March 19, 2018 2:02PM

The IRS Took the Road Less Traveled By, Yet Judges Still Made All the Deference

In 1984, George Orwell famously defined “doublethink” as “holding two contradictory beliefs in one's mind simultaneously, and accepting both of them.” But even Orwell would blush at claims made by the Internal Revenue Service that one can somehow both follow the law and violate it with the same activity. Amazingly, this seems to be the exact argument employed against Duquesne Light Holdings and subsequently upheld by the U.S. Court of Appeals for the Third Circuit.

In the early 2000s, Duquesne filed a series of consolidated tax returns along with its wholly owned subsidiary AquaSource. Despite initially declining to challenge the company’s deductions in a 2004 audit, the IRS later determined that the losses claimed constituted a double deduction. Even though the company painstakingly followed the tax code and regulations to the letter, the IRS relied on a strained interpretation of an 80-year-old case, Charles Ilfeld Co. v. Hernandez (1934), to disallow $199 million in losses, demanding a $36.9 million payment.

The Third Circuit’s endorsement of this odd use of Ilfeld creates a broad new view of federal agency power. Rather than understanding Ilfeld as a background presumption for evaluating ambiguous agency rules, this new doctrine allows agencies to override their own regulations to penalize those who violate some unarticulated, uncodified policy principle. Duquesne followed the rules, which did not prohibit the deductions it claimed. But rather than allowing deductions that were legally authorized, the court imposed a “triple-authorization requirement” mandating an additional okay, specifically stating that the deductions may be taken together. In other words, the court said that it isn’t enough for the law to say “you may take deduction A” and elsewhere “you may take deduction B”; the law must then also explicitly say “you may take deduction A and deduction B at the same time.”

The court’s decision continues the long march toward unrestrained administrative power via judicial abdication. First came Chevron deference, whereby courts must defer to the statutory interpretation of the agency that enforces the relevant statute. Then came Auer deference, requiring that courts defer to an agency’s interpretation of its own ambiguous regulations. But the Third Circuit has now gone a step further, ruling that an agency can reinterpret its own unambiguous regulations to mean whatever it wants. If Auer deference is a jurisprudential black eye, then the Third Court’s decision here is an ocular enucleation.

The ruling against Duquesne amplifies three particular concerns that are endemic to Auer deference. First, both Auer deference and this case implicate separation-of-powers concerns. While Auer deference allows an agency to interpret the regulations that the agency itself promulgated, this new “Duquesne deference” would enable an agency to create, enforce, and adjudicate while at the same time completely ignoring the rules it previously created in its legislative capacity.

Second, both Auer and would-be Duquesne deference undermine the Administrative Procedure Act. By requiring that courts only give deference to agency interpretations of ambiguous regulations, Auer creates the perverse incentive to avoid APA rulemaking procedures by intentionally drafting vague, open-ended regulations that can later be interpreted as the agency sees fit. But this new deference would allow agencies to invoke policy concerns as an easy means of overriding even unambiguous regulations. Under that view, APA rulemaking is not just subject to potential agency abuse, it’s irrelevant.

Third, all this deference deprives regulated entities of fair notice of the rules they must follow. Auer deference at least allows those being regulated to attempt an educated guess about the meaning of an ambiguous regulation, but its expansion to covering even unambiguous regulations would allow agencies to convert regulatory certainty into unpredictability without any warning at all.

Because violations of unwritten rules are not legally punishable and the current deference given to administrative agencies is already bad enough, Cato has filed a brief asking the Supreme Court to review Duquesne Light Holdings v. Commissioner of Internal Revenue. The Court should clarify that no agency may use presumptions to penalize actions that are authorized by the express terms of that agency’s own regulations.

March 19, 2018 1:14PM

Yi Gang to Head China’s Central Bank

Yi Gang, an American-trained economist who taught at the University of Indiana, will take over as governor of the People’s Bank of China. Since 2008, he has been deputy governor under Zhou Xiaochuan, who became head of the bank in 2002. The unexpected appointment of Mr. Yi will provide continuity at the PBOC and lend credibility to the pledge for financial liberalization.

