Competition means losers, which goes a long way toward explaining why we embrace it heartily in theory and then often fight it bitterly in practice. A college classmate of mine worked for a congressman from Michigan shortly after our graduation. My friend was not allowed to drive his Japanese car to work, lest it be spotted in one of the Michigan congressman’s reserved parking spaces. That congressman will almost certainly tell you that he is a capitalist. Of course he believes in markets—unless a Japanese company happens to make a better, cheaper car, in which case the staff member who bought that vehicle should be forced to take the train to work. (I would argue that the American automakers would have been much stronger in the long run if they had faced this international competition head-on instead of looking for political protection from the first wave of Japanese imports in the 1970s and 1980s.) This is nothing new; competition is always best when it involves other people. During the Industrial Revolution, weavers in rural England demonstrated, petitioned Parliament, and even burned down textile mills in an effort to fend off mechanization. Would we be better off now if they had succeeded and we still made all of our clothes by hand?
If you make a better mousetrap, the world will beat a path to your door; if you make the old mousetrap, it is time to start firing people. This helps to explain our ambivalence to international trade and globalization, to ruthless retailers like Wal-Mart, and even to some kinds of technology and automation. Competition also creates some interesting policy trade-offs. Government inevitably faces pressure to help firms and industries under siege from competition and to protect the affected workers. Yet many of the things that minimize the pain inflicted by competition—bailing out firms or making it hard to lay off workers—slow down or stop the process of creative destruction. To quote my junior high school football coach: “No pain, no gain.”
One other matter related to incentives vastly complicates public policy: It is not easy to transfer money from the rich to the poor. Congress can pass the laws, but wealthy taxpayers do not stand idly by. They change their behavior in ways that avoid as much taxation as possible—moving money around, making investments that shelter income, or, in extreme cases, moving to another jurisdiction. When Bjorn Borg dominated the tennis world during my childhood, the Swedish government taxed his earnings at an extremely high rate. Borg did not lobby the Swedish government for lower taxes or write passionate op-eds about the role of taxes in the economy. He merely transferred his residence to Monaco, where the tax burden is much lower.
At least he was still playing tennis. Taxes provide a powerful incentive to avoid or reduce the activity that is taxed. In America, where much of our revenue comes from the income tax, high taxes discourage…income? Will people really stop or start working based on tax rates? Yes—especially when the worker involved is the family’s second earner. Virginia Postrel, a columnist on economics for the New York Times, has declared that tax rates are a feminist issue. Because of the “marriage tax,” second earners in families with high household incomes, who are more likely to be women, pay an average of 50 cents in taxes for every dollar they earn, which profoundly affects the decision to work or stay home. “By disproportionately punishing married women’s work, the tax system distorts women’s personal choices. And by discouraging valuable work, it lowers our overall standard of living,” she writes. She offers some interesting evidence. As a result of the 1986 tax reform, marginal tax rates for women in the highest income brackets fell more sharply than tax rates for women with lower incomes, meaning that they saw a much sharper drop in the amount that the government takes from every paycheck. Did they respond differently from women who did not get the same large tax break? Yes, their participation in the work force jumped three times as much.16
On the corporate side, high taxes can have a similar effect. High taxes lower a firm’s return on investment, thereby providing less incentive to invest in plants, research, and other activities that lead to economic growth. Once again we are faced with an unpleasant trade-off: Raising taxes to provide generous benefits to disadvantaged Americans can simultaneously discourage the kinds of productive investments that might make them better off.
If tax rates get high enough, individuals and firms may slip into the “underground economy” where they opt to break the law and avoid taxes entirely. Scandinavian countries, which offer generous government programs funded by high marginal tax rates, have seen large growth in the size of their black market economies. Experts estimate that the underground economy in Norway grew from 1.5 percent of gross national product in 1960 to 18 percent by the mid-1990s. Cheating the tax man can be a vicious circle. As more individuals and firms slip into the underground economy, tax rates must go up for everyone else in order to provide the same level of government revenue. Higher taxes in turn cause more flight to the underground economy—and so on.17
The challenge of transferring money from rich to poor is not just on the taxation side. Government benefits create perverse incentives, too. Generous unemployment benefits diminish the incentive to find work. Welfare policy, prior to reform in 1996, offered cash payments only to unemployed single women with children, which implicitly punished poor women who were married or employed—two things that the government generally does not try to discourage.
This is not to suggest that all government benefits go to poor people. They don’t. The largest federal entitlement programs are Social Security and Medicare, which go to all Americans, even the very rich. By providing guaranteed benefits in old age, both programs may discourage personal savings. Indeed, this is the subject of a longsimmering debate. Some economists argue that government old-age benefits cause us to save less (thereby lowering the national savings rate) because we need to set aside less money for retirement. Others argue that Social Security and Medicare do not reduce our personal savings; they merely allow us to pass along more money to our children and grandchildren. Empirical studies have not found a clear answer one way or the other. This is not merely an esoteric squabble among academics. As we shall explore later in the book, a low savings rate can limit the pool of capital available to make the kinds of investments that allow us to improve our standard of living.
