Basic Economics

by Thomas Sowell

  Another area where government expenditures are a grossly misleading indicator of the costs to the country are land acquisition costs under either “redevelopment” programs or “open space” policies. When local government officials merely begin discussing publicly the prospect of “redeveloping” a particular neighborhood by tearing down existing homes and businesses there, under the power of eminent domain, that alone is enough to discourage potential buyers of homes or businesses in that neighborhood, so that the present values of those homes and businesses begin declining long before any concrete action is taken by the government.

  By the time the government acts, which may be years later, the values of properties in the affected neighborhood may be far lower than before the redevelopment plan was discussed. Therefore, even if the property owners are paid “just compensation,” as required by law, what they are compensated for is the reduced value of their property, not its value before government officials began discussing plans to redevelop the area. Therefore government compensation expenditures may be far less than the actual costs to the society of losing these particular resources.

  It is much the same principle when land use restrictions in the name of “open space” or “smart growth” reduce the value of land because home builders and others are now prevented from using the land and no longer bid for it. The owners of that land now have few, if any, potential buyers besides some local government agency or some non-profit group that wants the land kept as “open space.” In either case, the money spent to acquire this land can completely understate the cost to the society of no longer having this resource available for alternative uses. As elsewhere, the real costs of any resources, under any economic policy or system, are the alternative uses of those resources. The prices at which the artificially devalued land is transferred completely understate the value of its alternative uses in a free market.

  Benefits vs. Net Benefits

  The weighing of costs against benefits, which is part of the allocation of scarce resources which have alternative uses, can be greatly affected by government expenditures.

  While there are some goods and services which virtually everyone considers desirable, different people may consider them desirable to different degrees and are correspondingly willing to pay for them to different degrees. If some Product X costs ten dollars but the average person is willing to pay only six dollars for it, then that product will obviously be purchased by only a minority, even if the vast majority regard Product X as desirable to some extent. Such situations provide political opportunities to those holding, or seeking to be elected to, government offices.

  What is a common situation from an economic standpoint can be redefined politically as a “problem”—namely that most people want something that costs more than they feel like paying for it. The proposed solution to this problem is often that the government should in one way or another make this widely desired product more “affordable” to more people. Price control is likely to reduce the supply, so the more viable options are government subsidies for the production of the desired product or government subsidies for its purchase. In either case, the public now pays for the product through both the prices paid directly by the purchasers and the taxes paid by the population at large.

  For the price of this particular ten-dollar product to become “affordable”—that is, to cost what most people are willing to pay—that price can be no higher than six dollars. Therefore a government subsidy of at least four dollars must make up the difference, and taxes or bond sales must provide that additional money. The net result, under these conditions, is that millions of people will be paying ten dollars—counting both taxes and the price of the commodity—for something that is worth only six dollars to them. In short, government finance in such cases creates a misallocation of scarce resources which have alternative uses.

  A more realistic scenario would be that the costs of running the government program must be added to the costs of production, so that the total cost of the product would rise above the initial ten dollars, making the misallocation of resources greater. Moreover, it is unlikely that the price would be reduced only to that level which the average person was willing to pay, since that would still leave half the population unable to buy the product at a price that they are willing to pay. A more politically likely scenario would be that the price would be reduced below six dollars and the cost rise above ten dollars.

  Many government expenditure patterns that would be hard to explain in terms of the costs and benefits to the public are by no means irrational in terms of the incentives and constraints facing elected officials responsible for these patterns. It is, for example, not uncommon to find governments spending money on building a sports stadium or a community center at a time when the maintenance of roads, highways, and bridges is neglected.

  The cost of damage done to all the cars using roads with potholes may greatly exceed the cost of repairing the potholes, which in turn may be a fraction of the cost of building a shiny new community center or an impressive sports stadium. Such an expenditure pattern is irrational only if government is conceived of as the public interest personified, rather than as an organization run by elected officials who put their own interests first, as people do in many other institutions and activities.

