Annoyed with Economics Textbooks

Once upon a time, the Carter administration wanted to reduce gasoline usage in the United States. Their plan was to put in place a gasoline tax and rebate the money to the consumer in a lump sum. Would this plan have (1) lessened the U.S.'s use of gasoline, and (2) made consumers better off?

It's pretty easy (especially if you've taken a microeconomics class or two) to see that the answer is (1) yes, and (2) no. Here (on page 3) is the graph (I can't figure out how to upload images) that makes this clear. But intuitively, it makes perfect sense that making a good more expensive will reduce its usage and that the government can't improve on the consumption decision of a consumer by spending and rebating the same money.

Why do I bring this up? This weekend, I was grading the exams from an intermediate micro class I'm TAing. The students are quite good, but a large number of them kept saying that the plan made consumers equally well off. This is clearly not the case: After the tax-and-rebate plan is enacted, the consumer is on a lower indifference curve, and thus worse off. (Some even said the consumer was equally well off while reproducing the correct graph.)

And yet, when I went and looked at the class handout on which the question was based (from a different textbook than we normally use), I can completely see why my students were mislead. The handout (correctly) bashes the critics of the plan who said there would be "no effect", since there is a substitution effect. But here's all it says about welfare:

In the end, the Carter administration's tax-and-rebate proposal was never implemented, largely because of the objections of critics who lacked the economic knowledge to understand it. And as a result, the United States remains dangerously dependent on foreign oil more than 25 years after Carter left office.

That's it. Even leaving aside the issue of whether energy independence makes sense or is as chimerical a goal as my being booze-independent of Binny's Beverage Depot, surely a complete discussion would note the consumer being worse off. Perhaps a rant is necessary in my next section.

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I think a common mistake

I think a common mistake would be to think along the following line

- everyone spends roughly the same amount of gas
- so everyone receives roughly the same amount of collected tax

Conclusion : everyone receives back what he paid in taxes, the government just borrowed the money, it has no effect. The key of course is that there is a disincentive to consume more because one only reaps a fraction more of the tax back. Even if everyone has the same preferences, consumption is lower because of a cooperation problem.

It could be what misled your students.

Conclusion : everyone

Conclusion : everyone receives back what he paid in taxes, the government just borrowed the money, it has no effect. The key of course is that there is a disincentive to consume more because one only reaps a fraction more of the tax back.

Oh, I agree that could confuse people, but they all pretty much recognized that there was a substitution effect. What they didn't see was that people are in fact worse off, not just consuming a different but "utility equivalent" bundle.

The big catch is the postage and handling fee

Carter would have collected the tax from commercial gas customers (as well) and paid it back to income tax payers? I don't remember this plan.

It would probably cost the taxpayers 10% of the tax for the government to collect the tax and mail the checks.

I support a $1/gal Bush Oil War Tax. Or do the grandkids pay for it through inflation and taxes?

There are good arguments for

There are good arguments for a gasoline tax (energy independence not being one of them). But the question wasn't referencing pollution externalities or congestion. It left the impression that the government can costlessly reallocate spending, and that's wrong.

Or do the grandkids pay for it through inflation and taxes?

You keep saying this. Inflation does not work this way. If prices are higher in the future, then the owners of goods and sellers of services (also our grandkids) are the beneficiaries of the higher prices as well as the payers. As Bryan Caplan puts it:

Since most inflation is anticipated, I don't see that it does transfer much; instead, it's built into raises and interest rates. But many members of the public have a different - and crazy - model. They imagine that if inflation were 0%, their nominal income would continue to rise at its current rate.

Furthermore, when inflation is unanticipated, many people ignore all of the transfers they receive. If you have a fixed rate mortgage, double-digit inflation is probably great for you. But how many home-owners who lived through the inflation of the 70s even stopped to think about how much inflation had done for them?

Inflation is bad, but not because it harms our grandkids.

Caplan seems to be wrong

Caplan seems to be wrong here, or at least not careful in his choice of words. Let's say a village has a counterfeiter who prints money and loves chocolate. Even if this is known, even if inflation is entirely taken into account, it will transfer wealth from those who are not skilled in chocolate making to those who are (and to the counterfeiter obviously)

At some point, when pressure builds up to repay the debt, it will be done with taxes or higher inflation. Both will hurt our grandkids. "Inflation will hurt my grandkid" does not imply the naive interpretation of inflation that you suspect.

Clarifying question

I’m not following this. And, alas, I can’t see the graph in question; the link takes me to a Heldref’s home page, or to an error page.

put in place a gasoline tax and rebate the money to the consumer in a lump sum.

I understand why an excise tax on gas would discourage consumption. I don’t understand why a rebate on gas wouldn’t produce the opposite effect.

How would the rebate system work? Would the government actually reward incremental gas consumption through a dollar-for-dollar rebate – for example, by permitting people to deduct the amount they pay in gas taxes from their income tax bill? If so, then it’s not obvious to me that this would have much of an effect on consumer welfare (“put them on a lower indifference curve”) – at least among people who file tax returns. Nor is it obvious that this would alter consumer behavior much. So I suspect the rebate system doesn’t work this way. Please clarify.

The rebate is just a

The rebate is just a lump-sum check to everyone regardless of gasoline consumption.

More in need of clarification than ever

If the amount the individual receives in rebate is unrelated to the amount the individual pays in tax, I can’t see how anyone could generalize about whether this policy puts people in general on a higher or a lower indifference curve.

Ignoring timing differences between the incidence of the tax and the rebate, people who pay more in taxes than they get in rebate would seem to be put on a lower curve, while people who get more than they pay would be put on a higher curve.

In another context I suggested that environmental regulation is a means by which society can defend the property rights that each citizen has in the environment. After all, if someone dumps trash on my lawn, I have recourse against him, but if he dumps trash in my air, what remedy do I have – other than the remedy granted by environmental laws? Arthur B. argued that environmental regulations provide an insufficient link between the regulation and reparations to the victims. That’s a fair criticism – although I’m not persuaded that having no remedy is better than having an imperfect one.

So let’s look at the Carter proposal then. Let’s say that the price of gas does not reflect its actual cost – that the true cost of oil would reflect environment costs, the cost of wars to maintain order in the Middle East, and/or the cost of financing terrorists (or at least despots). In the absence of efforts to internalize these costs, consumption of oil will exceed efficient levels. So we tax oil consumption up to the level where it reflects its true cost, and then use the tax proceeds to reimburse those who bear the cost of the environmental damage, war, and terrorism/despotism.

Does this proposal pose logistical challenges (quantifying the relevant costs, identifying the harmed parties, implementing disbursements to people living in despotism, etc.)? Sure. But is it conceptually flawed? Not that I can yet see.

Then again, I haven’t had the benefits of seeing that graph. It must be darned illuminating.

It's a representative

It's a representative consumer model (yeah, I know they're pretty problematic at times). And as I said, the problem was abstracting away from externalities like pollution (I'm less persuaded by the national security argument, but that's an argument for another day). But in the context of the model, consumers are worse off, and that should be noted.

I'll see if I can dig up the graph elsewhere; it's a pretty standard intermediate micro argument.