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Can tax cuts increase economic growth?

5 Dec

The current “debate” about tax cuts (actually, there appears to be more hand waving than debate but my parents taught me the virtue of politeness!) revolves around a central assertion: Tax cuts will spur economic and job growth. This assertion is based on the assumption that corporate and income tax cuts (many small businesses pay income rather than corporate taxes) will be reinvested into the economy spurring job growth. This is not entirely clear (https://www.bloomberg.com/news/articles/2017-11-29/trump-s-tax-promises-undercut-by-ceo-plans-to-reward-investors) but let us for the moment assume it will indeed happen.[1]

When businesses reinvest their capital, business grows and demand for labor goes up. Basic microeconomics does support this position. More capital increases labor productivity. Therefore, for a given supply of labor wages go up. Given the current tight labor market, this may indeed be the case. However, life is seldom static. The wage increase relative to the price of capital implies that new investment is likely to be capital intensive rather than labor intensive. This process actually exacerbates the current trend toward robots and away from labor. Thus, it is unclear if these tax cuts will increase job growth dramatically. In any case, these, fewer, new jobs will tend to benefit the sort of labor that can run robots and write algorithms. People with older/no skills will be left out in the cold. Such a scenario may create a permanent unemployable underclass if e.g. schools are unable to pick up the training slack.

The corporate tax cuts have other effects as well – particularly if these cuts lead to companies moving their tax headquarters back to the United States. This move will show up as a capital account surplus in the United States international balance of payments. This influx of foreign money increases the demand for USD and leads to an appreciation of the dollar relative to other currencies. The more expensive dollar makes our exports more expensive and our imports less expensive – thus increasing the trade deficit. This is not a problem per se but I have to scratch my head at the Trump administration’s inconsistency in pushing for a tax cut designed to increase the trade deficit when they want to reduce the trade deficit. To reiterate though, I do not think a trade deficit is a bad thing because foreign lenders MUST finance it. Therefore, it keeps interest rates low as well.  That can help future growth. Alternatively, if the US increased tariff/non-tariff barriers to cut the trade deficit the capital account surplus would have to go down – i.e. businesses would not bring capital into the country. This of course would cut off some of the growth benefits of the corporate tax cut.

Bottom line effects:

  1. If the corporate tax cuts lead to capital reinvestment (and this is a big if) then labor productivity and wages will rise. This will lead to economic growth. However, job growth may not happen since firms will substitute labor with cheaper capital.
  2. Jobs will be skewed toward specific skills. This will continue the current process toward jobs with specific skills and away from low-skilled/old-skill jobs.
  3. Any attempt to lower the trade deficit will reduce the growth potential of the tax cuts.

[1] The income tax cuts are temporary. This may actually increase the incentive to pay out dividends which may then be taxed at lower income tax rates today rather than wait to be taxed at a higher rate I the future.

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Why does free speech matter? Channeling John Stuart Mill.

5 Dec

The assault on free speech seems to be growing. Millennials seem ok with limitations on “offensive” speech (http://www.pewresearch.org/…/40-of-millennials-ok-with-lim…/). Millennials also seem skeptical of democracy (https://www.washingtonpost.com/…/yes-millennials-really-a…/…). Forget the millennial angle. Let’s think about the connection between limiting speech and dying democracy. Can these phenomena be related? John Stuart Mill may have an answer.

Mill writes that free speech is important for three reasons. First, it may silence a true opinion. Second, engaging with false opinions help holders of true opinions get a better sense for why their opinion is correct. Indeed this is the basis of science – there can be no science without falsifiability. Last, different opinions may have different elements of the same truth; engaging with these different opinions helps people a clearer picture of the truth. In any case, as long as we believe that all individuals are equally capable of thought (if fallible) everyone’s opinion has value. Hearing out even mistaken opinions gives such thoughtful individuals an opportunity to learn. Thus, free speech helps people toward a realization of truth.

However, free speech has cultural effects as well. Engaging in free speech and keeping the space open for dissenting opinions generates a culture of fallibility. This reduces the risk of people forcing a wrong opinion on others. Moreover, free speech allows people to learn, thus allowing humanity to better respond to changes in their social, cultural, economic, political, and geographic environment. Free speech also vets opinions and therefore creates a systematic way to confer legitimacy on opinions, a process also known as science! This legitimacy has important implications for the legal fictions that govern the relationships between individuals (or society).

For example, the constitution is fiction; a mere piece of paper. The effectiveness of constitutional rule of law therefore depends on whether people believe that the constitution is legitimate. Free speech creates the environment for conferring this legitimacy through the three reasons stated above. Thus, free speech is the heart of democratic rule of law. Given this connection, when people do not believe in free speech they have no reason to believe in the legitimacy of constitutional democracy.

So what? A recent study by Basuchoudhary, Bang, David and Sen (“Predicting Conflict” forthcoming 2018 email: basuchoudharya[at]vmi.edu for more information) suggest that lack of institutional transparency and credibility are one of the biggest predictors of civil conflict. In short, the cultural institutions that allow free speech and confer legitimacy on governance institutions (albeit defined in a very constricted way for statistical analysis) are what is keeping humanity away from perpetual conflict. This should be of interest to everyone as we sip our $7 chai lattes.

