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  • Incentives and Economics

    Posted by Carl from Chicago on July 14th, 2014 (All posts by )

    A few years ago I went to Norway and had a great time. In this post I described how expensive everything was in Norway due to their highly valued currency (tied to oil riches) combined with the relentless decline of the US dollar (tied to ZIRP and other dubious economic moves). In the simplest terms, a fast food meal or a beer in Norway cost over $20 USD which is complete madness.

    Business Insider discussed the Scandinavian economic experiment, where high taxes are applied to goods and services in order to fund a vast social safety net. From the article:

    In Norway, a burger and fries at a fast food joint will set you back $23. A six-pack of warm grocery-store beer is nearly $30.
    These hefty price tags are due, in part, to high wages for low-skilled service jobs. But high taxes play a role too.
    Most products have a 25 percent value-added tax, which means that $5.50 of the cost of that burger goes to fund Norway’s generous social programs.
    As a visitor, you get little for the added price. But, as a resident, your daily spending helps to fund an expansive package of benefits, including health care, child care, high-quality education, pensions, and unemployment insurance.

    Some are now proposing this high-cost method, with large taxes embedded in everyday prices, as a solution to the inequity in incomes and wealth that is discussed widely in politics and economics today.

    From the perspective of someone who is highly interested in economics and tax policy, my two rules of thumb are:
    1) that the tax policy raise the money that it intends to raise
    2) that the tax policy not significantly distort economic activity

    Any society that implements high taxes such as Norway needs a comprehensive surveillance model in order to collect these taxes. It is difficult to avoid taxes that are broadly assessed on fast food, for instance, because each corporate location will set up cash registers and controls to remit these taxes onto the state. The same types of processes can be installed in liquor stores, formal bars and nightclubs, grocery stores, and restaurants.

    In a less-homogeneous society such as the USA, we already have major problems with tax evasion on cigarettes and likely liquor, and these are in responses to our sales taxes. The problems would be compounded if we placed value added taxes on all goods at a higher level and on services such as restaurants, hair care, etc… Smuggling would become rampant and informal or barter methodologies would increase in size and scope. These sorts of costs would have to be applied across the USA or some areas would become uncompetitive and see an out-migration of economic activity, starting with incremental additions (no one has opened a new manufacturing plant in Illinois in years, for instance) and eventually leading to the lock, stock and barrel out migration of existing industries (such as the exodus of car manufacturing out of the Midwest and California to the American South).

    On a broader level, however, the question is – “what do these taxes incent, and how does it make us economically stronger?” These taxes would encourage a broad “welfare state”, with a large safety net, huge numbers of governmental employees to track spending and provide services, and make doing business a “high cost” effort.

    For employees, high taxes on consumer goods and services would encourage them to stay home and cook as well as garden and do things by themselves rather than hire someone else, since the incremental costs are so high. It would also reduce incentives to work in the first place (if the disability net was cushy enough), since the differential between working and not working isn’t as great after the incremental costs are applied.

    Depending on how taxes are structured, if the tax rate is high on consumed goods and services and is not progressive on income (i.e., when you earn more, you pay a higher percentage of your income), this could remove one of the blockages to incremental effort, a high marginal tax rate. However, these sorts of schemes are often linked to “progressive” tax rates which also discourage work beyond a certain point. I did a bit of research on Norway and the taxes do not seem to be too progressive but they reach such a high rate (>50%) on high earners it likely accomplishes the same disincentive effect. Sweden does implement a progressive system so this compounds the situation instead of mitigating it.

    It is ridiculous for the USA to copy this model because Scandinavia is not a competitor to the US. Norway is awash in oil and can set up any sort of scheme and remain rich, and is a model citizen compared to the massive distortion found in countries like Saudi Arabia (where locals basically do next to nothing except reproduce and are a massive burden on the state). The other countries like Sweden are smaller than some US states and are homogeneous and can continue to work and thrive based on their high level of overall education, modest expenditures on defense, and bountiful natural resources. US industries have little to fear from the Swedes in terms of product and service competitors.

