Growthology

A Few Thoughts on Tyler Cowen's New Book

[Another guest post from Charles Johnson, one of our summer interns.]

Tyler Cowen's new book, Create Your Own Economy: The Path to Prosperity in a Disordered World is one of the more engaging books I've read recently. It rests comfortably in the niche between books about behavorial economics and social technology. Careful readers of this blog will note that Tyler Cowen was a participant in the Kauffman Economic Bloggers Forum in February. We prepared videos of the participants. You can see him on video discussing blogging here. Cowen is a seasoned blogger at his blog, Marginal Revolution. 

The thesis for Cowen's new book is that technology is allowing many of us to become autistic-like in our processing of information and consumption of entertainment and culture. We've moved into a "bits" culture where we can constantly be orienting and re-orienting our culture. This remix culture is evident in everything from iPods, to blogs, to delicious, and to Facebook. In a way, I took this part of the book as a kind of demonstration that we can all become renaissance men because the costs of such renaissance have plummeted. We don't need Jefferson's library when we have a worldwide web with easy information at our fingertips. 

Cowen's book can be read as an appeal, that, for the sake of society at large and the individuals in particular, we should embrace neurodiversity, or the different ways in which our brain is wired. (You can hear him discuss the book in an interview with John J. Miller of National Review here.)

I was struck by this paragraph about autism and the foundation of companies. We know that dyslexics tend to have high rates of firm creation. (See here for more details). But what about autistics? 

Here Cowen points to the work of Simon Baron-Cohen, who is a researcher of autism at the University of Cambridge. (Simon Baron-Cohen created an AQ test -- or autism quotient -- that you can take here to see if you might have autistic-like tendencies.) Cowen recounts that Baron-Cohen believes that there may be a lot more autistic high achievers than most people realize. On p. 24-25, Cowen writes about some of these high achievers. [The bolding is mine.] 

Craig Newmark, founder of the web forum Craigslist, has written on his blog that his history as a "recovering nerd" is connected to Asperger's. It is perhaps no accident that autistics are known for their attachment to lists as a means of processing, recording, and ordering knowledge. Bram Cohen, creator and former CEO of BitTorrent, also describes himself in terms of Asperger's syndrome. He founded the company at age twenty-nine and BitTorrent has been a pioneer in exchanging digital information over the web; one of his key insights was how BitTorrent could break up files into smaller bits and send through the bits rather than the whole file at once. Cohen mastered three programming languages by the age of sixteen and his work on BitTorrent is regarded as brilliant. The best-known example of an autistic high achiever is Temple Grandin, a woman who has pioneered commonly used improvements in animal treatment and slaughterhouses; her unique cognitive perspective has helped her understand when animals are afraid and how they can be made to feel more secure. 

I've yet to see a scientific paper or serious clinical discussion of the autistics who hold political office, work in Hollywood, start web 2.0 companies, or run major U.S. corporations or hedge funds.

If Baron-Cohen is right that there is the huge reserve of highly successful autistic achievers, I wonder why there hasn't been some kind of online, Craigslist-type sorting website that seeks to place autistic people with the things in which they specialize or some kind of wider texting that seeks to identify and help autistic people find their niches.  

I came upon this idea when I was spending time with my next door neighbor, who has Asperger's. He has an obsession with clocks and with taking them apart and putting them back together. Imagine the societal benefit if he could be placed with a clock making company. 

Indeed, if I could fault Cowen's book for one thing, it's that it doesn't take the ideas he's advocated and move towards policy. Still, perhaps policy is not one of those things for which Dr. Cowen is wired and I ought to respect his neurodiversity. 

Where good ideas go to die

Why has Washington, DC increasingly become the place where good ideas go to die?

On May 12, the Senate Finance Committee held a hearing on health care reform. There was a long table of 13 experts, and a vast majority agreed that ending the tax exemption on employer-provided health benefits should be part of a reform package.

They gave the reasons that experts — on right or left — always give for supporting this idea. The exemption is a giant subsidy to the affluent. It drives up health care costs by encouraging luxurious plans and by separating people from the consequences of their decisions. Furthermore, repealing the exemption could raise hundreds of billions of dollars, which could be used to expand coverage to the uninsured.

Democratic Senator Ron Wyden piped up and noted that he and Republican Senator Robert Bennett have a plan that repeals the exemption and provides universal coverage. The Wyden-Bennett bill has 14 bipartisan co-sponsors and the Congressional Budget Office has found that it would be revenue-neutral.

The Finance Committee’s chairman, Senator Max Baucus, looked exasperated. With that haughty and peremptory manner that they teach in Committee Chairman School, he told Wyden and the world that this idea was not going to happen.

In the World’s Greatest Deliberative Body, senators don’t run things. Chairmen and their staffs run things.

That is David Brooks; read the whole thing here.

Lessons:

1. The big battle over health care is now dead. The vast machinery of politics and media will trudge on for months, but essentially this is over. History will look back at the $1.6 Trillion CBO score and recognize it as the turning point. Why did it happen?

2. President Obama made the same vague mistake that President Bush made. Rather than specify a solid framework for legislation (on immigration, on Social Security, take your pick), the new way to kill your own agenda is to talk up general principles and leave Congress to craft actual legislation. Without clear leadership (and not just behind the scenes), the modern result is acrimony. Inside the beltway, the Clinton health care experience remains a searing lesson in the "wrong way" -- overly strong presidential specificity. But the lesson has been overlearned. What the Clintons did wrong was to hijack the legislative process with a massive semi-secret commission. That wasn't leadership. Somewhere between being a control freak and a mere rhetorician is the golden mean of presidential leadership.

3. It's not too late. Despite lesson #1 above, Obama and key Senators could skip the whole kabuki dance of failure. Announce the old approach dead. Admit you lost, and explain why. And then restart by working with a new coalition, a truly bipartisan one this time (hint Wyden-Bennett). It's been done before. Tax reform in 1986 died and was reborn many times, as recounted in The Showdown at Gucci Gulch.

Stimulating Fewer Jobs

In another strike against government effort to create jobs, the NYTimes excellent "You're The Boss" blog (which we should have on our blog roll) observes how the extension and modification of unemployment insurance is undercutting small businesses. This is an old saw, but research backs it up: legislation that tries to protect workers will chill hiring instead. When will they ever learn?

It gets even worse when the employee files for unemployment. A lot of people — including a lot of business owners — don’t understand how this works. Because the government cuts the unemployment check, it is widely assumed that it’s the government that pays the unemployment benefits. In reality, those benefits are funded by employer taxes. And here’s the killer: The more unemployment benefits your former employees collect, the higher your taxes go.

