Nessun Dorma Part 2

A few days ago there was a review by Steven Pearlstein of several books, one of which, “We Are Better Than This” by Edward D. Kleinbard,  I have already ordered from Amazon because of this quote in the Pearlstein review:

“Both our native talents and our good fortune are distributed through processes that we cannot fathom and do not ‘earn.’ Our loud proclamations that what we take from the market is our just deserts is just noise made against the darkness, trying to still the voice inside that asks, why me and not them?”

Yes!!  Exactly.

In my last post I wrote about the limits of information, the fact that because information is widely distributed and always changing, and because human beings are constantly striving and pushing and working toward their own ends, unexpected and unpredictable change is not the rare departure, the “exogenous shock”, that is envisioned by modern model-bound economists, but instead is the steady, constant economic norm.  Because of this shoving and pushing we can’t really make long run economic forecasts, and that the agents in our models cannot predict the future any better than we can.  They can’t know their own futures with any security: all of what I called the “the restless magma of human dedication” is bubbling under them, and it can bury them or it can push them to great heights.  They can’t really know which it will be.  They have to live their lives to find out.

 And that should form at least part of the ground on which our economic models stand; the agents in our models should not be rational agents who trade present against a simplistic future in which all possible outcomes are known to them well enough to attach probabilities to each, because in the real world all possible out comes are not known at all, to anyone, and in small or large ways the future will always be something we haven’t even imagined until it gets here.   I don’t know how to create models like that, but if we want our economic models to depict the way the real world works it has to be done.

And that brings us to a dangling thread that needs to be tied up from my last post.  It ended with the sense that economic models can’t be used to forecast very far into the future.  So we might ask: what good are they?  What are they for?  And this relates to a question that I have to answer from time to time, when I admit in some social setting that I do sometimes read the economic blogs.  People ask: what are they forecasting, what are they saying will happen?  Because, of course, that’s what everyone really wants to know, probably because it’s what no one actually can know.  And I have to tell them: they aren’t.  The economics blogs, and economists in general, usually don’t make forecasts.  Oh, just before the release of some new economic statistic, they’ll play the forecast game about what the new release will say---but that’s actually “forecasting” what has already happened, which is what those statistics report.

So if economists don’t forecast the long run, except for those few courageous people who make their living doing nothing else, what on earth do they do?  Why study economics at all?

The answer, I think, is that that we create economic models for at least three purposes.  First, We should recognize that our simple models are parables only, and like any parables they present basic ideas to help us understand the world we find ourselves living in, as humanity has tried to do for thousands of years.  They help us know how people are able to work together, in a sense as cooperative strangers, in a country or in a culture, or on a planet, to provide (or fail to provide) a good standard of living for everyone.  Perfect competition doesn’t exist in the real world, but understanding how it would work tells us some very powerful things about some of the forces that act on us and around us.  Second, models help us figure out the less obvious implications of assumptions we make, or simple things we believe to be true: by embedding those assertions in mathematics, and in models, we can derive implications that we would never find by just contemplating the assertions on their own.  And third, while we may not know what the long run future will be we know what the present is and what the recent past has been.   We can, if we are successful in understanding something about how the world works, still make strong arguments about what will make the near future in some way better, and even what will make the more distant future better or keep it from getting worse, no matter what its exact features will be.  We can do this in the same way that we can say that providing oil will make your car last longer and run better, but adding too much oil can damage seals.  I can’t really forecast what will happen to your car in the future.  You might run over a nail, or get a dent in a parking lot, or there might be some deeper mechanical problem waiting to emerge next week or next month or next year. But I can make conditional predictions about the impact that certain actions might have: put oil in, or the situation will get worse; don’t put in too much or the situation will get worse in a different way.  Similarly in economics we can make conditional forecasts: policy X will have impact Y.  In my view, stimulus will stimulate, which may be good or bad depending on the situation (stimulus during a boom is bad; stimulus in a recession is good).  Austerity will depress, which may be good or bad depending on your situation.  Investing in infrastructure will make the future economy more affluent, in part by making future businesses more productive and perhaps even more profitable.    In making these predictions about the impact of various policy actions, simple economic models help if they depict something true about the world. And if they depict something false, they may mislead us into policy actions that are dangerous, or outright harmful.  That’s why there are so many arguments about the foundations of economic theory: it matters, and our future welfare depends on finding simple models that are true, and avoiding simple models that are false.

And similarly, in each “agent’s” life, he or she has to accept the fact that his or her future can’t be known exactly, and that the farther away the future period is they’re looking at the less can possibly be known about it.  But we do all care about the future, and so the agent in our models still has to make choices about actions in the present that may impact the unknown and unknowable future.  So the agents have to decide what they believe about the future, and they have to decide what present actions will give them the best chance to prosper, or at least survive.  We may not know what the future will be, but we know we’ll have more flexibility to deal with it if our debts are all paid and current, and if we’ve saved something.  We will be better able to deal with whatever comes along if we are more educated, or we have good friends and a strong family to help us through, than if we aren’t or don’t. 

But no one makes present decisions based on any real knowledge of what their taxes will be in some imagined distant future.  They have no idea what their taxes will be, partly because they have no idea what their income will be in that future, and they have no idea what the whole country’s income will be either: their share of future taxes will depend on both.  People save to give themselves a better future, period.  It makes no sense to build a simple economic model, as, for example, the modern version of Ricardian Equivalence does, that assumes that people save today in order to pay taxes in the future, taxes that they can’t know will ever be imposed, and can’t know, even if the taxes are imposed, what portion of those taxes will fall on them.   That is a simple model that seems to me to be false, and so I think that depending on it will lead us to national actions that might cause actual damage to the future we are trying to achieve.

