Scrogues Converse: Lex asks an “innocent” question of Scrogue economists

At S&R, often there are days of debate and discussion on particular topics before we publish a post.  When these discussions are rich enough, we post them in the hope that you will weigh in on the conversation.

Here’s one such discussion, started when one of our colleagues decided to ask the “innocent” question: Should the government use tax breaks to encourage things like innovation or is there a better way? 

Lex: The new news on our fiscal cliff emergency aversion maneuver is that a fair number of “corporate subsidies” survived. These are basically subsidies, some of which are going to nascent industries in alternative energies. I’m not against the government helping industry per se; I maintain that it works. We can thank the Japanese government for subsidizing hybrid vehicle technology heavily for opening up a new form of competition in the car market, for example. What I question is whether arcane loophole additions to the tax code is an economically efficient way for the government to promote technology or adoption/adaptation. I fully understand the politics of it all, and it’s rotten even when it serves good purpose. I also understand that this method is ripe for political bullshit that’s overall detrimental to the economy and the political process.

Is there a better way? Are there benefits that I’m overlooking in doing it this way? Why, exactly, should my payroll taxes to up when Starkist gets a tax break for doing business in American Samoa?

Gavin: Oh, there are millions of ways to incentivize or subsidize business investment and all of them are terrible (i.e. have unintended consequences). One problem is that any special vehicle requires time, effort and know-how to take advantage of it. This automatically favors large companies (with these resources) over small ones. I.e. it protects old, entrenched hierarchies against young upstarts.

All businesses already get a massive subsidy and it’s so ubiquitous that people have forgotten it even exists: companies can set their expenses against their revenue to reduce their overall tax burden. Individuals can’t do this, despite the fact that getting to work is bloody expensive.

This expense deduction subsidy explains why, in a bumper year, everyone gets a new computer or the building gets a new coat of paint or whatever, so that the company can move heaven and earth to reduce their tax exposure.

Compare the way governments tax to the way private companies “tax.” I always use franchises as my example; they’re brand owners who tax their franchisees to pay for the cost of maintaining that brand. They do not tax on profits because they’d never get any money. Franchise owners are business people too. They know how the expense trick works. If they charged franchisees based on profits, then profits would sum zero. Franchises tax on revenue and only revenue, whether you’re profitable or not. Franchises call this the franchise fee. In tax policy terms it’s a flat tax.

They’re easy to administer, simple to collect and bigger businesses pay more. And there are countries that have done this. Though, I’m not sure how this would ever be accepted in the US.

Lex: Ok, I get the reasoning. But is there a place for government spending? Are things like battery tech for cars or alternative energy development better done by direct government grants to say universities for R&D? (Of course, that raises the issue of who should profit from the patents and discoveries that result.)

I question whether market mechanisms will create forward thinking and best allocate the resources to development. Not that it can’t happen, only that at this point in the development of American capitalism, it’s not likely to happen in the time frame that’s needed.

Gavin: Government spending tends to pick “winners” which is how the UK government ends up subsidizing solar panel installations in a country without sun.

There is certainly a role for government. It is in the enforcement of the pricing of externalities. There needs to be a price for carbon and it needs to be tradable. Businesses and consumers are NOT going to agree to this. They will not vote to pay for something they’ve never paid for before.

This is what this is all about. It is impossible to solve the problem of too much carbon if no-one is willing to pay for it let alone even agree a price for it. Governments have imposed prices on externalities before: water pollution, CFCs, mandatory car insurance for third party injuries. This is another of those externalities and it simply takes politicians willing to accept short-term unpopularity in order to pass a law.

Government is at its best when it prices ubiquitous externalities in such a way that they do not decide what the solution should be. They didn’t pick a replacement for CFCs, merely that there must be one that does not interfere with the ozone layer. They didn’t decide that cars need airbags or crumple zones to reduce passenger and third-party injury. High insurance prices did that.

The latest idea I’ve heard about “gun control” in the US is to force gun-owners to buy third-party insurance much as car owners are forced to. That way, if the buyer is a potential psychopath, insurance companies have an incentive to detect them in advance.

That’s what politics is meant to be about. Not doling out gifts to favored lobby groups, but ensuring that all are equal before the law, that no-one is subjected to force or fraud, and that externalities are priced appropriately.

Otherwise: I think you’re missing something. This goes back to our tariffs discussion of a few days ago. Yes, you guys who read the Economist hate tariffs because they distort, but the reason the WTO likes tariffs is at least they are visible. Pols are going to distort trade and protect their local industries/campaign donors. They will. Our grain industry is massively subsidized with loans, price guarantees, research grants, transportation infrastructure subsidies, etc, but we claim the high ground. So does Canada, although they run an entire rail system just to provide below market access to their grain ports. They question is what is the least pernicious way to do so, and time has proven that tariffs are best because they are visible.

