Tag Archives: Milton Friedman

Does Tax Increment Financing (TIF) generate economic development?

Tax increment financing, or TIF, is a method of financing economic development projects first used in California in 1952. Since then, 48 other states have enacted TIF legislation with Arizona being the lone holdout. It was originally conceived as a method for combating urban blight, but over time it has become the go-to tool for local politicians pushing economic development in general. For example, Baltimore is considering using TIF to raise $535 million to help Under Armor founder Kevin Plank develop Port Covington.

So how does TIF work? Though the particulars can vary by state, the basic mechanism is usually similar. First, an area is designated as a TIF district. TIF districts are mostly industrial or commercial areas rather than residential areas since the goal is to encourage economic development.

Usually, in an effort to ensure that TIF is used appropriately, the municipal government that designates the area as a TIF has to assert that economic development would not take place absent the TIF designation and subsequent investment. This is known as the ‘but-for’ test, since the argument is that development would not occur but for the TIF. Though the ‘but-for’ test is still applied, some argue that it is largely pro forma.

Once an area has been designated as a TIF district, the property values in the area are assessed in order to create a baseline value. The current property tax rate is applied to the baseline assessed value to determine the amount of revenue that is used for the provision of local government goods and services (roads, police, fire, water etc.). This value will then be frozen for a set period of time (e.g. up to 30 years in North Carolina), and any increase in assessed property values that occurs after this time and the subsequent revenue generated will be used to pay for the economic development project(s) in the TIF district.

The key idea is that municipalities can borrow against the projected property value increases in order to pay for current economic development projects. A simple numerical example will help clarify how TIF works.

In the table below there are five years. In year 1 the assessed value of the property in the TIF district is $20 million and it is determined that it takes $1 million per year to provide the government goods and services needed in the area (road maintenance, sewage lines, police/fire protection, etc.). A tax rate of 5% is applied to the $20 million of assessed value to raise the necessary $1 million (Tax revenue column).

TIF example table

The municipality issues bonds totaling $1 million to invest in an economic development project in the TIF district. As an example, let’s say the project is renovating an old business park in order to make it more attractive to 21st century startups. The plan is that improving the business park will make the area more desirable and increase the property values in the TIF district. As the assessed value increases the extra tax revenue raised by applying the 5% rate to the incremental value of the property will be used to pay off the bonds (incremental revenue column).

Meanwhile, the $1 million required for providing the government goods and services will remain intact, since only the incremental increase in assessed value is used to pay for the business park improvements. Hence the term Tax Increment Financing.

As shown in the table, if the assessed value of the property increases by $2 million per year for 4 years the municipality will recoup the $1 million required to amortize the bond (I’m omitting interest to keep it simple). Each $1 million dollars of increased value increase tax revenue by $50,000 without increasing the tax rate, which is what allows the municipality to pay for the economic development without raising property tax rates. For many city officials this is an attractive feature since property owners usually don’t like tax rate increases.

City officials may also prefer TIF to the issuance of general obligation bonds since the latter often require voter approval while TIF does not. This is the case in North Carolina. TIF supporters claim that this gives city officials more flexibility in dealing with the particular needs of development projects. However, it also allows influential individuals to push TIF through for projects that a majority of voters may not support.

While TIF can be used for traditional government goods like roads, sewer systems, water systems, and public transportation, it can also be used for private goods like business parks and sports facilities. The former arguably provide direct benefits to all firms in the TIF district since better roads, streetscapes and water systems can be used by any firm in the area. The latter projects, though they may provide indirect benefits to nearby firms in the form of more attractive surroundings and increased property values, mostly benefit the owners of entity receiving the development funding. Like other development incentives, TIF can be used to subsidize private businesses with taxpayer dollars.

Projects that use TIF are often described as ‘self-financing’ since the project itself is supposedly what creates the higher property values that pay for it. Additionally, TIF is often sold to voters as a way to create jobs or spur additional private investment in blighted areas. But there is no guarantee that the development project will lead to increased private sector investment, more jobs or higher property values. Researchers at the UNC School of Government explain the risks of TIF in a 2008 Economic Bulletin:

“Tax increment financing is not a silver bullet solution to development problems. There is no guarantee that the initial public investment will spur sufficient private investment, over time, that creates enough increment to pay back the bonds. Moreover, even if the investment succeeds on paper, it may do so by “capturing” growth that would have occurred even without the investment. Successful TIF districts can place an additional strain on existing public resources like schools and parks, whose funding is frozen at base valuation levels while growth in the district increases demand for their services.”

