December 02, 2007

Carbon Offsets--Posner

A number of firms, such as TerraPass, sell "carbon offsets" to consumers worried about global warming. You give TerraPass information about your driving, flying, and the size of your house, and TerraPass computes your annual carbon dioxide emissions and offers for a price to offset some or all of them by investing the proceeds from your purchase in projects (for example, wind farms) for reducing carbon emissions. In principle, if you purchase offsets for your entire carbon emissions, your net contribution to global warming is zero.

The carbon-offset movement is an echo of the "cap and trade" approach to pollution control, which is used for example to limit emissions of sulfur dioxide. (The Kyoto Protocol creates such a system for carbon emissions, but the United States is not a signatory to the Protocol and has no cap and trade program for carbon.) In cap and trade, each polluter is given a permit to emit a certain quantity of a pollutant. The total amount permitted to all polluters will be less than the total pollution, because the aim is to reduce pollution. The key point is that the cost of compliance varies across polluters. Consider two polluters. One can eliminate a ton of emissions at a cost of $10, the other at a cost of $50. At any price between $10 and $50, both polluters are better off if number one sells the right to emit a ton of emissions to number two; society too is better off, because the trade frees up $40 to invest in other goods.

The problem with carbon offsets is that they are purely voluntary. You do not obtain a monetary benefit by reducing carbon emissions, as you would if you had an emissions permit that you could sell to big emitters, or if you would be punished for exceeding a permitted level of emissions. When you buy a carbon offset, you are making a charitable contribution to fighting global warming. Since charitable motivation is weak compared to self-interested motivation, carbon offsets are a poor substitute for a cap and trade system, quite apart from the doubts that have been raised about the efficacy of the projects in which the firms offering carbon offsets invest. At best, moreover, carbon-offset programs are severely limited because consumers are not the only emitters of carbon dioxide. A further problem is that the investments by the carbon-offset firms in reducing carbon emissions may to a great extent simply replace existing investments. (An estimate of the replacement effect should be reflected in the price that TerraPass charges for offsets.) There is commercial and governmental investment in wind and nuclear energy, reforestation, climate research, fossil-fuel efficiency, and so forth, and if now consumers through carbon-offset programs invest in such projects, the commercial and governmental investors may scale back.

But the most serious drawback of the carbon-offsets movement lies elsewhere--though not, as environmental radicals would have it, because it makes emitting carbon dioxide into the atmosphere respectable, whereas it ought to be thought sinful, like littering, or driving without a catalytic converter. Although carbon emissions pose a much greater danger to the environment than other pollutants, they differ because they confer benefits as well as impose costs, and indeed reducing them to zero would be a disaster because atmospheric carbon dioxide is essential to maintaining a temperate climate. There is nothing wrong with emitting carbon dioxide. The wrong lies in the quantity being emitted, which is excessive.

The most serious drawback of the carbon-offsets movement is that it is likely to make the problem of excessive carbon emissions more rather than less serious, and this for three reasons. The first is that it creates the impression that modest reductions in the rate of annual increases in carbon emissions make a meaningful contribution to the fight against global warming. They do not. Given the limitations of the carbon-offsets movement that I have noted (its purely voluntary nature and the fact that only consumer emissions are affected), plus the fact that any reductions attributable to the movement are more than offset by continuing rapid increases in emissions by China, India, and other rapidly developing economies, the movement can at best limit only very slightly the rate of annual increase in carbon emissions, whereas the need is to reduce the level of those emissions. The reason is that, because atmospheric carbon dioxide is absorbed by the oceans only very gradually (and the ability of the ocean to act as a "carbon sink" apparently is declining), a high annual level of carbon emissions tends to have a cumulative effect, so that even if that level were steady (rather than increasing, as it is), the atmospheric concentration would rise.

Second, the movement encourages the belief that anyone who reduces his carbon "footprint" (that is, the emissions of carbon dioxide that he causes) to zero has done his bit to combat global warming. My wife and I have two cars, two houses, and fly a certain amount, but according to TerraPass's calculation, we can reduce our carbon footprint (roughly 32 tons of carbon dioxide a year) to zero at a cost of $282 a year. Then I will feel good about myself. But if a million American families having similar carbon footprints eliminate them at this rather modest price, the result--a reduction of 32 million tons of carbon dioxide emitted per year--will be microscopic, as the worldwide hourly emission of carbon dioxide is 16 million tons. A million American families would be roughly 1 percent of the U.S. population. Suppose the carbon-offsets movement, which is recent, and is getting a boost from the increasingly ominous evidence of global warming, grows beyond my expectations, to a point at which 10 percent of the U.S. population is paying TerraPass or other carbon-offset providers to offset an average of 32 tons per family. The effect would be to reduce annual worldwide carbon emissions by 20 hours' worth, or about one-quarter of 1 percent, and the reduction would be greatly offset by the worldwide growth of emissions, currently running at about 3 percent a year.

Third, and most serious, the carbon-offset movement, combined with well-publicized projects by Google and other companies to reduce carbon emissions, creates the false impression that global warming can be tamed by voluntary efforts, just as cleaning up after dogs has been achieved by voluntary efforts, without need for legal compulsion. Global warming cannot be tamed by voluntary efforts, because the costs of significantly reducing carbon emissions in order to reduce the atmospheric concentration of carbon dioxide (or at least stop it from increasing) are enormous. If people believe that voluntary efforts will suffice, there will be no political pressure to incur the heavy costs that will be necessary to avert the risk of catastrophic climate change.

Against this it can be argued that the carbon-offset movement is increasing the public awareness of the global warming problem, which may lead to other voluntary efforts to reduce carbon emissions, such as switching from SUVs to more fuel-efficient vehicles, or may exert pressure on politicians to support the regulation of carbon emissions. I am skeptical. I think very few Americans are prepared to incur substantial costs to deal with a problem that is so afflicted by uncertainty about its imminence and magnitude as global warming. They will avoid cognitive dissonance by exaggerating the practical efficacy of largely symbolic gestures, such as purchasing carbon offsets.

