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Shifting the (Online) Sales Tax Burden

Shifting the (Online) Sales Tax Burden published on 1 Comment on Shifting the (Online) Sales Tax Burden

Recently a friend (and former student) Tweeted about the politics of regulation (see the Tweet below). Today, the city (and county) where I live is voting on a new “use tax” that would be applied to all “purchases made from out-of-state vendors”. Ostensibly, this is to offset lost sales tax revenue due to online shopping–the bugaboo of many local retailers and governments.

This morning I lectured on the relationship of demand elasticity to the question of who pays for a sales tax. As illustrated in the simple example below, both the consumer and the seller pay portions of the sales tax–provided neither Demand nor Supply are perfectly elastic (flat) or inelastic (vertical). When the supply curve shifts up due to the tax, it reduces how many units consumers buy (Q1 vs Q). Consumer pay more than they would have without the tax (P1 vs P), and sellers receive a lower price (net of the tax) than they would have without the tax (Ps vs P). So both sides bear some of the burden of the sales tax. The question is, which side pays more? It’s a pretty simple exercise to show that the “steeper” curve pays the bigger share just by redrawing the picture with lines of different relative steepness. Try it for yourself using this simple graph as an example.

The steepness of the curve reflects the sensitivity of consumers (on the Demand side) and sellers (on the Supply side) to changes in price. The more sensitive either side is, the more their quantity decision will change when price changes. More sensitivity means ‘flatter’ lines. Less sensitivity means ‘steeper’ lines.

Consider demand for something that’s very important to the consumer, like insulin. Even if the price goes up, insulin-dependent consumers will not reduce their consumption of insulin very much at all–unless the price really goes up a lot. In that case, the Demand line would be very steep.

What affects the steepness of Demand? Lots of things, but one of the biggest is the availability of other goods that provide the same (or very similar) benefits to the consumer. For instance, if you need insulin, you don’t have many alternatives. Orange juice, on the other hand, has several. If the price of orange juice goes up much, I might choose another juice, milk, or just plain water.

What else has substitutes? Stuff sold in local stores that can also be bought online. If I’m willing to wait two days, a large percentage of the things I might buy locally can be delivered right to my doorstep without me having to leave my house. If the price of buying things online is lower than the price of things sold locally, buying online is a really good substitute–if I can exercise a little patience. And if the local sales tax does not apply to my online purchases, that gives online sellers an automatic price advantage over local sellers–as much as 4.5% where I live (and that doesn’t count State sales tax).

So, what does that have to do with who pays the sales tax or Per’s tweet above?

First, demand for local purchases is more price-sensitive because the price of substitute items (from online sellers) is lower. If we impose (and actually enforce) a use tax on online sales, that will make consumers a little less price sensitive in their demand for local stuff, i.e., their Demands for local goods will get steeper. That means the relative tax burden will shift from local sellers to consumers. And this is even before the retailer’s ability to increase prices (or to not lower them as much to compete with online sellers). Little wonder local retailers are more than happy to “level the playing field” with online sellers by imposing the tax. They get to increase prices and pay less of the sales tax themselves; a win-win.

Second, the process giving rise to this proposed tax follows exactly the process Per outlines:

  1. Government imposes a regulation (a sales tax) that makes local retailers less competitive in the market place. There are other forms of taxing municipalities can and do use. Ours chooses to use a sales tax (for lots of things).
  2. Higher sales taxes encourage more people to buy online to avoid the sales tax, which not only reduces local sales, but local government tax revenue. Two problems for the price of one!
  3. Blame “The Market” for the loss of sales and tax revenue. Our City Manager even suggested it is immoral for people to live in the City and use City services while buying stuff online.
  4. Demand new regulations (i.e., the use tax) to “fix” the problem created in Step 1.

So here we are on election day in Boone County, Missouri. The voters that bother to show up will get to decide: who should pay more of the tax burden? Consumers or retailers?

Epilogue
Record low voter turn out (suggesting few people cared–if they were even aware of the special election) and the proposed use taxes failed 49.2-50.8 and 45.3-54.7 in the city and county, respectively. Not surprisingly, those residents for whom brick-and-mortar shopping is even less convenient voted even more to keep the price of the substitute lower.

 

Calling a Cost a Cost: NY Anti-Free Speech Edition

Calling a Cost a Cost: NY Anti-Free Speech Edition published on

Seems the State of New York is going to the Supreme Court for another of its protectionist regulatory policies. Yesterday the US Supreme Court granted a petition to hear the case of Expressions Hair Design v. Schneiderman. As the WSJ explains, at issue is whether New York’s regulations concerning credit-versus-cash retail prices constitute a First Amendment speech violation.

