The Tax-Reform Obsession

SYNOPSIS: Krugman discusses permits to allocate non-marketable resources, like rights to use high-traffic roads and the airwaves, which cannot be exchanged since property rights over those resources can't be established without government intervention

Steve Forbes's presidential campaign may have crashed and burned, but tax reform lives on, and on, and on. Should President Clinton lose in November, a flat tax will become a top priority in Congress. Even if he should win, Republicans will spend the next four years blaming the tax system for all our economic failings. Either way, we will continue to hear a lot about taxes, which raises a question.

Why are Republicans so obsessed with tax reform? Why don't they promise instead to eliminate traffic jams? This is not a silly question. The case for doing something about traffic is based on impeccable free-market economics, every bit as solid as the argument for reforming our tax system. Tax reform, however, is an iffy business -- the flat-tax plans peddled this year by Forbes and others would probably do more harm than good.

By contrast, traffic reform is a $40 billion sure thing. But traffic congestion, along with a number of similar issues like pollution management and water rights, goes unmentioned in current political discussion. And when such issues do come up, conservative politicians are often on the wrong side, which tells you something important about the blinkered vision of many people who fancy themselves champions of free markets.

Serious tax-reform advocates point out that the current system has two main flaws that harm economic efficiency. First, some people pay a "marginal" tax rate as high as 40 percent -- that is, of every extra dollar they earn, 40 cents goes to the Government. This surely discourages people from working as hard as they might. Second, because the Government taxes interest and profits, the system discourages people from saving for the future. So theorists have devised alternative tax systems that might lead to greater work effort and higher savings, and might therefore expand the American economy.

But how big would these gains be? A lot of savings are already tax exempt, because of special tax breaks for retirement accounts. And we can't do away with taxes altogether: like it or not, we still need to pay for the government services we want. This limits the scope for reducing marginal rates. For example: a realistic flat tax, one that would raise as much money as the current income tax, would still have to involve a marginal rate of well over 20 percent. That's lower than the 40 percent rate some people now pay, but most people don't pay that rate anyway. And even that 20-something rate is possible only if we eliminate the tax deduction for interest on home mortgages -- which means that while the economy might gain from the new tax, millions of middle-class families would lose.

The fact is that serious tax analysts believe that the net benefits from even a complete overhaul of the tax system would be modest -- almost surely less than a 1 percent increase in the nation's income, or about $60 billion a year -- and that while most people might gain, many would lose. In practice, the prospect of middle-class outrage means that schemes like the flat tax are usually sold with the promise of unrealistically low tax rates. And while a realistic flat tax might help the economy a bit, a Forbes-style proposal, with its promise to provide large tax cuts for the rich without any increases for the middle class, would create a huge budget deficit, thereby doing the economy far more harm than good.

Now let's talk about traffic. Traffic congestion is not a minor annoyance. Last year Americans lost more than eight billion hours to traffic delays, at a total cost of more than $80 billion -- mainly in the form of wasted time, but also through extra consumption of gasoline, wear and tear on autos and so on.

But aren't traffic jams just a fact of life? No. In large part they are the result of a system that, like the tax system, encourages people to make economically inefficient decisions.

Consider, for example, my own antisocial actions a few weeks ago. A colleague and I were going to a meeting in San Francisco, 30 miles away. At the cost of some minor inconvenience we could have traveled together. But we didn't, and by taking my own car I added marginally to the already world-class traffic congestion on Highway 101.

I probably didn't delay any individual's morning commute by more than a fraction of a second, but that tiny delay was imposed on each of thousands of cars crawling along the freeway behind me. It's a good bet that the total delay that other people suffered for the sake of my slight convenience was more than an hour.

There ought to have been a way to make a deal: I wouldn't clog the freeway, and other drivers would compensate me for the inconvenience of car pooling. Since the cost I imposed on other people by driving during rush hour was much greater than the benefit I derived, such a deal could have made everyone happier. Of course, it is impractical to make such a deal directly, but we can try to reproduce its results.