    Our actual competition, today and tomorrow, comes from China, other Asian countries, and perhaps India and South America if they can get their act together. These countries have a completely opposite model, with a focus on investment, high technology, commodity resource extraction, limited to no “welfare state” functions, and growth. Of all the elements dis-incented by the “high tax” model, growth is most dis-incented because high taxes continually steal profits throughout the chain to pay for a vast government which turns around and spends it on salaries and processes that do not increase competitiveness. Every day you would be siphoning off private sector capital and sending it to state and local capitals to feed this net.

    In the short or medium term, the relative competitiveness of your economy doesn’t matter; you can live off the educated people who don’t want to uproot and part ways and businesses for whom the cost of re-locating is prohibitive. Or if your entire economy is based on physical location (i.e., a tropical island), you could apply high costs and pass them on to tourists until it reaches a point that they pack up and suntan elsewhere.

    For all others, it is necessary to build competitive industries to have a high quality of life and to provide the goods and services needed for a modern society. Unless you are completely self-sufficient, you must pay for imported goods, services and commodities and if your economy isn’t competitive you soon will find yourself unable to pay for these goods and services. During the 2007-8 crash parts of Greece went without medicine and heating fuel; the international markets are no joke and merciless if you don’t have the wherewithal to pay. Today Venezuela doesn’t have much in the way of air service and Argentina has little in the way of imported goods – this is the market at work when all the local stopgap measures run out, and stripping companies of their ability to compete through government fiat finally comes home to roost.

    In the USA, the issue is the “relative” cost of living – perhaps NYC or San Francisco could pull off high local costs because so many services / arts / investment / technology people want to live there – but the rest of the country would see an exodus over time with these sorts of policies, moving to friendlier locales to do business until they ended up like the industrial wasteland in Detroit, Cleveland, Baltimore, Camden and lots of Chicago.

    On a theoretical not practical level, the plan of a wide “nanny state” and paying people high wages for entry level jobs just won’t play out well for many Americans. They don’t want vast governmental involvement in their lives and don’t want to pay the immense taxes needed to subsidize those jobs. In addition, businesses would rapidly automate their way out of these high cost models and just shed low skill jobs entirely.

    Everything goes in waves and the post WW2 lessons with socialism have been forgotten. Unions took the UK down to its knees in the 1970s and socialism stunted the economy of China for decades. It was once reflexive that free markets and free economics powered America, especially when we faced a cold war against the USSR. However, dodgy economic schemes have become commonplace, powered by the Keynesian idea that “all spending is good spending” and somehow consumer spending is the root of economic power, rather than efficiency, productivity, and investment. Today it seems that the majority of the work force is de-facto run by the state – schools, universities, hospitals, insurance, “straight” government, cartel businesses like beer distribution, as well as a melange of non-profit organizations of all sorts.

    “Raw” economics comes to the fore in times of trouble or shortages; we can’t always count on debt to bail us out and we can’t always assume that we will have a high standard of living if we don’t have a productive and thriving private sector. Comparing ourselves to “old Europe” and their straightjacket economic policies won’t prepare us for competing with the Chinese and other rising economies.

    Cross posted at LITGM

     

    33 Responses to “Incentives and Economics”

    1. pseudoerasmus Says:

      None of this makes much sense to me. The United States has had a current account deficit almost every year since 1980, which means it has been producing less than required to meet foreign obligations (imports and other payment liabilities). The shortfall has been made up by foreign capital inflows. Has the United States been uncompetitive since 1980 ? Of course not. And what does any of that have to do with the sort of tax policy a country ought to have ? Why, for example, would having high value-added taxes on consumption goods and having a high marginal tax rate on personal income, lower the competitiveness of US industries ? Direct taxes on businesses could, but high taxes on consumers and wage-earners ? Why I”m not arguing any particular country should or should not have high taxes on personal income and consumption. I just don’t see what that has to do with “competing” with India or China. Besides, does the United States actually compete with China economically speaking ? How ? And why would you have an exodus from Chicago to “friendlier” places if the high-tax regime is national ?