The problem stems from the fact that the State of New York has attempted to have its cake and eat it to by ignoring economic rcredit-card-1520400_1280ealism and prohibiting retailers from calling a cost a cost. The State prohibits retailers from charging customers a fee for using a credit card, but allows retailers to give customers a discount if they use cash. A group of hair salons, led by Expressions Hair Design, sued the state for infringing on its right of free commercial speech. The salons won their initial case, which was reversed on appeal. Now SCOTUS will have an opportunity to weigh in.

The Cost of Using Credit
From an economic perspective, the issue is fairly simple. Credit card companies charge vendors a fee every time a consumer pays with plastic. How much depends on the credit card company, whether the transaction is run as debit or credit, and the amount of the transaction. But typically, the fee is around 2-4% of the amount of the purchase. This reduces the amount of revenue retailers receive when the customer uses plastic. Put another way, when customers choose to use plastic, it raises the retailer’s cost of doing business for that sale.

In a free economy, retailers could choose one of three options: 1) force the credit card user to pay the additional transaction fee, which raises the price at the point of sale, 2) charge the same price for all buyers, implicitly charging cash users more for the product to subsidize the costs of the plastic users, or 3) pass the transaction fee savings on to cash users by giving them a discount. The only economic difference between 1 and 3 is what the sticker price is relative to the price actually paid. In #1, credit card users pay more than the sticker price; in #3, cash users pay less than the sticker price. In #1, the credit card fee is made explicit by adding it on just for those consumers who use plastic. In #3, the sticker price includes (i.e., hides) the cost of using a credit card and by default is the price everyone pays unless they are aware of the cash discount. In either case (1 or 3), the retailer is price discriminating between cash and plastic users. Or the retailer could simply post two sets of prices, one for credit and one for cash, which would then beg the question of “why the difference?” And that is where the NY regulations become a problem.

The NY regulation prohibits retailers from choosing #1 but allows them to choose #3. In other words, the regulation allows retailers to price discriminate, but only if they present it as a discount for cash users rather than a surcharge for credit card users. In short, NY allows the exact same price discrimination between two sets of consumers, but restricts the speech of retailers in how they are allowed to describe that price difference. As Expressions Hair Design argues in their complaint, this places a burden on the business in how it is allowed to explain or justify what is otherwise a perfectly legal two-price pricing system since the regulations make it illegal for employees to explain that the difference between the cash price and the credit price is due to the cost of the credit transaction. It would be like passing a law prohibiting a restaurant from explaining the cost of its steaks went up relative to its pork chops because the price of beef rose.

Framing matters
Why would the State of New York prohibit credit card surcharges but not prohibit cash discounts? Consumers respond to price signals, so how those signals are presented matters. If consumers are charged an extra fee for using their credit card, it makes the cost (price) of using the credit card very obvious to the consumer and she is more likely to change her behavior by using cash instead. This would be bad for the banks that make a significant amount of money on credit card swipe fees. Not surprisingly, banks support laws prohibiting explicit credit card surcharges. However, as noted in #2 above, charging cash and plastic users the same forces cash users to subsidize the purchases of plastic users, which also tends to penalize lower income persons relative to wealthier shoppers. So allowing retailers the opportunity to provide cash discounts is socially superior to not allowing differential pricing. However, the NY’s prohibition on calling a cost a cost and explaining the price difference for what it is, is not only an infringement on speech, but unjustifiable as anything other than an attempt to mislead consumers and protect credit card issuers.

Thursday's Interesting Reads

Thursday's Interesting Reads published on

A couple of interesting articles came across my screen today.

The first, by Alex Tabarrock over at Marginal Revolution, corrects a popular misconception about the relative bargaining power of workers. He points out the problems (both conceptually and factually) in framing employment issues as “firm versus worker,” which focuses on the threat of worker unemployment. He also shares a nice chart from the St. Louis Federal Reserve illustrating how this perception of employers having control over employment relationships is quite incorrect. One of my favorite lines/points:Buyers don’t compete against sellers, buyers compete against other buyers (and sellers compete against other sellers). See how that’s important in this context.