I once read an interview with a multimillionaire who (of course) was asked how others could achieve wealth.  His very honest response was: “I don’t know”.  But later he did amend that.  He said something like this: “Save your money.  Everyone gets a couple of opportunities in their life.  If you have money saved you have one more tool you can use to pursue an opportunity when it comes.  Who knows?   It might succeed, and make you richer than you are.”

Doesn’t that sound more like the life we all lead than the models that assume we all can calculate our expected futures with mathematical precision?

Nessun Dorma

This post will be long, partly wonkish, and partly just odd.  I have to work up a little courage to write this, because in a way it’s a minor assault on the dominant economic paradigms of recent decades.

I’ve been trying to figure out how to comment on a quick exchange that took place a few weeks ago that included blog posts by Mark Thoma, Simon Wren-Lewis, Paul Krugman, Robert Waldmann and David Glasner, among others. It’s over an issue that has come up before, and which I think will come up again and again over the next few years, because I think we’re at a shifting point in economic theory, partly due to the complete failure of macroeconomists to foresee the severity of our recent mini-depression, and partly due to the disastrously wrong predictions that flowed in rivers from the neoclassical economists about the possible impacts of macroeconomic policies.  Investors will flee from U.S. debt soon, soon, soon!! Hyperinflation is just around the corner!!  Interest rates through the roof!! Austerity will solve all of our problems!!  Really?  Well---no. Not really.  The real world did not behave anything like that. 

The question in this blog exchange is: what the heck happened forty years ago when the old Keynesian economics many of us older folks were taught in school more or less vanished from the journals and conferences and textbooks, and was replaced by rational expectations and neoclassical micro-founded macro models?  In this now forty-year-old counterrevolution to Keynes, macroeconomics starts with agents at the micro level who rationally, with infinite mathematical precision, select a present action that maximizes their overall welfare by trading off their welfare in the present time with their expected welfare in future times.  This trade of present against future is an absolute in these models: it has to be there, or the model is suspect.  All of the bloggers above see this wholesale expulsion of meso-Keynesian theory from the academic respectability as a bad thing, although some seem to approve at least part of the neoclassical vision.  Simon Wren-Lewis, for example, starts by saying that “intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy.”  Waldmann disagrees, and to some extent I do too, for reasons I’ll talk about below.  But it was Glasner, whose blog posts are almost as long as mine, who wrote openly and eloquently what I have been feeling for forty years, but was too intimidated to say out loud:

“the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption…

Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment.”

Wow.  And yes, exactly.

There is one point I want to add to the excellent blog exchange from a few weeks ago, but I’ll start obliquely, because it was this personal experience a few days ago that reminded me of it:

From time to time, when I find myself idly staring at the walls in the evening, too groggy to write a blog post or even read one but still too awake to retire altogether, I wander to YouTube to see what I can find.  Usually I’m looking for some kind of classical guitar music, or old acoustic blues, but the column of related videos down the right hand side of the YouTube web site is a grand choose-your-own-adventure book.  Once I lose control and click on one of those links, because it seems to point to something adventurous, I end up spending an hour or two following link after link.  (Be patient.  I know the wait is making you fidgety, but I’ll get to the economics of all this in a minute.)

I try to avoid anything that has the phrase “got talent” in the title; I’m not a big fan of watching people embarrass themselves in public, and that’s what those shows display much of the time.  But every now and then I slip, and end up watching the YouTube versions of a “got talent” performance.  And so, late in the evening, in a quiet and pleasant mood after a glass or two of Sauvignon Bordeaux at dinner, I ran across a video from 2007 of the very first session of the very first winner of Britain’s Got Talent.  His name is Paul Potts.  Since I don’t follow these shows I had never heard of him; maybe you have. 

The performance was astounding.  But I don’t really want to talk about Mr. Potts.  I want to talk about the reactions of the judge named Amanda.  Because the point of all of this is to comment on her description of Mr. Potts once he had finished performing.

So here’s the link.  Take a look, and watch Amanda.

What did you think of her, and how she acted and what she said?  She was clearly enormously moved by him; it was all she could do to keep her eyes dry toward the end.  She had to breathe heavily during the last phrases of the aria that he chose to sing, Nessun Dorma (“no one sleeps”) from Turandot, and finally she had to press her cheeks with her palms to keep the tears from launching from her eyes, flooding the desktop and ruining her TV makeup. I don’t blame her.  Sitting ten feet from a voice like that must feel like standing at the far end of a jetty when the typhoon hits.

And when she said what she said---that he was “a little lump of coal that is going to turn into a diamond”---I could hardly do anything but completely agree.  (I don’t know if you’re an opera fan, but if not, trust me: that was an awe-inspiring performance for a Welsh mobile phone salesman, as you could see toward the end when the entire panel of judges was staring open mouthed at the stage.) 

Later in the video she talks about finding frogs that are going to turn into princes. 

It was not for half an hour, and another few links down the evening’s chain of music---and I admit, a few returns to watch Mr. Potts perform again---that I finally thought: wait a minute.  Turn into a diamond?  He already was a diamond, wasn’t he?   She was visibly moved by the voice he already had, the performance he could already give.  What was she thinking was going to change?  Was she forecasting that his performance that night would bring him fame and fortune, and that those things, fame and fortune, would make him a diamond or a prince?  No.  I don’t really believe that.  I don’t think she had really thought through what she meant.  If presented with this argument, I think she would agree that he might have been a frog at some point, but he had already turned himself into a prince long ago.

