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The Becker-Posner Blog: October 2012

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October 2012
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Is Banking Unusually Prone to Risky Practices? Posner

I think the answer is y es, and that this becomes apparent if we understand the Darwinian character of competition, though this is not to suggest that competition inv ariably , or ev en ty pically , leads to corrupt behav ior. There are many analogies between biological ev olution and commercial markets, and as a result words like competition and equilibrium are important both in ev olutionary biology and in economics. In an article published in 1 950 the economist Armen Alchian argued that standard economic results could be predicted as products of a struggle for surv iv al among competitors, without need to assume conscious profit max imization by any of them. But the ex plicit analogizing of economic behav ior to Darwinian theory is far older than 1 950, and in fact reached its apogee in the decades following the publication in 1 859 of The Origin of Species in the mov ement that came to be known as Social Darwinism. In its ex treme form Social Darwinism adv ocated eugenic breeding, to improv e the human race, and the elimination of poor relief and other redistributiv e policies, v iewed as interfering with the struggle for surv iv al and hence with the surv iv al of the fittest. But the Social Darwinists had committed a big, though common, error, which is to confuse fitness with goodness. The fitness in Darwinian theory is adaptation to the env ironment, not improv ementwhich brings me at last to banking, and economic competition more generally . A competitiv e env ironment fav ors firms that adapt to that env ironment; and so to determine whether a market is working well from an ov erall social standpoint, one has to understand the env ironment, and the business behav ior that best enables a firm to surv iv e and thriv e in it. An analy sis so motiv ated is a fruitful application of Darwinian theory to competitiv e markets. Banking traditionally meant borrowing from persons who want by inv esting to defer production or consumption (in other words, to sav e but be compensated for sav ing, rather than just stuffing their sav ings under their mattress) and lending the borrowed money to persons who want to sav e less and produce or consume more. Increasingly the word banking is defined more broadly , as v irtually any form of financial intermediation, in recognition of the greater v ariety of inv estments made by what are still called banks in our still lightly regulated financial sy stem. But the traditional form of financial intermediation is all I need to discuss in order to make my point. The obv ious problem for a bank is how to earn a spreadthat is, how to lend at a higher interest rate than it borrows, as otherwise it will not cov er its costs. The standard answer is to borrow short and lend long. Shortterm interest rates are lower than long-term rates because the risk of default is lower (there is no need to predict the borrowers long-term health) and because the borrower retains liquidity , which is v aluedin the traditional demand deposit the borrower can withdraw at a moments notice the money that hes lent the bank (a deposit is a loan). Because a long-term loan is riskier and the lender surrenders liquidity , long-term interest rates are higher, so by borrowing short and lending long the bank earns the spread it needs to surv iv e and thriv e. The shorter the term of the banks borrowed money , and the longer the term at which it lends, the bigger the spread but the greater the risk of default. If the lenders to the bank decide that the bank is making risky loans, they , or some of them, may decide to withdraw their money . The more who do, the riskier the position of the
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other short-term lenders to the bank is, and so they will follow suit--hence bank runs. Because the banks lending is long term, the bank can quickly find itself with no liquid capital and with long-term assets consisting of loans that are risky (which is what precipitated the depositors to flee the bank) and hence may be likely to default. One might think that, cognizant of such risks, banks would be cautious borrowers and lenders; they would not borrow so short (and thus risk a run) or make such long-term (and therefore risky ) loans. But that need not be true. Max imizing spread may be v ery risky in the long run, but in the short run it may generate v ery high profits that shareholders and managers may be able to pocket and may compensate them for the risk of a future disaster, the costs of which will be borne by others. Banks that follow a more cautious strategy and therefore hav e lower profits may hav e trouble attracting and retaining talented employ ees and may not be able to hold on to short-term capital (the demand deposits) against the competition of more profitable banks (profitable because less risk av erse) for short-term capital. As we know from the global financial collapse of 2008 and the ensuing global economic depression (and there are numerous historical precursors), the collapse of a banking industry can create large ex ternal costs. For, to repeat, Darwinian ev olution is toward fitness rather than goodness. A high-risk industry with frequent bankruptcies may be optimally adapted to its economic env ironment, but its risks may create serious danger for the economy as a whole. That is the argument for federal deposit insurance and other traditional, though now largely dismantled, regulations of bank solv ency . Other high-risk industries with frequent bankruptcies, such as the airline industry , do not pose macroeconomic risk because they are small and because the firms can continue operating in bankruptcy ; they do not ex perience runs that leav e them assetless. For such industries, deregulation may be optimal. But for banking it is not. In recent decades some influential conserv ativ e economists, notably Alan Greenspan, the long-term chairman of the Federal Reserv e, committed a v ariant of the Social Darwinist fallacy . They deemed markets, including financial markets, as self-regulating, in the sense of achiev ing socially optimal results without need for traditional regulatory controls. At the urging of these economists and under pressure from the financial industry itself, some regulatory controls were rescinded and others ceased to be v igorously administered. The underly ing assumption was that markets work. They do work, but in much the same way that biological ev olution works. Biological ev olution has produced a marv elous v ariety of life forms, and economic ev olution has produced a marv elous v ariety of products and serv ices that hav e greatly increased human well-being. But both ty pes of ev olution produce good results only as by -products to the struggle for surv iv al. Unregulated all they can achiev e is fitness in the sense of adaptation to the env ironment. That may be good enough in most industries, but it is not good enough, for the ov erall health of the economy , in banking. Lax regulation, particularly of nonbank banks like Bear Sterns, Lehman Brothers, and Merrill Ly nch, encouraged sharp banking practices. Firms in a competitiv e market cannot afford to be v ery ethical, any more than a tiger or other predator can afford to be gentle or kind. The firms will be under heav y pressure to engage in any highly profitable practice they can get away with, ev en if the profits that the practice promises are short term, prov ided those profits are great enough to dispel or at least greatly lessen the concern of managers and other key employ ees and inv estors with the long term. The short-term orientation will influence the business decisions of the managers and other employ ees (loan officers, traders, etc.) who ex ercise discretion; they will try to make as much money for themselv es and their firms as they can, as quickly as they can, to av oid economic ex tinction. The Darwinian analogy of markets to nature is aptand it is a warning against a certain ty pe of economic complacency that appears to hav e contributed decisiv ely to the economic doldrums in which much of the world is languishing, as well as to the frauds and other corrupt practices in banking that hav e surfaced. When an industry s structure and centrality to the economy pushes it toward assuming macroeconomic risk, the need for careful regulation is acute. Posted at 09:1 7 PM | Permalink | Comments (1 4) Reblog (0) | |
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The Becker-Posner Blog: October 2012