Why Nations Fail

9 Feb

I recently wrote a review of Acemoglu and Robinson’s newest book “Why Nations Fail.” The review is available behind a pay wall for the journal Public Choice (here). But here’s the gist:

Why Nation’s Fail is an ambitious and worthwhile attempt to understand the origins of power, prosperity, and poverty. It provides a succinct narrative for how institutions may diverge. The many examples that show this divergence are entertaining and informative. However, Acemoglu and Robinson’s unwillingness to incorporate the well-established toolkit of public choice economics hobbles their analytical narrative. Ultimately, they fail to make their case – and make no mistake it is an important case to make – because they ignore the individual and they ignore history.

The impact of Republican intransigence on passing the budget and raising the debt ceiling

4 Oct

It should come as no surprise that our country finds itself in yet another internecine squabble regarding questions about how much to, or maybe even if we should, fund governmental operations.  It is a source of national embarrassment that the United States hasn’t passed a full slate of Appropriation Bills since Fiscal Year (FY) 2008.  Looking back to FY 1977, there have been 17 funding gaps of at least one day or more (Congressional Research Service). The funding gap in Fiscal Year 1997 was, until now, the most highly publicized funding gap.  In FY 1997, the U.S. Government shut down from 15 December 1996 until 6 January 1997.  While our current shutdown commands the attention of the vast majority of the press, the effects of a shutdown are mostly temporary; they do not extend much past the lost productivity of government workers. There may be very real impacts in specific sectors of the economy. Closed national parks may affects tourism related businesses, closed Headstart facilities would affect the working poor, and closed licensing authorities may affect whether businesses get certain permits or not. However, this could be balanced against the economic activity created by people who substitute their vacation dollars away from national parks or by depending on friends and family for daycare. Moreover, the impact of the shutdown will begin to be felt – even in these sorts of affected sectors – only if the shutdown drags on. Thus, it is hard for us to get overly excited about another crisis of artificial proportions.

The bigger issue associated with yet another game of brinksmanship played by two kids who can’t play nicely on the playground, is the issue of a possible link between this fight and the yet-to-be-had fight over raising the debt ceiling.  Even without the current intervention by the Federal Reserve, the United States dollar enjoys reserve currency status, which allows the U.S. to borrow at very low interest rates.  Certainly artificially low interest rates hurts U.S. savers, but it is a boon for the U.S. in terms of lessening the burden of servicing the fast-growing U.S. debt.  Now, though, we are quickly approaching the date when all extraordinary financial measures will be exhausted and the U.S. will default on its legal obligations.  This date is widely believed to be 17 Oct (side note – just approaching the debt-ceiling deadline in 2011 caused the U.S. to suffer a downgrade to its heretofore sterling credit rating; an actual default will potentially have long-lasting implications, as it will most likely raise borrowing costs substantially and it will make asset valuation harder because treasury bonds will not be risk free anymore), but the first large, default-inducing payment comes on the 1st of November when benefit checks are due.  Currently there are no indications that countries are actually worried about a default; in fact, the yield on the 10-year U.S. Treasury bond closed unchanged on the first day of the shutdown, which suggests there isn’t any panic selling as of yet.  But let’s do some back-of-the-envelope calculations to get an idea of what may transpire.  As of 31 August 2013 (latest data available from Treasurydirect.gov), there is $16.7 trillion of total U.S. Treasury securities outstanding.  The average interest rate now is 2.4 percent; this equals about $400 billion a year in interest payments.  Assuming that a simultaneous credit rating downgrade and a limited default causes a one percentage point increase in the average interest rate from 2.4 percent to 3.4 percent (a rate last seen in August 2009), interest payments will increase by $170 billion a year.  To put this in perspective, last year’s Fiscal Cliff deal is projected to raise $617 billion in new revenue over 10 years; all of this new revenue will be subsumed by increased interest payments in less than four years.

A less obvious but more pernicious consequence is the uncertainty that results from nearly five continuous years of partisan gridlock.  Businesses and individuals cannot plan if they do not know whether a law will exist or not. This puts a damper on economic activity and job creation. Moreover, to the extent larger businesses have more resources to deal with uncertainty, partisan bickering serves as a tax on small job creating businesses.

— Commentary provided by me and Jeff Smith.

Gerrymandering and the failure of the US political market.

27 Jan

Acemoglu and Robinson in their book “Why Nations Fail” argue that Venice — the global superpower of its day — became a museum because inclusive institutions like the “commenda” were slowly replaced by extractive institutions which led to the “La Serrata.” Venice effectively became a hereditary aristocracy because the election system was rigged to favor incumbents and their families.  Congressional districts in the United States are often redrawn in a way that favors incumbents. Only people belonging to a certain “family”  — political party — can get elected from these districts. This restriction of political competition has echoes of Venice! So will the United States become a pretty museum? Probably not. But it may lose its economic superiority by ignoring inclusive founding principles.

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