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.

Why Divorce Should Be Easier

The divorce rate is often held up as proof of social breakdown. Asides from the collapse of the nuclear family and bringing misery on former spouses and their children, it represents the triumph of selfish individualism over responsibility and self-sacrifice. Divorce is often painful, especially where children are involved. However, if people are definitively committed to divorce, staying married could be even worse. 

Still, the fact that forty percent of marriages now end in divorce can be taken as proof that the process is too easy. But is it? England and Wales do not have ‘no faults divorce’. Unless you separate for two years and agree to end the marriage (or five without agreement), some form of proven fault on one side is necessary, whether this is adultery, desertion, or unreasonable behaviour.

In some cases this is easy to establish and it is fair to blame one party. Proving unreasonable behaviour is not especially hard, given the wide and vague definition. As far as the actual divorce goes, it is not difficult, not withstanding the recently increased court fee, presumably intended as a disincentive.

The current rules become problematic when dividing financial assets and reaching agreement about childcare and access. Given the usual need for fault on the part of one party, any acrimony is exacerbated and the person taking the blame is at an automatic disadvantage. Where unreasonable behaviour is emotional or physical abuse, this is fair. 

However, as one party can simply concede their ‘unreasonable behaviour’ to speed up the process, it can create unnecessary unfairness and resentment. In other cases, where both parties have been at fault this can incentivise a race to pin blame first and most squarely.

A positive step would be to allow a marriage to be dissolved unilaterally without the need for justification, so long as there are no children under eighteen. Even in child cases, a less protracted and more harmonious process can only be positive, and it is unlikely that children benefit from having two parents living together who openly despise each other. The separation period could be reduced to one year with agreement and two without, given that by this stage the family has already broken down.

Where there are no underage children, there is no reason for obstacles to divorce. The idea that all committed, meaningful relationships have to last forever is rather odd. For many people, it works, and is wonderful. But, others may find a marriage attractive at one stage of their life, and, without fault, simply not feel this way later.

In general, a high churn rate is a healthy indicator. People change service providers and employer regularly. They are happy with one for a period, but due to their priorities or situation, or the other party’s terms, changing they are free to exit and choose something they prefer under new conditions. There is no reason marriages should not work more like this.

A neoliberal case for a basic income, or something like it

If I’d never encountered the idea of a basic income before reading Laurie Penny’s recent article on it, I’d come away hating it. For Penny, it’s about replacing capitalism with something better. For me, it’s about improving the capitalism we already have.

Penny thinks that the idea is ‘blasphemy to conventional, liberal, “free-market” economists’. It’s not: we here at the Adam Smith Institute have proposed something along these lines for a couple of years, and Milton Friedman proposed a similar Negative Income Tax way back in 1962.

I suspect her utopianism will be off-putting to most people. She asks, “What would society look like if that sort of freedom were available to everyone: if advances in technology and productivity could benefit not only the very rich, but all of us?”, but most people actually benefit quite a lot from advances in technology and productivity already. 66% of British adults own a smartphone (also known as “the sum of all human knowledge, in your pocket”); wages are up by over 62% in real terms since 1986; and that doesn’t even mention the enormous global reduction in poverty in the age of neoliberalism.

Penny says that “unconditional basic income is a proposal that requires us to rethink the economic and ethical framework of neoliberal capitalism that has governed our lives for generations”, and for a basic income to work, “all that it requires is that we trust one another.” Er, thanks, but no thanks.

I’m a capitalist, neoliberal advocate of a basic income, or something like it. I don’t think it’s perfect, I don’t think it will solve every problem. I just think it would be an improvement, for three main reasons:

  1. It addresses in-work poverty well.
  2. It reduces complexity in the welfare system.
  3. It facilitates other reforms that would raise overall living standards.

1. It addresses in-work poverty. Our existing welfare system is designed for a world where finding a job would be enough to give most people a tolerable standard of living. But in-work poverty is an increasing problem, particularly as good jobs for poorly educated workers become unviable, and the welfare system that we have at the moment isn’t well built for that.