Because that voice didn’t just emerge from his mouth that evening by spontaneous generation. Somewhere along the road, probably in his early childhood, he fell in love with opera, and spent long, long hours working at it, working at it, and yes, performing.  He had to have had training, as well.  Lots of it.  Years of it.  He may have been the lead in his high school musical, and sung in choirs, and done some community theater musicals or something, and probably been part of an amateur opera company.  Amateur: for free!  I think the rules of entry to the “got talent” shows is that you haven’t made money with your talent in the past.  But even without being paid for it he sang, and sang, and sang, and trained and trained and sang scales and sang arpeggios, and sang phrases, again and again, to achieve that voice.  Some of the singing was undoubtedly fun for him, but much wasn’t; it was hard practice, and he did it when he was tired.  He did it after long days at Carphone Warehouse.  Doing all of that, and having the driving desire in him to stick with all of that, made him a prince long before he entered “Britain’s Got Talent”.  That show was just the first time the rest of us had been given an opportunity to notice that there was a prince living among us, selling mobile phones in Wales.

And that, of course, is why there are competitions like Britain’s Got Talent: we know that the world is full of things we haven’t seen, and full of people working hard, alone, often for free, to do things that may someday amaze us.  This hidden world of dedicated work is like a current deep under the surface of the ocean, like magma deep under the ground, invisible to us, but moving and pushing until, sometimes, it breaches the surface and changes everything.

Which made me think about the nearly universal assumption in labor-leisure trade-off models that we are all so abysmally lazy that we can only be induced to work by offering us a wage that is worth more to us than our leisure time.  Leisure time?? How do these models explain Paul Potts, and the fact that he worked so hard for so long, working to exhaustion without ever being paid, and training at his own expense?   Why did he do that?  But more relevant to this post, it also made me think about the distribution of information in a market economy and about Hayek and the role of prices, and, yes, about the ubiquitous, insistent use of macro models based on every agent’s ability to rationally, precisely, trade present and future welfare.  If we are all so good at seeing the future, and basing present actions on their present and future impacts, how do we explain the fact that Mr. Potts could suddenly appear in front of us fully trained, a magnificent opera singer?  You understand that in order to form a present expected value of future outcomes we have to be able to define all the possible future outcomes, and attach a probability to each of them.  Where is Mr. Potts in our rational deliberations?  How can we attach a probability to something we don’t even know could ever exist?  Did the price system really convey to us all the information that we could possibly find useful about his existence? 

I don’t mean to dismiss Hayek here; just the opposite.  As far as it goes, his paper is right.  He explained his point very well in the link above.  Hayek was trying to compare a price mechanism in a competitive economy with a central authority that simply imposed an answer.  His point was that the economy is so complicated, and the actors so local, that no central authority could possibly know enough to solve the complete problem of proper behavior, proper production and consumption, by every possible consumer and business, and of every possible resource and product.  Importantly, it’s not just that the problem is too big for us to calculate.  Maybe a bigger computer could fix that.  It’s that the required information is just too obscure and far too widely distributed, and constantly changing.  No individual, and no central authority, can possibly weigh one change against another, and allocate resources to accommodate them all, simply because only the few people involved in the changes are really aware of them.  A price mechanism manages to convey just exactly enough information, if we want to call it that, or enough incentive, so that each local actor everywhere will react in more or less the right way to adjust current demand and supply to distant changes he or she cannot possibly know about, simply because scarcity causes prices to rise, and so induces each actor to use less or produce more, and abundance causes prices to decline, and so induces each actor to use more or produce less of whatever it is.  We never have to know why a scarcity or abundance has happened.

And I agree with that completely---in the instant.  Paul Potts is an opera singer who was hidden from almost all of us until he performed in Britain’s Got Talent, and to the extent that his long solitary efforts to achieve his skill made some resources more scarce or abundant, we, in some infinitesimally small way, all helped to adjust the economy to that change, even though we had no idea he existed.  But we couldn’t predict his skill.  The price mechanism may help us adjust in the instant, but it can’t help us adjust to the long run emergence of something we can’t foresee.

Our inability to forecast Mr. Potts’ skill may not strike you as important.  If not Mr. Potts, then some singer will come along; we can forecast that.  Right?  But Mr. Potts is not the only person out there working from sheer dedication to something, and far from our awareness.  There are people who are inventing new technologies, or new methods, or new science that will change not only what is, but what is even possible; or new methods of attack or destruction (not all invisible change is good).  We may not need to know what they are doing to adjust our consumption or production to materially accommodate them, but when their efforts suddenly thrust their way into our worlds they will transform us.  And because their activities are hidden from us we cannot possibly predict their impact on our lives.  Seemingly from out of the blue one technology is tied to another, the clunky text based internet is enhanced with hyperlinks, and then with a print media markup language, and the World Wide Web explodes into a tech bubble in the 1990s.  From out of the blue an obscure group of discontents across the world decides to use commercial airliners as a weapon of terror, and crashes them into towering buildings in New York and squatty pentagonal buildings near Washington DC, and our political world is transformed utterly.  We can’t possibly plan “rationally”, in the way that many microfoundation-based macroeconomic models use that word, for a future filled with events like these that we can’t predict, at least partly because things from distant places or distant minds, things that Hayek’s paper says we don’t ever need to know about, will appear to us like miracles or catastrophes when they finally reveal themselves to us fully formed.

There are undoubtedly events in the future that no one on earth can predict, at least not yet: acts of God or human genius, sheer incalculable accidents, chaotically emergent “shocks” to our economic system.  But there are thousands upon thousands of events, huge and tiny, that are created by human effort, events that are part of the solid ground of economic life, but that only a few, only those that are working on them directly, can really predict; and because there are so many of them there is no one who can predict all of them.  And because there are so many of them, it’s absurd to act, as the modern models require, as though each “representative agent’s” economic future were stochastic but subject to predictive calculation, and dully reducible to “rational” expectations. 

