Questions and answers about coronavirus and the UK economy
Questions and answers about coronavirus and the UK economy

Are lockdowns taxes?

Lockdowns place burdens on businesses forced to close and people unable to work. The perspective of public economists, who have long studied government interventions in markets, offers insights on the strictness of enforced immobility and its impact on the economy and inequality.

There are basically two ways in which governments can intervene in the economy with the goals of changing the behaviour of individuals and organisations, and/or raising public revenues: price instruments; and quantity instruments (Gruber, 2015). The Covid-19 pandemic has required interventions that are unconventional by normal standards and which mainly show a preference for regulations over tax interventions. But are lockdowns and other restrictions used to combat the spread of coronavirus somehow equivalent to taxes?

Taxes are price instruments, because they drive a wedge between the price that buyers pay for a product and the amount that sellers receive when they sell a product. The difference between those two is the amount of tax, which goes into the government’s coffers. In contrast, quantity instruments regulate firm and individual behaviour directly rather than via prices in market transactions. For example, one simple quantity instrument is a quota, which caps the amount of goods and services that can be sold, either by prohibiting activity or via licensing.

The short answer to the question is that lockdown orders are more like quotas than taxes: they restrict the quantities of various activities that buyers and sellers can undertake. But it turns out that economics has a lot more to offer here than simply classifying the policy intervention.

Which is better: quotas or taxes?

First, why use a quantity instrument rather than a price instrument to combat Covid-19? The first step in answering this question is to ask another: why are we intervening? There is an obvious answer: communicable diseases impose costs known as externalities on individuals other than the buyer and seller in a particular transaction.

If I go to a concert during the pandemic, I risk infecting the people around me. My decisions might account for my own risk of infection, but I might ignore the risk of infecting others because I do not bear the full consequences of doing that. Thus, the emergence of Covid-19 marked the arrival of a sweeping negative externality affecting activities across the economy. Given the mathematics of exponential growth, even a small amount of activity could trigger a wave of infection that could cost lives.

Related question: Externalities: why do we need coordinated public action in the pandemic?

The question of whether to use price or quantity instruments to combat externalities was the subject of a seminal study by Martin Weitzman (1974), revealingly titled simply ‘Prices versus Quantities’. Before this work, economic theory advised that with perfect knowledge of everything about a market – firms’ costs, buyers’ preferences and the size of the externality – either a price or quantity instrument could restore efficiency perfectly in the presence of an externality.

But in reality, governments do not have perfect information about these things. Covid-19 illustrates this: policy-makers had little time to figure out how costly lockdown would be for firms, or just how many lives would be saved. So how do we decide what to do?

Weitzman’s solution to the problem boils down to this: if you know how to value the externality, use a price instrument; if you know the efficient quantity, use a quantity instrument. With regard to Covid-19, the ‘efficient quantity’ would entail a level of restrictions whereby the spread of the disease is contained at as little cost as possible to the overall economy. The mathematics of exponential growth therefore give us a strong indication of the efficient quantity: we must prevent exponential growth of infections; we must keep the infamous ‘R’ parameter in the epidemiological models below 1.

What type of tax policy would cause this to happen is totally opaque. We have virtually no idea how people would respond to taxes on a wide swathe of activities that could spread Covid-19, or how to value the underlying externality here.

But the science of social distancing gives us a pretty good idea of what quantity restrictions would work. Thus, governments have used lockdowns – painful quantity instruments such as they are – and not taxes. The same decision was taken in the 14th century to fight the Black Death. Both decisions were in line with Weitzman’s analysis.

How should enforcement work?

Here things get a little more interesting. In the classic models, taxes and quantity restrictions are both perfectly enforced. Headlines about young partygoers or the prime minister’s top adviser violating rules make it plain that in reality, enforcement is imperfect.

The fact that administering policies can be difficult is a central focus of contemporary economic research, especially when it comes to taxes (Slemrod and Gillitzer, 2014). There is comparatively less research on enforcement of quantity restrictions, although economists interested in environmental issues do study this topic (see, for example, McAllister, 2010). Nevertheless, optimal enforcement of a quarantine is a trickier question to answer than the choice of which type of policy instrument to use.

Governments around the world have approached enforcement in varied ways. Some of the most stringent rules were imposed in East and South East Asian countries, which implemented strictly enforced lockdowns and extensive tracking. Perhaps the most lax approach was taken by Sweden, which imposed few legal restrictions or penalties but did issue general ‘guidance’, including social distancing. The UK falls somewhere between these, with restrictions that, based on the headlines and casual observation, were not aggressively enforced.

A quick glance at the mortality statistics suggests that stricter enforcement helped some countries initially threatened by Covid-19 to keep their mortality rates down. A more detailed unpacking of why policy varied so much by country, the political frictions involved, what ultimately led some countries to prevent more deaths and at what cost will surely keep researchers busy for many years to come.

How strict is too strict?

Every country that shuts down its economy feels immense pain, even if doing so saves lives. How to deal with this pain and incorporate it into our optimal policy analysis is the subject of continuing debate in many countries.

