Alternatives to the Pigou Club

Today’s Wall Street Journal prints various letters in response to my oped on gas taxes. Rather than responding to to the specific points, or to all the comments posted on this blog, let me try to spell out more generally the alternatives from which we must choose.

Members of the Pigou Club favor higher Pigovian taxes in order to remedy externalities such as pollution and congestion while raising government revenue. If you aren’t a member of the Pigou Club, you most likely fit into one of these four categories.

1. You deny the existence of these externalities as a type of market failure. Perhaps you think you live in a Coasian fantasy world where people bargain without transaction costs to reach efficient allocations. (Note: I am not suggesting that Coase himself thought we lived in such a world—he considered it only a useful thought experiment.)

2. You recognize the externalities but you don’t think the government should try to respond to them. You are such a believer in small government that you are willing to live with inferior economic outcomes, such as pollution and congestion.

3. You recognize the externalities, think the government should try to correct them, but think the current low taxes we put on gasoline are sufficient. In this case, you have weighed and rejected the evidence, such as that of Parry and Small, that higher Pigovian would be optimal. (Parry and Small calculate an optimal tax of $1.01 for the United States in today's dollars. After my proposed phase-in of a $1 hike, the U.S. tax would be $1.40. Assuming 10 years of 3 percent inflation, the tax in real terms would approach almost exactly what Parry and Small recommend. By the way, the published version of Parry and Small was in the American Economic Review, September 2005.)

4. You recognize the externalities but think the government should try to correct the market failure through regulations (such as CAFE standards) or through market-based solutions that do not raise government revenue (such as cap-and-trade systems). Perhaps you are concerned that government would waste the extra revenue on useless government programs.

Let me respond to group 4, because my guess is that this is the largest group of antipigovians.

The reason I am less concerned that the extra revenue will be spent is that it already has been spent. The federal government has promised benefits to the elderly far in excess of what it can pay. At some point the nation will have to reckon with the looming fiscal gap. The most likely political compromise will involve higher tax revenue. We should, therefore, be ready to increase revenue in a way that does the least damage—or, better yet, the most good. If not Pigovian taxes, then other taxes will be increased.

An optimistic libertarian might hope that we can deal with the looming fiscal gap without raising the ratio of taxes to GDP above its current level. I wish I could believe that this were possible. In a previous oped, I advocated increasing, slowly but substantially, the age of eligibility for Social Security and Medicare. But even if we could scale back government spending in such a radical way, Pigovian taxes would not lose their appeal. Let’s use the extra revenue from Pigovian taxes to reduce distortionary taxes, such as income taxes. Politically unrealistic, you say? Surely, if a future government were so libertarian as to manage a radical reduction in entitlement promises to the elderly, it would have no trouble delivering equally radical cuts in income taxes. In fact, the tax cuts would be the easy part of the package.

Update: Some comments suggested new categories of nonpigovians, and some suggested the categories I described were strawmen. To be clear, my goal was to categorize, as logically as possible, the various points of view. Let me try to put the issue in terms of a flow chart.

Question: Do you believe consumption of gasoline is free of negative externalities leading to market inefficiency?

If YES, you are part of group 1.
If NO, continue.

Question: Do you believe that public policy should ignore these externalities?

If YES, you are part of group 2.
If NO, continue.

Question: Do you believe the current tax on gasoline sufficiently internalizes the negative externalities?

If YES, you are part of group 3.
If NO, continue.

Question: Do you believe the best remedy for the remaining externalities is a regulatory system rather than a higher tax?

If YES, you are part of group 4.
If NO, you are a member of the Pigou Club.

A Pigou Biography

Ian Kumekawa's biography of A.C. Pigou has been sitting on my shelf since it was published a few years ago, but I just got around to reading it, and I very much enjoyed it. The book tells the story of the arc of Pigou's career--from a top student of Alfred Marshall, to a leader of his field, to a fading star struggling with age and declining relevance, to finally a content elder statesman of academia. The general public won't find the book of much interest, but for economists like me, it is a great read.

