A variant of Romer’s hypothesis that is less specific to Silicon Valley and its imitators is that the presence of more educated people makes everyone else more productive. It turns out, however, that the evidence that we are all becoming more productive as a result of having more educated people around us is not overwhelming. We do observe that everyone earns more in cities where there are more educated people, but this could be for a variety of reasons. Cities with more educated people may also attract more high-paying firms (high-tech firms, more profitable firms, firms that care more about the quality of work, etc.), drawn in by the prospect of being able to find the right kind of workers. The problem is finding instances where the level of education in the population at large goes up significantly without other things (policies, investments, etc.) changing at the same time.
There is clear evidence, however, that cities as a whole can benefit from a large investment. Michael Greenstone, Rick Hornbeck, and Enrico Moretti (who is the author of The New Geography of Jobs,39 which argues that spillovers are the reason why cities are growing and rural areas are not) ask whether cities as a whole benefit from attracting a high-profile plant, much like Amazon’s HQ2.40 To answer this question, their study compared the winners of bidding wars to attract companies to the first runners-up. They find that TFP of the plants already present in the winning county surged, consistent with there being large spillovers—TFP five years after the plants were set up was on average 12 percent higher in places that received the plant than the ones that just missed out, translating into $430 million per year more in earnings for the county. Both wages and employment went up. In many cases, we do not know how much the average state or city spent to attract the plant, but we have some examples. For instance, in the case of the BMW plant that eventually went to Greenville-Spartanburg, South Carolina, over Omaha, Nebraska, the subsidy on offer was $115 million. If they got the average 12 percent benefit, the investment clearly paid off handsomely. This was the argument made in New York City in support of the subsidies to Amazon: that as an investment they were well worth it.41
An alternative way to attract businesses to a particular location is to build infrastructure. This is what the Tennessee Valley Authority (TVA) did for Tennessee and its neighboring states over the period 1930–1960, using public funds to build roads, dams, hydroelectric plants, etc. The idea was that infrastructure would attract firms, firms would attract other firms, and so on. Jane Jacobs, one of the most influential American urbanists of the twentieth century, was skeptical. She wrote a piece about it in 1984, called, quite simply, “Why TVA Failed.”42
But it did not fail. Enrico Moretti and a colleague compared the TVA region with six other areas initially supposed to receive the same type of investment but where, for various political reasons, nothing happened. They found that between 1930 and 1960, the TVA counties generated gains both in agricultural and manufacturing employment relative to this comparison group. It is true that once outside funding for the program stopped in 1960, the gains in agriculture vanished, but the gains in manufacturing persisted and actually continued to intensify all the way until 2000, consistent with a widely held view that spillovers are more important in manufacturing than in agriculture. The effects are substantial; the authors estimate that over the long run the income gains as a result of TVA in the region will be $6.5 billion more than what it cost to set it up.43
Does this mean countries can create the conditions for permanently faster economic growth by promoting regional development, perhaps in multiple regions at the same time? There are two reasons why this does not follow. First, it is not enough that the firms gain from the initial investment. They have to gain enough to overcome the usual forces that slow down growth: shortages of land, labor, and skills. Moretti estimates that a 10 percent change in employment today will increase employment in the future by 2 percent, which is not big enough to generate sustained growth over the long term; pretty rapidly the original boost will peter out.44
Second, growth in one region is different from national growth because it can happen in part by cannibalizing growth in the rest of the economy, drawing capital, skills, and labor away from other areas. The cities where Amazon eventually locates will grow, but partly that will be at a cost to other American cities. Moretti estimates the two effects might actually net out, with the result that national growth will be more or less unaffected.45
Moretti concludes from his reading of this entire literature that regional development is unlikely to be the lever that will help us avoid the end of growth.46 It is possible his assessment is slightly too pessimistic, but the note of warning is certainly valid. While it may make sense for an individual city to try to lure jobs away from another, this is unlikely to be a large win for a country as a whole, unless it is a very small country (the city state of Singapore, for example) that can grow at the expense of others.
CHARTER CITIES
It is worth emphasizing, however, that this evidence mainly comes from the United States or Europe. It could be that the developing world is quite different in this respect. Certainly, high-quality urban infrastructure is much more concentrated in a few cities in most of these countries, and a case could be made both for building more “high quality” cities and for making the few existing big cities more livable in order to promote economic growth. This is a key policy focus of the World Bank. For example, a 2016 report on urbanization in India47 highlights “messy” and “hidden” urbanization, dominated by slums and sprawl. In essence, cities grow horizontally, by outgrowing their formal boundaries, rather than vertically through taller and better-quality buildings. In total, 130 million people in South Asia (more than the population of Mexico) live in informal urban settlements. Distances are long, traffic is impossible, and the pollution levels are extraordinary. This makes it more difficult to attract talent to cities, and also limits the effectiveness of cities as places of production and exchange. Better cities could potentially generate entirely new growth opportunities for the countries, without taking any growth away from elsewhere.
