Skip to content

Category: microeconomics

Published on Leave a comment on Why I Don’t Like 529 Plans: Another Pecuniary Externality

Here's another tax-induced pecuniary externality that concerns me. The list price on college costs has been rising faster than inflation. This prompted politicians to act, and they created 529 plans to allow families to save for college in a tax-advantaged way. Austan Goolsbee has strongly and correctly criticized some of the design issues of these plans, particularly the administrative links to states and the (I think resulting) high management fees. For now, I just want to focus on how the tax advantage is distributed and its impact on future prices.

Contributions are made with after-tax dollars, sometimes with a state income tax deduction, but the returns on the portfolio compound tax-free and withdrawals are tax-free as long as they are used for college expenses. It's like a Roth IRA that way. (You can learn more here.) The benefits of the 529 plan accrue in proportion to a family's tax rate and desired amount of education expenses. Let's leave aside the almost surely positive correlation between (family) income and desired education expenses, which will reinforce the following points, and focus just on the simple fact that the tax rate increases with family income. It is more financially advantageous for a high-income family to invest a dollar in a 529 plan than it is for a low-income family to do so.

But you might say, "Okay, but doesn't the low-income family still get a benefit?" The answer depends on whether you think the supply curve for education is flat or upward sloping. Do you believe that colleges, when faced with dedicated accounts like 529 plans that will pay a penalty if they are not used on college costs, will raise their list prices? About 20 years ago, the conjecture that they would was named the "Bennett Hypothesis," after then-Secretary of Education William J. Bennett, who decried the tendency for colleges to raise tuition prices when the federal government stepped up its financial aid programs. I have little doubt that it is true.

The pecuniary externality comes in when we think about how much the tuition will go up. What drives that? I'd argue that it will be the average size of a 529 plan, as would be the case in any market responding to an increase in consumers' willingness to pay for a good. Since the tax advantage is positively related to income, even if all of the money going into 529 plans were new saving, it would be the higher income families that would have the larger-than-average 529 balances and the lower income families that would have the smaller-than-average 529 balances. (If the higher income families are simply shifting money from other accounts to 529 plans, then this strengthens the argument.)

Putting this all together, we can infer that the list price increases in college costs could outstrip the capacity of low-income families to pay them from their 529 plans. Depending on how much colleges raise their list prices and how the details of financial aid programs work out, lower income families may be worse off by the presence of 529 plans, even if they are saving through them. It is not the low-income families' own 529 plans that make them worse off--it is the high-income families' 529 plans and their greater benefits to using them. The impact of the latter on the price is the tax-induced pecuniary externality.

It's lousy public policy. But as much as I don't like these plans as a policy instrument, I have one for each of my two children. It doesn't make sense financially to leave the money on the table, given what's going to happen to list prices.

Published on Leave a comment on Pecuniary Externalities

For what it's worth, I think Paul Krugman makes some good points about the problems inherent in using the tax code to encourage or discourage the purchase of health insurance in his column today (original here, reposted here). I obviously don't sign on to his characterizations of "Bush and his advisers," and he stops short of his usual call for a single-payer system, so there's no reason to get into that today.

Were it up to me, I'd completely eliminate the exclusion of health insurance premiums from taxable income. That levels the playing field between premiums and other expenses (as the Bush plan tries to do), but it does so without forcing the tax code to be the arbiter of whether something was a legitimate health expenditure or not. It also raises tens of billions of dollars in additional tax revenue that can then be directed to all the other things the government needs to pay for.

However, I found this statement (highlighted in bold) in Krugman's column to be odd:

While proposing this high-end tax break, Mr. Bush is also proposing a tax increase — not on the wealthy, but on workers who, he thinks, have too much health insurance. The tax code, he said, “unwisely encourages workers to choose overly expensive, gold-plated plans. The result is that insurance premiums rise, and many Americans cannot afford the coverage they need.”

Again, wow. No economic analysis I’m aware of says that when Peter chooses a good health plan, he raises Paul’s premiums. And look at the condescension. Will all those who think they have “gold plated” health coverage please raise their hands?

Is he kidding me? That is almost the definition of a pecuniary externality. Wikipedia describes it as follows:

A pecuniary externality is an externality which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.

This is in contrast with real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment.

Both pecuniary and real externalities can be either positive or negative.