  The top priority of an elected official is usually to get re-elected, and that requires a steady stream of favorable publicity to keep the official’s name before the public in a good light. The opening of any major new facility, whether urgently needed or not, creates such political opportunities by attracting the media to ribbon-cutting ceremonies, for example. Filling potholes, repairing bridges, or updating the equipment at a sewage treatment plant creates no ribbon-cutting ceremonies or occasions for speeches by politicians. The pattern of government expenditures growing out of such incentives and constraints is not new or limited to particular countries. Adam Smith pointed out a similar pattern back in eighteenth century France:

  The proud minister of an ostentatious court may frequently take pleasure in executing a work of splendour and magnificence, such as a great highway, which is frequently seen by the principal nobility, whose applauses not only flatter his vanity, but even contribute to support his interest at court. But to execute a great number of little works, in which nothing that can be done can make any great appearance, or excite the smallest degree of admiration in any traveller, and which, in short, have nothing to recommend them but their extreme utility, is a business which appears in every respect too mean and paultry to merit the attention of so great a magistrate.{687}

  GOVERNMENT BUDGETS

  Government budgets, including both taxes and expenditures, are not records of what has already happened. They are plans or predictions about what is going to happen. But of course no one really knows what is going to happen, so everything depends on how projections about the future are made. In the United States, the Congressional Budget Office projects tax receipts without fully taking into account how tax rates tend to change economic behavior—and how changed economic behavior then changes tax receipts. For example, the Congressional Budget Office advised Congress that raising the capital gains tax rate from 20 percent to 28 percent in 1986 would increase the revenue received from that tax—but in fact the revenues from this tax fell after the tax rate was raised. Conversely, cuts in the capital gains tax rate in 1978, 1997, and 2003 all led to increased revenues from that tax.{688}

  Undaunted, the Congressional Budget Office estimated that an extension of a temporary reduction in the capital gains tax to 15 percent would cost the Treasury $20 billion in lost revenues—even though this temporary tax cut had already resulted in tens of billions of dollars in increased revenues.{689} From 2003 through 2007, the disparities between the Congressional Budget Office’s estimates of tax receipts were off by growing amounts—under-estimating tax receipts by $13 billion in 2003 and by $147 billion in 2007.{690} Many in the media reason the same way the Congressional Budget Office reasons—and
are caught by surprise when tax revenues do not follow those beliefs. “An unexpectedly steep rise in tax revenues from corporations and the wealthy is driving down the projected budget deficit this year,” the New York Times reported in 2006.{691}

  A year later, the deficit had fallen some more and was now just over one percent of the Gross Domestic Product. Moreover, a growing proportion of all the federal tax revenues came from the highest income earners, despite widespread use of the phrase “tax cuts for the rich.” Back in 1980, when the highest marginal tax rate was 70 percent on the top income earners, before the series of tax cuts that began in the Reagan administration, 37 percent of all income tax revenues came from the top 5 percent of income earners. After a series of “tax cuts for the rich” over the years had reduced the highest marginal tax rate to 35 percent by 2004, now more than half of all income tax revenues came from the top 5 percent.{692}

  Nevertheless the phrase “tax cuts for the rich” has continued to flourish in politics and in the media. As Justice Oliver Wendell Holmes once said, catchwords can “delay further analysis for fifty years.”{693} When it comes to tax policy, such catchwords have delayed analysis even longer.

  Neither the Congressional Budget Office nor anyone else can predict with certainty the consequences of a given tax rate increase or decrease. It is not just that the exact amount of revenue cannot be predicted. Whether revenue will move in one direction or in the opposite direction is not a foregone conclusion. The choice is among alternative educated guesses—or, what is worse, mechanically calculating how much revenue will come in if no one’s behavior changes in the wake of a tax change. Behavior has changed too often, and too dramatically, to proceed on that assumption. As far back as 1933, John Maynard Keynes observed that “taxation may be so high as to defeat its object,” and that, “given sufficient time to gather the fruits, a reduction of taxation will run a better chance, than an increase, of balancing the Budget.”{694}

  Since budgets are not records of what has already happened, but projections of what is supposed to happen in the future, everything depends on what assumptions are made—and by whom. While the Congressional Budget Office issues projections of what future costs and payments are expected to be, the assumptions from which they derive these projections are provided by Congress. If Congress assumes an unrealistically high rate of economic growth, and therefore a far higher intake of tax revenues, the Congressional Budget Office is required to make its projections of future budget deficits or surpluses based on Congress’ assumptions, whether those assumptions are realistic or unrealistic. The media or the public may treat the Congressional Budget Office’s estimates as the product of a non-partisan group of economists and statisticians, but the assumptions provided by politicians are what ultimately determines the end results.

  A similar situation exists at the state level, whether the assumptions provided by politicians are about growth rates, rates of return on the government’s investments or any of the many other factors that go into making estimates of the government’s finances.