It works like insurance. If the government pays a claim, your rates go up. In fact, if your former employee collects $10,000 in unemployment payments, you can expect to pay close to twice that in increased premiums. At least that’s how it works in my state, Illinois.

Thus, this becomes another cost of doing business that smart owners attempt to control. How do you control it? By making as few hires as possible, by making sure that those hires you do make are as strong as possible, and by combining documented rules with good management.

And now, thanks to the stimulus package, unemployment insurance has been extended as much as an additional 20 weeks. If you’ve had to lay off 10 people, this could easily result in additional taxes of $10,000, $50,000, or even $100,000. It’s a time bomb that won’t go off until after employers get their contribution-rate increase in November, but it will go off.

And therein lies the final irony: Even after the economy improves, I’m going to think long and hard before I hire anyone. Thanks to the stimulus package — the stimulus package — the costs, paperwork, and legal exposure associated with hiring employees is on the rise. I’m not saying the package is all bad, but it does make it less appealing for small businesses to hire more people, or even to offer health insurance, for that matter.

Uncompetitive Ohio?

A fundamental part of any period of rapid growth or decline is movement. Creative destruction plus a large, open, continental economy yields massive shifts in population. Rural moves to cities. Old cities give way to new. I like to say that a downturn is more of a restructuring than a recession. It's not as if when the economy grows back, all the saggy parts will inflate again.

Michigan, California, we know about those states. But did you know Ohio is on the downswing as well? The Dayton Daily News reports:

NCR will move its corporate headquarters from Dayton to Duluth, Ga., taking with it more than one thousand jobs from here. ... In the memo sent to employees, Nuti wrote, “The decision to consolidate functions in Georgia and build a corporate headquarters campus focused on innovation is in line with our business strategy to drive growth, improve our innovation output, increase productivity and continually upgrade our focus on the customer. In addition, we will decrease time-to-market for innovative solutions, improve our internal collaboration, deliver next generation employee education programs and lower our current operating costs.”

Somewhere in that lies the truth. Or part of it. The full article digs deeper and identifies the direct international flights that go direct to and fro Atlanta. From Dayton, it's 60-90 minutes just to get to one of the regional hubs in Columbus or Cincy. But I wonder. 

The article makes no mention of taxes, so I turned to the handy-dandy Tax Foundation's 2009 State Business Tax Climate Index. So guess which state is ranked 47th out of 50?  And guess which state is ranked 27th? Nothing to see here, folks. Move along.

Is the U.S. becoming a command and control economy?

The Washington Post's editors think so (HT Virginia Postrel). The cap-and-trade bill seems to have a million points of tyranny hidden in the footnotes. If you can read this and see how federalism (that system of 50 entrepreneurial states) lives, let me know. And keep in mind, I've come out in favor of taxing carbon, specifically the cap-and-trade approach.

With those targets in mind, the bill expects organizations that develop model codes for states and localities to fill in the details, creating a national code. If they don't, the bill commands the Energy Department to draft a national code itself.

States, meanwhile, would have to adopt the national code or one that achieves the same efficiency targets. Those that refuse will see their codes overwritten automatically, and they will be docked federal funds and carbon "allowances" -- valuable securities created elsewhere in the bill that give the holder the right to pollute and can be sold. The Energy Department also could enforce its code itself. Among other things, the policy would demonstrate the new leverage of allocation of allowances as a sort of carbon currency -- leverage this bill would be giving to Congress to direct state behavior.

I'll Take "Optimal Taxation" for 300 ...

Answer: This British Prime Minister's experience implementing tax theory showed that when politics trumps economics, the politics can actually be right.
Question: Who is Margaret Thatcher? (She believed, as economic theory held, that lump-sum taxes are optimal. Theory neglected to consider the aspect of humanity known as individual diversity.*)

*[T]he problem of optimal taxation becomes too easy: the optimal tax is simply a lump-sum tax. After all, if the economy is described by a representative consumer, that consumer is going to pay the entire tax bill of the government in one form or another. Absent any market imperfection such as a preexisting externality, it is best not to distort the choices of that consumer at all. A lump-sum tax accomplishes exactly what the social planner wants.

In the world, there are good reasons why lump-sum taxes are rarely used. Most important, this tax falls equally on the rich and poor, placing a greater relative burden on the latter. When Margaret Thatcher, during her time as the Prime Minister of the United Kingdom, successfully pushed through a lump-sum tax levied at the local level (a “community charge”) beginning in 1989, the tax was deeply unpopular. As the New York Times reported in 1990, “[W]idespread anger over the tax threatens Mrs. Thatcher's political life, if not her physical safety. And it may prove to be the last hurrah for her philosophy of public finance, in which the goals of efficiency and accountability take precedence over the values of the welfare state” (Passell, 1990). The tax was quickly revoked, and not coincidentally, Thatcher’s term of office ended not long after.

Answer: This rate has been estimated to be zero, surprisingly, by many researchers, while some economists argue it should optimally be 50 or even 80 percent.
Question: What is the top marginal income tax rate?  

Finally, the relevant elasticities are crucial for optimal marginal tax rates. While optimal tax simulations often assume a uniform elasticity, Feldstein (1995) estimated large elasticities of taxable income with respect to tax rates among high earners. Gruber and Saez (2002) subsequently estimated smaller elasticities, but their estimates also support the hypothesis that the elasticity increases with income. If high-income workers are particularly elastic in how their taxable income decreases with higher tax rates, this would imply lower optimal marginal tax rates on high incomes, all else the same. But as with the distribution of abilities and the social welfare function, there is much debate over the true pattern of elasticities by income.

All this leaves the policy advisor in an uncomfortable position. Early work, following Mirrlees (1971), assumed a shape for the ability distribution, social welfare and individual utility functions, and a pattern of labor supply elasticities that yielded clear but surprising results— declining marginal tax rates at the top of income distribution. Some recent work has yielded dramatically different results more consistent with existing policy, but many of the key assumptions are open to debate.

Answer: 29 out of 30 OECD countries have this tax, all but the United States. It is flat, taxes only final goods (and sometimes services), and tends to generate large amounts of revenue.
Question: What is the value added tax or VAT?  

Moreover, 11 of the 12 OECD countries who have used a value-added tax since 1976 raised their rates over this period, and the average rate among these 12 countries increased from 15.6 percent to 20.4 percent. The only exception (France) lowered its rate only slightly from 20 percent to 19.6 percent over this period.

Combined, the increase in countries using a value-added tax and the increased rates in countries that already had a value-added tax have led to a near doubling of the share of tax revenues (on an unweighted average basis) collected by general consumption taxes in the OECD from 1960 to 2003 (OECD, 2006). Furthermore, this growth in the value-added tax has largely replaced excise taxes on specific goods, which violate either the condition that intermediate goods (like oil) should not be taxed or the condition that final goods (like tobacco and alcohol) should all be taxed alike.

