Elasticity, more than just keeping your socks up

Elasticity - probably not something that you think of every day, but, it is a concept often used in economics and tax policy.  Unfortunately, the nuances of elasticity can be somewhat confusing.  To the best of my ability, I will try to make it a little more comprehendible.

Elasticity is a measure of how a tax system keeps up with changes in the economy.  It shows how tax revenues compare with the economy in good times, bad times, and over the long run.  An ideal tax system will keep pace with the economy and remain as steady as possible in both good times and bad.  If a tax system keeps pace with changes in the economy, then it is said to have good elasticity. Elasticity, or Short Run Elasticity (SRE) (as the 2002 Washington State Tax Structure Study calls it), measures the relationship between two economic factors.  More precisely, elasticity measures the percent change in one economic variable in relation to the changes in another economic variable.  Still with me? 

The goal of a well-designed tax structure is to have a 1 to 1 ratio in SRE. When one factor goes up, the other follows relatively closely, the same is true when one of the factors goes down.  Tax structures that are able to weather economic and business cycles without any drastic disproportionate changes in revenue are said to have good elasticity.   A tax system with a SRE ratio greater than one is volatile, subject to compounded fiscal crises.  In periods of economic expansion, tax revenues grow faster than the economy; in times of recession tax revenues shrink faster than the economy.

To try and put this in perspective, think of a roller coaster (I know, not the most comforting tax policy analogy, but it works).  A roller coaster has a number of cars to hold passengers.  Ideally, you want your economic activity (measured by personal or corporate income) and your revenue collections in the same car, so that when one goes up the other is right beside it.  If these two riders are generally instep, it is said that the system has good stability or elasticity.

Unfortunately, in Washington those two thrill seeking roller coaster riders are not in the same car, they are not even on the same ride.  In both the short and long term view, state revenue is not keeping pace with personal or corporate income.  This creates BIG problems when trying to plan and develop solid public programs like education, environmental protection, and infrastructure maintenance and development. 

http://www.eoionline.org/

One way to add elasticity to our tax code in Washington is to connect revenue collections to the major economic driver of the state—this has been done before in Washington.  The first time was before Washington’s statehood through the 1930s when Washington was a property tax state, and the economy was driven by agriculture.  The second time this was done was the shift to a consumption-driven sales tax that reflected Washington’s transition to a manufacturing economy.

As we transition further away from a consumption driven economy to an innovation driven economy we should make appropriate changes in our tax code to increase the elasticity and stability of funding streams used to fund core public programs and resources.  An introduction of an income tax would be one step towards greater stability and elasticity in Washington’s tax code.

Tax Discussion Definitions: Revenue Neutral

A popular phrase that comes up when talking about taxes is that “____ policy is revenue neutral.” What does that mean? Revenue neutrality is when tax reforms are made and the end result doesn’t lead to an increase or decrease in revenue for the government.  The ending balance is neutral when compared to what was in place before.  This phrase is really popular, especially if you’re advocating for change without raising taxes.

However, it’s important to know that even with revenue neutrality, there are winners and losers.  If you reform a tax structure by reducing a tax, you’ll have to raise another tax to claim revenue neutrality.  Someone will be better off and another won’t be based on these changes. The Tax Foundation described this balancing act as robbing Peter to pay Paul and discusses a few examples of when states would lower certain income tax rates, but raise excise taxes to cover the difference.

For this term, neutrality portrays a sense of equality and fairness that might fly when looking at the big picture of a budget, but doesn’t pass muster when looking at the changes made to get there.   Even though the overall tax burdens haven’t changed, the variables to keep the neutrality have. 

Also, neutrality doesn’t account for another important aspect of taxation--values. Jason Furman from the Brookings Institute mentioned this when testifying before U.S. Senate Committee on Finance: “In other cases, deviations from a neutral tax system reflect the goals of policymakers. The tax system is designed to encourage home ownership, contributions to charity, health insurance, and higher education and to discourage smoking and drinking alcohol.”  By focusing on the fiscal goal of revenue neutrality, lawmakers might have to change their interpretation of citizens’ values when it comes to increasing or decreasing taxes for certain activities (link to elasticity brief).

That’s a quick synopsis of revenue neutrality. Just remember that neutrality just refers to the total amount of money that government collects, not how it collects it or who’s impacted by potential tax reforms. I’d like to close with a quote from Christopher Bergin’s entry on this issue on tax.com:

“My point is that if we go down the road to tax reform now, we need to chuck the principle of revenue neutrality and replace it with a new principle; call it loser equality. Because if ‘winners’ in tax reform are those who don’t see their taxes go up or actually see their taxes go down, and ‘losers’ are the ones who see a tax increase, and we do the next round of tax reform responsibly, we are all going to need to be losers. We are all going to need to pay more taxes.

Besides, nothing is neutral.”

Tax Discussion Definitions: Elasticity

In order to have a better understanding of all the nuances of discussing tax policy, I’m going to spend some time talking about terms that policy wonks and lawmakers throw around a lot. This entry will focus on the concept of elasticity; if you’re an economist this might be old news but a refresher never hurts right?

So what is elasticity?  Basically, elasticity is a measure of responsiveness. It tells how much one thing changes when you change something else that affects it.  Best analogy is a rubber band; it’s elastic when it stretches in response to you pulling it.  In economics, there is elastic demand—this happens when a consumer buys less of something when the price increases and more of something when the price drops.  There’s also inelastic demand, which occurs when a consumer buys about the same amount if the price goes up or down. Dr. Samuel Baker from the University of South Carolina created an interactive tool that provides more examples of this concept. The first example he provides is about a bleeding unconscious man that’s brought to an emergency room.  This would be considered inelastic since he’ll get treatment regardless of the price.

So what does this have to do with tax policy?  Lawmakers always have to consider how much of a burden they’re imposing when raising taxes and know who actually ends up paying for a tax that might be aimed a different group (example: buyer vs. seller).  This concept is know as tax incidence

If a tax is raised too much, use of the taxed service or product could decrease below the expected level of tax revenue a government is aiming to collect.  Also, politicians need to be aware of how the public will react to certain taxes.  For example, food is pretty inelastic since we need it to survive. If groceries were taxed in Washington, consumption might decrease some but the tax will be paid due to the necessity of eating. This would be a burden on families, especially those with lower incomes (Link to Catherine’s food brief). 

Also, policymakers use the concept of elasticity to reduce certain behaviors. The best example of this is tobacco (link to Catherine’s tobacco brief).  It’s commonly known that the long-term effects of smoking and chewing tobacco physically harm and kill people.  This makes tobacco an easy target in terms of raising taxes. To change consumption behavior, lawmakers raise the tax to try and make smoking too expensive for consumers.  When this happens,  revenue from the tax declines and it’s easy for the Legislature to argue in favor of the declining revenue of tobacco sales because the decreased use offsets future healthcare costs.  As Catherine mentioned, the State recently closed a loophole for consumers when they raised the fee for roll-your-own cigarettes.

That’s elasticity in a nutshell!  Without using mathematical models to describe pricing points and such, just know that elasticity is how you react to certain things like cost and how flexible you are when market variables change.  This is a relationship that government needs to understand well if it wants to implement tax policies that are a) fair to the majority of citizens, and b) politically possible.   We’ll add more definitions like this one to give you a clearer perspective of underlying issues that come up when folks talk about taxes.