Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

In my last blog, I pointed out the inherent nature of uncertainties in climate projections, and the long list of reasons for particular uncertainties about the effects of anthropogenic greenhouse gas emissions on the change in future temperature levels, droughts, severe storms, sea level rise, and about measures of economic damages from any such event.  The range of possible outcomes is enormous, but I argued that the uncertainties are not a reason to wait and do more research before enacting legislation to reduce those emissions.  Indeed, the huge range of probability outcomes is a big reason to act now to reduce the possibility of such costly events.

In this blog, I want to expand that point to talk about the various kinds of uncertainties and what to do about them.  I just read an interesting blog by Keith Kloor that lists five kinds of reactions to uncertainty.  I will describe HIS five points, but what they bring to mind for me are the FIVE STAGES OF GRIEF (when a loved one dies, for example).  I’m sure you’ve heard these before:

1-Denial

2-Anger

3-Bargaining

4-Depression

5-Acceptance

Well, those approximately label his five reactions to uncertainty about climate change.  First, one could DENY the uncertainty, which might be done to try to further some political agenda.  Those who want environmental protection might say we KNOW that anthropogenic greenhouse gas emissions will cause significant global warming, and therefore we must act to prevent it.  That’s just wrong; we don’t KNOW that global warming will be significant and highly costly.

In fact, “uncertainty deniers” have done a great disservice to their own cause.  The claim that global warming is certain just gives the other side the opportunity to point out correctly that it’s NOT certain!  But that whole argument is irrelevant!  The relevant problem is that global warming MIGHT be significant and highly costly!

Second, one could react by trying to REDUCE the uncertainty, such as through herculean research efforts to make better predictions.  Research might well be worthwhile, and it might help reduce some of the uncertainties, but it will not reduce all of them, and it might introduce new uncertainties that we’ve not yet considered!

Third, one could try to SIMPLIFY the uncertainties, such as to explain in simple terms the complex scientific reasons for the inherent uncertainties listed in my previous blog.  It’s not wrong to try to explain complex uncertainties, and even to fit them into a finite set of categories, but the danger is that such simplification be taken as a replacement for consideration of all the complexities.   The problem is that simplification may in effect minimize those uncertainties.  Anyway, this kind of reaction is somewhat like bargaining: “maybe if we make up simple categories for these complex uncertainties then they might not seem so daunting.”

Actually, Kloor’s fourth reaction sounds even more like bargaining, when he says “Uncertainty detectives – well all scientists should work hard to understand, represent, and reason about uncertainty (. . .). The conflict is when political opponents seize on this uncertainty as an excuse for inaction.”  Now that is a cause for depression!

Anyway, of course, the fifth and final reaction to uncertainty is ACCEPTANCE: “include uncertainty information in rational decision support systems and policies.”  We need to know what is known, and what is unknown, to be able to make rational decisions as a society to adopt policies that can insure us against the worst possible outcomes.  We at least need to make the right tradeoffs between the costs of that insurance and the benefits of reducing those risks.  We need to undertake any available low cost measures to reduce fossil-fuel-fired electricity generation, to increase energy efficiency of vehicles and appliances, to increase alternative fuel use, to build water storage that can help deal with a possible increase in the number of droughts, and to build levees that can help deal with a possible increase in the number of severe storms.

Accepting the fact of uncertainty means giving up the idea of building in those protections because we know things will get worse.  Instead, it means building in those protections because things might get worse, and they might get a lot worse.

When the financial crisis hit last year, a lot of news sources started speculating that people would be forced to work longer to make up for the losses in their 401(k) plans.  Yet there seemed to be some puzzlement when data started indicating that more people were retiring earlier.  What happened here?

Some new research sheds a bit of light on this.  The answer to the puzzle is essentially that there are different groups out there who were affected differently.  Higher income individuals with large 401(k) balances were indeed likely to postpone retirement as a result of the negative wealth shock.

However, the financial crisis was also accompanied by a deep and prolonged recession that significantly increased unemployment, or more broadly, joblessness.  A study by Courtney Coile and Phil Levine of Wellesley College shows that a rise in unemployment during a recession leads to earlier retirement.  In essence, older individuals choose to retire rather than try to find another job. 

