Tag Archives: NYT

Lessons from North Carolina’s proposed budget

In today’s Room for Debate at The New York Times, I discuss what’s good and what is worrying about North Carolina’s proposed biennial budget.

The good: a doubling of the state’s Rainy Day Fund and end to the estate tax. But a big controversy surrounds the legislature this week. Lawmakers decided to cut unemployment benefits by one-third. This move disqualifies the state from receiving additional emergency unemployment insurance funds from the federal government, affecting 170,000 jobless in the state.

The issue points to the perennial calls for reform to the federal-state Unemployment Insurance (UI) program. North Carolina is one of many states that must pay the federal government back what it has borrowed to offer extended benefits to its residents, or face higher payroll taxes. Their choices are tough ones to make: raise the state payroll tax (or taxable wage base) and replenish the trust fund – which has its own effects on the economy and the workforce – or cut benefits. A better solution is to re-think our approach to social insurance, something economists, such as Harvard’s Martin Feldstein, have been highlighting the structural flaws of UI since the 1970s.

n.b. update: a reader rightly notes at the NYT – the states must pay back the money they’ve borrowed from the federal government to continue paying benefits. But they don’t have to pay back the temporary EUC program. 

What is Economic Freedom and What Can it Say About Prosperity?

My post in the NYT’s Room for Debate blog elicited a good number of comments and questions. So today I thought I might elaborate on the most-important of these questions: What exactly is economic freedom and what do we know about the way it affects prosperity?

First, its impact. The economists Chris Doucouliagos and Mehmet Ali Ulubqasoglu recently reviewed 45 studies examining the freedom-growth relationship. They concluded:

[R]egardless of the sample of countries, the measure of economic freedom and the level of aggregation, there is a solid finding of a direct positive association between economic freedom and economic growth.

Studies also find that economic freedom tends to be associated with a whole host of other factors that humans tend to value such as:

  • Higher income levels: Faria and Montesinos (2009) Dawson (1998), De Haan and Siermann (1998), De Haan and Sturm (2000), Cole (2003), Gwartney et al. (2004) and Weede (2006);
  • Lower poverty levels: Norton (2003);
  • Less volatility in the business cycle: Dawson (2010);
  • Better environmental outcomes: Norton (1998), ch. 2);

even:

  • Fewer homicides: Stringham and Levendis (2010); and 
  • Greater levels of reported happiness: Ovaska and Takashima (2006)

But what is economic freedom?

The concept is quite old, dating back to well-before Adam Smith. For his part, he called it “a system of natural liberty” and gave us a view of what he meant by it when he wrote:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.

This, however, is still pretty vague.

So in the last quarter-century, a number of economists have focused on defining and—importantly—measuring economic freedom. There are now a number indices of economic freedom at both the national and sub-national levels. Among academics, the most-widely cited of these is the Economic Freedom of the World index, the latest of which is authored by Professors James Gwartney, Joshua Hall, and Robert Lawson. This index grew out of a series of conferences initiated by (Nobel Laureate) Milton Friedman and the Fraser Institute’s Michael Walker in the mid-1980s to early 1990s. Other attendees included economic luminaries such as “Lord Peter Bauer, Gary Becker, Douglass North, Armen Alchian, Arnold Harberger, Alvin Rabushka, Walter Block, Gordon Tullock, and Sir Alan Walters” (a number of whom have either won Nobel prizes in own their right or are likely to in the years that come). Out of these conferences, a consensus began to emerge that the four cornerstones of economic freedom were:

  • Personal choice,
  • Voluntary exchange coordinated by markets,
  • Freedom to enter and compete in markets, and
  • Protection of persons and their property from aggression by others.

From these conceptual cornerstones, the authors of the index began to gather data with an eye toward objectively measuring the degree to which the laws of different nations permit (or don’t) the exercise of economic freedom. Their index includes factors such as government consumption spending as a share of total consumption, top marginal income tax rates, the degree of judicial independence, growth in the money supply, taxes on international trade, and regulation of private sector credit (among 17 other components). The index now covers more than 140 countries, with data on many going back to 1970. And now there are literally hundreds of peer-reviewed articles that are based on this index or one of many others like it.

Since the publication of this index, a number of others have gotten in on the game. There are now indices that measure freedom at the sub-national level, the most-recent of which is Sorens and Ruger’s Freedom in the 50 States, published by Mercatus (the next addition of which is coming out soon). 

As I have recently noted, these state level indices suggest that economic freedom is a powerful predictor of prosperity.