Romer’s own focus for several years (even before his short and rocky tenure as the World Bank’s Chief Economist) was on the cities of the third world. It continues to be a priority of his. He wants these countries to build cities where creative people would want to come together and new ideas would be born out of the cross-pollination. Cities that would be business friendly but also genuinely livable—Shenzhen without the pollution and the traffic. Unusually for a successful academic, he believed and cared enough in his message to set up a nonprofit think tank to help in the creation of what he called “charter cities.” These would be giant protected enclaves (Romer wants hundreds of them around the world, each of them hosting eventually at least a million people) that live by Romerian rules within nations that do not. There would be a contract by which the national government agreed that a third-party government, from a developed country, would enforce those rules. So far, there has been just one taker, the government of Honduras, which had plans to set up as many as twenty zones for employment and economic development (ZEDEs). Unfortunately, though it claimed inspiration from Romer’s ideas, the Honduran vision seemed closer to the banana enclaves the United Fruit Company and its competitors ran in the first part of the last century, where the company’s writ was law. They deviated from the project from the get-go when they decided not to use the oversight of a third-party government. It eventually turned out that the Honduran government was more interested in Romer’s name and fame than his counsel, and when it signed a deal with an American entrepreneur with a strong taste for totally unregulated capitalism to develop the ZEDEs, Romer walked out. This story suggests charter cities are unlikely to hold the key to sustained growth in developing countries for the very good reason that the internal political compulsions the charter is intended to hold at bay often have a way of biting back.
CREATIVE DESTRUCTION
To summarize the previous sections, regional spillovers seem real, but bas
ed on the limited evidence we have, probably not powerful enough for the task of keeping growth going at the national level. Perhaps anticipating this, Romer had a second story up his sleeve; in that story, growth is driven by firms developing new ideas, which turn into more productive technologies.48
Romer was describing a force that ensured technologies would constantly keep improving, and more so in countries pursuing pro-innovation policies. Unlike in Solow’s world, technological progress would no longer be some mysterious force we have no control over.
To build a model where there is ongoing innovation and unbridled growth, Romer needed a force to counterbalance what every scientist and engineer knows: the more things have already been invented in the past, the harder it is to find an original idea. To get there, Romer assumed that once produced, new ideas become freely available for others to build on. Knowledge spills over. The advantage of building on previous ideas is that the new inventor is standing on the shoulders of giants. The inventor just needs to tweak the previous invention, not invent something entirely novel. In this way, the growth process can continue unabated.
Romer is a true optimist, as is perhaps evident from his faith that he would be able to entirely ring-fence his charter city project from the notorious politics of Honduras. The same optimism inspires his vision of the innovation process. In his world, new ideas just waft in like the smell of roses on a summer breeze.
In the real world, it seems, the production of new ideas is a much more fraught affair. Many marketable ideas are produced by firms, and firms tend to be possessive of their discoveries. Pharmaceutical companies and software firms, for example, do many things, legal and sometimes not so legal, to acquire and retain control over new ideas. Industrial espionage is a major global industry today, and so is its foil, patent law. A classic paper by Philippe Aghion and Peter Howitt, published a couple of years after Romer’s, argued that innovation-led growth was possible even in that much more cutthroat environment.49 In their world, firms innovate less out of a desire for knowledge than to make sure they get there before the competition. Nevertheless, new ideas do continue to get produced, as long as patent protection does not entirely preclude building on past ideas.
This shift in perspectives is not without its consequences. In Romer’s world, innovation is a boon innovators offer the world. They do make some money, but what the economy gets in return is incomparably more valuable because future generations of innovators get to build on it, for free. As a result, Romer in particular wants us to bend over backward to make the world as friendly as possible for innovators—low taxes on profits and capital gains, incubators and innovation cells, patents that protect the innovators’ rights as long as possible, and so on.
Aghion and Howitt have a much less romantic view of innovators. Interestingly, Aghion is the rare economist who had a chance to observe the innovative process close at hand. His mother, who was from a French-speaking Jewish family, founded the well-known designer brand Chloé when she moved to France, after being forced to leave her home in Egypt in the early 1950s. The years when Chloé went from being a dressmaker to a global brand were exactly the years of Philippe’s growing up. Nevertheless, inspired by Joseph Schumpeter (the Harvard economist of the mid–twentieth century and braggart extraordinaire50), Aghion sees innovation as a process of creative destruction, in which each innovation involves both creation of the new and destruction of the old.51 In his world, sometimes the creative dominates, but at other times the destructive holds sway; novelties get created not because they are useful but because they defeat someone’s existing patent. Making it more rewarding to innovate might backfire as a result. Innovators may worry that the time interval between the moment they displace the previous incumbent patent holder and the less happy moment they lose their own patent to someone else could be frustratingly short. Patent protection is important to get people to innovate, but it is easy to get too much of it, permitting the incumbents to rest on their laurels. Instead, there needs to be a balance between greenfield innovation and the possibility of adopting other people’s ideas.
CUT TAXES
You’ll recall that one of the reasons why economists like Lucas were dissatisfied with the Solow model is that it did not provide any direction to an eager policy maker. Romer’s model does. Conveniently, the advice is not exactly revolutionary. In particular, for Romer the government needs to get out of the way of stifling incentives to work hard and invent the new technologies that will make everyone more productive. In other words, cut taxes.