Government Regulation, Competition, and Corruption-Becker

A widely accepted definition of corruption by businessmen is that their behav ior v iolates laws or widely accepted ethical norms. Using this definition I would claim that the banking industry is more corrupt than the ty pical industry not because it is reasonably competitiv e, but partly because it is a highly regulated industry , and partly because it is an industry trusted with large amounts of money of customers. I will consider in turn the effects of competition, regulation, and trust. Many believ e that competition leads to a race to the bottom, where cheating of customers and other forms of corrupt behav ior prev ail because of competitiv e pressures. Howev er, if repeat business is important for a company s profitability , and if customers are aware of when they are cheated or are the v ictims of other unethical behav ior by companies, competition tends to eliminate corrupt companies and promotes companies that behav e honestly toward consumers. The reason is that corrupt companies will hav e little repeat business, and by assumption that would crush their profit prospects. When repeat business is of little importance, as in many tourist centers, corrupt businessmen hav e much better chances of surv iv ing and ev en thriv ing. It is in these cases that honest businessmen hav e trouble doing well because they are outcompeted by corrupt businessmen. Tourists do not hav e sufficient incentiv es to inv est in knowledge of the reputations of local businessmen since they usually do not return to the same locality . In that case, their unhappy ex perience with cheaters would not affect their future behav ior v ery much. Unfortunately , the empirical ev idence is limited on the relation between the degree of competition in an industry and its degree of corruption. Part of the reason for the scarcity of reliable information is that empirical studies of competitiv eness do not tend to account for how important repeat business is, and the interaction between regulation and competitiv eness. One widely cited study on international corruption is Transparency Internationals annual ranking of countries by the degree of corruption among gov ernment officials (its Corruption Perception Index ). New Zealand, Denmark, Finland, Sweden, and Singapore head the list, while Sudan, Turkestan, North Korea, and Somalia are at the bottom. Some countries at the top hav e large gov ernments, such as Norway and Sweden, but all the top countries hav e rather competitiv e economies, certainly much more competitiv e than countries at the bottom. These international comparisons do not indicate that competition leads to greater corruption, when corruption is measured by corruption of gov ernment officials. While these index es show that gov ernment officials are more corrupted in some countries than in others countries, greater regulation and gov ernment control in an industry often induces more corrupt practices in that industry . Companies that are successful at bribing or otherwise influencing officials to gain ex tra business or other adv antages clearly are more likely to surv iv e such competition. Of course, the adv antage to corrupt business behav ior would be eliminated if all officials and lawmakers were completely honest, but that is far from alway s the case. Numerous ex amples are av ailable of the adv antages to businesses from corrupting regulators and other gov ernment officials. Fannie Mae and Freddie Mac, quesi-priv ate companies, engaged in v arious corrupt practices during the housing boom in order to gain added business (see the ex pose of these companies in Reckless Endangerment by Morgenson and Rossner). Chinese gov ernment officials are accused of widespread corrupt practices as they allocate v aluableland and capital to different companies. From this perspectiv e, the banking industry may well be more corrupt than the av erage industry not because it is reasonably competitiv e, but partly because it is highly regulated. Banks gain financially if they can induce regulators and others officials to giv e them adv antages in the enforcement of the many complicated regulations that gov ern modern banking. Corruption in the banking industry is also induced by the large quantities of money that that they receiv e in trust from depositors and others. Some regulations hav e undoubtedly protected lenders to banks from corrupt practices by bankers, although not sufficiently to prev ent v arious highly suspect banking practices during the run up to the financial crisis. Still, an ex pansion of certain rules-based regulations of the banking
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industry has been warranted, such as greater capital requirements relativ e to bank assets. In any case, my discussion indicates that the corruption of businessmen depends mainly on the importance of repeat business in a competitiv e env ironment, the ability of companies to influence the decisions of lawmakers and regulators, and the magnitude of the liquid assets of customers that are entrusted to companies.