    2. dearieme Says:

      “socialism stunted the economy of China for decades”: look here, I don’t visit this website for ironic understatement.

    3. pseudoerasmus Says:

      Though its mention in the same sentence as trades unions in the UK is unwarranted !

      Also, even under the worst periods of communism, Chinese growth (in terms of per capita income) was better than many developing countries under freer economic systems and even slightly above average in a group of other poor countries with similar initial levels of income.

    4. Dan from Madison Says:

      Pseudoerasmus – if you are OK with the price that was paid under the “worst periods of communism” that is fine. I’m not. Broken eggs and all that.

    5. Grurray Says:

      “Also, even under the worst periods of communism, Chinese growth (in terms of per capita income)”

      We don’t even know for sure how much or how little China is really growing right now. I’d be pretty suspicious of any assessment of their economy from decades ago. I’m sure per capita growth really took off when tens of millions of Chinese didn’t have to be counted because Mao starved them to death.

    6. Mrs. Davis Says:

      Government can only tax (purloin) three things; income, expenditure, net worth.

      What ever you tax, you get less of.

      We tax, in order of priority, income, net worth and expenditure. Is it any wonder we are borrowing and spending ourselves to oblivion. 100 years ago the prioritization was the opposite. We were growing richer every year.

      The question of how a government taxes is independent of how it spends. A comparison to 100 years ago is equally enlightening.

      All this proves is that Adam Smith was right. There is a great deal of ruin in a nation

    7. pst314 Says:

      “Also, even under the worst periods of communism, Chinese growth (in terms of per capita income)”

      Growth according to whose figures? The ones produced by the Chinese government were garbage.

    8. MikeK Says:

      Growth from very low levels can be high but not mean too much. Per capita income from $600/year to $1200/year is 100% growth but only $600.

    9. MikeK Says:

      “100 years ago the prioritization was the opposite. We were growing richer every year.”

      100 years ago, the Progressives passed the 16th Amendment with the intention of redistribution. That worked pretty well. They passed the 18th Amendment which prohibited alcohol beverages. That didn’t work as well. The 17th Amendment, direct election of Senators, was intermediate. The 16th and 17th created the present regulatory state. Harding and Coolidge were the reaction to the Progressive government of Wilson but the 1929 panic brought them back with a vengeance. We have still not recovered.

    10. Mark L Says:

      The high cost of food in Norway is less due to high wages than it is due to high tariffs on imported food. With a short growing season and a very limited amount of agricultural land the cost of producing food in Norway is as high as their mountains. The Norwegian government wants agricultural self-sufficiency to the maximum extent possible (Although enough cannot be grown to feed the population anyway). If Norwegian farmers had to compete with even just the rest of Europe (much less the world) they would go broke. So, to “level the playing field” Norway puts sky-high tariffs on food. Hence the $25 hamburger.

    11. pseudoerasmus Says:

      I’m not “OK” with the millions dead under Mao. I’m just saying that even under Mao Chinese growth wasn’t as bad as many economically freer developing countries. Amartya Sen has plausibly argued that India in 1950-80, despite having no famine, had much worse performance in morbidity and mortality than China ; and because of that, excess mortality in India was almost 4 million per year. “India seems to manage to fill its cupboard with more skeletons every eight years than China put there in its years of shame”.

      “I’m sure per capita growth really took off when tens of millions of Chinese didn’t have to be counted because Mao starved them to death.”

      The rate of growth doesn’t work that way.

      “Growth according to whose figures? The ones produced by the Chinese government were garbage.”

      According to data that have been revised and published by the likes of the World Bank and used by academic economists. Anyway, if these were completely hallucinatory it’s kind of strange that the Great Leap Forward and the Cultural Revolution do show up as huge dips in the growth trend. Normally, competently fabricated data hide such embarrassments.

    12. pseudoerasmus Says:

      Growth from very low levels can be high but not mean too much. Per capita income from $600/year to $1200/year is 100% growth but only $600.

