The Reformed Physicist

My wife and I have lived in downtown Ottawa for nearly 20 years. When we moved to Ottawa we chose the downtown core because we like an active lifestyle with amenities close by. Today, downtown Ottawa is rotting in no small part because of my progressive city councillor, Ariel Troster. She has welcomed a permissive attitude toward open air drug consumption, vagrancy, and general lawlessness. As I found out this week, she will not tolerate respectful disagreement on her social media accounts, blocking concerned citizens for politely challenging policy.

I have never met Ariel, but I have had interactions with her, including as a board member of my condo corporation. My immediate sense is a self-righteous know-it-all who feels that any disagreement with her is a symptom of your own moral failings. I am not surprised – activists who become politicians keep up a crusade-mindset instead of trying to reach reasonable compromises with diverse constituents. Activists want to engineer society; they are not interested in building a more operational – more tolerant city that works for everyone.

I don’t use social media much. I have an X and Bluesky account that I use mostly to reply to ideas from people I follow. I don’t hide behind an alias, and I don’t call people names on social media. On several occasions I have challenged Ariel on her policies that she advocates on Bluesky. This week Ariel proposed eliminating right turns on red lights in downtown Ottawa because of some recent incidents. She leaps on recency bias with her activist attitude, writing an op-ed in the Ottawa Citizen, calling for the city to change its downtown traffic laws. Unlike Ariel, I live in the core and I have a unique perspective on this issue because my wife and I don’t own a car and haven’t for over 20 years. Our bicycles are our sole means of transportation, year round. Responding to her Bluesky post, I pointed out that banning right on red will inconvenience drivers and that cyclists like myself have to reach compromises with motorists. A War-on-Cars attitude helps no one. You can see my post below.

Of course I expected the usual hate from Ariel’s followers – some of them responded to positively by Ariel, one of which had a user name that suggests cutting people’s heads off.

I then commented on Ariel’s post about her desire to make transit free for children along with reduced fares across the board. I pointed out that her idea is economically inefficient – the net beneficiary of such a policy are well-off civil servants who commute. If we want to help poor people, that’s fine, but do it without distorting prices or giving money to people who can definitely afford to pay. You can see my post below.

For these comments Ariel has blocked me on Bluesky, posting a message saying “This man needs new hobbies.” It appears that Ariel does not believe that the citizens of Ottawa should engage with their councillors, take an interest in their community, or challenge policy respectfully. She believes that her Bluesky account is not for engaging with the public, but only for pushing her brand of propaganda. Of course I have no time for those who use social media to threaten, abuse, or personally insult people, but that is not what is going on here as you can see from the screenshots of my Bluesky posts. I don’t expect Ariel to necessarily respond to my replies, though it would be nice if she did on occasion, but to block all content for disagreeing is unbecoming of a politician who claims to respect democracy.

The people of Ottawa, and Somerset Ward in particular, should have no illusions about Ariel Troster. Ariel is an activist only interested in championing causes for an uncompromising, militant, and aggressive minority of voters with little regard for people who have different priorities.

Activists make terrible politicians. Somerset Ward is case in point. Let’s remember that come October 2026.

Playing economic Master and Commander is just too much fun, I suppose. The temptation of other people’s money fuels the ambition of dirigistes the world over. Why bother with free markets and limited government when you know you’re better than everyone else? This week finance committee chair MP Karina Gould expressed concern when she learned that the Canada Pension Plan (CPP) invests only 12% of its total fund in Canada. She wants to understand why so little of the fund invests in Canada when, as she puts it, we could use the CPP to “bolster the Canadian economy”. And so the game begins!

To understand investment means understanding risk, return, and asset pricing – something to which our Prime Minister has purported expertise. Of all the publicly traded companies in the world, about 50% of the total market capitalization is American; just 2% is Canadian. A hard-nosed efficient market approach would therefore allocate a portfolio in the same proportion. If the whole world puts only 2% of its capital in Canada, why should anyone deviate? If anything, the CPP is already overweight Canada. On the other hand, when you have a political agenda and you see a big pile of money, thinking about optimal asset allocation becomes entirely secondary.

I find Ms Gould’s surprise this week itself surprising. Like almost all Canadians with her level of earnings, she almost certainly has investments and uses the help of an advisor. Her portfolio probably looks similar to the CPP with most of her assets invested outside of Canada and with about half in the United States. Not too many investment advisors will advise investing primarily in Canada. So if Ms Gould pays any attention to her own investment portfolio or that of her family and friends, the CPP allocation should not surprise her. Perhaps she’s playing at being naive – at least I hope so.

