Politics, Economics and other Stuff

Taxes vs Cap and Trade: the international dimension

David A. Weisbach (Chicago) has posted Instrument Choice is Instrument Design on SSRN.  Here is the abstract (via TaxProf blog):

This paper analyzes the choice between taxes and cap and trade systems (also referred to here as a permit system or a quantity restriction) as methods of controlling greenhouse gas emissions. It argues that in the domestic context, with proper design, the two instruments are essentially the same. Commonly discussed differences in the two instruments are due to unjustified assumptions about design. In the climate change context and within a single country there is sufficient design flexibility that these differences can be substantially eliminated. To the extent that there are remaining differences, there should be a modest preference for taxes, but the benefits of taxes are swamped by the benefits of good design; even though the very best tax might be better than the very best quantity restriction, the first order of business is getting the design right.

In the international context, however, taxes dominate more strongly. The design flexibility available within a single country is reduced in the international context because of the problems of coordinating systems across countries and minimizing holdouts. Moreover, the incentives to cheat and the effects of cheating are not equivalent for the two instruments in the international setting. Because climate change will require a global system for emissions, these considerations mean we should favor taxes for controlling greenhouse gas emissions.

I have pretty clear cut preferences for emission taxes over cap and trade schemes, partly for international coordination and political economy reasons.  So it is nice to see that topic come up -- it seem surprisingly absent in the discussion.   Not clear if Weisbach's analysis holds up under scrutiny, but it seems like analyzing the international dimension is essential for understanding how these schemes are going to work. 

Tax Structure and State Objectives

Bruce Bartlett recommends Junko Kato's book Regressive taxation and the welfare state: path dependence and policy diffusion.  I'd not heard of this book, though I read Kato's first book when it came out.  Since this is an important and timely topic, I googled some of the recent literature.  There's more out there, but these papers that seem to state one perspective, a perspective I'm quite sympathetic to, succinctly. Though I'm not sure political scientists fully understand that labels don't necessarily indicate tax incidence -- or maybe they just need to get their papers out the door. 

Jeffrey F. Timmons, The Fiscal Contract: States, Taxes and Public Services

Using data from approximately 90 countries, I show that the more a state taxes the rich as a percentage of GDP, the more it protects property rights; the more it taxes the poor, the more it provides basic public services. The catch is that total revenue typically has no effect on property rights or basic public services. Furthermore, there is no evidence that states tax the rich to benefit the poor or vice-versa, contrary to state-capture theories; nor is there any evidence that taxes and spending are unrelated, contrary to state-autonomy models. Instead, states operate much like fiscal contracts, with groups getting what they pay for.

Jeffrey F. Timmons, Left, Right and Center: Partisanship, taxes and the welfare state

This article argues that partisans tax their supporters, challenging, in particular, the notions that the welfare state is primarily an instrument of redistribution and that left wing governments tax the rich to benefit the poor. Using insights from the tax compliance literature, data for 18 OECD countries from 1970-1999 and historical vignettes from the 1950s onward, I show that countries with more long-term left influence finance welfare expenditure primarily through regressive taxes on consumption and labor, rather than progressive ones on income and capital. Furthermore, I provide preliminary evidence showing that countries with more right wing influence raise more revenue from income and capital. These findings indicate that conventional accounts of partisanship, taxation and the welfare state need re-evaluating. While left wing and center parties have been vital for the development of the welfare state, the extent of redistribution is exaggerated. Political parties act like insurance agents, not Robin Hood.

Thomas R. Cusack and Pablo Beramendi, Taxing Work: Some Political and Economic Aspects of Labor Income Taxation

This paper examines the development of tax regimes across the OECD countries in the latter part of the 20th century. It pays particular attention to taxes on labor income. A number of results emerge from this examination. First, not only do taxes on labor income represent a major drain on private households; they have become the mainstay of many of these countries’ public sector finances. Second, taxes on labor income, and not taxes on capital, appear to be the preferred instrument of finance for those economic and political interests that advocate and support a strong (and thereby expensive) welfare state. There is little “free lunch” to be had in these welfare states; if anything, “socialism in one class” seems to be the rule. Third, while the effort at financing the welfare state this way comes at cost in terms of loss in employment, the magnitude of such loss is inversely related to the degree of wage coordination in the labor market.