It is tempting to characterise the decision as a trade-off between economic damage and lives saved. The studies we have of the economic consequences of lockdowns suggest that things are more complicated than it might at first seem. For example, the economic contraction in Sweden was only very slightly smaller than the contraction in neighbouring Denmark, even though the latter implemented a strict lockdown and the former only some very loose guidelines (Andersen et al, 2020). This finding suggests that much of the damage wrought by the pandemic resulted not from government policy but from people’s own fears of the virus.

Governments should incorporate the economic costs of lockdowns into their decision calculus, but they must also be wary of overstating the economic benefits of easing lockdowns, and of short-term thinking. As has been seen in England in recent months, a resurgence of infections if lockdowns are lifted too soon for the economy’s sake can necessitate further lockdowns in the future, which in turn could cause tremendous economic damage (Kaplan et al, 2020).

Related question: How much will lifting lockdown start to reverse the UK’s economic slump?

Finally, the ideal strictness of a lockdown may also depend on the extent to which other policies can mitigate the associated economic costs. Most governments have combined lockdowns with a variety of fiscal policies to combat the worst economic damage wrought by Covid-19, including furlough or unemployment insurance schemes for workers and loans to keep businesses afloat. When they work well, these policies can make a strict lockdown far less painful.

One novel policy along these lines was the UK’s ‘Eat Out to Help Out’ campaign, which, in the wake of the first lockdown, subsidised people to eat at restaurants, which were particularly hard hit by lockdown. Notably, these subsidies are price instruments, and because of this, they had the added advantage of targeting benefits toward restaurants that, based on demand, are most valued by consumers.

Unfortunately, though, the government made the ill-advised decision to require that people actually dine in person inside a restaurant to receive the subsidy (Fetzer, 2020). Given that Covid-19 could still spread at this time, this policy directly subsidised diners to engage in an activity associated with a negative externality, contrary to a century of economic wisdom (Pigou, 1920).

Do lockdowns worsen inequality?

Finally, there is the question of what effect these policies might have on inequality. This reflects a tradition in economics of separating questions of efficiency from questions of equity. Externalities fall into the former set of questions – they make a market inefficient – and steps to curb them move an economy towards efficiency, although not necessarily towards an equitable or fair outcome.

Several studies find that Covid-19 is likely to exacerbate inequality in Western countries (Blundell et al, 2020; van Dorn et al, 2020). There are a number of mechanisms at play: high-income workers are more often able to work from home than low-income workers; a number of large corporations have benefited from the pandemic; and disparities in healthcare were intensified by the pandemic. Some of these mechanisms reflect a well-known disadvantage of quantity instruments: they redistribute away from those who, because of their preferences or circumstances, have a harder time adjusting to the restrictions (Stigler, 1971; Peltzman, 1976).

A textbook proposition in public economics is that when policy creates winners and losers, we should accept the policy as an efficiency enhancement if the gains to the winners outweigh the losses to the losers (Hicks, 1939; Kaldor, 1939). The idea is that in this case, the winners could compensate the losers and leave everyone better off.

With lockdowns, the winners are those that keep their lives, and those whose incomes and businesses do well; the losers are those who lose their lives, and those on the receiving end of the economic damage. When the winners tend to have higher income and wealth, the Kaldor-Hicks logic is not quite satisfactory: just because the winners could compensate the losers does not mean that society has the capability to redistribute resources to make the losers whole. And of course, we cannot compensate those who lose their lives.

In any case, equity concerns clearly played a role in the use of policy to limit the economic damage from Covid-19. It may be some time before we fully understand just how well these policies limited the economic fallout on vulnerable members of societies. When the Covid-19 crisis is finally over, countries will have to reckon with pandemic inequality, including the harms imposed on vulnerable people.

All this has happened before – and all this will happen again

The reasoning applied here to the externalities brought on by Covid-19 can be applied in similar ways to other externalities. In the early 1900s, Arthur Pigou was famously inspired to introduce externalities into the lexicon of economists by his experience of terrible air pollution in London. Currently, we see these same discussions – of price instruments versus quantity instruments, how to intervene without causing too much economic damage, or the distributional consequences of interventions – playing out in the debate about climate change.

In this context, the price instrument that many economists favour is a tax on carbon emissions. In reality, however, governments have found it easier to implement quantity instruments: emissions trading schemes, fuel efficiency standards for vehicles, mandates for energy saving devices and so on. The reasons that governments often use these interventions in lieu of a carbon tax are perhaps not so different from the reasons they have used quantity instruments to combat Covid-19. But in both cases, for Covid-19 and climate change, there are terrible consequences of waiting too long to take action.

Where can I find out more?

  • Consumer responses to the COVID-19 crisis: VoxEU column showing the big fall in consumer spending in the early phase of the crisis was mostly concentrated in goods and services where supply was directly restricted by government interventions.
  • Lockdowns and economic performance: Centre for Macroeconomics survey of economists in which the majority assess that lockdowns have caused limited economic damage beyond what the pandemic itself would have caused unabated, and that the economic costs of the autumn lockdown are limited relative to the milder measures employed this summer.
  • The effectiveness of lockdowns: learning from the Swedish experience: Analysis suggesting that lockdown in Sweden, which stands out among its European peers for not imposing one, would have reduced the number of Covid-19 infections by a half and deaths by a third.
  • COVID-19 and inequalities: Institute for Fiscal Studies report on the impacts of the crisis on inequalities across several key domains of life.

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Author: Daniel Reck
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