The researchers also note that it’s often larger corporations that municipalities are trying to attract with TIF dollars, and any subsidies via TIF that the municipality provides to the larger firm gives it an advantage over its already-established, local competitors. This is even more unfair when the local competitor is a small, mom-and-pop business that already faces a difficult challenge due to economies of scale.

There is also little evidence that TIF regularly provides the job or private sector investment that its supporters promise. Chicago is one of the largest users of TIF for economic development and its program has been one of the most widely studied. Research on Chicago’s TIF program found that “Overall, TIF failed to produce the promise of jobs, business development or real estate activity at the neighborhood level beyond what would have occurred without TIF.”

If economic development projects that rely on TIF do not generate additional development above and beyond what would have occurred anyway, then the additional tax revenue due to the higher assessed values is used to pay for an economic development project that didn’t really add anything. Without TIF, that revenue could have been used for providing other government goods and services such as infrastructure or better police and fire protection. Once TIF is used, the additional revenue must be used to pay for the economic development project: it cannot be spent on other services that residents might prefer.

Another study, also looking at the Chicago metro area, found that cities that adopt TIF experience slower property value growth than those that do not. The authors suggest that this is due to a reallocation of resources to TIF districts from other areas of the city. The result is that the TIF districts grow at the expense of the municipality as a whole. This is an example of the TIF working on paper, but only because it is pilfering growth that would have occurred in other areas of the city.

Local politicians often like tax increment financing because it is relatively flexible and enables them to be entrepreneurial in some sense: local officials as venture capitalists. It’s also an easier sell than a tax rate increase or general obligation bonds that require a voter referendum.

But politicians tend to make bad venture capitalists for several reasons. First, it’s usually not their area of expertise and it’s hard: even the professionals occasionally lose money. Second, as Milton Friedman pointed out, people tend to be more careless when spending other people’s money. Local officials aren’t investing their own money in these projects, and when people invest or spend other people’s money they tend to emphasize the positive outcomes and downplay the negative ones since they aren’t directly affected. Third, pecuniary factors don’t always drive the decision. Different politicians like different industries and businesses – green energy, biotech, advanced manufacturing, etc. – for various reasons and their subjective, non-pecuniary preferences may cause them to ignore the underlying financials of a project and support a bad investment.

If TIF is going to be used it should be used on things like public infrastructure – roads, sewer/water lines, sidewalks – rather than specific private businesses. This makes it harder to get distracted by non-pecuniary factors and does a better – though not perfect – job of directly helping development in general rather than a specific company or private developer. But taxpayers should be aware of the dangers of TIF and politicians and developers should not tout it as a panacea for jump-starting an area’s economy.

State government spending hits new heights

There is a large literature in macroeconomics that examines the extent to which federal spending “crowds out” investment in the private sector. Basic theory and common sense lead to the conclusion that government spending must replace some private sector spending. After all, dollars are scarce – if the government taxes Paul and uses his money to build a road Paul necessarily has less money to invest in his landscaping business. In theory government spending on public goods like roads could be a net gain. This would occur if the additional value produced by spending one more dollar on roads was greater than the additional value produced by investing one more dollar in Paul’s landscaping business. But even in this scenario, Paul himself may be worse off – he’s one dollar poorer and he may not use the new road – and there is still a dead-weight loss due to the tax.

In reality, the federal government does a lot more than build roads, especially productive ones. In 2014, only 1.9% of federal income tax revenue was spent on transportation. And most of the other stuff that the government does is way less productive, like shuffling money around via entitlement programs – Medicare, Medicaid, and Social Security – and investing in businesses that later go bankrupt like Solyndra. So while it is possible that a dollar spent by the government is more productive than a dollar spent by a guy like Paul, in a country with America’s spending habits it’s unlikely to be the case.