In aggregate, it appears that the unemployment-induced increase in retirement outweighs the 401(k)-loss-induced delay in retirement.  The net result is the average person retiring earlier, not working longer.

Of course, the most important point of all is that both effects are likely to reduce retirement security.  Whether forced out of the labor force early due to job loss or forced to stay in the labor force longer due to a negative wealth shock, individuals are made worse off.  And that, ultimately, is the real story.

Nobody has any doubt that climate forecasts are uncertain.  They are uncertain with or without anthropogenic (human caused) effects of greenhouse gas emissions.  Then, when trying to gauge the effects of humans, we have to take the difference between the uncertain climate forecast with extra emissions and the uncertain forecast without extra emissions.  That only compounds the uncertainty!

Suppose for example that without our extra carbon dioxide and other greenhouse gas emissions, the temperature in 2050 is predicted to average 50°F plus or minus 5°.  And suppose the temperature with our current rate of emissions is predicted to average 52°F plus or minus 5°F.  Then the difference (the effect of emissions) is not just 52-50 = 2°F.  Rather, it could be anywhere between 57-45 = 12°F, at the high end, or 47-55 = -8°F, at the low end.  We just don’t know.

That simplified example is overstated.  But look at the figure from the IPCC Fourth Assessment Report’s “Summary for Policymakers”.  It shows a set of model simulations with a range of results anywhere from no global warming to about 4°C (which is about 7°F).   That is a lot of uncertainty, but that figure does not reflect all possible uncertainties.  Those include (but are not limited to): uncertainties about the amount of GHG emissions in the future, about the effect of those GHG emissions on ambient atmospheric concentrations, about the effect of ambient atmospheric concentrations on air temperature, about the effects of air temperature on ocean water temperature at different depths, about the feedback effects of ocean water temperature back on air temperature, the effects of all those changes on polar ice caps, the effects of polar ice caps on sea level rise, the effects of sea level rise on millions of miles of coastline around the world, and the effect of all those changes on economic damages.

Many have taken this inherent uncertainty as a reason not to act now, but instead to wait, to undertake more research, and to try to reduce that uncertainty.

That may be a natural initial reaction, but it is not a good one.  It assumes that uncertainty reduces the need to act, when in fact increases in uncertainty only increase the need to act!  That is not to say research is unwarranted, or that we have nothing more to learn. We can and should try to find out more and try to reduce uncertainties.  But a lot of that research may raise additional considerations and uncertainties!  Uncertainty is inherent to the problem and will never disappear, so waiting for resolution of the uncertainty means waiting forever and doing nothing forever.

Uncertainty itself is a problem we need to face, as it raises additional costs we can reduce.  A single hot summer or drought is a problem with which we have learned to cope.  But now we don’t even know whether we are facing that same level of heat and drought, or perhaps much more heat, reduced rainfall, extreme storms, huge loss of landmass, etc., etc., etc.  It is the unknown possibility of such loss that ought to make us act now to protect ourselves.

To the extent that anthropogenic GHG emissions raise uncertainties about future climate, the more we need policies that are resilient to those uncertainties: policies that increase our abilities to deal with drought, to make it possible to increase crop production with less rainfall, and to protect ourselves against the possibility of storms worse than Katrina.

Which brings us to the key distinction between adaptation and mitigation.  One way to protect ourselves is to adapt to droughts and storms, as just mentioned.  But another way to protect ourselves against those adverse possibilities is to start now to mitigate climate change by reducing GHG emissions.

Several recent news reports have indicated that Illinois is planning on selling pension obligation bonds in order to come up with the cash to make its contributions to the five state public retirement systems for the next fiscal year.  This is by no means the first time that the state has used POBs: In 2009 it issued just under $3.5 billion of bonds to fund its pension contributions for 2010.  Back in 2003, it issued about $10 billion in bonds for the same purpose.

So, are issuing such bonds a good idea or not?  The answer depends on who you are, and what you are trying to achieve.

