October 14, 2002
From the desk of Jane Galt:The other night, I was
The other night, I was discussing the problem of intellectual honesty with Susanna Cornett. It boils down to this: I don't try to fudge up numbers to back my ideological predispostitions. I try to look at the data and see what it really says, not just mine it for items that tell me what I want to here. I try to present disconfirming data as well as confirming. I try to show where I am making a value judgement that can't be validated empirically. I try to assume that my opponents are ignorant or making a different value judgement from me, not venal dishonest fools who are just lying because they're mean. I try not to engage in ad hominem attacks. Oh, sure, y'all have seen me wing a couple of people, but I hope that it was only after they'd repeatedly attacked me. Or in a couple of special cases, because I know beyond a shadow of a doubt that the person involved doesn't really believe what they're saying.
Larry Summers came and spoke at Chicago while I was there. Now, most of you probably think that Chicago economists are just a bunch of fanatic Republicans, but the fact is (apparently -- I haven't confirmed this myself) that the faculty of both the business schools and the economics department splits about 50/50 Republican/Democrat. Nonetheless, you knew that Summers was about to get roasted, because Al Gore's economic plan was a) fictional and b) dreadful.
[I thank my Democratic readers in advance for their angry letters. Yes, I am a drooling, venal dishonest fool who is just lying because she's mean. I'm sorry, I actually ran through the numbers analysis on both the Gore and Bush budget proposals, and both of them were so far off in never-never land that you couldn't even see them without a handful of pixie dust and Peter-Pan to guide you.]
What was particularly dreadful about Gore's tax plan was the "targeted tax cuts" that appear to be the dearest wish of half the left-wingers in the Blogosphere. From the point of view of most economists, there is nothing more distortionary and growth-hammering than "targeted tax cuts", aka deductions. For those of you who have run simple neo-classical models, this is the "D" variable that always produces those outlandish reductions in growth with a very small raise in the amount of the deduction. Let me see if I can explain why:
We'll work with a very simple economic model in which there are two ways to grow the economy: increase the supply of capital, or increase the supply of labor.
When we look at the effect of a tax cut on the economy, we want to know whether it encourages people to work or save more or less; this will tell us whether or not it grows or shrinks the economy.
There are two types of tax cuts you can have: cuts in marginal tax rates, like George Bush's cut, or deductions, like Al Gore's. Deductions can be implemented in a number of ways. You can increase the standard deduction, or you could increase the number of things people are allowed to deduct, like child care, education, home mortgages, etc, or the amount of each "targeted" deduction. Clear so far?
[There's actually a third type of tax cut you could have - a cut in the capital gains rate. But neither party was proposing one, so I'm not going to go into it.]
Now, there are tradeoffs involved in decisions to save or work: every dollar saved is a dollar you can't consume now. And every hour worked is an hour of leisure lost.
When people are making tradeoffs between two goods, economists analyze it from the point of view of two effects: the income effect, which is the effect on your demand for a good of a change in your income, and the substitution effect, which is the effect on your demand for a good in the change of the relative prices of the good and it's substitutes.
Breathe deeply. The bleeding from the ears stops after a little while.
Seriously, it's not that hard to understand. Think of a good -- say Ramen Noodles. The income effect on this good is negative: as your income goes up, your demand for Ramen goes down.
The substitution effect is also easy to understand: if McD's is having a 99 cent Big Mac special, you shelf the cup o' noodles and head out for some mystery meat.
Got it? Great. So let's look at the two types of tax cuts.
First, a cut in marginal rates.
Is there an effect on savings? The income effect is good -- richer people tend to save more of their income. But the substition effect is very complicated, as it depends on things like how permanent people think the tax cut is -- if they think it's temporary, they'll save more than if they think it's permanent, because people like to smooth their consumption over a long period of time, and saving lets them push some of their current consumption into the future. However, the difference in the savings produced by marginal rate cuts and deductions probably isn't large, so if it's all the same to you, we'll just look at the effect on labor, rather than capital.
Well, the cut in marginal rates effectively increases your income. The income effect on demand for leisure v. work is unambiguous: as they feel richer, people want to work less and play more.
The substitution effect is also easy to comprehend. The tax cut just effectively raised your hourly rate. Leisure is therefore more expensive. Say you were taking home $10 an hour, but now you're getting $12. Every extra hour you decide to play instead of work is costing you more money. The marginal hours, the ones you spent watching shows you don't really like on Saturday afternoon, or arguing with your boyfriend about whose turn it was to get the car washed, might have been worth $10 but just aren't worth $12. So you work more.
The entire argument about the effect of marginal tax cuts on the economy thus hinges on a debate over whether the income effect or the substitution effect is larger. That debate is still raging, and it's a post for another day. Suffice it to say that Bush's economists think that the substitution effect outweighs the income effect, so that cutting marginal rates will grow the economy.
[Righties -- this is why simply cutting marginal tax cuts is not an unambiguous boon to the economy. Lefties -- this is why marginal rate cuts are not just "giving money to the rich"]
Now, let's look at Al Gore's tax cut.
The income effect is just as clear: people get more money, so they stay home more.