Of course “re-purposing” the CPP confers certain political advantages – the warnings from Public Choice Theory echo loud and clear. The real questions are: Why do we have a Canada Pension Plan at all? What problem does it solve? And more to the point, what problems does it create?

The usual answer we get from our betters: we need a national pension plan to prevent people in old age from slipping into penury. Without a national pension plan, the story goes, we would find grandmothers eating cat food. To avoid such national calumniates, the government takes some of your paycheck – for your own good – and puts the money into a fund where “top minds” make wise investment decisions. When you retire, you’ll reap the benefits. Yeah, yeah; it’s all bullshit.

First, “top minds” at the CPP do not beat the market on a risk adjusted basis. They do ridiculous things like invest in many different hedge funds at once. The problem is, the more hedge funds you invest in, the more your returns start to look like the index only at higher cost. They chase illiquid private equity with valuations that are at best guesses. The Plan has become a giant actively managed fund with fees of over $6 billion dollars per year (almost 1% of assets under management, if you believe the value of the almost certainly favourably priced private equity assets). The entire approach is silly. Markets are not so inefficient that the CPP can generate alpha. Canadians would do better using their CPP contributions to buy the S&P 500 along with a bond fund.

Second, in reality the CPP increasingly acts more like a disability benefits scheme with a pension attached to the side. Unless you become disabled, you will not receive what you contributed and you have no capacity to bequeath your share of the plan’s assets after death. While politicians sell the CPP as a great deal for Canadians, if you carefully look at how much you’re paying and what you’ll actually receive in retirement, few would voluntarily sign up. People can and do save for their own retirement while also using those assets as part of their estate planning. CPP contributions lower take home pay which displaces private investment. Sure, some people won’t save enough for retirement but it’s nowhere near as bad as fear-mongers suggest. Having the government take your money and invest it for you smacks of paternalism.

Finally, allowing the CPP to invest in risky assets makes little economic sense. The government has created a riskless liability in that it promises to pay you an exact pension amount in retirement according to some formula. But the government has tied this obligation to risky assets! Imagine that I make a promise to pay you $100 a year from now. If the riskless interest rate is 4%, I need $96.15 from you today to make good on the promise. If the risky rate is 10%, on average I only need $90.91 from you but if something bad happens I won’t have the $100 I promised. Tying riskless liabilities to risky rates of returns fails finance 101 but the government does it all the time, including with the public sector pension funds. Discounting with risky rates gives a rosy picture, but there is no free lunch. Implicit taxpayer funded bailouts provide the stopgap but if risky assets fail to perform, it probably means we hit bad economic times with a taxpayer who won’t be able make up the difference. It’s all fun and games while it works, and better yet, it will be some other government’s problem if it all goes sideways.

Compounding these three problems with the giant-pile-of-money-temptation and we can easily see that creating a national pension plan might not be such a good idea. As for seniors at risk of poverty or the disabled, we can handle that with special on-budget programs, not by reaching for yield with hedge funds. We don’t need the government to take people’s money for retirement, invest it in a risky actively managed high fee fund, all while transforming the program into a disability benefits scheme. People can invest their own money and make those who want to play Master and Commander find something else to do.

Real problems come out of the blue. They happen in an instant and the world changes forever. In November 2000, after wrestling with hanging chads, George W. Bush could not have imagined that his presidency would be defined by a late-summer Tuesday morning. Justin Trudeau’s “sunny ways” melted with his approach to a once-in-a-century pandemic. The world has a way of being radically unpredictable. It’s on those events which the world turns. The chattering class has a low imagination for where the real leviathans live.

Trump fills the headlines. Yes, his approach to trade is vandalism. Yes, he’s a blunderbuss. Yes, the usual crowd clutches pearls. He makes good TV and social media, but Trump is not the crisis. The real threat is a sovereign debt run and it hangs over the world like a Sword of Damocles. If it falls, the world will change as radically as it did at end of World War II.

In my previous post I pointed out how trade deficits are simply savings minus investment. When a country imports it must somehow pay for those goods and services. The importing country can pay with an exchange of its own goods and services or it can pay with financial assets. Paying with financial assets does two things, first, if savings are low, it generates a trade deficit for the importer, and second, it means that the importer must eventually pay back with real goods and services. In the end, money is a veil.