The same crowding out that occurs at the federal level can occur at the state level. In fact, in many states state spending as a percentage of gross state product (GSP) exceeds federal spending as a percentage of GDP. The graph below shows state spending as a percentage of GSP for all 50 states and Washington D.C. in 1970, 1990, and 2012 (data). The red, dashed line is federal spending as a percentage of GDP in 2012 (21.9%).

state spending gsp graph

As shown in the graph, nearly every state increased their spending relative to GSP from 1970 – 2012 (triangles are above the X’s). Only one state, South Dakota, had lower spending relative to GSP in 2012 than in 1970. In 2012, 15 of the 50 states spent more as a percentage of GSP than the federal government spent as a percentage of GDP (states where the triangle is above the red, dashed line). In 1990 only two states, Arizona and Montana, spent at that level.

It used to be the case that state and local spending was primarily focused on classic government services like roads, water/sewer systems, police officers, firemen, and K-12 education. But state spending is increasingly looking similar to federal spending. Redistributive public welfare expenditures and pension expenditures have increased substantially since 1992. As an example, the tables below provide a breakdown of some key spending areas for two states, Ohio and Pennsylvania, in 1992 and 2012 (1992 data here, 2012 data here). The dollar per capita amounts are adjusted for inflation and are in 2009 dollars.

ohio spending table

penn spending table

As the tables show, spending on public welfare, hospitals, and health increased by 120% in Ohio and 86% in Pennsylvania from 1992 to 2012. Pension expenditures increased by 83% and 125% respectively. And contrary to what many politicians and media types say, funding for higher education – the large majority of state education spending is on higher education – increased dramatically during this time period; up 250% in Ohio and 199% in Pennsylvania. Meanwhile, funding for highways – the classic public good that politicians everywhere insist wouldn’t exist without them – has increased by a much smaller amount in both states.

The state spending increases of the recent past are being driven in large part by public welfare programs that redistribute money, pensions for government employees, and higher education. While one could argue that higher education spending is a productive public investment (Milton Friedman didn’t think so and I agree) it is hard to make a case that public welfare and pension payments are good investments. This alone doesn’t mean that society shouldn’t provide those things. Other factors like equity and economic security might be more important to some people than economic productivity. But this does make it unlikely that the marginal dollar spent by a state government today is as economically productive as that dollar spent in the private sector. Like federal spending, state spending is likely crowding out productive private investment, which will ultimately lower output and economic growth in the long run.

The Sharing Economy

Over at the Tech Liberation Front, my colleague Adam Thierer has sketched out a few themes in the debate over the sharing economy. His discussion of leveling the regulatory playing field is particularly important. Here is my favorite part:

Alternative remedies exist: Accidents will always happen, of course. But insurance, contracts, product liability, and other legal remedies exist when things go wrong. The difference is that ex postremedies don’t discourage innovation and competition like ex ante regulation does. By trying to head off every hypothetical worst-case scenario, preemptive regulations actually discourage many best-case scenarios from ever coming about.

Adam asks for comments and additional reading suggestions. In that spirit, here are my own additional talking points on the issue:

  • Reviving dead capital: Something that Dan Rothschild has emphasized in a lot of his writings and that I’ve tried to stress when I can is that the “peer production economy” breathes life into otherwise dead capital. Cars, tools, apartments, planes, kitchens, and even dogs are now creating value for people when they otherwise would just be collecting dust (or fleas). This may help to explain the extraordinary value investors see in firms like Uber.
  • Exposing regulatory failure: Another—though not mutually-exclusive—view is that these new firms are making lots of money not because they are doing anything particularly revolutionary. Instead, they are doing well because they have found a way around traditional regulations which have rendered incumbent services truly abysmal and consumers are rewarding them for this. In this sense, Uber is profitable because it isn’t a cartelized taxi company. This is generally the view that Mike Munger expresses in his EconTalk with Russ Roberts. This is probably more applicable to Uber and Lyft than to AirBnB or 1000Tools.com since the ride-sharing firms compete with an industry that has obviously captured its regulator.
  • Transitional gains trap: The whole experience offers us an opportunity to illustrate one of Gordon Tullock’s most-valuable and least-appreciated points. When regulators contrive some artificial exclusivity, they allow incumbent firms to earn above-normal profits (rents). But often these firms are only able to earn above-normal profits for a time (a transitional period). That’s because eventually, the value of the rent is “capitalized” into whatever assets must be purchased in order to enter the industry. These assets may include taxi medallions, specially-outfitted cabs, well-connected lobbyists, or any other asset that is necessary to gain access to the exclusive club. This is important because it means that many of the current incumbents had to pay large sums of money for their exclusive position and, net of these payments, they really aren’t cleaning up. Just as Adam is right to say that “regulatory asymmetry is real” we should also acknowledge that, in many cases, taxi regulations that started out as privileges are now more like burdens.
  • Value is subjective: No two customers have the same values and interests. I may want the windows down on a hot day and you may want them up. It’s simply absurd to think that regulators could devise an objective quality-control checklist for firms to follow or that they could properly vet cab drivers better than consumers. Yet that is exactly the approach they’ve taken (see here for just how clumsy it’s been in VA). The customer rating systems are really revolutionary because they collapse these subjective, multidimensional quality scales down to one simple 5-point rating that captures a driver’s ability to tailor his or her services to the subjective needs of each customer. Your Uber ride begins with a conversation between you and your driver about what is important to you (music, temperature, windows, speed, route, etc.) and ends with a 1 to 5 rating. It’s as simple as that.
  • True competition is a discovery process: Regulations “lock in” the status quo technology (again, because they attempt to objectively state every possible quality that customers might care about). But this misses the whole point of competition. As Hayek taught us, true competition is about discovering things you never knew (and never knew you didn’t know), such as that customers like being able to order cars from their smartphones.
  • Empowering Diffuse Interests: Traditional public choice models predict that small, concentrated interests such as an incumbent taxi industry willtypically prevail in a political battle with a large, diffuse interest such as taxi customers. This time may be different though. Wherever it goes, the peer-production economy has quickly developed a large and happy base of tech-savvy customers. Since the firms themselves have tended to innovate without asking for permission, this has often meant that a city will have tens of thousands of loyal peer-production customers long before its regulators can say “cease and desist.” So in a number of places, we’ve seen regulators move to shut down the peer production economy, then we’ve seen customers protest en masse and regulators withdraw their proposals.
  • Safety: Uber and Lyft drivers carry no cash. Customers have an electronic record of the ride and their driver. Drivers have an electronic record of the customer. These simple solutions accomplish what reams of taxi regulations never could: they ensure that both the customer and the driver are as safe as possible.
  • Flexibility: Because they don’t work for the companies, Uber and Lyft drivers work when they want to. Most of them seem to report that this is one of the best features of the job.
  • Beware of Uber too!: As Milton Friedman put it, one must be careful to distinguish being “pro-free enterprise” from being “pro-business.” The goal here is not to allow Uber to be profitable but to allow competition which will enhance the customer experience. We have already seen that when given the chance, Uber—like most firms—will take an exclusive privilege when one is offered. We must be very careful that Uber isn’t let inside the regulatory velvet rope only to put it back up behind them.

Conservatives, Liberals, and Privilege

Utah Senator Mike Lee (R) delivered an important, and timely address at the Heritage Foundation this week. It was focused squarely on what he called “America’s crisis of crony capitalism, corporate welfare, and political privilege.”

It is a problem, he said, that “simultaneously corrupts our economy and our government.” He pointed to a number of ways in which it manifests itself, including “direct subsidies,” “indirect subsidies, like loan guarantees,” “tax carve-outs and loopholes,” “bailouts,” the implicit bailout of “too big to fail,” and “complicated regulations.”

The Senator is careful to point out that the problem has a long history:

Just like the crises of lower-income immobility and middle class insecurity, the crisis of special-interest privilege is not Barack Obama’s fault. It predates his presidency. And though his policies have made it worse, past Republican presidents and Congresses share some of the blame.

He also stresses that the problem is bipartisan:

Too many in Washington have convinced themselves that special-interest privilege is wrong only when the other side does it.

And he’s willing to call Republicans to task for the part they have played:

We [Republicans] have tried being a party of corporate connections and special-interest deal-making. And we’ve lost five of the six presidential popular votes since [Reagan left office].

