Tax Cuts and Government Investment

Richard Serlin:

A dollar spent on tax cuts costs more than a dollar over the long run, a lot more., by Richard Serlin: With regard to ... "The Whole Analysis Sounds Pretty Fishy":

So the the right wing propaganda tank, Tax Foundation, claims that tax cuts recover up to 40% of their costs through so-called dynamic effects, while Bush's own Treasury Department estimated less than 10%.

Even if it actually were 40%, are tax cuts a good idea, especially tax cuts going predominantly to the rich and extremely rich? They're still costing the government 60% that can't go to many extremely high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics (real, scientific, academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Suppose we consider continuing Republican policies and spending another 1 trillion on tax cuts for the rich. Even if 40% were recovered (and in the long run, as opposed to just looking at short run effects, the dynamic effects go in the opposite direction -- a dollar in tax cuts ends up costing a lot more than a dollar in government revenue if that means a dollar, or even 60 cents, less in investment in high return government projects.).

The vast majority of the tax cuts, it has been shown, will eventually be spent on consumption items of little long run investment value -- leaving little to show or to grow. If instead, even just 60% of that 1 trillion were spent by the government on extremely high social return investments like infrastructure, education, basic scientific and medical research, alternative energy, etc., then 10 or 20 years from now that 600 billion could result in many trillions, or even tens of trillions more in national wealth, as opposed to having the whole 1 trillion spent on rapidly depreciating Ferraris and yachts, and ultra luxury vacations and other things for the rich that have little or no productive value.

In the long run, a dollar spent on tax cuts for the rich, instead of badly needed social investment puts us one more step closer to losing our status as the most wealthy and modern nation, and over the long run, like any other decision to increase frivolous consumption at the expense of high return investment, it costs us a lot more than a dollar, not less.

He has a follow-up post here.

Comments

[Robert Olson]

This seems to be very hypothetical, particularly in making the assumption that the government can make investments in "high return" projects.

Plus, you know, discount rates affect what sort of consumption preference we like to have over time.

[Noni Mausa]

I enjoyed the follow-up post, especially this vivid example:The idea is this: if you raise someone's wage from $8/hour to $12, they may go from 40 hours/week to 45, because they get $4 more for giving up an hour; that's the substitution effect. But if you raise their wage from $8/hour to $1 million/hour, they will probably work like 40 hours per year! And then spend the rest of the year enjoying all of that money. That's the income effect; when you raise someone's wage per hour, they don't have to work as many hours to live in a way they consider well. Empirically, it appears that with taxes at about their current level, the income effect becomes greater at about the middle class level, and then we get what's called a backward bend to the labor supply curve. Cornell economist Robert Frank has a nice brief New York Times Economics Scene article explaining all of this, "In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up". [located here: http://tinyurl.com/5z49es]

[George J. Georganas]

The difficulty is with identifying the "high return" projects and separating them from the many low or negative return projects that the same government must, also, be running. Furthermore, having arrived at a proper ranking, one must make sure that a majority of people also share it. The job of weeding out unproductive uses of society's resources is beyond the capacity of government as government is presently constituted in modern states.

[James]

I apologize for this being off-topic, but I've posted a little tidbit about Alaska Governor Sarah Palin and the "Bridge to Nowhere."

Even though Alaska got rid of the bridge, THEY KEPT THE FEDERAL MONEY! All they did was decide to spend your federal tax dollars on other stuff. They got rid of the symbol of wasteful earmark spending, but they kept the actual wasteful earmark spending.

[Invisible Hand]

This guy is so opinionated and hysterically anti-Republican that it is hard to take him seriously. An effective economist has to try to make an objective analysis without preconceived conclusions, and he fails badly.
I agree with him that tax cuts which are financed with government borrowing (such as the Bush-era cuts)are typically going to be negative for the overall economy. On the tougher issue of identifying "high social return investments" Serlin doesn't have credibility.

[Farrar]

Where is the problem in identifying high social return investments? Invisible hand must have placed it over his eyes if he can't see them now.