Posted by Richard Posner at 10:45 AM | Comments (25) | TrackBack (0)

On Carbon Offsets-Becker

Posner's discussion of carbon offsets is thorough, so I will concentrate on only a few issues. The main obstacles to a large reduction in the aggregate emission of carbon dioxide from any offset system are that the system is likely to affect only a small number of persons and companies that produce carbon emissions, and also that many alleged "offsets" have only a small net effect on emissions.

It is an impressive testimony to the power of the "green" movement that many consumers, and some companies responding to consumer pressure, are voluntarily seeking offsets for the carbon emissions from their diverse activities. Nevertheless, the carbon-offset movement still has only a tiny fraction of all consumers and companies worldwide. Even if the movement doubles or trebles in size, and even if the alleged offsets are real offsets, its overall effect on carbon emissions will remain quite small.

Of course, the numbers involved would multiply greatly if offsets for emissions became compulsory rather than voluntary. But then the carbon-offset system would be fundamentally no different from a carbon emission trading system of the cap and trade variety. Cap and trade systems, and any compulsory offset system, presumably would apply only to companies since enforcement and management of the system is much easier for the relatively small numbers of firms than with the hundreds of millions of consumers in the US alone.

The natural link between an offset system, whether compulsory or voluntary, and an emission trading system does dispose of the criticism that offsets are not desirable because they are like the indulgence system of the Middle Ages, In that system, sinners could purchase forgiveness for some of their sins without either having to repent, or having to agree not to sin anymore. Yes, an offset system does essentially involve buying the rights to pollute, but buying such rights helps get polluting into the hands of those businesses and consumers who get the most value from these rights. That is why the world has gravitated toward a cap and trade system rather than merely a cap system.

Another major problem with any carbon-offset system is that activities producing the so-called "offsets" may have happened anyway. For example, an initial and still popular type of carbon offset is to pay for the planting of trees in a reforestation project, particularly in the tropics. Forests help cool the atmosphere by storing carbon. It is quite difficult to determine whether any particular tree-planting program makes a net contribution to planting, rather than simply displacing other tree plantings that would have occurred anyway.

As one example, a country located in the tropics may have planned on a reforestation project for several reasons, including a reduction in the degree and rapidity of water runoffs during rainstorms. If a carbon-offset project began to plant trees in that forest, the country may cut back on its own efforts since these would be replaced by the tree plantings that serve as carbon offsets. TerraPass, an important company that sells carbon offsets, was accused of selling offsets in a methane recapturing project that allegedly would have happened without the TerraPass offsets (the company denied this claim; see the discussion in the Wikipedia article on "Carbon Offset").

In our complicated and interdependent global economic system, opportunities to create carbon offsets can be readily produced by both companies and governments without any significant affect on the scale of emissions. Mainly for this reason, but also because of the reluctance of most individuals to voluntarily pay significant costs for acting "green", a cap and trade system, despite its many flaws, is a far preferable direction to develop in order to cut down on carbon emissions.

Posted by becker at 10:25 AM | Comments (5) | TrackBack (0)

November 25, 2007

Why so Little Tax Evasion? Becker

All the rich countries are successful in raising sizable amounts of revenue from taxes with only a rather little tax evasion. Tax avoidance is the use of legal means to reduce taxes, whereas tax evasion uses illegal means. The federal government of the US raises almost 20 percent of American GDP through taxes on personal and business income, capital gains, estates, and the sale of gasoline and some other goods. The estimates from the 2001 IRS National Research Program indicate that the percent of income not reported is quite low for wages and salaries, but rises to over 50 percent for farm income, and about 40 percent for business income. Income tax payments overall are under reported by about 13 percent. What determines the degree of tax evasion?

If taxpayers responded only to the expected cost of evading taxes, evasion would be far more widespread. The reason is that only about 7 percent of all tax returns are audited (over a 7 year period), and typically the penalty on under reported income is only about 20 percent of the taxes owed. Virtually no one is sent to jail simply for evading taxes unless that evasion is on a very large scale, or involves massive fraud. If a person were to evade $1,000 in taxes, his expected gain would be 0.93x$1000 -0.07x$200 (=$1000/5) = $916. On these considerations alone, he should not hesitate to evade paying the $1,000, and presumably much more.

To be sure, the expected gain is not the right criterion since most taxpayers would be risk averse regarding audits and punishments, especially if there is some chance of much greater than the average punishment or likelihood of an audit. However, if the expected gain from evading $1,000 were $916, the degree of risk aversion would have to be huge, far higher than the risk aversion that is embodied in pricing of assets, for risk to explain why there is so little tax evasion.

This is not to say that possible punishments have no affect on the amount of tax evasion. Compliance rates are much higher when governments have independent evidence on a person's income since then the probability of audit when he under reports his income is much higher than when they do not have this information. For example, income from independent consulting to companies is better reported than tips on earnings, or than the incomes of farmers and other small business owners because employers report how much they paid to independent consultants, whereas no one reports how much they paid in tips, or how much they bought from a local store. A PhD study in progress at the University of Chicago by Oscar Vela also shows that persons in occupations where integrity is a more important determinant of success, such as law or medicine, are less likely to evade taxes. Presumably, any publicity that an individual in these occupations was convicted of tax evasion would damage his reputation and earnings.

Vela finds that considerations of reputation, along with more traditional variables in the tax evasion literature do help explain how much evasion occurs for different types of income. These variables include the likelihood of audits that varies for different classes of taxpayers, punishments for those audited, marital status (not surprisingly, married persons are less likely to evade taxes), the marginal tax rate, and the ease with which governments can match reported incomes with independent evidence on incomes, such as from 1040 and 1099 tax forms,

Note that tax avoidance as well as tax evasion tends to rise as the marginal tax rate increases. That is, with higher tax rates, individuals and businesses are both more likely not to report some of their income to the tax authorities, and also to search harder for ways to reduce how much of their income they are obligated to report. This implies, for example, that flattening the income tax structure would increase the amount of personal income reported to tax authorities because both the amount of evasion and the avoidance of the personal income tax would be reduced.