But though he believes Republicans bear some blame, the Senator contends that government-granted privilege is fundamentally incompatible with conservatism:

Properly considered, there is no such thing as a conservative special interest.

While I agree, I have a more ecumenical view of the issue.

Yes, privilege is incompatible with properly-considered conservatism, but I also think it incompatible with properly-considered progressivism (and properly-considered libertarianism, for that matter). The Senator, on the other hand, believes that “Liberals have no problem privileging special interests, so long as they’re liberal special interests.” As evidence, he quotes progressive thinker Herbert Croly, who wrote:

In economic warfare, the fighting can never be fair for long, and it is the business of the state to see that its own friends are victorious.

I won’t dispute that many progressives continue to view things this way. But I think there is value in framing the elimination of government-granted privilege in terms that attract progressives to the cause rather than in terms that seem destined to repel them.

And there is plenty of evidence that many progressives are at least open to the anti-privilege agenda. As I note in the beginning of the Pathology of Privilege, both the Tea Party and the Occupy movements oppose corporate bailouts. Consider the way progressive economist and Nobel Laureate Joseph Stiglitz framed the issue in Zuccotti Park:

Our financial markets have an important role to play. They are supposed to allocate capital and manage risk. But they’ve misallocated capital and they’ve created risk. We are bearing the cost of their misdeeds. There’s a system where we socialized losses and privatized gains. That’s not capitalism, that’s not a market economy, that’s a distorted economy and if we continue with that we won’t succeed in growing, and we won’t succeed in creating a just society.

Those words could have come out of Milton Friedman’s mouth.

Or consider the way progressives Mark Green and Ralph Nader framed regulatory capture in 1973:

The verdict is nearly unanimous that economic regulation over rates, entry, mergers, and technology has been anticompetitive and wasteful.

The result, they wrote, is a system which “undermines competition and entrenches monopoly at the public’s expense.”

Green and Nader’s concern about regulatory capture wasn’t just an academic exercise. It helped propel one of the most successful eliminations of government-granted privilege in U.S. history: the deregulation of trucking, air travel, and freight rail in the late 1970s. To the considerable benefit of consumers, these industries were substantially deregulated and de-cartelized. And it happened because liberals like Ted Kennedy and Jimmy Carter eventually joined the cause.

Our task today is to get modern libertarians, conservatives, and progressives to once again rally against government-granted privilege.

What is the greatest threat to freedom and prosperity?

FLORENCE— Bernardo Caprotti was a 45-year-old entrepreneur when he agreed to buy a suburban plot of land for a new supermarket.

Building permits recently came through. He’s now 88.

So begins an enlightening story in today’s Wall Street Journal on Italy’s sclerotic economy. The story continues:

Italy has emerged as a Technicolor example of the [EU’s] problems. Its growth has been stuttering for 20 years. Since 2008, its economy has shrunk by 9%, and this year it is struggling to expand by even 1%.

It is tempting to think that a simple solution is new leadership, that Italy just needs to elect more market-oriented politicians to sweep away the layers of red-tape and barriers to entrepreneurship that have ensnared the country’s entrepreneurs.

But the problem is much more intractable because established businesses benefit from the status quo:

The roots of the problem, say many Italians, lie in how vested interests in the private and public sectors gum up the economy, preventing change that replaces old practices with new, more efficient ones, and repeatedly frustrating political attempts to shake up the country.

It adds up to “deep-seated cultural obstacles to growth,” says Tito Boeri, a professor at Milan’s Bocconi University who is one of Italy’s top economists.

Years ago, Milton Friedman put his finger on the problem:

A few months ago, I attended a conference on the intersection between politics and capitalism (what we’ve called government-granted privilege). The eminent economic historian Robert Higgs was there and he said something that has stuck with me (I’m paraphrasing, but he just approved the quote):

I believe crony capitalism—the alliance between business and government—is the biggest problem of our age. And the reason is that it is robust. As alternatives to free-market capitalism, communism and old-fashioned fascism are thankfully dead. And genuine socialism has no real constituency in America. But crony capitalism, unfortunately, has a very active, organized, well-funded, and vocal constituency. It is the greatest threat to our prosperity and our freedom.

 

Does an income tax make people work less?