If you are a participant in one of the five public plans, the issuance of these bonds sure beats another year of having the state fail to make its contributions.  While I have written before that public employees have little to worry about given the nature of the constitution benefit protections that are in place, any lingering concerns about the state’s inability to make good on pension promises ought to be at least partially mitigated by having additional contributions made into the pension funds.  This is true regardless of whether the funds came from higher taxes, reduced spending, or borrowed funds.

If you are a politician, this is really a good plan because it allows you to – once again – avoid behaving like a responsible adult and making the difficult fiscal choices that ultimately need to be made.

If you are a current taxpayer, it also looks pretty good.  First, we avoid raising taxes now.  Second, we are essentially converting implicit debt (money owed to pensioners) into explicit debt (money owed to bondholders), with the key difference being that it is actually somewhat easier to default on the explicit debt than it is to violate the constitutional non-impairment clause (this is precisely the opposite for Social Security, in which it is easier to reduce benefits than to default on U.S. government debt). 

If you are a beneficiary of other government spending programs, you are also pretty happy.  After all, borrowing to fund the pensions puts less pressure on politicians to cut your favorite spending program.

So far, so good.  Sounds like everyone is a winner.  So, what is the catch? 

The catch is that issuing these bonds takes the pressure off of our elected officials to exert fiscal discipline.  It is like trying to cure a spend-a-holics debt problem by giving them a credit card.    

As such, the losers are all the future generations of taxpayers and program beneficiaries who are going to be saddled with several additional billion dollars worth of debt that must be serviced because we gave today’s politicians an “easy out” from facing their responsibilities today.  This reduction in fiscal discipline is made all-the-more dangerous when these bonds are portrayed as a way to magically reduce our obligations by more than the amount of the debt issuance.  All too often, one hears proponents of these bonds make statements about how the state can borrow at a low rate and invest at a high rate, and thus make money on the difference.  Invariably, such statements ignore the risk differences in the investments, and are akin to try to create a free lunch where none exists. 

Thus, the biggest downside to the use of these bonds is that they are an “enabler” for politicians who are addicted to deficit spending.  The direct effect of this resulting debt burden will be to increase the pressure to raise future taxes and cut future spending on education, health care, roads, state police and every other spending program that people may value.

The indirect effect is that higher future taxes will turn Illinois into an unattractive place for businesses to invest or for our most talented young people to build careers, homes and families.  Who wants to invest in a state that is saddling future generations of businesses and workers with debt?

It was just a matter of time until the comparisons of Illinois to Greece started flowing like the waters of the Agean.  Yesterday I came across this story on CNN/Money entitled “Illinois: Our Very Own Greece.”  Luckily, Businessweek says that things aren’t quite that bad. 

“The statement that any U.S. state is the next Greece, meaning a near default on their bonds, is not based on fact,” said Judy Wesalo Temel, a principal and director of credit research at Samson, which manages $7 billion. “Comparing the Greek debt crisis to state and local governments is not valid and is distracting from the real concerns about budgets.”

While that’s encouraging, I couldn’t help but notice that the article spends an awfully long time explaining why Illinois is not Greece.  So, the message seems to be that, while we are not Greece, we are the state most in need of an explanation why we’re not Greece.

A few days ago, AFL-CIO President Richard Trumka testified before the federal budget deficit commission.  In his remarks, he essentially argued (among other points) that we should try to grow our way out our problems.  Similarly, Edward Coyle, executive director of the Alliance for Retired Americans (an organization very closely affiliated with the union movement), objected to any discussion of raising the retirement age or reducing benefits.            

Sounds pretty good, right?  If we can just stimulate economic growth, we can avoid hard choices? 

Unfortunately, as with most “no pain” solutions to our nation’s fiscal problems, this one is too good to be true.  (In the name of bipartisanship, let me be clear that both Democrats and Republicans have their own version of the free lunch when it comes to Social Security – many free lunch Democrats argue we can grow out of the problem we have, and many free lunch Republicans believe that private accounts can solve the problem without benefit cuts.  Both are wrong – I will post about the flaws of the Republican form of free lunch at some other time.)

