DRI-280 for week of 7-7-13: Unintended Consequences and Distortions of Government Action

An Access Advertising EconBrief:

Unintended Consequences and Distortions of Government Action

The most important cultural evolution of 20th-century America was the emergence of government as the problem-solver of first resort. One of the most oft-uttered phrases of broadcast news reports was “this market is not subject to government regulation” – as if this automatically bred misfortune. The identification of a problem called for a government program tailored to its solution. Our sensitivity, compassion and nobility were measured by the dollar expenditure allocated to these problems, rather than by their actual solution.

This trend has increasingly frustrated economists, who associate government action with unintended consequences and distortions of markets. Since voluntary exchange in markets is mutually beneficial, distortions of the market and consequences other than mutual benefit are bad things. Economists have had a hard time getting their arguments across to the public.

One reason for this failure is the public unwillingness to associate a cause with an effect other than that intended. We live our lives striving to achieve our ends. When we fail, we don’t just shrug and forget it – we demand to know why. Government seems like a tool made to order for our purposes; it wields the power and command over resources that we lack as individuals. Our education has taught us that democracy gives us the right and even the duty to order government around. So why can’t we get it to work the way we want it to?

The short answer to that is that we know what we want but we don’t know how government or markets work, so we don’t know how to get what we want. In order to appreciate this, we need to understand the nature of government’s failures and of the market’s successes. To that end, here are various examples of unintended consequences and distortions.

Excise Taxation

One of the simplest cases of unintended, distortive consequences is excise taxation. An excise tax is a tax on a good, either on its production or its consumption. Although few people realize it, the meaningful economic effects of the tax are the same regardless of whether the tax is collected from the buyer of the good or from the seller. In practice, excise taxes are usually collected from sellers.

Consider a real-world example with purely hypothetical numbers used for expository purposes. Automotive gasoline is subject to excise taxation levied at the pump; e.g., collected from sellers but explicitly incorporated into the price consumers pay. Assume that the price of gas net of tax is $2.00 per gallon and the combination of local, state and federal excuse taxes adds up to $1.00 per gallon. That means that the consumer pays $3.00 per gallon but the retail gasoline seller pockets only $2.00 per gallon.

Consider, for computational ease, a price decrease of $.30 per gallon. How likely is the gasoline seller to take this action? Well, he would be more likely to take it if his total revenue were larger after the price decrease than before. But with the excise tax in force, a big roadblock exists to price reductions by the seller. The $.30 price decrease subtracts 15% from the price (the net revenue per unit) the seller receives, but only 10% from the price per unit that the buyer pays. And it is the reduction in price per unit paid by the buyer that will induce purchase of more units, which is the only reason the seller would have to want to reduce price in the first place. The fact that net revenue per unit falls by a larger percentage than price per unit paid by consumers is a big disincentive to lowering price.

Consider the kind of case that is most favorable to price reductions, in which demand is price-elastic. That is, the percentage increase in consumer purchases exceeds the percentage decrease in price (net revenue). Assume that purchases were originally 10,000 gallons per week and increased to 11,200 (an increase of 12%, which exceeds the percentage decrease in price). The original total revenue was 10,000 x $2.00 = $20,000. Now total revenue is 11,200 x $1.70 = $19,040, nearly $1,000 less. Since the total costs of producing 1,200 more units of output are greater than before, the gasoline seller will not want to lower price if he correctly anticipates this result. Despite the fact that consumer demand responds favorably (in a price-elastic manner) to the price decrease, the seller won’t initiate it.

Without the excise taxation, consumers and seller would face the same price. If demand were price-elastic, the seller would expect to increase total revenue by lowering price and selling more units than before. If the increase in total revenue were more than enough to cover the additional costs of producing the added output, the seller would lower price.

Excise taxation can reduce the incentive for sellers to lower price when it is imposed in specific form – a fixed amount per unit of output. When the excise tax is levied ad valorem, as a percentage of value rather than a fixed amount per unit, that disincentive is no longer present. In fact, the specific tax is the more popular form of excise taxation.

