Tuesday, April 1, 2014

Overhead Allocation vs. Theft

I was reading Dean Baker's excellent post today on high speed trading. My initial reaction was that this was simply theft, high frequency traders supply absolutely no value to anyone but reduce the gains made by legitimate traders.

The first comment, however, made me think. SteveB asks "I don't understand how the tax solves the problem. Wouldn't it just increase the spread between buy and sell prices, and make the exchange even less efficient?" This would be an instance where the government and private thieves are doing almost exactly the same thing. So why are they different?

An easy way to answer this is to compare what the government does to overhead. While the private thieves are simply skimming other peoples money a new government tax is more like a business adjusting how it applies overhead across its various business units. The new tax assigns more of society's cost to the trading sector while allocating the costs away from other productive activities.

While perhaps not the best way to describe government's role, the overhead analogy does bear a certain appeal for communicating government's role to the business minded. As organizations grow larger and more complex their direct costs tend to decline while overhead increases. A local mechanic shop is likely to have very high direct costs and low overhead compared to a company like Ford, yet Ford will be far more efficient despite so much of its costs accruing to overhead.

Something similar is happening as government's role expands. Modern society is vastly larger and more complicated than it was a few centuries ago. Modern businesses require employees with a much larger capital investment, does anyone think the graduates of a one room schoolhouse would be qualified for a Wall Street trading job? Modern capital markets are vastly more complex and trust between corporations requires a much more active oversight role today than it did in the past. I could go on ad nauseam, but the basic point is that modern businesses exist today only as a result of a large supply of social and institutional capital. Without this capital many would still exist but in a much smaller and less productive form.

So while a financial tax would result in a roughly similar decrease in profits accruing to the parties to the transaction this money would be going to indirectly support the activities of the traders. Resistance to these kinds of taxes are ultimately akin to a business unit arguing against the allocation of overhead assigned to it. While this can increase the book profitability of the unit, this often makes the enterprise as a whole less efficient since the individual unit is unlikely to have a full appreciation of the overall costs of the organization. This makes the organization as a whole less productive since costs are misallocated.

At an extreme, anti-tax fervor can be compared to a dirty salesman who asks for his project to be costed at "true"* cost and then goes ahead and sells at near list price, driving his margins and commissions way up by robbing the organization as a whole of the portion of cost allocated to overhead (many organizations have a sufficient level of control to prevent this from being done too blatantly, I don't think the 113th Congress is one of them).

Another point is that as more of our productivity results in overhead rather than direct cost it becomes increasingly easy for the egotistical and/or unscrupulous to argue that the increased productivity is the result of their efforts rather than from efficiencies stemming from an organization as a whole. This happens at both the national level and within organizations, with direct costs so low it also becomes more difficult to assign the overall productivity of an organization to individual members. Since Americans tend to be so individualistically oriented we are rarely satisfied with assigning results to the system, instead preferring to allocate costs and production to individual people; even when this is conceptually incomprehensible.

*I've run into a few organizations where the salesmen assume that the marginal product cost is the true cost. It can be very hard to make these folks understand that overhead really matters.

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