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What Limits to Using Money Prices to Buy and Sell? Becker

Perhaps partly due to the sev erity of the Great Recession, in recent y ears more books, articles, and blog postings than usual hav e argued against the use of markets to organize different parts of the economy . A subset of this ty pe of literature is opposed not to markets in general, but to the purchase and sale of particular goods and serv ices. One ex ample is the 201 2 book by the well-known philosopher Michael Sandel, What Money Cant Buy : The Moral Limits of Markets. Another ex ample is the opposition to a market in kidney s and other organs to be used in transplantation surgeries. Alv in Roth, the latest and highly merited winner of the Nobel Prize in economics, has argued that v irtually no country allows such a market because most people feel repugnant toward allowing organs to be bought and sold in an open market.

A general criterion that should be used in determining when money prices should be allowed to help bring demand into balance with supply is whether the priv ate and social gains of using prices ex ceed the priv ate and social costs. One major adv antage of allowing money prices is that the cost to buy ers equals the rev enue to sellers, so that no resources are lost in the process of equating supply and demand. By contrast, when markets are cleared by queues, the waiting time is a cost or price to consumers, but sellers do not receiv e rev enue from this cost imposed on consumers.

Another adv antage of prices is that the limited supply of goods will be allocated to consumers who are willing to pay the most for the goods. This is an attractiv e result when dealing with indiv iduals of similar incomes, but rationing by money price may be a disadv antage if richer persons get most of the medical care or other goods considered necessary for a decent life. Howev er, the way to meet this problem is not by eliminating money prices as a way of rationing supply , but instead by redistributing income to poorer indiv iduals, and sometimes perhaps by directly subsidizing the consumption of goods by the poor, as with Medicaid.

To show how these and other principles work out in practice I will discuss a few ex amples where the use of markets and prices has been criticized. I start with transplanting of organs since not only Roth and Sandel, but many doctors and others hav e ex pressed their opposition to allowing organs to be bought and sold. I concentrate on kidney s since kidney transplants are the most common, and indiv iduals can donate one kidney while they are liv ing as well as allowing their kidney s to be used after they die. The reasons giv en for opposing buy ing and selling kidney s are v aried, but include Roths discussion of repugnance, and a claim that many poor persons would either be tricked into giv ing organs or would giv e because they were desperate for money .

These and other reasons for opposing using money prices to increase the supply of organs for transplant are not completely without merit, although the v ast majority of indiv iduals who need a kidney transplant or
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hav e relativ es who need transplants want to increase organ supply by buy ing them and other means. Moreov er, there are great costs to the present sy stem that forbids the purchase and sale of organs. In the United States, about 90,000 indiv iduals are waiting for a kidney transplant, and the av erage wait is about 6 y ears. The great majority of those waiting are on dialy sis, and life ex pectancy while on dialy sis is short. For this reason, about 4,000 indiv iduals die each y ear while in the queue to get a kidney . Kidney ex changes, introduced in 2005, and other efforts to greatly reduce the waiting time hav e produced little ov erall benefit. In fact, the av erage waiting time rose from 4 y ears in 2005 to the 6 y ears wait at present.

Allowing kidney s to be purchased for transplant use would reduce the ty pical wait for a kidney to no more than a few months, and would eliminate all the deaths because of the time consuming queue to get a kidney . Since in the US and many other countries, gov ernments largely finance transplants, access to transplants under a sy stem when they can be purchased would not greatly depend on a persons income. In light of these considerations, I do not understand how any one who is knowledgeable of the great cost imposed by the present sy stem on the many indiv iduals who need kidney s could oppose allowing kidney s to be purchased and sold, ev en after taking full account of repugnance and the other alleged costs of allowing a market in kidney s (for a more detailed discussion of allowing a market in organs, see Becker and Elias, The Journal of Economic Perspectiv es, Summer 2007 , pp 3-24, and my blog post on organ transplants on 1 /01 /06) .

I briefly discuss two other controv ersial ex amples. Traffic congestion is a big problem in most cities in the world, such as Beijing, Los Angeles, and Mex ico City . Traffic congestion imposes major costs on driv ers since it often greatly increases the time to go from one destination to another. Again, as with the transplant market, time spent in traffic is an inefficient price since it wastes the time of driv ers without prov iding benefits to any one else. Indeed, it harms others because the driv ing time of other driv ers is increased when someone decides to driv e during congested times.