The United States runs a large trade deficit with China. China accepts US debt as payment for boatloads of iPhones and everything else Americans buy. But the Chinese will want to be paid back one day. The trade deficit results from low savings in the US – the government runs a giant fiscal deficit which largely funds extra consumption. In essence, by the Chinese accepting US debt as payment for imports, they finance the US fiscal deficit. As long as the Chinese believe that the payments will one day reverse – that is the Chinese will be able to collect on their debts with Americans eventually sending real goods and services to China – this arrangement can go on. But if the Chinese ever become convinced that they won’t get paid back, the US will suddenly find itself unable to roll over its debt at anything less than catastrophically high interest rates. The accounting identities, by definition, are going to hold. And it is not just the United States that has debt problems, so does Europe and Canada.

Sovereign debt runs happen fast. Everything seems fine until it isn’t. The periphery of the European Union saw debt runs in 2008-2009, but the rest of the EU could bail them out. There is nothing to bail out the United States or the entire EU. Sovereign runs on this scale would change the world so fundamentally that it is hard to guess the outcome.

The way to avoid such a nightmare is economic growth. It means lowering the fiscal deficit, especially reducing public spending that adds more consumption. We must encourage more savings which means lowering taxes that discourage it. We need to curtail bloated public administrations at all levels of government and public institutions, and roll back excessive regulation. And finally, we need to eliminate all tariffs, unilaterally if necessary. If we think that the rest of the world, and especially China, will be happy to accept Western debt as payment forever, we will destroy the world. Unfortunately, everyone is doubling down on more public spending, but man cannot live on debt alone.

While Trump captures the headlines, the real leviathan lurks.

Sometimes misconceptions really matter. A failure to understand, and an intransigence on misguided beliefs lead to disaster both public and private. It’s the spirit of a vandal.

Trump misunderstands accounting identities. He views a trade surplus as a win and a trade deficit as a loss. By his logic, the British Raj must have been the pinnacle of human achievement. Trump’s failure to understand the relationships in trade will impoverish Americans and the world over. For a country founded on a tax revolt, it’s strange to see the inheritors rejoicing in new taxes, declaring them a saviour.

A trade deficit simply means that you buy more from someone than you sell to them. As an example, nearly everyone has a trade deficit with the grocery store. You buy food, but you sell nothing to the grocer. On the other hand, you have a large trade surplus with your employer. You sell your labour and buy nothing in return. This is what a trade surplus and deficit means between nations. Canadians sell more stuff to Americans than Canadians buy from Americans. It’s tempting to talk as though Canada sells and the US buys, but it’s really millions of people and businesses making market decisions. Individual freedom is at the heart of trade. Perhaps Trump should take a careful read of the last stanza of his nation’s anthem and make sure to answer the question in the affirmative.

International trade is a large field of economics but we don’t need advanced training to understand the basics. Here are the essentials:

Imagine that a country generates output in a year. That’s everything made – cars, agriculture products, accounting services, everything. That output has to go somewhere. We can consume it (), the government can consume it (), we can invest it (), or we can export it (). That’s it; that covers where the output has to go. So:

(1)  

If exports are positive we have a trade surplus, if negative we have a trade deficit. The difference between what we produce and everything we consume is our savings ():

(2)  

Rearranging, we get,

(3)  

A trade deficit or surplus is determined by the difference between savings and investment. THIS IS AN IDENTITY. This is not a theory, this is the Piaget test of pouring water into different containers. The identity makes intuitive sense: If our savings equals our investment there is nothing left to (net) export.

In the case of the United States, is large; Americans run a large fiscal deficit. American consumers like to consume. They have a low savings rate; is high. The US has high production, , but investment, , is also high. As a result is negative for the US, yielding a trade deficit. To make positive the American consumer will have to consume less, the government will have to spend less, or the US must invest less. Unless some combination of those things happen, no matter what Trump does with tariffs, the trade deficit will remain. One way for Trump to get rid of the trade deficit would be to so damage American consumers that they have little opportunity to consume – drive C way down. Not fun in a democracy.

There is no sense trying to argue identities with a vandal. The optimal response is unilateral free trade. Allow Canadians to buy and sell from anyone, anywhere. Unfortunately, our political class is just as bad at arithmetic as Trump. Maybe we need to re-read our national anthem, too…

Canada is a great country. It is peaceful, wealthy, pluralistic, and democratic. Yet for all the positives, something rots in the foundations, quietly eating away at our national identity.