This is where the robots come in. I’ve heard it said that automation of the economy is a lot like going to Australia – it’s great when you get there, but it can be a difficult journey. As robots replace them we probably will think of new things for people who used to work in law firms, factories, call centres and hospitals to do, but it might take some time.

Automation and globalization will both raise overall living standards, and in the case of globalization it will make very poor people in the developing world a lot better off, but we cannot guarantee that the jobs people get instead will be as good as their old ones. Working tax credits already begin to tackle this issue, but a basic income would reorient the whole system towards helping people who don’t have enough money, irrespective of why that is.

2. It reduces complexity in the welfare system. Our existing welfare system has built up a large amount of unnecessary complexity that could be streamlined. Like much public policy welfare is ‘path dependent’ – no two country’s welfare systems are the same, even if their welfare problems are. Much of the complexity in the welfare system has built up over time and exists only because of loss aversion: once we’ve started giving winter fuel payments to pensioners it’s quite difficult to stop.

Many but not all of these benefits are fundamentally about giving money to people who do not have enough of it. Housing benefit, the pension credit, jobseeker’s allowance, income support and tax credits all do this. But the case for a basic income does not need to stand or fall on whether we could replace all benefits with it. Some people inherently need more money to live decent lives, like the disabled, infirm and elderly. Reducing complexity is valuable but not the only, or indeed the main, appeal of the basic income.

3. It facilitates other reforms that would raise overall living standards. Many other policies that would increase total wealth are not very progressive, distributionally speaking. Tax systems are better when they do not tax things like investment and when they don’t exempt certain things from consumption taxes (like VAT), but doing these things ends up making lower earners pay more tax than we would like. One objection to immigration is that even though it makes natives richer overall, it has a small, temporary negative hit to the poorest natives. An easy way to correct that would be to redistribute the overall wealth gain to those poor natives so that they too are made better off in the short run as well as the long run.

Some pernicious government policies are ones that attempt ‘off balance-sheet’ redistribution. The minimum wage, for example, is hoped to be a redistribution from consumers and shareholders to low-paid workers – profits fall and prices rise to pay for their new, higher wages. The problems with it are that it has other unintended consequences, like causing unemployment for some workers, and that higher prices may hurt the poor as well. There’s no free lunch here – it would be more effective to tax people and then redistribute it directly to poorer workers. A basic income could replace policies like this.

I’ve used the words ‘basic income’ and ‘negative income tax’ interchangeably for a long time, because at their core they are both pretty much the same thing. The basic income is certainly better known than the negative income tax. But the problem with it is that for equal levels of basic income and negative income tax, a basic income would require large headline tax hikes.

We couldn’t just take all existing welfare spending and divide by the population – that would mean taking loads of money from people currently on welfare and giving it to people on higher incomes. We’d need to set the level quite high to avoid this outcome, and then ‘claw it back’ in the form of higher taxes.

Since people are getting the money back we wouldn’t actually be taxing anyone any more, but there would probably be large deadweight losses to reckon with, as there usually are with higher marginal taxes. Even if we could reckon with them, it would be a difficult proposition politically. (Perhaps it would work if we did a huge one, as Charles Murray has proposed, that replaced most of the state's activites altogether with cash payments - that means scrapping the NHS and education systems and giving people the money instead.)

So, even if it is a simpler concept to explain, the ‘basic income’ might be a hard sell. The very similar Negative Income Tax, which tapers away as the recipient’s earnings rise, could be a simpler solution that avoids utopian pitfalls like the ones Laurie Penny has stumbled over.

Shareholder votes are not the backbone of modern capitalism

Some of the lessons that we've learned from the post-1979 move towards neoliberalism and markets have been wrong. Competition is good on the margins where it just happens, not when you have to shoehorn it in at great cost. High pay improves efficiency; it doesn't indicate higher moral worth or stem from greater desert. And shareholder capitalism doesn't require close votes over every executive pay packet to work.

Consider shareholders' impotent rejection of BP boss Bob Dudley's £14m pay packet, which came as around a quarter was cut off the oil behemoth's market capitalisation. Now, it's perfectly possible that the board does not need to pay Dudley so much to retain his talents, or that they could do better without him at the helm, as the majority of shareholders appear to believe. It's also possible that the board is right, and relative to very difficult conditions, Dudley did well—with someone else they might have lost more money and had yet more shaved off their stock price.

