Naked Economics

by Wheelan, Charles

  I wish I were making this stuff up.

  Let’s step out of our cynical mode for a moment and return to the idea that government has the capacity to do many good things. Even then, when government is doing the things that it is theoretically supposed to do, government spending must be financed by levying taxes, and taxes exert a cost on the economy. This “fiscal drag,” as Burton Malkiel has called it, stems from two things. First, taxes take money out of our pockets, which necessarily diminishes our purchasing power and therefore our utility. True, the government can create jobs by spending billions of dollars on jet fighters, but we are paying for those jets with money from our paychecks, which means that we buy fewer televisions, we give less to charity, we take fewer vacations. Thus, government is not necessarily creating jobs; it may be simply moving them around, or, on net, destroying them. This effect of taxation is less obvious than the new defense plant at which happy workers churn out shiny airplanes. (When we turn to macroeconomics later in the book, we will examine the Keynesian premise that government can increase economic growth by stoking the economy during economic downturns.)

  Second, and more subtly, taxation causes individuals to change their behavior in ways that make the economy worse off without necessarily providing any revenue for the government. Think about the income tax, which can be as high as 50 cents for every dollar earned by the time all the relevant state and federal taxes are tallied up. Some individuals who would prefer to work if they were taking home every dollar they earn may decide to leave the labor force when the marginal tax rate is 50 percent. Everybody loses in this situation. Someone whose preference is to work quits his or her job (or does not start working in the first place), yet the government raises no revenue.

  As we noted in Chapter 2, economists refer to this kind of inefficiency associated with taxation as “deadweight loss.” It makes you worse off without making anyone else better off. Imagine that a burglar breaks into your home and steals assorted personal possessions; in his haste, he makes off with wads of cash but also a treasured family photo album. There is no deadweight loss associated with the cash he has stolen; every dollar purloined from you makes him better off by a dollar. (Perversely, it is simply a transfer of wealth in the eyes of our amoral economists.) On the other hand, the stolen photo album is pure deadweight loss. It means nothing to the thief, who tosses it in a Dumpster when he realizes what he has taken. Yet it is a tremendous loss to you. Any kind of taxation that discourages productive behavior causes some deadweight loss.

  Taxes can discourage investment, too. An entrepreneur who is considering making a risky investment may do so when the expected return is $100 million but not when the expected return, diminished by taxation, is only $60 million. An individual may pursue a graduate degree that will raise her income by 10 percent. But that same investment, which is costly in terms of tuition and time, may not be worthwhile if her after-tax income—what she actually sees after all those deductions on the paycheck—only goes up 5 percent. (On the day my younger brother got his first paycheck, he came home, opened the envelope, and then yelled, “Who the hell is FICA?”) Or consider a family that has a spare $1,000 and is deciding between buying a big-screen television and squirreling the money away in an investment fund. These two options have profoundly differently impacts on the economy in the long run. Choosing the investment makes capital available to firms that build plants, conduct research, train workers. These investments are the macro equivalents of a college education; they make us more productive in the long run and therefore richer. Buying the television, on the other hand, is current consumption. It makes us happy today but does nothing to make us richer tomorrow.

  Yes, money spent on a television keeps workers employed at the television factory. But if the same money were invested, it would create jobs somewhere else, say for scientists in a laboratory or workers on a construction site, while also making us richer in the long run. Think about the college example. Sending students to college creates jobs for professors. Using the same money to buy fancy sports cars for high school graduates would create jobs for auto workers. The crucial difference between these scenarios is that a college education makes a young person more productive for the rest of his or her life; a sports car does not. Thus, college tuition is an investment; buying a sports car is consumption (though buying a car for work or business might be considered an investment).

  So back to our family with a spare $1,000. What will they choose to do with it? Their decision will depend on the after-tax return the family can expect to earn by investing the money rather than spending it. The higher the tax, such as a capital gains tax, the lower the return on the investment—and therefore the more attractive the television becomes.

  Taxation discourages both work and investment. Many economists argue that cutting taxes and rolling back regulation unleashes productive forces in the economy. This is true. The most ardent “supply-siders” argue further that tax cuts can actually raise the amount of revenue collected by the government because we all will work harder, earn higher incomes, and end up paying more in taxes even though tax rates have fallen. This is the idea behind the Laffer curve, which provided the intellectual underpinnings for the large Reagan-era tax cuts. Economist Arthur Laffer theorized in 1974 that high tax rates discourage so much work and investment that cutting taxes will earn the government more revenue, not less. (He first sketched a graph of this idea on a restaurant napkin while having dinner with a group of journalists and politicians. In one of life’s delicious ironies, it was Dick Cheney’s napkin.)13 At some level of taxation, this relationship must be true. If the personal income tax is 95 percent, for example, then no one is going to do a whole lot of work beyond what is necessary to subsist. Cutting the tax rate to 50 percent would almost certainly boost government revenues.

