Thursday, July 15, 2010

Why Complexity is Better than Simplicity

There's been talk recently about pushing forward climate change legislation...again. So far as I can tell, this is the third time this year it's been resurrected. Something tells me it won't go through yet again. The lack of action by all parties is beginning to strain our connections with europe (so says The Times), and I suppose it could potentially have significant trade implications down the line if we continue not to act (as U.S. goods won't have certain externalities priced in).

The more I consider the issue, though, it seems to me that the framing is wrong. Caps sound negative, and don't speak to incentives (even though they are fundamentally embedded). Instead, let's frame it as a withholding tax. OK, I realise that sounds just as bad, but bear with me.

Every paycheck, your employer withholds a certain amount of tax based on what you have in your W4 form and your expected earnings.If the amount of tax you owe is under what was withheld: bingo, sweet refund! Alternatively, if you withheld too little: pay up, buddy. Federal tax rates are progressive (10% on the first $8, 375, 15% from $8,375 to $34,000, etc.) based on your earnings, but then there are certain deductions which reduce the amount on which you're taxed. The government provides programs to its citizens, and our taxes go to support these programs and help pay for certain social benefits.

Think about a pollution withholding scheme (see, sounds better already) as similar to this. First, we have to assume that polluting shouldn't be free, and it has to be priced into the system to pay for its effects. Let's say, under this scheme, we decided to go for a straight tax of 1% of revenue for every 10,000t of carbon emitted.

Then let's assume there are deductions, say for the amount you invest in clean technology as a percentage of your overall revenues (for every 1% of revenue reinvested in clean technologies/renewable energy sourcing, you get a 10,000 t reduction in your total carbon 'bill'). So a business that's smart could actually negate its tax by ensuring it invested enough in renewables to reduce its tax burden (which could end up being less expensive than paying the tax). The brilliant thing about this is that assuming it made good investments in, say, increasing the efficiency of its plants, the tax burden would be lowered in that first year with the deduction, as well as the subsequent years since you would continue the tax benefits of a reduced CO2 output.

I'm not going to go into the effects for small business and consumers, as economically we are already paying those costs, just indirectly. This actually allows people to be more empowered to pick businesses that chose to be efficient assuming some costs are passed on to consumers.

Yes, it would be simpler to just have a cap. I'll admit that, but you have to remember that people like to 'game' the system and feel like their winning. You can tell people, just save a bit each month to pay off your taxes. But our complex tax code actually lets people feel like they 'win' when then find a deduction. It's a little victory. A straight tax, while simpler, doesn't give that feeling. A cap sounds simple. People get it, but in many ways people don't WANT to get it. If you can let them feel like they game the system a bit, its empowering, and that's ultimately what people want. Is the power to win over the big guy. Sounds counterintuitive. But think about what brings you more joy (or utility)--paying a straight 10% tax rate, or finding that student loan deduction meaning you now pay...a 10% tax rate.

Though counterintuitive, there is joy in finding loopholes, something a straight cap doesn't bring. So I say, bring on the complexity!

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