The Biggest Tax Policy Mistake of the Year

The fine folks over at the New York Times Freakonomics blog recently asked me to identify the “biggest potential tax policy mistake that might be made this year.” Here’s my answer:

With little time left on the legislative clock, policymakers will be hard-pressed to top the tax policy blunders they’ve already made this year. Most notable is their failure to decide what this year’s tax law should be. While politicians, analysts and the media endlessly debate how expiring tax cuts might affect taxpayers in 2011, the real disgrace is that we still don’t know what the tax law is in 2010.

Will our leaders really allow the alternative minimum tax to hit 27 million taxpayers this year, a whopping 23 million more than in 2009? Did the estate tax really expire back in January, making 2010 the year without an estate tax? Will companies really receive no tax credits for their investments in research and development?

Under existing law, the answer to each of these questions is yes. Unless Congress acts, the AMT will expand its reach almost 500 percent, George Steinbrenner’s estate will pay no estate tax, and America’s most innovative companies will go without the R&E tax credit. But in today’s world, existing law doesn’t mean much until Congress throws in the legislative towel. The upcoming lame-duck session will thus feature healthy debate about patching the AMT, retroactively resuscitating the estate tax and extending a host of expired business tax credits — all policies that would determine 2010 taxes.

Such retroactive policymaking is an embarrassment. In a well-functioning democracy, policymakers should establish the laws of the land in advance so that families and businesses can knowledgeably plan their activities. Surprises may sometimes necessitate mid-course corrections. An economic downturn may justify mid-year tax cuts, or a sudden crisis may require mid-year tax increases. But persistent retroactive lawmaking undermines the core idea that ours is a nation of law.

Needless uncertainty also creates real costs. Uncertainty about the R&E tax credit, for example, limits its usefulness as an incentive. If businesses think that it might expire, they have less reason to take it into account when planning their research efforts. That can turn a helpful incentive into a pointless giveaway.

Needless delay also undermines the IRS’s ability to implement the tax system. In 2007, for example, Congress fiddled until just before Christmas before deciding to enact that year’s AMT patch. Because of that delay, affected taxpayers couldn’t begin filing their returns until February 15, when IRS computers finally reflected the new law.

Congress has made a huge mistake by leaving taxpayers in limbo for more than 10 months. Let’s hope they resolve that quickly when they return for what promises to be a frantic lame-duck session.

Joel Slemrod, Bill Gale, and Clint Stretch also contributed to the discussion.

Will Budget Concerns Ever Influence Carbon Policy?

Climate change legislation died an ignominious death in the Senate earlier this year. If you’d like to understand why, check out Ryan Lizza’s autopsy of the effort in the latest New Yorker. Lizza documents how the “tripartisan” trio of John Kerry, Joe Lieberman, and Lindsey Graham came up short in their effort to craft a 60-vote coalition in the Senate. Among the bumps along the way:

  • On March 31, President Obama announced a dramatic expansion in offshore waters open for oil and natural gas drilling. In so doing, he gave away one of the sweeteners that the trio was hoping to use to attract pro-drilling senators.
  • On April 15, Fox News reported that, according to “senior administration officials”, the White House was opposing efforts by Senator Graham to increase gasoline taxes. That claim was perverse–the bill didn’t include higher gasoline taxes and Graham certainly wasn’t pushing them–but not surprisingly it created problems for Graham back home.

Lizza’s article is rich with such anecdotes, but it’s the larger picture I’d like to emphasize. Kerry, Lieberman, and Graham adopted a traditional approach to building a Senate coalition. They identified their main goal–comprehensive climate change limits–and then started negotiating with individual Senators and special interests to see how they could get to 60 votes. Nuclear power, electric utilities, oil refiners, home heating oil, even cod fisherman all make an appearance at the bargaining table. But it’s not clear that such horse-trading could ever yield 60 votes.

This failure makes me wonder whether the traditional approach will ever generate a substantive climate bill. I suppose that’s still possible, particularly if the EPA begins to implement a burdensome regulatory approach to limiting carbon emissions. That might bring affected industries running back to the table.