All the quotes are from a new paper by Greg Mankiw, Matthew Weinzierl and Danny Yagan (which is forthcoming from a well-known econ journal). The Jeopardy-style A&Q is from your devoted blogger.

Lincoln's Industrial Policy

Paul Kedrosky has a good essay in the most recent Washington Monthly, the provocative thesis of which is: "So while it's true that our best hope for future growth is riding on America's entrepreneurs, the best hope for our entrepreneurs may be riding on government."

In describing how economic crises can often produce rather enlightened public policy, Paul highlights an oft-overlooked characteristic of President Abraham Lincoln--his economic policies. Understandably, Lincoln is usually remembered in the context of war and slavery and political philosophy, but his Second Annual Message to Congress was basically a far-sighted industrial policy that helped lay the foundation for an era of inspired entrepreneurial capitalism. (Lincoln's economic insight has not gone completely unremarked upon, of course; Michael Novak provided a brilliant meditation on it in The Fire of Invention.)

Atlantic and Pacific telegraphs; the Pacific Railway Act for the construction of a transcontinental railroad; uniform currency; development of the West's mineral resources; canals--all were at the heart of Lincoln and the Republicans' economic policy. Granted, the South's secession played no small part in opening up the legislative road--before the Civil War, the future Confederate states had basically acted like a gigantic reactionary obstacle to everything from economic development to women's rights. With Confederate legislators gone, the new Republican party helped boost the American industrial revolution. 

Paul also mentions the Morrill Act, which Lincoln signed in 1862 and is one of the most frequently cited Congressional achievements of the nineteenth century. To a certain extent this is true, but it is also overblown. The Morrill Act helped put many of the existing small-time state schools on the road to national importance, but its effect was limited by a shortage of resources. It was really the Hatch Act of 1887, establishing the agriculture extension system, and the Second Morrill Act of 1890, providing money for the first Act and adding discrimination clauses, that pulled higher education and industry into a tight and enduring embrace. As higher education historian Frederick Rudolph wrote several decades ago:

"[T]he growth of a body of applied agricultural science, the experiment stations, farmer approval, and federal and state financial assistance all fed upon one another."

One of professors summed all this up with what I still think is one of the best phrases used to describe what government economic policy should (ideally) do: releasing the energy of people to create. Things like the Hatch Act and the Bayh-Dole Act cannot anticipate the nature and scope of the far-reaching effect they will eventually have since they're usually passed in response to a discrete issue. (In the latter case, university-industry linkages had increased markedly in the 1970s and companies like IBM were constantly pushing against the cumbersome commercialization process. In a historical analogy to general incorporation in the 1800s, Congress finally created a general platform for university commercialization. Incidentally, "platform" is another wonderful term for describing what economic policy should be about.) Likewise, the gradual separation of military and civil government in Europe helped, as John Keegan has written, free up the energies of people to create and innovate, resulting in the Industrial Revolution.

So the question for policymakers, always and particularly in times of crisis, should be: where are the points at which a specific policy or repeal of policy can release individual energy? This need not presume any particular knowledge on the part of policymakers, but it should prompt a more nuanced understanding of economic complexity. 

Entrepreneurial Experiments -- Research and Questions

This post is to share some original research I have in process with readers of this blog. For the last few months, I've been preparing to conduct some new economic experiments, and would love to engage in a discussion with you & get your advice. Dan Houser, a professor at George Mason University, and a graduate student, Xiaofei Pan, are helping me prepare to conduct the experiments at the GMU ICES labs, hopefully this summer.

The experiments are for the study of work and entrepreneurial behavior under different policy regimes, including taxation, welfare, and social insurance. I'll share a link to the preliminary literature review / experimental design working paper in a future post. Questions on my mind are:

1. Will higher federal taxes reduce entrepreneurship and growth, or are those fears overblown?

2. What's the best way to design an experiment for work under different policy regimes? Once we nail that down, what is the best way to design the choice of riskless versus risky (entrepreneurial) work?

3. Is there research already in existence informing this topic?

I was inspired by Vernon Smith (wikipedia entry here) after I spoke with him at Chapman University during last November's Global Entrepreneurship Week (hat tip to the Leatherby Center there). I was surprised to learn that experimental economics hasn't pushed very deeply into growth policy questions. According to a 2003 paper by Sutter and Weck-Hanemann (2003), “Experimental studies on issues of taxation abound.” However, these generally explore tax evasion, whereas “studies on the effects of tax laws on labor supply are very rare." Tax evasion is really just a subset of income shifting in response to taxes, related to the subset that naturally interests the Kauffman Foundation, which is the degree to which higher taxes are a barrier to entrepreneurial risk-taking.

The study of labor supply's elasticity has evolved in recent years. A consensus exists, holding that the number hours worked (i.e. labor supply) is inelastic with respect to tax rates, especially for males (primary earners). However, Larry Lindsey suggested in a 1987 paper that the key elasticity is not labor per se, but income. Martin Feldstein explored the idea of "elasticity of taxable income" (ETI) thoroughly in the late 1990s. Clearly, this is where my interest in entrepreneurship comes in. If higher taxes act as a job-lock by keeping more workers tied to their riskless salaried job (with untaxed fringe benefits) instead of a risky startup, then there is a short-term loss, measurable in terms of deadweight loss, and also a long-term loss, the immeasurable reduction in potentially innovative activity.

So what does the ETI literature tell us about entrepreneurship? Glenn Hubbard, Austan Goolsbee, and Doug Holtz-Eakin have written on this, including chapters in the 2000 tome, Does Atlas Shrug?, edited by Joel Slemrod. Goolsbee describes the "new tax responsiveness" (NTR) literature in terms of a methodology using econometric analysis of empirical data from natural experiments. The term confused me when I first heard it, because these are not really experiments in the proper usage of the term. But economists are able to assess activity before and after an unanticipated (exogenous) event such as a major tax reform, they call it a natural experiment. In any case, the early estimates of ETI were above 1, meaning that income was highly sensitive to taxation to the extent that an X percent increase in the marginal tax rate led to an equal or greater than X percent reduction in taxable income.

There may be more detailed papers about ETI and entrepreneurship, but the most useful survey of ETI I have found is a recent chapter (ungated here) by Seth Giertz in the 2009 AEI book Tax Policy: Lessons from the 2000s. Giertz reports that "recent studies report [ETI] estimates closer to 0.4." Estimates are narrowing, while at the same time we are learning that the ETI is not constant over time nor across earners. It seems the ETI rises with income itself -- the rich are so sensitive. Some studies that are able to focus on higher-income earners find estimated ETI slightly over 1.