Pols are going to meddle in the economy to try to encourage different industries. They will. I know dozens of bureaucrats, and none of them, deep in their hearts, trust the free market. (Nor, by the way, do corporate executives, of whom I know hundreds.) We are theoretically a free market, but if you look at the twin missions of the Fed (manage inflation and unemployment,) and couple it with a bizarre tax code that is full of exemptions (hidden subsidies) that make unprofitable industries like pharma absurdly profitable, we have a de facto MITI (Japan.) But while Japan’s is upfront and admitted, we pretend it doesn’t exist and that the government isn’t playing a role.

I’d make the same argument with “pick ’em” subsidies. Yes, industry encouragement subsidies are bad, but are they worse than what we have now? I doubt it.

By the way, the best argument for “pick ‘em’s” was put forward by Alexander Hamilton in The Federalist Papers. His excuse was national security, the new language is around economic development. Only the wallpaper is new, the basic floorplan is still the same.

Gavin: The WTO exists to get rid of tariffs.

Otherwise: Not exactly. Under the “transparency” mandate GATT/ITO and now the WTO calls for tariffs as an alternative to other, less transparent trade barriers. Yes, they want to get rid of tariffs, but they view them as a lesser evil.

Lex: Gavin, I see the point. The US defense industry does huge amounts of research with government money and ends up with overly expensive, flawed fighter jets that nobody wants to buy and likely have no real use.

Nonetheless, I’m with Otherwise in that corrupt, fallible people are highly unlikely to build an uncorrupt, rational system. Given that, there needs to be a mechanism of control. After all, there wasn’t a mandate against CFCs until there was already a giant hole in the ozone. And if the people most plugged into the issue of carbon are right, we’re already too late. Maybe markets can react with long term foresight, but I have yet to see an example of it. Government picking winners can be (often is?) dangerous, but if markets can’t pick them until it’s too late to matter and government can’t be a part of building the competition, then don’t we all lose in the long run?

Brian Angliss: One thing that’s been bugging me about this since I read Gavin’s first response this morning is his use of “unintended consequences” and what I’m interpreting as an unstated claim that only government incentives have them. Now, perhaps I’m wrong about that unstated claim, but if I work forward from that point, here’s the problem I see: everything, and I mean literally everything, has unintended consequences.

Yes, subsidies and incentives of various types will distort the marketplace in unanticipated ways. But even simple tax codes will have unintended consequences – flat taxes affect the poor more harshly than the wealthy, progressive taxes make the company more beholden to the wealthy who pay the taxes, consumption taxes affect the poor more harshly because they have to spend every penny they earn, and so on.

Even the free market itself has the unintended consequence of being utterly without sympathy for human suffering, and so stripping out subsidies and leveling the playing field is likely to have the unintended consequence of less employment stability, fewer pensions, and sicker employees as health care is likely cut.

Put another way, businesses that are not required to behave ethically / morally generally won’t, and historically haven’t. There’s a reason why unions came to exist, why government had to stop child labor and why OSHA exists, after all. Taken to its extreme (which you may not be intending to do).

Government is useful for more than pricing externalities, unless you’re implicitly defining something like the physical health of an employee as an externality. If so, then that’s a much broader definition than I’m familiar with.

In general I agree with you, Gavin, that government should ensure that everyone is equal before the law, limit force/fraud, and price externalities appropriately. But it’s an article of ideology that that’s the only things that governments should do. The problem is that governments can’t do those things without ALSO doing other, related stuff.

Going back to subsidies of varying types, I disagree that they’re inherently bad. Markets cannot regulate themselves the vast majority of the time. That’s demonstrated every time a new externality is discovered or a bubble pops and takes a national or the global economy with it. Fundamentally, what we know as the “business cycle” is a result of the market simply not being able to adapt to the real world and the hopes and fears of people, and as such it’s a form of market failure. Subsidies are one tool that governments can use to manage the market and smooth out some of the ripples. Yes, they distort the market in sometimes unpredictable ways, but unpredictable isn’t always bad.

I’d love it if the government would stop subsidizing all sorts of things, either directly or indirectly through the tax code. But barring that, I’d rather have equal and/or visible to unequal and/or hidden subsidies. There are all kinds of hidden subsidies that benefit fossil fuel industries, for example, from low federal lease rates to low royalties to direct payments to frack. These subsidies are massive compared to what renewables are getting in the US. And even if you take away all the obvious subsidies, if the government can’t ALSO price the carbon emitted, then the cost of the externality itself becomes a form of subsidy. Government subsidizing of renewable energy would, in that hypothetical case, simply become the method by which the playing field is leveled. Again – if we can’t get rid of ALL subsidies (including unpriced externalities), then I’d rather have equal subsidies for everyone.

