Uncertainty and Taxes

December 13, 2010

The much-discussed Bush-era tax rates expire on December 31, 2010. Republicans have pushed for a permanent extension of all the current tax rates, while Democrats have pushed to make rates on the middle class—defined as individuals earning under $200,000 and married couples earning under $250,000—permanent and to let the existing rates on higher earners expire and return to a high of 39.6 percent. It now appears that the most likely compromise will be a temporary extension of all the tax rates, possibly for two years.

Kicking the tax reform can down the road introduces a new element into ongoing political discussions. At a time of growing concerns about issues including mounting federal deficits and entitlement reform, the consensus seems to be to extend the current tax code only until these problems can be fully addressed and then tackle tax reform. However, the environment of uncertainty that a temporary extension of the current tax rates imposes in the meantime will have disastrous consequences.

People do not like uncertainty, especially when it comes to their taxes. Uncertainty in the tax code leads to economic paralysis because, in such an environment, it does not make good business sense to hire and invest. Moreover, under uncertainty, individuals are fearful of spending and/or taking additional investment risk. Without that spending and investment, the economy will not return to full employment growth.

As this paper will show, tax reform is necessary. However, given our current tax structure, any increase in marginal income-tax rates will actually retard economic growth and stall recovery further. It is important for Congress to focus on implementing stable low marginal tax rates that do not discourage working, saving, or investing and provide taxpayers with some degree of certainty to make growth promoting economic decisions.

Speed Bankruptcy as the TARP Alternative

February 3, 2010

In the fall of 2008, the U.S. government invested hundreds of billions of dollars in the nation's banks through the Troubled Asset Relief Program (TARP). At the time, policy makers, both Republican and Democrat, claimed that this was the only practical way to save the banking sector. Without massive government purchases of equity shares in the big banks, they alleged, the financial sector—and with it, the real economy of paychecks, jobs, and profits—would collapse.

Congress did, however, have another option: It could have given the FDIC power to initiate speed bankruptcy when major financial institutions are in trouble. Speed bankruptcy, also known as debt-to-equity swaps or prepack bankruptcy, is essentially the rapid conversion of bonds into equity. This option, which was supported by prominent academic economists,1 would have made the banks healthier by breaking promises to bondholders. Speed bankruptcy could become the path forward as Congress decides how to deal with future financial crises.

A BANK'S BALANCE SHEET

To understand how speed bankruptcy works, we first need to consider what makes a bank healthy. Let's begin with the old accountant's truism, the balance sheet identity:

Assets = Liabilities + Owner's Equity

This means that "what you own" (assets like land, machines, and money that other people owe you) equals "what you owe" (liabilities like money you owe to others) plus whatever is left over. In a healthy company, assets are much higher than liabilities—the company has a promising future and has few debt promises to repay—so there's a lot of value left over for the owners. When assets fall below liabilities, the company is insolvent.

For a bank, assets mostly refer to loans, financial investments, and the value of the bank's branches and offices—all the things that the bank could, in a pinch, sell to other companies to raise money. A bank's liabilities fall into two major categories: deposits and bonds. A bank deposit is funds put into a customers' account for safekeeping, to be retrieved at a later date, while a bond is simply an IOU, a note to a customer promising that a specific amount of money will be repaid to the customer at a given time.2 In both cases, the bank owes a fixed number of dollars to someone in the future. So buying a bond is a lot like depositing money in a bank, with one major exception: Though the Federal Deposit Insurance Corporation (FDIC) rarely guarantees bank bonds, it guarantees most bank deposits with the full faith and credit of the U.S. government.

The FDIC will typically take over a bank that is insolvent. During this process, depositors' funds are typically untouched since they are insured by the FDIC, and the FDIC sells the banks to new owners. The bank's old bondholders get repaid with the proceeds of the bank sale. This speed bankruptcy process can occur in a matter of days, as it did with two large bank holding companies, Washington Mutual and FBOP. Using a similar mechanism, General Motors emerged after 40 days, marking the fourth-largest filing in U.S. history.3 So while the process can be rapid, there's a widespread misperception that bankruptcy must, by definition, take months or years, a process that was considered too lengthy during the 2008 financial crisis.

WHAT ABOUT THE BIGGEST BANKS?

FDIC-initiated speed bankruptcy seems to work well with some large banks, but what about Citigroup, JPMorgan Chase, Bank of America, and other financial behemoths? For instance, the liability side of Citigroup's balance sheet is roughly $2 trillion. And of that amount, only about $700 billion are made up of deposits, while the rest includes bondsand other financial obligations. How can speed bankruptcy work for institutions this large?

The answer lies in the difference between $2 trillion and $700 billion (the latter are largely guaranteed by the FDIC). The central tenet of speed bankruptcy is slashing away at liabilities in order to get to a point where:

Assets > Liabilities

The FDIC (or a bankruptcy judge) can quickly reduce liabilities by informing bondholders that they will receive less than they thought. Once assets are greater than liabilities, the firm has enough value for it to function well in the future. As for the bondholders' plight, Luigi Zingales of the University of Chicago4 has offered a straightforward solution: Convert the mega-bank's debt into equity; convert bonds into stock. This might sound like a late-night infomercial promising to "transform debt into wealth," but it's nothing of the sort. Instead, it's a way of giving a consolation prize to bondholders without the need for the FDIC to search for a new buyer. Instead, the FDIC can just turn the old bondholders into new shareholders.