Nonetheless, the NTR literature is limited to empirical econometrics, with all the pros and cons it entails. Giertz identifies a handful of issues that complicate ETI estimation: exogenous shifts in income distribution, mean reversion, endogeneity of the tax rate, institution factors in the tax system (shifting base, enforcement), transitory responses and income shifting, and transfers between economic agents. I know enough econometrics to worry that the empirical ETI debate is unlikely to be resolved since the results will be so sensitive to the inclusion or exclusion of other variables. It is worth noting that Giertz' paper makes no mention of insights made by experimental econ. But it seems to me that experiments can isolate ETI behavior and control for all the noise that muddies the signal in empirical work. It sure can't hurt.

Experiments and Taxes. A pioneering study was published by C.W. Swenson in 1988, updated and improved by M.A. Sillamaa in 1999, which confirmed Lindbeck’s theorem that higher marginal labor taxes will depress work effort even when all income is redistributed. Sillamaa reports that a marginal labor tax rate rising from 12 to 87 percent (across five discrete rates) - with revenue fully redistributed as a demogrant - is associated with a decline in total work intensity of 21 participants, from 7734 tasks to 6824. But by focusing narrowly on the Lindbeck theorem, this research sheds little light on richer, and more realistic, aspects of fiscal policy. Full revenue redistribution, in particular, is a very strong assumption.

And yet, the Sillamaa study establishes a firm foundation for future research using an experimental framework that includes (1) tedious work, (2) real money payments based directly on work effort, and (3) leisure opportunities as a valid participant activity. This framework could be extended to richer policy environments which would yield valuable insights into work behavior.

More recent experimental studies have explored the Laffer curve (Sutter and Weck-Hanemann 2003; Levy-Garboua, Mascalet, and Montmarquette 2008). But these studies use a 2-player game design where one player is the worker and the other is the tax authority. The results inform psychological motivations and rules of fairness, showing for example that a “veil of ignorance” about which player will fill role A or B leads to a greater sense of work obligation and a subsequently lower work elasticity. These papers treat tax revenue as a total loss to the worker, an assumption of zero redistribution. This is also a very strong assumption, but in the extreme opposite direction of the earlier papers.

The experimental framework I am planning on uses elements from both of these branches. The innovation I have in mind is structuring games so that all players are worker-taxpayers facing an identical environment, a faceless governing authority that can set taxes and welfare policies exogenously. A big question on my mind is whether work effort will change when the redistribution rate changes. If we redistribute a portion of tax revenues equally (so that all players get the same split), then I assume the free rider problem will loom larger as the rate of redistribution rises from 0 to 100 percent of tax revenues. But maybe social pressure in small groups will cause work to intensify with high redistribution rates.

Well, that's a pretty long preview. I'm excited about the research, and really happy to use the blog to share it with you. My hope is that experiments will offer a clean room approach to identifying ETI, which the empirical approach will have difficulty resolving alone. I can only imagine one topic of greater importance for economics, which is the precarious state of the global financial system (though I'm confident Bob Litan has that covered). The decades ahead will see developed countries struggling with the limits of taxation (here, here), and the more light we can shed on that topic, the better.

Can the U.S. learn from California?

The bankruptcy of California's government, and how it heals itself, will foreshadow how the federal government faces its own looming debt crisis.  Both state and federal legislators have been overspending, running large budget deficits, and tilting tax rates towards higher progressivity.  I worry that the national crisis is on the way to becoming just as bad as the California crisis. The question is when. Ten years?  Twenty? It all depends when investors lose faith in the ability to repay debt, right?

If the Congress decides to bail out California, it will be the most significant policy disruption of the recession. Yes, I know, there have already been profound shifts in policy -- the Federal Reserve's aggressive tactics, the bankruptcy of Chrysler and ongoing circuitous nationalization of the auto industry. But the fabric of America is its federalism: independence of the 50 states.

I find it very hard to imagine that voters in the other 49 states will tolerate their elected representatives raising THEIR taxes to pay for California. The Constitution was designed specifically for each state to make its own decisions and reap its own consequences, and for that independence to serve as a learning laboratory of democracy. The Founders also designed Congress so that representation was based on geography, not ideology. So if the Congress bails out California (in any way: guarantees for more debt, outright grants, whatever) it means that partisanship trumps the nature of our Republic. It will send a signal that state legislators can act with the utmost irresponsibility. And it will probably be the death of federalism.

As we witness the crisis, remember the populist political reforms of the 1990s. Term limits were adopted when Prop 140 passed in 1990. The result, unfortunately, is much like what happened to Wall Street firms. Short-term gains became the rule, and creating a leagacy of any kind was no longer possible. Legislators focused their energies on big new spending projects, congratulatory celebrations, while passing the buck to the next crop. Note also that California's term limits (6 total years for Assembly representatives and 8 for state Senators) are the lowest among the 50 states, matched only by Michigan. I'm pretty sure those are not the states to emulate this year, as their citizens would attest.

Add in the infamous 2002 political gerrymandering in California (great wiki article here) -- which both parties preferred and the Supreme Court did not overturn -- and you get something worse than gridlock. You get self-destruction. Who wants to bail out that?

Entitlements and Growth

I don't want to bury the lede, so here's a link and quote from one of the finer essays I have read in years. Andrew Biggs' essay in The American titled "The Straw Men of Social Security" actually makes Social Security reform and wonky debates about entitlement math seem sexy:

Due to the recession and to faster-than-expected increases in life expectancies, the long-term 75-year deficit increased by 18 percent, from 1.7 percent of payroll to 2.0 percent of payroll. This implies that if the 12.4 percent payroll tax were immediately and permanently increased by 2.0 percentage points (or benefits were cut across the board by 13 percent), the system would remain solvent through 75 years. In the 76th year, however, it would once again become insolvent. This means that workers who paid a full career of tax increases would not receive their promised benefits. To make the system sustainably solvent would require an immediate increase in the payroll tax of 3.4 percentage points, to 15.6 percent of wages. ...

Faster economic growth is great, but a) no one has any clear idea how to produce it over the long term; and b) its effects on Social Security are limited because benefits are indexed to wage growth. That is, higher taxes today equal higher benefits tomorrow. Even doubling the rate of wage growth would erase only about half the Social Security deficit. (Calculate it yourself from this table.) And there is no way any policy is going to double the rate of wage growth. (For those who like math, click here for a technical paper showing that faster growth could actually hurt solvency over the long term.)

