Red Herring Alert

Last week, I heard a local liberal radio talk show host repeat, with gusto, the claim that President Obama has the lowest spending growth since Eisenhower.

Several places have addressed this claim. Here’s one and another. They raise some good points.

But I think spending growth is a red herring. The issue is actual government spending, not spending growth.

As Arthur Laffer and Steve Moore pointed out in the Wall Street Journal, President Obama took over after the grandest public spending binges of all times, one that was supposed to be temporary.

Claiming that locking that temporary spending binge into the budget going forward is a sign of conservative fiscal management is spin.

Consider a CEO who gives himself a $300 million bonus and draws the ire of the Occupy Wall Street types. He gets fired and the next CEO gives himself a $301 million bonus and tells Occupy friends not to worry because the growth in his salary is the lowest in recent history. I don’t think many people would fall for that.

Bottom-up experimentation

The nice thing about having 50 states is that we get to experiment with policies and see what works and what doesn’t.

As individuals, it’s nice to have choices, too. If you’re not happy with your state, rather than struggle to convince more people to vote with you, you can just choose to move to another state that has more attractive policies.

In the Wall Street Journal today, Arthur Laffer and Stephen Moore take advantage of the information we have from the 50 experiments on tax policies to build a persuasive case that lower taxes is good for everyone. I recommend reading, A 50-State Tax Lesson for the President.  Here’s a good snippet:

Every year for the past 40, the states without income taxes had faster output growth (measured on a decadal basis) than the states with the highest income taxes. In 1980, for example, there were 10 zero-income-tax states. Over the decade leading up to 1980, those states grew 32.3 percentage points faster than the 10 states with the highest tax rates. Job growth was also much higher in the zero-tax states. The states with the nine highest income tax rates had no net job growth at all, and seven of those nine managed to lose jobs.

Then there’s the question of in-migration from state to state—or how people vote with their feet. As common sense would dictate, people try to move from anti-growth states and cities to more welcoming climates. There are relevant factors other than tax policy, of course (as in North Dakota today, where the oil boom has brought about the lowest unemployment rate in the nation), but in general the most popular destination states don’t have income taxes. That’s as true recently as it was 40 years ago.

Over the past decade, states without an income tax have seen 58% higher population growth than the national average, and more than double the growth of states with the highest income tax rates. Such interstate migration left Texas with four new congressional seats this year and spanked New York and Ohio with a loss of two seats each.

Where does the Laffer Curve bend?

Laffer Curve

What is t*?

Thomas Sowell says that when tax rates are raised on high-income individuals, they respond to incentives by arranging their financial affairs differently to minimize those taxes.

Folks, like blogger Megan McArdle, lecture/patronize opponents of tax increases that current marginal tax rates are not near the bend in the Laffer Curve (the point where increasing tax rates would reduce revenue).

This is from Mark Perry’s blog, Carpe Diem:

The U.K. government is learning about the economic lesson that “if you tax something, you get less of it.”  Following an increase in the top marginal income tax rate to 50%, tax revenues from high-income taxpayers are falling, and are not going up, as the Treasury somehow expected by ignoring the economic lesson that “people respond to incentives.” A U.K. Treasury official explained the disappointing drop in tax revenues by saying it “was partly due to highly-paid individuals arranging their affairs to avoid paying the 50% rate.”  Duh.

Incentives matter

Here’s a nice paragraph from Arthur Laffer’s opinion piece in the Wall Street Journal today:

Government taxes cigarettes to stop people from smoking, not to get them to smoke. Government fines speeders so they won’t speed, not to encourage them to drive faster. And yet contrary to common sense, it seems perfectly natural to some people that government would tax people who work or companies that are successful only to give that money to people who don’t work and to bail out losing companies. The thought never crosses their minds that these policies are the very reason why our economy is in such bad shape.

Incentives Matter

Courbe de Laffer

Image via Wikipedia

Arthur Laffer writing a piece called Reaganomics: What We Learned in the Wall Street Journal today, plainly explains the Laffer Curve:

The key to Reaganomics was to change people’s behavior with respect to working, investing and producing.

Changing tax rates changed behavior, and changed behavior affected tax revenues. Reagan understood that lowering tax rates led to static revenue losses. But he also understood that lowering tax rates also increased taxable income, whether by increasing output or by causing less use of tax shelters and less tax cheating.

Moreover, Reagan knew from personal experience in making movies that once he was in the highest tax bracket, he’d stop making movies for the rest of the year. In other words, a lower tax rate could increase revenues. And so it was with his tax cuts. The highest 1% of income earners paid more in taxes as a share of GDP in 1988 at lower tax rates than they had in 1980 at higher tax rates.

I always appreciate humility:

To Reagan, what’s been called the “Laffer Curve” (a concept that originated centuries ago and which I had been using without the name in my classes at the University of Chicago) was pure common sense.