      Actually doubling a very low level of per capita income means a lot more (in terms of basic material needs being satisfied) than doubling a high level of per capita income.

      Besides, the point was, many countries started from a very low level in 1950 but some grew faster than others.

    13. pst314 Says:

      “According to data that have been revised and published by the likes of the World Bank and used by academic economists.”

      Glad to hear that, although I’m not familiar with it.

    14. pst314 Says:

      “better than many developing countries under freer economic systems”

      But how many is many? I do doubt that it was very many.

      India, for instance, although freer than China (no death camps) nonetheless was a socialist state that took China and the Soviet Union as its models. It was not until India began to throw off its socialist controls that the economy took off.

    15. Jason in LA Says:

      Here’s a stunner I just read on Wikipedia (FWIW): The Norwegian sovereign wealth fund, established in 1995, “controls about 1.3% of all listed shares in Europe and more than 1% of all the publicly traded shares in the world.”……Be advised no source was provided, but if true that is impressive.

    16. Mrs. Davis Says:

      Norway, Switzerland of tomorrow.

    17. MikeK Says:

      Norway has elected a new relatively conservative government but you wouldn’t know it from the Obama ambassador designate. He thinks the new government is an extremist group.

      The nominee for ambassador to Norway, for example, prompted outrage in Oslo by characterizing one of the nation’s ruling parties as extremist. A soap- opera producer slated for Hungary appeared to have little knowledge of the country she would be living in. A prominent Obama bundler nominated to be ambassador to Argentina acknowledged that he had never set foot in the country and isn’t fluent in Spanish.

      The ambassador to Thailand is about as dumb .
      She is a career FSO but sounds like an Obama bundler. State seems to be happy with her antics .

    18. pseudoerasmus Says:

      But how many is many? I do doubt that it was very many.

      The average growth of per capita income in the whole world between 1950 and 1980 was about 2.6% per annum. China in the same period grew at roughly 2.8%.

      India, for instance, although freer than China (no death camps) nonetheless was a socialist state that took China and the Soviet Union as its models. It was not until India began to throw off its socialist controls that the economy took off.

      Not exactly. The pre-reform India was more crony capitalist than socialist in the Soviet and Chinese sense (= no private ownership of means of production). India had some state-owned enterprises, and there was “central planning” of sorts, but the latter was mostly a corrupt system of licences for large private corporations. You know the Indian company that bought Jaguar and Land Rover ? That has been around as a private entity since 1945 despite the Soviet system you believe existed.

    19. Grurray Says:

      Businesses in the United States and Chicago do indeed compete with China. Many companies in Guangdong perform the exact same operations as companies here.
      This competition involves quality of services (sometimes pretty good from China, other times pretty awful) and price (always much better from China).

      Higher marginal rates hurt competitiveness because the vast, vast majority of companies in the US (like 30 to 1 more than C Corporations) are pass-through entities which are taxed at the individual rate of their owners.
      Higher taxes then cause a negative cascade effect:
      Higher taxes get passed on to customers, prices become even higher than China, fewer goods are sold, fewer workers are hired.
      Fewer new businesses are started, market share is monopolized and oligopolized which causes prices to go up even more and quality to go down, negating the previous advantage over Chinese goods.

      The European value added tax isn’t just a tax on consumer consumption, but on all transactions at every stage of the supply chain. Higher prices are passed on downstream ultimately making the final cost that much greater, further widening the gulf between US and China.

    20. pseudoerasmus Says:

      Actually, even the question of whether the corporate income tax gets passed onto consumers, is subject to numerous qualifications. See here : http://economix.blogs.nytimes.com/2010/07/23/who-ultimately-pays-the-corporate-income-tax/?_php=true&_type=blogs&_r=0 In order for the corporate tax incidence to fall even partly on consumers/workers, you need corporations to be able to move abroad easily and export goods & services back home easily. Even with the very open economy of the USA that situation still exists only imperfectly. Ultimately it is an empirical question and the evidence is mixed. There is zero chance, however, that the corporate income tax is entirely passed onto consumers. As for pass-through entities, I’m sure the vast majority of those are in the non-tradeable sector, especially services (accounting firms, plumbers, tree services, etc.). In that situation higher income taxes in that sector will fall primarily on capital, not labour.