Biggs is responding to the latest annual Trustees report, but also partly, to this pre-emptive and somewhat hostile but eloquent rant from the New America Foundation's Michael Lind. A week later (today), Lind published this follow-up piece, "The Right's Social Security Scare Tactics,"

The "generational equity" theme is used by opponents of Social Security to imply that future generations will stagger under the burden of paying taxes for Social Security alone (and not just in conjunction with Medicare). But according to the trustees, even when the trust fund runs out (in 2037 or 2041 or whenever) and Social Security becomes a pure pay-as-you-go system, in which working-age Americans finance retirees, Social Security minus other changes would pay about three-quarters of what it owes. Lifting the cap on the amount of income subject to the payroll tax would eliminate that problem forever. So would an extra 1 or 2 percent of GDP decades from now, obtained by diverting revenues from other programs, like a more modest defense budget, or raising new revenues -- say, from a modest national consumption tax. Whether the new revenue came from a payroll tax without a cap, diverted revenues or new taxes, the burden would fall disproportionately on the affluent, who overall will be much more affluent half a century from now, assuming even low economic growth. In other words, the contract between elderly Americans and the rest can be honored in half a century by slightly higher taxes that would fall chiefly on much richer Americans in a much richer America.

And The Winner Is ...

In his first essay, Lind makes a good point that fixing Medicare is much more daunting than Social Security, and he provoked my interest by noting that economic growth can fix the problem without cutting retiree benefits or raising taxes. He's absolutely right. But he's wrong to suggest economic growth alone can do this, which Biggs carefully observes, because Social Security is very oddly structured to give each new crop of retirees a better deal than the year before. For purposes of the debate, we see Lind change his tone in the second article by suggesting that a new tax on consumption or the rich will be necessary to siphon off some of that growth.

To summarize, growth alone can't solve the entitlement crisis because the entitlement programs are either indexed to growth (SS) or have costs outpacing growth and inflation, take your pick (MC).

What I think sinks Lind are two things.  First, in an article that goes after people by name for being crafty, it would seem he should be brutally honest. But suggesting that all deficit hawks are creatures of the Right is absurd. If it were true, then conservatives would actually have some credibility. The fact is that concern about the rising deficits in America, especially the broken entitlement programs, is one of the few genuinely non-partisan issues in Washington. Offhand, I would suggest that only opposition to racism has similarly wide support. Entitlement reform is a classic case of good policy versus bad politics, and the politics have been winning for decades. The second problem for Lind is his suggestion that a new tax can solve things. The math may work, but only by breaking Roosevelt's promise.  The noble promise of Social Security is a special contract between a worker and the state where the insurance provided was paid for by the worker himself. Modify that contract into an uncapped tax on the rich, and you have a very different program, philosophically. 

Naturally, one could argue that the program has changed over time. And it has. But the roots of the system should not be violated by another reform, they should be restored. A good place to start would be to let economic growth work its magic, and by that, I mean Congress should fix automatic raise each new generation of retirees gets. It seems to me a very strong argument for politicians to make that tomorrow's retirees should not be getting a better deal than today's, a system that becomes bankrupt for retirees the day after tomorrow. It's not fair in both directions.

Recession = Weak Job Creation

Viewing the economy as a dynamic rather than a static system yields paradigm-shifting insights. The most spectacular in my experience has been understanding that the rate of job losses is much less important than the static perspective can understand. So, the fact that that media trumpets "job loss" stories during downturns emphasizes exactly the wrong thing. What causes a net decline in employment is not, in fact, job losses but a collapse in hiring.

David Leonhardt pulls down some of the latest data to make this point. But Leonhardt doesn't go any further with this line of analysis, concluding instead, "Why? How should the government respond? How should the country’s long-term economic policies be changed to reverse this long-term decline in hiring? All are good, hard questions."

Let's not pull punches here. The answers are not elusive, and point directly toward policies that encourage job creation and job creators, and sharply away from policies that aim to save jobs. On that note, the Obama administration's language about "creating or saving" 2-4 million jobs is unhelpful. More talk among the political class about spurring job creation and new venture creation would be a good first step towards actual policies along these lines. Payroll tax cut, anyone? 

And help me out here, but why does California have an $800 fee to start a new LLC? Oh wait, maybe they don't (because this court seems to have ruled it an unconstitutional tax.  We'll see ...)

Want a job? Get a license.

Would it surprise you to know that 29 percent of the U.S. workforce has a job requiring a license, up from 5 percent in the 1950s? Would it further surprise you to know that the economic consensus is that licensing raises prices, restricts job opportunities from the less privileged, and offers little or no quality improvement in service rendered?  And would it surprise you to know, lastly, that the ivory tower has essentially turned a blind eye to this research?

Let me recommend this tremendous and readable paper by E. Frank Stephenson and Erin E. Wendt in the May '09 EJW:

Consider the textbook by George Borjas. There are 11 pages covering the minimum wage. If he devoted pages in proportion to workers covered, then 11 pages on the minimum wage would correspond to 99 pages on licensing. Ehrenberg and Smith would give 72 pages to licensing. Hyclak, Johnes, and Thornton would give 135 pages to licensing. Instead, in each case, there is zero.

That this is terrible policy is hopefully self-evident. But are we surprised that its use is rampant? In a world where fear sells protectionism, not so much. In states that really care about fighting poverty, you will see lower licensing regulations.

Limits of Taxation (Glaeser edition)

Edward Glaeser says that mobile labor constrains the effectiveness of tax rates. Since successful development relies on attracting skilled workers, it seems that raising state and local taxes deter those very workers from establishing roots.

Typically, every five years, 43 percent of Americans change houses, 18 percent of Americans change counties, and 8.4 percent of Americans change states. Mobility radically constrains the ability of geographically small governments to redistribute.

Hmmm.  Maybe this is why Massachusetts has a flat tax, but it doesn't explain why Texas has no income tax at all.  Anyway, the post is very highly recommended (indeed, I will probably re-read Glaeser's post and follow the links again this year).

Unlocking Jobs

One of the surprises in our recent surveys of blogger experts and the public (via Doug Schoen) is the importance of medical insurance as a job lock, the phrase used to describe how Americans become captured with iron (if not golden) handcuffs to their existing employers with untaxed benefits.  Health benefits are arguably the most important, since they are protections against catastrophic loss, and the fact is that self-employment cannot compete on a level playing field with those protections. Entrepreneurship, from this perspective, is much more risky than it would be normally. It's one thing to risk your income, and it is something altogether different to risk the health of your family.

Economist bloggers in our survey identify the loss of benefits as the #1 barrier to starting a new company in the minds of most Americans.  Similarly, they said that the #1 change to encourage more start-ups would be allowing people to "keep existing health benefits."  In Kauffman's major 2007 Roadmap paper that Bob Litan assembled and published with a dozen experts, decoupling health care from employers was positioned as one the top policy changes that would enhance entrepreneurship.