HOW THE HOUSING CRISIS CRIPPLED THE BANKING SYSTEM

RELIVING THE PAULSON PANIC

Instead of asking Congress for $700 in TARP funding, Secretary Paulson and Chairman Bernanke should have recommended a few modest changes in U.S. bankruptcy code.5 These changes entail giving a bankruptcy judge or the FDIC the authority to convert bank bonds into new shares of common stock in the same bank. This power wouldn't change the rules of the game—after all, such "debt-to-equity conversions" are a routine, even expected part of bankruptcy—but they would clarify that the judge or the FDIC would have power to make such decisions quickly and with little interference when large, systemically important financial institutions are involved.

After Congress enacts the new speed bankruptcy legislation— perhaps giving resolution power to FDIC—then the speed bankruptcies commence.6 It would be both wise and fair to convert long-term debt (10 years plus) into equity before doing so for short-term debt—after all, short-run debt is a key source of liquidity in financial markets, and long-term debt is always considered higher risk than short-term debt.7 Interestingly, in 2008 there was enough long-term debt on the books of the nation's mega-banks. The five biggest recipients of TARP funding collectively held over $1 trillion in long-term bond liabilities on their balance sheets, more than the total TARP bill itself (see table 1).

Table 1

If the new shareholders don't want to be shareholders, they are entirely free to sell their new shares to other investors. They can go from being bondholders to being partially-repaid former bondholders within a matter of days. And by letting bondholders know that they really can lose money when they buy bank bonds, the FDIC will encourage bondholders to monitor the health of America's banks more carefully in the future.13

SPEED BANKRUPTCY AS A PATH FORWARD

Congress is considering new "resolution authorities" that would give the FDIC power to enact some form of speed bankruptcy when big banks get into trouble.14 As this Mercatus on Policy has shown, speed bankruptcy—FDIC-mandated conversion of bonds into common stock—could have rebuilt our banking system without spending a dollar of taxpayer money. In fact, the Bush Treasury considered the possibility of speed bankruptcy, but decided it was politically impossible. Philip Swagel, a Treasury economist at the time, later noted,

The simple truth is that it was not feasible to force a debt for equity swap or to rapidly enact the laws necessary to make this feasible. To academics who made this suggestion to me directly, my response was to gently suggest that they spend more time in Washington, DC.15

What was "not feasible" in the fall of 2008 is now being debated in the halls of Congress. One can only hope that political reality has changed to reflect the economic reality: Speed bankruptcy works.

ENDNOTES

1. See Joseph Stiglitz, "A Bank Bailout that Works," The Nation, March 4, 2009, http://www.thenation.com/doc/20090323/stiglitz, and Luigi Zingales, "Plan B," The Economists' Voice 5, no. 6 (October 2008), http://faculty.chicagobooth.edu/luigi.zingales/research/papers/plan_b.pdf.

2. For example, an investor might purchase a one-year, $10,000 bond, which means that the investor will pay the bank $9,500 with the expectation of receiving $10,000 after one year.

3. John D. Stoll and Sharon Terlep, "GM Takes New Direction," The Wall Street Journal, July 11, 2009, http://online.wsj.com/article/SB124722154897622577.html.

4. Luigi Zingales, "Why Paulson is wrong: Saving capitalism from capitalists," VOX, Center for Economic Policy Research, September 21, 2008, http://www.voxeu.org/index.php?q=node/1670.

5. See Luigi Zingales, "How to Fix the Credit Mess Without a Government Bailout: Quickie Bankruptcies," October 27, 2008, http://faculty.chicagobooth.edu/luigi.zingales/research/papers/forbes_how_to_fix.pdf. Also, there are minor changes that would be needed—the rules regarding derivatives clearing are a prime barrier to speed bankruptcy.

6. The House of Representatives has passed new legislation that would encourage speed bankruptcies, by giving regulators authority to force major financial institutuions to issue bonds that convert into shares in a financial crisis. Section 1116 of HR 4173 states that regulators can force major firms to issue: "long-term hybrid debt that is convertible to equity when...the [U.S. government] determines that a specified financial company fails to meet prudential standards...threats to United States financial system stability make such a conversion necessary."

7. The Economist, Guide to Economic Indicators: Making Sense of Economics, Fifth Edition (Princeton, New Jersey: Bloomberg Press, 2003), 181.

8. Citigroup's 2008 Annual Report on Form 10-K, February 2008, http://www.citigroup.com/citi/fin/data/k08c.pdf?ieNocache=892.

9. Bank of America's SEC 10-K filing, February 2008, http://investing.businessweek.com/research/stocks/financials/drawFiling.asp?docKey=136-000119312508041665-57U28B9875QTNNK0T4KK5TE9TE.