The classic economist's prescription for dealing with traffic is for the government to impose "congestion fees," tolls for using roads during periods of overcrowding. With modern technology, such tolls could even be collected without tollbooths: an electronic sensor could pick up the signal from a tiny gizmo on your dashboard, or a low-powered laser could read a bar code on your windshield. The fees could then be rebated to the public. Realistic estimates suggest that such fees could cut the cost of traffic congestion considerably, and leave the great majority of people better off. Most of those deterred from rush-hour driving would be more than compensated for their inconvenience through the rebate scheme. Those who continued to drive would be compensated for the extra tolls with a much faster trip to work.

I know what some conservatives are thinking -- this is just another government intrusion into daily life. But think of it another way: what we have here is a problem of inadequately defined property rights. Space on Highway 101 during rush hour is a scarce resource, just like waterfront real estate. Unfortunately, nobody holds clear title to that resource, and so it is overused.

So why don't we try to establish a properly functioning free market in road space? Suppose we issue registered drivers in a metropolitan area a specified number of "rush hour points," which they are free to sell at their discretion, and require anyone who drives during rush hour to present (electronically) the appropriate number of points. Let us also create a market in these points. Some people will continue to drive every day; they will need to purchase extra points. Others will find new ways of getting to work and will sell their points for whatever the, ahem, traffic will bear. How market-oriented can you get? And such a scheme, like congestion fees, would make most people better off, either because they get extra money by selling their points or because the cost of buying points is more than offset by a quicker commute.

The reason that creating a market in road space and imposing congestion fees would produce similar results is, of course, that -- as any bright Econ 1 student can tell you -- they are essentially equivalent. Either way, what you are doing is creating a market incentive for people like me to take into account the costs we impose on others by driving during rush hour.

The benefits of such a scheme would not be small change. Traffic experts tell us that a sensible system of congestion fees could easily cut the annual cost of highway delays by $30 billion or $40 billion. These savings are offset to a degree by the inconvenience to those who are deterred from driving. But the net benefits could be $15 billion a year or more. Tacking on fees for heavy trucks that damage highways and for air travel to overcrowded airports yields a middle-of-the-road estimate (and what other kind of estimate would you want?) that traffic reform could enrich the American public by $40 billion to $50 billion every year.

There are other places where properly defined property rights could yield a big payoff. Water is a very scarce resource in the American West. Under the current system, thirsty cities are rationed even while desert farmers feed irrigated alfalfa to their cattle. Why not create a free market in water rights? Another example is the airwaves, which used to carry only radio and television but are increasingly in demand to allow wireless communication among people and computers. Broadcast rights could be traded in a free market but -- despite the recent auction of a limited slice of the spectrum -- mostly aren't, with the result that a bandwidth that could be carrying vital business data is carrying infomercials instead.

So why isn't there a major conservative politician out there campaigning on a platform of extending free-market principles, of creating property rights where they should exist but don't? Such a politician could promise to raise national income by $60 billion, $80 billion, even $100 billion a year -- and could do so honestly, without the slippery arithmetic that underlies the promises we hear about tax reform.

To be fair, many conservative economists have advocated the kind of reforms I have described. (So have many liberal economists.) But for the most part they have been ignored.

The reason, I believe, is that the political appeal of economic conservatism really has very little to do with the virtues of free markets. Instead, it is about the promise of something for nothing -- a rejection of the idea that taxes must be collected, that scarce resources must be conserved. The reason the electorate likes tax- reform schemes is that they always end up being tax-cutting schemes, based on the premise that the voters pay taxes but someone else gets the benefits -- even though anyone who looks at where the money actually goes quickly realizes that Pogo was right: we have met the enemy, and he is us.

As a result, not only do prominent conservatives rarely support proposals to extend the range of the market, but also they often actively oppose them. For example, the supply-side guru George Gilder has vociferously campaigned against plans to auction off a limited slice of the airwaves. Instead, incredibly, he advocates anarchy -- let anyone broadcast on whatever frequency. This is crazy. What it reflects, one suspects, is a basic unwillingness to accept the idea that there are any scarce resources, any limits that must be respected.

So the next time you encounter a conservative who likes to talk about the virtues of the free market, ask him what he thinks about creating a market in rights to drive in rush-hour traffic, or to use Western water. If he demurs, then he doesn't really believe in free markets -- he believes in free lunches.

Originally published in The New York Times, 4.7.96