So in the President's defense, there's a very simple argument to be made here. When one person feels inclined, for whatever reason, to purchase more health care services, that puts upward pressure on the price of health care services (if the supply curve is not flat) and thus the cost to everyone else in the market. Normally, we don't pay any attention to this, because that is precisely the mechanism by which a competitive market achieves economic efficiency.

The President is referring to the pecuniary externality generated by a tax distortion in the treatment of health insurance, which interferes with a market achieiving economic efficiency and thus should concern us. It goes as follows. Premiums are fully excludable from income tax, but out-of-pocket expenses are not tax advantaged. That favors health insurance arrangements in which there are low deductibles and high premiums. Such arrangements can lead to higher utilization of health services, since the insured faces no financial cost at the margin once the low deductible has been met. (This is just a standard moral hazard argument.) Krugman may not believe that the relevant behavioral effects are large here, but he's on shaky ground with his "Wow ... no economic analysis ..." comment.

For more on pecuniary externalities, I came across this source.

Published on Leave a comment on Catching Up on the Basics

A reader e-mails with the following question:

I'm not sure I ever realized what interesting things happened at the intersection of economics and politics -- now I'm starting to wish I had taken some econ courses as an undergrad! Could you give me an idea of where I could start reading to play catch-up on some of the terminology and the basic principles of economics?

I think there are two places to start, outside of the textbook market. The classic answer to this question is Economics in One Lesson by Henry Hazlitt. I remembering reading this one as I was taking undergraduate economics courses and feeling like it did a very good job of clarifying what economics was about.

A more recent book that has also been praised for its clarity and accessibility is Naked Economics by Charlie Wheelan. Charlie is an instructor at the Harris School at the University of Chicago and an alumnus and occasional visitor here at Dartmouth. He also writes a column, by the same name as the book, for Yahoo, which I also recommend.

Published on Leave a comment on Of Crowds and Cold

Today was the first really cold day of the season in Hanover. It's 6 degrees Farenheit outside, even at midday. I confess I carpooled with the rest of the Voxfamily for a short ride to work this morning. And the recent bout of freezing rain made the 45 minutes with the snowblower this week more challenging than usual. But I wouldn't want Hanover without the cold winters.

As much as the cold is uncomfortable, I've got a higher threshold for it than most people I've met. The cold keeps the place uncrowded. And it turns out that I've got a much lower threshold for crowds and congestion than most people I've met. So the rest of the world and I sort ourselves into communities where we each get relatively more of what we like and relatively less of what we don't like. And at important times, the fact that we were not in competition made us both better off. Consider, for example, what the prices we paid for our respective first homes might have been if we were all searching in the same market.

To tell the truth, I might even like it even ... colder.

Published on Leave a comment on Who “Owns” My Telephone, Anyway?

The Washington Post reports today on growing frustration with campaign phone calls:

This year's heavy volume of automated political phone calls has infuriated countless voters and triggered sharp complaints from Democrats, who say the Republican Party has crossed the line in bombarding households with recorded attacks on candidates in tight House races nationwide.

Some voters, sick of interrupted dinners and evenings, say they will punish the offending parties by opposing them in today's elections. But critics say Republicans crafted the messages to delude voters -- especially those who hang up quickly -- into thinking that Democrats placed the calls.

Republicans denied the allegation, noting that their party acknowledges its authorship at the recorded calls' end. After citizens' complaints in New Hampshire, however, the National Republican Congressional Committee agreed to end the calls to households on the federal do-not-call list, even though the law exempts political messages from such restrictions.

Whether "robo-calls" are positive or negative, mean-spirited or humorous, thousands of Americans are sick of them, according to campaign organizations that have been fielding complaints over the past two weeks.

Two points are worth emphasizing.

First, I think that the telephone subscriber should be given maximal opportunity to restrict the type of number of phone calls received. There should be a do-not call option for all solicitations, including those from political candidates. Answering the question posed in the title, I own my telephone, and I would lobby the government to give me greater freedom to prevent someone else from intruding through it. I'd also pay money to any company that would help me restrict such access through new technology.

Second, hanging up immediately is the non-cooperative response to this problem. When the Samwick household receives unsolicited phone calls (and I'm talking about you, Car Store), we employ either of two strategies that have a common element. If the VoxSon is feeling punchy, we let him answer the phone and have a little fun. Otherwise, we answer the phone, possibly responding that we will "go get" the person in question, and then just put the phone down.