10. JPMorgan Chase, SEC 10-K filing, February 2008, http://investing.businessweek.com/research/stocks/financials/drawFiling.asp?docKey=136-000119312508043536-63QOL0BL415B4AM0NV2IDC8PBN.

11. Wells Fargo & Company, SEC 10-K filing, February 2008, https://www.wellsfargo.com/downloads/pdf/invest_relations_2008_10k.pdf.

12. U.S. Bancorp, SEC 10-K filing, February 2008, http://investing.businessweek.com/research/stocks/financials/drawFiling.asp?docKey=136-000095012408000806-13OS9MDLUFOEVP1KHSJ5PQEEL1.

13. Charles Calomiris, "Blueprints for a New Global Financial Architecture," October 7, 1998, http://www.house.gov/jec/imf/blueprnt.htm. He argues that subordinated debt holders would be a conservative force for restricting bank risk-taking.

14. HR 4173 makes this an option for regulators, not a requirement—so even if HR 4173 is enacted, speed bankruptcy will be only a possibility, not a reality.

15. Philip Swagel, "The Financial Crisis: An Inside View," Brookings Papers on Economic Activity, 38, http://www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2009_spring_bpea_papers/2009_spring_bpea_swagel.pdf.

A Self-Regulatory Proposal for the Hedge Fund Industry

January 13, 2010

Although they are fairly new investment vehicles for institutional investors and wealthy individuals, hedge funds can achieve remarkable returns. Still, high fees on profit have encouraged some hedge fund managers to engage in illicit behavior. Following a few recent cases of such fraud, the Securities and Exchange Commission (SEC) has expanded its regulatory efforts to restrict hedge funds.1 Most recently, the Obama Administration has advanced several regulatory proposals to promote robust supervision and regulation of financial firms, arguing that at various points in the financial crisis "de-leveraging by hedge funds contributed to the strain on financial markets."2

As part of a broad legislative effort to regulate hedge funds, Congress has introduced a bill that would require hedge funds to register with the SEC and comply with new recordkeeping and disclosure requirements.3 A much more effective method of regulating hedge funds would be to institute a strategy which effectively encourages markets to self-police by instituting financial regulatory policies that support self-regulation of hedge funds.

BACKGROUND

Though hedge funds' investment strategies are more diverse today than they were at the market's start in 1949, they have retained many of their original characteristics. They provide liquidity to U.S. markets by taking short positions in equities in which other large institutions, like mutual funds, cannot engage.4 Hedge funds also trade more actively and invest more resources in determining their trading strategies than mutual funds and other players in the market, which causes asset prices to trade at levels that reflect their real values.5 Additionally, they engage in corporate governance by taking large positions in firms and then advocating for organizational changes to enhance efficiency and returns for investors. As such, hedge funds have an extraordinary degree of leverage in comparison to other vehicles.6

High leverage, management expertise, and absolute return strategies are hallmarks of the industry.7 Still, the high fees charged by hedge funds are the source of much strife for regulators. Hedge fund managers get 20 percent of the amount by which they can make an investment grow along with 2 percent of assets under management. With typical hedge funds running a minimum of $100-500 million, and many running $1-5 billion, those fees can be enormous.8 Such earning potential has led a handful of hedge fund managers to engage in illicit behaviors that violate their duty to their investors and tempt institutional investors to violate their fiduciary duty to their principals.9

REGULATING HEDGE FUNDS

Though previously exempt from mandatory registration with the SEC under the "private adviser exemption" of the Investment Advisers Act of 1940, hedge funds face increasing regulation. In 2003, the SEC required any hedge fund with fifteen or more "shareholders, limited partners, members or beneficiaries"10 to register as an investment adviser,11 subjecting hedge funds to an intense compliance inspection program.

The SEC justified requiring registration on the grounds that information gained through registration and compliance will increase the probability that it will be able to detect fraud in the future in this rapidly growing industry.12 The SEC also argued that registration would be a constructive solution to the SEC's concerns about hedge funds' lack of disclosure to their investors. As individuals charged with managing money may have vested financial interests contrary to those of the individuals whose money they are managing,13 registration would give regulators more information about and oversight over these active, but secretive, market participants.14

Critics of hedge fund registration, such as former Federal Reserve Chairman Alan Greenspan, argue that over-regulating hedge funds would stifle the liquidity that these funds bring to the securities markets.15 They also question why the SEC needs to protect the sophisticated investors in these funds, since the regulatory exemption of hedge funds only applies to multi-millionaires. Still others argue that certain hedge funds, especially those already running mirror offshore entities, might simply move offshore to avoid the regulation. They note that offshore funds would still pose the same risks to U.S. markets, but would escape all government oversight.16 Finally, critics assert that registration might send the wrong signal to investors that hedge funds are completely safe when registration only means that the SEC conducts minimal compliance audits of some firms.17

When the registration requirement passed, fund managers immediately challenged the SEC's authority to promulgate this rule, and in a 2006 ruling, Goldstein v. SEC, the District of Columbia Court of Appeals invalidated the 2004 registration provision.18

GOVERNMENT REGULATION OR SELF-REGULATION?