Following his appointment, Yi Gang declared: “The main task is that we should implement prudent monetary policy, push forward the reform and opening-up of the financial sector, and maintain the stability of the entire financial sector.”

In November 2007, Yi Gang spoke at Cato’s Annual Monetary Conference, and his speech, “Renminbi Exchange Rates and Relevant Institutional Factors,” was published in the Spring/Summer 2008 Cato Journal, which also included an article by Fed Chairman Ben Bernanke. That special issue of the CJ raised important questions about the types of monetary regimes that best protect the value and stability of money while promoting economic freedom.


Yi Gang speaking at Cato's Annual Monetary Conference in 2007

Yi Gang speaking at Cato’s Annual Monetary Conference in 2007

In his article, Yi Gang, then deputy governor of the PBOC, gave a detailed view of the evolution of China’s exchange rate regime and argued that real reform takes time, so the West should be patient. He concluded:

The RMB exchange rate is an economic issue. The best way to bring about an equilibrium exchange rate is further reform. Constructive dialogue will help speed up the reform process and make the convergence to a new equilibrium smoother. However, it should be noted that it takes time to establish an efficient market. . . .

To move toward equilibrium, coordinated policy measures are needed for structural adjustment. To resolve China’s large trade surplus and restore external balance, measures are required for promoting domestic demand, increasing imports, investing abroad, and accelerating urbanization—in addition to currency appreciation. In fact, many measures can generate impacts similar to currency appreciation, such as imposing environment protection requirements, enhancing labor standards, strengthening labor protection, and upgrading the judiciary system. All these measures mean higher costs, lower competitiveness, and a reduced trade surplus, which will move the economy toward equilibrium. Also, it is important to recognize that it will take time for these measures to bring about structural changes. Policymakers in Washington and elsewhere should therefore be patient as China makes its way toward a full-pledged foreign exchange market [Yi Gang 2008: 195–96].

As governor, Yi Gang will work closely with Liu He, the newly appointed “economic czar” and vice premier, who is also in favor of economic reform.  By making these appointments, President Xi Jinping is signaling that he intends to address structural problems in China’s economic system. The question is whether he can do so while maintaining an iron grip on political power and preventing a free market in ideas.

Cracking down on dissent will be the job of Yang Xiaodu, who has been appointed to head the new National Supervisory Commission (a super “anti-corruption” body), designed to ensure that officials and public-sector workers adhere to the Chinese Communist Party line.   

President Trump and his advisors should listen carefully to the PBOC’s new governor and Mr. Liu and work with them to help move China toward a more liberal trading regime, including a larger scope for trade in ideas as well as in goods and services.

Meanwhile, President Xi, who now has absolute power for life, should remember the words of Lao Tzu:  “The more restrictions and limitations there are, the more impoverished men will be. . . . The more rules and precepts are enforced, the more bandits and crooks will be produced. Hence, we have the words of the wise [sage or ruler]: Through my non-action, men are spontaneously transformed. Through my quiescence, men spontaneously become tranquil. Through my non-interfering, men spontaneously increase their wealth” [Chap. 57, Tao Te Ching, translated by Chang Chung-yuan].


March 19, 2018 11:45AM

Small Marijuana Growers Squeezed Out by Legalization and Regulation

It's often been noted that regulations can impose larger relative costs on small businesses and can serve to protect incumbent firms from new competitors. Goldman Sachs CEO Lloyd Blankfein noted that new regulations created a "moat" around his firm:

That all industries are being disrupted to some extent by new entrants coming in from technology. We, again, being, you know, technology-oriented ourselves, try to disrupt ourselves and try to figure out what's the new thing, and come up with new platforms, new forms of distribution, new products. But in some ways, and there are some parts of our business, where it's very hard for outside entrants to come in, disrupt our business, simply because we're so regulated. You'll hear people in our industry talk about the regulation. And they talk about it, you know, with a sigh: Look at the burdens of regulation. But in some cases, the burdensome regulation acts as a bit of a moat around our business.