  When the state of Florida estimated in 2011 how far the money it had set aside to pay its employees’ pensions fell short of what was needed to pay those pensions, it proceeded on the arbitrary assumption that it would receive an annual rate of return of 7.75 percent on the investments it made with that money. But if in fact it turned out to receive only 7 percent, this difference of less than one percentage point would translate into being nearly $14 billion deeper in debt.{695}

  If Florida received only a 5 percent rate of return on its investment of the money set aside to pay these pensions, that would produce a shortfall nearly five times what the state officially estimated, based on a 7.75 percent rate of return. Because Florida had in fact received only a 2.6 percent rate of return on this investment in the previous ten years, {696}these comparisons show the enormous potential for deception when preparing government budgets, simply by changing the arbitrary assumptions on which those budget projections are based.

  Florida was not unique. As the British magazine The Economist put it, “nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are.” Among the reasons: “Governors and mayors have long offered fat pensions to public servants, thus buying votes today and sending the bill to future taxpayers.”{697}

  Chapter 20

  SPECIAL PROBLEMS IN

  THE NATIONAL ECONOMY

  Demagoguery beats data in making public policy.

  Congressman Dick Armey{698}

  Economic decisions affect more than the economy. They affect the scope of government power and the growth of government financial obligations, including—but not limited to—the national debt. There are also sometimes misconceptions of the nature of government, leading to unrealistic demands being made on it, followed by hasty denunciations of the “stupidity” or “irrationality” of government officials when those demands are not met. To understand many issues in the national economy requires some understanding of political processes as well as economic processes.

  THE SCOPE OF GOVERNMENT

  While some decisions are clearly political decisions and others are clearly economic decisions, there are large areas where choices can be made through either process. Both the government and the marketplace can supply housing, transportation, education and many other things. For those decisions that can be made either politically or economically, it is necessary not only to decide which particular outcome would be preferred but also which process offers the best prospect of actually reaching that outcome. This in turn requires understanding how each process works in practice, under their respective incentives and constraints, rather than how they should work ideally.

  The public can express their desires either through choices made in the voting booth or choices made in the marketplace. However, political choices are offered less often and are usually binding until the next election. Moreover, the political process offers “package deal” choices, where one candidate’s whole spectrum of positions on economic, military, environmental, and other issues must be accepted or rejected as a whole, in comparison with another candidate’s spectrum of positions on the same range of issues. The voter may prefer one candidate’s position on some of these issues and another candidate’s position on other issues, but no such choice is available on election day. By contrast, consumers make their choices in the marketplace every day and can buy one company’s milk and another company’s cheese, or ship some packages by Federal Express and other packages by United Parcel Service. Then they can change their minds a day or a week later and make wholly different choices.

  As a practical matter, virtually no one puts as much time and close attention into deciding whether to vote for one candidate rather than another as is usually put into deciding what job to take or where to rent an apartment or buy a house. Moreover, the public usually buys finished products in the marketplace, but can choose only among competing promises in the political arena. In the marketplace, the strawberries or the car that you are considering buying are right before your eyes when you make your decision, while the policies that a candidate promises to follow must be accepted more or less on faith—and the eventual consequences of those policies still more so. Speculation is just one aspect of a market economy but it is the essence of elections.

  On the other hand, each voter has the same single vote on election day, whereas consumers have very different amounts of dollars with which to express their desires in the marketplace. However, these dollar differences may even out somewhat over a lifetime, as the same individual moves from one income bracket to another over the years, although the differences are there as of any given time.

  The influence of wealth in the marketplace makes many prefer to move decisions into the political arena, on the assumption that this is a more level playing field. However, among the things that wealth buys is more and better education, as well as more leisure time that can be devoted to political act
ivities and the mastering of legal technicalities. All this translates into a disproportionate influence of wealthier people in the political process, while the fact that those who are not rich often have more money in the aggregate than those who are may give ordinary people more weight in the market than in the political or legal arena, depending on the issue and the circumstances.

  Too often there has been a tendency to regard government as a monolithic decision-maker or as the public interest personified. But different elements within the government respond to different outside constituencies and are often in opposition to one another for that reason, as well as because of jurisdictional frictions among themselves. Many things done by government officials in response to the particular incentives and constraints of the situations in which they find themselves may be described as “irrational” by observers but are often more rational than the assumption that these officials represent the public interest personified.

  Politicians like to come to the rescue of particular industries, professions, classes, or racial or ethnic groups, from whom votes or financial support can be expected—and to represent the benefits to these groups as net benefits to the country. Such tendencies are not confined to any given country but can be found in modern democratic states around the world. As a writer in India put it: