"Sin" taxes Vs "Yuck" ads!

Public health experts across the world have been concerned at the increasing consumption of sugary soft drinks and holds it partly responsible for the increased incidence of obesity, high blood pressure and heart diseases. Accordingly, policy makers have been relying on two main approaches to reduce the consumption of these beverages - awareness creation through ("Yuck") advertisement campaigns and soda (or sin) taxes.

I have already posted earlier here and here about the benefits of an obesity tax on such foods. The New York City has been running high-visibility anti-soda advertisements that repulsively illustrates the harmful effects of these sugary beverages. And taking cue from how cigarette taxes have helped curb smoking, the Obama administration is considering imposing a soda tax on soft drinks, energy drinks, sports beverages and many juices and iced teas.



While public health specialists support these efforts, economists have been more ambivalent in their responses. Liberatarian paternalists, following the lessons from behavioural psychology, strongly advocate such ad-campaigns and taxes as efforts to nudge people away from consuming these beverages. There are others who argue that taxes will help internalize the external costs imposed by obesity and other harmful effects on health - increased burden on government health care systems (Medicare/Medicaid), social contagion effects of obesity etc. However, libertarian opponents, who favor respect for individual decision-making, argue that people drink beverages because of the utility and pleasure they derive from its consumption. Accordingly, they strongly oppose any government intervention in advising them about what is good for their health.

The case in favor of atleast some form of restraints on consumption of beverages is well established and needs no reiteration. In any case, whatever the arguements against public paternalism and protection of individual's right to indulge himself (to destruction and death if he so desires), the net economic cost inflicted on the society by these individual actions are too large to be ignored. One man's liberty stops where it starts adversely affecting another man's (or society's) liberty.

In the scale of liberty, awareness campaigns are surely on the liberatrian side while taxes would appear to verge on paternalism. However, I am inclined to side with Edward Glaeser in favoring paternalism as the more efficient form of controlling consumption of sugary beverages. Both taxes and instrusive and unpleasant ads seeks to internalize the external costs of consuming these beverages by making it costlier for the consumer. But while the former involves collection of the costs in the form of tax revenues, the latter option ends up dissipating the costs.

In other words, as Prof Glaeser writes, "An effective ad that makes drinking soda less psychologically pleasant is essentially a tax without revenues... The case for taxes and against ads is that if we are going to impose costs on cola drinkers, it is better to get some revenue back." And also, from the experience of the efforts to curb smoking, the "bigger decreases in smoking followed big increases in the tax on cigarettes".

Carbon sequestration in power plants

Amidst all focus on carbon taxes and cap-and-trade approaches to control carbon emissions, carbon sequestration has hitherto taken a back-seat. Now the Virginia based Mountaineer power plant in the US is all set to become the world’s first coal-fired power plant to capture and bury deep inside earth some of the carbon dioxide it churns out. The hope is that the gas will stay deep underground (around 8000 ft), squeezed into tiny pores in the rock by displacing the salty water there, for millennia rather than entering the atmosphere as a heat-trapping pollutant.



The success of this experiment assumes significance in view of the fact that the overwhelming majority of power plants are coal or fossil-fuel based and retrofitting them could prove far more feasible than building brand new, cleaner ones.

Opponents claim that the cure could turn out far worse than the disease. They point to the possibility of pollution of water suplies (the carbon dioxide could mix with water underground and form carbonic acid which could leach poisonous materials from rock deep underground that could then seep out) and the substantial energy consumption in the process ofcapture and sequestration itself.

Update 1
See also this post.

SHG membership as a signalling mechanism

In the last two decades, Self Help Groups (SHGs) and the micro-finance movement have emerged as one of the most important, if not the dominant, platform for addressing the challenge of eradicating poverty in many developing countries. The penetration of SHGs have been especially strong in many parts of India. However, there is a growing danger that these SHGs are becoming an end in themselves, rather than be instruments in fighting the scourge of poverty. I have blogged about this in an earlier post here.

These groups which started out as a means of empowering and inculcating thrift among women continue to remain stuck with the same paradigm and objectives. At best, the existing sets of policies have helped these groups start and expand on small, livelihood-based business activity. However, even in the specific activity of accessing formal sources of financing (for various purposes), the SHGs have not gone beyond traditional bank-loan driven group borrowings.

This post will seek to make a case in favor of a signalling role for SHGs in helping their individual members (and not as a group) access the broad spectrum financing options in the market. I will flag off one dimension - accessing all available formal financial/financing markets - in which SHGs, especially those with adequate capacity, can be invaluable in spurring more macro-level economic activity.

Now, a large number of these groups have gathered substantial capacity to deliver on outcomes beyond those intially envisaged. With some assistance and a different set of policy tools, many of them are capable of leveraging their capacity and built-up strengths in moving up into a higher trajectory of growth. More specifically, those SHGs can enable the transition of the SHG and micro-finance movement from addressing poverty alleviation to promoting vibrant entrepreneurship and economic development.

One of the most important dimensions of the utility of SHGs is in their role as an effective signalling mechanism. The poorer borrowers suffer from an especially acute risk aversion among lenders arising from the greater probability of adverse selection. The peer-pressure driven compulsion among SHG members to repay bank loans has become an effective credit guarantee for banks in making group loans to the SHGs. A logical extension of this argument would be to use the same credit-worthiness signal arising from SHG membership (atleast in the case of the stronger groups) to leverage loans for individual group members.

This would enable individuals to use their group membership to access/draw individual loans from banks for specific productive investments like business expansion or starting new businesses, constructing homes, purchasing consumer durables and automobiles, loans for education and health care, and so on. Presently, individual group members who want to make these purchases or investments access credit through the group loans, and then use it to incur their expenditures, thereby causing considerable transaction costs and duplication of activities.

Further, group loans generally involve equal distribution of the loan amounts among all group members. However, within a group, different members have varying levels of credit thresholds. Members use these loans for different purposes, move along varying growth trajectories, and have non-uniform credit needs and repayment abilities. In the circumstances, it becomes likely that those members who are more enterprising and have higher credit appetite gets constrained (in access to more credit) by their laggard compatriots. All these only highlight the importance of enabling individuals to access loans at their terms.

Here are a few examples of how this would work. Retailers (or their partner financing institutions) selling consumer durables on EMI can lend directly to poor customers, without the standard collateral requirements, by banking on the implicit guarantee provided by the individual's group membership. Typically, in the rural areas and smaller towns, there are likely to be only a handful (even only two or three) of retailers in the local market selling consumer durables or automobiles. It is easier and more efficient for them to administer these EMI sales of consumer durables and automobiles to the small numbers of local customers.

Poor people, looking to construct their homes, face numerous problems in accessing home loans in the regular financial markets. Given the large demand for home loans and the massive government spending on providing housing to the poor, it is natural that it offers ample mutually beneficial opportunities for both banks and the poor customers. The regular government housing programs for the economically weaker sections can be dove-tailed with direct bank lending to individual members of good SHGs, either by government providing the interest subvention subsidy (soft loans to beneficiaries) directly to the bank or the individual leveraging bank loan to top up the government assistance and construct a larger house with an additional loan.

Similarly, individual members should be able to access education loans by leveraging their membership of the SHGs, especially for higher education in professional courses. Here too, the regular government interest subsidies can be transferred directly to banks, thereby minimizing transaction costs and effectively addressing the targeting problem.

By encouraging the banks to lend directly to individuals using the signalling platform of SHG membership, and then transferring the interest subsidy directly to these banks, the government can reduce the considerable transaction costs and other numerous distortions associated with government subsidies.

It is true that there is nothing that prevents bankers today from providing loans to credit worthy individuals who are members of SHGs. But a formal recognition of provision of individual loans to the members of SHGs with good track record on the back of an implicit (not explicit) guarantee as a component of priority sector lending of banks, would go a long way in boosting the demand for such loans. It would encourage bankers to lend and borrowers to access formal financial institutions to meet their financial requirements. Bankers do not bear much additional substantive risks. Afterall, loans provided to SHGs were done so without any collateral backing and have borne impressive returns till date.

In the absence of credible signalling mechanism about the credit-worthiness of these individuals, such transactions would not have materialized. The banks benefit by increasing their loan portfolio without a disproportionate increase in the risk assumed, while the poor consumer gains access to the formal sources of credit provisioning, and government becomes able to more effectively target and deliver its assistance. We have a clear Pareto improvement, brought about by the signal emanating from membership of a credit-worthy SHG.

In order to avoid any moral hazard arising from this, it may be prudent to limit such lending to only those groups which have availed of and repaid atleast one or two tranches of loans in the recent period. The lending should be done strictly only after a resolution has been passed by all the members of the group permitting the specific individual to access the loan. Further, such lending can start off with small loans and the credit limits can be progressively loosened, both among group members and specific individuals availing of the loans. Also, the initial rounds of such loans can be limited to specific categories of expenditures like purchases of consumer durables, automobiles, student education loans etc.

The relevance of industrial policy

World Bank's Chief Economist Justin Yifu Lin has kicked off a debate with his version of new-structuralist economics that favors an active role for governments in promoting industrial policies that works with a country's comparative advantage. Critics like William Easterly, who favor the markets and entrepreneurs to do the job of allocation of scarce resources and industrial development, feel that governments cannot identify the sources of comparative advantage and even if they do cannot have in place the incentives to support those sectors.

Justin Lin argues that "comparative advantage should drive policy. The optimal economic structure is endogenously determined by the endowment structure - resources, labor, capital, and hard and soft infrastructure - and differs for each country at different stages of development." He claims that the role of the state is to "develop the required infrastructures and use industrial policy to facilitate the upgrading to industries that are consistent with the country’s comparative advantages". He feels that the market can handle static efficiency, but can’t handle the transition from one stage of exporting to another, like from lighter to heavier industry. Under such circumstances, governments can be guided by following those countries ahead of it on the technological ladder and put in place policies to achieve those objectives. I am inclined to favor Justin Lin for a number of reasons.

First, it is not as simple as merely identifying the comparative advantage and then promoting it by supporting government and private firms in the identified sector. The East Asian economies had in place a comlementary set of policies - education, health care, infrastructure, etc - which addressed the backward and forward linkages that are necessary to sustain any industrial policy. These policies and resultant institutional structures and ancillary markets underpinned the East Asian success story. Unfortunately, most developing economies are sorely deficient in these basic pre-conditions.

Second, even if the basic pre-conditions in terms of development of human resources are met, in the absence of pro-active government interventionary support it will be difficult for the fledgling domestic industries to survive the onslaught from the more efficient and cheaper external competitors. Such support through an effective industrial policy is important to establish a level playing field, especially in the inital few decades of industrial development till a threshold of economic maturity and development is reached. The industrial and economic development paths of all the major economies of the world across history, without exception, has followed this trajectory.

Third, identifying comparative advantage is not about picking specific products and services (like women’s cotton suits or ceramic toilets or building a national car), but locating borader areas of competence and advantage like labor intensive manufactures in the first stage among East Asian economies and subsequent movement up the production chain. Similarly, the Indian government realized the comparative advantage conferred by its large pool of skilled and English speaking manpower and put in place policies, however flawed, to promote sectors like software and bio-technology. Countries at different stages of development will have industries locate at different segments in the spectrum.

Industrial policies are about promotion of savings, provision of access to timely and adequate finance, policies to develop human resources and endow them with requisite technical skills, facilitate easy access to capital goods, judicious use of export subsidies and other support to provide a level-playing field against foreign competitors, atleast till the domestic firms find their foot-hold.

Finally, there is a thin line that differentiates good and beneficial industrial policy from protectionism. However, this cannot be held against industrial policies, since protectionist barriers have been a constant in the economic landscape of even market-friendly developed economies like the United States. Protectionism has never been the exclusive preserve of governments.

In the circumstances, it endows on economists to help policy makers design appropriate policies that take into account each nation's comparative advantage. They can help stitch together the most effective and least distortionary set of policies and construct the institutional architecture that aligns incentives with the achievement of the pre-defined policy objectives. They should also study the conditions under which such industrial policies are likely to be successful in different economies.

Prof Easterly's example of the corruption in giving driver's licences in India is surely irrelevant to the debate about government's role in initiating industrial policies. Inefficiencies and distortions in the implementation of policies, which are not uncommon even in the developed economies (witness the extent of inefficiency and incentive distortions in the US health insurance market), cannot be taken to abandon government intervention of any kind.

To answer Prof Easterly, poor country governments certainly have a comparative advantage, atleast over its its nascent or under-developed private sector and its market structures, in discovering their comparative advantage.

Update 1 (18/4/2010)
Dani Rodrik on the return of industrial policy, "British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right."

He has three important pre-requisites for a successful industrial policy.

1. Industrial policy is a state of mind rather than a list of specific policies. Its successful practitioners understand that it is more important to create a climate of collaboration between government and the private sector than to provide financial incentives. Through deliberation councils, supplier development forums, investment advisory councils, sectoral round-tables, or private-public venture funds, collaboration aims to elicit information about investment opportunities and bottlenecks. This requires a government that is 'embedded' in the private sector, but not in bed with it.

2. Industrial policy needs to rely on both carrots and sticks. Given its risks and the gap between its social and private benefits, innovation requires rents – returns above what competitive markets provide. That is why all countries have a patent system. But open-ended incentives have their own costs: they can raise consumer prices and bottle up resources in unproductive activities. That is why patents expire. The same principle needs to apply to all government efforts to spawn new industries. Government incentives need to be temporary and based on performance.

3. Inustrial policy’s practitioners need to bear in mind that it aims to serve society at large, not the bureaucrats who administer it or the businesses that receive the incentives. To guard against abuse and capture, industrial policy needs be carried out in a transparent and accountable manner, and its processes must be open to new entrants as well as incumbents.

Capture of regulatory and policy-making instruments?

The debate on financial market regulation proposals have focussed attention on procedural and structural issues like capital adequacy requirements, systemic risk regulation, caps on executive compensation, and so on. However, the equally important role of personal conflicts of interests inherent in policy makers and market regulators appears to have been confined to the sidelines.

The back and forth movement of bankers and financial market actors to prominent policy making and regulatory positions is widely acknowledged and the numerous instances of very strong and immediate conflicts of interests, at the very highest levels of decision making, has been adequately documented. It is surprising that a political and administrative system like that in the US which pays attention to disclosure requirements and potential conflicts of interests, has virtually ignored these massive moral hazard generating situations. Even more surprising has been the lack of public indignation and outrage at this serious problem.

Imagine the public outcry it would have generated in India if Vijay Mallaya was made our Civil Aviation Minister or Chanda Kochar was made the RBI Governor or any of the Ambani brothers were made the Petroleum Minister! Given the overarching role of the financial markets in the overall American economy, it is no stretch to compare the aforementioned Indian scenarios with the elevation of the likes of Robert Rubin, Hank Paulson and Co to important public policy making positions.

In an excellent op-ed in the Times, Simon Johnson and Peter Boone examine this issue and writes,

"Since our top regulators are political appointees, it should be no surprise that, in the face of heavy lobbying by the financial sector, they often turn out to be regulatory doves. We’ve permitted our mid- and high-level regulators to revolve between jobs in finance and officialdom. To name just two examples, during the Clinton administration, Robert Rubin left Goldman Sachs to become secretary of the Treasury, then returned to the industry to take an oversight role at Citigroup, while Henry Paulson, the secretary of the Treasury during the last years of the George W. Bush administration, came straight to government from Goldman Sachs.