Defenders of the modern economic faith will reply that the models may not incorporate them, because they can’t, but everyone is aware of the possibility of rare “external” economic shocks---external to their models.  But I’m saying that these shocks are not rare, not unusual, that they are part of the core and constant fabric of economic life, and that everyone who is not steeped and vested in economic theory knows it.  Can we predict 6 months out?  Possibly, unless there is a major “external” shock in the next 6 months.  But we expect to be at least a little wrong, in part because there will, without any question, be a vast array of minor external shocks that no central planner, and no economic forecaster, can possibly predict.  And our forecasts out 5 years, or 10 years, are the best we can do, but they will, with absolute certainty, be wrong. 

Our economics should acknowledge this fact: the general public doesn’t try to make forecasts out that far, because unlike us they understand that it’s an impossible task.  Even those who are working hard on one of these hidden things can’t be sure what the reaction will be, how it will interact with other things happening at the same time, how it will really impact the world.  And they can’t predict what reactions their ambition will cause, creating new ambitions in others.  The world is busy.  Nessun dorma, nessun dorma, no one sleeps.  Or rather, more accurately, we don’t all sleep at the same time; there is always someone awake.  Twenty-four hours a day someone, somewhere on earth, is devoting long dedicated hours to creating a future event, large or small, that will astonish the rest of us when it emerges.  We see the economic surface, but far under that the magma flows, the restless magma of human dedication, for good or evil, presses against the world, and when the world cracks to release it all of our prior expectations are scattered across the ground, and a new future covers them.  And that, among many reasons, is why the perfect-world, rational-expectations, Euler-equation dominated macroeconomics that assumes a stochastic general equilibrium future that we can reduce to a current expectation, simply doesn’t work, and never will work no matter how much we refine it.    Others out there are awake, and moving and working, invisible to the workaday wage economy, and they are creating a future the representative agents in these models can’t even imagine, much less assign a probability to and reduce to some bland “present value”.

Nessun dorma: and for economic forecasts, including the forecasts we attribute to the representative agents that we embed in our models, that ground truth matters.

Capital, corporations, and a post for labor day.

(note: this post turned out to be way longer than I meant it to be, so I should take the time to cut it down.  But I want to get it out on Labor Day, a day dedicated to workers rather than owners of capital.  I put a line about halfway down; there's a bunch below the line, but I'll understand if you want to stop there.  Actually, I'll understand if you want to stop here.  Follow your whim.)

Let’s see…I said I would talk about taxing capital.  Before I do that, I want to clarify something from my last post.  It will probably give you some indication of my age if I tell you that William of Ockham was a personal friend of mine when I was young, and I always admired his razor.  Simplicity is good.  When I said in my last post that we should raise corporate income tax rates and increase the deductions available to corporations to drive the effective tax on corporations to zero, I didn’t mean that we should multiply their number or complexity, only the total size of the deductions they provide. 

The comment about my advanced age was largely because the discussion about capital taxation, which has been raised repeatedly by at least one segment of the corporate tax discussion, seems to be dominated by a result that is often called “classic”---and that was first published well after I completed my trip through the graduate program in economics, and well after the turbulence of my early career had landed me in a job where instead of doing economics I supervise engineering project.  It dates to the mid-1980s.  It’s called, in the usual academic shorthand, by the names of the people who first offered it, and in particular to  Christophe Chamley and Kenneth Judd: it’s called the Chamley-Judd result, sometimes even the Chamley-Judd Theorem. The theorem claims that we should not tax returns to capital at all, and that all taxes should be paid by labor.

 

To understand what Chamley and Judd are getting at, you have to understand that the “capital” they have in mind is tangible capital, not financial capital: plant and equipment, computers, office buildings, hammers, cranes, trucks, tools, but not bonds or other financial assets.   This kind of capital is the stuff that economists want to put into a production function that looks something like this: Q=f(L, K), which means that the total quantity produced is a function of the labor used and the capital they have to work with.  The Chamley-Judd theorem, which is pretty interesting if used reasonably, shows that under a bunch of very restrictive conditions the optimal rate of taxation on the income earned by owning this kind of capital is zero---and they mean optimal in the long run for workers even though the workers will have to pay additional taxes to make up for the revenues lost by eliminating taxes on capital income.  Sometimes politicians and some economists use this theorem to justify proposals to decrease taxes on corporations, although usually not to zero.  (There are other inputs to this discussion that come to a different optimal rate by relaxing some of the restrictive conditions required to get the Chamley-Judd result.  A recent paper by Thomas Piketty and Emmanuel Saez found that the optimal taxation of inherited capital was as high as 60%. ) 

Here’s a sample of the kinds of things people say, more or less as an argument to stop taxing corporate dividends, from the Library of Economics and Liberty:

“let me sum up a key implication of Chamley-Judd: 

Under standard, pretty flexible assumptions, it's impossible to tax capitalists, give the money to workers, and raise the total long-run income of workers.    

Not, hard, not inefficient, not socially wasteful, not immoral: Impossible…

Good economic policy doesn't try to do things that are impossible.  And if the world works roughly the way Chamley and Judd assume it does, a long run policy that redistributes total income from capitalists to workers is impossible.  “

To which the proper response is:  wow.  This isn’t the usual let’s-reduce-the-rate-and-eliminate-loopholes-to-be-revenue-neutral argument.  It isn’t the end-double-taxation-of-corporate-income argument.  This is a theorem, proved with mathematical rigor, that shows that it’s bad for workers in the long run to tax either corporations or dividends at all, at least if “corporations” and “capital” are interchangeable words, so that taxing corporate income is the same thing as taxing capital.