Harry Truman famously asked for a one-handed economist since all of his seemed reluctant to decisively answer anything: “on the one hand,” they’d tell him, but “on the other…”

When asked whether an income tax makes people work more or less, the typical economist gives the sort of answer that would have grated on Truman like a bad music critic.

If, however, we change the question slightly and make it more realistic, it’s possible to give a decisive answer to the question. Income taxes do reduce overall labor supply. This is something that economists James Gwartney and Richard Stroup explained in the pages of the American Economic Review some 30 years ago. And last week, the CBO’s much-discussed report on the ACA and labor-force participation illustrated their point nicely.

Continue reading

Why do almost all economists oppose U.S. farm policy?

There are many policies about which economists disagree. To read the news you might think that economists disagree about everything. In reality, there are plenty of areas in which the economics profession has reached a consensus. One is farm policy. Economists from Greg Mankiw to Paul Krugman oppose the “insane” (Mankiw’s word) and “grotesque” (Krugman’s) handouts to farmers that constitute U.S. farm policy. More broadly, Robert Whaples has found that more than 85 percent of surveyed economists oppose agricultural subsidies. (I’m willing to bet that many of the remaining 15 percent also oppose agriculture subsidies but are uncomfortable ending them cold-turkey).

Why is there so much agreement on this issue? Here are a few thoughts.

Subsidies and Price Supports Create Dead Weight Losses

U.S. farm policy is a grab bag of over 80 separate programs with confusing names like the “shallow loss program” and the “dairy indemnity program.” But for all the arcane language, the programs match pretty neatly to the simple microeconomic models that we teach undergraduate economics majors. They are price supports, they are subsidies, or they are barriers to trade. And whatever they are, they are inefficient.

Consider the Dairy Product Price Support Program. According to the CRS, it “specifies minimum purchase prices of: block cheese, $1.13/lb.; barrel cheese, $1.10/lb.; butter, $1.05/lb.; and nonfat dry milk, $0.80/lb.”

With the mandated price set above the market price, consumers gain less from exchange than they otherwise would and producers gain more than they otherwise would. Importantly, though, the simple economic model of a price floor (see below) tells us that consumers lose more than producers gain. Economists call this “dead-weight loss.”

Minimum PriceOr consider the Direct Payments program. According to the CRS, it pays growers of “wheat, corn, grain sorghum, barley, oats, upland cotton, rice, soybeans, and other oilseeds” a fixed subsidy that does not vary according to the market price. This effectively lowers the marginal cost of production, lowering the price and increasing the quantity sold. In this case, producers and consumers gain, but taxpayers lose. Moreover, the simple producer subsidy model tells us that taxpayers lose more than consumers and producers gain. Thus, this program too creates a dead-weight loss.

SubsidyNo Coherent Story of Market Failure or Imperfection

These interventions might be rationalized by some sort of story about market imperfection (externality, monopoly, asymmetric information, etc.). But as a commodity industry with so many producers and so many consumers, agriculture is much closer to the textbook ideal of a perfectly competitive industry than one plagued by market failure.

Safety Nets for People Not for Firms

“Well yes,” a champion of farm policy might reply, “but poor American farmers deserve a safety net.” Lots of economists (even Milton Friedman and F.A. Hayek) have conceded that publicly-funded social safety nets might be worthwhile. But these nets should catch people when they fall, not the firms that these people work for. The farm safety net makes even less sense when you dig into the numbers. As Vincent Smith has shown in his recent Mercatus paper, average household farm income is substantial greater than overall average income. Moreover, about 80 percent of direct payments go to the largest 15-20 percent of farms and a majority goes to the top 10 percent “whose owners, for the most part full-time farm operators, typically earn many times the national average household income.”

As Smith points out, many in the farm lobby claim that farmers need the safety net because they are in a particularly risky line of business. But, he says, this claim doesn’t stand up to scrutiny:

Farms fail at an annual rate of 0.5 percent: only one in every 200 farms goes out of business because of financial problems.24 By comparison, the annual business-failure rate is over 7 percent, 14 times greater. Among small nonfarm businesses, the companies most comparable to farms in terms of sales, the failure rate is about 14 percent, almost 30 times greater than among farms.