Not long after Justin Trudeau became prime minister, he made a remarkable assertion in the New York Times, “There is no identity, no mainstream Canada” making “us the first post-national state”. In the face of President Trump’s tariff threats, Trudeau bookended his time in office by adding, on American television no less, that Canadian identity revolves around not being American. It’s all an odd way to define a country, but a foreigner might be forgiven for not understanding the difference between the two countries. Both peoples know the intricacies of the infield fly rule and the consequences of five for fighting. Culturally we seem indistinguishable. Most Americans – and Canadians – would probably never guess that the most American of actors, Tom Cruise, fell in love with acting as a student at a Canadian public elementary school. When pushed for more substance, Canadians will place their identity on public health care, social programs, the Charter of Rights and Freedoms, our military contributions to both world wars, with a final nod to the principle of peace, order, and good government. But these are placeholders for identity. As much as it pains me to admit, Trudeau has his finger on something important.

Geography defines Canada and yet our founding institutions shoehorn the country into a spatial straitjacket. Ultimately, the architects of Confederation sought to solve the political problems of Canada West (Ontario) and Canada East (Quebec) by, in essence, creating a treaty between two founding nations. Confederation sees the rest of Canada as appendages, used occasionally to balance central priorities. Unlike the United States, Canada does not balance regional interests against popular representation. Canada has no body like the American Senate or the Electoral College. The founders favoured a strong federal government that forced the regions to accept the will of Ontario and Quebec. To them, regional power led to the US Civil War and British North America would not import the seeds of such disorder. But regionalism and division lurk in the shadows of Canada with an expectation that the prime minister will provide the glue. The result: an increasingly powerful Prime Minister’s Office that horse-trades with the provinces while side-stepping Cabinet. We long ago abandoned the precepts of responsible government in the name of an expedient form of executive-federalism. The prime minister is no longer the first among equals, Cabinet provides little more than window dressing. No prime minister in Westminster style governments the world over has more power than the Canadian one. Canadians instinctively understand the regional tensions. In 2016 both candidates for president of the United States came from New York City and no one thought to mention it. If the two main candidates for prime minister happened to both come from Edmonton ridings, it would create a national crisis.

When Canadians point to the world wars as part of our identity, we forget that Canada of the second half of the 20^th century is not the Canada of the first half. Canadians during both wars – and English Canadians in particular – thought of themselves as British subjects. What made us different from Americans was our commitment to the Empire, our adoration of the monarchy, and our deep ties to the United Kingdom. Even our currency sported multiple members of the royal family, including future Queen Elizabeth II as a child. In Quebec, Catholicism and the French language provided identity, “Les canadiens”. As the victors of WWII reorganized the globe, the time of empire finally came to a close. No longer a colonial outpost in the New World supporting an empire on which the sun never set, Canada needed an identity. Quebec with its quiet revolution threw off the Catholic Church, forging a new national sense of purpose while English Canada struggled for meaning. If we weren’t British, then who were we?

The zeitgeist of the 1960s, expressed through Pierre Trudeau, offered Canada an answer: we are a socialist minded people, bilingual, a cultural mosaic – not a melting pot, a country that eschews military power with a focus on multilateralism and peacekeeping, and a nation that embraces state intervention in the form of nationalized monopolies for the benefit of all. Privileging individual liberty smacked of gauche Americanism from yesteryear; collective rights were the future. With a new flag capturing this new Canadian identity, we could take our place in a brave new world of exuberant and ascendant global socialism. Prime minister Trudeau performing a pirouette behind the Queen, gallivanting with Castro, while maintaining a Walter Duranty-like admiration for Mao Zedong, put an exclamation mark on this confident, if not arrogant, new Canada.

Trudeau pere’s vision failed to live up to expectations. The shine of socialism faded around the world as global markets unlocked human potential and ushered in prosperity never before imagined. And yet Canadians continue to jealously guard their Crown corporations, managed industries, and cloistered oligopolies even as they have failed to deliver low prices or good services. Official bilingualism did not resolve the Quebec question. Two referendums on secession later – one narrowly defeated – today, Quebec lives in a solitude completely distinct from the rest of Canada. It is easier for English speaking Canadians to work in the United States than in Quebec. A Swiss-like linguistic trajectory is clear: Quebec will remain French, in part through provincial decree, while French will gradually disappear from almost the entire rest of the country. Years of neglect have led our military to a shambolic state. Long gone are the days when Canada controlled a beach at Normandy; our contributions to NATO make little difference. We disproportionally rely on intelligence from our allies for own domestic security. Today, our military ranks below Singapore’s. We can no longer build great national projects like pipelines. It is doubtful that the transcontinental railway of 1885 could be achieved by modern Canada. We have little sense of purpose other than to say that we cherish a state monopoly on health care, no matter how much it creaks and groans under the weight of increasing demand.