None of this should be interpreted as a blanket argument against taxes or government programs. Rather, economists spend much more time than politicians thinking about what kind of taxes we should collect and how we should structure government benefits. For example, both a gasoline tax and an income tax generate revenue. Yet they create profoundly different incentives. The income tax will discourage some people from working, which is a bad thing. The gasoline tax will discourage some people from driving, which can be a good thing. Indeed, “green taxes” collect revenue by taxing activities that are detrimental to the environment and “sin taxes” do the same thing for the likes of cigarettes, alcohol, and gambling.
In general, economists tend to favor taxes that are broad, simple, and fair. A simple tax is easily understood and collected; a fair tax implies only that two similar individuals, such as two people with the same income, will pay similar taxes; a broad tax means that revenue is raised by imposing a small tax on a very large group rather than imposing a large tax on a very small group. A broad tax is harder to evade because fewer activities are exempted, and, since the tax rate is lower, there is less incentive to evade it anyway. We should not, for example, impose a large tax on the sale of red sports cars. The tax could be avoided, easily and legally, by buying another color—in which case everybody is made worse off. The government collects no revenue and sports car enthusiasts do not get to drive their favorite color car. This phenomenon, whereby taxes make individuals worse off without making anyone else better off, is referred to as “deadweight loss.”
It would be preferable to tax all sports cars, or even all cars, because more revenue could be raised with a much smaller tax. Then again, a gasoline tax collects revenue from drivers, just as a tax on new cars does, but it also provides an incentive to conserve fuel. Those who drive mo
re pay more. So now we’re raising a great deal of revenue with a tiny tax and doing a little something for the environment, too. Many economists would go yet one step further: We should tax the use of all kinds of carbon-based fuels, such as coal, oil, and gasoline. Such a tax would raise revenue from a broad base while creating an incentive to conserve nonrenewable resources and curtail the CO2 emissions that cause global warming.
Sadly, this thought process does not lead us to the optimal tax. We have merely swapped one problem for another. A tax on red sports cars would be paid only by the rich. A carbon tax would be paid by rich and poor alike, but it would probably cost the poor a larger fraction of their income. Taxes that fall more heavily on the poor than the rich, so-called regressive taxes, often offend our sense of justice. (Progressive taxes, such as the income tax, fall more heavily on the rich than the poor.) Here, as elsewhere, economics does not give us a “right answer”—only an analytical framework for thinking about important questions. Indeed the most efficient tax of all—one that is perfectly broad, simple, and fair (in the narrow, tax-related sense of the word)—is a lump-sum tax, which is imposed uniformly on every individual in a jurisdiction. Former British Prime Minister Margaret Thatcher actually tried it in 1989 with the community charge, or “poll tax.” What happened? Britons rioted in the streets at the prospect of every adult paying the same tax for local community services regardless of income or property wealth (though there were some reductions for students, the poor, and the unemployed). Obviously good economics is not always good politics.
Meanwhile, not all benefits are created equal either. One of the biggest poverty-fighting tools in recent years has been the earned income tax credit (EITC), an idea that economists have pushed for decades because it creates a far better set of incentives than traditional social welfare programs. Most social programs offer benefits to individuals who are not working. The EITC does just the opposite; it uses the income tax system to subsidize low-wage workers so that their total income is raised above the poverty line. A worker who earns $11,000 and is supporting a family of four might get an additional $8,000 through the EITC and matching state programs. The idea was to “make work pay.” Indeed, the system provides a powerful incentive for individuals to get into the labor force, where it is hoped they can learn skills and advance to higher-paying jobs. Of course, the program has an obvious problem, too. Unlike welfare, the EITC does not help individuals who cannot find work at all; in reality, those are the folks who are likely to be most desperate.
When I applied to graduate school many years ago, I wrote an essay expressing my puzzlement at how a country that could put a man on the moon could still have people sleeping on the streets. Part of that problem is political will; we could take a lot of people off the streets tomorrow if we made it a national priority. But I have also come to realize that NASA had it easy. Rockets conform to the unchanging laws of physics. We know where the moon will be at a given time; we know precisely how fast a spacecraft will enter or exit the earth’s orbit. If we get the equations right, the rocket will land where it is supposed to—always. Human beings are more complex than that. A recovering drug addict does not behave as predictably as a rocket in orbit. We don’t have a formula for persuading a sixteen-year-old not to drop out of school. But we do have a powerful tool: We know that people seek to make themselves better off, however they may define that. Our best hope for improving the human condition is to understand why we act the way we do and then plan accordingly. Programs, organizations, and systems work better when they get the incentives right. It is like rowing downstream.