Pigou Club News

• Pigou Club member wins the Nobel Peace Prize.
• Pigou Club founder talks today at the University of Connecticut.

How to join the Pigou Club

Kevin Burke, a student at the University of Pennsylvania, has opened a facebook arm of the Pigou Club. The group now has 73 members. Anyone registered in facebook is free to join.

One member posted a link to the above graphic from Foreign Policy. For previous Pigou Club posts, click here and here.

Rogoff joins the Pigou Club

I am pleased to welcome my Harvard colleague Ken Rogoff into the Pigou Club. In his latest op-ed, he writes:

As for the US, a sharp hike in energy taxes on gasoline and other fossil fuels would not only help improve the government’s balance sheet, but it would also be a way to start addressing global warming. What better way for new US Treasury Secretary Hank Paulson, a card-carrying environmentalist, to make a dramatic entrance onto the world policy stage?

The Pigou Club is an elite group of economists and pundits with the good sense to have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes. Here are some examples of the current membership:

• Greg Mankiw (Fortune 5/24/99, WSJ 1/3/06, 5/31/06)
• Bill Nordhaus (Foreign Policy in Focus 3/27/06)
• Martin Feldstein (WSJ 6/4/92)
• Gary Becker (Businessweek 5/27/02)
• Robert Frank (NY Times 2/16/06, 6/8/06)
• Andrew Samwick (his blog)
• Ted Gayer (Regulation)
• Mike Moffatt (about.com)
• Ken Rogoff (Project Syndicate)
• Paul Krugman (Slate 4/18/97)
• Greg Easterbrook (NY Times 5/25/04)
• John Tierney (NY Times 10/4/05, 5/23/06)
• Jonathan Rauch (National Journal 2/9/02)
• Thomas Friedman (NY Times 9/21/05, 2/8/06, 6/16/06)
• Joe Klein (Time 5/7/06)
• Andrew Sullivan (Time 4/11/04)
• Jane Galt (her blog)
• Christopher Farrell (Businessweek 8/19/05)
• William Baldwin (Forbes 6/19/06)
• Clive Crook (National Journal 6/2/06)
• Al Gore (Charlie Rose Show 6/19/06 at 42:45)

We are always looking for more members. An elected official or two would be nice.

Update: Alan Greenspan signs up. So do George Schultz, Tony Lake, Nicholas Stern, Hal Varian, Larry Summers, Richard Posner, David Frum, Nouriel Roubini, Joe Stiglitz, Brink Lindsey, Tim Harford, Rob Stavins, Ray Magliozzi, Robert Samuelson, Dan McFadden, Charles Krauthammer, Paul Mulshine, Kevin Hassett, Jason Furman, Anne Applebaum, Paul Volcker, Bill Frenzel, Isabel V. Sawhill, Charles Stenholm, William Hoagland, Robert Shapiro, David Leonhardt, Morton Kondracke, Gilbert Metcalf, Fred Foldvary, Arthur Laffer, and a majority of economists.

Al Gore in the Pigou Club

Al Gore on the Charlie Rose Show this week reaffirmed his membership in the Pigou Club. Starting at 42:45, he endorses a revenue-neutral shift toward carbon taxes.

The Pigou Club is an elite group of economists and pundits with the good sense to have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes. The current membership includes:

• Greg Mankiw (Fortune 5/24/99, WSJ 1/3/06, 5/31/06)
• Bill Nordhaus (Foreign Policy in Focus 3/27/06)
• Martin Feldstein (WSJ 6/4/92)
• Gary Becker (Businessweek 5/27/02)
• Robert Frank (NY Times 2/16/06, 6/8/06)
• Andrew Samwick (his blog)
• Paul Krugman (Slate 4/18/97)
• Greg Easterbrook (NY Times 5/25/04)
• John Tierney (NY Times 10/4/05, 5/23/06)
• Jonathan Rauch (National Journal 2/9/02)
• Thomas Friedman (NY Times 9/21/05, 2/8/06, 6/16/06)
• Joe Klein (Time 5/7/06)
• Andrew Sullivan (Time 4/12/04)
• Jane Galt (her blog)
• Christopher Farrell (Businessweek 8/19/05)
• William Baldwin (Forbes 6/19/06)
• Clive Crook (National Journal 6/2/06)

We are always looking for more members.