      Exactly the same caveat applies to the European value added tax. You can’t just arbitrarily assume it all gets shifted to consumers.

    21. pseudoerasmus Says:

      It may not have been clear enough : in the absence of the ability to leave and set up shop outside the tax jurisdiction, any producer who attempts to raise prices to compensate for higher taxes will be underbid by competitors — assuming a competitive market in the first place. In a competitive market, margins are driven down by the presence of many producers. So that tree-service LLC, facing many other tree-service LLCs, almost certainly cannot pass higher taxes onto consumers — if the higher taxes even apply to him.

    22. MikeK Says:

      “You can’t just arbitrarily assume it all gets shifted to consumers.”

      Yes, you can assume that the money comes from trees but that assumption is not a very good one.

    23. pseudoerasmus Says:

      The example could have been : legal services, tax-preparation services, plumbing, electricians, realtors, dry-cleaners, the local dive, tanning salons, “life style counselors” and palm readers.

      In short, the sort of commercial enterprises which are more likely to be structured as pass-through entities AND where the value added is less affected by the international economy.

    24. Grurray Says:

      “I’m sure the vast majority of those are in the non-tradeable sector, especially services (accounting firms, plumbers, tree services, etc.). In that situation higher income taxes in that sector will fall primarily on capital, not labour.”

      Because high tax rates are eliminating labor intensive privately owned businesses. See my previous post about monopolies and oligopolies. They get underside by large entrenched incumbents able to take advantage of tax shelters.

    25. Grurray Says:

      “Undercut” that is.

      “You can’t just arbitrarily assume it all gets shifted to consumers.”

      I don’t have to assume it. I have witnessed it after working with many small businesses.

    26. Grurray Says:

      http://www.sba.gov/community/blogs/small-manufacturers-driving-job-creation-economic-growth

      98% of American manufacturing firms are small businesses. That’s a smaller percentage of the overall economy than it used to be, but from our discount about tax rates we can surmise why. Added expenses from higher taxes have to go somewhere.

    27. pseudoerasmus Says:

      So, in other words, in the one area (manufacturing) that is powerfully subject to international economic forces, there has been job growth ? So the tax rates that are supposedly so high according to you, are not so high after all !

      “That’s a smaller percentage of the overall economy than it used to be, but from our discount about tax rates we can surmise why. Added expenses from higher taxes have to go somewhere.”

      Incorrect.

      Manufacturing, in absolute terms, has gotten bigger over the long run. But its overall share in the economy gets smaller. Why ? Because the extra income from productivity growth in manufacturing does not all go back into manufacturing. Why ? Because when income rises, part of the extra income goes to buy services, not more goods. If you have a rise in salary, your consumption of goods does not rise by the same amount. You will want to take a trip to Hawaii, not necessarily buy a second refrigerator.

      “Because high tax rates are eliminating labor intensive privately owned businesses..”

      Why on earth would personal income taxes, even in the case of disregarded business entities, shift business activity from labour-intensiveness to capital-intensiveness ? You would actually have to make workers more expensive.

    28. John Pierce Says:

      For years, the mantra of the drug legalizers in the US was “Make it legal and tax it, and the criminals will go away”. After Colorado did just that with marijuana, a funny thing happened. The price of an ounce of legal weed in Colorado approaches $400, mostly due to state and local taxes. There are long lines at approved shops selling the legal product. What to do? Why, start growing the stuff and selling it off the books, without collecting the taxes owed the state. Apparently, no one thought the marijuana growers would have anything in common with past tax-dodgers, like moonshiners or cigarette smugglers.

      http://www.denverpost.com/ci_23493035/colorado-marijuana-dispensary-owner-11-others-indicted-71

      Also, for various reasons, the MJ industry in Colorado is an all-cash business, which leads to further abuses and law breaking because cash transactions are harder to trace. Colorado’s response is to create a new financial regulatory system aimed at closing these loopholes in the industry, so the government apparatus gets bigger to make sure the state isn’t cheated of its expected revenue.