Here's a quick scan of the job lock literature:

• RAND (2007) by Fairlie, Kapur, and Gates, "Is Employer-Based Health Insurance A Barrier To Entrepreneurship?"
• Heritage Foundation (2009) by Winfree, "Does employer-sponsored health insurance reduce job mobility?
• ILRR (2007) by Bansak and Rafael, "SCHIP and Job Mibility"
• This highly readable 2006 literature review by the blogger Healthcare Economist.

I am surely missing some other good papers and summaries (and I found the wiki page disappointing).  Any suggestions?

My quick analysis of the issue, which is not set in stone ...

1. The tax treatment of health and other benefits is harmful to economic efficiency.  All emplolyment benefits should be treated as income, which would be both progressive and pro-growth!

2. Job lock may be hard to identify empirically, but survey data show it to be a major concern. I suspect much early-stage entrepreneurship is hampered into a part-time activity due to job lock, which means current policy is bogging down growth and innovation.

The Triumphant Return of Harold Bradley

He's back, this time to elucidate the hidden connections between the beloved SNL duo Hans and Franz and the utter tautology of investment consulants and prudent man standards. (I also hear he will be writing the script for the sequel to The Departed based on this pseudo-protection racket.)

The Limits of Taxation: Cato edition

How high can marginal tax rates rise until the loss of work incentives becomes unbearable?  Unbearable for citizens is one aspect, but the operational aspect is probably the tolerance of governments. Taxes so high that revenues decline?  Unlikely a society can reach that point, unless of course the society is globalized. When high tax rates chase out entrepreneurs, societies will notice. This notion of tax competition is the motivation of Chris Edwards and Dan Mitchell's book  Global Tax Revolution.

Though the book focuses mainly on the mobility of capital rather than labor, Chapter 5 is all about "Mobile Brains and Mobile Wealth." It starts with the surprising fact that "the number of people living outside their country of birth has doubled since 1980, from 100 million to 200 million."

Although the authors hold that tax competition is the driving force in knowledge economy immigration, but much of this chapter is a review of the many factors that favor higher rates of immigration. The fall of communism (which walled in its citizens) is surely one key factor. The new economy with higher rates of churn is another. But the basic forces of globalization - cheaper intercontinental travel and internet communication - are a third force that promises to intensify. Trade agreements and political unions (like the EU) are a fourth factor. Finally, the fifth factor is the policy innovation of immigration "points" systems in places like Australia, Britain, Canada, and New Zealand. Notice how these are English-speaking nations aiming, presumably, for English-speaking (American) brains.

One might read the chapter more as a critique of restrictive immigration policies than tax policies, but the authors turn to the competition among nations for wealthy people. With 31 percent of the world's 10 million millionaires, America has much to lose. But countries like Britain, with light taxation toward non domicile migrants or "nondoms" understand that only a small portion of wealth is inherited. Most wealth is created by first-generation earners / entrepreneurs. Thus, it is not the estate tax which is the most important, or even the nefarious wealth tax, but the most basic tax of all: the burden on current work and investment.

As a throwaway observation, I've long pondered the phrase "capital gains." It's a puzzle to me why gains made from investing in a firm are treated as "capital gains" just the same as gains made from creating that firm. Newsflash: I'm not an expert on this, but I can't help but wonder if an economy encourages more entrepreneurship if its tax code distinguishes between the two types of gains: capital and creative.

Back to Edwards and Mitchell ... the remainder of their Chapter 5 is a stunning world tour. The French state's hunger for tax revenue is appalling and not a little sad. With 300,000 French citizens living in Britain, numerous stories about fleeing young workers, and an internal advisory report to the government in Paris that "10,000 business leaders have left France in the last 15 years," one can't help but shudder. The wealth tax translates into an immediately unpayable burden on successful entrepreneurs whose illiquid firms are valued highly.

Germany, Italy, even Britain have their own weaknesses, but America is one the least responsive to the growing policy competition. The U.S. still has powerful advantages, but it does not seem to realize how quickly they are eroding.

Government to Recruit New Regulators from Planet Krypton

The latest buzzword in the ongoing debates over how to overhaul financial regulation is "systemic risk." The Obama administration and Fed chairman Ben Bernanke have floated the idea of a regulator to monitor institutions that are so densely interwoven or so ginormous that their failure puts the entire financial system at risk of collapse.

At one level, this is a needed recognition that the world of finance functions much like any other network, real or artificial--large hubs often dominate and are connected to millions of smaller nodes, the system can often be seen to act as a cohesive whole, etc.

The obvious question, however, is what, exactly, a systemic risk regulator would do differently from the current regulatory apparatus. Surely our myriad regulators knew about the breathtaking leverage ratios at investment banks? Of course they did: the S.E.C. authorized lifting the cap on leverage amounts. And it seemed like every other week over the past several years a newspaper published a chart showing the explosion of credit default swaps and collateralized debt obligations. Part of the reason the Fed helped rescue Bear Stearns was the firm's interconnectedness: it had at least 5,000 institutional counterparties to its CDSs. Wasn't the rescue's rationale the stanching of systemic risk?

In his highly interesting if dense 2003 book, Why Stock Markets Crash (was this book required reading for everyone, bankers, traders, regulators, academics? if not, why not?), Didier Sornette noted that in complex financial systems, the critical points of collapse are brought about by those essential elements at the heart of the system: "the dynamics of confidence and of contagion and decision making based on imperfect information."

In other words, financial systems soar and collapse for rather mundane and unsurprising reasons: after all, human beings comprise them. When confidence shifts, when contagion spreads, when imperfect information is mistaken for perfect information (something many economists still do), the system moves quickly from resiliency to vulnerability.

Government regulation unquestionably plays a crucial role in the health of any economy and any financial system (although those now blaming the crisis entirely on government are often the same people who a few years ago were lionizing the wonders of liberated finance). The idea of monitoring systemic risk is not inherently bad. But it takes a leap of the imagination to think anyone, even a super-regulator, can gather enough information and have adequate foresight to forestall crises, large or small. And this crisis has keenly demonstrated the shortcomings of everyone involved.

In a commentary on Marketplace yesterday, Susan Lee pointedly observed that a super-regulator requires "super-people." Given the apparent requirement of a systemic risk regulator to supervise confidence, contagion, and imperfect decision making, that sounds about right. So don't be surprised if in their next public statements, Secretary Geithner and Chairman Bernanke send out an all points bulletin to Krypton, beseeching their financial experts to immigrate here.