And while Canadians often point to the Charter of Rights and Freedoms as a touchpoint of identity, they have failed to read it. A popular federal government can constitutionally remove freedom of speech, and apply laws differentially based on race and creed. There is no separation of church and state. Canada’s head of state is literally the Supreme Governor of the Church of England. Public funding of Catholic schools is constitutionally protected. And while some might argue that convention has overtaken the actual text of the document, technically a federal government can reverse any provincial bill it doesn’t like. Unlike the American constitution, ours contains actual delineated powers that used to be used, but if used today would trigger the end of Confederation. Little anchors interpretation of the constitution within Canada’s living tree form of jurisprudence. I am not sure fair-minded Canadians would point to our constitution as superior to the American one.

Since the end of WWII, Quebecers found their identity, but the rest of Canada remains in the wilderness. We are a regional hodgepodge spread over an unkind geography. It’s easier to find Canadians apologizing for past wrongs than seeing them celebrate national accomplishment. Our founding statesman has turned into He-Who-Must-Not-Be-Named. We know more about the United States, its culture, its politics, than we know about ourselves. I am confident that Canadians understand the aftermath of the George Floyd riots far better than the issues behind the ongoing arsons, shootings, and sabotage in Nova Scotia’s lobster fishery. Maybe we are more American than we care to admit; perhaps in spirit, English Canada has already joined the Union.

For all its warts, I am grateful to be Canadian. I have had more opportunity made available to me in Canada than I deserve. Our motto of peace, order, and good government provides a worthy north star. To paraphrase Hemingway, Canada is a fine place and worth fighting for, but today, the whole country stands at a crossroads. We must find better answers to the question of Canadian identity than the ones offered by either Trudeau pere or fils.

President Trump has challenged us to do so.

Next week Canada will learn its Trump tariff fate. As the Canadian elite and its chattering class hand-wring over Trump’s tariff threats, politicians have arrived at a consensus that we must respond with our own tariffs and trade restrictions. Canada has no control over what Americans do, but we don’t have to compound the problem by doubling down on a defunct mercantilist view of trade.

Tariffs are import taxes. In effect, tariffs prevent ships from arriving at our ports filled with goods that our citizens want to buy at prices they find favourable. Tariffs restrict the freedom of the people to transact at the best deal they can find. It’s poor policy, but if a foreign country wishes to impose import taxes on their citizens, that’s their business. However, it makes zero sense for us to respond to their tariffs by preventing their ships from arriving at our ports. How is the best response to a foreign country’s restriction on their people’s market freedom to restrict our own people?

The silliness of the situation arises because most people and most politicians have a ridiculous mercantilist understanding of trade – that somehow trade is a zero-sum game. Trade between two voluntary parties makes them both better off, otherwise they would not have traded. Think of a friendly foreign country as a machine with strange inner workings. If Canada pours in just the right amount of wheat, oil, minerals, lumber, etc., the machine spits out cars, computers, and other things we like. More than that, we value the stuff we get from the machine more than the stuff we put into it. None of this trade is organized by government. Individual citizens create the trade networks from their own buying and selling and it makes us better off.

We don’t need free trade agreements. Edmonton and Calgary don’t have a free trade agreement; Canada doesn’t need one with the United States either. Free trade agreements are actually anti-free trade because their purpose is to delineate which domestic industries remain protected by tariffs. Canadian politicians arguing for retaliatory tariffs are not defending the interests of Canadian prosperity.

If we want to put Canada first, then allow Canadians to buy from and sell to Americans, without interference, whenever we want. Who knows, maybe President Trump will want the same deal for Americans.

Update

It appears that Trump’s real goal is to eliminate the trade deficit that the US has with Canada. It’s a bit of a strange idea. All the trade deficit means is that Americans buy more stuff from Canadians than Canadians buy from Americans. If you think about it, you have a huge trade deficit with every single business or store that you buy from. On the other hand, you have an enormous trade surplus with your employer. No one pulls their hair out because they have a trade deficit with the grocery store.