However, audits, punishments, and the other deterrence variables mentioned in the previous paragraphs do not fully explain why there is not much more tax evasion. I believe it is necessary to recognize that most people believe they have a duty, moral or otherwise, to report their taxable income more or less honestly. I intentionally say "more or less honestly" because a little cheating on taxes is usually considered to be ok, as long as it does not go too far. Individuals might not pay social security taxes on their payments to workers who clean their houses, and they might pay a mason in cash because he then gives them a lower price, but these same persons would be very reluctant to engage in large-scale tax evasion.

Similarly, most people do not believe it is moral to steal money even when there is little chance they will be found out, and they feel obligated to obey many other laws, even when that entails inconvenience and cost to themselves. There would be considerably more crime if individuals only obeyed laws when the expected cost of being caught, adjusted for risk, exceeded the benefits from disobeying these laws. To some extent, people obey many laws, including tax laws, because most other persons are doing the same. If so, their behavior might change radically if they lost confidence that others would pay their taxes and obey other laws.

Clearly, morality about obeying laws does not apply to all types of taxes, or all laws-people often cross a street when the light is red, do not stop at stop signs when riding their bikes, and do not report much of their tips. Moreover, in many countries of Latin America, Africa, and Russia and other parts of Eastern Europe, individuals do not even feel much obligation to pay ordinary income and other taxes. They evade except when they expect the chances of being caught are high, as with businesses paying value added taxes. These countries are unable to raise substantial amounts from taxes on personal incomes or businesses except when marginal tax rates are low. Instead they rely greatly on value added and other more difficult to evade taxes.

Posted by becker at 04:51 PM | Comments (16) | TrackBack (0)

Tax Evasion--Posner's Comment

Becker presents persuasive evidence that the amount of tax evasion varies, as one would expect in a rational-choice model of taxpaying, with variance in the private costs and private benefits of evasion. I am inclined to believe that the private costs are higher than he suggests, which if true would mean that more tax compliance can be attributed to rational fear of punishment than he suggests and less to taxpayers' feeling a moral duty to pay taxes. For example, the civil penalties for tax evasion are quite severe (the fraud penalty is 100 percent of the amount of taxes evaded), and anyone charged with civil or criminal tax evasion will incur heavy legal and accounting expenses in defending against the charge. Although the audit rate is low, it is not random, but rather is higher for those taxpayers who are in the best position to evade taxes without being caught or whose tax returns raise a red flag because of unusually high deductions or other suspicious circumstances. And once one has been caught evading taxes, one can expect the rate of future audits of one's returns to be high. While it is true that underpayment of taxes is rarely prosecuted criminally, even when deliberate, criminal prosecution is likely if the tax evader takes steps to conceal the evasion, as by never filing a tax return, keeping phony books, or forging evidence of deductions. Moreover, the government does occasionally prosecute even small fry.

Thus far I have focused only on punishment costs. But a neglected point in the economics of crime is the information costs of committing a crime. Evading taxes requires more knowledge than stealing a bike. Most taxpayers probably don't have a clue as to how to evade taxes without being caught. It might seem awfully simple--just list your cat as one of your dependents. But to know whether this would work, you would have to know whether the government has any independent source of information about the number of a person's dependents. You can't just go to a lawyer and ask him what the best way of evading taxes is.

Most people comply with most laws most of the time. I believe that in most cases they do this not because they feel any moral duty to comply with law, but because the potential payoff does not seem to exceed the costs, including the information costs that I have emphasized. The reason I doubt that there is much of a felt moral duty to comply with tax law is that there is a vast amount of illegal behavior by normally law-abiding citizens. The flouting of the traffic laws, the theft of employer property, the nonpayment of social security taxes on household help, illegal gambling, and the employment (both personal and commercial) of illegal immigrants are only the most obvious examples. These are cases in which law enforcement is so lax that the expected punishment costs for most violations hover close to zero, and there are distinct benefits from violation.

Still, Becker is unquestionably correct that there is a good deal of tax evasion apart from the social security example. It could be greatly reduced by stiffer penalties and a greater investment of resources in law enforcement. Every dollar spent by the Internal Revenue Service on enforcement brings in several dollars in additional tax revenue, suggesting that an expansion in the IRS’s budget would be necessary to equate the marginal benefits of tax enforcement to its marginal costs. But this suggestion ignores the fact that the benefits are, as a first approximation, merely income transfers, whereas the marginal costs of tax enforcement are social costs. If taxes are evaded, the resulting shortfall in tax revenues is made up by increasing the tax rate, and there is no social loss unless the increase has worse misallocative effects than the evaded taxes would have had, had they not been evaded. One reason, therefore, that tax evasion is widespread is that it may be cheaper from an overall social standpoint to have slightly higher tax rates than to devote additional resources to law enforcement, though the first-best solution might be stiffer penalties, especially monetary penalties. Deliberately lax enforcement would then explain the amount of evasion.

The general question that Becker raises of the moral costs of committing crime is a fascinating one. I would be inclined to search as hard as possible for nonmoral costs before concluding that morality is a major motivator of behavior, especially with regard to crimes, like tax evasion, that do not have an identifiable victim. In the case of many crimes, the benefits to most people of perpetrating them would be so slight (and often zero or even negative) that sanctions play only a small role in bringing about compliance; enforcement costs needn't be high in order to deter when nonenforcement benefits are low. Some examples: the demand for crack cocaine among white people (including cocaine addicts) appears to be very small. Both altruism and fear deter most people from attempting crimes of violence, quite apart from expected punishment costs. The vast majority of men do not have a sexual interest in prepubescent children. Well-to-do people often have excellent substitutes for crime: any person of means can procure legal substitutes for illegal drugs (for example, Prozac for cocaine, Valium for heroin). Fear of injury deters most people from driving recklessly or while drunk. People who have no taxable income are incapable of evading income tax. People who do have taxable income can obtain benefits from evading it, but the costs of evasion are, as I have emphasized, nonnegligible, so there is widespread compliance along with a good deal of evasion. I would therefore expect differences across countries in tax evasion to be related more to differences in penalties, collection methods, and so forth than to differences in morality. Americans may exhibit higher tax compliance than Italians, but Americans are not a more moral people than Italians.