Also nice is Thomas R. Cusack, Torben Iversen, David Soskice, Economic Interests and the Origins of Electoral Systems

The standard explanation for the choice of electoral institutions, building on Rokkan’s seminal work, is that proportional representation (PR) was adopted by a divided right to defend its class interests against a rising left. But new evidence shows that PR strengthens the left and redistribution, and we argue the standard view is wrong historically, analytically, and empirically. We offer a radically different explanation. Integrating two opposed interpretations of PR – minimum winning coalitions versus consensus – we propose that the right adopted PR when their support for consensual regulatory frameworks, especially of labor markets and skill formation where co-specific investments were important, outweighed their opposition to the redistributive consequences; this occurred in countries with previously densely organized local economies. In countries with adversarial industrial relations, and weak coordination of business and unions, keeping majoritarian institutions helped contain the left. This explains the close association between current varieties of capitalism and electoral institutions, and why they persist over time.

What counts as evidence for any of these views is the hard part...

The Federal Budget: Tax Revenue-GDP ratio lowest since 1950

In lieu of any posting by me -- out of time and in need of sleep --, a rant from Bruce Bartlett.  Bolding is by me. 

Yesterday, Mort Zuckerman, owner of the New York Daily News, exercised his prerogative by publishing an essay in that publication complaining that "Obama's spending and borrowing leaves U.S. gasping for air."

This is common criticism among Republicans, who have a vested interest in blaming everything bad that happens on the Democrats. The implication is that if voters weren't so stupid and had instead elected John McCain to be president then the budget would be balanced, the debt would have disappeared, and the economy would be booming. ..

According to the Congressional Budget Office's January 2009 estimate for fiscal year 2009, outlays were projected to be $3,543 billion and revenues were projected to be $2,357 billion, leaving a deficit of $1,186 billion. Keep in mind that these estimates were made before Obama took office, based on existing law and policy, and did not take into account any actions that Obama might implement.

Therefore, unless one thinks that McCain would have somehow or other raised taxes and cut spending (with a Democratic Congress), rather than enacting a stimulus of his own, then a deficit of $1.2 trillion was baked in the cake the day Obama took office. Any suggestion that McCain would have brought in a lower deficit is simply fanciful.

Now let's fast forward to the end of fiscal year 2009, which ended on September 30. According to CBO, it ended with spending at $3,515 billion and revenues of $2,106 billion for a deficit of $1,409 billion.

To recap, the deficit came in $223 billion higher than projected, but spending was $28 billion and revenues were $251 billion less than expected. Thus we can conclude that more than 100 percent of the increase in the deficit since January is accounted for by lower revenues. Not one penny is due to higher spending.  ...

According to the Council of Economic Advisers, as of August the actual budgetary effect of the February stimulus was to reduce revenues by $62.6 billion and raise spending by $88.8 billion. Of the spending, the vast bulk went to transfers such as extended unemployment benefits and aid to state and local governments, which may have prevented cuts in spending that would otherwise have occurred but probably didn't do anything to increase spending. Only $16.5 billion in stimulus funds went to investment outlays for things such as public works. This is a trivial amount of money in a $14 trillion economy. ...

I continue to believe that the Republican position is nonsensical. Final proof is that the previously cited CBO report shows total federal revenues coming in at 14.9 percent of the gross domestic product in FY2009. According to the Office of Management and Budget, one has to go back to 1950 to find a year when federal revenues were lower as a share of GDP. For reference, revenues averaged 18 percent of GDP during the Reagan administration and were never lower than 17.3 percent - 2.4 percent of GDP above where they are now.

I think there are grounds on which to criticize the Obama administration's anti-recession actions. But spending too much is not one of them. Indeed, based on this analysis, it is pretty obvious that spending - real spending on things like public works - has been grossly inadequate. The idea that Reagan-style tax cuts would have done anything is just nuts.

So how did federal outlays fall $28 billion short of their January projections if the stimulus added $88 billion in spending?  Did CBO underestimate automatic stabilizers?  Did inflation come in that much lower?  I don't quite see how you save $100 billion on those effects, or 3% of the budget. 

I'm also mystified by why federal revenues are so low -- is this what simple model would predict given income and asset returns?  Or are we facing a shortfall in revenues compared to what models would predict?  If so, what is going on?  I fear firms/households are stalling on tax payments and building up liabilities versus the government, some of which will default. 