The farm safety net makes even less sense when you think about justice on a global scale. Daniel Sumner explains it well in his Agricultural Subsidy Program entry in the Concise Encyclopedia of Economics:

Some of the poorest countries in West Africa have traditionally been cotton exporters. In 2001 and 2002, they faced a world price of cotton ranging from thirty-five cents to forty-five cents per pound. Meanwhile, cotton growers in the United States, the world’s largest exporter, received seventy cents or more per pound from the subsidies plus the market price. Economists have estimated that U.S. exports of cotton would have been substantially lower, and the world price of cotton 10 to 15 percent higher, if U.S. cotton subsidies had been unavailable during this period. Reducing farm subsidies in the United States and other rich countries would help poor cotton growers and other farmers in poor countries, and, moreover, would begin a process of relying more on trade rather than aid for economic growth.

Given the near-consensus among economists, why does the U.S. continue this grotesque and insane experiment? I’ll explore this question in subsequent posts.

The Bush Tax Cuts

This episode should have advocates of limited government asking themselves an important question: are tax cuts without spending cuts good for the cause of limited government? Decades ago, Milton Friedman answered this question with a resounding yes. Cut taxes, he counseled, and starve the beast. With less revenue, spending will fall too. Tax cutters from Ronald Reagan to George W. Bush have been convinced of “starve the beast” ever since.

But there is another Nobel laureate with free market bona fides who begs to differ. James Buchanan, a founding father of public choice economics—which uses the tools of economics to shed light on the incentives of policy makers—has long questioned “starve the beast.” When politicians are legally and politically permitted to run deficits, he warned, they will simply fund government by borrowing. In this case, tax cuts give voters the illusion that government spending is cheap. And with government seeming less-costly, voters will be happy to have more of it.

That’s me, writing on the Bush Tax Cuts in the latest issue of Reason. It was part of broader piece, edited by Peter Suderman on the fiscal cliff and it includes great essays by Charles Blahous, James Pethokoukis, Veronique de Rugy, Tad DeHaven, Susan Dudley, Maya MacGuineas, and Marc Goldwein. The whole piece can be found here.

Also this week, I did a podcast with the Heartland Institute on the Bush Tax Cuts, based on my research with Andrea Castillo.

Finally, Lars Christensen has some insightful comments on our paper here.

On behalf of all of us at Mercatus and Neighborhood Effects, Happy Holidays to all.

 

Would You Oppose a Tax Cut on the Grounds that it Only Applied to a Few Firms?

A few weeks ago, Pete Boettke graciously invited me to speak at the Philosophy, Politics and Economics workshop at GMU. During the course of the talk, I extolled the virtues of what Hayek called “generality”—the idea that political action should not (positively or negatively) discriminate against any person or group of persons. (Note: generality goes beyond the 14th Amendment guarantee of equal protection under the law. That only prohibits discriminatory application of laws, but it does nothing to prohibit discriminatory laws such as taxes that apply to one group but not another. A true generality principle says that the laws themselves should not discriminate.)

Near the end of the talk, one of the attendees asked if I would oppose a tariff reduction for one (and only one) industry on the grounds that it violated generality. I believe many free-market advocates would say “No; we should always take any opportunity to expand economic freedom.” Milton Friedman expressed this view when he declared he’d “never met a tax cut I didn’t like”

My answer, however, is that in some circumstances the advocates of economic freedom should oppose such a tariff reduction. This is because I believe those of us who value economic freedom should also value generality. I have four reasons.