Well, since I said in my last post that I want to drive effective corporate taxes (not corporate tax rates!) to zero I probably should not question the Chamley-Judd result; I should just go with it as a statement not just about capital but about corporations.  But I have some reservations about how applicable it really is to whatever it is that corporate taxes (or even taxes on corporate dividends) tax.  First, as we noted before, the capital considered leaves out any incomes corporations receive from bonds, mortgages, insurance or any other financial capital.  But the model doesn’t include human capital either, or non-capital human progress; all labor is the same, present and future.  Actually, all capital is the same too, which means it doesn’t include the kind of intellectual capital that is embodied in technological progress in production, and which is often created through the labor of workers (for example, by workers called "engineers").   A different formulation of the model argument might conclude that we should never tax the income of engineers.  I’m not by any means the only one to recognize all of these things; here’s Steve Randy Waldman on it:

“In empirical fact, 'human capital' and its more sociable, incorporeal twin 'institutional capital' seem to be much more important predictors of the growth path of an economy than physical capital. Europe and Japan bounce back quickly after war devastates their infrastructure. But imagine that a Rapture clears the Earth and pre-agrarian nomads take possession of perfect gleaming factories. I think you will agree that production does not recover so fast. Human and institutional capital dominate physical capital...

Further, while physical capital grows by virtue of nonconsumption, it seems plausible that human capital development is proportionate to its use, which would render a tax penalty on 'wages' particularly destructive. Fundamentally, Chamley-Judd logic suggests that we should tax least the factor most capable of expanding to engender economic growth. You don’t have to be a new-age nut to believe that human and institutional development, which yield return in the form of wages, may well be that factor. It is perfectly possible, under this logic, that the roles of capital and labor are reversed, that the optimal tax on labor should be zero or even negative, because returns to physical and financial capital are so enhanced by human talent that even capitalists are better off paying a tax to cajole it.”

The model also barely recognized the existence of government except as some external agency that for some reason sucks away taxes every year and uses the funds to buy some of the produced goods and make them magically disappear.  In other words, in this model government doesn’t actually do anything, it just costs money and gobbles things that could otherwise be consumed by its citizens.  And the theory doesn’t include corporate reputation, or branding, or business relationships, business culture, or any culture for that matter, at least not in a straightforward manner, so taxing corporations and corporate dividends is not quite the same as taxing capital in the sense that Chamley and Judd have intended.  Finally, the equation above is about how to produce things, not to sell them (there is often an unstated presumption in these small models that anything produced will be sold, which, of course, would immediately eliminate the need for advertising, which in turn would be a real downer for any future season of “Mad Men”), and production is only increased in the model by adding more labor (not improving it), or adding more capital (not improving it), or both.  (If value of a company were the same as the value of the physical capital owned by the company, then the book value would be the same as tangible book value, which excludes all kinds of values that are not tangible assets.  Needless to say, those are not the same thing and never the same value.  And even total book value doesn’t contain every asset that makes a share worthwhile or makes a company profitable; if that were true, the ratio of price to book value would always be 1.  It isn’t. )

So “corporate profits” and “returns to capital” are not the same thing.  But it’s still worth a look at Chamley Judd, because the model makes at least one very good point, which, frankly, is all you can expect of a model that so heroically simplifies the world.  This is what I think much of the world of conservative economists fails to understand, not only about this but about a lot of small models that make a point, such as the modern version of Ricardian Equivalence.   It’s a parable.  It describes a simple lesson, one lesson, not a complete panoramic intellectual tapestry of the meaning of life.  And in particular, models that assume away unemployment or demand failures are completely at odds with the tapestry and meaning of life.  So the models are good for illustrating their single lessons, but they are useless as a basis for policy.

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There are (at least) two basic ideas that appear to me to drive the result: that an increased rate of investment in new capital will raise wages over time, in the long run, enough to compensate workers for accepting the total burden of funding the government without any help from a tax on capital income, and that a reduction of tax rates on capital will induce increased rate of investment in new capital.  Let’s look at both of them. 

The first relies on the assumption that capital accumulates over time and labor doesn’t, as Dr. Waldmann observed in the link above; if we encourage the formation of this cumulative capital workers in the future will have more capital to work with, and so their labor will be more valuable---and so their wages will be higher.  Taxing labor more heavily might discourage labor in the short run, but lower labor availability right now, in the world the model describes, won’t impact next year’s production possibilities, since the same amount of raw labor will be available then.  But if taxing capital discourages capital formation, that does impact next year’s possibilities, and the following year’s, and all future years’ possibilities.  In the long run, accumulation of capital will raise production and productivity of workers so much that the increased rate of taxes on workers to pay capital-income’s share of the cost of government will simply be overwhelmed by increased wages.  So the specific lesson within the model is that the cumulative formation of capital in the production function is in the best interests of workers even if encouraging capital formation means higher short run taxes on labor.

But the generalized lesson, given how the model comes to its conclusions, is that anything that cumulatively increases production possibilities should be encouraged even if that means that we have to pay higher tax rates in the short run.   And if that’s the generalized lesson, then why stop with privately owned capital?  Why not include the accumulation of national infrastructure as an input to the production function?  Or the human capital that is created by public schools?  Or the intellectual capital that is created or at least seeded by government research?  Surely a similar model that includes a government that doesn’t just gobble goods and make them vanish, but instead turns them into additional public capital, human capital, and intellectual capital that are cumulative inputs to the production function, would show that higher taxes to pay for those things are justified by long run increases in productivity.  I don’t plan to create a model like that just for this blog post---way, way too much work---but the underlying generalized logic of Chamley-Judd sounds like it would lead to that conclusion.   Also, a similar model would show that if the value of capital is cumulatively enhanced by technological progress created by labor, then the owners of capital should be willing to pay some taxes in order to reduce the tax burden on those workers to induce them to work more, and to create more cumulative technological change. 