State Tax Revenue Volatility

I am puzzled by the the state tax revenue volatility of the last 10 years.  With the census department's figures for 2009 Q2 out this week, I see a report in the WSJ:  Falling Tax Revenues Slam States.

 

How does a 17% decline in state tax revenues happen Q2 2008 to Q2 2009?  GDP didn't go down 17% -- that decline is around 2.6% for nominal GDP and 3.3% for real GDP.   State taxes are not very progressive and should not be this volatile, and the federal tax system with its more progressive tax structure has less volatile revenues (see...to be filled in).  Even state income tax and sales tax revenues are down a lot more than GDP, and these taxes are close to linear in most states (though not the income tax for NY -- how about California?):

The biggest drop among major revenue sources was in state income taxes, which were down 28% from a year ago. Sales-tax revenues fell 9%.  .... Eleven states -- including California, New York and Wisconsin -- saw personal income taxes fall more than 30%.

As can be seen from the graph, this puzzlingly high volatility in a relatively new phenomena, with the first year to year decline in state tax revenues during the mild 2001 recession.   What is going on?  People always talk about the outmoded state revenue systems -- see for instance the recent commission report suggesting a state level VAT in California -- , but how are they generating this time series? I've heard a lot of handwaving about this, but none of it seems to explain the magnitude or the recent amplification of the effect. 

My wild guess here is that businesses are withholding income taxes on their employees, but failing to pass them to the states in a timely fashion, using the credit extension this provides to finance operations.  Firms do this since a) this is now cheaper financing than what financial markets provide, if you can borrow at all, b) state revenue authorities are more lenient about late payments in recessions.  I have been a bit shocked to learn recently how much discretion businesses have here.  But I cannot see that effect being so large either.  But it must be something like this, with accounting efforts affecting the timing of tax liabilities or payments. 

Tax Concequences from the Cancellation of Debt

via TaxProfBlog, Daniel L. Simmons (UC-Davis) & Martin J. McMahon, Jr. (Florida) have posted A Field Guide to Cancellation of Debt Income, 63 Tax Law. ___ (2010), on SSRN.  Here is the abstract:

The United States is awash in a sea of debt. In the midst of the most severe recession since the Great Depression, loan delinquencies and charge-offs are at levels heretofore unknown in the modern financial era. Every loan charge-off and mortgage foreclosure has tax consequences. While the creditor most often claims a bad debt deduction or business related loss, the debtor generally must recognize gross income and pay income taxes on an amount roughly equal to the creditor’s loss, unless a special exception applies to exclude the debt relief from income. This article deals with the tax consequences to the debtor of the discharge of a debt for less than full payment. It first explain the origins and rationale for the rule, now codified in § 61(a)(12), that requires the inclusion of '[i]ncome from discharge of indebtedness.' The article then examines the various events that trigger recognition of income under § 61(a)(12). Following that discussion, the article deals with the manner in which the amount of income from discharge of indebtedness is computed. This part of the article also discusses the tax consequences to a business entity that issues an equity interests to a creditor to satisfy a debt. Finally, the article explores the myriad of statutory rules in §108 that permit nonrecognition income from discharge of indebtedness under particular circumstances, and the various ancillary consequences that follow from nonrecognition. Throughout, the article explores the relationship of income from discharge of indebtedness to realization of gain from the transfer of property to satisfy a debt by contrasting the tax consequences of transfers of property to discharge a debt with the consequences of discharge of a debt for less than full payment.

Residency Fraud in Public School Enrollment

Back in the New Haven suburbs the NHR reports -- one issue untouched in the reporting is how much of this occurs and the extent to which these rules are enforced in a discretionary manner:

Police have arrested a New Haven man and an Orange woman who allegedly conspired to illegally send two children to Amity Regional High School, and officials are hoping to recoup nearly $76,000 in tuition.

Superintendent of Schools John Brady said this is the first time in his educational career he has had to refer a residency matter to police, but because the students received an education illegally for six years, he had no choice.

“It’s a theft of service,” Brady said. “One can empathize with families seeking the best quality of education. We have an obligation to ensure taxpayer money is being spent on educating students who live in our towns.”

Brady said he hopes a judge will require the suspects to pay back taxpayers of Orange, Woodbridge and Bethany who collectively fund the Amity school system.

Police Sgt. Frank Cappiello said Wednesday police arrested Lura Godenciuc, 51, of 569 George St., New Haven, and Mary Antonyshyn, 75, of 944 Rainbow Trail, Orange, on larceny charges.