  But would the same relationship hold true in the United States, where tax rates were much lower to begin with? Both the Reagan tax cuts and the George W. Bush tax cuts provided an answer: no. These large tax cuts did not boost government revenues (relative to what they would have been in the absence of the tax cut);* they led to large budget deficits. In the case of the Reagan tax cuts, Mr. Laffer’s conjecture did appear to hold true for the wealthiest Americans, who ended up sending more money to the Treasury after their tax rates were cut. Of course, this may be mere coincidence. As we shall explore in Chapter 6, highly skilled workers saw their wages rise sharply over the last several decades as the economy increasingly demanded more brains than brawn. Thus, the wealthiest Americans may have paid more in taxes because their incomes went up sharply, not because they were working harder in response to lower tax rates.

  In the United States, where tax rates are low relative to the rest of the world, supply-side economics is a chimera: In all but unique circumstances, we cannot cut taxes and have more money to spend on government programs—a point that conservative economists readily concede. Bruce Bartlett, an official in both the Reagan and the George H. W. Bush administrations, has publicly lamented that the term “supply-side economics” has morphed from an important and defensible idea—that lower marginal tax rates stimulate economic activity—into the “implausible” notion “that all tax cuts raise revenue.”14 When Senator John McCain told the National Review in 2007 that tax cuts “as we all know, increase revenues,” Harvard economist Greg Mankiw (who served as chairman of the Council of Economic Advisers for George W. Bush) posed the logical follow-up question on his blog: “If you think tax cuts increase revenue, why advocate spending restraint? Can’t we pay for new spending programs with more tax cuts?”15 If I sound rather emphatic in making this point, I am. The problem with the tax-cuts-increase-revenue fallacy is that it confuses the debate over our public finances by giving the illusion that we can get something for nothing. You should recognize by now that this is not usually the case in economics. There are a lot of good things about tax cuts. They leave more money in our pockets. They stimulate hard work and risk-taking. In fact, the increased
economic activity caused by lower tax rates usually does help to make up for some of the lost revenue. One dollar in tax cuts may only cost the government eighty cents in lost revenue (or fifty cents in extreme cases), as government is taking a smaller slice of a bigger pie.

  Think about a simple numerical example. Suppose the tax rate is 50 percent and the tax base is $100 million. Tax revenues would be $50 million. Now suppose that the tax rate is cut to 40 percent. Some people work extra hours now that they get to keep more of their earnings; a few spouses take second jobs. Assume that the tax base grows to $110 million. Government revenue is now 40 percent of that bigger economy, or $44 million. Government has lost revenue by taking a smaller percentage of preexisting economic activity, but some of that loss is offset by taking a percentage of the new economic activity. If there had been no economic response to the tax cut, the 10 percentage point cut in the tax rate would have cost the government $10 million in lost revenue; instead, only $6 million is forgone. (In the case of a tax increase, the same phenomenon is likely in reverse: The increase in new revenues will be offset in part by some shrinking of the economic pie.) Tax experts typically take these behavioral responses into account when projecting the effects of a tax cut or a tax increase.

  In all but the most extraordinary of circumstances, there is no free lunch. Lower tax rates mean less total government revenue—and therefore fewer resources to fight wars, balance the budget, catch terrorists, educate children, or do anything else governments typically do. That’s the tradeoff. The bastardization of supply-side economics has taken an important intellectual debate—whether we should pay more in taxes to get more in government services, or pay less and get less—and transformed it into an intellectually dishonest premise: that we can pay less and get more. I wish that were true, just as I wish that I could get rich by working less or lose weight by eating more. So far, it hasn’t happened.

  Having said all that, the proponents of smaller government have a point. Lower taxes can lead to more investment, which causes a faster long-term rate of economic growth. It is facile to dismiss this as a bad idea or a policy that strictly favors the rich. A growing pie is important—perhaps even most important—for those with the smallest slices. When the economy grows slowly or sinks into recession, it is steelworkers and busboys who are laid off, not brain surgeons and university professors. In 2009, in the midst of the recession induced by the financial crisis, the American poverty rate was more than 13 percent—the highest rate in more than a decade.

  Conversely, the 1990s were pretty good for those at the bottom of the economic ladder. Rebecca Blank, a University of Michigan economist and member of the Council of Economic Advisers in the Clinton administration, looked back on the remarkable economic expansion of the 1990s and noted:

  I believe that the first and most important lesson for anti-poverty warriors from the 1990s is that sustained economic growth is a wonderful thing. To the extent that policies can help maintain strong employment growth, low unemployment, and expanding wages among workers, these policies may matter as much or more than the dollars spent on targeted programs for the poor. If there are no job opportunities, or if wages are falling, it is much more expensive—both in terms of dollars spent and political capital—for government programs alone to lift people out of poverty.16

  So, for two chapters now I have danced around the obvious “Goldilocks” question: Is the role that government plays in the United States economy too big, too small, or just about right? I can finally offer a simple, straightforward, and unequivocal answer: It depends on whom you ask. There are smart and thoughtful economists who would like to see a larger, more activist government; there are smart and thoughtful economists who would prefer a smaller government; and there is a continuum of thinkers in between.

