Happy birthday, TMS

Today, the Scottish thinker Adam Smith (1723-1790) is best known for his pioneering work of economics, The Wealth of Nations (1776). But the book that actually propelled him to fame was The Theory of Moral Sentiments, published on this day in 1759.

Moralists had been struggling to work out the principles that made some actions morally good and others morally bad. To churchmen, the answer was obvious: it was the word of God. Skeptics speculated about whether we had a sixth sense, a ‘moral sense’ that would guide us towards good.

Smith’s breakthrough was to identify our moral judgements as a matter of human beings’ deep psychology as social creatures. Human beings, he argued, have a natural ‘sympathy’ (today we would say ‘empathy’) for others. That enables them to understand how to moderate their behaviour and preserve harmony. It is the basis of moral judgements about behaviour, and the source of human virtue.

Writing exactly a century before Charles Darwin’s The Origin of Species (1859), Smith was not sure why such social behaviour should prevail. He put it down to providence: today we would put it down to evolution. 

The book was an intellectual sensation. Churchmen, of course, did not like it very much, but it caught the eye of Charles Townsend, an intellectual and senior member of the British government, who was highly impressed and sought an introduction to Smith through their mutual friend, the philosopher David Hume (1711-1776). Townsend immediately hired Smith, on a salary of £300 a year for life, to be tutor to his stepson, the young Duke of Buccleuch. It was a fortune – and it gave Smith the independence and experience to start writing the work for which he is remembered today, The Wealth of Nations.

Owen Paterson's Brilliant Brexit Patter

Former UK cabinet minister Owen Paterson has just delivered the most intelligent case for the UK leaving the European Union that I have ever heard. His basic point is that the EU is not the ‘status quo’ but something that is rapidly moving to destinations that are uncertain and dangerous, particularly for the UK; and that being outside is the safer, more stable option.

Take the eurozone. It is rapidly becoming one country, says Paterson. In order to deal with the imbalances that the fixed currency has only exacerbated, it needs to centralise decision making on budgets and bailouts. Plans for this are well advanced, eurozone sovereignty is being pooled, members’ discretion over their own budgets is being curbed and the eurozone will in effect be its own political union by 2025 – just nine years away. That is a very different kind of EU that is being envisaged, and not one that strikes a chord in the UK.

The UK government says that the UK will have ‘special status’ outside this and the other centralising tendencies. But how? There is no binding agreement that grants the UK any special status: the only sort of special status around seems to be a Norway-style outer circle. Not in the euro, not at the core, out on the fringes – it is clear that the UK’s influence could only diminish. The UK would still be outvoted, still overruled by the ECJ, still expected to chip in to eurozone bail-outs (as it was with Greece), but even less able to do anything about it.

Then there are security issues, with five new countries, 87m new potential EU citizens, waiting to join. Such as Turkey, with its leaky 700-mile border abutting a war zone. Once migrants make it to Germany or the other countries that are supposed to share them out, before long they become EU citizens and able to travel and work in their destination of choice – the UK. And we have no say in it. Migration, as ASI has shown, is generally beneficial: but far more so if it happens at a manageable rate.

Paterson’s vision for a UK outside these uncertainties is one of a self-governing, free-trading nation, a true part of the global family, its international trade and participation no longer absorbed into the EU. And as for trade deals, the EU is far weaker than the UK would be alone, each member having its own interests to throw into the horse-dealing, and proceeding only as fast as the slowest and most intransigent. The UK could do deals with China, India – and indeed the US, far quicker. It would also have greater representation on trade and other international bodies such as the WTO, where currently it is represented by the EU.

Leaving the EU is not an instant commitment, but a process. There would – and certainly should – be a long process of discussion before the formal commitment to withdraw (and the two-year i-dotting period that follows it) is given. In the meantime, the UK would continue to trade with the EU – something that 5m EU jobs, and EU supply chains, depend on. But meanwhile, we could be opening up better relations with the rest of the world.

There is no status quo. If the UK remains in the EU, it will be a second-class citizen, and the EU’s political centralization will continue, dragging the UK along with it. The eurozone, politically integrated by 2025, will dominate the rest. Outside, the UK could at least control its borders, its budget, its national debt, its public services, its international trade. What’s not to like?

Perhaps the 1% improve poor peoples' health?

Perhaps the 1% improve poor peoples' health?

A rather interesting little finding from over The Pond concerning the connection between inequality and the health of the population. Over here we've had Michael Marmot insisting for decades that health inequality is to be explained by economic inequality. And Wilkinson and Pickett have been shouting that they are not just connected by economic inequality is the direct cause of ill health for all. At which point we get the American study into health and inequality and we find something a little different:

This morning's Guardian produces a bit of a giggle

This morning's Guardian produces a bit of a giggle

That's our first reaction, at least, to this story that a Welsh billionaire is willing to invest some of his own money in a rescue of the Port Talbot steel assets. The giggle coming from, no, not the idea that there is a Welsh billionaire, the thought that, well, yes, that's what we rather expect from people when they buy something. They use their money to buy the thing that they're buying. Seems a reasonable and logical idea to us but it's obviously caught The Guardian by surprise:

The effects of Osborne's new national living wage

St Joseph's Hospice is in Liverpool, where it cares for the terminally ill in a manner that the National Health Service simply never can manage. They have sent the following around to their supporters:

Charity shop staff who work for Jospice face the prospect of losing their job due to rises in the minimum wage…

There are currently eight retail managers working across these shops but it is proposed that this number be reduced to five.