Furthermore, there is something to be said for government taking on projects that corporations simply don’t want to or can’t do, things like major infrastructure projects that benefit entire regions. It’s not possible for me to imagine any way that any entity smaller than the US federal government could have taken on the Interstate highway system, and while estimates differ, it has returned at least six times (1996 estimate) and likely more than 15 times more money than it cost to build it out over the last ~50 years (I found a source claiming 35% ROI annually, and assuming it’s not compounding, that’s about 17.5x ROI).

Yes, there were unintended consequences as a result of the interstate highway system. A few I can think of right away include US oil dependence, the US trade imbalance, and significant carbon emissions, but the economic growth created a country that is wealthy enough to address all three (if the US politicians can pull their heads out first, of course).

Otherwise: Not sure about your interpretation of market efficiency. I think bubbles are not proof that markets can’t regulate themselves, but rather evidence they can. Efficient market theory doesn’t say that markets are always right in the short run, but rather that they correct quickly and are more likely to be right in the long run.

Gavin: This started off as a question about government’s role in supporting innovation through tax. I’m going to stick to that. How government should ameliorate the psychological consequences of poverty is a bit beyond my remit and skill.

Firstly, tax is about raising revenue for government expenditure. The perfect tax does not change the behavior of the person / entity paying the tax. A tariff is an inducement or punishment; it is expressly designed to stop or change a behavior. It’s a bloody awful revenue tool since it is designed to make something stop (e.g. tax on cigarettes or alcohol … the “sin”taxes). That doesn’t mean that they don’t raise revenue, just that it’s a terribly unreliable one (technologies can rapidly change and obviate an entire class of product).

Secondly, creative destruction. Schumpeter’s idea is that markets and free competition are good for everyone because new ideas have a chance to actively displace old ones. This is good, because just when everyone thought Microsoft was everything, Apple came along with the iPhone and changed everything. Incumbency is only temporary. As compared to places like the old Soviet Union where there was one manufacturer and it was the state. It doesn’t matter who the monopoly is – public or private – it results in stagnation. Entities don’t invent new things because they want to (it’s very expensive), they do so because they’re looking for a competitive advantage over everyone else. That cannot happen when only one company is protected and is the reason we have anti-competition legislation.

Thirdly, unintended consequences. Of course this happens with every decision (think of the average person eating a lifetime of donuts; no one donut causes the heart attack). However, only government has a mandate, derived from the people, to both study and act on these consequences. This is why we have the regulation of pharmaceuticals, including very clear guidance on clinical trials. Where a danger is somewhat predictable, then the state has the duty to enforce a process for reducing the risk (crash testing in cars, standards testing in products, blood tests for donors, etc). The government doesn’t have to do this directly, but they can affect the right of enforcement for others through law.

Fourthly, mandate. Do you really want a world in which corporations set the law? You rightly protest when private companies lobby for rules that would favor their interests. You should similarly protest when companies propose rules you like. By what mandate does a private entity derive the right to set rules for everyone? Only a duly elected polity, deriving its mandate through universal suffrage, can justly claim to represent the interests of society.

I could go on, and there are great examples of private vs public (from NASA in the US, to La Gamarra in Peru, to private mobile phones in East Africa.)

You have to recognize, though, that tariffs favor certain companies. They do not favor taxpayers or their elected representatives.

Otherwise: Sorry, I was using tariffs as an example of an imperfect solution that is better than the alternatives, and drawing a parallel between tariffs and subsidies, the idea being that both are “pick ‘em” strategies.

BA: One of these days I’ll remember that, when you (Gavin) say what sound like stereotypical American-style libertarian talking points you actually mean something quite different and much more inclusive than American-style libertarians do.

Ultimately I have a problem with almost any claim that applies universally, such as the claim you made originally that all tariffs are “terrible” and what I interpreted as a similar statement about subsidies always being bad, too. In my experience with my own job, there are appropriate and inappropriate times to use a particular engineering tool, but no tool is always right or always wrong. What I know about economics indicates that the same applies to economic tools like tariffs, sin taxes, subsidies, and the like.

While I agree that a perfect tax wouldn’t change behavior, the only tax that would be like that is no taxes of any kind – simply by levying taxes, governments reduce the amount of income/capital that entities can use for some other purpose (including no purpose at all, aka savings, if they choose). Since taxes always change behavior to some greater or lesser extent, I think sin taxes are acceptable ways to intentionally distort the marketplace, especially when those taxes are used to mitigate the impact of the “sin” on the rest of society. A cigarette sin tax, for example, should be focused largely on mitigating the effects that treating smoking-based cancers have on the health care system. Yes, that transfers money around the economy and creates winners (those entities to whom the sin tax revenues go) and losers (the entities from whom the sin taxes are collected), but intelligent and wise design can mitigate the unintended consequences. The problem is that the US government in particular, and democracies in general, are proving to have issues with doing anything intelligently and wisely.