The second basic idea that is required for this theorem is that the level of investment in new capital is a function of the return to capital, which is decreased by the tax rate on capital---lower tax rates, higher after-tax return, more investment.  If that’s not true, then why lower rates?  The workers would get nothing out of paying a higher share of the cost of government if the sacrifice didn’t induce more capital formation.  

So is that true?  Certainly it’s true that a lower tax rate would increase the after tax returns to the owners of capital, but is it true that the rate of investment in new capital depends largely on the after-tax returns to owners of capital?  That’s what the usual train of thought that’s drilled into us a undergrads would lead us to expect. 

Here’s a graph from FRED (Federal Reserve Economic Data).  The blue line is private nonresidential fixed investment as a share of GDP.  The red line is the best measure I could come up with on short notice for average after-tax return on investment; it’s total corporate after tax profits as a share of nonfinancial corporate business nonfinancial assets.  Hey, it’s not perfect, particularly since corporate profits are a function of a lot more than just the owned capital, but it’s something.

I don’t know about you, but I don’t see an exact correlation between these two lines. 

Well, then, if it’s not after tax profits, what does drive private nonresidential fixed investment?  Good question.  It’s clearly not just interest rates either, or investment would have soared after 2008 when the interest rate was driven down close to zero.

I have a theory: it’s all driven by magical creatures.   No, really.  The link is to my second post in this blog, where I said:

“I do have a kind of faith in something beyond the mathematics that moves the economic world.  I believe that there is a group of magical creatures out there, a special kind of creature that makes the economy come alive; when they arrive in large numbers, businesses pop into existence like mushrooms in the woods after a spring rain; when they arrive jobs are created, and wealth is created.  When they leave, jobs are lost, wealth is lost and businesses die.  Really.  I’m not making this up, and I’m not the only one who believes in these creatures.  Sober businessmen know about them and seek them out, and spend large amounts of money hoping to coax them from their hiding places. 

We call these creatures ‘customers’.”

In this case, it’s not really the customers themselves that make businesses invest in new productive capacity.  It’s the belief that customers are coming, that when the new capacity comes online and starts producing stuff that there will be customers out there to buy it.  There is a regularity I notice in the graph above in the investment/GDP line: it always seems to have a downward slope during or before recessions (the gray vertical bars). 

In terms of the model we’ve been talking about, though, this means that the way to induce increased investment in each year is to convince investors that there will be enough customers available with enough income in the following years to buy all the new product their investment will enable them to make.   Which is a problem: the providers of labor get about 70% of total national income; owners of capital and land get the rest.  Reducing taxes on the income from capital won’t, by itself, create a rosy vision of a future teeming with consumers.  But reducing taxes on wages might…and increasing taxes on wages, in that case, would produce exactly the opposite of the effect presumed by Chamley-Judd.

How to stop inversions: increase the corporate tax rate. Yeah, you heard me.

I’m not going to write about the Netherlands today, even though Craig said I should.  He said that because I’ve had an inexplicably large number of blog hits from the Netherlands lately, and he wanted to see what would happen if I actually wrote about the Netherlands, just as an experiment.  Maybe just using the word “Netherlands” a lot of times in this first paragraph will be enough to conduct at least a minor experiment on this question.  (Just to be clear, for casual visitors who arrived here by taking a wrong turn at Google, an “inexplicably large number” in the case of this blog is 40 or so on several recent days.  Other than my friends, I get only  a few visitors.  Which is ok; I’m just one more economics blogger in the vast universe of economics bloggers, and many of the best economists on earth have excellent blogs.  But here are the numbers: even though I haven’t posted anything since July 20^th, and have only written four entries this year, I’ve had 515 hits in the past month on this blog.  241 of them---nearly half---were from the Netherlands.  I don’t have any idea why.)

Here’s what I am going to write about: Charles Krauthammer, Dean Baker, Jared Bernstein, Matthew Yglesias, Josh Barro and a whole bunch of other responses to the recent excitement about “inversion”, corporations moving their headquarters to other countries to escape high tax rates here in the United States.  I mention Krauthammer first because (and this shakes my faith in myself to the core; if this keeps up I’m going to stop reading my blog altogether) I agreed with almost everything he said.  Almost.  I also agree with Baker and Bernstein, mostly, although they were writing to dispute each other.  After a couple words about inversion, or maybe tomorrow, I’m going to add a word or two about the relationship between taxing corporations, which is what this issue is about, and taxing capital, which is way more interesting than it sounds, and is sometimes mistaken for the same issue.  (Hint: they are not at all the same issue.)

The first thing I want to say about inversion is to speak as a liberal to my brothers and sisters on the liberal side of the political spectrum, and to the White House.  What I want to say to them is this: chill freakin’ out! If you keep hyperventilating you’re going to faint.  Obama’s fevered reference to “corporate deserters” is irrational, and unfair.  It’s silly to blame corporations for doing whatever is in their best interest to do, as long as it’s not illegal or immoral, and seeking out the best legal tax environment is neither.  It makes no more sense to blame corporations for seeking most advantageous location to settle in than it does to blame rivers for flowing downhill instead of up.  Water seeks the lowest point it can find, and corporations seek profits.   After-tax profits.  That’s what they’re created to do. 

Here are the raw numbers from the OECD on total corporate tax rates.  The table combines “Central and Subcentral” taxes, which means that state and local taxes are included.  There’s a scroll-bar at the bottom so you can move through the years from 1981 to 2013.  If you do that you’ll notice that the issue is not that our tax rates are historically high, but that other nations have reduced their corporate tax rates over time to draw businesses.  There’s been a race to the bottom in corporate tax rates, and we have chosen not to compete in the race, or not to compete as vigorously as other countries have.  In 1981 our corporate income tax rate was 49.7%; now it’s 39.1%.  By contrast, Sweden’s corporate tax rate in 1981 was 57.8%, and now it’s 22%; Ireland’s was 45% in 1981, and now it’s 12.5%.  We have the highest corporate tax rate in the OECD table now, not because our taxes have gone up---they haven’t---but because everyone else’s tax rates have come down so much farther than ours have.