Cartoon Keynesiansim = Slamming Amity Shlaes

The Economist (magazine) blog is schizophrenic this week.  On the one hand, it does a drive-by ad hominem attack on Amity Shlaes, calling her "empirically challenged" without actually mentioning any facts she got wrong in her book, The Forgotten Man. On the other hand, the blog has a post today that points out the fallacy in the idea of Keynesian growth. The fallacy of Keynesian growth is the basic idea of The Forgotten Man, by the way, a much bigger story than spending multipliers.

Clearly, the global economy is in a deep recession, and the Democratic monopoly in power in DC is moving boldly to address it. Indeed, the moves have been so bold that Republicans are essentially united in opposition. This isn't just partisanship, as there were many centrist Democrats voting against the recent stimulus bill, and already vocal Democratic defections from other economic plans coming from the White House (witness the quiet multi-month delay in consideration of the Orwellian "Employee Free Choice Act"). These are simple facts. Unfortunately, the heated politics of the worsening recession have boiled over to the economics, and made for some nasty exchanges.

One of the core concepts being debated is whether fiscal stimulus is an effective remedy for recessions. As Harvard economist Greg Mankiw has recently and repeatedly observed, this idea was out of favor among mainstream academic economists in recent years. Unfortunately, the very word "Keynes" has become, in political conversation, an invitation to draw battle lines and simplify discourse entirely. Naturally, we all struggle to make technical economics accessible to the lay reader (i.e. the policymaker), but discussions of Keynesianism are particularly cartoonish. It is unhelpful enough when politicians want to believe that everything Keynes did, said, wrote, researched was somehow socialist. It's even worse when academics (Brad DeLong, are you listening?) play on those same cartoonish sentiments.

Defenders of the stimulus want to confuse Shlaes history book into some kind of wild-eyed hostility to all things wise and wonderful written by Keynes and every great economist since. She's no economist, they thunder! Consider BigPicture which ridiculed Shlaes last November as "economically clueless" and a "no-nothing" (know kidding) for describing a recession as two quarters of GDP decline, which is exactly what Ph.D. economists do all the time as a non-technical rule of thumb. 

Advocates of activist policy are really guilty not just of a war against apostates, but distorting their own prophet's words. They are turning Keynes into a caricature: all spending is good spending! Cartoon Keynesianism sees all politics as a struggle over the size of G, government. This cartoon is offensive and seems like a willful distortion with ulterior motives.

In truth, Keynesian stimulus need not be government spending, it can also be tax cuts. Shocker! I, for one, support the basic Keynesian idea of automatic stabilizers in place and wish we had more built into the tax system. Yet too many voices in the punditry space lump all tax cuts in the capitalism/Republican side and all spending in the socialism/Democratic side. It's insulting to both sides, and worse it marginalizes the more important conversation about growth policy. Here's the honest way economists should be talking about any short-term Keynesian spending plan: "Recovery? Maybe. Growth? No." 

That conclusion, in fact, is from the Economist blog. Quote: "Stimulus can help with recovery, but it can't do much to aid reformation—indeed, it could retard structural transitions."  Keep in mind that not all economists are even that kind to stimulus policies. Research by UCLA economists Harold L. Cole and Lee E. Ohanian in 2004 conclude FDR's policies extended the Great Depression, saying: "We found that a relapse [into another long Depression] isn't likely unless lawmakers gum up a recovery with ill-conceived stimulus policies." A 1999 paper by the economists for the Minneapolis Fed reviewing the Great Depression opens:

[T]heory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s.We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income.

Validation

A lot of good theory works on paper, but is humbled by reality. This is what happened to Old Keynesianism, and is why modern teaching in grad schools is now done under the banner of Neo- or New Keynesianism. The identity Y = C + I + G + NX is simply too crude to tell us anything about how an economy grows. The crudest interpretation, and dumbest, was followed by Washington policymakers for decades and imagines the national income identity can be managed by fiscal policy. Whether such policy is sustainable is irrelevant. And yet, history tells us that constantly pushing G to manage Y causes an uncontrollable price inflation. Uncontrollable in the Keynesian paradigm, that is. The whole framework was superseded by expectations macro and validated by Volcker when he stopped Keynesian inflation of the 1970s with the 1980-82 monetarily induced recession.

The defenders of Cartoon Keynesianism want to believe their framework had a similar validating experience, which was the New Deal's curative power over the Great Depression. The simple history taught in most high schools today (and non-economics college courses) is that FDR's expansion of government saved the national economy. That's just not true.

There are four presidential names being bandied about: Hoover, Roosevelt, Bush, and Obama. The cartoon story says that Bush like Hoover wrecked the economy with laissez-faire extremism and that Obama like Roosevelt will tame capitalism's failure with strong government action. The reality is that government spending and budget deficits under President Bush were massive, while Hoover is infamous for raising tariffs in 1930 as well as the top income tax rate from 25 to 63 percent in 1932. So Hoover wasn't really laissez-faire in his policies, and Bush wasn't either. Every president - especially Obama - offers a mixed bag of tricks that defy labels, especially old ones.

So why did Free exchange go after Amity Shlaes?  For starters, it was echoing a long and current piece by Jonathan Chait in the New Republic, whose purpose is to paint modern Republicans as little Hoovers. Except for the little things like tax rates and free trade, which he ignores, choosing to selectively make a case about somebody else making a selective case. My theory is that this is part of a larger reckoning.

Chait wants his readers to think the Amity Shlaes is an outlier (and not the smart kind). But Chait -- perhaps because he also has no economics degree -- makes false claims about consensus in the profession, such as "the essential framework constructed by Keynes--that recessions are caused by a failure of demand, and that at the very least government should not respond to an economic slowdown by paring back its largesse--is no longer in dispute." This is just wrong. It may comes as some surprise that a 1995 survey of economic historians published in the Journal of Economic History said this:

On top of the profession's lack of agreement about the genesis of the Great Depression, there is a disagreement about the effect of the New Deal. In fact, the economists in the sample are almost evenly divided on the question of whether or not when taken "as a whole, government policies of the New Deal served to lengthen and deepen the Great Depression."

The Reckoning

This is important not just to make the point that partisans on the Left (and Right) are mean, dishonest jerks. The global recession is very real, so when even the Economist (magazine) falls into this shallow smear game, I get worried that we are collectively taking our eye off the ball. If your goal is rip-roaring growth, fixing banking, fixing mortgages, or a real cure for poverty, a debate about stimulating the short-run economy is irrelevant. At best, another trillion in G arrests a couple points of GDP decline for a couple years if you believe the macro sim models. Add up all the new plans, and you get annual trillion-dollar deficits for the next decade, according to the Brookings Instituion.