The Washington Post reports on a new example: the legalized marijuana market in California. Libertarians have long urged the legalization of marijuana and other drugs. Certainly I expect better results from a legal regime where people are not arrested for buying, selling, or using marijuana. But governments can't just repeal laws and stop arresting people; instead, they prefer to set up a regime of taxes and regulation. And that's having an effect on the small marijuana growers in the state's "Emerald Triangle." As Scott Wilson reports in the Post:

Humboldt County, traditionally shorthand for outlaw culture and the great dope it produces, is facing a harsh reckoning. Every trait that made this strip along California’s wild northwest coast the best place in the world to grow pot is now working against its future as a producer in the state’s $7 billion-a-year marijuana market.

A massive industry never before regulated is being tamed by laws and taxation, characteristically extensive in this state. Nowhere is this process upending a culture and economy more than here in Humboldt, where tens of thousands of people who have been breaking the law for years are being asked to hire accountants, tax lawyers and declare themselves to a government they have famously distrusted. 

Wilson estimates that "Fewer than 1 in 10 of the county’s estimated 12,500 marijuana farmers are likely to make it in the legal trade....Less than 1 percent of the estimated 69,000 growers statewide have received a permit to farm marijuana since the beginning of the year."


As many experts on drug prohibition predicted, prices are dropping in the legalized market. But for Humboldt and neighboring counties, the price drop is happening

at a time when small growers most need the money to begin complying with California’s stiff regulatory demands. At the same time, the state’s licensing of retail shops has been slow, leaving a lot of legal product without a legal place to be sold.

Marijuana from Humboldt that used to sell for $1,200 a pound three years ago is now selling at a 75 percent discount. State officials and many growers predict the vast overproduction will be curtailed by the new rules, likely by consolidating cultivation among large agriculture companies that can afford the regulations.

Humboldt countians feared this sort of effect. Wilson notes the history:

The population grew and changed in the 1970s, when disaffected hippies migrated north, a “back to the land” exodus from the Bay Area that brought a contempt for government ethos here. Marijuana emerged as the county’s next-generation commodity.

There is no reason people chose Humboldt to grow marijuana other than that Humboldt, as a society, allowed it to be grown. The same was true for neighboring Trinity and Mendocino counties. Collectively, the three are known as the “Emerald Triangle,” a globally renowned pot paradise.

And so in 2014 a lot of Emerald Triangle growers opposed Proposition 64, the legalization initiative, because they foresaw that it would lead to bigger companies squeezing out small growers.

It's definitely a good thing to stop arresting people for marijuana. But once again regulations are going to serve to concentrate an industry and thus concentrate wealth. Chances are, a few people are going to get rich in the California marijuana industry, and fewer small growers are going to earn a modest but comfortable income. Just one of the many ways that regulation contributes to inequality.



March 19, 2018 9:03AM

Hospitalized Patients Are Civilian Casualties in the Government’s War on Opioids

A recent story by Pauline Bartolone in the Los Angeles Times draws attention to some under-reported civilian casualties in the government’s war on opioids: hospitalized patients in severe pain, in need of painkillers. Hospitals across the country are facing shortages of injectable morphine, fentanyl, and Dilaudid (hydromorphone). As a result, trauma patients, post-surgical patients, and hospitalized cancer patients frequently go undertreated for excruciating pain.

Hospitals, including the ones in which I practice general surgery, are working hard to ameliorate the situation by asking medical staff to use prescription opioid pills such as oxycodone and OxyContin instead of injectables, when possible. But many patients are unable to take oral medication due to their acute illness or post-operative condition. In those cases, we are often asked to use injectable acetaminophen, muscle relaxants, or non-steroidal anti-inflammatory agents. But many times those drugs fail to give adequate relief to these patients—which is why they are not the first line of drugs we use.