This is not to deny the independent behavioral effect of social (including moral) norms, but on reflection one can see that these norms are enforced, even if not by law. When the cost of compliance with a norm is low, as in the case of picking up after one's dog, dirty looks alone may impose a cost greater than that of compliance. But taxes are not paid in public, so shaming is not a feasible alternative penalty to the legal sanctions for tax evasion.

Posted by Richard Posner at 04:16 PM | Comments (17) | TrackBack (0)

November 18, 2007

Is the Bond Market the Best Predictor of the Outcome of a War?--Posner

An article in the business section of the New York Times last Sunday (November 11) by economist Austan Goolsbee, summarized an academic paper by an MIT economist named Michael Greenstone that uses Iraqi government bond prices to estimate the bond market's response to the Bush Administration’s "surge." Greenstone's paper, available from the Social Science Research Network, is dated September 18, which is two months ago, and perhaps developments since would alter his conclusions. To estimate default risk from the bond's current trading price, and in particular to estimate the effect of the surge on the default risk, is not straightforward. For example, Greenstone adjusts for the probability that a Democrat will be elected President next year (regarded as increasing the likelihood that Iraq will default on the bonds); that probability may have changed since September 18. The worldwide credit crunch has worsened since then, and that might have an effect, independent of the surge, on the price of the Iraqi bonds.

The bonds ($3 billion worth issued in January 2006), which mature in 2028 and until then pay 2.9 percent on their face value twice a year, so almost 6 percent per annum, are trading at a steep discount (currently about a 40 percent discount, which jacks up the yield to almost 10 percent--almost $6 for a bond that costs $60). This means that purchasers of the bonds (which are actively traded) are demanding compensation for bearing a substantial risk of default. The most interesting conclusion in Greenstone's study is that, after correction for other factors, the surge is correlated with a 40 percent increase in the bond market's estimate of default.

It seems unlikely that the surge itself would increase the risk of default, though it might, by enabling both the Sunnis and the Shiites to rest and augment their forces for the eventual showdown, taking advantage of a kind of truce imposed by the additional American troops. More likely, the bond traders see the surge as a desperate last gamble by the United States; as a preclude to U.S. withdrawal and specifically as a sign that the United States will withdraw soon after the next Presidential election, whoever wins the election; as a political gimmick; and as a failure in the aim of the surge of promoting progress toward a political settlement that will enable Iraq to be a functioning nation when we leave. If, as the bond traders fear, Iraq is likely to be divided well before 2028 into three separate nations (Kurdish, Sunni, and Shiite), a default is likely.

There are two general questions that Greenstone's interesting study raises. The first is the relation between default risk and U.S. failure. For comparison, consider another recent study, by Kim Oosterlinck and Marc Weidenmeir, this one of the price of Confederate bonds in the Amsterdam market during the American Civil War. Initially the bond prices traded at a discount that indicated that the Confederacy had a 42 percent chance of winning the war and therefore presumably of repaying the bonds; but with the crushing twin defeats of the Confederacy at Gettysburg and Vicksburg in the summer of 1863, the bond market quickly downgraded the Confederacy's chances of winning the war to only 15 percent, and the estimate kept falling till the end of the war. The difference between that case (and other examples of using bond prices to predict the course of a war) and the Iraq case is that the risk of the Confederacy's defaulting on its bonds depended essentially on just one event, namely whether the Confederacy--the issuer of the bonds--lost the war. In the case of Iraq, the relation of the risk of default to the outcome of the war is obscure. No one thinks that the United States can actually be defeated by Sunni insurgents, al Qaeda in Mesopotamia, Shiite militias, Iranian infiltrators, or any other armed groups in Iraq or the surrounding areas. At the same time, few believe that the United States can win the war in the sense of eliminating widespread violence and coupling withdrawal with handing over control of the country to a functioning government, as the United States was able to do several years after the end of World War II in Germany and Japan. Moreover, if we wanted to avoid a default, we could do so simply by buying up the bonds (at the current discount, they would cost only $1.8 billion, provided they were bought up surreptitiously so as not to force up the price significantly) and then forgiving the debt. And finally, one can imagine a scenario in which American policy is an utter failure, but the utter failure actually reduces default risk. Suppose we pull out of Iraq and Iran takes over. Iran might decide to pay off the bonds in full (the amount of money is small) in order to increase its credit standing.

So really the only (though major) significance of Greenstone's bond market study, so far as our situation in Iraq is concerned, is that it is evidence that the surge, while it has reduced the number of deaths in Iraq, has not increased the viability of the Iraqi state, but instead has revealed (possibly even contributed to the prospect revealed) that the attainment of viability is increasingly unlikely.

The second general question raised by Greenstone's paper is whether financial markets are better predictors of the outcome of wars and other political crises than experts are, including the experts who staff intelligence agencies. One might think that experts would be better predictors because they had specialized knowledge that bond traders would lack and that experts who work for intelligence services would have not only expert knowledge but knowledge that bond traders could not obtain by consulting experts, because it would be classified knowledge. A careful historical study (and access to classified information, at least for recent crises) would be required to answer the question which predictor is better. But it would not be surprising if the financial markets turned out to do better than the experts, including national security personnel. Financial markets aggregate the opinions of a vast number of investors, and those investors who at least think that they have real insight tend to be the ones who determine the prices in those markets.

Friedrich Hayek's great legacy to economics was to show that the price system can aggregate vast amounts of information much more efficiently than a centralized bureaucracy can do. And intelligence agencies are centralized bureaucracies. The innumerable mistakes that the United States has made in Iraq suggest that our government does not have good means of obtaining and evaluating information concerning that country, possibly because of a combination of bureaucratic inefficiency and the vastness of the quantity of relevant data. The people who trade Iraq government bonds do so not because they are told to study Iraq or paid a salary to do so or have an academic or journalistic interest in the country, but because they hope to make money. Presumably therefore they are self-selected for knowing a lot about Iraq—and for thinking they know enough to put their money where their mouth is. They may be right.

