax system offers a “standard deduction” that you can take so that you don’t have to bother with the hassle of entering all of the tax deductible stuff you did over the course of the year. (Similarly, the standard deduction makes things easier for the IRS since there’s no verification to be done.) That sounds fine on the surface, but wait- isn’t there the unintended consequence that the first $X of my tax deductible stuff doesn’t actually help me in terms of lowering tax liability, where X is the amount of the standard deduction? Yup, since the actual choice isn’t between “itemized deductions” and “no deductions” but instead “itemized deductions” and “standard deduction.”
Obviously my next step was to look up how large the standard deduction is in order to determine how annoyed to be. It was a bit lower at the time, but the standard deduction is currently $6,300 for single filers or married couples filing separately, $9,250 for head-of-household filers, and $12,600 for married couples filing jointly. Wait what? What sort of mythical creature has more than $6,300 in tax deductible stuff? (said my 21-year-old self) More importantly, why wasn’t I aware of this when I gladly signed up for a recurring donation to the Human Rights Campaign on the grounds that the tax deduction would basically make it a wash in terms of disposable income? (yeah, I now know that’s incorrect on multiple levels) Or, perhaps more significantly, why wasn’t I bludgeoned over the head with this information when I signed up for a student loan? (For the record, no one told me about the income limits for student loan interest to be tax deductible either, but that’s for another post.)
The point that I’m trying to make here is twofold. First, making expenditures tax deductible is one of those things that sounds nice in theory (since it sounds like a subsidy or discount of some sort) but that likely doesn’t actually impact the bottom line of many households because of the standard deduction situation. Furthermore, even when they do matter- my mortgage interest, for example (since I’m totally a grownup now)- it’s only the amount above and beyond the standard deduction that affects a household’s bottom line. Second, tax deductions are kind of insidious because people don’t seem to fully think through the standard deduction issue when deciding whether to undertake their tax deductible activities. For example, I remember being presented with some sort of “rent vs. buy” real estate calculator a number of years ago, and it definitely didn’t take the standard deduction consideration into account. As a result, many households are likely underestimating the real cost of the “tax deductible” opportunities they are presented with, which leads to distortions in consumption of these opportunities.
But wait, I’m not done ranting about tax deductions…to see why, let’s take a quick tax deduction quiz:
Q: You just donated $100 to the Human Rights Campaign. This contribution is tax deductible. What is the effective cost to you of this contribution?
A: This is a trick question on multiple levels. First, as noted above, your effective cost is $100 if the contribution doesn’t put the total of your tax deductible expenditures above the standard deduction. So let’s assume for the sake of argument that there is no standard deduction and, for simplicity, that this $100 is your only tax deductible expenditure (you scrooge). You still can’t answer this question without looking at how much money you make! This is because tax deductions reduce the amount of income that is taxable, so your discount is equal the amount of taxes that you would have paid on the $100 you contributed. With a progressive tax system, the amount of taxes you would have paid on the $100 depends on how much money you make overall. So let’s take a look at some marginal tax rates (assuming you’re single, but you can see the complete set of numbers here):
If you make $50,000 per year, you’re paying a 25% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $49,900 and you avoid $25 of taxes. In this case, your $100 contribution effectively cost you $75.
Now let’s see what happens if you were to make $300,000 per year. (Lucky you! Also, Why didn’t you donate more than $100?) In this scenario, you’re paying a 33% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $299,900 and you avoid $33 of taxes. In this case, your $100 contribution effectively cost you $67.
This simple illustration shows how making expenditures tax deductible provides bigger subsidies to higher-income households than to lower-income households. (Not surprisingly, some expenditures are only tax deductible for households making below a certain amount, which puts the bias in the other direction.) Put this together with the observation that lower-income households are less likely to even clear the standard deduction in the first place and it becomes clear that making expenditures tax deductible disproportionately helps higher-income households. I guess what I’m saying is that I want you to come back and read this every time you hear a politician suggesting making an expenditure tax deductible in order to provide relief to income-strapped households.
So…is there a better way? If by “better” we mean “impacts all households equally,” then yeah, probably, and it’s called a tax credit. Tax credits are importantly different from tax deductions in that they operate to lower taxes directly rather than lowering the amount of taxable income. For example, if a 25% tax credit were given for donations to the Human Rights Campaign, then the $100 donation in the example above would result in a $25 reduction in taxes owed for every household that makes such a contribution.
I get that the details of taxes are boring- I mean, this is basically the stuff that accountant jokes are made of. But it’s so important to get right- tax deductions and tax credits are used not only to provide income relief but also to change incentives, and it’s really hard to respond optimally to incentives when you don’t fully get how the incentives offered affect you and your financial situation. In a more general sense, you want to understand how the policies that politicians propose actually affect households so that you know what you’re voting for.
In related news, for example, here are two proposals for easing the burden of child-care costs. You now have the tools you need to think about where the benefits of the policies go, which is good since I sure don’t trust politicians to provide this information themselves in an unbiased fashion.