So that, in a nutshell, is economic freedom.

Why We Need a Tax AND Spending Cut

Republicans are talking a lot about certainty. But even if they had won some sort of a victory where they got the current tax rates written in stone, spending is on such an unsustainable path in terms of entitlements, it really isn’t certain at all.

That is me in the NYT. If I had had more space and more eloquence, I might have said something similar to this:

If you hate taxes, cut spending! …Short-term, uncertain duration “tax cuts” are not tax cuts at all, but deficit-financed spending.

That’s Mike Munger, economist and political scientist from Duke University. There is more here and here

What is the economic logic behind this result? Why is it that a tax cut without a concomitant spending cut might not improve the economy? There are two economic models that predict just such an outcome:

Extreme Case:

In what might be called an “extreme case”, a tax cut without a spending cut has zero effect on the economy. This is an extreme case because it requires a rather generous view of humans: it assumes we are all super-logical forward-looking processing machines (all of us, of course, except for politicians; the model assumes they don’t have a clue). The model works something like this:

Step 1. Government cuts (lump-sum) taxes without cutting spending.

Step 2.  This requires an increase in government borrowing.

Step 3.  Forward-looking taxpayers recognize that deficits are future taxes (Munger uses the helpful acronym DAFT). Because of this, they reduce current consumption in order to save for the taxes.

Step 4.  The reduction in taxpayers’ consumption completely offsets the deficit-financed government consumption. And the increase in taxpayers’ savings completely offsets government’s increase in borrowing.

In the end, switching from taxes today to taxes in the future has no effect on interest rates, national savings, current consumption, exchange rates, future domestic production, or future national income.

Economists will recognize this as the Ricardian Equivalence theorem. Non-economists will likely find this a tad implausible.

But we don’t have to rely on such an extreme model to find that a tax cut without a spending cut might not be much help. Consider another, less-extreme, model:

The Less-Extreme Case:  

Step 1.  Government cuts (lump-sum) taxes without cutting spending.

Step 2.  This requires an increase in government borrowing.

Step 3.  Only some taxpayers recognize the deficits as future taxes. As a result, these taxpayers reduce their consumption and increase their savings. But these actions only partly offset government’s deficit-financed consumption.

Step 4.  Since the public’s increased appetite for savings isn’t enough to fully finance all of the extra government borrowing, government has to get its money from somewhere. It therefore draws on two sources:

  1. Government can borrow more domestically, but has to pay a higher price in the form of a higher interest rate (under the Ricardian model, the public wants to save more, so government doesn’t have to pay a higher price). Higher interest rates make it more difficult for private investors to fund their own projects (private investment is crowded-out), lowering the nation’s capital stock.
  2. Government borrows the money from foreigners. Under this scenario, interest rates may not rise, but future national income falls because of the burden of repaying the increased borrowing from abroad.

Step 5.  Because the nation’s capital stock shrinks, future growth suffers.

Under either scenario, a reduction in lump-sum taxes—unaccompanied by a reduction in spending—fails to jump-start the economy the way politicians hope that it might.

A Big Assumption:

There is one other assumption that I have smuggled into the analysis above. Note that “Step 1” under both scenarios is a reduction in “lump sum” taxes. A lump sum tax is a tax that everyone has to pay, regardless of how much they work or consume. Economists often use it as a benchmark for efficient taxation because if the tax isn’t associated with working or consuming, then it won’t affect peoples’ decisions to work or to consume, and therefore won’t do economic harm.

It is standard for economists to assume lump sum taxation when they are talking about deficits because it makes the analysis cleaner. But, of course, taxes are not lump sum. In the real world, most of government’s revenue is derived from income taxation.

And we know from theory and data that high marginal tax rates reduce the incentive to work, save, and invest, harming economic growth. Moreover, we have reason to believe the effect can be quite large.   

So in evaluating the recently-struck tax deal, we have to weigh the “tax increases harm economic growth” evidence against the “deficits harm economic growth” evidence. In the end, I suspect we are better-off in the short-run without a major tax increase in two weeks. But in the long-run we need to cut BOTH taxes and spending. As Professor Munger puts it, the alternative is “DAFT.”

Hoping it will Go Away? Employee Benefits Breaking Budgets

During their first gubernatorial debate, Maryland Governor Martin O’Malley and former government Robert Ehrlich didn’t tackle the question of Maryland’s $33 billion pension and health benefits shortfall. As The Washington Post reports, it is a sum equivalent to the state’s entire budget. In fact, the tab is much higher when applying the risk-free discount rate.