Posted by Richard Posner at 05:41 PM | Comments (19) | TrackBack (2)

Iraqi Bonds and the Effects of the Surge-Becker

Michael Greenstone of MIT had the excellent idea of using financial data to provide information on what global investors believe about the viability of this government. In an unpublished article revised on September 18th of this year, he uses data on movements over time in the yields on Iraqi bonds issued in 2006 by the present Iraq government to assess what investors believed about the prospects for success of the "surge" in American military personnel that began in mid-February, 2007. He shows that yields remained at about 9.6 percent from the beginning of the surge in February to midsummer, then climbed to 11.5 percent in August, and was at that level when he finished his study. What can one make out of this analysis?

The bonds were issued with a 5.8 percent annual yield, which seems too low, given the high risks of a default by this government, and that high yield bonds (junk bonds) typically provide considerably higher yields. So not surprisingly, these Iraqi bonds have been priced in the marketplace at a considerable discount in order to yield to buyers returns that are much higher than 6 percent if the government manages to pay both the interest and principal (due in 2028).

I agree with Greenstone and Posner that prices of these bonds offer a valuable way to determine expectations about the stability of the Iraqi government held by the savvy investors in the international bond market who are placing substantial financial resources at risk. This does not mean that these investors are never wrong, or do not change their views as the evidence unfolds, but rather that bonds prices offers relevant information about the assessments of Iraq's future by persons who have an important financial stake in whether they are right or not.

The additional evidence available since Greenstone's September study provides a more optimistic assessment than at that time of how the surge is going. Both American military and civilian casualties are way down during the past two-three months-Greenstone also refers to such data up until the end of August- and civilian life in Baghdad has returned to a semblance of normality for the first times in a few years. Explosions, mortar attacks in Baghdad, and bombings all declined by a lot in recent months. As a result, Iraq bond prices have also rallied significantly, so that their yields are down to about 10.5 percent recently. This is still about 10 percent above yields in February, but the additional premium has been reduced from almost 2 to a little less than 1 percentage point.

Several commentators have emphasized that the steep decline in Iraqi bond prices and corresponding increase in yields that began in August coincided with the beginning of the credit crunch, which significantly raised interest rates on all bonds. The crunch especially raised rates on riskier bonds, so it is not surprising that highly risky bonds like those issued by the government of Iraq should have fallen greatly in value starting in August. To correct for this, it would be valuable to compare Iraq bonds with bonds of comparable risk. Some traders have suggested comparisons with bonds issued by the government of Lebanon since that government's stability is also highly uncertain. Apparently, Iraqi bonds have outperformed Lebanon's since the beginning of the surge.

This would suggest that the surge may be having a positive effect on investor's expectations about the viability of the Iraqi government, at least relative to the viability of other governments with questionable stability in that most unstable region. However, Greenstone in his paper, and in some updated calculations of his that he sent me, prefers to use not a single country's data (a single country could be biased by choice of country), but an index of emerging market bonds. The gap between Iraqi yields and emerging market yields did decline noticeably from September, but the gap is still much larger than in February.

Another consideration relates to the ability of bond prices to accurately reflect what is happening to risk. Suppose investors and others believe that the surge has greatly improved the average financial and other prospects of Iraq, including the stability of its government. However, it is plausible that the riskiness of these outcomes has increased because of growing uncertainty about America’s commitment to continue its involvement, and the greater chaos that might follow if the surge failed. On this view, the surge could have improved by a lot the average outcome expected for Iraq in the future, while at the same time it would have increased the likelihood that the government would fail, and that bonds would go into default. Since the best that bondholders can do is receive interest and principal, while the worse is default on either or both these classes of payments, any increased risk produced by the surge would lower bond prices and raise yields even if expected outcomes greatly improved.

A more appropriate way to assess the effect of the surge on expectations about the economy, and presumably indirectly about the stability of the government, would be to examine changes in valuations on the nascent Iraq stock exchange. Greenstone discusses trying to do that, but gave up because few stocks are traded, and trades are highly irregular. Since the market is very thin, it is hard to reach any strong conclusions, but I have the impression from a few reports that prices of stocks on the Iraq stock exchange have risen in recent months.

Whatever the final conclusions about the evidence on the political future of Iraq provided by its bonds, financial markets are an underutilized source of information about the expectations of investors about political outcomes. To be sure, financial expectations can be very wrong. For example, Eugene Lerner has shown that the Confederate currency did not depreciate very rapidly (relative to the growth of the money supply) until only a few months before the end of the Civil War, even though historians are unanimous that the South had effectively lost the war long before that. Still, I generally would have more confidence in the accuracy of the expectations of persons with a serious financial stake in outcomes than in the forecasts of most others who express their views on future political outcomes.

Posted by becker at 05:28 PM | Comments (6) | TrackBack (1)

Reply to Comments on Billionaires--Posner

There were a number of interesting comments. I cannot reply to all of them, but I will reply to a few. One comment was that "wealthy private donors often take an interest in the results they are purchasing with their donations. Few would argue that government is equally demanding with its funds. Thus, an increase in government spending to replace charitable donations seems counter productive." I do not agree. The reason is that charitable foundations are perpetual, and are controlled by self-perpetuating boards of trustees. As a result, the original donors do not control a foundation. There is thus less monitoring of foundations than there is of government programs.

Another comment questions how eliminating charitable deductions from the estate tax would generate much tax revenue. "People will simply give whatever money they had otherwise intended to charity while they are still alive, noting they don't need tax deductions to do so." This might be largely true if there were no gift tax (it would not be completely true because, not knowing when they die or what their future expenses will be, people are reluctant to give away almost all their money before they die). There is and must be a gift tax to back up the estate tax.