Even though research indicates that the hedge fund industry significantly outperformed the heavily regulated mutual fund sector and was never in jeopardy of collapsing during the financial crisis,19 various sectors of government are calling for increased regulation of the hedge fund industry. Recently, the Department of Treasury announced its intention to support a further regulatory effort.20

The Treasury claims that requiring the investment advisers of hedge funds and other private pools of capital to register with the SEC would allow the SEC to collect data that would enable it to determine how such funds are changing and "whether any such funds have become so large, leveraged, or interconnected that they require regulation for financial stability purposes."21 Besides requiring hedge fund advisers to keep particular records, the SEC would conduct periodic examinations to monitor compliance.

The Treasury also argues that there is a compelling investor protection rationale for regulating hedge fund advisors and their funds.22 After all, in the last five years, the SEC has initiated roughly 40 enforcement actions involving hedge fund fraud. Although this is not a disproportionately large number compared to the number of fraud cases involving other investment vehicles, the SEC enforcement staff alleges that, due to the lack of information about the industry, the losses involved in each case were far higher than usual because the SEC was unable to act until long after the fraud occurred. Though subjecting hedge funds to regulation does not ensure fraud detection (recall the Enron scandal), the SEC believes regulatory oversight at least increases the chances of earlier detection.23

Nevertheless, these legitimate concerns about investor protection and fraud are best addressed not through government action, but through a combination of market discipline and regulatory policies that limit direct investment in such pools to sophisticated investors (see Figure 1).24 Regulators can achieve investor protection by allowing the private market to regulate itself through encouragement and support from a government oversight body.25 In theory, this self-regulatory strategy would utilize many of the advantages of a consolidated market structure while sidestepping many of its disadvantages.

Figure 1

For starters, unlike government regulators, self-regulators are not severely constrained in their ability to regulate the rapidly innovating hedge fund market because of regulatory limitations stemming from institutional focus and the slower pace of bureaucratic change.26 Further, businesses have a more specialized knowledge of current and abusive strategies and the task of regulation is ultimately beyond the SEC's resources to oversee.27

Government-sponsored, self-regulatory strategies have a long-standing tradition in the area of finance. For instance, from its very origins, national securities regulation utilized, in part, a self-regulatory strategy for regulation of some parties, such as broker-dealers, supplemented by SEC oversight.28 Additionally, the Financial Accounting Standards Board (FASB), National Futures Association (NFA), National Association of Securities Dealers (NASD), Financial Industry Regulatory Association (FINRA), and to some extent the Federal Reserve are all examples of self-regulatory organizations (SROs) sponsored by federal regulators.29

The benefits of self-regulation are frequently paired with supplemental government oversight. The SEC would therefore be instrumental in establishing and maintaining an SRO since creating a regulatory regime that effectively signals fiduciary duty violations to investors requires government authority.30 In the hedge fund market, the SEC's oversight role would play out in four ways. First, since the hedge fund industry suffers from a collective-action problem in coming together to form an SRO,31 the SEC would have to encourage hedge funds to establish the SRO. Second, the SEC would have to design the SRO's charter to define the rulemaking process and approve any amendments to it. Third, the SEC would need to approve members of the rulemaking body to ensure that they encompassed a representative sample of the hedge fund industry so that, for instance, the regulations do not work to the advantage of larger funds over smaller ones. Fourth, the SEC would need to establish that individuals with a working knowledge of the hedge fund world, but independent of industry ties, would compose the decision-making body of the hedge fund SRO.32

CONCLUSION

In the post-Sarbanes era,33 criticism of the self-regulatory model is in vogue. Failures at the New York Stock Exchange (NYSE) to oversee a reasonable compensation package for Dick Grasso, former chairman and chief executive of the NYSE, signaled the end of self-regulation to some. However, agency conflicts over remuneration between the SRO executive and the board are a different animal from SRO oversight of member firms. Additionally, some version of self-regulation will remain in the financial community for some time. No one is considering abandoning the NASD.34

As the Madoff scandal shows, government entities do a poor job of preventing fraud. Moreover, they present the false impression that investments are safe merely because the government regulates them. To avoid these problems in the areas of hedge funds, the SEC should support significant elements of self-regulation as an alternative to onerous registration and compliance requirements. A self-regulatory model that uses the inherent advantage of firms in regulating each other could overcome the severe disadvantage that bureaucratic regulators face in the field.

ENDNOTES

1. J.W. Verret, "Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation, Part II, a Self-Regulation Proposal," Delaware Journal of Corporate Law 32 (2007): 799-800, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1109245.

2. Department of the Treasury, Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation (June 17, 2009), 12, http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.

3. Fawn Johnson and Sarah N. Lynch, "US House Panel Approves Hedge Fund Adviser Registration at SEC," The Wall Street Journal, October 27, 2009, http://online.wsj.com/article/BT-CO-20091027-718496.html.

4. Rene M. Stultz, "Hedge Funds: Past, Present, and Future 3," (Fisher College of Business working paper no. 2007-03-003, February 2007), 11, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=939629.

5. Troy A. Paredes, "On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission," University of Illinois Law Review 975 (2006): 986.