Police said the investigation began in June when Brady received information concerning two possible residence violations and notified police. An investigation conducted by police and school personnel confirmed that two students, who are brothers, had been attending Amity Regional High School in Woodbridge, and Godenciuc allegedly had falsely reported to school officials that the brothers lived in Orange.

One of the students graduated in June after attending all four years, while the other student attended the past two years, police said. Police and school officials declined to state the relationship between Godenciuc and Antonyshyn. Brady said an anonymous phone call sparked the investigation.

Police and school officials said they determined educating the two students over six years cost the district $75,990.

Harvard Fundraising

TaxProf blog writes:

In today's Harvard Crimson, Caspersen Taxes May Be Suspect:

Harvard Law School’s biggest donor, who died last week in an apparent suicide, may have owed up to $100 million in back taxes and fines, the New York Times reported this week.

Finn M.W. Caspersen, who gave over $30 million to the Law School and tens of millions more to other philanthropic enterprises, may have been implicated in a sweeping federal investigation of offshore bank accounts, said the Times’ anonymous source. ...

According to the Times’ source, federal authorities have placed liens on the personal trusts of Caspersen’s four sons, all of whom also attended the Law School.

The TaxProf Email Discussion Group today debated whether the IRS could clawback any of the $30 million gift to Harvard Law School under the transferee liability rules of § 6901.  Mary O'Keeffe (Union College) noted that much of the $30 million may be in the form of a pledge, and Ellen Aprill (Loyola-L.A.) directed the group to a 1993 article, Pledges to Nonprofit Organizations: Are They Enforceable and Must They Be Enforced?, which concludes:

When it comes to enforcing pledges, charities have demonstrated a timidity not characteristic of their solicitation practices. Charities seem to fear the loss of subscribers if it became practice to sue to enforce the subscriptions. Indeed, a review of the reported cases shows that the great majority of such actions were brought only after the death of the subscriber, when the charity was willing to dispute with the heirs over the assets.

Who pays for health care?

Drum writes:

Still, I'd like to highlight this comment from James Kwak:

One reason the Baucus bill is “cheaper” than the House bill is that it has lower subsidies. For illustration, let’s assume that the whole $140 billion difference is due to lower subsidies. Relative to the House bill, then, the Baucus bill costs the government $140 billion less; but it costs middle-income people exactly $140 billion more, since they have to buy health insurance. The difference is that in the House bill, the money comes from taxes on the very rich; in the Baucus bill, it comes out of their own pockets. Put another way, the Baucus bill is the House bill, plus a $140 billion tax on people making around $40-80,000 per year. That’s not only stupid policy; it’s stupid politics.

Can't argue with that.  As regular readers know, I'm more concerned with subsidy levels than I am with the public option.  This is why.  The public option is a good thing, but even in the best case it's available to only a small number of people and will likely have only a modest impact on the cost of health insurance.  Subsidy levels, conversely, affect lots of people and have a significant impact on the cost of health insurance.  According to CBPP, for example, a family making $45,000 would have to pay annual premiums of $4,800 under the Baucus plan, compared to $3,600 under the House plan or $2,500 under the Senate HELP plan.  That's a pretty big difference.

So: adopt the the Baucus version of subsidies and when 2013 rolls around you'll have lots of pissed off middle income families desperately trying to scrape up an extra five grand each year.  Adopt the HELP version of subsidies instead and these registered voters families will mostly think they're getting a pretty good deal.  And to fund it, all you have to do is raise taxes on, say, Wall Street bankers.  What's not to like?

See also the WSJ on the lower middle class squeeze in Massachusetts after health reform.  

I have no comments right now, since the comments above raise quite a few questions that would take quite long to address even superficially...again, better analysis and data would be helpful. But I do want to mention that it is my impression that in Germany redistribution in health care financing is from the middle class to the lower classes, with upper middle class and above households contributing little, something that is built into the institutional structure of the system.  But I need to look into it more...

The Unequal Geographic Burden of Federal Taxation

Since I'm moving to an even higher wage and higher cost location, I though I'd mention this. The point -- despite what the title of the article may imply -- isn't that redistribution from higher income to lower income persons is bad, but that who is higher income in real terms is mismeasured by the US tax system and that this mismeasurement has efficiency costs. Do other countries do better on this dimension?