Krauthammer says that the solution to the problem of corporate flight from high tax rates is tax reform here, rather than building a legal wall to keep corporations from leaving.  So far I agree completely with Krauthammer, which is, as I said, disturbing. Later in his column he does recognize that the 35% top federal corporate tax rate is not really the effective rate that corporations pay: because of loopholes some of the larger corporations, according to Krauthammer, have effective tax rates of 13%.  I’m not sure where he got that figure.  Some corporations, some years, pay no taxes at all.  And this matters: corporations’ decisions on whether to move to another location will be based (in part) on the effective overall tax rates they pay in each place, not on an imaginary top possible rate.

Of course Dr. Krauthammer blames Obama for the lack of corporate tax reform, forgetting that there are big differences of opinion on what constitutes “reform”, and also that if Obama proposed a bill honoring motherhood and entirely eliminating corporate taxes the Republican house would be bent double in a seizure of feigned indignation, and would threaten to throw Boehner out of the House leadership if he even brought it to the floor, which, of course, he would not do.  They would turn it into a scandal of some kind, God knows how.  Darryl Issa would hold hearings on whether to impeach Obama and Hillary Clinton and possibly Bill Clinton and John Kennedy too, for proposing such things; his committee would eventually produce a final report at enormous public expense basically exonerating everyone on whatever they had decided to be upset about, and Fox News would ignore the final report and maintain their outrage on the grounds that, well, on the grounds that outrage is more fun than pretty much anything and anyone who exonerates Obama or Clinton is a poopy stupid-head.  So I disagree with him on whom to blame, but that’s secondary.  The real question is what we should do now.  And “tax reform” is as good a name for what we should do as any.  But to Krauthammer and most people on the right (and many on the left), “tax reform” means reducing the tax rate, but eliminating loopholes so that the action is revenue neutral.  In other words, reduce the top rate, but keep the average effective rate the same, more or less, which, if effective tax rate is the motive, doesn't really sound to me like it would reduce the incentive for corporations to find some other lower-tax location for their headquarters.   And also, the first part of that (lower rates) is easy, the second part (eliminate loopholes) is damned near impossible, as Matthew Yglesias points out at the link above, which is why it’s so hard to get done.  And anyway, as I’ll explain in a minute, this is exactly the opposite of what I think corporate tax reform should be.

Now, I’ve said before that I don’t like the corporate income tax anyway---if there were a way to do it I’d favor a zero tax rate for corporations.  I’ve written about that here on this blog.  Corporations are not people, so they have to pass the taxes we levy on them along to real human beings one way or another, and it’s not at all clear that the owners of corporations pay all of it, or even most of it.  From Matthew Yglesias:

“An interesting theoretical question is who actually does pay the corporate income tax? Does it fall on workers? On owners of land? On owners of capital? I can assure you that after reading a few papers on this thanks to the National Bureau of Economic Research's search tools that the answer is credible researchers disagree and the answer is highly sensitive to modeling assumptions!”

When I first said that decades ago, and even fairly recently, people on the liberal side of the world were aghast at the thought.  But apparently there’s been a revolution brewing that I never saw.  Dean Baker’s post, at the link above, comes out in favor of eliminating the corporate tax and raising the tax on the wealthy to make up the lost revenue.  Josh Barro, at the link above, suggests the same thing. 

But Jarred Bernstein raises the issue that has always actually given me some pause, and states it so well that I have to change my mind about eliminating the top corporate tax rates.  As he says (at the link above), eliminating corporate taxes:

“risks turning the corporate structure itself into a big tax shelter: If income generated and retained by incorporated businesses should become tax-free, then guess what type of income everybody will suddenly start making?”

Yeah.  Dammit.

So eliminating, or even reducing, the corporate tax rate is not a good idea.  Time to uncork the theory of the second-best, then.  If we can’t reduce rates to zero because ordinary people would suddenly become corporations, I’d suggest that corporations should pay the personal tax rate on their income, so there’s no incentive at all for people to pretend to be corporations as a way to shelter their income from taxation.  But I still think that corporations should pay zero or near-zero effective income taxes.  In other words, we should raise tax rates and increase tax deductions (which is the other word we use for “loopholes”) not just to be revenue neutral, but to drive revenue from corporate taxes down near zero.   Of course, there would be a huge fight about which deductions are worthwhile and which are not, and how to design the system so that all industries have exactly the tax breaks they need to get them to zero effective profit tax.  And yes, that means that we would need to raise the lost revenues elsewhere.  But there are plenty of good options: how about a carbon tax to fight global warming, or other Pigovian taxes to internalize production costs and promote the general welfare (which according to the preamble to the Constitution is one of the primary goals of the government that constitution created)?  How about a financial transactions tax to reduce computer driven speed trading in the stock market, which seems to have no purpose other than to make money for the computer’s owners and lose money for everyone else?  I know, those would be big political fights, but the point here isn’t what’s easy to do, it’s what might be good to do if we could.  And if we could reduce the effective tax rate to zero by adding good loopholes, that would also eliminate any reason for corporations to move somewhere else---unless the other location had effective taxes less than zero.

See?  Definitions of tax reform differ from one person to the next.

I guess I’ll talk about taxing capital tomorrow. 

Frayed border. Or 'fraid knot.

Just a quick rant on the border children.  Please, if you have an opinion on this, leave a comment.  I’m not an expert on any part of it, so please educate me.   But I can see what it looks like: a flood of refugees, as we have seen in this world in other places and at other times, fleeing from wars or disasters.  Only in this case, at this time and at the border of our country, there is a very large component of young people, mostly teenagers but also younger children, in this refugee population.