The same commenter said that I am "radically underestimating the incentive effects of giving to one's offspring. Assume you can close all the 'loopholes' permanently and it is impossible to give one's wealth to one’s children (what a hideous thought) after death or while alive, then I assure you an awful lot of our most prolific job creators would either retire or stop being workaholics and instead take time out to smell the roses." This comment conflates closing loopholes with confiscatory tax rates. Even if there were no deductions, an estate tax of less than 100 percent would allow people who accumulated an estate to pass some of the money in the estate to their children or others, including charities.

Another commenter makes the following good point in defense of the estate tax: "Most of the wealth of these billionaires is not from income and has not been taxed, e.g. Balmer has not sold and rebought his Microsoft stock on which to pay capital gains, but has held it and his wealth is from appreciation that has not been taxed. So the estate taxes, for the most part, are taxes on money as it passed to heirs that has not yet been taxed.” When the heirs sell the stock, moreover, they pay income tax only on the difference between the value of the stock at the time of the donor's death and its current value, so that the appreciation in stock value during the donor's life is never taxed.

Finally, one unrelated and very strange comment: "I take great offense at your recent statements that all Muslims in America should be under surveillance." Neither recently nor ever have I made such a suggestion.

Posted by Richard Posner at 01:54 PM | Comments (2) | TrackBack (0)

November 11, 2007

Billionaires-Becker

The wealth of some individuals is so staggering that it is hard for the rest of us to fathom. All of the world's 100 richest individuals are worth much more than $1billion. Even persons with a few billion dollars would not make this exclusive list since Donald and Samuel Newhouse are tied for the bottom spot with $7billion (the rankings are for March of 2007, and were compiled by Forbes magazine-the data are available at http://www.forbes.com/lists/2007/10/07billionaires_The-Worlds-Billionaires_Networth_7.html; see also the excellent discussion of a similar list in a November 7th article by Martin Wolf in the Financial Times). Bill Gates, Warren Buffet, and Carlos Slim of Mexico top the list with a net worth estimated to be between $50-60 billion; the asset values of these and others on this list fluctuate a lot over time with changes in the valuations placed on stock and other assets.

This list has 39 Americans, 14 Russians, 8 Indians, and several each from Germany, France, Sweden, and Saudi Arabia. Mainland China has none yet among the wealthiest individuals (Hong Kong has three), but the rapid wealth accumulation in China means that before long several mainlanders will join this exclusive club. The list contains both individuals who inherited most of their wealth,and those who made it by building businesses. Only a couple of those on this list acquired their wealth from just being a CEO of a significant company. I am impressed that the strong majority of the world's richest individuals (about 30 out of the 39 richest Americans) made their money rather than inherited it. The wealthiest individuals are mainly self-made because inherited wealth gets dissipated over a couple of generations through bad investments, or is given to various charities, or gets broken up and divided among many grandchildren, cousins, and divorced members. For this reason, no descendants of John Rockefeller, Andrew Carnegie, or other titans of the beginning of the century are among the very wealthiest.

To be sure, some of these "self made" billionaire businessmen accumulated some of their wealth from political connections that gave them protected markets. This category includes Carlos Slim, many of the richest Russians, and some others. They tend to be able businessmen, but there is a vast difference between the contribution to society from starting a Google, Microsoft, Wal-Mart's, Arcelor Mittal, or IKEA, and the extraction of profits from a monopoly position protected by government regulations.

If we assume an average rate of return on this wealth of about 6 percent in real terms, then the combined income of the 39 richest Americans amounts to about ¾ of 1 percent of US gross domestic product (GDP). This is a sizable share for only 39 out of 300 million Americans, but Carlos Slim alone gets about 1 percent of Mexico's income. The wealth of the14 richest Russians generate a combined income that is over 4 percent of that country's GDP.

Given the enormous wealth of these individuals, it might be surmised that the gap between the incomes of the very richest and the average individual increased substantially during the past 100 years. Actually, the opposite appears to be true. John D. Rockefeller's income was about 1/3 of 1 percent of the much smaller American GDP of his time, whereas Bill Gates' income is less than 1/12 of one percent of current US GDP. More generally, the overall inequality in wealth also declined greatly in the US, UK, and other western European nations during the first 60 years of the 20th century. Inequality has increased significantly since then, but it is still less than at the beginning of the century.

Clearly, governments should not offer individuals protected markets that enable them to accumulate such enormous wealth. However, as I indicated earlier, the Americans on this list, and most others from Western Europe, Hong Kong, and India acquired their wealth through creating sizable value to consumers from new products and processes, greater efficiencies, and novel services. Obviously, these individuals were well rewarded for doing this, but consumers have benefited by much greater amounts.

Still, there is pressure in most countries to tax heavily the very wealthy. One possible reason to do so would be to prevent their children and other descendants from having large advantages over descendants from financially modest families. But to help in equalizing opportunities, taxes should be on inheritances, not as in the US and many other countries, on estates. Even inheritance taxes, however, do not reduce the advantages from growing up in very wealthy environments, nor do they affect the huge head start from being raised in educated households that are not wealthy. From the perspective of getting a better education and higher earning power, having educated parents is considerably more advantageous than having very wealthy parents.

A heavy tax on the very wealthy would also raise tax revenue that could replace income and other taxes on the not so wealthy. I believe that individuals with wealth in excess of hundreds of millions of dollars would tend to work about just as hard when their estates would be heavily taxed as they would without estate taxes, as long as they would still have a very large after-tax estate. However, the revenue raised has to be balanced against the costly evasions and avoidances that such a tax generates. These costs take the form of trusts that skip generations, the use of insurance policies with irrevocable beneficiaries, migration to low taxing countries, and other techniques known much better to the very rich than to me.

