Thursday, November 20, 2008

The Tax Economics of the Auto Industry

It is estimated that U.S. automakers spend about $1600 per car on so-called legacy costs (health benefits for retirees) and another $800 per car on other union-related added costs, although some of the latter have been cut a bit due to recent negotiations with the UAW. This amounts to an implicit to a $2400-per-car implicit "tax" on American automobile sales that is not levied on the sales of foreign cars.

For the purposes of this essay, I follow the traditional (and likely dubious) assumption in tax economics that retiree benefits cannot be cut. It follows that automaker bankruptcy may free the auto consumer from paying for those retiree benefits, but only by shifting the burden to taxpayers and previous (stock and bond) investors in the U.S. auto industry. In the worst case scenario, taxpayers foot the entire bill, even for the $800-per-car in union related added costs.

Even if taxpayers make up for all of the revenue that would have been obtained by the implicit $2400 per car tax, taxpayers will be better off than they would be if U.S. automakers continue to operate under current union contracts because they are also auto consumers. This is a result known as "Ramsey's Optimal Tax Formula" -- if we must have revenue to pay off a politically favored group, it is better to finance the payoff with a broad-based tax (such as the federal income or payroll tax) than with a narrow tax such as an implicit tax on American auto sales. In this case, the benefits of taxpayer finance (rather than auto consumer finance) are quite large.

In theory, there is a caveat to this result. If the U.S. government had already been following the optimal tax formula, it would have taxed the auto industry more lightly in recognition of the UAW's implicit tax. In this case, changing the UAW's implicit tax into an explicit tax has no effect on the taxpayer-consumer.

Either way, given that the taxpayer is also an auto consumer, he cannot be worse off by letting car companies go bankrupt even though he recognizes that he will foot some or all of the bill for autoworker benefits.

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