Here is the data.  (Always nice to start with the facts, don’t you think?)  Go ahead, take a look, I’ll wait.

Notice that in every sector except Tucson the “apprehension” of “unaccompanied alien children” has had a huge increase, but in one sector, the Rio Grande sector, it has been staggering: from 14,565 in 2013 to 42,164 in 2014 (which isn’t even over yet!).  That’s an increase of 189% so far and it will be far larger by the time the year is over.  But even that understates the problem, because there has also been an over 500% increase in that sector in the apprehension of “family units”.  These are people that seem to be traveling as a family.  But it’s more than possible that a very large number of these family units were not families when they started their journeys toward refuge.  Some “families” were probably formed rapidly as the border approached, so that the adults involved could have a better chance of staying here for at least a while.

Congress, of course, is going on recess.  But I’m tired of complaining about Congress.  Let’s discuss this among ourselves, and let them pursue their bewildered irrelevance at their leisure.  They are involved in a deep argument over whether this influx resulted from a 2008 law passed under George Bush or from a more recent executive action by Barack Obama.  Both of those may contribute, but to attribute the flood of refugees to either of those is just wrong: the cause of the flood is not a porous border or leniency for children.  The cause is that the life they are fleeing is enormously worse than the life they expect when they get here, and that life, the life faced by those few who are allowed stay, is no picnic.  They will be paupers, and illegal immigrants with no rights here at all.  And the journey they undertook to get that dismal chance was long and terrible. 

But what they left is overwhelmingly worse.  It must be worse, or why would they come?

There are several pieces in the Washington Post this morning on this, but there is only one that is required reading.  Oscar Arias (Nobel Peace Prize winner and twice President of Costa Rica) wrote this article on the Opinion page in the front section.  If I quoted as much of his comments as I’d like to I’d undoubtedly run afoul of some copyright law, but let me give you this much:

“The conservatives who oppose President Obama’s request for emergency funds for the crisis criticize him for dealing only with the symptoms and not with the ‘root cause’ of the problem. They are half right — but the half that’s wrong is very, very wrong. For them, the root cause is a lax immigration law, weak protections or insufficiently severe punishments. But no punishment, no wall and no army can solve this problem…If these children … are willing to risk their lives atop the infamous train through Mexico known as La Bestia (“the beast”), face the rape and abuse that many children experience during the journey, sell their possessions and their bodies, and give their life savings to unscrupulous smugglers, what else could possibly deter them? What can the United States do to these children that would be worse than what they are already suffering? And why is such a great country even asking that question?”

Yes.  They face certain danger, hunger and abuse on the road here, a high probability of rape, or of being sold into servitude, or of death.  They are leaving the country they know, the language they know, the customs and people they know, their families, their friends.  What punishment can we impose, what deterrent can we bring to bear, that is worse than what they are enduring to get here?  We can send them “home”, to face dangers that they think are even worse than the journey here.  And if we don’t make an anguish for them here that is worse than the one they are fleeing, they will continue to come.  This is basic economics: these people are making, we assume, a rational choice, weighing one set of risks against another, and will continue to make that same choice as long as it appears to be rational to do it.  

But it’s the last question in that list that haunts me.  Why the hell are we talking, and waiting, as though this were simply a dessicated debating point?  Why is a great country, this great country, my great country, asking that question?  There are tens of thousands of children who need help, who are desperate and alone in the world, facing poverty and legal limbo if they are allowed to stay and vastly worse poverty and violence if they are sent back home with no support and no help from the world.   

Arias goes on to say:

“The root cause of this crisis is not U.S. immigration law or the policies of one U.S. president. The root cause is the violence and poverty that make these children’s lives at home intolerable. The root cause dates to the parents and grandparents of the young people fleeing their countries today — our region’s ‘lost generation,’ those who were children and teenagers in the 1980s. Back then, two superpowers — the United States and the Soviet Union — chose our region as a place to work out their disputes. They were eager to help Central America transform students into soldiers. They were eager to provide the weapons while we provided the dead.”

Does he sound bitter?  Maybe.  But he lived through that period; he was President of Costa Rica the first time from 1986 to 1990.  And his comments make sense to me.  But in truth it doesn’t matter much right now who we blame, or how far back the blame goes.  It doesn’t matter whether it is Obama’s fault, or Bush’s fault, or the cold wars, or the drug wars. 

What matters, for the moment, is the present tense, not the past tense or even the future tense; what matters is the human story, the many human stories, appearing on our side of the border every day.  They need shelter, and food, and medical care.  We know how to provide those; we’re probably the best in the world at that task.  Every time there’s a disaster anywhere on earth---tsunamis, earthquakes, volcanoes, hurricanes---our rescue teams and our Coast Guard and our National Guard, and our Marines, with all their ships and aircraft and trucks and ambulances, and thousands of eager young people who want to make a difference in the world, show up to help. 

I’d like to invite the President and the Speaker to please get their heads out of their darker and more political body parts.  But if they can’t manage that, maybe the rest of us can.  Let’s take care of those children.  We can assign blame, and choose what path we want to take to make the world harsher, and colder, and less human, when we’ve got the current flood of children cared for.

Or---once the immediate crisis is under control---maybe we can undertake the radical (from the root) solution everyone says they want.  But that won’t involve some fiddling fix to our immigration laws.  Since, as Arias argued above, nothing we can do here will make our border harsher or colder than the situation these people have left behind, why don’t we take the alternative path.  Instead of making things worse for them here, why don’t we work with the Central American countries they’re escaping to make things better for them there? 

Naah.  Maybe that’s a bit too radical.