The US imposes a 45 percent tax on all (taxable) estates above a few million dollars. This tax yields a moderate amount of revenue, but at the cost of creating a large industry of highly skilled estate tax professionals who would have used their talents at more socially productive activities were it not for the demand to find loopholes. One justification for such high taxes that has some appeal even when only modest sums are collected is that high taxes have encouraged the very wealthy to create large tax-exempt educational and charitable foundations in order to reduce their taxes. Yet since Rockefeller, Carnegie, and other highly wealthy individuals also created foundations when estate taxes were low, it is not clear how many modern foundations have been created mainly to avoid these taxes. In any case, larger foundations could still be encouraged with much bigger exemptions from the estate tax-perhaps $50 million or even more. This tax should only affect the extremely wealthy.

Posted by becker at 08:47 PM | Comments (32) | TrackBack (1)

The Proliferation of Billionaires--Posner's Comment

The Forbes and Financial Times articles to which Becker refers present an astonishing portrait of immense personal fortunes. I shall limit my comment to the Americans on the list. Becker is correct to note that the very largest fortunes are made rather than inherited. The reason probably is that most of them are the result of recent advances in digital technology and the increased globalization of financial and other markets. At a guess (because I don’t recognize all the names in the Forbes list), more than half of the 20 largest American fortunes are due to those recent developments and so could not be the product of inheritance. As one moves down the Forbes list, inherited wealth appears to account for an increasing number of the American fortunes.

The American fortunes are overwhelmingly due to lawful entrepreneurial efforts rather than to politics or illegality. It is true that Microsoft lost a major antitrust case (and a number of minor ones), owing to its attempt (or so the courts found) to smother Netscape. But it is highly unlikely that Microsoft’s campaign against Netscape accounts for any of the Gates, Ballmer, or Allen fortunes, as in retrospect it is apparent that Netscape lacked the business acumen to mount a successful challenge to Microsoft's dominance of the personal-computer operating-system market, as Microsoft feared.

I also agree with Becker that the benefits to consumers from the entrepreneurial efforts that produced Microsoft, Google, Apple, E-Bay, Amazon.com, Wal-Mart, private-equity firms, hedge funds, and other commercial successes that have generated large personal fortunes are much larger than the personal fortunes garnered by the founders and principals of such companies.

It does not follow, however, that these billionaires "deserve" their fortunes and therefore should be as lightly taxed as they are. As the economist Sherwin Rosen showed in a famous article, in certain circumstances a very small difference in ability can translate into an enormous different in reward. The key is the reproducibility of a product or service or innovation. If one pianist is slightly better than any other, his recordings may capture the entire market for recordings of the kind of pieces he plays best because the consumer has no reason to buy his rivals' slightly inferior recordings, provided prices are comparable. As transportation costs and tariff barriers fall and foreign countries become richer, the markets for the best American products expand, increasing the profit potential for producers with the lowest quality-adjusted costs. The greater output of the superior producer confers real value, but there is only a loose relation between that value and the reward to the producer. Bill Gates is extremely able, but not a thousand times abler than pikers worth a mere $50 million.

But of course we must not kill the goose that lays the golden eggs, through a level of taxation that discourages entrepreneurship, a risky activity. We might want to clip the goose's wings if we thought that huge fortunes were politically destabilizing, but this is not a danger in the United States, however much the left rails against Richard Scaife and the right against George Soros. There may well be a legitimate concern with the influence of campaign contributions on public policy (as illustrated by the opposition of New York's Democratic establishment to taxing hedge funds more heavily), but that concern argues for placing limits on contributions rather than on huge fortunes.

Yet even without thinking these fortunes dangerous, or the product of anything more sinister that skill and luck, we might as Becker suggests see in them an attractive source of tax revenues. The ideal tax is a tax that produces large revenues but has minimal allocative effects. A uniform head tax, avoidable only by emigration, would have minimal effects on people's behavior but would generate only modest revenues, because if genuinely uniform the tax would have to be set at a level that the poorest person could pay. A highly progressive income tax, without loopholes, would produce a great deal of revenue but probably would generate significant misallocative effects by causing people to substitute leisure for work and riskless jobs and investments for risky ones.

In these respects the estate tax is somewhere in between the head tax and the highly progressive income tax. Death cannot be averted, and in that respect an estate tax resembles a head tax. But the potential revenues are much greater, especially in an era of large fortunes. Adding up the fortunes listed in the Forbes article for just the 10 wealthiest Americans yields a total of almost $600 billion. The estate tax has as many holes as a very large Swiss cheese, but they could be closed.

There are two objections, however, to a stiff estate tax on large fortunes. The first is that it would encourage the wealthy to spend rather than invest, in order to reduce their taxable estates. But this is a more serious concern for the taxation of modest or even large estates than of immense ones, simply because of the limits of personal consumption. How much of a $3 billion annual income can a person spend on consumption rather than investment? The estate tax is likely to have a significantly smaller misallocative effect than an income tax that would produce the same revenue.

The second concern with stiffening the estate tax is that it will reduce gifts to charity. It will, because one of the biggest loopholes in the estate tax is the charitable deduction, though, as Becker points out, some very wealthy people, such as Andrew Carnegie and John D. Rockefeller, made large charitable donations before there was an estate tax (first introduced in 1916). To the extent that charitable expenditures substitute for government expenditures in areas such as education and medical research (not, however, religion--the largest beneficiary of charitable expenditures--because government is not permitted to subsidize religion), a reduction in charitable deductions is tantamount to a reduction in tax revenues, but the reduction cannot be dollar for dollar--otherwise there would be no incentive to make charitable gifts to any activity that government also funds. The reduction in charitable deductions from repealing the charitable exemption might not be great, moreover, because if one person reduces his contribution to a charity, this increases the incremental effect of another person's contribution. I worry, too, about charitable gifts overseas on the scale of the Gates Foundation; my post on January 1 of this year questioned the appropriateness of compelling U.S. taxpayers to fund (through the charitable deduction from income tax as well as from estate tax) contributions to foreign nations or their populations.

So although a stiffer estate tax on large fortunes (which would not require an increase in the tax rate but merely a closing of loopholes) would probably impose some cost in loss of charitable donations, which could in turn increase demand for public spending, I believe the revenue potential of such a tax would offset the costs. The tax increase could be made revenue-neutral, enabling a less efficient tax, such as the personal or corporate income tax, to be reduced.