The common element here is that we keep the offender on the line as long as possible. This prevents the offender from bothering the next household on the call list until the offender terminates the call. This is the way to tax the resources (i.e. time) of the offender, making the enterprise less profitable and thus less likely in the future. If we all cooperated to employ this strategy, we would all be better off for it.

So the next time your phone doesn't ring during dinner, you can be grateful to me, since I'm probably keeping that telemarketer on the line. But whatever you do, don't call to thank me.

Published on Leave a comment on Working Harder, Not Smarter, in Medicine

In today's Wall Street Journal, Dr. Benjamin Brewer gives as succinct a statement of the morass of treatement incentives in the practice of medicine as you will find:

One of the problems with our medical system is the bias to pay doctors more for performing a test or procedure than for using our heads to make a diagnosis or manage a disease.

Obtaining a thorough history and physical exam and reviewing tests to make a challenging diagnosis pay much less than conducting a battery of tests or performing a diagnostic procedure.

If I spend 30 minutes in an extended office call for a patient with diabetes, high blood pressure and heart disease, I get paid an average of $69. If I remove a skin cyst off the patient's back in that same time, the minor surgery would bring $110.

If I do a screening colonoscopy at the hospital to check for colon cancer for the same patient in the same time, my average reimbursement is $478 with essentially no office overhead. It's no wonder that medical students want to go into procedural specialties like gastroenterology and fewer want to pursue cognitive specialties such as general medicine.

Fascinating. As always, there are tradeoffs involved. There are two types of errors that can be made with respect to procedures: they can be implemented when they were not medically necessary or they can be not implemented when they were medically necessary. As a society, we put a lot of weight on avoiding the latter type of error. The field of medical malpractice exacerbates this. So it is not surprising that we have poor safeguards against the first type of error given the high fees. But if we tried to improve them, we should expect to have more of the second type of error.

Brewer's point about choice of specialty is also a good one. After we had the VoxSon, it became very clear to me that the medical industry tremendously undervalues and undercompensates pediatricians, who epitomize the need for using their heads rather than tests.

Published on Leave a comment on Trans Fat Tradeable Permits

As I was planning to spend the day in New York today, I was pleased to read that "the New York City Board of Health plans to prohibit the city's 20,000 restaurants from serving food that contains more than a minute amount of artificial trans fats." Outstanding, New York City must have solved all of its big problems, since it has now decided to focus on this one.

What can I say? I'm an economist, and I'm here to help. Imposing a quantity restriction on trans fats does not accommodate different costs of trans fat abatement across cuisines. Taking the trans fats out of french fries may disproportionately reduce their taste or increase their costs. Instead, why not grant all restaurants an allotment of permits to cook with trans fats and allow them to buy and sell extra permits as the menu demands? As with other pollutants, tradeable permits allow the trans fat reductions to occur where the relative costs of doing so are lowest.

Economics in action -- working alongside the nanny state to keep you healthy.

Published on Leave a comment on Passing Along the Cost of Security

Via Ben Mutzabaugh's excellent Today in the Sky blog, we discover a place in Paris that could be described as a microeconomics-free zone. It's the IATA. Consider:

PARIS (AFX) - Giovanni Bisignani, director general of the International Air Transport Association (IATA), said national governments should pay for the additional security costs required to protect airlines from terrorist attacks, instead of imposing new security levies on passenger tickets.

In an interview with French daily Le Monde on Saturday, Bisignani said it is too early to estimate the financial impact of the disruptions seen after an alleged airline terror plot was foiled in the UK earlier this month.

However, he said the global airline industry already pays an additional 5.6 bln usd per year in security costs since the Sept 11, 2001 terror attacks in the US.

'National security is the responsibility of governments,' Bisignani said. 'Very clearly, governments must bear these additional costs for security.'

'There is no reason why rail stations and sports stadiums should benefit from state subsidies, but not airports and airlines,' he added.

It is true that most aspects of national security are the responsibility of governments, including the top level of oversight and a considerable amount of the implementation. But his statement that "... governments must bear these additional costs for security..." is inaccurate in this context.

The presence of a security threat increases the social cost of an additional person taking a flight. Imposing a security levy on people taking flights helps bring the private cost of taking the flight in line with the social cost. A Pigovian tax is exactly the right policy here. (Though I don't claim that the current or prospective levels of these security fees are optimally set.)

On his last statement, I might be tempted to agree with the first part, "There is no reason why rail stations and sports stadiums should benefit from state subsidies ..." if he ended it there. I have always been skeptical of why sports stadiums need public funding--the social and private returns appear to be in line. I don't mind subsidies for rail transportation (again, without signing on to the optimality of the current system), given its ability to relieve congestion and reduce pollution, the benefits of which don't accrue only to the rail passengers.