But the real question is this: should BP's shareholders vote be binding; should we force all firms to adhere to a corporate form where owning a right to a share of the returns of the firm also means a right to controlling important firm policies directly, as well as merely electing representatives to the board?

I don't think that anyone should have a purely principled perspective here. In principle, we can write any sort of investment contracts, structuring obligations in any sort of way. In practice, we adhere to a limited variety of standards, because for the most part people want to take on only a discrete number of specific risk-reward bundles. But equities are simply a financial security, like bonds. No one suggests bondholders should regularly get a say in a firm's management; no one suggests that firms shouldn't be able to issue equity which gives holders a binding say on pay; no one suggests investors should be required to buy into firms which give them no say. The question is merely should firms be allowed to issue a security structured in a specific way: you own the firm's returns but don't get a vote on every issue directly.

I say yes because there is a growing wealth of evidence that this corporate form was one of the reasons Western capitalism has been so successful. One recent test of the hypothesis comes from "The Shareholder Value of Empowered Boards" by Martijn Cremers and Simone M. Sepe. Previous studies of board power had tended to look cross-sectionally: do firms with staggered boards do better than firms without? But this question ignores the confounding factor that these firms might already be fundamentally different. So Cremers & Sepe look at decisions within firms and their effects—does giving boards more power make firms more or less successful, within a huge dataset of firms, 1978-2011. They find that "[more powerful] boards are associated with a statistically and economically significant increase in firm value". Other recent papers back this result up.

Their hypothesis for why staggering board elections—and hence making it more difficult to overturn director majorities—makes firms do better chimes closely with the examples of market misunderstandings above. Shareholder democracy, insofar as it is indeed useful, is useful because it monitors and polices director activity, in order to resolve the principal-agent problem—the divergence in interest between an employee and employer.

However, if shareholders can immediately boot out directors when their short-term performance underwhelms, directors have an incentive to focus on short-term investment projects and plans. Lower risk of removal ameliorates this problem and allows directors to commit—a market mechanism solving an apparent market failure. Other odd or surprising features of corporate capitalism often have similar explanations.

The real way that shareholders police boards is by taking their money out of the firm: this directly punishes directors, who usually hold large shares in the firms whose boards they sit on; and it redistributes capital away from badly-run firms and toward well-run firms. It's quick, efficient, clean, and doesn't even require any shares to actually change hands—share price moves do the job just as well. Voting works best with your feet. The lesson we should have learned from Thatcherism, neoliberalism and the drift towards markets is that markets just work when you let them exist, not that you need to try and make them exist everywhere.

The howling immorality of zero hours contracts

We've all recently been subjected to yet another of those campaigns. Zero hours contracts, where someone is trained and ready to work but no hours of work are guaranteed, were just the immoral exploitation of labour by the plutocratic capitalists and their lackey running dogs. Apparently: although one of the journalists who made this claim was really very put out when we pointed out that she, as a freelance journalist for a number of publications, was on a number of zero hours contracts herself. And indeed are several of us when we write for various places, chat on the radio and all that. 

So, McDonald's probably the country's largest user of such contracts has been offering more secure ones:

Paul Pomroy, the boss of McDonald’s UK, said the company was revamping its employment policy after staff told him they were struggling to get loans, mortgages and mobile phone contracts because they are not guaranteed employment each week.

As a result, the company has started offering staff the option of moving to contracts guaranteeing a minimum of four hours a week, 16 hours or 30 hours.

Pomroy said a trial in St Helens, Merseyside, had been very successful and McDonald’s is now looking to roll it out across the country.

About 80% of workers in the trial elected to stay on zero hours...

We certainly wouldn't decry people being offered more choice. But it does rather look like the screaming chatterati were wrong on this one too, doesn't it? Far from zero hours contracts being something which the workers hate as exploitation they exist because the vast majority of the workers are entirely happy with them, prefer them, actively choose them. How rare it is for that howling about a fashionable issue to be wrong, eh? 