Posted by Richard Posner at 08:19 PM | Comments (43) | TrackBack (1)

November 06, 2007

Why Is So Much Product Information False or Incomplete, Yet Not Misleading?--Posner

Here is a puzzle. With the recent deterioration of airline service, airlines' posted flight schedules have become uninformative. "On time" is defined as within 15 minutes of scheduled arrival, and a large percentage of flights are not "on time" even as so generously construed. Flights often are delayed by hours, and sometimes canceled, in which event the delay is the interval between the scheduled arrival of the canceled flight and the arrival of the later flight that one is booked on. A truthful airline schedule would list the mean length of a flight on a given route together with some indication of variance--perhaps the standard deviation, or what the media call the "margin of error," which is two standard deviations, from the mean. So why don't airlines publish accurate, informative schedules? Instead they have surreptitiously adjusted their schedules to enlarge scheduled flight times slightly in order to reduce measured delay.

Some airlines have better on-time arrival records than others. Why don't they publish accurate schedules, or at least advertise their better on-time record? The problem, it might seem, is that such disclosures have a two-edged quality. They draw the consumer's attention to the seller's own faults as well as to his competitors' faults. The disclosures say "I'm bad, but he's worse." But this is not an adequate explanation. Airline travelers know that airline schedules are grossly inaccurate. All they would learn from truthful comparative advertising would be which airlines' schedules are least inaccurate, and one might think that that would be both valuable information to consumers and effective advertising for the better airlines.

At the same time that sellers forgo much product disclosure that would seem advantageous both to them and to their customers, they make disclosures that have no information value and should not persuade any rational consumer, such as implausible, self-serving, and empty claims that their product is better, or super; and these claims are often wrapped in clever, funny pictures or anecdotes that are designed to seize the attention of the viewer, but that convey no information.

The purpose of the empty claims is easier to understand than the dearth of the type of negative comparative advertising that one might expected the better airlines to publish. The informationally empty claims convey to the reader the name of a product (so they are not really completely empty) and the sense that it must be a dependable product in some sense to be the subject of such classy advertising. It may be oversubtle to suggest as some economists have that media advertising signals a commitment to quality because if consumers are disappointed with the product the heavy investment that the seller made in advertising will be wiped out. It is enough that the glossy ads convey that this is a product that consumers ought to have in mind the next time they are shopping for that class of products, so that when they are scanning a shelf in a grocery store or drugstore or other retail outlet they will recall the brand name and give it a careful look before passing on to the next brand on the shelf. The brand name incidentally serves the important function of providing an assurance of at least approximately uniform quality, since that is required to enable the seller to retain trademark protection and thus prevent other sellers from selling their products under the same brand name.

But the reluctance of sellers to engage in the type of comparative advertising that would reveal shortcomings in the advertiser's product remains mysterious, since, as in the airline example, these shortcomings are usually quite well known to the persons at whom the advertising would be aimed. Automobile manufacturers were reluctant to install, let alone advertise, safety features such as seatbelts until the government required the installation of them and partly as a consequence of this consumers became safety conscious. But people always knew that automobile accidents were frequent and that tens of thousands of Americans were killed every year in such accidents. Some cars were safer than others and why didn't the manufacturers of those cars advertise their safety features? Why were auto manufacturers reluctant to open a new front, namely that of relative safety, in their competitive war with each other?

Evidently people have an aversion to being reminded of bad things that they know. To know something does not require that one be thinking about it. Everyone knows that he is going to die some day, and that that day may come very soon, but we do not like to dwell on such things. Advertisements for life insurance intimate mortality, of course, but very obliquely. They do not say: you had better buy our insurance today because tomorrow you could be dead from an aneurysm, a terrorist attack, or a broken neck from slipping on a banana peel. If you fly, you know about and dread long delays, but you do not want to be told: "our planes have never been stuck on runways because of thunderstorms for more than four hours, but X Airlines' plans have been stuck for as long as eight hours, with overflowing toilets, etc."

Then too there may be a sense that the part of such dismal comparative advertising that unavoidably disparages one's own product will be thought more credible than the part that disparages one's competitors' products. The former is in the nature of a confession, the latter of an accusation; and confessions are highly credible. The reader will know that all airlines experience delays, but if only one--the advertising airline--admits to this, it becomes associated in the reader's mind with delay.

The idea that products can pick up unwanted associations that are harmful, though it might seem from a strictly rational standpoint that they should not be, underlies the legal concept of trademark "dilution." Suppose you sell roasted chestnuts on a street corner in Manhattan and you call your stand "Rolls Royce." No one will think that the manufacturer of Rolls Royce is also engaged in the retail sale of nuts. So there would be no "passing off," in trademark jargon. But Rolls Royce could sue you for trademark dilution. (An alternative theory of such a suit would be that you are appropriating the aura that Rolls Royce has acquired as a result of the investment in quality by its manufacturer, and that aura should be treated as a property right of the manufacturer that you are infringing.) Because the next time a person is shopping for a luxury car, and trying to choose between a Rolls Royce and an Aston Martin, he may find himself involuntarily associating the Rolls with the nut stand.

An even clearer example is the legal concept of trademark "tarnishment," illustrated by a case in which a seller of T-shirts stenciled "I Like Cocaine" on them in the style of the Coca-Cola company's advertising slogan "I Like Coke." In rational-choice terms, we might try to explain the dilution and tarnishment cases by suggesting that the trade name or advertising alleged to infringe trademark creates a distracting mental association that requires a mental exertion to overcome, and thus imposes a cost on the trademark owner that may exceed the benefit to the alleged infringer.

I suspect that Internet advertising is more informative than media advertising, and that the gap will grow. The reason is that the Internet can pinpoint ads to particular tastes of the viewer (see the recent articles on Facebook's advertising plans, which will enable better matching than Google advertising) and thus give the viewer pertinent information. This is difficult with media advertising because the audience that reads or views the advertising is heterogeneous.

Posted by Richard Posner at 09:46 PM | Comments (18) | TrackBack (0)