6. Verret, "Dr. Jones and the Raiders of Lost Capital," 826.

7. Stultz, "Hedge Funds: Past, Present, and Future," 3.

8. Ibid., 7.

9. Verret, "Dr. Jones and the Raiders of Lost Capital," 799.

1010. Code of Federal Regulations, title 17, sec. 275.203(b)(3)-2(a) (2007).

11. Hedge Fund Registration Rule, Registration Under the Advisers Act of Certain Hedge Fund Advisers, Federal Register 69, no. 72,054 (December 10, 2004) (codified at Code of Federal Regulations, title 17, sec. 275, 279 (2007)).

12. Steven B. Boehm and Cynthia A. Reid, "Shedding Light on Hedge Funds," Business Law Today 13, no. 5 (June 13, 2004,): 53, http://www.abanet.org/buslaw/blt/2004-05-06/reid.shtml.

13. Verret, "Dr. Jones and the Raiders of Lost Capital," 814.

14. Willa E. Gibson, "Is Hedge Fund Regulation Necessary?" Temple Law Review 73 (2000): 681, 709.

15. Nomination of Alan Greenspan: Hearing Before the Committee on Banking, Housing, and Urban Affairs, 108th Cong. 25-26 (2004) (statement of Alan Greenspan, Federal Reserve Chairman), http://www.access.gpo.gov/congress/senate/senate05sh.html.

16. Douglas Cumming and Na Dai, A Law and Finance Analysis of Hedge Funds (September 27, 2007), 21, http://ssrn.com/abstract=946298.

17. Verret, "Dr. Jones and the Raiders of Lost Capital," 830.

18. Goldstein v. SEC, 451 F.3d 873, 874 (D.C. Cir. 2006).

19. Houman Shadab, Hedge Funds and the Financial Crisis, Mercatus on Policy (Arlington, Virginia: Mercatus Center at George Mason University, January 2009).

20. J.W. Verret, "A Self-Regulation Proposal for the Hedge Fund Industry," Administrative and Regulatory Law News (Winter 2008), 2.

21. Department of the Treasury, "Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation," June 17, 2009, 37.

22. Ibid.

23. See Steven B. Boehm and Cynthia A. Reid, "Shedding Light on Hedge Funds," Business Law Today 13, no. 5 (June 13, 2004,): 53.

24. The 2007 PWG Report can be found at http://www.treasury.gov/press/releases/reports/hp272_principles.pdf, 1.

25. Other professions self-police, including law and medicine. For a study of the effects of self-regulation in the medical field, see James Morrison and Peter Wickesham, "Physicians Disciplined by a State Medical Board," Journal of American Medical Association 279 (1998): 1889.

26. See generally Paul G. Mahoney, "The Exchange as Regulator," Virginia Law Review 83, no. 7 (1997), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10539 (arguing that exchanges serve as more effective regulators than government institutions due to their ability to respond to rapid market innovation).

27. Joel Seligman, "Cautious Evolution or Perennial Irresolution: Stock Market Self-Regulation During the First Seventy Years of the Securities and Exchange Commission," Business Lawyer 59, no 4, (August 2004).

28. Ibid.

29. Verret, "Dr. Jones and the Raiders of Lost Capital," 832.

30. For more on this and how government oversight is particularly effective in the SRO sphere, see Peter M. DeMarzo, Michael J. Fishman, and Kathleen M. Hagerty, "Contracting and Enforcement with a Self-Regulatory Organization," (working paper, August 2001), http://ssrn.com/abstract=297302.

31. See Verret, "Dr. Jones and the Raiders of Lost Capital," 836.

32. Ibid., 836-7.

33. In 2002, Congress passed the Sarbanes-Oxley Act to protect investors of securities. See Sarbanes-Oxley Act, Public Law No. 107-204, U.S. Statutes at Large 116 (2002): 745.

34. Indeed, just this year the NASD's regulatory arm merged with its regulatory cousin at the NYSE to consolidate and enhance the effectiveness of its self-regulatory capability. For an earlier criticism of self-regulation, see Thomas Gehrig and Peter J. Jost, "Quacks, Lemons, and Self-Regulation: A Welfare Analysis," Journal of Regulatory Economics 7, no. 3 (May 1995): 309, http://www.springerlink.com/content/w63x537h22046433/.

Speed Bankruptcy: A Firewall to Future Crises

January 10, 2010

In light of the 2007-2008 financial crisis, policymakers are reforming financial regulations in order to create a resolution system for large failing financial institutions. This paper advocates that speed bankruptcy, specifically overnight debt-to-equity conversions be considered as a viable option to recapitalize troubled financial institutions. At the very least, overnight debt-to-equity conversions could have been used to provide hundreds of billions of dollars of extra equity to weak firms in 2008, and could still be used the next time a firm that is ostensibly “too big to fail” comes close to going bust.