One alternativ e to traffic jams is to place a charge on using roads and highway s during congested time periods, as the city of London does by pricing admission to the central business district during prime week day times. This "congestion price" would reduce driv ing times by encouraging some people to shift their driv ing to less congested times, to use carpools, to take slower and more indirect routes to their destinations, or to reduce their driv ing.

Of course, people who place higher v alues on their time would be more likely to pay congestion fees and continue to use the main roads. Since richer indiv iduals tend to hav e high v alues of time, poorer persons would be more likely to shift their driv ing patterns. Howev er, a better way to help lower income driv ers than by using congestion is to use the rev enue collected from congestion tolls to help poorer indiv iduals, such as by improv ing roads in poorer neighborhoods. Congestion is too inefficient a method to ration road use and help driv ers who place less v alue on their time.

My final ex ample deals with the v oluntary army that uses pay instead of a forcible draft to get a sufficient number of men and women to serv e in the armed forces. Most readers are too y oung to remember the opposition to eliminating the draft in the US prior to conv erting to a fully v oluntary armed force in 1 97 3. It was then claimed, among other things, that a v oluntary army would be mercenary and reduce patriotism, that only the poor and minorities would enlist, that a v oluntary army would not fight well in difficult wars, and so on.

The ev idence from the past almost 30 y ears in the US and from other countries that use a v oluntary army is just the opposite; namely that a v oluntary army is v ery professional and fights hard under difficult
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circumstances (think of Afghanistan and Iraq), that many y oung men and women from middle class families, and ev en upper class families, do v olunteer, and that instead of ex ploiting minorities it prov ides some of the best opportunities for their adv ancement (Colin Powell is just one prominent ex ample).

I hav e not attempted to draw a sharp line between where prices and markets should be used and where they should not be. Nor do I deny that for some activ ities the cost of using money prices would ex ceed the gains. I do believ e, howev er, that in the US and other economies, the bigger problem is not ex cessiv e use of prices and markets but insufficient use. The ex amples I discuss illustrate the reasoning behind this conclusion. Posted at 07 :26 PM | Permalink | Comments (3) Reblog (0) | |
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Sale of Body PartsPosner

I agree with Becker that a market in kidney s should be permitted. The repugnance that the idea of selling body parts engenders in many people seems to me to hav e no rational basis; it would be otherwise if one were talking about the sale of ones ey es, heart, etc. The only function of a second kidney is as a spare. A person who loses a kidney does not ex perience a loss of health as a result. What is true is that if y ou sell a kidney , y ou hav e no back up. It is sometimes suggested that the problem be solv ed by a rule prov iding that a donor seller of a kidney goes to the head of the queue for a kidney transplant if his remaining kidney starts to fail and if necessary he is giv en the new kidney free of charge. But such a rule would be unnecessary , as Ill point out. The present sy stem, much like the ban (frequently ev aded though it is) on buy ing a baby for adoption (that is, of compensating the mother for giv ing up her birth child for adoption), has created a serious shortage of kidney s for transplantation. As a result of this shortgage, the av erage waiting time for a kidney transplant is six y ears in the United States, during which time the prospectiv e recipient of the transplant is likely to be on dialy sis. Dialy sis usually takes at least 1 2 hours a week, and the death rate of dialy sis patients is high. If kidney s were salable, the waiting time for a transplant would drop precipitately , probably to zero (which is why its unnecessary to guarantee a donor that hell go to the head of the queue if his remaining kidney failsthere will be no queue), because demand is fix ed at the number of people who hav e adv anced kidney disease, while the supply would be highly elastic since many of the worlds poor, who are in the billions, would regard giv ing up a spare kidney as a low-cost way of earning some badly needed money . The market would be worldwide because the cost of shipping kidney s long distances is negligible. (Kidney s from cadav ers would hav e to be harv ested quickly , but I dont think cadav ers would continue to be a major source of kidney s for transplanation, as they are now.) The U.S. demand would be small; there are fewer than 20,000 kidney transplants per y ear in the United States, although there would be more if there were a market in them, because there would be fewer deaths of people awaiting transplants and hence more transplant candidates. I imagine that the equilibrium price of a kidney would be low, and the ov erall cost of treating kidney disease lower than today because there be so much less dialy sis. Hence mov ing to a market would not increase ov erall U.S. health costs, and would in fact reduce them. Moreov er, there would be attractiv e incomeredistributiv e effects. The market solution would cause a modest shift of income from phy sicians and other personnel of dialy sis centers to poor people, assuming realistically that the poor would be the principal sellers of kidney s.

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The financial collapse of 2008 and the ensuing economic depression that the United States is slowly crawling out of hav e created some second thoughts about the nations commitment to free markets. But there is an important distinction between the fallacy (associated particularly with Alan Greenspan) that markets are self-regulating and a general skepticism about the efficiency of markets. Markets are self-regulating only in the Darwinian sense; competition weeds out losers, but the winners may be imposing heav y costs on society that they do not bear (pollution, for ex ample, or the kind of macroeconomic damage that the highly competitiv e financial sector has caused because of its competition-driv en risk taking). A market in kidney s would hav e to be regulated, but the regulatory challenge would be slight, giv en all the ex perience we hav e in the regulation of phy sicians, hospitals, drugs, medical dev ices, and surgical and other medical procedures.