[save_the_rustbelt]

It is a very strange notion that when a citizen is allowed to keep their own dollar, it is "spending."

It may be bad policy, but the idea that is in an expenditure is a concept only economists and politicians could love.

[ilsm]

Tax cuts with concurrent deficit spending making upper income bond buyers who would otherwise be paying taxes.

Tax cuts are also funded by excess receipts in OASDI, and Medicare taxes.

Bait and switch; tax and borrow scams.

[Political Game Theory]

"Where is the problem in identifying high social return investments?"

The biggest problem is the incentives that we give our politicians. We allow politicians to redistribute wealth as they please (with total disregard for the Constitution). They try to direct as much government spending to their district, regardless of the NPV of the project. During non-election years they will be busy giving hand outs to their friends, and during election years they will be bribing their constituents by giving them handouts. And these immoral pigs do this while they go around claiming that they act in the best interest of the American people. Bullshit!

[Opportunity Costs]

Not to mention that every dollar the mafia confiscates is a reduction of $1 in a combination of consumption and investment in the (so called evil) private sector.

[bakho]

It is not difficult to estimate a multiplier for any government program. There are many studies on infrastructure and educational spending and their effect on the economy and development. There are ways to identify and target those opportunities. This is especially true at the level of state government where spending has important local effects.

Serlin assumes people know that (probably a bad assumption given the considerable bashing of government spending).

The highest return investments keep bumping up against the political will to undertake them.
Certainly in the top 10 would be
1. Investment in early childhood education, especially in poor school districts where students have poor learning readiness skills.

2. Health care reform that brings the cost in line with other countries, improves the outcomes and addresses important problems like obesity, diabetes, smoking and unhealthy lifestyles.

The numbers are clear. The political will is lacking and undermined by special interests.

[btg]

str: It is a very strange notion that when a citizen is allowed to keep their own dollar, it is "spending."

well, sending out tax rebate cheques is pretty much the same thing as spending - government could just as easily send out cheques to be used for things like, say, education, dental care, energy conservation, etc. - things which clearly produce a social return...

or government could just as easily give those cheques to construction workers to build a highway or transit line, or to rebuild New Orleans.

[bakho]

Not everyone agrees that the Bush administration and the party of K-Street is totally corrupt but it certainly explains their behavior in office. They have managed to divert a LOT of our tax dollars to special interests, cronies and outright crooks. Efficient investment of tax dollars requires OVERSIGHT, by both the press and a healthy tension between the executive branch and Congress. In most of the 1990s, there was a great deal of oversight (some of it unhealthy) but it did insure that tax dollars were spent efficiently. This decade has been characterized by almost total lack of oversight. This is THE clear failure of the Republican Party and much of our press. It derives from a political party that has developed a governing philosophy of favors from special interests in return for campaign donation to run attack ads to sway public opinion. The result is 80 % disapproval of the current direction of our country and hopefully more limited ability of false advertising to sway voters.

[Richard H. Serlin]

With regard to the commenters who question whether the government can or will make high return social investments, the answer is that they certainly can, and they certainly have, spending many billions each year on basic scientific research of the kind that lead to the invention of the computer and internet and the discovery of DNA, the interstate highway system, the GI bill for college which largely created the great middle class and made college affordable for the wider population for the first time, and much more, and again these are the kinds of things that the free market will grossly underprovide and/or provide much less efficiently due to the market problems I described in my posts (externalities, impracticalities of patenting, etc.).

The government spends money far more productively than many people think, and I will show this with detailed analysis in future posts. A dollar to the government is far from a dollar to the mafia, as one commenter intoned. In spite of Republican efforts, there's still a lot of transparency, checks and balances, and accountability to the voters. These post, however, may have to wait a while, as I'm going to need to focus on business and academic activities.

Let me note also, though, that any large organization, even a private business, will have some waste. The CEO of Tyco spent $5,000 of company money on a shower curtain, and $1 million on a birthday party for his wife. You can never completely avoid waste, but very often the meat you get is well worth having to put up with the fat. If you spend $1 billion on alternative energy. Even if $500 billion of were flushed down the toilet, the other $500 billion would create far more wealth over the long run than if the full $1 billion was spent on Ferarris, yachts, and five star hotels by way of tax cuts for the rich. I'll provide a lot more information and data on this in future posts.