David Albouy, The Unequal Geographic Burden of Federal Taxation

In the United States, workers in cities offering above‐average wages—cities with high productivity, low quality of life, or inefficient housing sectors—pay 27 percent more in federal taxes than otherwise identical workers in cities offering below‐average wages. According to simulation results, taxes lower long‐run employment levels in high‐wage areas by 13 percent and land and housing prices by 21 and 5 percent, causing locational inefficiencies costing 0.23 percent of income, or $28 billion in 2008. Employment is shifted from north to south and from urban to rural areas. Tax deductions index taxes partially to local cost of living, improving locational efficiency.

Is a “tax advantage lease” at fault for the DC Metro Accident?

Concurring Opinions wrote a few days ago:

As you have doubtless seen elsewhere, two Metro trains collided when one train ran into the back of a stopped train, killing at least nine and injuring over 75 others.  The first car of the moving train was, the Washington City Paper reports, the oldest type of Metro car in the system, a 1000-series Rohr car.

The City Paper reports that the National Transportation Safety Board repeatedly recommended that Metro (more formally known as the Washington Metropolitan Area Transit Authority, or WMATA) retrofit or replace these older cars, but Metro refused.  Why?  Because “WMATA is constrained by tax advantage leases, which require that WMATA keep the 1000 Series cars in service at least until the end of 2014.”

What are these “tax advantage leases”? They appear to be standard sale-leaseback transactions, in which WMATA sold equipment, including train cars, to another party and now leases it back.  The other party gets various tax advantages (depreciation, credits, and so forth) associated with owning the equipment, and WMATA, which as a tax-exempt organization cannot use these advantages, gets cash.  But apparently the leases did not include language that permits WMATA to break the leases if newer, safer equipment comes along.

Setting the Bar very very Low

The WSJ reports

The compromise version of “cash-for-clunkers” announced by the House offers prospective car buyers between $3,500 and $4,500 vouchers for trading in old cars to get new ones. But the bar is set really, really low.

For passenger cars, “clunkers” that get less than 18 miles per gallon can be traded in—for cars that get at least 22 miles a gallon. The corporate average fuel economy for new cars is 27.5 miles a gallon

If the new car is 4 mpg more efficient, the consumer will get $3,500. If the new car offers a 10 mile-per-gallon improvement, the payout rises to $4,500.

Things don’t get any more ambitious when it comes to light trucks. Says the House Energy and Commerce Committee plan: “New light trucks or SUVs with mileage of at least 18 mpg are eligible for vouchers.” A similar sliding-scale payout applies.

The problem with all this, as Duke’s Bill Chameides pointed out last month, is that making a new car produces, on average, about 6.7 tons of carbon dioxide. By his calculations, it would take at least five years to “pay off” the environmental impact of building the new car with a 22-mile-per-gallon purchase. That SUV might be even worse—the estimated payback time is almost 20 years.

18 mpg...wow. I was sort of proud that the US wasn't engaging in the German Abwrack-Prämie nonsense...oh well, it looks like we're going to get an even worse version of the scheme in the US now. 

E-Filing Taxes and Spouses

I e-filed my taxes this week after the customary extension on April 15 (I've not filed before April 16 since I've been married).  One thing I've been wondering about: since e-filers do not sign their returns and just verify their identity by providing their Social Security numbers and the AGI [adjusted gross income] from the previous year's income tax filing (as well as making up PIN numbers for later access to the tax filing), how does this affect spouses?  With paper tax filings, the spouse has to sign the tax return and this provides some evidence that the spouse has at least seen the tax return and maybe read some of it, for instance the AGI number.  How many husbands file electronically and don't involve their spouse at all?  I know of husbands who don't tell their wives what they earn, understating their income substantially, and this just further their ability to keep their wives in the dark.  I assume it isn't uncommon. 

In my case, I told my wife I was filing and she didn't request to review it.  So no, she didn't see this tax return, though she will get to file the print-out of the pdf (but I need to get a new toner cartridge first).

And it might make 'innocent spouse' claims easier as well.  

Taxes and Credit as alternative methods of identifying Ability to Pay

More later...