But I would like to suggest another strategy: Perhaps the environmental community should make common cause with the budget worrywarts. In principle, a carbon tax is a powerful two-birds-with-one-stone policy: it cuts carbon emissions and raises money to finance the government. (This is equally true of a cap-and-trade approach in which the government auctions allowances and keeps the proceeds.) Perhaps there’s a future 60-vote coalition that would favor those outcomes even if various energy interests would be opposed?

Such a coalition is unthinkable today. Opposition to energy taxes runs deep, as Senator Graham experienced. But fiscal concerns will continue to grow in coming years, and spending reductions may not be enough to get rising debts under control. If so, maybe we’ll see a day in which a partnership of the greens and the green eyeshades will take a stab at a carbon tax.

Water Funds: Coase in South America (and New York)

Rivers often create important resource conflicts. Downstream cities want clean water to drink. Upstream residents want to make a living, but that sometimes damages water quality. In the highlands above Quito, Ecuador, for example, residents often convert land to farming and ranching; that allows them to raise valuable crops and livestock, but weakens the land’s ability to naturally cleanse water before it flows downstream.

How can we solve this problem? One response would be for a central government to enact laws and regulations that force the upstream folks to take better care of the watershed. Such laws can play an important role in improving water quality, but they raise several practical concerns. For example, regulatory burdens may place undue economic burdens on upstream residents. And the laws and regulations may be hard to enforce, particularly if local communities view them as an unwelcome burden.

Another strategy is for the downstream water users to pay the upstream residents for keeping the water clean. Such payments can make protecting the watershed into a profit center for upstream communities and can encourage them to accept rigorous approaches to monitoring and enforcement. (In the economics literature, this approach is often distributed as Coasian, in honor of Ronald Coase, who emphasized it in his work.)

Last week Esther and I dined with some officials of the Nature Conservancy (TNC) and learned that they are encouraging exactly this approach to water conservation in South America. TNC is helping create water funds:

Water users pay into the funds in exchange for the product they receive — fresh, clean water. The funds, in turn, pay for forest conservation along rivers, streams and lakes, to ensure that safe drinking water flows out of users’ faucets every time they turn on the tap.

Some water funds pay for community-wide reforestation projects in villages upstream from major urban centers, like Quito, Ecuador, and Bogotá, Colombia. In other cases, like in Brazil’s Atlantic Forest, municipalities collect fees from water users and make direct payments to farmers and ranchers who protect and restore riverside forests on their land through water producer initiatives.

“These ‘water producers,’ as we call them, are being fairly compensated for a product they’re providing to people downstream in Rio de Janeiro and São Paulo: fresh water,” explains Fernando Veiga, Fernando Veiga, Environmental Services Manager for the Conservancy’s Atlantic Forest and Central Savannas Conservation Program in Brazil. “They’re receiving $32 per acre, per year, for keeping their riverside forests standing.”

TNC has an informative interactive graphic that illustrates how it works in the headwaters above Quito. (Note to TNC: the graphic would be even better if it involved less clicking.)

Perhaps needless to say, this idea is not unique to South America. New York City, for example, has been pursuing a related approach, buying up buffer land around the upstate reservoirs that supply the city.

Positive Feedback and the Flash Crash

The CFTC and SEC staffs are out with their analysis of the May 6 “flash crash.”

Short version: A large trader (identified by the media as Waddell & Reed) initiated a large sell order to be executed based on volume, not time or price. The initial selling boosted trading volumes which prompted the algorithm to sell even faster. That positive feedback then spawned the short-lived crash.

The whole report is worth a skim for the details about market functioning, but if you are pressed for time here’s the key part of the Executive Summary (with my emphasis added and footnotes deleted):

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex]) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010). Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program.

However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes.

This sell pressure was initially absorbed by:

• high frequency traders (“HFTs”) and other intermediaries in the futures market;

• fundamental buyers in the futures market; and

• cross-market arbitrageurs who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.

HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.

The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.

What happened next is best described in terms of two liquidity crises – one at the broad index level in the E-Mini, the other with respect to individual stocks.

For more, click on over to the report.