The shortage is uneven across the country. Some hospitals are feeling the shortage worse than others. According to the American Society of Anesthesiologists, the shortage is so severe in some hospitals that elective surgeries—such as gallbladder and hernia operations—have been postponed.

Some hospitals have resorted to asking nursing staff to manually combine smaller-dose vials of morphine or other injectable opioids that remain in-stock as a replacement for the out-of-stock larger dose vials. Dose-equivalents of different IV opioids vary and are difficult to accurately calculate. This increases the risk of human error and places patients at risk for overdose, as was explained in a letter to the U.S. Drug Enforcement Administration by representatives of the American Hospital Association, American Society of Anesthesiologists, American Society of Clinical Oncology, American Society of Health-System Pharmacists, and the Institute for Safe Medication Practices. The letter asked the DEA to adjust its quota on the manufacture of opioids to help mitigate the shortage.

As part of the effort to address the opioid overdose crisis—which is really a fentanyl and heroin overdose crisis—the DEA, which sets national manufacturing quotas for opioids, ordered a 25 percent reduction in 2017 and another 20 percent reduction this year.

National shortages of drugs are not confined to injectable opioids. Over the years, various drugs in common use have gone on national “back-order” and health care practitioners have had to develop workarounds. The causes of these recurring shortages, not unique to the US, are complex and multifactorial.

For example, regulations and market forces have led to consolidation in the pharmaceutical industry and, for some drugs, have reduced the number of manufacturers to just one or two. Reimbursements to manufacturers of generics by Medicare and other third parties have reduced profit margins to levels that, in some cases, have caused manufacturers to leave the market.

The Food and Drug Administration also plays a major role. FDA regulations of manufacturing facilities add to costs and sometimes lead to temporary plant closures in order remediate the findings of FDA inspections. According to testimony given to Congress in 2011 by Scott Gottlieb (now the FDA Commissioner), many of the FDA’s drug production safety policies are outdated and inflexible: “…The FDA and the manufacturers often don’t understand the drug-production processes well enough to detect the root cause of problems. Instead of calling for targeted fixes of troubled plants, the agency has often required manufacturers to undertake costly, general upgrades to facilities. As a result, in 2010, product quality issues – and the subsequent regulatory actions taken by FDA to address these problems – were involved in 42% of the drug shortages.”

In February 2017, an FDA inspection found significant violations in Pfizer’s McPherson, KS manufacturing facility, where injectable opioids are manufactured, which was followed by a cutback in production at that plant in June 2017. Pfizer controls roughly 60 percent of the injectable opioid market. This production cutback has played a major role in the current injectable opioid shortage.

Another factor is the FDA’s generic drug approval process. While Commissioner Gottlieb is committed to streamlining the process, it has been historically slow with large backlogs in applications. The median time to approval in 2016 was 47 months.

Also, disruption in the production supply chain—sometimes by natural disasters such as Hurricane Maria in Puerto Rico—can lead to temporary shortages, although this has not been a factor in the present opioid shortage.

But the above elements already existed before the DEA decided to help “fix” the opioid overdose problem. The DEA’s decision to make deep cuts in the national quota for opioid production only exacerbates the situation. The DEA made the quota determinations based upon the fatal conceit (an attribute of all central planning) that the agency can know how many opioids will satisfy the needs of this nation of 325 million people. Ms. Bartolone quotes the agency as saying, “DEA must balance the production of what is needed for legitimate use against the production of an excessive amount of these potentially harmful substances.”

Non-US injectable opioid manufacturers have received numerous requests to relieve the shortage but importing heavily regulated narcotics from other countries is complicated and difficult, requiring federal approval.

To address the alarming and steadily rising rate of overdose deaths, policymakers seem intent on reducing the prescription and supply of opioids by doctors to patients. Failing to recognize that the deaths are the result of nonmedical users accessing dangerous and potentially tainted drugs in a black market caused by drug prohibition, they charge full speed ahead, blinders tightly fastened. Patients in pain—and the doctors who want to help them—are the collateral damage in this futile war.


