Friday, August 22, 2008

Friedman, Taxes and Pidgeonholing Economists

Scott Adams, Dilbert Cartoonist is funding a survey of 500 economists about which candidate they support. A comment to the unveiling of this read as follows:
Milton Friedman is the most respected economist of the 20th century.
Friedman says in all cases raising taxes and increasing government
slows down the economy. This is principle is pretty universally known
by now.
Given that Obama wants to do exactly that, if we find these 500
economists think Obama has the better way, we'll know that the fix is
Why do I have the feeling it will turn out that way?

There are about 3 things wrong with this statement: (1) Milton Friedman (was) a very highly respected economist of the 20th century, but not necessarily the "most" - at the very least you would have to qualify it to only look at MACROeconomists; (2) raising taxes slows the economy, ceteris paribus, you know, assuming the money is thrown in a bottomless pit (the devil is in the details of how those taxes are structured, and how their revenues would be used), and; (3) that something that is universally known can be universally applied (the "law" of gravity works great at sea level and in a vacuum).

I'll start with point (1). Friedman was a great macroeconomist. Think of it like the difference between the 30,000 feet up that Rummy looked on Iraq from versus the ground-level view on which the troops are getting shot at. There are tons of other fields of study in economics: International trade, developing economies, labor markets, econometrics, microeconomic theory, environmental economics, economic history, game theory, public finance, political economy, etc., etc. How you feel about the candidates may depend on the issue at hand. Take for instance the environment. I've railed on the misuse of the term "incentive" as a euphemism for "subsidy," because incentives can be negative, too. In a MICROeconomic context taxes are negative incentives, and often sticks (taxes) work better than carrots (subsidies) to do the job. In the case of the environment, if your goal is reducing emissions, taxes work "better" in the sense that (a) they encourage pollution abatement to save on the cost of the tax, and; (b) they discourage output in pollution intensive industries.

Next consider the proposition about higher taxes. For starters, this comment is intended to mean that lower taxes will reduce government spending and involvement in our lives. The last 8 years have done exactly the opposite with lower taxes - Bush spends more, saddles us with more public debt, and gets in our business more than any administration in a long, long time. Also, the premise of Friedman's neoclassical model begins from a balanced budget and no debt (heroic?). Finally, just because taxes slow production, it is not universally true that either (a) the converse (lowering taxes helps growth) is true, or; (b) higher taxes are not necessary for accomplishing certain objectives. Let's look at the current situation. We have a large and growing debt and are waging a war without funding it. When the government spends (say, on a war) it is committing itself to higher taxes, now or later. Since it is the rich who also own most of the Treasury's debt, by supporting irresponsible taxcuts today's administration is screwing tomorrow's middle class for the sake of todays upper class. This is where I wish conservatives would go back to true fiscal conservatism and stop railing a dogma of "low taxes - good." Higher taxes, if used to reduce the current deficits and debt, might actually promote growth in the long run.

I think a fair argument for (3) against Joe Commenter's claim follows from the previous arguments. Still, the fact remains that the structure of the taxes is important. The taxes that are most "universally-accepted" to be harmful are those levied against capital. Therefore, it is probably true that capital gains and dividends could be taxed less with quite a bit of benefits. In particular, interest income and capital gains should, at the very least, be indexed against inflation (deflated) in terms of the basis against which the value of the asset or principal is compared. On the other hand, it is probably true that raising the tax on the highest marginal income bracket will not be very harmful. Taxes on wages and salaries have been found in both the theoretical (Ramsey, other optimal tax macro models here) models and empirical literature to be pretty benign. Taxing the million and first dollar earned from salary another percent does not drastically impact effort; taxing the 10,001st might.

I'm sorry that the world of economics is such a complicated place. Ultimately my rule, is that most politicians do a pretty good job of ignoring economic advice from pros, and neither party has a monopoly on ignorance of economic theory. So feel free to go out and vote on the basis of some banal social issue like gay marriage, guns, or which party has had more sex scandals in the last 90 days.

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