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Luck, Wealth, and Implications for Policy--Posner

Liberals and conserv ativ es tend to disagree about the role of luck in financial success, the former thinking it play s a v ery big role, the latter thinking it play s a small role: that instead financial success is largely attributable to talent and hard work. Taken to its ex treme, the second position is the one that was espoused by the radical libertarian Ay n Rand. The economic significance of the disagreement has mainly to do with tax ation. Tax ing success that is attributable to pure luck does not hav e disincentiv e effects, and so is a cheap away of financing gov ernment. Tax ing success that is attributable to hard work may induce a substitution toward leisure, reducing money incomes, and tax ing financial success attributable to talent may induce some talented people to substitute activ ities that generate substantial nonpecuniary income (apart from leisure), which may not be socially as productiv e as business. Bey ond the economic concern, howev er, is an ethical one that is particularly acute in a society , such as ours has become, in which there is great inequality of income and wealth. I dont find any merit to the celebration of the ty coon by Ay n Rand and her followers. I think that ultimately ev ery thing is attributable to luck, good or bad. Not just the obv ious things, like IQ, genes that predipose to health or sickliness, the historical era and the country in which one is born, the wealth of ones parents, whom one happens to meet at critical stages of ones life and career, ones height and looks and temperament, to the ex tent genetic, and ones innate propensity to risk or caution (that is an ex ceptionally important factor); but also the characteristics that cause a person to make critical decisions that may turn out well or badly , characteristics that really are deriv ativ e from some of the prev iously noted luck characteristics. The decision-determining characteristics include intelligence, imagination, attitude toward risk, and personality characteristics such as aggressiv eness, maladjustment, indolence, and hav ing a low or high personal discount rate (how future-regarding one is or is not). Talent is luck but so is the propensity for working hard (often the consequence of a compulsiv e personality ) or not working hard.
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In short, I do not believ e in free will. I think that ev ery thing that a person does is caused by something. It is true, and is the basis of belief in free will, that often we are conscious of considering pros and cons in deciding on a course of action; we are deciding, rather than hav ing the decision made by something outside us. But calculation and decisionmaking are different. Deciding may just mean calculating the balance of utility and disutility ; the result of the balance determines the decision. No doubt when a cat pounces on a mouse, it has decided to do so; but the decision was compelled by circumstancesthe feline diet, the presence of the mouse, etc. A complete description of the incident would not require positing free will. If this is right, a brilliant wealthy person like Bill Gates is not entitled to his wealth in some moral, Ay n Randian sense. But it would be ridiculous to infer from this that the gov ernment should take his wealth away from him and scatter it among the poor, on the theory that the only difference between Gates and a poor person is that one is lucky and the other is not. But the reason that it would be ridiculous is that it would hav e terrible incentiv e effects, not that it would v iolate some deep sense of human freedom. The effects of heav y tax ation of wealth may depend in part on the kind of luck that generated the wealth that is now to be taken away and giv en to someone else. There may be different effects from tax ing wealth that results primarily from personal qualities, such as IQ and ambition, and tax ing wealth that is unrelated to such qualitiesinherited wealth, for ex ample, or wealth obtained by winning a lottery , or, a subtler and more important ex ample, wealth resulting from financial risk taking unguided by real insight (or, it hardly needs noting, from antisocial activ ities such as crime). Heav y tax ation of earned wealth is likely to induce many able and energetic people to increase their leisure activ ities relativ e to productiv e workbut to induce other such people to increase their work effort relativ e to leisure in order to preserv e or augment their wealth in the face of the heav y tax ation. Heav y tax ation of unearned wealth is more likely to hav e the second than the first effect, because, lacking talent, such people will have to work hard (to work, periodmay be they were liv ing off their inherited or otherwise bestowed wealth and not working at all) in order to maintain a decent standard of liv ing, lacking as they do the talent of the wealthy people who earned their wealth rather than hav ing it fall into their laps. I mentioned financial risk taking. Because of the uncertainty (in the Knight-Key nes sensethat is, a probability that cannot be quantified) of speculation, speculativ e profits, as by trading stocks and bonds, are mainly the result of dumb luck rather than of skill or hard work. In fact many speculators work hard, but the number who are consistently successful seems little if any greater than one would ex pect as a result of mere luck. Speculativ e profits tend to soar in rapidly rising markets and collapse when markets sour. Market turns are hard to spot and fluctuations in the prices of particular stocks are difficult to predict because, as Key nes famously pointed out, when y ou are speculating on stock prices y ou are speculating not merely about the fortunes of the company that issued the stock but about how other speculators assess those fortunes and indeed how they assess y our assessments. Although speculation tends to generate information about underly ing v alues and to that ex tent is socially productiv e, the benefits of that information bear no relation to the profits and losses that speculation generates. Those are gamblers profits and losses and tax ing the profits heav ily would probably hav e only a small negativ e effect on the generation of socially v aluable
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information. So there is in my v iew nothing unfair about heav y tax ation of wealth, but there are practical objections. One is that the wealthy hav e sufficient political influence to pepper any new tax law with loopholes that will enable wealthy persons to minimize their tax liability . Another is that the additional tax money raised will be squandered on unproductiv e gov ernmental activ ities, including handouts that reduce recipients work incentiv es. This objection would disappear, howev er, if the proceeds of additional tax es on the wealthy were earmarked for reducing the federal deficit. There are complaints that already , though the max imum federal income rate is low (the top marginal rate is 35 percent, and for capital gains, div idends, and interest is only 1 5 percent), the v ery wealthy pay a v ery high proportion of total federal income tax , and almost half the adult population pay s no federal income tax at all, though it pay s federal pay roll tax es and state tax es. I cant see why any one should care that the wealthy pay a disproportionate share of federal income tax , unless there is ev idence (of which Im unaware) that tax ing the wealthy at ev en lower rates than they are being tax ed would elicit greater productiv e effort. Indeed, I dont ev en know what disproportionate should mean in this contex t. Would it be disproportionate to require the highest-earning 1 percent of the population to pay 1 .5 percent of total federal income tax ? Federal tax law is riddled with deductions and ex emptions that are loopholes in the sense that they hav e no social product. An ex ample is the mortgage-interest deduction, which incentiv izes people to own rather than rent their homesand why encourage home ownership? Another ex ample is the ex emption of employ er-paid employ ee health benefits from federal income tax , which encourages ex cessiv e ex penditures on health care. Some tax es, such as the corporate income tax , cause distortions, as does treating div idends and interest differently by allowing interest but not div idends to be deductible by corporations. Reform of the tax code would be preferable to raising tax es on any one, but the major loopholes and deductions and ex emptions are sacred cows, leav ing changes in tax rates and spending lev els as the only feasible methods of achiev ing fiscal discipline. Posted at 05:58 PM | Permalink | Comments (21 ) Reblog (0) | |
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Luck and Taxation-Becker