Let me be clear – growth is undoubtedly a good thing.  Of course I am pro growth.  Faster economic growth enlarges the economic pie, increases average wages, and thus provides more revenue for the same level of tax rates.  And there is no question that faster economic growth is a net positive for Social Security’s finances.

Unfortunately, faster growth is not sufficient to solve Social Security’s financial problems.  Let me point out two of the many reasons for this:

First, let’s remember that projections of Social Security’s long-term fiscal situation already assume that our economy will grow.  It is not as if Social Security’s trustees had not thought of this possibility.  So for growth to save us, it needs to be growth in excess of the baseline assumption.

Second, while it is true that faster growth and resultant higher wages increase payroll tax revenues to Social Security, this same wage growth also increases the benefits that Social Security must pay out in the future!  This is because the Social Security benefit formula is directly indexed to growth in the “average wage index.”  You may recall that the 2001 reform commission – and, in 2005, the Bush Administration itself – came out in favor of switching from a wage-indexed system to a price-indexed system.  Part of the rationale was to break this link and allow for us to get more of a fiscal “bang-for-the-buck” out of economic growth. 

There have been a lot of analyses to back up this analysis.  Of them all, the one that is most accessible to the non-PhD economist is probably the one written in 2003 by Rudolph Penner of the Urban Institute.  Hs conclusion: “Given the pending demographic pressures on the federal budget, we face a serious problem.  Increased growth cannot save us from breaking strong historical precedent.”  And that was back in 2003.  Sadly, the situation has gotten worse, not better …

So the short answer to the question posed in the title is “no.”

The New York Times ran a long piece last week about Illinois’ budget problems.  We are dangerously close to passing California as the biggest fiscal mess in the country, if we haven’t already.  Virtually everything is scary, but I found this to be most disturbing:

The state’s income tax burden is not terribly high — Illinois ranks in the bottom half of states — and its government is not terribly large. (The budgets in New York and California, per capita, are much larger).

The Tax Foundation ranks Illinois’ total state and local tax burden (2008) as 30^th highest out of the 50 states and Washington DC.  Federal government data (2009) ranks Illinois 22^nd highest in terms of state and local spending per capita, 12^th highest in terms of debt per capita, and 17^th in terms of GDP per capita.   Relative to other states, we have a very large unfunded pension liability, and as Jeff has pointed out, it is probably even larger than the official numbers show.  And, there are reasons to think that the unfunded pension liability is a symptom of the problem rather than its cause.  Unemployment is high here, but arguably our problems predated the current recession.

Which brings us to the big question.  How did we get into the state we’re in?  If we had an unsually high, or low tax burden, then maybe that would be the cause, and moving taxes in the other direction would help.  If we had an unusually large government, maybe trimming the size of government would be the solution.  But, none of these indicators point to why our state is doing so much worse than others.  The Times article suggests the following:

More broadly, Illinois is caught between blue state convictions about social safety nets and a red state aversion to taxes. For years, the Democratic-controlled legislature has passed budgets that are, in effect, in deficit. Lawmakers routinely skip around the state’s balanced-budget law, with few consequences. (Republicans are near monolithic in voting against any tax increases and borrowings. When one broke ranks to try to keep the pension solvent, he was stripped of a committee position, reducing his pay and pension.)

This week, I’m following up on my earlier post regarding the gap between the wages earned by public and private sector workers.  Given the financial problems faced by state and local governments across the country, the idea that overpaid public employees are, in part, responsible for these problems (and that, by extension, lowering their compensation should play a part in solving the problems) has gotten a lot of attention lately.  However, the best evidence we have on the point, not to mention common sense, suggests that the main factual claim underlying this argument – that state and local employees are overpaid on average – is wrong.

The issue of comparing wages across sectors is complicated.  Fortunately, a recent report from the National Institute on Retirement Security provides a nice introduction to the difficulties of the analysis and a comparison of the compensation earned by state/local workers to that of the private sector that paints a very different picture than the one that has been in the newspapers lately.  To be sure, the NIRS study is not without a point of view, and I think that the analysis is off in places, but it is certainly closer to correct than the naïve figures driving the headlines.