Taxing Sin

July, 2009

Sin taxes in modern economic terms amount to excise, or per unit, taxes that are chiefly designed to reduce specific behaviors thought to be harmful to society.1 Sin taxes have played roles of varying importance throughout U.S. tax history. The ever-expanding list of taxable "sins" proposed by governments includes cigarettes, alcoholic beverages, gasoline, bullets, and, more recently, sugary soft drinks and fatty snacks.

In 1790, Alexander Hamilton proposed the first excise tax on whiskey to refund Revolutionary War debts, following Adam Smith's direction in the Wealth of Nations.2 Made immortal by the rebellion it spawned, Hamilton's whiskey tax was subsequently rescinded, but selective excise taxes have hardly disappeared. History reveals that federal excise taxes have been predominantly enacted as wartime emergency measures, and the majority of the taxes were customarily repealed when hostilities ended. Recently, however, the arguments for imposing new excise taxes and increasing existing ones have reemerged across party lines and have spawned several myths about the efficacy of sin taxation.3

MYTH 1: SIN TAXES DISCOURAGE UNHEALTHY BEHAVIORS

State and local governments are increasingly imposing sin taxes as political activists try to force Americans to adopt their own version of "clean living."4 These taxes are designed to raise prices so that "sinful" goods become so expensive that consumers will give them up for something healthier. However, this rarely happens.

Research has shown that when the price of a "sinful" good increases, consumers often substitute an equally "bad" good in its place. For example, two studies found that teen marijuana consumption increased when states raised beer taxes or increased the minimum drinking age. Another study found that smokers in high-tax states are more likely to smoke cigarettes that are longer and higher in tar and nicotine than smokers in low-tax states. Specifically, they discovered that young adults aged 18–24 are much more responsive to tax changes than older smokers. For young smokers, the switch to cigarettes with higher tar and nicotine is so large that tax hikes actually increase average daily tar and nicotine consumption.5

The federal government has also attempted to impose "hefty" taxes on sugared sodas and sports drinks to reduce obesity in the United States.6 The assumption is that this sin tax would reduce caloric intake because consumers would stop drinking high-calorie drinks and/or switch to lower-calorie drinks. However, as table 1 shows, if consumers respond to the proposed sin tax on sodas and sports drinks by switching to some of the potential substitute drinks, their caloric intake would either remain the same or actually increase.

MYTH 2: SIN TAXES ARE A GOOD WAY TO RAISE REVENUE

Although the underlying rationale for sin taxes is to discourage consumption of "sinful" products, it is often argued that the tax would also help raise revenue that would, in turn, be used to finance projects like federal health insurance. The problem with this argument is that these regulatory and revenue-raising justifications work at cross-purposes. If the tax is actually effective at discouraging consumption of a "sinful" good, after all, then there would be very little revenue raised because people would purchase much less of the more expensive good in question.

To help solve the obesity problem, some localities have already begun to impose "hefty" taxes on sugared sodas and sports drinks to reduce obesity in the United States.7 This appears to be most true for cigarette taxes as many continue to purchase cigarettes at the higher taxed prices.8 Recent anti-smoking initiatives at the federal, state, and local levels have gained unprecedented popular support, probably because of their ability to raise revenue. For instance, President Obama recently signed a law that increased federal tobacco excise taxes on a pack of cigarettes from $0.39 per pack to $1.01.9 However, as we shall see, the revenue raised is hardly ever used for its proposed purpose.

Furthermore, if the object is to raise the most revenue, economists generally prefer broad-based taxes to narrow-based "sin" taxes on efficiency grounds. In other words, economists have generally argued that the welfare loss resulting from excise taxation is significant enough to justify "spreading" taxes across many commodities.10

MYTH 3: PRIMARY SUPPORT FOR SIN TAXATION COMES FROM CIVIC-MINDED CITIZENS

Generally speaking, people support taxes that benefit them directly; that is, they lobby for taxes to receive "rents." In many cases, two dissimilar groups may support taxes for completely different reasons and be wooed by revenue-hungry politicians. Bruce Yandle calls this phenomenon "Bootleggers and Baptists," an expression derived from an unlikely alliance that formed during Prohibition.11 Bootleggers, or those who smuggled alcohol illegally, gain business at the expense of their legal competitors, while Baptists, who sought to reduce alcohol consumption, see their moral goals legislated. For the result to be durable, both parts of the coalition must remain in place. For instance, the cooperation of "Baptist" government officials and ethanol producers have kept ethanol subsidies in place.

Another example of rent seeking is the 1987 lobbying effort by a coalition of nonprofit organizations to more than triple California's cigarette tax from 10 to 35 cents a pack.12 The tax was expected to raise over $500 million annually, much of which would ostensibly go to these very organizations for research, indigent medical care, and antismoking "education" campaigns. This obviously represents a huge conflict of interest for the nonprofit organizations: Are their lobbying efforts directed at the cause they fight or merely at raising funds for their organizations? When tax receipts first became available, the president of one of these nonprofits, the California Medical Association, actually admitted to legislators that his organization and the health charities were "fighting for this money like jackals over a carcass."13

Nonprofits fighting for a particular cause also have to fear competition from the government. Often, they end up having to fight against politicians who are first and foremost interested in increasing government funding. For instance, a coalition of California nonprofit antismoking organizations, directed by the umbrella group Americans for Nonsmokers' Rights, brazenly sued Governor Pete Wilson for "illegally diverting" more than $165 million that supposedly should have been spent on "education" programs and instead was "improperly used for health screening and immunization of poor children.14 In fact, there is never any guarantee that tax funds will be used as advertised, and there is very little public control. These funds usually go into the general fund or toward other politically favored causes.