 

Government Needs a Dave Ramsey

Arthur Laffer, of Laffer Curve fame, writing in the Wall Street Journal today debunks the idea that cutting government spending might hurt the economy:

After World War II, the U.S. cut federal government spending dramatically. In 1945, federal government spending as a share of GDP peaked at 31.6%, and by 1948 it was down to 14.4%. Private real GDP (e.g., GDP less government purchases) for the three years 1946, 1947 and 1948 grew at a 7.5% annual rate. So much for the idea that cutting government spending hurts the economy.

The rest of the column is good too.

I liked this:

Addressing the possibility of the GOP-led Congress not voting to raise the debt ceiling, Austan Goolsbee, President Obama’s top economic adviser, histrionically asserted this month: “This is not a game. The debt ceiling is not something to toy with. If we hit the debt ceiling, that’s . . . essentially defaulting on our obligations, which is totally unprecedented in American history. The impact on the economy would be catastrophic.”

In context, his comments are more than a bit hypocritical. Over the past four years—including the last two years of the Bush presidency—he and his boss supported every big, misguided spending program they could find, regardless of how much the electorate protested. There wasn’t a dollar that didn’t burn a hole in their pocket.

Government spending should not be used to justify more government spending.  That’s bad logic.  It’s the logic that folks use for the few years leading up to the point when they call Dave Ramsey for personal finance advice.   Fortunately for those people they have Dave Ramsey who will help them face reality and realize the error of their ways.

Austan Goolsbee, who should be the government’s Dave Ramsey, is acting more like the credit card companies.  Spend more.

And back to Patrick Ewing’s logic: “Yeah, we make a lot of money, but we spend a lot too.

Arthur Laffer in the Wall Street Journal

Arthur Laffer, of Laffer Curve fame, gives some recommendations on how to improve the economy in today’s Wall Street Journal.  First, Laffer provides some reasoning for why the economy isn’t working to its fullest potential:

Employment is low because the incentives for workers to work are too small, and the incentives not to work too high. Workers’ net wages are down, so the supply of labor is limited. Meanwhile, demand for labor is also down since employers consider the costs of employing new workers—wages, health care and more—to be greater today than the benefits.Firms choose whether to hire based on the total cost of employing workers, including all federal, state and local income taxes; all payroll, sales and property taxes; regulatory costs; record-keeping costs; the costs of maintaining health and safety standards; and the costs of insurance for health care, class action lawsuits, and workers compensation. In addition, gross wages are often inflated by the power of unions and legislative restrictions such as “buy American” provisions and the minimum wage. Gross wages also include all future benefits to workers in the form of retirement plans.

For a worker to be attractive, that worker must be productive enough to cover all those costs plus leave room for some profit and the costs of running an enterprise. Being in business isn’t easy, and today not enough workers qualify to be hired.

But workers don’t focus on how much it costs a firm to employ them. Workers care about how much they receive and can spend after taxes. For them, the question is how the wages they’d receive for working compare to what they’d receive (from the government) if they didn’t work, plus the value of their leisure from not working.

The problem is that the government has driven a massive wedge between the wages paid by firms and the wages received by workers. To make work and employment attractive again, this government wedge has to shrink.

He then goes on to make several recommendations to shrink the government wedge.  I particularly like this one:

The cancellation of all spending that punishes those who produce and rewards those who don’t. This is really the distinction between demand-side economics and supply-side economics. Stimulus spending and quantitative easing don’t make it more rewarding to work an extra hour. If the government pays people not to work and taxes people who do work, is it really so difficult to see why employment is so low?

Incentives matter.  Fact.

I’ve seen firsthand the incentives Laffer writes about in play in two separate conversations over the past month with out-of-work colleagues.  These are smart, productive people who have been continuously employed for most of their careers and currently find themselves without work. I heard them say things like:

I have offers on the table, but I’m not interested in working until after the beginning of the year, otherwise I’ll be paying too much in taxes.

And:

I’m in no hurry to find work.  With unemployment and severance I’m making more than I was when I was doing something.  I’m taking a little break.

Of course.  I think most of us would feel the same way.  We make the same trade-offs each day without realizing it.

I’m reminded of a conversation I had long ago with a fellow who couldn’t fathom that incentives matter.  We were discussing tax cuts for the rich.   He thought tax rates for high income earners should be much higher. Since he wasn’t wealthy, he couldn’t personalize how raising rates on marginal income could change behavior. I also believe he didn’t understand the concept of opportunity cost very well.

He’d say things, “it won’t matter if they bring home 60% or 40% after tax, their goal is to maximize their wealth.”

I’d ask him if he works for pay during every waking hour of every day.

No.

Why not?

My job only pays me for 8 hours a day.

Why don’t you find a second job?  You can deliver pizzas.

I wouldn’t make enough doing that to make it worth my while to give up my leisure time.

Hmmm…..

I still don’t think he could transfer that personal trade-off he just made to that vision he had of the fat cat, wealthy person.