Tax Policy

via TaxVox:

S.857 : A bill to amend the Internal Revenue Code of 1986 to allow a $1,000 refundable credit for individuals who are bona fide volunteer members of volunteer firefighting and emergency medical service organizations.
Sponsor: Sen Schumer, Charles E. [NY] (introduced 4/22/2009) 

TaxVox writes:

Some of these provisions might have merit as tax policy, but the really noteworthy feature is that there are a lot of them, almost all would cost tax revenues, and some would take the tax system into brand new areas.  (Should the IRS run a cash grant program for volunteer firefighters and emergency medical workers?  Who will certify the bona fides for eligible recipients?  And is it still “volunteer” if you’re getting $1,000 from the feds to do it?)

Most, if not all, of these proposals are going nowhere.  Senator Schumer will probably get an award from the Association of Volunteer Firefighters for his support and that will be the end of it.  But wouldn’t it be great if members of congress applied as much creativity to making the tax system simpler, fairer, and capable of financing the government as they spend on finding new ways to undermine the tax base?

And what is the federal policy interest in promoting, at the extensive margin, volunteer firefighter and emergency service organization membership numbers?  I could see, maybe, funding a retention program for volunteers who are somehow judged valuable, or a training program, or a recruitment program.  But is a cash payment to all volunteers a good idea?    Why is this a federal interest? 

Targeting Child Support by Parent Quality

The FAZ has an article that raises an issue I've thought about quite a bit, but haven't written about here yet: the targeting of child support measures by parent quality, especially in the tax structure.  Having a decent theoretical and empirical framework that can accommodate the multiplicity of interests at stake here would be welcome, and lots of the public discussion doesn't have either. 

Tax Avoidance undermines Corporate Governance

Shaviro writes about AIG tax and regulatory avoidance schemes using complex off-shore structures:

This is pretty much the point Mihir Desai makes in his work on taxes and corporate governance. Once there is a planning excuse for complex structures [i.e. tax avoidance or regulatory avoidance], they can be used for multiple nefarious purposes, e.g., tax fraud, avoiding internal and market as well as formal regulatory oversight, looting the company, etcetera.

Complex structures kill transparency. At the limit, they make corporate governance impossible and genuinely profitable activity by publicly traded companies a pipe dream. To some extent, this is a problem of financial not "real" activity, as the latter is much easier to observe. E.g., Apple Computers and General Motors both are presumably well-judged by the market because to a considerable extent one can see how well or poorly they are doing. But even companies engaged in real productive activity often have such large finance wings (think GMAC, or GE's recent problems) that the virus of non-transparency extends well beyond the pure banking and finance sector.

In general I think the relationship between internal firm governance and the tax system is insufficiently studied and taught.  Taxes can be efficiently collected to a great degree only because it in the interest of firm owners to organize firms to document income for internal control reasons (i.e. deciding how to run the firm by seeing what activities are profitable and making sure employees don't loot the firm) and the state can then observe and tax this income.   This also applies to making income streams for employees and small firms visible when they are employed by or hired by large firms with greater internal control need for documenting transactions.

This means, for instance, that small family owned firms with family members as workers selling to individuals are the most efficient firms at tax evasion, simply because they have little need to truthfully document income streams in a way the state can observe.  On the other hand, if entities like AIG try this things can go terribly wrong: having an excuse to hide things, even just via complex structures, from the state can mean hiding it from top management and firm owners as well and loosing control of the firm. 

Not your standard story about government spending in open economies

via VoxEU, is see that Paolo Epifani and Gino Gancia have a paper out, forthcoming in REconStd, Openness, Government Size and the Terms of Trade:

This paper investigates the relationship between trade openness and the size of governments, both theoretically and empirically. We argue that openness can increase the size of governments through two channels: (1) a terms of trade externality, whereby trade lowers the domestic cost of taxation, and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a uni…ed framework for studying and testing these two mechanisms. Our main theoretical prediction is that the relative strength of the two explanations depends on a key parameter, namely, the elasticity of substitution between domestic and foreign goods. Moreover, while the …first mechanism is inefficient from the standpoint of world welfare, the second is instead optimal. In the empirical part of the paper, we provide new evidence on the positive association between openness and government size and we explore its determinants. Consistently with the terms of trade externality channel, we show that the correlation is contingent on a low elasticity of substitution between domestic and foreign goods. Our …findings raise warnings that globalization may have led to ineffciently large governments.

