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The Cruelest Tax of All is Not Inflation, but Inefficiency

November 2022


Officially, the Democrat Party favors taxes only on the very rich. But in fact, its spasms of economic populism are financed with camouflaged taxes that burden ordinary folk. They go by the names Inflation and Inefficiency.


Inflation, of course, refers to the rising prices of goods and services. The recognition that price inflation can be a sneaky tool of fiscal policy is nothing new. Inflation helped to pay for the military misadventures in Vietnam and Iraq. Today, it's the the war on Covid that is financed in part with an inflation tax on consumers.


Price inflation is the tax that automatically kicks-in when excessive government spending is financed with borrowed money. An inflation tax pays for deficit-spending in two ways: when the prices of goods rise unexpectedly it takes time for wages to catch up. As long there is a gap between the price level and wages, consumer are robbed of income. Inflation also erodes the value of the principal that must be repaid (i.e., the national debt).


An obvious example is the pair of pandemic relief bills passed in 2020-21. They were intended to rescue people whose livelihoods and businesses were upended by the lockdowns. Larry Summers warned that excessive spending could ignite inflation. But the Dems couldn't resist the political temptation to lavish $1400 checks onto everyone who didn't need relief. The culmination of $5.7 trillion in deficit spending over two years was more than enough to put upward pressure on prices, adding about 2.5% to the inflation rate.


Obviously, raising the price of milk, eggs, and rent violates Democrats' tax-the-rich principle. Nevertheless, they knowingly unleashed a regressive tax on American consumers for the venal purpose of scoring political points with the "middle class."


By the way, America's progressive-in-chief lied when he promised to do "everything possible" to curb inflation. He could have cut 1.3% off the CPI simply by revoking Trump's tariffs on imported metals and other trade restrictions. But that would have offended the special interests supporting his "buy America" scheme, such as GM, Nucor Steel, and the habitually corrupt Teamsters Union.


And, he could have postponed the loan forgiveness edict which, by adding $21B to the annual deficit, would actually exacerbate inflation. But that didn't happen because anxious Dems needed to fire up the college student base for the upcoming mid-terms.


Inefficiency Tax


Here, the meaning of inefficiency is different than the usual news stories about government misdeeds such as cost-overruns, bureaucratic bottlenecks, and cheesy pork-barrel projects. Rather, it refers to the inherent cost-effectiveness of alternative policy mechanisms for achieving a specific goal: e.g., taxes vs. subsidies vs. mandates; command-and-control vs. market mechanisms; and Federal control vs. state/local discretion.


The inefficiency tax is more insidious than the inflation tax. Inflation is a decline in purchasing power that is viscerally evident to consumers. But the cost of inefficiency is often an invisible loss: it's the absence of benefits people would have enjoyed if the most efficient policy had been enacted.


Whenever politicians knowingly sacrifice an efficient policy in favor of a more costly way to solve a problem, they are imposing an inefficiency tax on the American people.


Why would progressive Democrats willingly stifle efficiency? After all, efficiency is a hugely valuable asset for their cause because it means more-bang-for-the-buck. It maximizes the good they can do with scarce public resources. To choose an inefficient policy is to steal resources from other opportunities to do good.


However, even the most idealistic progressives need to get elected. And as it turns out, the most efficient policies often threaten vested interests and provoke broad opposition, especially when they entail tax increases. Being tagged as soft on taxes (and crime) is politically lethal. That's why Democrats are willing to coalesce around inefficient approaches to a problem.


By absorbing the cost of the Party's wasteful choices, i.e., by paying an inefficiency tax, the American people are unwittingly financing the Democrats' quest for electoral victory. Of course, Republican policy makers are guilty of the same thing. As John Adams put it, "There is nothing which I dread so much as a division of the republic into two great parties."


Joe Biden's Climate Plan offers two outstanding examples.


1. Ditching the Carbon Tax. Economists do agree on one thing: a tax on carbon emissions is the most efficient way to reduce CO2 emissions. According to computer models, a modest tax of $30 on each ton of CO2 emissions would induce power companies and other energy users to burn less fossil fuel and install more solar PV. This switch to solar by itself would cut annual CO2 emissions by about 30 megatons, at an annual cost of $900 million.


However, since a carbon tax would raise everyone's electricity bill, AOC and the Squad are against it. So, instead of the tax, the Biden plan incentivizes the switch to solar with taxpayer subsidies. Power companies and home owners would be rewarded with generous tax credits for installing utility scale and rooftop solar PV.