OK fine, Trump wants Canadians to buy more stuff from Americans than Americans buy from Canadians – hence his 25% tariffs. Tariffs are a form of taxation. But will Trump’s tariffs accomplish his goal? And in the end who bears the tax incidence of the tariffs? It’s not clear because the exchange rate shock absorbs the effect – changes in trade also change the demand for each country’s respective currency. Broadly there are three scenarios:

1) The effect of the tariffs and the realignment of trade perfectly balance such that the exchange rate does not change. In that case, Americans pay more for Canadian imports and so their demand will drop. Canadians continue to buy just as much from the US (if we don’t apply tariffs) because Canadians see the same price for American products as before the tariffs. The entire tax incidence of the tariffs falls on Americans and the trade deficit with Canada shrinks. Americans bear the cost of the tariffs, the US-Canada trade deficit is much smaller or eliminated, and apparently Trump is very happy. Weird, but whatever.

2) The tariffs cause the Canadian dollar to depreciate somewhere between 0% and 25%. In that case, Canadians buy less from Americans as American products become more expensive. However, Americans continue to pay more for Canadian imports, but not as much as in the first scenario because the stronger US dollar softens the blow for them. What happens to the US trade deficit is unclear – maybe it goes down a bit, maybe up a bit, but probably it doesn’t change much. Americans and Canadians share the tax incidence of the tariffs. Trump grumbles that his tariffs aren’t doing enough.

3) The Canadian dollar depreciates by the full amount of the tariff, 25%. In this case, Americans continue to buy just as much from Canadians as before the tariffs (again if we don’t add tariffs ourselves) because the exchange rate perfectly offsets the tariffs. Canadians see much higher prices for American products so we import less. In this case, the US trade deficit with Canada INCREASES, but the entire tax incidence of the tariffs falls on Canadians. Even though Canadians bear the cost of the tariffs, Trump finds the result unacceptable – what wild tales he’ll spin, who knows.

The anchor to the problem is the accounting identity: Net Exports = Savings – Investment. Since US savings and investment are not likely to change, the US trade deficit with Canada is also unlikely to change. Probably something like case 2 is in our future.

Again, the best thing for Canada to do is nothing. If we must do something, eliminate all tariffs with everyone in the world – including the US. It’s hard for Canadians to claim moral principle over Trump when we have all kinds of protective tariffs on dairy, and other agriculture products. If you think we are justified with our existing tariffs, then you have to accept that Trump is justified with his protectionist arguments; he’s just making them on a larger scale.

Unilateral free trade is the only sensible answer to American tariffs. We have an opportunity to increase our own prosperity, regardless of what Trump does or doesn’t do.

Economics is a beautiful discipline. Done right, it’s a science on par with physics. Unfortunately, too often, economists debase their discipline when they speak in the press. The public remains confused, and convinced that economists can get any result they want – a truly dismal science. Case in point is professor Trevor Tombe’s article in The Hub Why raising capital gains taxes makes sense—yes, really. Instead of helping the public understand the economic reasoning behind taxes on capital income, Tombe simply runs cover for the recent federal budget. Maybe everything in the budget is wonderful, including the new treatment of capital gains, but if economists want to explain the idea to the public, perhaps treating their discipline like a science instead of political punditry would be a good start.

What is efficiency?

Efficiency is a technical concept in economics and Tombe serves to confuse the public by using the word casually. Tombe says “An efficient tax system is one that is neutral and doesn’t bias such decisions.” Sure, but efficiency means far more. In economics efficiency hinges on the Pareto criterion: economic activity that makes everyone better off without making anyone worse off. For example, if you have more wheat than barley and your neighbour has more barley than wheat, and if you can find mutual agreeable terms, a trade would make you both better off while hurting no one. In economics, Pareto efficiency provides the foundation for understanding markets and policy intervention. In an idealized free market the entire economy becomes Pareto efficient through mutually improving trades, leaving the government or central planner with little if anything to do. In reality, markets are not perfect and just because an idealized society is Pareto efficient, for subjective reasons, we might not like the distribution of wealth, even if arrived at through voluntary means. Regardless of the government’s wisdom, it must generate revenue to fund programs. An optimal tax policy ensures that revenue collection minimizes additional distortions to decision making that further break the Pareto criterion. That’s what Tombe means by an efficient tax system, but keep in mind governments that redistribute wealth almost always sacrifice efficiency for equity. Maybe for political harmony it’s a good idea to give up some efficiency for equity, but economics as a science can’t offer too much about what is “fair” – that’s why we have philosophy (and a democracy).