      Even for products legal across all 50 states, like liquor and tobacco, high taxes assessed by certain cities like New York, still keep the relatively unglamorous smuggling of untaxed cigarettes from regions with lower taxes very profitable.

      All of these utopian ideas have faltered in practice because the proponents of these ideas consistently discount human nature in their calculations.

    29. Grurray Says:

      “Why on earth would personal income taxes, even in the case of disregarded business entities, shift business activity from labour-intensiveness to capital-intensiveness ? You would actually have to make workers more expensive.”

      There are advantages to investing in capital assets over labor. Tax deductions on depreciation of equipment allow for the recovery of the cost over time. The more money you spend, the faster you recover the cost.
      There are now some tax breaks for hiring workers, but they are mostly tied to political agendas and don’t get much use.

      The reason these tax incentives exist is because they have a powerful effect on behavior. As do tax increases.

    30. Jonathan Says:

      John Pierce:
      For years, the mantra of the drug legalizers in the US was “Make it legal and tax it, and the criminals will go away”.

      This hasn’t been the idea of anyone who gives serious thought to incentives, since it should be obvious that high excise taxes create incentives for criminal behavior similar to the incentives legalization is supposed to remove. You correctly point out that this has been the case for liquor and cigarettes.

      I think the “make it legal and tax it” trope is popular because it appears to propose a reasonable tradeoff, one that people who for whatever reasons are not confident in making straightforward pro-legalization arguments find rhetorically attractive.

      There are better reasons to legalize drugs, including the injustice of punishing victimless crimes, the corruption of police and courts, the waste of public resources, and the pervasive degradations of freedom justified by the war on drugs.

    31. pseudoerasmus Says:

      “There are advantages to investing in capital assets over labor.”

      Sure, but that’s not what we had been talking about. You were somehow under the impression that income taxes cause a shift from labour to capital (hire fewer workers, replace with more equipment). That doesn’t make sense to me. The way to cause that shift is to make labour more expensive to hire.

      “The reason these tax incentives exist is because they have a powerful effect on behavior. As do tax increases.”

      Yes, but incentives are a matter of degree, which can’t be assessed by mental deduction.

    32. Grurray Says:

      “The way to cause that shift is to make labour more expensive to hire.”

      Which is what tax breaks do – make equipment cheaper than hiring workers.

      So if you are losing margin from higher taxes, you will make it up by cutting workers and buying more robots.

    33. Carl from Chicago Says:

      Thanks for the great comment thread. Probably shouldn’t have tossed that reference to China in there.

      In general – when people start to mess with the “core” of the economy and layer on all sorts of taxes and extra costs, there will be significant distortions, and there better be 1) a goal for all of this 2) a good reason to do it.

      In general the idea that we just raise everyones’ wage and then raise the cost of all the goods and services through taxes is one that has a hazy goal and massive distortions in the local economy. Beyond that, the economy becomes less and less competitive internationally (or in US terms – on a regional or state level) and this causes other, even more significant problems.

      I do have a lot of sympathy for someone trying to make it on minimum wage. I see them in my neighborhood all the time, waiting for the bus to go home. The answer, however, is not just to raise the minimum wage, because at that point there will be a significant substitution of labor for automation. No business owner is stupid enough not to see this trend.

      I don’t know why they don’t automate everything in Norway. Maybe there is a social construct that prevents them from doing this, or the tax system incents them to hire labor (as a note, the US tax system does NOT do this, and the legal system absolutely makes it risky to hire direct employees, as well). Or maybe it doesn’t make sense for McDonalds to automate the few outlets they have in that tiny population and the other local businesses don’t have enough scale to do it.

      From my brief time in Norway the local labor did seem highly intelligent and productive. This must in some sense make up for the high wages in terms of productivity loss overall.