The second, by Andrew Flowers at FiveThirtyEight Economics, reports on a recent study by Montazerhodjat and Lo (MIT) that argues how the Food and Drug Administration (FDA) should change its one-size-fits-all approach for approving drugs to take into account the opportunity cost of making the wrong decision. This idea isn’t at all new to economists. Currently, the FDA uses the same standard for all drugs, regardless the severity of the consequences of making the wrong decision (in the trade-off between Type 1 and Type 2 errors). Montazerhodjat and Lo’s study (available here) is pretty technical, but Flowers’ piece does a great job of summarizing the economics and the results in a much more lay reader-friendly way.

Happy reading!

Markets, Incentives and a Krugman (et al.) Fail

Markets, Incentives and a Krugman (et al.) Fail published on

Pity the poor teenager taking an AP Economics course whose father is an economist. Especially when the local school district has adopted a text that is based on Paul Krugman’s Economics (3rd ed., coauthored with Robin Wells). Even more especially when the father-economist has a fundamental disagreement with much of what Mr. Krugman has become since surrendering his academic credentials for political punditry. Yeah, that’s my lucky kid.

So of course, I had to thumb through the text. I suppose I shouldn’t have been too surprised to find on only the third page of Module 1 a gross error in explaining the trouble with command economies. After explaining the failed history of command economies, the text asserts (p. 3):

At the root cause of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices.

Where to start? How about with the simple fact that incentives always exist, no matter the type of economy. And there were plenty of incentives in the former Soviet Union (the textbook example of a command economy–literally in this case). I remember the late Nobel Prize-winning economist James Buchanan sharing the story of his visit to Moscow shortly after the fall of the Soviet empire during which he was surprised to learn of a market for burned out light bulbs — because people could use them to steal working light bulbs from their workplaces when they couldn’t get light bulbs in the stores. People responding to incentives. It’s The Basics 101. The problem with command economies is not a lack of incentives–but a lack of incentives that are based on the wants of consumers themselves and a lack of incentives for innovation or efficiency. In short–the absence of the incentives created by a free market economy.

More importantly, the focus on incentives misses the point in a way that has significant implications for what the text goes on to say about economic policy. At the root of the problem with command economies was the lack of information available to decision-makers about the wants and desires of an entire population of individual consumers with different tastes and preferences and about the conditions of scarcity and desires in dispersed local markets across the society’s economy. As F.A. Hayek (another Nobel Prize winner) explained, the fundamental role of markets is to discover and reveal information based on the complex interactions of individuals across product types and geographic space.These interactions result in prices that reflect the relative scarcity and value of goods across society. Those prices create incentives, and those incentives are fundamentally important in guiding individuals to use their resources in ways that innovate, create value, and serve consumers. But the incentives are secondary–derived from the information discovery role of the market that cannot be replicated in a command economy.

Why is this such an important distinction? Because of the way the text goes on to describe the objective of policy making. After (fairly accurately) explaining how prices create incentives, the authors state (p. 3):

In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to do so is more likely to succeed.

The implication? All we need to do is create incentives (implicitly, in the form of taxes, fines or subsidies) to create financial incentives for manufacturers (or people) to do what we want them to do. But this line of argument ignores the more fundamental question of determining whether the plan makes social or economic sense in the first place. What is the economic basis for whether we uses fines or subsidies and how large they should be? At what point, if any, would doing nothing be economically more efficient than doing something? By taking away the fundamental information function of the market and jumping immediately to incentives, we skip the whole messy discussion of the information requirements by legislators, bureaucrats and policy makers in coming up with “the plan” to begin with. All we need to do is trust the omniscience and beneficence of policy makers to know what the “right price” is–and to set arbitrarily the incentives to get the outcomes we want. But that’s exactly why command economies fail.

The root problem of a command economy is not that there are no incentives, but that there are socially inefficient incentives. The incentives are socially inefficient because it is impossible for a central authority to know the value individual citizens place not only on existing goods and services, but on the latent value of potential goods and services that can only be discovered by innovation and experimentation–and a central planner cannot think beyond her own imagination in the realm of possibilities. And it’s not only true of Soviet-style planned economies, but of any central decision-making authority–including the US federal government–even in the context of a heavily market-dominated economy.

Note: AP Economics students (and teachers), remember….the correct answer on the test may not be the right answer in reality. Answer the questions from the textbook based on the information in the textbook. But in your real life as a consumer of information and participant in the market place of ideas and politics, be sure to get to the fundamentals rather than the superficial.

SCOTUS Rejects USDA's Raisin Cartel

SCOTUS Rejects USDA's Raisin Cartel published on

A couple years ago I posted (here) about a lawsuit progressing through the courts concerning the USDA’s raisin marketing order. The Raisin Administrative Committee (RAC) basically sets a quota on the amount of raisins that can be marketed in a given year as a way of maintaining high-priced raisins. The RAC requires produ799184_1280x720cers to turn a portion of their crop over to the RAC, which then markets the “excess” raisins to other countries or uses.