As they write at VoxEU:

More open countries have larger public sectors because the cost of providing public goods is lower the higher a country’s involvement in foreign trade. The basic idea is that an expansion of the public sector crowds out private production, thereby reducing the domestic supply of exports. As long as the world demand for domestic products is downward sloping, a fall in domestic exports brings about a terms-of-trade improvement that partly compensate the increase in public expenditures. In other words, the rise in export prices shifts some of the costs of the public sector onto foreign consumers. This effect is stronger in more open economies, because the real-income effect of terms-of-trade movements is proportional to the volume of trade. Moreover, such a terms-of-trade improvement materialises independent of whether a country is large or small, provided that it produces differentiated goods. For instance, given that Nokia’s mobile phones are perceived as different from Motorola’s, even a country as small as Finland is a price setter in world markets. Hence, insofar as the price of a Nokia mobile reflects high domestic taxes, every unit sold to foreigners provides a subsidy to the Finnish welfare state.

In our data, we find that the positive correlation between openness and government size holds strongly only for countries producing differentiated products. Moreover, simple calibrations suggest that the mechanism illustrated above is quantitatively relevant, as it can explain the entire empirical correlation between openness and government size, and between one-third and one-half of the overall average increase in public spending over the second half of the last century.

That the growth in governments’ size is driven by terms-of-trade considerations may appear implausible at first. It is less so once it is understood that terms of trade and relative wage are closely related in open economy, for any policy that increases the relative demand for domestic labour also affects positively the terms of trade. This is indeed the case with public expenditure. A shift in the composition of expenditure from private to public raises the relative demand for domestic labour, because public goods and services are produced almost entirely locally, whereas private goods are partly imported. Evidence on this is compelling. In a sample of developed and developing countries with available data, we find that the average import share in government consumption is 1%, versus an economy-wide import share equal to 50%.

Hence, the logic behind our results is closely related to the Keynesian view that public expenditure can be used to sustain demand for domestic labour. The current crisis offers numerous examples of how globalisation affects this logic. For instance, when asked how to give a stimulus to the US economy, a PIMCO spokesman said: "Consumers will just buy more Chinese goods with stimulus package money, more of the same. What is needed is public investment to fill demand void of private sector". This is the mechanism we stress in action. In a world of integrated product markets, sustaining demand via public spending is considered more effective than a tax cut.

I need to look into this more.  Their results do seem to show up in the standard version of the differentiated trade model people use now, but that model has all sorts of weird simplifying features that means one has to think seriously about how robust results are and how applicable to the real world. 

My first concern is that differentiated producers like Nokia already fully exploit their market power and that hence there is little government can do to impose an additional pecuniary externality on the rest of the world.  At least one would want to look into the issue of how firms and the government interact in setting prices, both statically and dynamically, in differentiated goods industries with firm specific capital (and consumer habits). Which reflects one of my pet peeves about this literature, the lack of dynamic demand systems with distinct short and long-run demand. 

Update #1: Another paper from the same authors that also works through what appears to be a model very close to the standard model, though I should check: Procompetitive Losses from Trade

We argue that the procompetitive effect of international trade may bring about significant welfare costs that have not been recognized. We formulate a stylized general equilibrium model with a continuum of imperfectly competitive industries to show that, under plausible conditions, a trade-induced increase in competition can actually amplify monopoly distortions. This happens because trade, while lowering the average level of market power, may increase its cross-sectoral dispersion. Using data on US industries, we document a dramatic increase in the dispersion of market power overtime. We also show evidence that trade might be responsible for it and provide some quanti…cations of the induced welfare cost. Our results suggest that, to avoid some unpleasant effects of globalization, trade integration should be accompanied by procompetitive reforms (i.e., deregulation) in the nontraded sectors.

Tax Tips you can't use

via MR, the Internal Revenue Service writes:

Topic 357 - Tax Information for Parents of Kidnapped Children

You may claim a kidnapped child as your dependent if the following requirements are met:

1. The child must be presumed by law enforcement to have been kidnapped by someone who is not a member of your family or a member of the child's family, and
2. The child had, for the taxable year in which the kidnapping occurred, the same principal place of abode as the taxpayer for more than one-half of the portion of such year before the date of kidnapping.

If both of these requirements are met, the child may meet the requirements for purposes of determining:

• The dependency exemption
• The child tax credit, and
• Head of household or qualifying widow(er) with dependent child filing status.

This tax treatment will cease to apply as of your first tax year beginning after the calendar year in which either there is a determination that the child is dead or the child would have reached age 18, whichever occurs first. 

For more information, refer to Publication 501, Exemptions, Standard Deduction, and Filing Information.