MYTH 4: SIN TAXES ARE FAIR

Sin taxes are regressive, falling disproportionately on consumers at the lower end of the income distribution.15 Not only do "lower income classes tend to lose slightly more of their total income than higher income classes..." on a wide range of excise-taxed products, but Daniel Suits actually found that excise taxes are the most regressive form of taxation.16

A significant number of studies, though somewhat controversial, argue that excise taxes have negative health consequences because they crowd out private expenditures, a portion of which would have been spent on private health and safety measures. This means that by instituting sin taxes, the government is effectively preventing people from spending their own money on things like safer cars, preventive medical check-ups, baby gates, and smoke detectors. Evidence shows that for every $15 million taken out of the hands of consumers, there is one statistical death.17 Another paper finds statistical evidence that the poor suffer more on the health front from dollars being crowded out by government policies.18

MYTH 5: SIN TAXES ARE THE BEST WAY TO CHANGE UNDESIRED BEHAVIOR

If the objective of sin taxation is to alter "objectionable" behavior, less-costly options exist in the private sector. For example, a coalition of scientists, academics, health organizations, food producers, and retailers developed the Smart Choices Program to better inform consumers about the nutritional characteristics of food.19 Through its front-of-pack labeling program, Smart Choices identifies healthier food and beverage choices within specified product categories. Unlike coercive government measures to tax unhealthy foods and beverages, this program provides the information people need to stay within their recommended caloric intake and make product-by-product nutritional comparisons at their discretion.

Another example is given by the Phoenix Companies Inc. insurance company, which has started offering discounts to customers who maintain a low Body Mass Index (BMI).20 Their program offers discounts up to 20 percent on life insurance policies to customers whose BMI is verified by a doctor to be between 19 to 25.21 In fact, most insurance companies already provide a discount for customers who do not smoke or drink.22 Private market programs and products like these that encourage and reward healthy lifestyles instead of punishing personal choices are more efficient solutions to curbing obesity than sin taxes on unhealthy products.

CONCLUSION

So-called sin taxes, even those passed with the best of intentions, have undesirable consequences because they contradict basic principles of economics, finance and, most importantly, free choice. In general, since proposals to tax lifestyle choices are concentrated on narrow consumer choices, they are rarely efficient. What's more, taxing sin usually does not end up significantly altering the "sinful" behavior but rather rewards the very private organizations or politicians who have lobbied for the tax. Also, sin tax revenue is collected primarily at the expense of the poor and crowds out private expenditures on health care.

Sin tax activists strongly believe that most citizens are inherently incapable of making consumption decisions for themselves. Carried to its logical extreme, "the notion that any product or lifestyle choice that even remotely contributes to health care costs should be taxed to help finance public spending would leave nothing untaxed."23 Once it becomes "legitimate for government to protect individuals from their own follies,"24 there is no way to establish limits to governmental powers. As Nobel Prize winner James Buchanan pointed out, any attempt of a government to restrict private consumption choices with sin taxes is nothing but a "meddlesome preference."25

ENDNOTES

1. Adam Gifford, Jr., " Whiskey, Margarine, and Newspapers: A Tale of Three Taxes," in William F. Shughart II, ed., Taxing Choice: The Predatory Politics of Fiscal Discrimination (New Brunswick, NJ: Transaction Publishers, Rutgers—The State University of New Jersey, 1998), 57–77.

2. Gary M. Anderson, "Bureaucratic Incentives and the Transition from Taxes to Prohibition," in William F. Shughart II, ed., Taxing Choice, 139– 161. There were, of course, numerous inconsistencies in Smith's discussion of the revenue maximization objectives of government, despite the extensive application of his ideas to promote the revenue-generating power of taxes on "sin" even today. See Kelly D. Brownell and Thomas R. Frieden, "Ounces of Prevention—The Public Policy Case for Taxes on Sugared Beverages," http://www.yaleruddcenter.org/resources/upload/docs/what/industry/SodaTaxNEJMApr09.pdf/.

3. Breanda Yelvington, "Excise Taxes in Historical Perspective," in William F. Shughart II, ed., Taxing Choice, 31–56.

4. Thomas J. DiLorenzo, "Taxing Choice to Fund Politically Correct Propaganda," in William F. Shughart II, ed., Taxing Choice, 117–138.

5. William N. Evans and Matthew C. Farrelly, "The compensating behavior of smokers: taxes, tar and nicotine," The RAND Journal of Economics 29, no. 3 (Autumn 1998): 578–595, http://www.jstor.org.mutex.gmu.edu/stable/pdfplus/2556105.pdf/.

6. Anemona Hartocollis, "New York Health Official Calls for Tax on Drinks with Sugar," The New York Times, April 8, 2009, http://www.nytimes.com/2009/04/09/health/09soda.html/.