Similarly, while there is no question that tariffs distort the marketplace, there’s also no question that they provide protection for the development of various types of national resources. Tariffs provide a way for governments to protect their country from potential predation by larger, more economically powerful trading partners. Applied at a local level instead of to the national/international sphere, tariffs are no different than a private company like Microsoft requiring the use of Office internally. It’s a form of corporate protectionism.

And large corporations subsidize their own products all the time. Using Microsoft as an example again, they offer their own products to employees at a massive discount knowing full well that many of those products will not be used by the employee directly, but rather by his family, friends, and even friends of friends. This subsidy enables each Microsoft employee to function as a form of corporate cultural ambassador, it helps create a built-in market, build brand, and so on. Product subsidies created by governments can do the same internationally.

Even monopolies aren’t always bad. The United States has a unified standard for telephony not because the government stepped in and required one, but because all the telephone lines were originally created and owned by a single company. Even now industries who have a vested interest in voluntarily creating standards have a hard time agreeing on what the standard will be – monopolies don’t have that problem. In the developed world, where government is sophisticated enough to require standardization, monopolies are nearly always bad. But in countries where the government is less sophisticated, a monopoly isn’t necessarily a bad thing – so long as the government realizes that it needs to keep a firm leash on the monopoly and is strong enough to do so.

Lex: Actually, it started off as a question about government helping industry through tax breaks. I used Japan’s heavy subsidizing of early hybrid vehicle technology as an example of government intrusion into the market working, because no one would have paid the real price for an Insight or first gen Prius. I could expand that argument to the Japanese auto sector as a whole, which was heavily nurtured by the government (still is actually) until it could compete with established manufacturers. The unintended consequences of the Japanese market distortion was greater, worldwide competition. The US wasn’t concerned with producing smaller, efficient vehicles with good reliability. Its companies laughed off the American manufacturing innovations that the Japanese adopted and applied to eating Detroit’s lunch.

My question was if there is a better way than the weird politics of subsidies and tax breaks the US uses to keep its traditional Mercantalist advantages while espousing free trade. My first inclination is to suspect that using tax revenue for general research and development makes the most sense. We gained a lot of technology used on Earth from going into space, for example.

While I agree that the government “picking winners” in new tech is likely fraught with trouble, there’s nothing to suggest that the market will develop new tech in say alternative energy because it and its participants have any concern for people or long term environmental consequences. The English industrial revolution was, for example, coal based because they had already used up all the timber, whereas it was wood based in the US. (Most early American train boilers were fed cord wood and cars were all wood until they became too big for wood to provide the necessary structural stability.) it was obvious that the great forests were being used up quickly, and often wasted in forest fires … It took a long time for the US to mandate spark arresters on trains that were spewing hot cinders into the surrounding countryside.

So, sure, actually pricing externalities would solve a lot of problems more efficiently than subsidies, tax breaks, and/or tariffs. Such a regime would likely generate the R&D into new tech. But that’s not happening, and it appears that the market would howl about it because it would put a huge pinch on short term profits.

And since the government already heavily funds/subsidizes R&D in fields like pharmaceuticals, look at the corp budget comparison between R&D and advertising and how much the government contributes to research and trials, I have to think we’re doing it wrong.

Let’s imagine taking half of the defense budget, conservatively figured at $600M/year and dumping it into university research…broadly so as not to pick winners. Give the government the patents and a low cost, wide open licensing regime. The market is good at setting prices and terrible at innovating without significant reason to; the government can help on the innovation end and theoretically have the foresight to help direct that innovation. Trying to remove government from the equation won’t work, because the forces Gavin says need to be controlled through fair governance will, by the dictates of rational self-interest always work to capture government.

BA: There’s a lot of what you’re describing going on now, although not anywhere near the level you’re suggesting. The National Science Foundation funds massive amounts of research, much of it on basic science that doesn’t have an obvious application to goods or services. But someone always eventually comes up with an idea on how to use some new theory, and then it’s off to the races. Major research universities get a lot of money from licensing inventions that were invented at the university and then licensed back to the company that the inventing professor founds and develops into a real product / service using private venture capital.

I personally think a lot of this problem comes back to defining corporations as juristic persons, with many of the same rights (but few of the responsibilities) as people. Changing that would solve a huge number of problems. But that discussion is a different tangent. Related to economics, yes, but perhaps too far afield.

Otherwise: I think it’s time to turn it over to the Commenters. If there’s a one line conclusion from the discussion above, it’s that we all (reluctantly, apparently) agree that there is a role for government in markets, but none of us exactly agree on where to draw the line. So over to you: Should the government use tax breaks to encourage things like innovation or is there a better way?

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