The irony of this unintended consequence is felt most keenly in times of rising gasoline prices. Demagogues hold sway with talk about price conspiracies and monopoly power exerted by “big corporations” and oil companies. Talk-show callers expound at length on the disparity between price increases and price decreases and the relative reluctance of sellers to lower price. Yet the straightforward logic of excise taxation is never broached. The callers are right, but for entirely the wrong reason. The culprit is not monopoly or conspiracy. It is excise taxation.

This unintended consequence was apparently first noticed by Richard Caves of Harvard University in his 1964 text American Industry: Structure, Conduct, Performance.

ObamaCare: The 29’ers and 49’ers

The recent decision to delay implementation of the Affordable Care Act – more familiarly known as ObamaCare – has interrupted two of the most profound and remarkable unintended consequences in American legislative history. The centerpiece of ObamaCare is its health mandates: the requirement that individuals who lack health insurance acquire it or pay a sizable fine and the requirement that businesses of significant size provide health plans for their employees or, once again, pay fines.

It is the business mandate, scheduled for implementation in 2014, which was delayed in a recent online announcement by the Obama administration. The provisions of the law had already produced dramatic effects on employment in American business. It seems likely that these effects, along with the logistical difficulties in implementing the plan, were behind the decision to delay the law’s application to businesses.

The law requires businesses with 50 or more “full-time equivalent” employees to make a health-care plan available to employees. A “full-time-equivalent” employee is defined as any combination of employees whose employment adds up to the full-employment quotient of hours. Full-time employment is defined as 30 hours per week, in contradiction to the longtime definition of 40 hours. Presumably this change was made in order to broaden the scope of the law, but it is clearly having the opposite effect – a locus classicus of unintended consequences at work.

Because the “measurement period” during which each firm’s number of full-time equivalent number of employees is calculated began in January 2013, firms reacted to the provisions of ObamaCare at the start of this year, even though the business mandate itself was not scheduled to begin until 2014. No sooner did the New Year unfold than observers noticed changes in fast-food industry employment. The changes took two basic forms.

First, firms – that is, individual fast-food franchises – cut off their number of full-time employees at no more than 49. Thus, they became known as “49’ers.” This practice was obviously intended to stop the firm short of the 50-employee minimum threshold for application of the health-insurance requirement under ObamaCare. At first thought, this may seem trivial if highly arbitrary. Further thought alters that snap judgment. Even more than foods, fast-food firms sell service. This service is highly labor-intensive. An arbitrary limitation on full-time employment is a serious matter, since it means that any slack must be taken up by part-timers.

And that is part two of the one-two punch delivered to employment by ObamaCare. Those same fast-food firms – McDonald’s, Burger King, Wendy’s, et al – began limiting their part-time work force to 20 hours per week, thereby holding them below the 30-hour threshold as well. But, since many of those employees were previously working 30 hours or more, the firms began sharing employees – encouraging their employees to work 20-hour shifts for rival firms and logging shift workers from those firms on their own books. Of course, two 20-hour shifts still comprises (more than) a full-time-equivalent worker, but as long as the total worker hours does not exceed the 1500-hour weekly total of 50 workers at 30 hours, the firm will still escape the health-insurance requirement. Thus were born the “29’ers” – those firms who held part-time workers below the 30-hour threshold for full-time-equivalent employment.

Are the requirements of ObamaCare really that onerous? Politicians and left-wing commentators commonly act as if health-insurance were the least that any self-respecting employer could provide any employee, on a par with providing a roof to keep out the rain and heat to ward off freezing cold in winter. Fast-food entrepreneurs are striving to avoid penalties associated with hiring that 50th full-time-equivalent employee. The penalty for failing to provide health insurance is $2,000 per employee beginning with 30. That is, the hiring of the 50th employee means incurring a penalty on the previous 20 employees, a total penalty of $40,000. Hiring (say) 60 employees would raise the penalty to $60,000.