First and foremost, we must recognize that government jobs are different than private sector jobs and government workers are different than private sector workers.  In many cases, public jobs (e.g., police, fire fighters) have no private counterparts and vice versa. It is impossible to compare what a police officer earns in the public and private sectors, since there are no private police officers.  In addition, even when jobs have the same basic title, government jobs often have very different responsibilities than their private sector counterparts.  This results in, for example, almost 54% of state and local workers having college degrees, compared to only about 28% in the private sector.

These differences suggest that comparing average wages across sectors, as is done in the USAToday and BLS studies I cited last time, is likely to get the answer wrong due to differences in the composition of the two workforces.  An alternative approach, and the one that is used in the NIRS study, asks the question “given a person’s age, education, experience and other demographic factors, how much more would he or she be paid in the private sector than he would be paid in the public sector?”  Using this “people-based” approach, the analysis comes up with the answer that a typical public employee’s wage is about 11% lower than it would be if that person were employed in the private sector, reversing the basic finding of the newspaper analysis.  (In Illinois, the difference is more like 12 – 13%.)  Even when the study takes into account that public sector employees earn more in benefits than private workers, the gap is still about 7%.  So, the study’s basic finding is that state/local employees have, on average, lower total compensation than private-sector workers.

The NIRS study does a lot to dispel the idea that average state/local employees are earning more than they would in the private sector – getting fat off the taxpayer, as it were.  However, it is not without problems of its own.  The first, which the paper recognizes in a technical appendix, is that the analysis should also take into account that the mix of jobs done by state/local workers differs from that of the private sector.  Controlling for this shrinks the wage gap somewhat.  The second, which Jeff has written about, is that typical government accounting methods undervalue benefits, in particular they undervalue pension benefits.  Properly valuing pensions would further erode the gap.  In the end, I suspect that the gap between state/local (and federal for that matter) workers and private sector workers is quite small and is not systematically either positive or negative.  In other words, markets probably get things about right.

As a final note, here are a couple of economist “smell tests” for wages.  First, when our department tries to hire someone, we are competing against other public and private employers.  When we succeed in hiring someone, we have negotiated to the point where they are willing to accept our offer when compared to their alternatives.  So, almost by definition, the value they place on total compensation at the two places (relative to the demands of the job) should be pretty close.  Of course, since they chose to come here, they must like our packages somewhat better, but if we did a decent job of negotiating, not too much better.  Second, if total compensation in the government sector is systematically higher or lower than those of the private sector, we should see massive flows of workers in one direction or the other.  The fact that we don’t see this suggests that people are, by and large, happy with the jobs they have.  This, again, suggests that the market has wages about right.

In my blog called “Buy Low and Sell High”, I talked about “arbitrage”:  with enough information about prices in different places, you can buy any commodity at a low price in one location and sell it simultaneously at a higher price in a different location.  If the price difference exceeds the transportation cost, you have a guaranteed profit.  Also, because of “tax arbitrage,” different jurisdictions may find it hard to charge different tax rates, if people can just buy their goods in a neighboring jurisdiction.   In the May 23 Champaign News-Gazette, “Gas Tax Proposal Will Have Obstacles” says that the City of Urbana plans to raise their gasoline tax by 2 cents per gallon.   It points out that the City of Champaign is very close, and many people commute back and forth and can easily buy gas in the other city. 

In that blog, I also pointed to a direct quote from Adam Smith (1776):  “High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes.”  In other words, Adam Smith knew that the increase in a tax rate might not lead to additional revenue. 

Here is another example of tax arbitrage.  A fascinating paper by David Merriman was just published in the American Economic Journal: Economic Policy, called “The Micro-Geography of Tax Avoidance: Evidence from Littered Cigarette Packs in Chicago.”  As of July 2007, the City of Chicago had a combined state and local tax of $3.66 per pack of cigarettes, while nearby Indiana had a state tax of only 55.5 cents per pack, and no local tax.  The Chicago tax rate also exceeds the rate in other nearby Illinois cities.  By purchasing cigarettes whenever they visit neighboring jurisdictions, residents of Chicago can easily engage in tax arbitrage.  If so, the tax is hard to enforce, and it may reduce total revenue to the city of Chicago.