Today, the US Supreme Court ruled in Horne v. Department of Agriculture that the USDA-sponsored Raisin Administrative Committee’s process amounts to an unconstitutional governmental “taking”. Apparently the decision is limited to the raisin program and it opens the doors to other ways for the USDA to control the raisin market, but the decision also raises questions about the constitutionality of other agricultural commodity programs.

 

Bye-Bye Bookstores

Bye-Bye Bookstores published on

When you read a story about a local bookstore going out of business, you kind of expect the culprit to be lost business to on-line retailers (e.g., Amazon), e-book sellers (e.g., Amazon’s Kindle or Apple’s iBooks), or maybe, just maybe, a large brick-and-mortar bookstore (e.g., Barnes & Noble ). And while it may make one sad, at least one can understand the consequences of competition.

What you wouldn’t normally expect is that the store’s loyal customers and local citizens voted to shut it down–without even knowing it. But apparently that’s exactly what happened to the beloved Borderlands Bookstore in the Mission District of San Francisco according to the Bay Area’s ABC 7 News. As a result of the voter-approved increase in minimum wage, the bookstore can’t afford to remain open and has announced it will close at the end of March.

“You know, I voted for the measure as well, the minimum wage measure,” customer Edward Vallecillo said. “It’s not something that I thought would affect certain specific small businesses. I feel sad.”

The San Francisco Board of Supervisors seemed to have expected it though, but they forwarded the initiative to the voters nonetheless:

“I know that bookstores are in a tough position, and this did come up in the discussions on minimum wage,” San Francisco supervisor Scott Wiener said.

Apparently Wiener takes comfort that it was the will of the people, with 77% voting in favor of the increase. But this just really points out a problem in what is often a democratic-wannabe, spineless-republican form of government. Legislators pander to interests and ideas they know are bad for the economy, but pass the buck on responsibility by “letting the voters decide”.

And while Jonathan Gruber was mocked for saying Obamacare supporters had to hide the details because of the stupidity of the American voters, time and again local (and state-wide) referenda on things like minimum wage give credence to his claim. The average voter either has no clue about how markets really work or is tremendously myopic in thinking through the consequences of the policies they support…most likely, both. (Although, if voters were more economically competent, Obamacare supports would have had even more reason to hide the details.)

So the chickens have come home to roost in San Francisco. If you go there, plan to leave your heart…and your money…but don’t plan on enjoying the beloved local bookstores. Or the many other small, local businesses that can ill-afford an arbitrary (in this case, 50%) increase in their labor costs. Because that’s what minimum wage laws do.

The Price and Quality of Wine, Part II

The Price and Quality of Wine, Part II published on

After my previous post on the relation between the price and quality of the top red wines and the top wines under $50 in Vivino’s 2014 “People’s Choice” rankings, I got curious about the price-quality relation for the top white and sparkling wines. And I must say, i was a bit surprised.

For the Top 100 white wines, there is actually a moderate correlation between the quality rankings and prices; with a correlation coefficient of 0.51. Price isn’t a perfect signal for quality. In fact, the seventh best white wine cost only $27, just more than half the average price of $52.48. But price and quality are at least somewhat related overall, with the top five wines ranging from $244 to $404 and 21 of the last 25 wines below $50. As expected, the variance in price relative to the average was less than for the reds (std dev of 63.84).

However, if you’re looking for sparkling wine, it’s much safer to let price be your guide in judging quality. Price and quality rating have a correlation coefficient of 0.715, suggesting a fairly strong correlation between the two. This is completely opposite the case of the reds (recall, the price-quality correlation for those was just 0.053). And while the range of the Top 100 sparkling wine prices was considerable, from a high of $476 to a low of $10, the variance was lower relative to the average than for either the reds or the white (std dev = 95.779, average = $126.78)

Now, there are some caveats one should make about inferring too much from such a simple comparison. But the basic lesson is pretty straight-forward: if you’re shopping for quality sparkling wines, let price be your guide–at least in an ordinal sense. You’ll have to judge for yourself how much the additional quality is truly worth (i.e., is the quality of a top 10 wine five times better than the quality of the lowest 25, as their price difference would suggest?). If shopping for whites, price is a bit less reliable a guide, but not wholly unrelated. If shopping for reds, however, be careful about reading too much into the quality of the wine from the price on the bottle.

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