7. William F. Shughart II, "The Economics of the Nanny State," in William F. Shughart II, ed., Taxing Choice, 13–29.

8. Evans and Farrelly, "The compensating behavior of smokers: taxes, tar and nicotine."

9. National Conference of State Legislatures, "2009 Proposed State Tobacco Tax Increase Legislation," http://www.ncsl.org/programs/health/Tobacco_Tax_bill09.htm/ (updated May 21, 2009).

10. Harold Hotelling, "The General Welfare in Relation to Problems of Taxation and Railway and Utility Rates," Econometrica 6 (July 1938), 242–69, in Paula A. Gant and Robert B. Ekelund, Jr., "Excise Taxes, Social Costs, and the Consumption of Wine," in William F. Shughart II, ed., Taxing Choice, 247–269.

11. Bruce Yandle, "Bootleggers and Baptists in Retrospect," Regulation 22, no. 3 (1999).

12. The coalition consisted of the American Cancer Society (ACS), American Lung Association (ALA), American Heart Association (AHA), and California Medical Association (CMA).

13. Thomas J. DiLorenzo, "Taxing Choice to Fund Politically Correct Propaganda," in William F. Shughart II, ed., Taxing Choice, 117–138.

14. Yelvington, "Excise Taxes in Historical Perspective," 31–56.

15. Ibid.

16. Daniel B. Suits, "Measurement of Tax Progressivity," American Economics Review 67, September 1977: 742–52, in Gant and Ekelund, "Excise Taxes, Social Costs, and the Consumption of Wine," in William F. Shughart II, ed., Taxing Choice, 247–269.

17. Randall Lutter, et al., "The Cost-Per-Life-Saved Cutoff for Safety-Enhancing Regulations," Economic Inquiry 37 (1999): 599.

18. Jackie Teague, Don Anderson, and Fred Kuchler, "Health Transfers: An Application of Health-Health Analysis to Assess Food Safety Regulations," Risk, 1999.

19. Smart Choices Program, "About the Coalition," http://www.smartchoicesprogram.com/about.html/.

20. MSNBC, "Shrink your BMI—and your insurance bill: Insurers offers discounts on policies for slender customers," http://www.msnbc.msn. com/id/17385151/.

21. BMI is a measure of body fat that based on an individual's height and weight. The Centers for Disease Control and Prevention defines obesity as a BMI of 30 or more; people between 25 and 30 are considered overweight. See Office of the Surgeon General, The Surgeon General's Call to Action to Prevent and Decrease Overweight and Obesity 2001 (Rockville, MD: U.S. Department of Health and Human Services, 2001), http://www.surgeongeneral.gov/topics/obesity/calltoaction/CalltoAction.pdf/.

22. Larry Hand, "Employer Health Incentives: Employee wellness programs prod workers to adopt healthy lifestyles," Harvard Public Health Review, Winter 2009, http://www.hsph.harvard.edu/news/hphr/winter-2009/ winter09healthincentives.html/.

23. William F. Shughart II, "Introduction and Overview," in William F. Shughart II, ed., Taxing Choice, 1–9.

24. Thomas J. DiLorenzo, "Taxing Choice to Fund Politically Correct Propaganda," in William F. Shughart II, ed., Taxing Choice, 117–138.

25. James M. Buchanan, "Politics and Meddlesome Preferences," in Clearing the Air: Perspectives on Tobacco Smoke, Robert Tollison, ed. (Lexington, Mass: D.C. Health, 1988) in Thomas J. DiLorenzo, "Taxing Choice to Fund Politically Correct Propaganda," in William F. Shughart II, ed., Taxing Choice, 117–138.

Taxing Sins: Are Excise Taxes Efficient?

May, 2009

Policy makers and the public have become increasingly concerned about the dramatic growth in obesity that has taken place in the United States over the last several decades. While the public claims to be concerned about the issue, obesity rates continue to increase. People seem content to wait for a magic pill that will correct the problem. While science has so far failed in its attempts to invent that pill, policy makers think they have found it. It's called excise taxes.

Most economists, particularly those in public finance, find it preferable to raise revenue by taxing a broad base at a low rate in order to maximize the amount of revenue while reducing the distortions to the economy.  The opposite of a broad-based tax is an excise tax, a tax levied on particular goods. Historically, governments have used soft drink excise taxes, which have existed since at least 1920, primarily to generate revenue. Today, however, states and localities increasingly view the taxation of soft drinks as a social tool—a way to curb rising obesity rates.

Policy makers and the public have become increasingly concerned about the dramatic growth in obesity that has taken place in the United States over the last several decades.  Policies that tax sweetened soft drink for the purposes of reducing obesity and, in some cases, raising funds to advance this goal seek the same economic legitimacy as past attempts to tax “sin products” like tobacco, alcohol, and firearms.  Not surprisingly, though, this tax raises efficiency concerns similar to those taxes. Taxes on sweetened soft drinks do not necessarily advance the overall public interest, may be regressive in nature, and hardly ever work as intended.