A 2011 study by the Hudson Institute found that the average fast-food franchise makes a profit of $50,000-100,000 per year. Thus, ObamaCare penalties could eat up most or all of a year’s profit. The study’s authors foresaw an annual cost to the industry of $6.4 billion from implementation of ObamaCare. 3.2 million jobs were estimated to be “at risk.” All this comes at a time when employment is painfully slow to recover from the Great Recession of 2007-2009 and the exodus of workers from the labor force continues apace. Indeed, it is just this exodus that keeps the official unemployment rate from reaching double-digit heights reminiscent of the Great Depression of the 1930s.

Our first distortion was an excise tax. The ObamaCare mandates can also be viewed as a tax. The business mandates are equivalent to a tax on employment, since their implementation and penalties are geared to the level of employment. The Hudson study calculated that, assuming a hypothetical wage of $12 per hour, employing the 50th person would cost the firm $52 per hour, of which only $12 was paid out in wages to the employee. The difference between what the firm must pay out and what the employee receives is called “the wedge” by economists, since it reduces the incentive to hire and to work. The wider the wedge, the greater the disincentive. Presumably, this is yet another unintended consequence at work.

ObamaCare is a law that was advertised as the solution to a burgeoning, decades-old problem that threatened to engulf the federal budget. Instead, the law itself now threatens to bring first the government, then the private economy to a standstill. In time, ObamaCare may come to lead the league in unintended consequences – a competition in government ineptitude that can truly be called a battle of the all-stars.

The Food Stamp Program: An Excise Subsidy

In contrast to the first two examples of distortion, the food-stamp program is not a tax but rather its opposite number – a subsidy. Because food stamps are a subsidy given in-kind instead of in cash – a subsidy on a good in contrast to a tax on a good – they are an excise subsidy.

Food stamps began in the 1940s as a supplement to agricultural price supports. Their primary purpose was to dispose of agricultural surpluses, which were already becoming a costly nuisance to the federal government. Their value to the poor was seen as a coincidental, though convenient, byproduct. Although farmers and the poor have long since exchanged places in the hierarchy of beneficiaries, vestiges of the program’s lineage remain in its residence in the Agriculture Department and the source of its annual appropriations in the farm bill. (Roughly 80% of this year’s farm bill was given over to monies for the food-stamp program, which now reaches some 47.3 million Americans, or 15% of the population.)

The fact that agricultural programs help people other than their supposed beneficiaries is not really an example of unintended consequences, since we have known from the outset that price supports, acreage quotas, target prices and other government measures harm the general public and help large-scale farmers much more than small family farmers. The unintended consequences of the food-stamp program are vast, but they are unrelated to its tenuous link to agriculture.

Taxes take real income away from taxpayers, but – at least in principle – they fund projects that ostensibly provide compensating benefits. The unambiguous harm caused by taxes results from the distortions they create, which cause deadweight losses, or pure waste of time, effort and resources. Subsidies, the opposite number of taxes, create similar distortions. The food stamp program illustrates these distortions vividly.

For many years, program recipients received stamp-like vouchers entitling them to acquire specified categories of foodstuffs from participating sellers (mostly groceries). The recipient exchanged the stamps for food at a rate of exchange governed by the stamps’ face value. Certain foods and beverages, notably beverage alcohol, could not be purchased using food stamps.

Any economist could have predicted the outcome of this arrangement. A thriving black market arose in which food stamps could be sold at a discount to face value in exchange for cash. The amount of the discount represented the market price paid by the recipient and received by the broker; it fluctuated with market conditions but often hovered in the vicinity of 50% (!). This transaction allowed recipients to directly purchase proscribed goods and/or non-food items using cash. The black-market broker exchanged the food stamps (quasi-) legally at face value in a grocery in exchange for food or illegally at a small discount with a grocery in exchange for cash. (In recent years, bureaucrats have sought to kill off the black market by substituting a debit card for the stamp/vouchers.)