[RW]

"I'll provide a lot more information and data on this in future posts."

Looking forward to it. Who knows, perhaps even a few of our less hidebound disestablishmentarians will learn something too, at least one can hope.

[Invisible Hand]

Farrar,
Instead of using the term "identifying highly productive social investments", I should have said "determinig what social investments the USG will invest in". Although you or I could easily come up with a list of $500 billion in productive government investments, the actual decision is made by 535 Congressmen and the Administration, and they have their own lists.
Getting specific, the corn-to-ethanol program is a multibillion investment with strong support from corn farmers and some environmentalists, but opposition from other environmentalists and anti-hunger activists. You will find economists on both sides of the argument.
Right now the Big Issue is propping up the home mortgage markets, which will likely cost taxpayers over $100 billion. When 535 congressmen are finished, the ultimate program will probably cost much more. Is all of this "highly productive social investment?"

[robertdfeinman]

Let's suppose that money spent by Bill Gates is just as "efficient" as that spent by Dept of Health and Human Services.

They both support some worthwhile project to improve human health. Which is the better way to spend the money?

1. Gates got his fortune by being a monopolist and avoiding paying taxes on his excess income because of the way the tax laws are structured. So his source of fund came from the government in the form of forgone revenue anyway.

2. Gates gets to chose his projects according to his own whims. If he wants to support Malaria then he supports Malaria even if HIV is a bigger issue.

3. HHS spends it money according to priorities established through congressional appropriations and internal vetting schemes which evaluate grants and other programs. Congress is, ultimately, responsible to the people, so the money is spent using democratic means, not by whim.

4. Private spending (whether on yachts or Malaria) is not accountable to anyone. So we have no way to determine if there is fraud or abuse.

5. Government spending (when done right) has oversight which means that fraud and cronyism get exposed on a regular basis. This gives those who oppose democracy an excuse to bash government spending since it is the only area where waste is reported.

6. Government spending can be devoted to areas which don't provide short term ego satisfaction, something demanded by spending by the wealthy. Charities frequently report that donors drop out when results aren't as immediate as they wish and take their money to someplace where more bang for the buck. This explains why many projects funded by the wealthy end up as named buildings - the edifice complex. What better way to immortalize your generosity than having your name emblazoned on a new eyesore.

So allowing the rich to accumulate sufficient wealth that they can fund projects of a size that should be left to government is undemocratic, inefficient and immoral. If there is waste in government it is because there is too little democratic oversight, not too much.

[Julio]

Richard H. Serlin,

"I'll provide a lot more information and data on this in future posts. "

Please do, you'll be providing an excellent public service.
I've tried to make the same arguments many times, informally, and I'm sure so have many others. Though often met with "don't confuse me with facts, my mind is made up", I still could use more facts and examples.

A related question where I'd appreciate your views is this: sometimes a single government program gets measured against a bunch of private initiatives many of which go bust. That's not counted as "waste" but a form of "creative destruction". Supposedly the competition provides a better result, i.e. the surviving entities are better than the government program would have been, but I'm skeptical. And at what cost?

Are there examples of this you would count as "waste"?

[Data Mining]

"With regard to the commenters who question whether the government can or will make high return social investments, the answer is that they certainly can, and they certainly have, spending many billions each year on basic scientific research of the kind that lead to the invention of the computer and internet and the discovery of DNA, the interstate highway system, the GI bill for college"

You can't just hand pick which mafia programs you want to analyze. You have to take the good with the bad. "If only we choose the 'right' leaders who will choose only the right policies" is as much of a pipe dream as flying pink unicorns.

[No Such Thing As a Government Failure]

And don't forget that in the private sector when an enterprise is inefficient it goes under. Underperforming government agencies get more money thrown at them.