I do not believ e that differences in v alue judgments are the main source of the disagreement among economists ov er how much to tax indiv idual with different lev els of wealth and income. These v alue judgments include beliefs about how much of high incomes are due to good luck, whether high-income indiv iduals deserv e their incomes, or whether there is free will. Such considerations, howev er, may be more important among the general public since, for ex ample, they may not want to tax heav ily a Stev e Jobs or Brad Pitt because they admire these (and some other) successful indiv iduals and their accomplishments. For economists, differences in v iews on what the tax structure should be and on other policies mainly come down to different beliefs about how tax es and other policies affect behav ior. For ex ample, economists who support much greater tax es on higher income indiv iduals believ e that higher tax es will not much affect how hard these indiv iduals work, their propensity to start businesses, or other kinds of behav ior. On the other
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hand, other economists, including me, believ e that high marginal tax rates not only discourage effort and other choices by those being tax ed, but also affect the form in which they take their incomes. These adjustments include increases in non-tax able perquisites, such as greater use of a company s plane, hiring ex pensiv e accountants and lawy ers to search for loopholes in the tax code, conv erting income into capital gains when these gains are tax ed at lower rates, and inv esting abroad if the income earned there is tax ed at lower rates. Unfortunately , the empirical ev idence accumulated so far does not conclusiv ely support either approach. That is, it is unclear how large is the effect of higher income tax es on the behav ior of richer indiv iduals. The relev ant ev idence is growing, but so far different perceptions of these effects prev ent the resolution of the sharp differences in opinions among ev en a-political economists on the damage done by high marginal income tax rates. The important point for our discussion is that beliefs about the importance of good or bad luck in determining high or low incomes is not usually the decisiv e source of differences in attitudes about tax rates and other public policies. For ex ample, one may correctly believ e that luck has a major role in determining the genes, education, and other opportunities of highly successful indiv iduals, and y et believ e as well that high tax rates on their income and wealth would induce major changes in their behav ior. Conv ersely , one can believ e that luck is unimportant in determining success, and at the same time believ e that high tax rates on rich indiv iduals would little affect their behav ior. And, of course, v arious other combinations are possible about the relation between the role of luck in achiev ement and induced responses to tax es and other policies. A well-known illustration of the link between luck and behav ior is the adv ocacy of a single tax on unimprov ed land proposed in the 1 9th century by the American economist Henry George. His argument was that the intrinsic quality of land was entirely due to the luck of its location with respect to soil, rainfall, sunshine, and other relev ant determinants of land productiv ity . This led George to argue that tax ing heav ily the higher v alue of unimprov ed better land would raise considerable rev enue, and y et cause no harm since the v alue of unimprov ed land is determined entirely by its good luck in location. Critics of this single tax proposal responded that while George deid not want to tax the v alue due to heav y use of fertilizers, machinery , and other agricultural inv estments, in practice it is impossible to separate accurately the unimprov ed v alue from the total v alue. As a result, some of the inv estments in land would also be tax ed. These agricultural inv estments would surely be affected by tax es on land, ev en though the location of land with regard to sunshine, soil, etc. is entirely a matter of luck. My conclusion is that ev en though luck play s a huge role in determining genes, family , education, and other determinants of success or failure, this does not imply v ery much about the desirable tax rates and other public policies. Posted at 05:1 7 PM | Permalink | Comments (3) Reblog (0) | | 1 0/07 /201 2
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Will Long-Term Growth Slow Down? Becker