Why tax capital gains differently?

Tombe provides a confused answer to this question. He starts with the argument that a dollar is a dollar, suggesting all sources of income should be taxed the same. He then compares the special capital gains treatment an investor receives when selling a second home to the need for partial capital gains inclusion on corporate profits because of existing corporate taxes. The implication is that second-home investors are still “not paying their fair share” but the corporations and shareholders at the new inclusion rate are. Tombe provides a graphic showing Canada’s “improved fairness” from the federal budget’s increase in the capital gains inclusion rate. Hurrah! The new capital gain inclusion rate is both more efficient and more equitable – the Holy Grail of economic policy!! Yeah, none of this is economics.

Remember: optimal tax policy requires that the government raises its revenue in a way that distorts decision making the least by keeping the Pareto criterion intact as much as possible. It is not clear – and it does not follow from anything in Tombe’s article – that equalizing tax rates across labour and capital accomplishes this goal. Optimal taxation economics shows that it actually does matter how a dollar is generated. There is an enormous body of research on this topic which Tombe completely ignores.

Optimal taxation theory has a core result, the Chamley–Judd theorem. This theorem states that over a long time horizon, the optimal tax rate on capital income goes to zero. More than that, the theorem shows that taxes on capital over the long run harm workers – capital taxes end up Pareto inefficient. The intuition is simple: when the capital stock shrinks, less is left for reinvestment which means lower productivity, less innovation, and therefore less consumption and leisure possibilities for workers (of course there are a lot of important details I’m skipping). The result is mathematically technical with lots of “ifs” that approximate the real world but none of which hold exactly. Chamley-Judd provides an important background result for thinking about optimal tax policies – optimal tax polices robustly separate capital income from other sources. Applying economics as a science in this instance is about identifying, through careful empirical and theoretical research, how the “ifs” of Chamley-Judd and the related literature are violated in a real economy at an actual point in time. One example of a violation is tax arbitrage created by shifting labour income to capital through various compensation schemes. Careful work can help determine the optimal tax rate on capital income in a real world situation. Where we land is complicated. Tombe offers no such insight and teaches us nothing about these difficult questions as they pertain to Canada. Instead he provides book-keeping accounting about “fairness”.

Economists, be scientists!

I don’t know what the optimal tax rate on capital income in Canada should be. Based on Tombe’s article, I don’t think he does either. Maybe capital gains inclusion rates should be increased because of the specifics around the failures of the assumptions behind Chamley-Judd, and those increases will lead us closer to an optimal tax policy. Or maybe taxes on capital income should be higher even though they will lead to inefficiencies and lower economic growth because the trade-off is politically savvy. Or maybe they should just be lower. I don’t know. Whatever the level, an evidence-based approach looks nothing like Tombe’s article.

For all economists out there: Please treat your discipline like a science. When given the opportunity teach the public, start from scientific principles like physicists do. Economics does not have to be the dismal science!

On X, Professor Stephen Gordon issued a challenge to rebut An Open Letter from Economists on Canadian Carbon Pricing. Professor Gordon, challenge accepted.

First, I want to make clear that we are talking about the real world – and that includes everything that goes into the climate change agenda, from carbon taxes to public choice. The carbon tax debate is about something much larger than an idealized commodity tax used to mitigate an externality as argued from a second year undergraduate econ textbook. The public and the political parties are well aware of the real debate taking place: Climate change mitigation is an invitation to an incredible centralization of government power of which a carbon tax is not a replacement for inefficient alternative policies, but the first of many potentially slippery steps toward dirigisme. How much centralization of power, with all the risks and threats to liberty and economic growth that that power entails, is worth it for mitigating the externality created by greenhouse gas emissions? In that sense An Open Letter from Economists on Canadian Carbon Pricing is naively partisan and the letter will be used by the political class for its partisan implications. They’ve already started.

Yes, the economists are right about the efficiency of a commodity tax with rebate, which is the essential content of their letter. Carbon burning activities are normal goods and higher prices will reduce demand. Wealth compensation will restore, and in many cases improve, the original utility level of most consumers at a lower level of carbon consumption, even if they can afford their previous consumption level. Distorting effects follow the standard triangle of the second order of smallness deadweight loss arguments (provided the absence of other pre-existing margins of distortion). As policies go, using prices to do the work of resource reallocation is far more efficient than top-down government decree. The basic idea is that the market price of carbon burning does not reflect the full cost to society and the commodity tax restores cost/benefit margins across consumption. Basic econ; got it. And it has nothing to do with the carbon tax debate in Canada.

