Danny Taggart's Blogarama

A more-or-less daily dose of news, politics, techmology, and any random thoughts that pass through my head.

Friday, March 11, 2005

Tax rate market, continued

To clarify my tax rate market idea, here's how it would work:

Step 1: Investors Bid

Each investor places a bid for:
S percentage share of government revenue,
for the next T years,
at price P,
for policy change D

S = 1/100 billion
T = 3
P = $60
D = -10% capital gains

The investor in this example expects that if the government cuts capital gains taxes by 10%, revenues would average $2 trillion per year over the next 3 years, plus the rate of return to compensate the investor for risk. (2 trillion * 1/100 billion * 3 = 60)

Step 2: Government Chooses a Policy

The government looks at its policy options:
1. The status quo
2. A policy change in the tax rate market

The government will choose a policy change from the market if:
A majority of congress and the president believe that the total value of the bids for the policy change exceeds expected revenues.

Step 3: Payout

For the next 3 years, each of the investors receives his share of government revenues (the government covers its obligations with the capital from the tax rate market). If, as a result of the selected policy change, the economy improves and government revenues are better than expected, the investors profit. If government revenues are lower than expected, investors lose out.

Problems with the idea:

The biggest problem is that a risk-neutral government will engage in risky behavior. Even if the tax code is frozen so that only the specified policy is enacted, the government can still adversely affect the economy through:
1. Legislation
2. Regulation
3. Monetary policy

Since the government still operates under political constraints, it may be reasonable to assume that excessively adverse legislation or regulation is unlikely. Furthermore, a tax rate market would probably only exist for dramatic tax changes, which would overwhelm most effects of legislative/regulatory action (or other adverse economic factors).

In the comments of my last post, McGroarty said, "I'm apprehensive about anything that aligns government fiscal interests against the public's." The reason the government engages in economically risky behavior is that it balances the needs of the economy (and hence future revenues) vs. the needs of its constituencies (special interests). Politicians are risk averse because of the ballot box, so they are biased towards their constituents' interests.

The tax rate market, in effect, boosts the political constituency for the economy by exposing the real value of optimal tax policy. The stake that the investing public has in the economy translates into additional accountability at the ballot box. So, instead of the government guessing what its fiscal interests are (i.e., optimal tax policy), it can simply focus on responding to political pressure from the investing public.

That leaves monetary policy. Since the Fed is not tied to political constraints, it may be more aggressive with the knowledge that its actions will not affect government revenues (in the short term). This is a big issue, although the Fed would still be wary of long-term economic consequences.

Another lesser problem is the difficulty of raising so much capital. It may be more feasible to implement such a market at the state level first. This has the following benefits:
1. The policy change does not have to affect the entire national economy.
2. Monetary policy is not an issue.
3. It would be easier to raise capital.
4. It would be politically easier to implement (less risky to try it in one state, which may be ailing badly anyway).

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