March 16, 2018 4:06PM

Economists Fail at Forecasting and Micromanaging

In a new study, economist Mickey Levy included a chart illustrating the inaccuracies of Federal Reserve economic forecasts. Levy is with Berenberg Capital Markets and a member of the Shadow Open Market Committee.

The chart shows the Fed’s year-ahead projections for real GDP (gray bars) and actual GDP (red bars). The projections are often way off, which is remarkable since the Fed has hundreds of skilled economists and access to unparalleled statistical and anecdotal economic data. The Fed generally overestimated growth until 2016, but for 2017 it underestimated.

Media Name: fed_res.png


Levy’s study concludes:

“The clear pattern of the Fed’s forecasting errors reflects the Fed’s tendency through 2016 to over-estimate the stimulative impact of extending its unprecedented monetary ease well after the recovery was self-sustaining, and tendency to under-estimate the economic impacts of the government’s fiscal and regulatory policies and other nonmonetary factors.” By the latter items, Levy means “the government’s tax and regulatory policies that increased business operating costs, raised uncertainties and dampened business confidence.” 

More recently, “There has been a marked change in regulatory and tax policies that have changed the economic landscape, and the Fed’s perspective on the economy seems to be lagging behind. The Fed’s forecasts understated the dampening impacts of tax policy and growing web of burdensome regulations through 2016, and those policy thrusts have now reversed. The pickup in economic growth—both business investment and consumption—beginning in 2017 has been supported by the shift toward deregulation and the associated sharp rise in confidence.”

I have noted that CBO economic projections are also pretty bad. The agency missed the onset of the last recession, and over a recent 15-year period its projections of real growth for the following year were 1.7 percentage points off, on average. That indicates huge errors given that the average growth rate during the period was 2.1 percent. (Discussed here.)

If the government cannot predict the future, it won’t be able to successfully micromanage the future through interventionist monetary and fiscal policies. That is especially true because government is such an inflexible institution and has trouble changing course. I discuss these themes in this study on government failure.

What then should policymakers do? Economist Adam Smith advised them to adopt the “simple system of natural liberty.” By removing government interventions “the sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society.”

Levy penned a recent study for Cato Journal here.

March 16, 2018 3:32PM

Local Taxes: Death by “Special Revitalization”

At the Washington Post, Rachel Chason reports on how the Washington, D.C. suburb of Seat Pleasant, Md. has just levied an eight-fold tax hike on five local businesses, with one seeing its $5,991 tax bill jump to $55,019. Several of the owners are suing, but the town says it went through the proper procedures needed to adopt a special tax, which is supposed to be predicated on the provision of amenities such as sidewalk improvements that are of special benefit to the taxed properties. One business owner says he and others didn't learn about a hearing on the measure until it was too late.

Whoever wins in the court challenge, the episode symbolizes a wider problem. Specialists in local and state government policy are full of ideas for business-by-business and location-by-location tinkering with tax rates, both downward (as part of incentive packages to lure relocating businesses) and upward (to finance special public services provided in some zones, such as downtown revitalization). But there is a distinct value in terms of both public legitimacy and the rule of law in having uniform and consistent taxation that does not depend on whether a property owner or business is on the ins or on the outs with the tax-setting authorities. It is not necessarily wrong for your tax bill to vary based on services rendered—but it should not vary based on political clout.

March 16, 2018 1:51PM

Ominous Trends in China

On March 11, China’s National People’s Congress made official what had been rumored for more than two weeks, voting to abolish the two-term limit on the presidency. Current president Xi Jinping is now able to serve in that post indefinitely. That decision is merely the latest in a series of ominous developments that have occurred since Xi took office in 2013. 