The size of the discount represents the magnitude of the economic distortion created by giving poor people a subsidy in excise form rather than in cash. Remarkably, large numbers of poor people preferred cash subsidies to markedly that $.50 in cash was preferred to $1.00 worth of (government-approved) foodstuffs. This suggests that a program of cash subsidies could have made recipients better off while spending around half as much more money on subsidies and dispensing with most of the large administrative costs of the actual food-stamp program.

Inefficiency has been the focus of various studies of the overall welfare system. Their common conclusion has been that the U.S. could lift every man, woman and child above the arbitrary poverty line for a fraction of our actual expenditures on welfare programs simply by giving cash to recipients and forgoing all other forms of administrative endeavor.

Of course, the presumption behind all this analysis is that the purpose of welfare programs like food stamps is to improve the well-being of recipients. In reality, the history of the food-stamp program and everyday experience suggests otherwise – that the true purpose of welfare programs is to improve the well-being of donors (i.e., taxpayers) by alleviating guilt they would otherwise feel.

The legitimate objections to cash subsidy welfare programs focus on the harm done to work incentives and the danger of dependency. The welfare reform crafted by the Republican Congress in 1994 and reluctantly signed by President Clinton was guided by this attitude, hence its emphasis on work requirements. But the opposition to cash subsidies from the general public, all too familiar to working economists from the classroom and the speaking platform, arises from other sources. The most vocal opposition to cash subsidies is expressed by those who claim that recipients will use cash to buy drugs, alcohol and other “undesirable” consumption goods – undesirable as gauged by the speaker, not by the welfare recipient. The clear implication is that the food-stamp format is a necessary prophylactic against this undesirable consumption behavior by welfare recipients, the corollary implication being that taxpayers have the moral right to control the behavior of welfare recipients.

Taxpayers may or may not be morally justified in asserting the right to control the behavior of welfare recipients whose consumption is taxpayer-subsidized. But this insistence on control is surely quixotic if the purpose of the program is to improve the welfare of recipients. And, after all, isn’t that what a “welfare” program is – by definition? The word “welfare” cannot very well refer to the welfare of taxpayers, for then the program would be a totalitarian program of forced consumption run for the primary benefit of taxpayers and the secondary benefit of welfare recipients.

The clinching point against the excise subsidy format of the food-stamp program is that it does not prevent recipients from increasing their purchases of drugs, alcohol or other forbidden substances. A recipient of (say) $500 in monthly food stamps who spends $1,000 per month on (approved) foodstuffs can simply use the food stamps to displace $500 in cash spending on food, leaving them with $500 more in cash to spend on drugs or booze. In practice, a recipient of a subsidy will normally prefer to increase consumption of all normal goods (that is, goods whose consumption he or she increases when real income rises). Any excise subsidy, including food stamps, will therefore be inferior to a cash subsidy for this reason. In terms of economic logic, an excise subsidy starts out with three strikes against it as a means of improving a recipient’s welfare.

So why do multitudes of people insist on wasting vast sums of money in order to make people worse off, when they could save that money by making them better off? The paradox is magnified by the fact that most of these money-wasters are politically conservative people who abhor government waste. The only explanation that suggests itself readily is that by wasting money conspicuously, these people relieve themselves of guilt. They are no longer troubled by images of poor, hungry downtrodden souls. They need feel no responsibility for enabling misbehavior through their tax payments. They have lifted a heavy burden from their minds.

The Rule, Not the Exception

These common themes developed by these examples are distortion of otherwise-efficient markets by government action and unintended consequences resulting from the government-caused distortions. By its very nature, government acts through compulsion and coercion rather than mutually beneficial voluntary exchange. Consequently, distortions are the normal case rather than the exception. Examples such as those above are not exceptions. They are the normal case.