As we've said before, if zero hours contracts are just fine for us, if we actively choose them in our own working lives, then why aren't they just fine if other people wish to make the same choice? After all, it's not as if every newly minted and left wing (but we largely repeat ourselves) graduate wouldn't cut their left leg off for a chance to freelance for one of the national papers, is it? And if that is fine then why one earth should the hoi polloi be excluded from a choice that we're allowed to make?

George Monbiot says we're to blame for everything. Perhaps he's even right

George Monbiot's latest tome gets an airing in The Guardian. And we're specifically fingered as being some of the evil ones who imposed neoliberalism upon the world. From Mises and Hayek, through the Mont Pelerin Society, leads us directly to the Adam Smith Institute and the condition of the world today.

We think that's rather overdoing our contribution to be frank but we are willing to accept responsibility all the same. As a point or argumentation that is: assume that the charge is correct, we really have been plotting all these decades to make the world as it is today.

OK, so what is it that our pushing of neoliberalism has done? You could look at that chart above from Max Roser. This last generation of globally applied neoliberalism, all that free trade, globalisation, that application of the Washington Consensus (that list of stupid things that governments should not do), what has been the effect? The greatest decline in absolute poverty in the history of our entire species. That decline has been so great that global inequality has been falling.

Or if you prefer it in words, from 2013:

The number of people living on less than $1.25 per day has decreased dramatically in the past three decades, from half the citizens in the developing world in 1981 to 21 percent in 2010, despite a 59 percent increase in the developing world population. However, a new analysis of extreme poverty released today by the World Bank shows that there are still 1.2 billion people living in extreme poverty, and despite recent impressive progress, Sub-Saharan Africa still accounts for more than one-third of the world’s extreme poor.

Or 2015

The number of people living in extreme poverty around the world is likely to fall to under 10 percent of the global population in 2015, according to World Bank projections released today, giving fresh evidence that a quarter-century-long sustained reduction in poverty is moving the world closer to the historic goal of ending poverty by 2030.

The distribution of the economic growth that has been happening. Yes, certainly, the global 1% have been doing well (that global 1% is just about everyone a bit over median income in the rich countries. Over about £30,000 a year in the UK and you're the 1%) but look at Branko Milanovic's chart to see what has been really happening elsewhere:

The top 1% of the global income distribution has seen its real income (adjusted for inflation) rise by more than 60% over those two decades.

What is far less known is that an even greater increase in incomes was realized by those parts of the global income distribution that now lie around the median. They achieved an 80% real increase in incomes.

It is there — between the 50th and 60th percentile of global income distribution, which in 2008 included people with annual after-tax per capita incomes between 1,200 and 1,800 international dollars — that we find some 200 million Chinese and 90 million Indians, as well as about 30 million each in Indonesia, Brazil, Egypt and Mexico. These 400 million people are among the biggest gainers in the global income distribution.

The real surprise is that those in the bottom third of the global income distribution have also made significant gains, with real incomes rising between more than 40% and almost 70%. (The only exception is the poorest 5% of the population, whose real incomes have remained about the same.)

Monbiot namechecks Milton Friedman, of course. And there's an interesting comment that has been made about Friedman. Which is that he wasn't right wing at all (his railing against the monopoly of the AMA should be enough for people to see that) but was a very left wing extreme utilitarian. The goal is to make the poor richer. What is to be done is what works in making that happen. We rather share that goal and outlook.

So, back to Monbiot's accusation. We're, in part at least, responsible for the state of the modern world, for the way things have gone these recent decades. What has happened is that the greatest curse upon humanity, that absolute , peasant, poverty has been alleviated as never before and looks as if it's well on the way to extinction.

We're really very happy indeed to be blamed for that. We'll celebrate, in fact we do celebrate, that it has happened and might even suffer from that warm smug glow of knowing that a plan has worked. 

At which point a question or four for George himself. What's wrong with wanting the global poor to be richer? What's wrong with advocating policies that promote that goal? And what on Earth is wrong with the application of policies which have, largely, achieved that goal?

Just what is it we are supposed to be ashamed of?