Ending term limits significantly alters China’s political system. Deng Xiaoping, the architect of the country’s radical economic reforms beginning in the late 1970s, also implemented that crucial political reform. He and his followers did so to guard against a repeat of the horrid abuses committed during the long, tyrannical rule of Mao Zedong. And the restriction did achieve a limited success. China hardly became a democratic state, but within the context of a one-party system, Deng’s successors served more like chief executive officers, with other members of the party elite acting as a board of directors that could, and did, serve as a check on the president’s power. Removing the limit on presidential terms means that an incumbent now has abundant time to accumulate more and more personal power. The threat of strongman rule, with all its potential abuses, has returned.

As I point out in a recent article in Aspenia Online, Xi was exhibiting troubling behavior even before pushing through the legislation ending term limits. Under the guise of combatting corruption (admittedly a very real problem in China), he systematically purged officials who showed signs of independent views. There has been a troubling hardline ideological aspect to his rule as well. Xi initiated a campaign to revitalize the Party, aiming at achieving a renewed commitment to Maoist principles. Even pro-market academics felt the chill of the new political environment, with crackdowns directed against several prominent reformers, including economist Mao Yushi, the 2012 recipient of the Cato Institute’s Milton Friedman Prize for Advancing Liberty. 

Internet censorship has steadily intensified in the past three years. Such intolerance of dissent culminated during the weeks leading up to the National People’s Congress vote on term limits. Authorities quickly silenced domestic critics of the planned constitutional revision—and there were a surprising number of them in the blogosphere and beyond

The consolidation of Xi’s personal power, especially if it continues to exhibit neo-Maoist characteristics, not only has ominous domestic implications, it has worrisome implications for China’s external behavior. Indeed, the hardening of Beijing’s stance on several international issues has tracked closely with Xi’s inexorable moves toward strongman rule. 

China has accelerated its land-reclamation efforts on several partially submerged reefs in the South China Sea. Some of the projects have become so extensive that Beijing has installed military installations on the expanded surfaces, and in a few cases, built military airstrips. The Xi government also has engaged in complete defiance of a 2016 international tribunal ruling rejecting most of China’s expansive territorial claims in that body of water. Finally, Beijing’s warnings to the United States about U.S. “freedom of navigation patrols” in the South China Sea have become increasingly strident.

China’s growing assertiveness toward Japan regarding disputed islands in the East China Sea (called the Senkakus in Japan and Diaoyus in China) is evident as well. In July 2017, Beijing escalated bilateral tensions dramatically when it sent six nuclear-capable bombers over the islands, and responded to Tokyo’s protests by telling Japanese leaders to “get used to” more flights of that nature. A few months earlier, Beijing warned the new Trump administration not to back Japan in the territorial dispute, despite established U.S. policy to support the claim of its longstanding ally.

It is the Taiwan issue, though, where Xi’s government has shown the most worrisome signs of uncompromising behavior. Over the past two years, the PRC has intensified its efforts to lure the small number of nations that still maintain diplomatic relations with Taipei to switch ties to Beijing. Warnings that China will use force if necessary to prevent any “separatist” initiatives by Taiwan have become more insistent, if not downright threatening. The sharp increase in the number and scope of provocative Chinese military exercises in the Taiwan Strait and other nearby waters suggests that Xi’s government is not bluffing. 

Any one of the above domestic or foreign policy developments would be cause for concern. Taken together, they suggest that China might be reverting to a virulently authoritarian country determined to pursue an abrasive, perhaps even an aggressively revisionist, foreign policy. Granted, China potentially would have much to lose economically by engaging in such behavior, and that factor might be enough to deter Xi from embarking on such a course.

But the mounting evidence that Xi Jinping intends to be an unconstrained strongman instead of merely being the head of a collective leadership should cause U.S. officials to conduct a comprehensive policy reassessment. Since the onset of China’s market-oriented economic reforms in the late 1970s, U.S policy has been based on two assumptions. One was economic reforms would lead to a more open, tolerant political system, perhaps ultimately culminating in China evolving into a full-fledged democracy. The other belief was that a less autocratic China, fully integrated into the global economy, would become, in the words of former Deputy Secretary of State Robert Zoellick, a “responsible stakeholder” in the international diplomatic and economic systems. Both of those assumptions now are very much in doubt.