The decision has been blamed on the government’s new National Living Wage, which rose to £7.50 an hour for over 25s as at the start of April and is expected to rise to £9 by 2020.

A spokesperson for Jospicesaid: ‘We have informed our eight retail managers that we propose to implement a new retail team structure.  Due to ever rising costs and the introduction of the National Living Wage we are unable to continue with the existing staff structure within our retail team….

As a charity we have to raise half our income through fundraising in our local communities and so we have to be as efficient as possible.

We'd just like to say well done Chancellor, well done.

Prosperity Mr President? The EU is the slowest-growing trading bloc in the world

President Obama says the UK needs to stay in the EU to promote ‘peace, prosperity and democracy’. Sadly, the EU does not promote any of these.

Peace in Europe is promoted by NATO. Look at the Balkans war. Though appalling genocide was going on under the noses of EU ‘peacekeepers’, the EU was unable to bring the conflict to an end. It was only when NATO – led in large part by the UK – stepped in that the carnage was stopped. 

And take Ukraine. It wanted closer links with the EU, but the EU’s ‘all or nothing’ policy made Putin fearful that this buffer state would turn into a Western enemy. The EU could do nothing to resist the occupation that followed.

Prosperity? The EU is the slowest-growing trading bloc in the world. Partly that is because of its sclerotic common currency, the euro – a political project that was pursued in the face of economic commonsense. 

Democracy? Power in the EU centres on the Commission, a group of appointed, not elected, politicians and officials. The public do not directly elect the national politicians who sit on the Council of Ministers – nor, for that matter, the panels of finance and foreign-policy ministers. And the vast majority of people in the UK have no idea at all who their Member of the European Parliament is. Not that the Parliament has any power to initiate legislation anyway. Our own legislation, and our Supreme Court, are overridden by EU institutions. 

For such a powerful nation, America is remarkably naive about foreign policy. The Administration seems to think that the EU is a kind of NAFTA, a loose free-trade agreement. In fact it is a political union – and one that no American would, on closer inspection, ever wish on itself or its friends.

Something of a blow to Piketty's thesis

The more research that gets done into the details of Thomas Piketty's thesis (essentially, wealth concentration will leave us all as serfs again) the more there seem to be great gaping holes in it. For example, a central piece of the logic is that wealth will pile up, this will be inherited, and that wealth inequality will thus get worse over the generations. We're not convinced that such a bourgeois world would be a bad one but that thesis does depend upon the idea that inheritance concentrates wealth.

Which, apparently, it doesn't:

 Studies analysing the link between inheritance and wealth inequality have used different methods and data sources, ranging from simulated distributions to individual observations in surveys or data on wealth from tax records (e.g. Davies 1982, Wolff 2002, 2015, Boserup et al. 2016). Consensus has not yet been reached over the exact relationship. However, a recurrent result, which Wolff (2002) was the first to find, is that, perhaps surprisingly, inheritances tend to decrease wealth inequality.

Note that this isn't a new finding: it's just that Piketty assumed the opposite.

In a recent study (Elinder et al. 2016) we examine how inheritances affect wealth inequality using a new population-wide register database. The database contains detailed accounts on wealth and inheritances (including zeros) for all family and non-family heirs of every deceased person in Sweden during several years in the early 2000s. These rich data enable us to estimate the causal effect of inheritances on the distribution of wealth and, importantly, to also uncover the mechanisms underlying this effect. We are also able to study the distributional consequences of inheritance taxation and the effect of inheritances on wealth mobility.  

Our main results establish what previous studies have pointed to, namely that inheritances decrease the inequality of wealth.

The Gini coefficient decreases by 6%, a relatively large effect which is roughly in line with the wealth compression following the burst of the dotcom bubble in 2000 when stocks in internet companies, held mostly by the wealthy, lost their value.1

We also find that inheritances increase the absolute dispersion of wealth among heirs, measured as the difference in wealth between the heirs in the 25th and 75th percentiles of the distribution.

Isn't that fascinating? And more, the taxation of inheritances itself increases wealth inequality.

We observe the exact amount of inheritance taxes paid by each heir (some pay nothing), and when we examine how the tax payments affect the wealth distribution we find that the tax has a dis-equalising effect. That is, all else equal, the tax by itself tends to increase wealth inequality.

Of course, dependent upon what the money raised is spent upon the act of spending can reduce inequality again. But if inequality is the point and purpose of inheritance tax, which for many it is, there seems little point in increasing inequality by said taxing only to use the revenues to undo the effects just caused.

Our own longer term view has been that inheritance tax hasn't worked. The truly rich don't pay it, using trusts and lifetime gifts and so on. It's the less than plutocratic but still successful that do pay it. We've noted that old folk wisdom, clogs to clogs in three generations, and think that it has good predictive power. Even the inheritance of the grandest fortune cannot survive an inheritor truly determined to waste it and eventually, given the way genetics seems to work, one does always turn up to do such.