[Lee A. Arnold]

It's funny how the "public-choice" criteria keep popping out, even though Gordon Tullock himself wrote that "it has no policy implications." Yet if one point is refuted, they hop to the next. In this comments thread, it's (1) government can't identify "high-return" investments, (2) there's no valid decision-making process to implement them, (3) there are no brakes on politicians and special interests. Because it has nothing to do with facts, it is defending the defunct Republican ideology that keeps making these things come true.

Democracy is the decision-making for government spending, and it works very well too, although on a different time scale. Actually very many government programs have been ended or transformed over the years, as they became obsolete or inefficient. The difference is in the decision-making process which performs the trick: markets have prices, governments use votes.

And of course there are lots of high-return investments that only governments can make, as have been listed above.

[Lee A. Arnold]

Richard H. Serlin, have you seen the book by Peter H. Lindert, GROWING PUBLIC: Social Spending and Economic Growth Since the Eighteenth Century, volume 1 (Cambridge, 2004.) He shows that over 300 years, large social spending in market economies has had no net effect on GDP, while of course it can improve quality of life.

[Richard H. Serlin]

Ok, a quick chime in: Lee A. Arnold is misinterpreting Lindert's book. The book focuses on government transfer payments, rather than investment focused projects in a high tech modern economy, where such projects can have enourmous return, and be especially underprovided by the private sector. Nonetheless, even redistributive transfer payments end up not costing growth in his analysis. From famed Columbia economist Jeffrey D. Sachs:

"Two of Lindert's major conclusions are that the spread of democracy has historically played a pivotal role in the rise of social expenditures; and that social spending has not gravely weakened economic incentives and long-term economic growth, despite the drumbeat of criticisms from free-market devotees. Indeed Lindert concludes that the net national costs of social transfers, and of the taxes that finance them, are essentially zero." (http://www.amazon.com/Growing-Public-Spending-Economic-Eighteenth/dp/0521821746/ref=sr_1_1?ie=UTF8&s=books&qid=1220129070&sr=1-1)

And from the books product description, you'll note that they call them policies that redistribute income"

"Peter Lindert inquires as to whether social policies that redistribute income impose constraints on economic growth. Although taxes and transfers have been debated for centuries, only recently have we been able to obtain a clear view of the evolution of social spending. Lindert argues that, contrary to the intuition of many economists and the ideology of many politicians, social spending has contributed to, rather than inhibited, economic growth." (at: http://www.amazon.com/Growing-Public-Spending-Economic-Eighteenth/dp/0521821746/ref=sr_1_1?ie=UTF8&s=books&qid=1220129070&sr=1-1).

As I said, in a future post I'll talk about the compelling research both theoretical and empirical showing that many categories of government investment programs have extremely high social returns, especially in a complex, high tech, modern economy, and this isn't cherry picking, the evidence and logic is for types of programs, not just specific ones.

[Lee A. Arnold]

Richard H. Serlin, please quote exactly where I "misinterpreted Lindert's book." I don't understand that.

You mentioned education once or twice above, and fully one-quarter of Lindert's book is concerned with the rise and effectiveness of public education, from its beginnings up though the 20th century.

And the end of Lindert's book is an acute (and for me surprising) analysis of the structure of taxation in the successful welfare states, showing how they reward economic growth much better that the United States does, in return for much higher government spending.

So, given your project of research, I simply thought that the book might be of factual or methodological interest.

Volume 2 contains the data and analyses supporting the arguments.

If you want to use Amazon for evaluation, go to the pages for both books, and underneath the pictures of the covers, hit "Search inside the book." You can read the entire tables of contents, excerpts from Chap 1, the entire indexes, the back covers.

[Patrick]

At the risk of stating the obvious, there is a balance to be struck. Examples: there's been no need to provide incentives (e.g. tax breaks) for US companies to invest in productivity enhancing IT, on the other hand I don't see the private sector rushing to fix the terrible toll on productivity caused by 40-odd million people having no access to reasonable health care.

