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August 14, 2006

William Coleman poses a challenge to popularisers of economics: The Undercover Economist - Tim Harford

Posted by William Coleman

The Undercover Economist
by Tim Harford
Pp. 276. London: Little, Brown, 2006
Hardback, 17.99

Books which popularise economics - such as Steven D. Levitt and Stephen J. Dubner's Freakonomics and Tim Harford's The Undercover Economist - are now appearing on the bestsellers lists. Dr William Coleman, Reader in Economics at the Australian National University, poses a challenge to the economic popularisers.

Tim Harford's The Undercover Economist is a clever, cute and altogether too untroubled exercise in the demanding art of teaching economics to people who would rather watch the Da Vinci Code.

The book is an album of the author's happy snaps of his travels, taken through the lense of a standard array of theoretical topics: rents, rent-seeking, congestion charges, auctions, "convergence", screening, signalling, asymmetric information and incomplete markets. His zoom shot on price-discrimination is a particular success, and deserves to become a classic of popular economics. That 60 pence for the vanilla shot at Starbucks will never look the same again.

The book has two flaws. Firstly, Harford would have the reader believe that we exist in a "policy utopia". He would have us believe that all correct policy decisions are painless decisions. There are no difficult bits. There are no dilemmas. Just free the market, and enjoy!

But there are difficult bits. Globalisation illustrates. Economic theory implies that unimpeded immigration will increase national income. But theory also teaches it will reduce labour incomes. So it seems that to increase mean income, by immigration, is to reduce median income. Enjoy?

Another example: theory teaches that free capital flows will increase the national income of every country. But it also teaches that free capital flows will halt the "convergence" of poor countries upon rich countries. There will be no more catch-up. The disparities in consumption across the world that exist today will be frozen solid. Sound good?

The proof of this last proposition is not trivial. At least, it cannot be convincingly conveyed in a newspaper column. And that constitutes another motive for undertaking a study of economics lengthier than reading a paperback. Which brings me to the second flaw of the book.

Harford implicitly assumes that we live in a "cognitive utopia". It assumes that most important economic truths can be demonstrated by no more than a deft travelogue. The pity of it is that economics is not easy. It is complicated. And economists themselves are as much perplexed as knowing.

But, undeniably, Harford has shown how much popularisation can do. He makes a good fist of explaining Ricardian theory of rent, something that clearly always defeated the late J. K. Galbraith.

So in the spirit of popularisation, I will now call the attention of popularisers to three theorems that they may wish to include in their future editions. All three concern public finance. All three are "equivalence propositions". All are easy to show, and as incontestable as anything you can find in economics.

Ricardian Equivalence: Barring default or surprise inflations, government borrowing must eventually be repaid by means of taxation. Thus a government deficit is no more than a delayed tax. And a deficit financed tax cut is no tax cut at all.

The notion of "Ricardian Equivalence" exposes the illusion of "tax cuts" under the Bush presidency. The truth is taxes have been substantially increased under Bush, because government spending has been substantially increased. Benchmarking by the last Clinton budget, US government expenditure has been increased by $955 billion thus far. That means $955 billion of increased taxes, now or later.

Dalton's Law: A tax levied on the seller is effectively equivalent to a tax levied on the buyer. To put it another way, the legal incidence of a tax (who pays in law) is completely irrelevant to the effective incidence of a tax (who pays in effect). Thus it is a matter of indifference to the seller whether the tax in law is levied wholly on themselves or the buyer. Thus it is a matter of indifference to all whether an x percent tax on wages is paid by the employer (a payroll tax) or the employee (income tax).

The inflation tax: Printing money is equivalent to taxing currency balances. Both confiscate part of the real value of currency. So a monetary policy that has raised prices 10 percent higher is equivalent to 10 percent tax on currency. Put briefly, inflation is a tax. It is as much a tax as the VAT; just the base is different.

Notice that none of these equivalence propositions promise any policy utopia. Raising resources for government will remain irksome. But if the public appreciates these propositions they can make the necessary decisions without illusion.

Dr William Coleman is Reader in Economics at the Australian National University and the author of Economics and its Enemies: Two Centuries of Anti-Economics, (Palgrave Macmillan, 2002).

To read Tim Worstall's take on The Undercover Economist see: Why Do Starbucks' cappuccinos cost so much? Tim Harford explains this and other "mysteries" of economics: The Undercover Economist - Tim Harford.


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Dalton's Law looks good on paper but doesn't work in practice: it assumes 100% compliance in paying tax, or at least that there is no difference in evasion/avoidance between different economic actors. These are very charitable assumptions. They ignore risk.

Consider for a moment what would happen if PAYE were abolished and instead 40 million taxpayers had to file an annual return and pay their income tax in one go every January. Aside from the severe cashflow problems for the Exchequer (with consequent borrowing/national debt implications) and administrative nightmare it is just possible that a few chaps might under-declare their income leading to tax leakage. In effect PAYE allows the Exchequer to sub-contract its tax collection to employers - that's why it exists.

There may also be a psychological difference with economic effects. Prospect Theory would suggest that workers would attach different values to (a) being told their job is worth 100 gross and then withholding 20 from it to give them 80 net; and (b) taxing the employer's profits to reduce his free cash by 20 to leave only 80 to pay untaxed wages. I'm not quite sure what the difference would be, but it could be significant if for example you completely scrapped employment income tax and placed the entire burden on corporate tax or self-employed income tax. There's probably a doctoral thesis waiting for someone here.

On the Ricardian equivalence point, yes taxation is required to service extra borrowing (I can't imagine why you would want to pay off the whole national debt). Also, I'm not running to the defence of Bush's financial policies.

But borrowing to fund tax cuts is in effect a conversion of capital in the hands of lenders into revenue in the hands of employees/profit-creators/consumers (depending on which taxes are cut). It is possible to imagine a situation where this would have a dynamic effect such that the boost to economic activity made the subsequent tax rises more affordable. We can also imagine a situation where this injects liquidity into a stagnant economy - a solid gold statue isn't much use in the desert.

Surely you have to compare the net present cost of future tax against the current proposed tax cut, and that must imply taking a view on economic growth, interest rates, inflation etc etc.? I don't think you can necessarily assume that they are equal or that the tax cut goes 100% into extra saving to fund the borrowing.

No quibbles with the inflation tax proposition, though. Inflation is theft.

Posted by: William Norton at August 16, 2006 01:25 PM
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