The trouble is, each ton of CO2 eliminated by means of solar subsidies costs $108* instead of $30; and this increases the total cost of avoiding 30 megatons of emissions to $3.2 billion instead of $900 million.


This amounts to an annual inefficiency tax of $2.3 billion ($3.2 -$0.9). Americans pay this tax by foregoing the goods and services that could have been produced with $2.3 billion in wasted resources.


2. CEPP: the inefficient version of CES. As an alternative to carbon tax, some Congressional Democrats advocate a "clean energy standard" (CES) that would require power companies in all states to transition from fossil fuel to clean energy according to a fixed timetable. CES is almost as efficient as a carbon tax because it also incentivizes energy conservation through higher energy prices. But CES is less politically risky than a national tax because blame for price increases would be dispersed to state and local utilities.


But less risky is still too much for the Democrats to bear. So the Biden plan ditches CES in favor the Clean Electricity Performance Program (CEPP) in which big electric utilities are paid to make the clean energy transition with taxpayer subsidies. This guarantees that electricity prices will NOT increase.


Consequently, CEPP is much less efficient than a carbon tax because it fails to incentivize energy conservation.


For example, a $30 carbon tax is predicted to reduce electric power emissions by 670 megatons. Energy conservation alone accounts for 22% of that reduction.

Other things equal, the cost of achieving the same reduction (670 M) by means of CEPP, without the benefit of conservation, would be more costly than a carbon tax by $5.6 billion. So, the political choice of CEPP is financed by a $5.6 billion inefficiency tax on the American people.


The total economic burden of inefficiency taxes.


I chose the two examples above because they are recent and newsworthy. But there are literally thousands more that have been codified into law over decades of political expediency. If just two policies affecting the narrowest of economic sectors (electricity generation) can result in an efficiency deficit of $7.9 billion (2.3 + 5.6), then imagine what a complete inventory of inefficient policies would add up to.


Such an inventory would document the accretion from past policies that still persist. For example, in 1975, for the purpose of suppressing gasoline consumption, the Congress chose to impose CAFE (mileage) standards on car makers rather than the more efficient option of raising gasoline taxes. America has followed that course ever since. The result, according to the Congressional Budget Office, is an annual inefficiency tax of at least $2 billion/yr.


And in 2006, a huge empirical study of market and government economic failures reported that America's inefficient transportation policies result in a "deadweight loss" of $51 billion/yr.


Biden promises more of the same. When Trump was President the Dems castigated his nationalism as xenophobic. But under Biden, nationalism has been rehabilitated as economic populism; e.g., buy-American mandates, re-shoring manufacturing jobs, labor union favoritism, and tacit acceptance of Trump's tariffs on imported metals.


While legitimate national security concerns may justify some of this, the truth is, America-first protectionism is inefficient. Suppression of free trade and the requirement of union-level wages in public projects will raise prices and reduce productivity - another massive inefficiency tax.


As the ghost of Senator Dirkson would say, "a billion here, a billion there, it adds up to serious money after a while."


I don't pretend to know how much it adds up to. However, a major historical event offers a glimpse as to how much efficient policies contribute to U.S. GDP. The event is WWII, the five-year period from the Japan's attack on Pearl Harbor to its surrender in 1945.


The point of this post is that today's policy makers willingly sacrifice economic efficiency for political advantage. But during WWII, efficient policies prevailed over political expedience because of these optimal conditions:

  1. The war effort required big changes in domestic policy that put a premium on cost effectiveness. High stakes clarify priorities.

  2. Leaders enjoyed enough political capital to implement harsh and unpopular policies such as rationing, wage caps, conscription, and higher taxes. Their authority derived from two things: Americans were united by an external threat; and from 1932 through 1945, FDR and the Democrat Party won over large majorities of American voters.


The economic impact was a huge spike in labor productivity, as shown below. During the war years, output per hour grew 4%/yr, twice as fast as the previous 60 year trend. As a result, by 1946, GDP was 10% higher than it would have been otherwise.


If such a 5 year surge in efficiency were to occur today, America's GDP would be greater by at least $2 trillion. This is an indication, albeit iffy, of how much inefficiency taxes are costing us.


labor productivity WW-II spike

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*This estimate is explained in a previous post.


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