This might not draw nods of approval from those who would plan society but we've at least an urge to let people inherit as they may and leave the occasional existence of spendthrifts to deal with wealth concentration. There's very, very, few (in fact, other than those very few aristocratic families who held substantial urban land and kept it, we're not sure there are any) fortunes that have survived more than three generations.

The sands of time seem to deal well enough with this problem, why plan for it?

Jared Bernstein is wrong about supply side economics

Jared Bernstein, former chief economist to US Vice President Joe Biden, has an op-ed on the Washington Post website purporting to refute supply-side economics, the school of thought that believes that lower taxes (and better taxes) means higher economic output overall. He plots a few charts that show that the top marginal tax rates of the USA in a year is uncorrelated (or even positively correlated in some cases) with investment growth, employment growth, productivity growth, growth in GDP/capita, family income growth, and tax revenue growth.

He makes astonishingly strong claims on the back of this data, but he is deeply confused and mistaken about the evidence he'd need to make the case he wants to make. What's more, there is a lot of rigorous empirical evidence against his argument. This evidence suggests that lower taxes do lead to more output being created; although at the current rates, tax cuts are unlikely to create so much more output that they 'pay for themselves' like some previous cuts.

Before explaining why the bulk of the evidence goes against Bernstein, we should ask why an economic model of the economy predicts that lower taxes means higher output, employment, productivity and so on. Nearly all taxes distort incentives—that is reduce the incentive to do productive and socially beneficial things. Taxes on consumption and labour income make leisure cheaper compared to market goods, so people take more leisure than they otherwise would. They also make career paths with higher hours, more delayed consumption, less pleasant conditions, and less social prestige, less attractive compared to more pleasant but less well-paid careers. Taxes on transactions gum up efficient allocation, reducing the incentive for older people to downsize in the housing market, and reducing the incentive for traders to buy when they think prices are away from reality. Taxes on investment returns reduce saving and investment, and increase current consumption, so there are less tools, training, communication and less efficient organisation in the future.

Bernstein's argument assumes that people ignore these incentives—but economists believe there is strong evidence both anecdotally and in the empirical academic literature that people respond to incentives, even when it comes to very serious personal decisions. For example, when a US state bans affirmative action policies, multiracial Americans are 30% less likely to self-identify as their minority ethnicity. American divorcees who had been married for 10-years are eligible for spousal Social Security benefits—divorces rise 20% around the 10-year mark.

A swathe of papers show that financial incentives drive retirement decisions—when benefits are more generous, people retire earlier. Immigrants will typically not leave their country unless their expected lifetime earnings are at least $500,000 more in their new home. They often return to their native country if their earnings expecations fall—as did a third of Polish immigrants in the UK. And travellers in Sierra Leone even pick between different modes of transport between Freetown and the airport—ferry, helicopter, hovercraft, and water taxi—based on a trade-off between mortality risk and cost. It would be very surprising then if people weren't partly affected by financial incentives when interacting in the market sphere. In fact, there is a consensus among economists that taxes have very large costs in terms of distorted activity.

Aren't Bernstein's graphs evidence against this? No. When you test an economic theory, you need to try and control for "confounders"—factors that you haven't measured that could affect your results. If you find a strong correlation between breastfeeding and child IQ, but you haven't controlled for parental IQ, then you don't know whether the breastfeeding itself is driving higher child IQ, or if those children had high IQ mothers, and would likely have had high IQs whether or not they'd been breastfed.

In the same way, the top marginal income tax rate is not the only thing going on in a year—for one thing, there are lots of other taxes in the economy, all of which could be high when income taxes are low, and vice versa. We don't even know how many people are paying this top rate—this will change between years. Supply-side economists predict that lowering the overall tax burden will improve economic outcomes, not that the top rate of one particular tax is the key issue. But supply-side economists also think that there are other very important factors. For example, the entire world grew very quickly in the 1940s, 50s and 60s, as we rebuilt after the second world war, trade links expanded, and new technologies filtered through economies. The US also had high top tax rates then—but with lower rates, the US might have grown even faster.

So one more rigorous way academic economists test theories about the macroeconomic effects of tax is by looking at the economy before and after tax changes. For example, James Cloyne's paper "Discretionary Tax Changes and the Macroeconomy: New Narrative Evidence from the United Kingdom" in the top economics journal, the American Economic Review finds that "a 1 percent cut in taxes increases GDP by 0.6 percent on impact and 2.5 percent over three years". A 2012 literature review from the Tax Foundation found only three of 26 empirical studies where higher taxes did not mean lower growth.

It would be very surprising if Jared Bernstein was right that taxes do not affect growth and other economic variables, because our simplest, most intuitively appealing, most empirically verified models predict large effects when incentives are distorted. But Jared Bernstein is wrong: his own tests are extremely simplistic, and do not attempt to account for confounding factors. Once you do, the evidence is clear: higher taxes mean lower growth. Of course, there are still reasons why we might want to tax—but it's a tough trade-off: the more government programmes we fund, the poorer we are on average.