CHAPTER 3
Government and the Economy:
Government is your friend (and a round of applause for all those lawyers)
The first car I ever owned was a Honda Civic. I loved the car, but I sold it with a lot of good miles left in it. Why? Two reasons: (1) It didn’t have a cup holder; and (2) my wife was pregnant, and I had become fearful that our whole family would get flattened by a Chevy Suburban. I could have gotten beyond the cup holder problem. But putting a car seat in a vehicle that weighed a quarter as much as the average SUV was not an option. So we bought a Ford Explorer and became part of the problem for all of those people still driving Honda Civics.*
The point is this: My decision to buy and drive an SUV affects everyone else on the road, yet none of those people has a say in my decision. I do not have to compensate all the owners of Honda Civics for the fact that I am putting their lives slightly more at risk. Nor do I have to compensate asthmatic children who will be made worse off by the exhaust I generate as I cruise around the city getting nine miles to the gallon. And I have never mailed off a check to people living on small Pacific islands who may someday find their entire countries underwater because my CO2 emissions are melting the polar ice caps. Yet these are real costs associated with driving a less fuel-efficient car.
My decision to buy a Ford Explorer causes what economists refer to as an externality, which means that the private costs of my behavior are different from the social costs. When my wife and I went to the Bert Weinman Ford Dealership and the salesman, Angel, asked, “What is it going to take for me to put you in this car?,” we tallied up the costs of driving an Explorer rather than a Civic: more gas, more expensive insurance, higher car payments. There was nothing on our tally sheet about asthmatic children, melting polar ice caps, or pregnant women driving Mini Coopers. Are these costs associated with driving an Explorer? Yes. Do we have to pay them? No. Therefore, they did not figure into our decision (other than as a vague sense of guilt as we contemplated telling our environmentally conscious relatives who live in Boulder, Colorado, and flush the toilet only once a day in order to conserve water).
When an externality—the gap between the private cost and the social cost of some behavior—is large, individuals have an incentive to do things that make them better off at the expense of others. The market, left alone, will do nothing to fix this problem. In fact, the market “fails” in the sense that it encourages individuals and firms to cut corners in ways that make society worse off as a result. If this concept were really as dry as most economics textbooks make it seem, then a movie like Michael Clayton would not have made millions at the box office. After all, that film is about a simple externality: A large agribusiness company stands accused of producing a pesticide that is seeping into local water supplies and poisoning families. There is no market solution in this case; the market is the problem. The polluting company maximizes profits by selling a product that causes cancer in innocent victims. Farmers who are unaware of (or indifferent to) the pollution will actually reward the company by buying more of its product, which will be cheaper or more effective than what can be produced by competitors that invest in making their products nontoxic. The only redress in this film example (like Erin Brockovich and A Civil Action before it) was through a nonmarket, government-supported mechanism: the courts. And, of course, George Clooney looks good making sure justice is done (as Julia Roberts and John Travolta did before him).
Consider a more banal example, but one that raises the ire of most city dwellers: people who don’t pick up after their dogs. In a perfect world, we would all carry pooper scoopers because we derive utility from behaving responsibly. But we don’t live in a perfect world. From the narrow perspective of some individual dog walkers, it’s easier (“less costly” in economist speak) to ignore Fido’s unsightly pile and walk blithely on. (For those who think this is a trivial example, an average of 650 people a year break bones or are hospitalized in Paris after slipping in dog waste, according to the New York Times.)1 The pooper-scooper decision can be modeled like any other economic decision; a dog owner weighs the costs and benefits of behaving responsibly and then scoops or does not scoop. But who speaks for the woman running to catch the bus the next morning who makes one misstep and is suddenly having a very bad day? No one, which is why most cities have laws requiring pet owners to pick up after their animals.
Thankfully there
is a broader point: One crucial role for government in a market economy is dealing with externalities—those cases in which individuals or firms engage in private behavior that has broader social consequences. I noted in Chapter 1 that all market transactions are voluntary exchanges that make the involved parties better off. That’s still true, but note the word “involved” that has left me some wiggle room. The problem is that all of the individuals affected by a market transaction may not be sitting at the table when the deal is struck. My former neighbor Stuart, with whom we shared an adjoining wall, was an avid bongo drum player. I’m sure that both he and the music shop owner were both pleased when he purchased a new set of bongos. (Based on the noise involved, he may even have purchased some kind of high-tech amplifier.) But I was not happy about that transaction.
Externalities are at the root of all kinds of policy issues, from the mundane to those that literally threaten the planet:
The Economist has suggested somewhat peevishly that families traveling with small children on airplanes should be required to fly at the back of the plane so that other passengers might enjoy a “child-free zone.” An editorial in the magazine noted, “Children, just like cigarettes or mobile phones, clearly impose a negative externality on people who are near them. Anybody who has suffered a 12-hour flight with a bawling baby in the row immediately ahead or a bored youngster viciously kicking their seat from behind, will grasp this as quickly as they would love to grasp the youngster’s neck. Here is a clear case of market failure: parents do not bear the full costs (indeed young babies travel free), so they are too ready to take their noisy brats with them. Where is the invisible hand when it is needed to administer a good smack?”2
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