Is Bad Tax Policy an Equilibrium?

April 29, 2005

One of the virtues of commercial society is that when foolish people get out of hand, smart people have incentives to correct them.

Thanks to arbitrage, rational people stand to profit when irrational people let prices and wages stray from efficient levels. That’s what keeps markets rational as a whole even when many participants aren’t.

Unfortunately, tax policy has no such mechanism. Though tax policymakers have the same cognitive biases as everyone else, the “market” for tax policy—made up of legislators, voters and lobbyists—is much less self-correcting. In normal markets, bad business practices get pushed out by competition. But in tax policy, bad laws can survive on the books for generations.

That’s the argument in an excellent recent paper from Prof. Edward McCaffrey (USC), “Thinking About Tax” (PDF):

In private markets, arbitrage mechanisms, including the stock market for financial assets and competition itself for consumer goods, allow some to profit from the biases of others. Private actors can capture the gains from trade, so to speak, in laying bare cognitive illusions and inconsistencies, with overall prices showing little effect. In the public sector, the absence of any simple, general arbitrage mechanism, such as a market — indeed, the absence of any clear incentive to develop such a mechanism — gives reason to believe that the adverse effects of cognitive biases can persist for long periods of time.

It’s a discouraging realization that the process of rising tax complexity followed by rising political pressure for tax reform followed again by rising complexity is an endless loop of predatory rent seeking and political entrepreneurship. Bad tax policy is a stable long-run equilibrium under our current constitutional rules.

In the current intellectual climate where the tax code is seen as a mechanism for guiding preferred social outcomes, internalizing externalities, promoting public health, discouraging immoral behavior, promoting marriage and childbirth, rewarding education, and on and on ad nauseaum, predatory rent-seeking through the tax code is an inevitable fact of life.

Without an intellectual consensus that the tax code has just one legitimate function—raising necessary revenue for programs in the least harmful way—it’s hard to see how lasting tax reform is possible.

But don’t despair. Even in political markets there are forces keeping things from getting too bad—including tax competition, political entrepreneurship and, of course,


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