  1. Generality is morally intuitive. Kant called it the “categorical imperative,” others more prosaically call it the “golden rule.” Whatever you call it, it seems that lots of humans in lots of cultures value the idea that laws ought to treat us equally.
  2. Violations of generality make us poorer. When government discriminates in the way it taxes or in the way it spends, people change their behavior (note that in traditional public finance, a head tax creates no loss because it doesn’t discriminate between work and leisure or between consumption and non-consumption). And these changes in behavior are costly because they tend to discourage mutually-beneficial exchange. Economists call this the deadweight loss of taxation and these costs are greater when policy is more discriminatory. Thus, a tax that raises $100 million by taxing goods and services equally will involve less deadweight loss than a tax that raises $100 million by taxing only goods. What’s more, the tax rate on goods will have to be higher if the government wants to obtain the same amount of revenue. (I could mention other economic costs under this same heading. For example, knowledge problems and malinvestment, both loom large under discriminatory taxation).
  3. Violations of generality create rent-seeking loss. When government is in the business of privileging some and punishing others, citizens tend to invest resources (time, money, effort) in asking for their own privileges or in asking that others not be privileged. Quite often, these efforts produce no value for society and are a loss.
  4. Violations of generality make it easier to violate economic freedom. In the long run, I believe a norm which permits violations of generality will tend to make it easier to violate economic freedom. Consider a proposal to tax each of three people $10, plus one additional dollar in deadweight loss, in order to turn around and redistribute $10 to each of these same three people. None of our three citizens would be willing to vote for it. But now consider a proposal that costs each of three people $11 ($10 in tax + $1 in DWL) in order to turn around and redistribute $15 to two of the three. Now a majority coalition can easily be formed. The coalition is made viable only by violating generality. What’s more, the coalition will be even stronger if the proposal not only violates generality on the spending side but also on the taxing side. That is, if the proposal is to impose $33 in costs on only one person in order to distribution $15 to each of the other two, then the coalition will be especially strong. In fact, if it can shield itself from the pain of taxation, the coalition will be prone to ask for much more revenue. So in the long run, economic freedom is protected by adhering to generality, even if in the short run the two values appear as a trade-off.

None of this is to say that we shouldn’t also value economic freedom. To put it in terms that economists will quickly grasp, my indifference curves look like this:

 

 

 

 

 

 

Not like this:

 

 

 

 

 

 

Too often, in my view, conservative policymakers are suckered into violating generality because they believe they are advancing economic freedom. They end up supporting tax preferences for manufacturing, ethanol, housing, child bearing, and much else on the grounds that any tax cut is a good tax cut. Many of these tax preferences are the result of cronyism and each entails a host of economic and social costs. The end result is a tax code that is monstrously complex and that, too, is a cost.

The first-best solution is low and non-discriminatory taxation. Beyond that, I think we need to recognize that there are (short run) trade-offs.

 

Government Failure and Market Failure

Chicago school economists are often maligned for their supposed blind faith in markets. And it is true that some of the theories associated with Chicago have a certain Panglossian feel to them; they give the impression that markets everywhere and always yield the best possible results.

But as Milton Friedman noted in an interview for A Modern Guide to Macroeconomics (p. 174 of the first ed.), one need not have blind faith in markets to think that government intervention will make matters worse:

I believe that what really distinguishes economists is not whether they recognize market failure, but how much importance they attach to government failure, especially when government seeks to remedy what are said to be market failures.…Speaking for myself, I do not believe that I have more faith in the equilibrating tendencies of market forces than most Keynesians, but I have far less faith than most economists, whether Keynesians or monetarists, in the ability of government to offset market failure without making matters worse.

With this, the founder of the Chicago school was articulating a notion more closely associated with the Virginia School of Political Economy than Chicago. The Virginia School emphasizes the inherent biases of public policy and the ways these biases can make government intervention fall far short of the imagined ideal:

At every step of the political process, perverse incentives ensure that economic-policy-in-reality is a far cry from economic-policy-as-it-is-ideally-envisioned. So even if there is a rationale for government correction of market failure, it is irresponsible to ignore the very real possibility that government “correction” of market failure often makes matters worse.

In a post last month, I used this line of argument to critique an article by Dylan Matthews on fiscal stimulus. I noted that if the macroeconomics of stimulus look murky, the public choice of stimulus look downright bad: the incentives of democratic politics do not encourage voters, politicians, political aids, or bureaucrats to implement stimulus as Keynesian theory says it ought to be implemented.

Yesterday, Matthews helped me make my case. In a superb post he pointed to the results of a recent survey which found that fully 15 percent of Ohio Republicans are willing to give Gov. Romney credit for killing Osama Bin Laden. To help explain this bizarre result, Matthews cited research showing ideological beliefs tend to affect voters’ assessment of objective facts. I’d note that this doesn’t mean people are dumb. It just means that the political process–in contrast with the market process–does not reward information gathering or information processing.

This should make one more skeptical of stimulus, and other government solutions.