Let’s deal with the size of the externality. The open letter is a little sneaky here and I think academics who are trying to educate the public on an important issue could do better. They state:

“A conservative estimate is that the impacts of climate change will cost our economy at least $35 billion by 2030, and much more in future decades.”

Fine, but starting from when? What the letter leaves out is that the $35 billion by 2030 is the estimated cumulative total cost from 2015. The $35 billion is not an annual figure; the letter should have made this point more clear. Canada’s GDP is about $2,000 billion per year. From 2015 to 2030, the total cumulative GDP is about $30,000 billion making the effect size of climate change about 0.1% of GDP per year. Economics always stresses the opportunity costs of alternatives. Why are we spending so much time and energy, let alone real money, on a problem with an effect size of 0.1% per year of GDP? How is that a “a real threat to Canadians’ economic well-being”? Even if the effect grows to 0.2% per year, it means that the economy would be about 15% smaller than it otherwise would have been in the year 2100. The real problem is that are in fact many pre-existing margins of distortion much more severe than climate change – inefficient taxes on capital and labour, rent control, marketing boards, red-tape in small business formation, over-regulation, protectionist tariffs, misaligned entitlements, and rent-seeking channels in nearly every walk of life from health care to hair styling. All of these issues shave off growth at least ten times greater than climate change and perhaps much more, and they are potentially much easier to deal with. Getting the basics wrong means we will squander perhaps as much as 1,000% of economic growth potential over this century – the difference between 5% and 2% GDP growth per year. Just imagine if the airplane was invented today. In our hyper-regulated world, how long would it have taken before a government would have allowed a business to carry passengers? Thankfully, the real world saw its first regularly scheduled airline service just 10 years after the Wright brothers at Kitty Hawk. If the signatories wish to be taken as non-partisan as they claim, perhaps instead of presenting the idealized arguments from an undergraduate lecture about the efficiency of a commodity tax with rebate that is super important to only one side of the political spectrum, they could pen a full-throated open letter that emphasizes those areas where Canada could make the greatest improvements to the growth rate of the economy. In the end, it’s economic growth that shatters poverty, pays for social programs, and eventually leads to a world with cleaner energy and a cleaner environment. A sclerotic and an anemic economy is the real threat to Canadians’ well-being; climate change mitigation chases couch change.

The Canadian public understands the carbon tax debate far better than the experts might imagine. The public is being asked to pay for a small, if not minuscule, externality in the present that will not move the needle on the issue globally. More importantly, the Canadian public sees climate change mitigation as an overwhelming call to centralize power. Politicians and activists supportive of the carbon tax also generally advocate for heavy government industry intrusion, with the carbon tax but one of a plethora of dirigiste policies. For similar reasons Milton Friedman opposed creating a negative income tax as just another welfare program on top of a behemoth system. The public will not believe any party that promises to implement a carbon tax in lieu of all other climate change mitigation programs and nor should it. The public also sees many, if not most, of those same advocates and politicians using climate change as an opportunity to address a long wish list of progressive causes. Whatever the merits of those causes, they have nothing to do with the simple argument of restoring marginal costs and benefits associated with an externality, and the public knows it. It’s true that climate change is a big collective action problem but mitigation creates a giant public choice problem with all its attendant real world capture issues. No government that depends on the climate change mitigation vote can withstand those power-centralizing pressures. Perhaps this is the reason so much political capital is spent on the climate change agenda. Opposition to the carbon tax is a political signal that says:

Given the smallness of climate change effect sizes on the economy, the trade-off from living with the externality is worth it, rather than accepting a slippery slope that centralizes power, magnifies regulatory capture, and portends a threat to liberal democracy itself.

Maybe the opposition is wrong and we have nothing to fear from the centralization of power, despite Eisenhower’s warning, but this is the real value-based debate Canadians are having through their elected representatives. The signatories might be right on the academics of curve pushing, but they are very wrong in understanding the nature of the political question being put to the Canadian public. And that’s why democracy with all its sham, political theatrics, and broken promises is far better at judging the real evidence than economists give credit. Let’s not forget Kennedy’s lament after the Bay of Pigs disaster:

“How could I have been so foolish to have trusted the experts?”