The substitution effect is. . . hey! Where's the substitution effect? Answer: there is none. There's no incentive to work more; you get the targeted tax cut for doing something non-wealth producing, like buying a house, having children, going to college, etc.
[Isn't education wealth producing? -- ed. You think so? What did you learn in school that is helping you produce wealth today? For engineers and such, yes, but for most people, education is an elaborate signalling tool that tells employers you were smart enough to make it through a tough admissions process -- or at least not to drool on yourself during history class. But it just serves to reallocate existing jobs, not improve them or create new ones.]
Actually, deductions hurt the economy in a third way: they're distortionary. For example, the mortgage tax credit doesn't seem to boost home ownership, but it does create a hugely volatile housing market in tight spaces like Manhattan, while encouraging people elsewhere to occupy larger houses than they otherwise would. There's no reason to divert resources to larger homes when people might prefer to have something other than a big house, in the absence of the tax credit. Education credits just mean that more people will be getting useless degrees; if there were a demand for their degree in the marketplace, it would already pay them to get it. MBA's, lawyers, and doctors have no trouble getting private loans instead of government ones for their education; it's the comparitive folk dancing students who need the help.
[Are you saying degrees in Folk studies are useless? -- ed. Not exactly; I'm saying that I don't want to pay people to get one.]
So, since Larry Summers, who everyone respects as an economist, had been on the stump for these "targeted tax cuts" that are the bane of economists, you knew it was going to be bloody. And indeed, one of my favorite professors grilled him mercilessly.
But Summers had an answer. Ultimately, he said, it's a value judgement. Sure, these tax cuts were going to hurt GDP. But he thought the amount of the hurt would be sufficiently small to merit helping groups he favored, and because most people are economically completely illiterate, getting the targeted tax cuts passed was the only way to help them. That's why I respect him so much -- he gave an honest answer, rather than trying to fudge up data to support his desires, as do many, many figures on both the left and the right. (Of course, a friend points out that he was hardly going to get away with fudging up data in a room full of Chicago economists, but he's subsequently kept impressing me. So there.)
That's why I do get angry when people make disingenuous arguments. For example, there was a guy here a while back who was arguing against privatizing social security. Now, I'm in favor of doing so, with some safeguards, but I can be convinced otherwise, provided you can show me some real data about how we think privatization would end up looking worse than the current system. (There are reasons, having to do with demand and earnings growth and the demographic effect on the economy, that I can conceive it might). Unfortunately, many lefty type economists, who don't want social security touched because it's currently a prime vehicle of income redistribution, haven't gone that route. They also haven't gone the route of saying "I don't want social security touched because it's currently a prime vehicle of income redistribution". They've gone the route of saying ridiculous things that they couldn't possibly believe to support their desire to keep social security intact.
This chap was arguing that there was no crisis because when social security starts running a deficit, they'll just start rolling over the bonds, and the net debt of the United States won't change until 2040 or some such.
This is ridiculous. Let me show you why:
It is one of the most basic identities of economics that government spending must equal taxes plus borrowing plus net foreign income (what foreigners give us, minus what we give them -- for the US, it's a trivial figure)
S = T + B + NFI
This chap was arguing that spending overall could rise -- that we would be increasing social security payments, without decreasing any other spending. Yet at the same time, he was also arguing that neither taxes nore borrowing would be going up. Unless he's found a large pool of foreign donors, this simply isn't possible -- the money has to come from somewhere.
[They could print it -- ed. Yes, they could print it. But that wouldn't help. What we're worried about is not having a sufficient supply of little green pieces of paper; it's about making enough stuff to support everyone in the style to which they've become accustomed. Inflating the currency just hurts the pensioners -- ask the Russians.]
I could also have refuted his argument more directly; he was using the strange structure of government accounts to obscure the cash flow issues. But here's the problem: that argument is very, very complicated, probably beyond my poor powers to simplify for popular consumption. To most of y'all, I'm just a talking head. He's another talking head. We're having an argument about something we understand and you don't. He can BS you guys, and I can stand here screaming "He's lying", which is true, but you don't know that. Those readers who desperately want to believe that social security is just fine as is will simply choose the talking head they like better. That's why journalists so often get things wrong -- they don't understand what they're talking about, so they just choose the expert who validates their beliefs. That's how you get articles on guns that only present the VPC side.
But there are people who ought to know better. When I make a statement about something like economics, I do my best to define my terms, show you my reasoning, and make sure you can follow along with me. When I make a judgement call, I tell you so -- for example, my opinion that drug price controls would effectively end pharmaceutical research, which I believe is right, but not empirically proveable without resorting to price controls. I don't always get it right, but when I miss, I do my best not to fudge, but to admit I erred. And frankly, I'm getting too old to debate people who want to use arguments to obscure the truth, rather than jointly determine what the truth is. It's too tiring, and frankly, if all you're looking for is some rationale for your political views, you're going to take their word over mine no matter how compelling my logical argument. I'm very interested in debate with people who are airing important questions. But not with people who are trying to snow readers who can't tell the difference.
Posted by Jane Galt at October 14, 2002 09:14 AM | TrackBack | Technorati inbound links