But how would one proceed to measure this effect?   Nobody ever records the necessary data on transboundary purchases.  Stores in Indiana don’t ask where the buyer is from.  Nobody in Chicago checks whether your cigarettes are from out of town.

Merriman’s ingenious solution was to organize teams (of students, I presume) to collect littered cigarette packs in a representative random sample of areas in the City of Chicago.   They collected a total of 2,391 littered cigarette packs, of which 1,141 still had their tax stamps showing the place of purchase.  As it turns out, only 25 percent of littered packs in Chicago had a Chicago tax stamp!  Only 59 percent even had Illinois stamps, while 29% had Indiana stamps.  In particular Chicago locations that are very close to the Indiana border, 80 percent of littered packs had an Indiana tax stamp.

Even if nobody were really trying to avoid tax, however, plenty of people cross these borders every day and could randomly buy cigarettes in different places.  Even after subtracting that normal cross-border flow, however, Merriman finds statistically significant and large effects of tax avoidance. 

I’m not sure if these estimates can be used to calculate whether Chicago could cut its cigarette tax rate and actually raise more money.  But that would be an interesting additional calculation if possible – and Adam Smith would like to see it as well!

An unintended benefit of Health Reform may be that it creates a new industry, full of high-paying jobs.  That industry?  Consulting on compliance with the inexplicable 10% tax on tanning salons that went into effect today, imposed to help pay for the bills.

Roughly speaking, the health reform bill is expected to cost about $940 billion over the next decade.  Maybe that number is a bit higher or lower, but the point is that, in order to pay for it, lawmakers for some reason thought there should be a 10% tax on tanning salons, which is supposed to generate around $2.7 billion over ten years.  For those of you doing the math, 2.7/940 = .0029.  In other words, the tanning tax is supposed to cover about three tenths of one percent of the cost of the health reform bill.

The tanning tax is a tiny part of a huge bill, and you’d think that it would be much easier to implement than, say, reshaping the entire health care system.  And yet, as detailed in this Wall Street Journal story, even the tanning tax is a complete mess.  According to the story, here are some questions that tanning operators are wrestling with:

• If a video rental story/tanning salon gives away a free tan with every three rentals, is that taxable?  If so, what is the right “price.”
• Ultraviolet tans are taxed, while spray tans are not.  How do you determine the tax on a membership that included unlimited ultraviolet and spray tans?
• “Qualified physical fitness facilities” that also have tanning beds aren’t taxed.  What makes them qualified?  How many treadmills does a tanning salon have to add in order to avoid the tax?  Do people have to use the treadmills, or do they just have to be available?
• How much should, say, a combination tanning salon/video rental store be willing to pay in order to keep track of tanning revenues for tax purposes?

Mostly this is just a fun story, but it does make some useful points about economics and taxation.  Taxation is costly for consumers, firms and the government.  Because of this, it is generally believed that broad-based taxes with low rates minimize the total burden of taxation.  Given the size of the health bill and the complicated nature of the tax, one must wonder if it was really a good idea.  Second, there’s more to who gets taxed than economics.  An alternative to the tanning tax, the so-called “Botax” on cosmetic surgery was pushed out of the bill by the AMA.  The tanning industry has no such lobby.  One has to wonder whether the health club exemption arose from their comparatively large bargaining power relative to small tanning salons.  Third, taxes induce behavioral distortions.  If the tanning tax causes people to get spray tans instead of ultraviolet ones, is that really what we want?  A bunch of orange people walking around?  Even in Champaign-Urbana that is not a pleasant idea.  Finally, as the article says, there’s no such thing as a simple tax.

Loyal readers:  I know I said I’d write about how state/local workers are actually paid less than their private counterparts.  I’ll post that next week.