[Invisible Hand]

Patrick,
It seems obvious that a balance needs to be struck, but a number of the posters on this blog might not agree. I notice that academic types predominate here, and Richard Serlin is a fairly extreme case.
Who would not agree that public investment can often be extremely productive? My objection to Serlin's argument is that he is too simplistic and too politically biased to make a practical case.
In a previous post I mentioned two real-world public investments that are on the front burner in Washington -- the ethanol-from-corn-kernels program and the Fannie-Freddie rescue mess. I don't see how either of these endeavors fits well with Serlin's description of the political decision-making process. It's also not clear that either of these huge public investments will become "extremely high social return projects".

says...

Invisible Hand,

Certainly it seems that academic types are in the majority here, and they all tend to have their favorite hobby horses they like to mount. This is only blog I've seen where comments impersonate an e e cummings poem. Truly bizarre.

Agreed that the ethanol thing is just stupid. As for Fannie and Freddy, I'm of the opinion that the gov't could temporarily take over their function in the mortgage market and let them go bankrupt. That's how insolvency is resolved after all. No need to invent something new. That way the incompetent management gets fired, the shareholders who made bad decisions get wiped out, and bond holders take a haircut. Capitalism at it's best.

says...

Apparently the author has never heard of the "Big Dig".

[Richard H. Serlin]

Sorry Lee, I just meant the way that you worded it may have made it look like government investment projects in a modern high tech economy had the same kinds of returns as transfer payments in historical economies.

Invisible Hand, first note that Adam Smith, despite the myth, even in 1776 understood that the invisible hand did not work well in many cases without a government role. As Cornell economist Robert H. Frank notes in his New York Times Economic Scene article of May 25, 2008:

ADAM SMITH’S modern disciples are far more enthusiastic about his celebrated invisible-hand idea than he ever was. In their account, Smith’s assertion was that purely selfish individuals are led by an invisible hand to produce the greatest good for all. Yet Smith himself was under no such illusion.

On the contrary, the relevant quotation from his “Wealth of Nations,” which describes a profit-seeking business owner, is far more circumspect. It says that this owner “is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” It continues: “Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

In short, Smith understood that the invisible hand is often benign, but not always.

(at: http://www.nytimes.com/2008/05/25/business/25view.html)

With regard to government investment programs, I'm not saying 100% of them have high social returns, but many many do, and those should be supported and funded to the max -- the more you spend on a positive NPV (excessively high return in finance lingo) project, the richer you end up over the long run, not poorer -- but Republicans oppose these knee-jerk as part of their simple-minded anti-thinking and anti-science ideology. History, and a comparison of the plans of Obama and McCain, shows that with Democrats, we get much more spending on these high return social projects -- with more waste cutting and efficiency in government as well -- and that's why as Princeton economist Alan Blinder points out in toady's post above:

The stark contrast between the whiz-bang Clinton years and the dreary Bush years is familiar because it is so recent. But while it is extreme, it is not atypical. Data for the whole period from 1948 to 2007, ... show average annual growth of real gross national product of 1.64 percent per capita under Republican presidents versus 2.78 percent under Democrats.

That 1.14-point difference, if maintained for eight years, would yield 9.33 percent more income per person, which is a lot more than almost anyone can expect from a tax cut.

Such a large historical gap in economic performance between the two parties is rather surprising, because presidents have limited leverage over the nation’s economy. ... But statistical regularities, like facts, are stubborn things. You bet against them at your peril.

[SanFranciscoJim]

Real world experience would tend to verify these findings, because if low tax rate economies always allocated capital more productively, then the US should be increasing its median GDP/head lead over Sweden, when in fact, over a long period of time, the opposite has happened.

The past few decades have been more or less even between the two economies. What is most important is that government's allocation of resources be done in a non-corrupt and democratic fashion.

Unsurprisingly, the Party that doesn't believe in the possibility of good government tends to do an extremely poor job of governing. If they accomplished this at a low cost, it could perhaps be forgiven, but during both the Reagan and W. Bush administrations all they did is run massive deficits. They have tended to see the public purse as simply a till to dole out cash to favored constituencies. One can say that the Democrats do the same, but the favored constituencies of the Democratic Party are groups like Teacher's Unions, where the investment tends to pay off.