Sustained long-term economic growth beginning in the near future would help greatly toward ov ercoming two major problems confronting the United States (and Europe and Japan). One is the high ratio of gov ernment debt to GDP that resulted from budget deficits due to the rapid increase in gov ernment spending during the past sev eral y ears. GDP that continues to grow faster than outstanding debt is the surest way to reduce the burden of the debt. Sustained long-term growth would also allay the fears of many parents that their children would not be any better off than they are. Improv ements in productiv ity due in large measure to new technologies hav e been the major source of longterm economic growth in per capita incomes. From 1 880 or so to the beginning of the financial crisis, American productiv ity adv anced on av erage at a rate of a little less than 2% per y ear. This helped, along with capital accumulation, to produce a long-term growth in American per capita incomes of about 2% per y ear.
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Since growth continued at such a steady rate for such a long time, one might reasonably ex pect that the US would resume growing at a similar rate once it gets bey ond the effects of the financial crisis and the Great Recession. Howev er, a recent study by Robert Gordon of Northwestern, one of the leading ex perts on productiv ity , puts a damper on these ex pectations (see his Is U.S. Economic Growth Ov er? Faltering Innov ation Confronts the Six Headwinds, NBER working paper 1 831 5, August 201 2). Gordon argues that adv ances in productiv ity were slowing ev en before the financial crisis hit because the innov ations of the past sev eral decades, including computers and the Internet, were less important than those at the end of the 1 9th century and beginning of the 20th century . He also argues that future growth in the U.S. is likely to be ev en slower than in recent decades because of six headwinds that he believ es will reduce growth. If Gordon is right, Americans face an unprecedented and dismal future of basically stagnating incomes. It is common during a long and deep recession or depression for economists and others to become pessimistic about the economic future. For ex ample, at the end of the Great Depression in 1 939, a leading American economist of that time, Alv in Hansen of Harv ard Univ ersity , argued that the U.S. and Europe were in for long-term (secular) stagnation, partly because he believ ed that technological progress would be much slower in the future. Of course, he turned out to be completely wrong. Howev er, Gordons forecasts abstract from the financial crisis and resulting recession, and he bases his pessimism on how the situation looked to him prior to the crisis. Gordon follows an established approach by div iding the past 200 y ears into periods of three Industrial Rev olutions. The initial one occurred during the last half of the 1 8th century and the first sev eral decades of the 1 9th century , with the steam engine and railroad being ex amples of the major new technologies from that rev olution. The second, and what he considers the most important, industrial rev olution occurred between 1 87 0 and 1 900. This rev olution gav e us, among other inv entions, electricity , the automobile, the airplane, and the small engine. The third rev olution started around 1 960, and encompasses computers, the Internet, and genomics and biotech. Gordons main reason for pessimism about future growth is the ev idence he presents that American labor productiv ity (measured by output per unit of labor input) adv anced much more slowly after 1 97 0 than it did between 1 890 and 1 97 0. He also points out that throughout most of history - that is, until the first industrial rev olution- annual growth in world per capita income was close to zero. Perhaps, according to Gordon, we should think of the 3 industrial rev olutions not as the norm for the future, but as temporary ex ceptions that will not be repeated in the future. Gordon makes a thoughtful case for his conclusion that future long-term growth for the U.S. will be much slower than past growth. Still, I do not find the case conv incing. While growth during the past two centuries was radically different from the slight annual growth during the prior two thousand y ears, the reason is not luck or accident, but in good part was due to the dev elopment of science, and especially to the application of science to industrial progress. Knowledge builds on knowledge, and the av ailable ev idence does not indicate that the accumulation of knowledge is subject to diminishing returns. This suggests that future knowledge could v ery well grow at a rate comparable to its growth during the past century and a half. Another difference between the past two centuries and prev ious history is the emergence of economies that relied on competition and priv ate enterprise. This was the economic sy stem in Great Britain when it led the world in productiv ity adv ances, and it describes the U.S. economy after it took ov er leadership from Britain. Adv ances in technology and productiv ity are likely to continue at a good rate if the U.S. and other leading countries continue to emphasize competition and the priv ate sector, and do not use gov ernments to try to determine future technology winners. I also believ e that Gordon underestimates the full impact of the third rev olution based on computers and other modern technologies. As he shows, the effects on productiv ity of the 2nd rev olution lasted for close to 1 00 y ears, while the 3rd rev olution has been going on for no more than about 50 y ears. It is ex tremely difficult ev en for the most informed indiv iduals to predict the long-run effects on productiv ity of new technologies. Gordon quotes someone working in 1 87 6 for Western Union, the major telegraph company ,
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who claimed, The telephone has too many shortcomings to be considered as a serious means of communication and Bill Gates who stated, 640 kiloby tes ought to be enough for any one. I will say little about the six headwinds that Gordon believ es will also slow down future growth since his arguments are not conv incing. To take a few of his headwinds, I believ e globalization will add to, not subtract from, U.S. growth and real per capita incomes, that the effects of hav ing fewer y oung persons working relativ e to the number of retired older persons will be partially ov ercome by considerable ex tensions of the ages at which workers ty pically retire, and that inequality will likely begin to decrease. Along with Gordon I am concerned about the effects of global warming on the economy , but I ex pect new technologies to go a long way toward solv ing that considerable problem, just as technological discov eries ov ercame many challenges in the past. I agree with Gordon that sizable future growth in per capita incomes in a leading economy like the American one will not come automatically just because past growth was considerable. Howev er, I do believ e that the div idends from the 3rd industrial rev olution are far from ex hausted, and that future growth can be robust giv en the right economic env ironment. What I mean by the right env ironment has sev eral components, but number 1 would be a continued reliance on competition and the priv ate sector as the principal way to organize the economy , and number 2 would be to improv e inv estments in education and other human capital. Posted at 09:59 PM | Permalink | Comments (3) Reblog (0) | |
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Will U.S. Economic Growth Slow? Posner