Published on Leave a comment on Is Netflix a New Economy Firm?

David Leonhardt writes a thoughtful piece in today's New York Times, "What Netflix Could Teach Hollywood." Here's his brainteaser:

Its [The Conversation's] return from oblivion is a nice illustration of a brainteaser I have been giving my friends since I visited Netflix in Silicon Valley last month. Out of the 60,000 titles in Netflix's inventory, I ask, how many do you think are rented at least once on a typical day?

The most common answers have been around 1,000, which sounds reasonable enough. Americans tend to flock to the same small group of movies, just as they flock to the same candy bars and cars, right?

Well, the actual answer is 35,000 to 40,000. That's right: every day, almost two of every three movies ever put onto DVD are rented by a Netflix customer.

"Americans' tastes are really broad," says Reed Hastings, Netflix's chief executive. So, while the studios spend their energy promoting bland blockbusters aimed at everyone, Netflix has been catering to what people really want — and helping to keep Hollywood profitable in the process.

It's a lesson we would do well to learn. We seem like a society that's being homogenized into one big McCity or McSuburb, but that may be more a function of the unimaginative media covering society than society itself.

Leonhardt continues:

Five million families now have Netflix accounts, and the company has basically reinvented the concept of a quick-turnaround mail-order business. It is, in short, one of the most impressive companies around. So why do so many people think it's doomed?

I don't think it's doomed, but nor do I think it is all that different from, say, L.L. Bean these days. You go to a website, you tell the website what you want, and the company sponsoring the website gives you what you want. You like what you get, so you get it again. L.L. Bean sells clothes not rental DVDs, doesn't do as much with the data collected on the website, and isn't based on quick turnaround. Are those the key differences that would make a company a "New Economy" company? Or is it just the amount of the firm's business that is done through the Internet relative to other means, leading to the following classifications:

  1. Old Economy: No important element of sales done through the Internet.
  2. 2006 Economy: An option to conduct sales through the Internet.
  3. New Economy: No option to conduct sales other than the Internet.

So your corner drug store is in #1, CVS (through CVS.com) is in #2 (as is L.L. Bean), and drugstore.com is in #3 (like Netlfix).

Read the article to the end. If you do, you get this gem from Reed Hastings:

"At the heart of any good investment, I tell investors, is a contrarian thesis that they and the company believe very deeply," Mr. Hastings said, "and that the rest of the world thinks is crazy."

Well said. This is what I like most about entrepreneurs.

Published on Leave a comment on Congestion Pricing by a Naked Economist

Charlie Wheelan, one of ten new columnists at Yahoo Finance, turns his attention in his second column to "congestion pricing" on highways. He argues that we should "raise the price of traffic jams" and offers San Diego as a prototype:

The future of transportation will look a lot like the I-15 FastTrak in San Diego. This expressway has free lanes and HOT (High-Occupancy/Toll) lanes that run parallel. Here's the twist: The price of the HOT lanes fluctuates between $.50 and $4.00 depending on traffic conditions. Carpools use the HOT lanes free at all times.

Your toll for the HOT lanes guarantees a "free flowing" speed of travel. If the HOT lanes begin to get congested, the toll will rise immediately, prompting more drivers to choose the free lanes rather than the HOT lanes. (The toll at any given time is advertised on electronic signs on the side of the road.)

There is a drawback to congestion pricing: The HOT lanes are sometimes referred to as "Lexus lanes" because those with deep pockets care less about $4 than those who are counting their pennies. But don't assume automatically that congestion pricing is bad for people lower on the economic ladder. If a plumber's assistant earning $14 an hour shows up for work half an hour late, he gets docked $7. Or, he can get there on time by using the HOT lanes--with a maximum toll of $4.00. Do the math.

And low-level employees get fined for picking up their kids late from daycare or fired for repeatedly being 15 minutes late. CEOs don't.

I think he's right. Eventually, all crowded highways will incorporate some of the elements. I wonder about the privacy aspects of these systems (whether or not they have congestion pricing), because they can record a person's location at a point in time. Some states seem to be better than others, and the issue is moving beyond just cars.

Wheelan's column is called "The Naked Economist," reflecting his recent book of the same name, which looks to be a great non-technical introduction to the field of economics.

Blogsearch Technorati