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector. These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes."

And they write on the need to prohibit such movements of personnel and favor the development of career regulators to man such important positions,

"We should prohibit companies and senior managers in regulated financial industries from making donations to political campaigns. We should also restrict public employees involved in regulatory policy from working in those industries for five years after they leave office. And we should prohibit people who move to government from the finance sector from making policy decisions on bailout and regulatory-related matters for a minimum of five years.

Our regulators need to be smart people who understand finance, but they don’t need to be drawn from the upper echelons of the financial industry. There are many proven, dedicated professionals in our regulatory agencies today, and we should support the development of an even stronger cadre of career regulators. It should be up to the financial sector to make its practices clear and simple enough for these professionals to understand, and any that are too complex should not be approved."

Internalize energy efficiency costs

The proliferation of consumer electronic devices over the past few years has considerably increased electricity usage in houeholds across the world. It is estimated that Americans now have about 25 consumer electronic products in every household, compared with just three in 1980, and that consumer electronics which now represents 15% of global household power demand is expected to triple over the next two decades.



This dramatic increase in the use of electricity consuming devices makes it imperative that there be stricter energy efficiency standards on newer electrical devices. Presently, many of the newer generation of electronic products like flat screen TVs and video game consoles, which are energy guzzlers, have no efficiency standards anywhere.

These are examples of classic negative externalities - in so far as these new generation devices impose a disproportionately larger burden on global energy reserves and the environment. In the absence of regulatory controls, such devices will continue to proliferate and expand at the same or faster pace. Therefore, as with any such negative externality, the solution lies in getting the producers to internalize the full external costs of these devices.

Manufacturers of these devices, who oppose stricter standards on the grounds that it would increase costs and stifle innovation, and its users should be made to fully internalize the external costs by spending resources to improve the energy efficiency and by paying higher prices comensurate with use of cleaner technologies, respectively.

Taxation and behavioural economics

I have blogged in earlier posts about the relevance of behavioural psyhology in formulating tax policies. Now, in a Brookings working paper, William J. Congdon, Jeffrey R. Kling, and Sendhil Mullainathan (via Freakonomics) explore the implications of deviations from the rational and self-interested utility maximizing agent of neo-classical economics due to cognitive biases and time-inconsistency problems, on tax policy.

They argue that imperfect rationality of human beings means that they choose sub-optimally, bounded self-control comes in the way of their realizing their intentions, non-standard preferences means that they care about the welfare of others and fairness and form their preferences around reference points (both in time and space).

Contrary to convetional wisdom that advocates simplicity in tax policy, behavioural psychology leads us to favoring certain types of nuanced complexity, especially in promoting welfare and fairness. For example, sales taxes (which are not posted on the good sold) and electronic toll fees (through E-Z Pass) are not salient and therefore pass through un-noticed, separately identified taxes to fund specific benefits are easier to levy, tax credits enable targetting and thereby optimize provision of subsidies.

They also point to the possibility of leveraging the automaticity inherent in tax administration (like deduction at source, and simplicity of tax filing channels) especially to take advantage of the imperfect rationality of tax payers. This can be used to facilitate automatic access to transfers and certain types of direct subsidies along with tax filings, encourage retirement and personal savings (eg channel tax refunds into default savings accounts), and have opt-out insurance policies.

About the relevance of such behavioural deviations from standard assumptions for fiscal policy, they argue that tax cuts presented as "bonus" might be more likely to be spent than tax cuts presented as a "rebate", since when individuals perceive the tax cut as a gain (a 'bonus') rather than as a foregone loss (a 'rebate'), they are more likely to spend the tax cut. Further, there is evidence that tax cuts delivered through reduced (monthly) withholding, as against lump-sum rebate or bonus, is more likely to be spent.