It is good to be reminded that the rate of economic growth is not constant, that it has v aried a good deal in the past, and that it may decline ov er the indefinite future, as feared by Robert Gordon in the study discussed critically by Becker. I agree with the criticisms, of which the central one is that the future is unpredictable, including not only the technological future but also the political future and the future of personal tastes and preferences. Moreov er, almost all prediction is ex trapolation from current conditions, so pessimism is characteristic of economic predictions made during a period of economic depression, such as the United States remains in. The material standard of liv ing of many Americans is v ery high; roughly 20 percent of American households hav e an annual income in ex cess of $1 00,000. At that lev el, desire for leisure (including early retirement), or for goods and serv ices that are labor-intensiv e, making productiv ity gains (from capital substitution) difficult to achiev e, may retard economic growth y et increase economic welfare. At the same time, growing inequality of income may reduce the demand for goods and serv ices in lower household-income quintiles, with negativ e effects on economic growth. Although it seems unlikely , one can at least imagine a situation in which growing inequality of income produces a rich upper crust satiated with material possessions and a v ast underclass unable to afford many such possessions, and this would be a pattern inimical to economic growth. For reasons ex plained by Key nes, consumption driv es the economy (by stimulating supply and hence employ ment, which in turn prov ides income for further consumption), and so if the desire for consumption flags, the economy would grow v ery slowly , or not at all, or would decline, unless gov ernment picked up the slack. Y et if the flagging of desire for consumption represented simply a satiation with material possessions and a resulting preference for leisure, economic welfare might actually increase rather than decrease. Europeans, judging from the av erage length of the work week in Europe relativ e to the United States, place a higher v alue on leisure than Americans, and may be we will grow more like Europeans, once our economy recov ers from its present doldrums. Of course we mustnt press the idea of material satiation too faras Key nes did in his 1 930 essay Economic
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Possibilities for Our Grandchildren. It predicts that barring another world war or some comparable tragedy , a century hence per capita income would be four to eight times greater because of continued capital inv estment. So far, so good; despite another world war, GDP per capita in the United States has increased almost six -fold since 1 930 (and Britains per capita income about the same), and we still hav e 1 8 y ears to go before the century is up. Key nes thought the increase in per capita production would lead to a dramatic fall in the hours of work; by 2030 a person would hav e to work only 1 5 hours a week to maintain his standard of liv ing. The economic problem would hav e been solv ed and the challenge would be to fill up peoples leisure time with rewarding leisure activ ities. Unlikely ! People in wealthy countries like the United States and Britain are working fewer hours per week on av erage than in 1 930: roughly 40 rather than 50. But Key nes thought that by 201 0 the av erage would be 20. Material satiation is not in the offing, but there is no iron law of economics that the work week shall not fall below 40 hours; increased substitution of leisure for work may continue as incomes continue to rise. Probably economic growth is not something to worry about, but rather concern should focus on correcting inefficient practices, such as reluctance to allow the immigration of highly qualified scientists and engineers because of the competition they would offer to our citizens in technical careers; or nepotism in higher education; or neglect of infrastructure; or ex cessiv e criminalization; or our screwed-up tax sy stemthe list goes on and on. Correcting inefficiencies will enable more rapid economic growthor less, if peoples preferences are for goods, serv ices, or activ ities (or inactiv ity ) in which productiv ity is difficult or impossible to increase. Economic growth should be thought of not as a goal, but as a by product of an efficient economy ; the focus of policy should be on means rather than ends. Posted at 09:36 PM | Permalink | Comments (3) Reblog (0) | |
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