Regardless of what discount rate is employed, states will have to contribute much more to their pension systems. The Center for Retirement Research at Boston College projects scenarios for several states. They find California, Illinois, and New Jersey will have to increase contributions to 8 percent of their current budgets (when using an 8 percent discount rate) and to 12.5 percent (when using a 5 percent discount rate). On average, states contributed about 3.8 percent of their budgets to their pension systems in 2008.

This represents a significant shift in spending priorities for many states.

Local governments are sure to be under even greater fiscal strain. At The New York Times, Mary Williams Walsh reports that taken together the cities, counties, and authorities of New York have promised more than $200 billion in health benefits. And they have set almost nothing aside.

A new report from The Empire Center for New York State Policy notes that while the state doesn’t have to come up with sum immediately budgetary reality will become increasingly painful for New Yorkers.

So far attempts to rein in costs by billing retirees for part of their premiums have met with lawsuits. And governments are only recently coming to terms with the size of these promises. Calculating the cost of Other Post- Employment Benefits (OPEB) is a new requirement for governments. As the NYT reports Schenectady, “found the cost too overwhelming to calculate, warning that it ‘will be astronomical, with the potential of bankrupting municipalities.'”

The “Things Would Have Been Worse” Excuse

The University of Chicago’s Casey Mulligan has a great post and an interesting chart over at the NYT’s Economix blog:

Here is the thrust of his argument:

  • In promoting the Stimulus, the Administration had assumed an employment multiplier such that for every 10 people hired under the Stimulus, another 6 jobs would be created. Thus, they said that if the law passed, the unemployment rate would be down to 7 percent by now.
  • The fact that the unemployment rate is still around 10 percent means one of two things: a) the stimulus didn’t work, or b) the stimulus did work and the recession was simply much worse than the Obama Administration thought.
  • This spring, the Census hired a bunch of new workers, providing a fresh opportunity to test the fiscal stimulus hypothesis. At the same time that the Census went on its hiring binge, non-Census worker employment seems not to have budged much at all.
  • Professor Mulligan then does something very clever: He takes the Administration at its word. He assumes—as they do—that for every 10 government employees hired, another 6 jobs were created. In order to reconcile this assumption with the fact that overall employment didn’t increase much at all, he concludes that the economy must have been hit (once again!) with some extraordinary countervailing contraction right at the very time that this government stimulus was taking place. What terrible luck! 

Stadium Debt and Monopoly Power

The old Giants Stadium was demolished this spring. The New York Times reports all that remains is a parking lot carrying $110 million in debt. This Sunday, the New York Giants will play their first game of the season in the new stadium, while New Jersey taxpayers will continue to pay the remaining principal and interest on $266 million in bonds issued to finance the original (1976) Meadowlands Sports Complex.

What went wrong? As the NYT notes, in the beginning the Meadowlands was successful. But by the 1980s, interest in horse racing started to decline. The NJ Devils and the Nets went to Newark. Revenues fell. Instead of responding to these signals the New Jersey Sports and Exposition Authority expanded operations.

The hypnotic fascination that sporting and entertainment facilities hold over local politicians dates to the 1960s and is a universal phenomenon. (The Olympic Games are a prime example, as is The World Cup). During this period, the definition of infrastructure changed to include not just roads and bridges but also stadiums and convention centers. Keynesian economic theories held sway. The idea that publicly financed sporting facilities would reap economic benefits for host cities continues to be the leading rationale for public investment in what should be privately financed ventures.

Economist Stefan Szymanski writes in his book, Playbooks and Checkbooks, “in recent years [major league sports franchises in the U.S.] have found a way to exploit their monopoly power.”During the early years of professional sports, team owners would build their own stadiums. With a shortage of major league teams, owners discovered they didn’t have to foot the bill, cities would gladly bid for the privilege. He estimates that over the last 20 years more than 60 publicly financed stadiums and arenas have been built in the U.S. totaling $20 billion. All a team must do is hint at leaving town to “extort a subsidy from the incumbent city.”

The problem is once the thrill is gone and attendance drops off the taxpayer is stuck with decades of debt. This “honeymoon effect” is well-understood. But even when put on ballot referendums in many cases voters still O.K. stadium debt. That may change in the near term with cities and states desperate to close budget deficits.  Another good sign: the Jets and the Giants financed the new stadium, one of the most expensive ever built at $1.6 billion. It’s probably not enough to convince politicians that they should stop committing the public purse to subsidizing ventures that are purely private goods.