Rather than take on half of the economics profession, or Brookings, or just engage in a serious discussion of growth policy, the partisans have instead decided to target Amity Shlaes for writing a history book two years ago about the New Deal and FDR. Ironically, if you understand her title, The Forgotten Man is not about macro stabilization theory, but about the unprecedented scope of powers that were centralized in 1930s America, running roughshod over the Constitution and the middle class Americans who pay for grand plans. This, too, is fact even for fans of big G. But I guess describing facts makes you an enemy of the state and its toadies.

What is really at stake is a year of budgetary reckoning, which I now believe will become a decade of reckoning. The crisis of big entitlement promises is about to clash with the limits of taxation. Shouting down Amity Shlaes is just a warm-up.

How about Teacher Choice?

President Obama's education speech today has been well received. Jay Matthews, the great WaPO education columnist raves,

President Obama’s education speech this morning was, in my memory, the largest assemblage of smart ideas about schools ever issued by one president at one time. Everyone will have a different favorite part — performance pay models for teachers, better student data tracking systems, longer school days and years, eliminating weak state testing standards, more money for schools that improve, more grants for fresh ideas, better teacher training, more charter school growth, faster closing of bad charters and many more.

Federalists will admire the fact that Obama said nice things about strict standards, such as those in Massachusetts, but did not call for national standards. Bottom line: the President is going in the right direction on education reform. His support of charter schools is the kind of breakthrough that may change everything.

Matt Yglesias' observes the challenge reality faces in meeting the President's serious rhetoric about removing bad teachers (Great!):

He made a call for performance pay programs of some sort to be implemented in 150 school districts, and paired that with an extremely tough statement on firing bad teachers—”Let me be clear: if a teacher is given a chance but still does not improve, there is no excuse for that person to continue teaching.” This comes after a commitment to making more funds available for programs to recruit people into the teaching profession. And underlying this commitment to quality teaching is the not-so-exciting issue of getting better data on student performance. Obama rightly lamented the fact that relatively few states have state-of-the-art data and tracking programs in place even though at the end of the day it’s very hard to improve if you don’t have a mechanism for telling how kids are doing. One thing he left out was that some states have already started adopting laws that prevent the data they have from actually being used in a variety of circumstances. This is, obviously, a big problem for anyone interested in data-based school administration. The clear implication of everything Obama said was that states shouldn’t do this, but nobody was called out specifically.

Let's back up. Why this catch - firing bad can't be done until an elaborate system of data exists on student performance? What's the logic here?

1. Principals are allowed no discretion or judgment.
2. The only objective way to evaluate teaching is some overlord data system (as if those can ever have perfect knowledge).

There's a better way to evaluate teacher performance.  Let students and parents choose. Good teachers will have full classrooms, bad teachers will have smaller classrooms, and principals will have all the information they need.

You don't need an elaborate data system, or funding, or a marketing campaign for recruiting, or nor even a charter school. Every public elementary school could - if it wanted - let parents have a voice in who teaches their children. At our local elementary, there are four teachers for each grade level, and some kind of lottery system assigns my children their teacher each August. Every parent in America knows who the good and bad teachers are, and you here constant conversations in our communities where one mom says to another at the grocery store, "Gee, I heard your Susie got Ms. Killjoy for 1st grade. Sorry to hear that. But hey, next year all the 2nd grade teachers are great." Everybody knows this. But it begs a deeper question: why are we not allowed to choose our children's teachers?

I can promise you that teacher choice would rapidly reveal who the worst relative teacher is in every grade level in every school. There is no need for standards or state-of-the-art data from central planning. Use the old fashion thing called a market that worked sorting out the good fish from the bad fish in medeival times. A Teacher Choice system would be easy to design, too. Imagine 100 sudents need to be allotted among 4 classrooms/teachers,simply allow each parent to submit a request designating 1st, 2nd, and 3rd choices for teacher. Miss Honey would get 33, Mister Bill would get 30, Mrs. Aniston would get 25, and Ms. Killjoy would get 8. Honestly, this isn't rocket science.Within 24 hours, principals would have all the information they desire to identify weak teachers. 

I'm sure we economists could design an even more alborate system of auction voting where parents could spend points that would reveal preferences. But there are two other things that teacher choice isn't.  It isn't expensive to implement. And it isn't politically correct.

The Agony and Irony* of Taxes

Since the release of President Obama's budget preview there's been a lot of noise made over the question of taxes, specifically relating to two issues. First, the federal government's long-term fiscal problems, which Tim wrote about yesterday. The second issue is the question of what impact higher taxes will have on entrepreneurship.

There's no doubt that Uncle Sam is flirting with budgetary fire--the numbers being thrown around about the long-term deficit are almost beyond belief. And quite frightening. It seems likely that some combination of higher tax rates and trimmed entitlements will be unavoidable. But it is also doubtful that higher taxes can make much headway against the enormous mountain of government debt, particularly given the towers of debt that households will continue to struggle with. California, moreover, is Exhibits A through Z as to the effects of relying solely on higher taxes to prop up the governmental edifice. 

Thus, it would seem that some sort of entitlement restructuring will end up being the only conceivable way to boost fiscal health. (I must admit, however, to being a tad mystified at the proposal to make Pell grants an entitlement--the rationale of making college more affordable for more people doesn't hold water against the evidence that rising tuition costs have been, in part, a product of expanded federal aid.)

The second tax issue--the effect on entrepreneurship--is much more ambiguous and thus emotionally-freighted. Will higher taxes on those with incomes over $250,000 dampen the entrepreneurial spirit? There is certainly reason to think it will: lots of small businesses, for example, file individual income tax returns and thus would face higher taxes. (Secretary Geithner maintains that this would be an incidentally small number.) The always-perspicacious Jim Manzi makes a persuasive case that higher taxes will in fact affect the probability calculations made by prospective entrepreneurs and dissuade many from taking the plunge.

Yet that can't be the whole story. For one thing, William Nordhaus has calculated that entrepreneurs capture only about two percent of the surplus they generate--consumers (society) capture the rest. Entrepreneurs take risks, to be sure, but it just doesn't seem quite right that they go through the analytical  probability calculations that Manzi outlines. In many cases, they are explicitly pursuing "psychic rewards," knowing that the pecuniary payoff might be less than that.

In a larger sense, let's put the whole tax issue in perspective: taxes might actually be one type of undergirding for entrepreneurship, so the dampening effect of a slight uptick in tax rates may be overstated. Last month there was a fantastic essay in The New Yorker on the struggles of free-market economists in Iran against the statist Islamic regime, which doesn't seem to understand anything close to basic economics. By depending almost exclusively on oil revenues, the Iranian government does not have any incentive to cultivate productive entrepreneurship--the citizenry depends on the government. In countries like the United States, the government depends on the people and entrepreneurs, and taxes are the mechanism of that dependency. This, needless to say, is much more salutary for economic growth and democracy.

*with apologies to Alkaline Trio