Romer is a Democrat in the United States. Or at least that’s what the economics rumor mill tells us. His father was a Democrat who was the governor of Colorado. But the idea that low tax rates can affect long-term growth by encouraging innovation is one that US Republicans have come to dearly love. From Reagan to Trump, Republican politicians have consistently promised to cut taxes, and the perennial justification is that they promote growth. Low tax rates are necessary at the top, because the likes of Bill Gates need to be given the incentive to work hard, be creative, and invent the next Microsoft to make us all more productive.
It was not always like that. Top tax rates were above 77 percent for the period 1936–1964, and above 90 percent for about half of that period, mostly in the 1950s under a solidly right of center Republican administration. The top tax rate was brought down to 70 percent in 1965 by a more left-wing Democratic administration, and since then it has drifted down to mid 30 percent. Every Republican administration has tried to cut it down further and every Democratic administration has tried to raise it a little, though always with great trepidation. Interestingly, for the first time in over fifty years, the idea of a top marginal tax rate above 70 percent has gained some traction among Democrats in 2018.
Yet, looking at growth rates since the 1960s, it is evident the low tax rate era ushered in by Reagan did not deliver faster growth. There was a recession in the beginning of the Reagan administration, followed by a catch-up phase when the growth rate went back to normal. Growth rates were a little higher during the Clinton years and declined afterward. Overall, if we take the long-run view (the ten-year moving average, which averages the ups and downs of the business cycle), economic growth has been relatively stable since 1974, remaining between 3 and 4 percent over the entire period. There is no evidence the Reagan tax cuts, or the Clinton top marginal rate increase, or the Bush tax cuts, did anything to change the long-run growth rate.52
Of course, as the Republican Paul Ryan, former Speaker of the House of Representatives, pointed out, there is no evidence that they did not. Many other things were happening at the same time. Ryan painstakingly explained to a journalist why all of these things lined up to make tax increases look good and tax decreases look bad:
I wouldn’t say that correlation is causation. I would say Clinton had the tech-productivity boom, which was enormous. Trade barriers were going down in the Clinton years. He had the peace dividend he was enjoying.… The economy in the Bush years, by contrast, had to cope with the popping of the technology bubble, 9/11, a couple of wars and the financial meltdown.… Some of this is just the timing, not the person.… Just as the Keynesians say the economy would have been worse without the stimulus [that Mr. Obama signed], the flip side is true from our perspective.53
Paul Ryan is right about one thing. Just looking at the variations over time, it is hard to conclude whether there is any causal effect of tax rates on growth. It is indeed possible there is a true relationship, but it is obscured by the many other things that are happening. The same lack of correlation between growth rates and tax rates remains true, however, when we look at changes in taxes across countries. There is absolutely no relationship between the depth of the cut between the 1960s and 2000s in a country and the change in growth rate in that country during the same period.54
Within the United States, the experience of individual states is also telling. In 2012, Republican leaders in Kansas passed deep tax cuts, with the promise this would
spur the economy. Nothing like that happened. Instead the state went broke and had to cut back on its education budget, the school week was cut to four days, and teachers went on strike.55
A recent study from the University of Chicago’s Booth School of Business (not a place known for its socialist tendencies) uses a clever trick to answer whether tax cuts that benefit the rich have more or less of a growth effect than tax cuts that benefit the rest of the economy. Different states have very different income distributions, and therefore tax cuts for the rich should have very different consequences in different states. Connecticut, for example, has many more rich people than Maine. Using the thirty-one tax reforms since the war, the study shows that tax cuts benefitting the top 10 percent produce no significant growth in employment and income, whereas tax cuts for the bottom 90 percent do.56
One can also directly look at the question of whether high-income earners slack off when taxes are higher. This question can be answered much more precisely than the effects on overall growth, because tax reforms affect different people differently, so it is possible to compare the changes in behavior for people who are more or less affected. The key conclusion from a very large literature, summarized by two of its most respected experts, Emmanuel Saez and Joel Slemrod, is that “there is no compelling evidence to date of real economic responses to tax rates at the top of the income distribution.”57
By now, there seems to be a consensus among a large majority of economists that low taxes on high earners are not guaranteed to, on their own, bring about economic growth. This was reflected in the response of the IGM Booth panel of top economists to the Trump tax cut of 2017. The tax cut provides deep and durable tax cuts for businesses, including a cut in the corporate tax rate from 35 percent to 21 percent. The bill also includes a new top tax rate of 37 percent for the wealthiest Americans (down from 39.6 percent), raises the threshold for top earners, and eliminates the estate tax. It has much smaller tax cuts for the rest of the population, and most of these are meant to be temporary. To the question “If the US enacts a tax bill similar to those currently moving through the House and Senate—and assuming no other changes in tax or spending policy—US GDP will be substantially higher a decade from now than under the status quo” only one person agreed with the statement and 52 percent either disagreed or strongly disagreed (the rest were uncertain or did not answer).58
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