  In some cases, the experts disagree over factual questions, just as eminent surgeons may disagree over the appropriate remedy for opening a clogged artery. For example, there is an ongoing dispute over the effects of raising the minimum wage. Theory suggests that there must be a trade-off: A higher minimum wage obviously helps those workers whose wages are raised; at the same time, it hurts some low-wage workers who lose their jobs (or never get hired in the first place) because firms cut back on the number of workers they employ at the new higher wage. Economists disagree (and present competing research) over how many jobs are lost when the minimum wage goes up. This is a crucial piece of information if one is to make an informed decision on whether or not raising the minimum wage is a good policy for helping low-wage workers. Over time, it is a question that can be answered with good data and solid research. (As one policy analyst once pointed out to me, it may be easy to lie with statistics, but it’s a lot easier to lie without them.)

  More often, economics can merely frame issues that require judgments based on morals, philosophy, and politics—somewhat as a doctor lays out the options to a patient. The physician can outline the medical issues related to treating an advanced cancer with chemotherapy. The treatment decision ultimately resides with the patient, who will interject his or her own views on quality of life versus longevity, willingness to experience discomfort, family situation, etc.—all perfectly legitimate considerations that have nothing to do with medicine or science. Yet making that decision still requires excellent medical advice.

  In that vein of thought, we can present a framework for thinking about the role of the government in the economy.

  Government has the potential to enhance the productive capacity of the economy and make us much better off as a result. Government creates and sustains the legal framework that makes markets possible; it raises our utility by providing public goods that we are unable to purchase for ourselves; it fixes the rough edges of capitalism by correcting externalities, particularly in the environmental realm. Thus, the notion that smaller government is always better government is simply wrong.

  That said, reasonable people can agree with everything above and still disagree over whether the U.S. government should be bigger or smaller. It is one thing to believe, in theory, that government has the capacity to spend resources in ways that will make us better off; it is another to believe that the fallible politicians who make up Congress are going to choose to spend money that way. Is a German-Russian museum in Lawrence Welk’s birthplace of Strasburg, North Dakota, really a public good? Congress allocated $500,000 for the museum in 1990 (and then withdrew it in 1991 when there was a public outcry). How about a $100 million appropriation to search for extraterrestrial life? Searching for ET meets the definition of a public good, since it would be impractical for each of us to mount his or her own individual search for life in outer space. Still, I suspect that many Americans would prefer to see their money spent elsewhere.

  If I were to poll one hundred economists, nearly every one of them would tell me that significantly improving primary and secondary education in this country would lead to large economic gains. But the same group would be divided over whether or not we should spend more money on public education. Why? Because they would disagree sharply over whether pouring more money into the existing system would improve student outcomes.

  Some government activity shrinks the size of the pie but still may be socially desirable. Transferring money from the rich to the poor is technically “inefficient” in the sense that sending a check for $1 to a poor family may cost the economy $1.25 when the deadweight costs of taxation are taken into account. The relatively high taxation necessary to support a strong social safety net falls most heavily on those with productive assets, including human capital, making countries like France a good place to be a child born into a poor family and a bad place to be an Internet entrepreneur (which in turn makes it a bad place to be a high-tech worker). Overall, policies that guarantee some pie for everybody will slow the growth of the pie itself. Per capita income in the United States is higher than per capita income in France; the United States also has a higher proportion of children living in poverty.

  Having sai
d all that, reasonable people can disagree over the appropriate level of social spending. First, they may have different preferences about how much wealth they are willing to trade off for more equality. The United States is a richer but more unequal place than most of Europe. Second, the notion of a simple trade-off between wealth and equality oversimplifies the dilemma of helping the most disadvantaged. Economists who care deeply about the poorest Americans may disagree over whether the poor would be helped more by expensive government programs, such as universal health care, or by lower taxes that would encourage economic growth and put more low-income Americans to work at higher wages.

  Last, some government involvement in the economy is purely destructive. Heavy-handed government can be like a millstone around the neck of a market economy. Good intentions can lead to government programs and regulations whose benefits are grossly outweighed by their costs. Bad intentions can lead to all kinds of laws that serve special interests or corrupt politicians. This is especially true in the developing world, where much good could be done just by getting government out of areas of the economy where it does not belong. As Jerry Jordan, former president and CEO of the Federal Reserve Bank of Cleveland, has noted, “What separates the economic ‘haves’ from the ‘have-nots’ is whether the role of an economy’s institutions—particularly its public institutions—is to facilitate production or to confiscate it.”17