A Reading for the Pigou Club

And also about the Pigou Club, from the NY Times.

Lindsey on Stimulus

Larry Lindsey's plan to stimulute the economy, including his membership application to the Pigou Club:

Permanent tax cuts offer a much better option. The incoming chairman of the Council of Economic Advisers, Christina Romer, has estimated that the macroeconomic benefits of tax cuts can be two to three times larger than common estimates of the benefits related to spending increases. The relative advantage of tax cuts over spending is even clearer when the recession is centered on the household balance sheet. Some relatively minor changes, like making the current 15 percent tax rate on dividends and capital gains permanent, would not only help household cash flow, but also put a floor under equity prices much as their introduction did in 2003. This would help protect against further wealth destruction and balance sheet deterioration.

But the centerpiece of any tax cut should be employment taxes: in particular, a permanent halving of the current 12.4 percent Social Security payroll tax on the first $106,800 of wages, split evenly between workers and employers. The direct revenue effect of that would be a bit under $400 billion per year, roughly in line with the present quantitative needs of the economy. It also meets our three tests of effective stimulus.

First, the funds would flow directly to households through higher take-home pay and indirectly through a reduction in the cost of employment. Economic studies conclude that the benefits of a reduction in the employer portion of the payroll tax are ultimately received by employees. But the immediate effect would be an improvement in the cash flow of credit-starved businesses (as well as being a marginal incentive to keep
employment up).

Second, the funds would be extremely timely, with the benefits hitting the economy with the first paycheck after the plan was implemented.

Third, by lowering the taxation of labor, the plan would help produce a higher-employment recovery than would otherwise be the case. Since the tax cut should be permanent to have maximum effect, the biggest challenge would be how to make up for the lost revenue once the macroeconomic need for fiscal stimulus had passed. In the short run, effective fiscal stimulus requires that government revenue drop, thereby enriching the private sector, and with the Treasury making the Social Security trust fund whole by way of intergovernmental bookkeeping. Longer term, however, spending cuts or a new source of revenue would be needed.

Given the agenda of the incoming administration, the best source of such funds would be a greenhouse emissions tax. It would be a much more efficient way of achieving the desired environmental objectives of the administration than any of the regulatory or "cap and trade" ideas now being considered. Such programs have failed in Europe since they are so easily gamed. Unlike regulations or cap and trade, moreover, an emissions tax can be phased in and calibrated as macroeconomic conditions permitted, specifically as the unemployment rate declined.

Sounds good to me.

Update: More Pigou Club endorsements here and here.

A Letter to the Pigou Club

From Congressman Bob Inglis:

Dear Pigou Club Members,

A revenue-neutral carbon tax could set up a bi-partisan triple play of this American century. We can clean up the air, create jobs, and enhance our national security.

My Raise Wages, Cut Carbon Act of 2009 cuts payroll taxes and, in equal amount, imposes a tax on carbon dioxide emissions. The tax is border adjustable and is designed to be WTO compliant.

We're conducting a "Virtual Hearing" on the Raise Wages, Cut Carbon Act of 2009 in the hopes of improving the bill before I actually file it. I've kicked off the "hearing" with an opening statement, which you can find here, along with a copy of the bill, a summary, and various white papers addressing different portions of the bill. I'd love for you to look over these materials, and then tell me what you think by posting a YouTube response to my opening statement. You can do that here.

Thank you, and I look forward to benefitting from your expertise and insights!

Sincerely,

Bob Inglis
Member of Congress (R-SC4)

The Stimulus versus the Pigou Club

A reader points out this small part of the budget story in California:

A 12-cent-per-gallon increase in gasoline taxes that was initially part of the package has been eliminated -- replaced with federal economic stimulus money.

So, in effect, part of the stimulus spending has gone to fund a lower gasoline tax. The Pigou Club would have preferred a cut in, say, the payroll tax.

News for the Pigou Club

Republican lawmakers back carbon tax (yes, that's right).
Phil Levy compares a carbon tax with cap-and-trade.
Pigou Clubbers win in the elections in British Columbia.

Pigou in Congress

Congressman Bob Inglis joins the Pigou Club.

A most welcome addition to the membership. The club is chock full of nerdy policy wonks. We could use a few more elected officials.

Update: An oil executive joins as well.

Chu and Pigou

The Wall Street Journal reports that Steven Chu, who was just named energy secretary in the incoming administration, is a member of the Pigou Club:

In a sign of one major internal difference, Mr. Chu has called for gradually ramping up gasoline taxes over 15 years to coax consumers into buying more-efficient cars and living in neighborhoods closer to work.

"Somehow we have to figure out how to boost the price of gasoline to the levels in Europe," Mr. Chu, who directs the Lawrence Berkeley National Laboratory in California, said in an interview with The Wall Street Journal in September.

But Mr. Obama has dismissed the idea of boosting the federal gasoline tax, a move energy experts say could be the single most effective step to promote alternative energies and temper demand.

N.B.: NEC Director Larry Summers is also a club member in good standing. Will the energy secretary and NEC director manage to convince the president-elect to change his mind? Stay tuned.

Pigou Club News

The Wall Street Journal reports that a member of the Pigou Club is running for the Republican nomination for Governor of California:

California's fiscal crisis is giving Tom Campbell, an ex-congressman with few resources, a fighting chance to become the state's next governor....Democrats scorn his ideas for permanent cuts to welfare and social services in lieu of one-time fixes, while Republicans strongly oppose his proposal for a steep increase in the state's gasoline tax....Armed with a University of Chicago doctorate in economics and a Harvard Law School degree, he represented Silicon Valley for five terms in the U.S. House, served as business-school dean at the University of California, Berkeley, and also as the state's finance director under Gov. Arnold Schwarzenegger.

Pigou Club News

A reader from across the Atlantic points out that the European Commission is poised to join the Pigou Club:

The Commission will on 28 March present ideas for “green taxes” to save energy and cut greenhouse gas emissions. It says that such an ‘ecological tax reform’ could increase the bloc’s competitiveness by shifting the burden away from labour taxes.

Happy Birthday, Professor Pigou

Arthur Cecil Pigou was born 132 years ago today.

2008 = 1929?

It has become fashionable lately to see parallels between the current financial turmoil and what happened during the Great Depression. See, for example, Paul Krugman's latest column.

Let me remind everyone of one important difference: Deflation was a large part of the story of the 1930s, and that does not seem like a significant risk today. Here is a relevant passage from my favorite intermediate macro textbook (sorry, I cannot post the referenced figure):

The Money Hypothesis Again: The Effects of Falling Prices

From 1929 to 1933 the price level fell 25 percent. Many economists blame this deflation for the severity of the Great Depression. They argue that the deflation may have turned what in 1931 was a typical economic downturn into an unprecedented period of high unemployment and depressed income. If correct, this argument gives new life to the money hypothesis. Because the falling money supply was, plausibly, responsible for the falling price level, it could have been responsible for the severity of the Depression. To evaluate this argument, we must discuss how changes in the price level affect income in the IS‑LM model.

The Stabilizing Effects of Deflation

In the IS‑LM model we have developed so far, falling prices raise income. For any given supply of money M, a lower price level implies higher real money balances M/P. An increase in real money balances causes an expansionary shift in the LM curve, which leads to higher income.

Another channel through which falling prices expand income is called the Pigou effect. Arthur Pigou, a prominent classical economist in the 1930s, pointed out that real money balances are part of households' wealth. As prices fall and real money balances rise, consumers should feel wealthier and spend more. This increase in consumer spending should cause an expansionary shift in the IS curve, also leading to higher income.

These two reasons led some economists in the 1930s to believe that falling prices would help stabilize the economy. That is, they thought that a decline in the price level would automatically push the economy back toward full employment. Yet other economists were less confident in the economy's ability to correct itself. They pointed to other effects of falling prices, to which we now turn.

The Destabilizing Effects of Deflation

Economists have proposed two theories to explain how falling prices could depress income rather than raise it. The first, called the debt‑deflation theory, describes the effects of unexpected falls in the price level. The second explains the effects of expected deflation.

The debt‑deflation theory begins with an observation from Chapter 4: unanticipated changes in the price level redistribute wealth between debtors and creditors. If a debtor owes a creditor $1,000, then the real amount of this debt is $1,000/P, where P is the price level. A fall in the price level raises the real amount of this debt‑‑the amount of purchasing power the debtor must repay the creditor. Therefore, an unexpected deflation enriches creditors and impoverishes debtors.

The debt‑deflation theory then posits that this redistribution of wealth affects spending on goods and services. In response to the redistribution from debtors to creditors, debtors spend less and creditors spend more. If these two groups have equal spending propensities, there is no aggregate impact. But it seems reasonable to assume that debtors have higher propensities to spend than creditors‑‑perhaps that is why the debtors are in debt in the first place. In this case, debtors reduce their spending by more than creditors raise theirs. The net effect is a reduction in spending, a contractionary shift in the IS curve, and lower national income.

To understand how expected changes in prices can affect income, we need to add a new variable to the IS‑LM model. Our discussion of the model so far has not distinguished between the nominal and real interest rates. Yet we know from previous chapters that investment depends on the real interest rate and that money demand depends on the nominal interest rate. If i is the nominal interest rate and πe is expected inflation, then the ex ante real interest rate is i - πe. We can now write the IS‑LM model as

IS: Y = C(Y - T) + I(i - πe) + G
LM: M/P = L(i, Y)

Expected inflation enters as a variable in the IS curve. Thus, changes in expected inflation shift the IS curve.

Let's use this extended IS‑LM model to examine how changes in expected inflation influence the level of income. We begin by assuming that everyone expects the price level to remain the same. In this case, there is no expected inflation (πe = 0), and these two equations produce the familiar IS‑LM model. Figure 11-8 depicts this initial situation with the LM curve and the IS curve labeled IS1. The intersection of these two curves determines the nominal and real interest rates, which for now are the same.

Now suppose that everyone suddenly expects that the price level will fall in the future, so that πe becomes negative. The real interest rate is now higher at any given nominal interest rate. This increase in the real interest rate depresses planned investment spending, shifting the IS curve from IS1 to IS2. (The vertical distance of the downward shift exactly equals the expected deflation.) Thus, an expected deflation leads to a reduction in national income from Y1 to Y2. The nominal interest rate falls from i1 to i2, while the real interest rate rises from r1 to r2.

Here is the story behind this figure. When firms come to expect deflation, they become reluctant to borrow to buy investment goods because they believe they will have to repay these loans later in more valuable dollars. The fall in investment depresses planned expenditure, which in turn depresses income. The fall in income reduces the demand for money, and this reduces the nominal interest rate that equilibrates the money market. The nominal interest rate falls by less than the expected deflation, so the real interest rate rises.

Note that there is a common thread in these two stories of destabilizing deflation. In both, falling prices depress national income by causing a contractionary shift in the IS curve. Because a deflation of the size observed from 1929 to 1933 is unlikely except in the presence of a major contraction in the money supply, these two explanations give some of the responsibility for the Depression‑‑especially its severity‑‑to the Fed. In other words, if falling prices are destabilizing, then a contraction in the money supply can lead to a fall in income, even without a decrease in real money balances or a rise in nominal interest rates.

Could the Depression Happen Again?

Economists study the Depression both because of its intrinsic interest as a major economic event and to provide guidance to policymakers so that it will not happen again. To state with confidence whether this event could recur, we would need to know why it happened. Because there is not yet agreement on the causes of the Great Depression, it is impossible to rule out with certainty another depression of this magnitude.

Yet most economists believe that the mistakes that led to the Great Depression are unlikely to be repeated. The Fed seems unlikely to allow the money supply to fall by one-fourth. Many economists believe that the deflation of the early 1930s was responsible for the depth and length of the Depression. And it seems likely that such a prolonged deflation was possible only in the presence of a falling money supply.

The Pigou Club Manifesto - Director's Cut

On my Harvard website, I have posted a talk I gave earlier in the year, called Smart Taxes: An Open Invitation to Join the Pigou Club.

Regular readers of this blog will recognize the issue and many of the arguments, but I thought it would be useful to collect the ideas in one place and to develop the case a bit more thoroughly than is possible in a blog post or in a newspaper op-ed.

Welcome to the Club, Jay

This is a first: A candidate for the U.S. Senate emails me to apply for membership in the Pigou Club.

Hello Greg,

I am a candidate for the U.S. Senate in New Hampshire (www.buckey08.com) and believe we should address our energy problem through a National Security Levy on oil. I have worked with Doug Irwin and Jon Skinner from Dartmouth on the National Security Levy (Doug says hello), and have also consulted with Andrew Samwick.

The details of the National Security Levy are enclosed. [Here is a link.] The e-mail we sent out about it earlier appears below.

Think we could be listed as a member of the Pigou club?

Look forward to talking with you.

Sincerely,
Jay

----

Dear Friends,

If we needed confirmation that we've lost control of our energy future, we got it on Tuesday. President Bush was in Saudi Arabia trying to convince King Abdullah to help out our economy by increasing oil production. According to the report I read, the King's response was "lukewarm."

Now it's time for the American people to choose our energy future. We can either devote ever-increasing resources to defending our access to oil overseas -- and deal with the effects of global warming. Or we can use our technological skills to make the transition to renewable alternatives.

At a news conference yesterday in Manchester, I proposed a new plan to take charge of our future through a National Security Levy on oil.

Basically, the National Security Levy would be a fee on every barrel of oil consumed in the U.S -- combined with a price floor guaranteeing that oil would not sink below a certain price. The National Security Levy would be phased in slowly so that consumers wouldn't face a sudden price shock.

Part of the revenues from the levy would be rebated to working families to help compensate for increased energy costs. The rest would help finance an Apollo Program for Energy to make the US a world leader in energy development and production. This technological drive would create new jobs and businesses here in New Hampshire, where we have a growing alternative energy economy. The details of the National Security Levy are on our website: http://www.buckey08.com/issues.html.

This plan is going to require everyone in the US to change how they use energy. This may make the plan unpopular with some. But I got into this Senate race not to just look for the politically popular path, but to do things that need to be done. And getting serious about our energy problem is way overdue.

As a nation, we can be great at this transition. No other country on Earth has the talents, resources, and drive to change from petroleum to renewable alternatives as well as we can. Also, spending billions of dollars for energy here in the United States that we otherwise would have sent to foreign governments is going to be an enormous economic boost for us. But we have to get started.

I'm very glad to be able to put this proposal forward. But I can't make it happen alone. Please tell your friends about it, ask them to join us, and contribute to the campaign. With your support, we can succeed. I look forward to hearing from you.

Sincerely,
Jay

Note to journalists out there: Give this guy the attention he deserves. It is brave and honorable to try to turn this good policy into successful politics.

Pigou Club news

From my inbox:

I thought you might be amused to see this. At Metrovino, a restaurant in Portland, Oregon where I run the bar, we needed a name for a drink we serve that's a slight variation on the Pegu Club (a classic gin cocktail). "Pigou Club" was the first thing to come to mind. I doubt many guests know what the name alludes to but it makes me happy and the drink has become one of our bestsellers. A photo of the menu is attached.  The recipe and background are here.

Also, by the way, Australia has joined the club, amidst significant controversy.