MAKING SENSE -- November 18, 2011 at 6:03 PM ET
Liberal Economist Frank: Congress Will Be Guilty of 'Gross Political Malpractice'
"Bob Frank and P.J. O'Rourke AGREE," Paul Solman tweeted recently, referring to the political differences of liberal economist Frank and conservative satirist O'Rourke. "Build the damn bridges. Now."
Frank and O'Rourke recently partnered to author an opinion piece on the need for liberals and conservatives to (quite literally) bridge their ideological divide and get the ball rolling on infrastructure projects.
"I'm utterly frustrated for what passes as discourse in this country," Frank said at a talk in Washington, D.C., in late October. "That the two of us would come together to write this, that's how stupid the political conversation has become."
The pair write:
"But political realists, no matter how conservative, know that if economic stagnation and severe unemployment persist, more stimulus will be tried. Politicians, whether Democrats or Republicans, are willing to be called almost anything except helpless. The attempted stimulation might come from lower taxes or higher outlays or both, but come it will."
"We're headed for an economic train wreck in this country from the current dialogue," Frank said. "But there are huge opportunities available to us to attenuate conflicts."
One of those opportunities Frank argues is a revamped tax system -- one that takes the complexity out of figuring out what one's taxable income is, while applying a progressive consumption structure and taxing companies commensurate with harmful activities, among other things. Taxes are one focus in his new book, "The Darwin Economy."
"You have to tax something," Frank said. "No adult argues that. So tax harmful activities. That's the message I get from Darwin.
At right, Frank and Solman discuss Darwin as the father of economics at a Darwin exhibit in a Georgia museum.
We delve deeper into Darwin's possible fatherhood of modern economics Friday night on the NewsHour broadcast. Given the smattering of tax proposals from GOP presidential hopefuls and that Republican legislators are now saying they're considering raising taxes to thwart a similar situation to the European debt crisis from playing out in the U.S., we thought we'd dig a bit deeper with Frank into the idea of Darwinian taxes:
How do taxes and Darwin relate?
Frank: One of my primary targets in the book is the uncritically enthusiastic boosters of Adam Smith's invisible hand theory, which in their view says that if we turn greedy individuals loose in unfettered markets, they will be led as if by an invisible hand to produce the greatest good for all. As the great naturalist Charles Darwin saw clearly, individual and collective interests often coincide, as in the invisible hand narrative. But he also saw that in many other cases, interests at the two levels are squarely in conflict, and that in those cases, individual interests generally trump. That simple observation suggests that market failure is often the result not of insufficient competition (the traditional charge from social critics on the Left), but of the very logic of competition itself. Commercial roadways in communities that lack zoning laws, for example, are often an aesthetic nightmare not because of insufficient competition, and not because merchants are stupid or lack taste. Rather, the problem is that any individual merchant's sign won't be noticed unless it's bigger and more garish than those of rival merchants.
My policy recommendations in the book rest on the idea that the most efficient and least intrusive way to mitigate conflicts between individual and group interests is to tax individual actions that cause undue harm to others rather than try to regulate them directly.
You've talked about using the tax system to regulate harmful environmental practices, such as a company's sulfur dioxide emissions. Is this an example of what you have in mind?
My preference for taxation over prescriptive regulation was heavily shaped by our early experiences with attempts to regulate environmental pollution such as SO2 emissions. Prescriptive regulations, such as telling electric utilities what kinds of coal to burn or what kinds of scrubbers to install on their smokestacks, were not only intrusive, they were also grossly inefficient. When I first came to Cornell in the 1970s, there were articles about acid rain in The New York Times almost every day. But we no longer hear anything about acid rain. The reason is that amendments to the Clean Air Act in 1990 established a system whereby firms could no longer discharge SO2 into the air for free. Those amendments required that for each ton discharged, firms needed to have a permit, which could be bought or sold in a secondary market. Once firms had to pay to pollute, they became incredibly inventive at figuring out cheaper ways to eliminate their SO2 emissions. In almost every instance, air and water quality goals were met more cheaply and quickly when we taxed pollution than when we tried to regulate it directly.
The same logic applies to other behavior that causes harm to others. If you buy a 7,500-pound passenger vehicle, for example, you put other motorists and pedestrians at significantly higher risk of injury and death. But the solution is not to ban the purchase of such vehicles. Some people have legitimate goals that can only be accomplished with one, such as towing a large boat or trailer. But others might get by almost as well with a 3,000-pound station wagon. Under current arrangements, neither has any incentive to weigh the risk that the heavier vehicle would create for others. But if we taxed vehicles by weight, all would have a clear incentive to take that risk into account when deciding which one to buy. Those who could get by almost as well with a lighter vehicle would buy it to escape the tax, while those for whom a heavier vehicle was significantly more valuable would pay the tax and buy it.
We've been reporting a series of stories on economic inequality in the U.S. What issues of disparity do you worry about most?
Frank: In "The Darwin Economy," I argue that the notorious middle-class squeeze has been largely the result of changes in spending patterns that have been caused by rising income inequality. For the three decades after World War II, incomes grew rapidly and at about the same rate for families at all income levels. In the decades since then, however, virtually all income gains have accrued to top earners. Earnings growth at the very top has been truly spectacular. For example, CEOs of the largest U.S. companies now earn more than 400 times as much as the average worker, up from a multiple of 42 in 1980. During that same time span, the median real hourly earnings of men actually fell.
Growing income disparities spawned a process that I've elsewhere called expenditure cascades. The first step is that top earners have been building bigger mansions, staging more lavish celebrations, and in general spending more in every category. That's not an indictment of them. Every group spends more when its income grows. There's no indication that middle-income families feel resentful about the bigger mansions and yachts. But the near-rich, whose social circles intersect those of the rich, are subtly influenced by them. Perhaps they, too, feel their houses must now have ballrooms, since it's become the custom to hold their daughters' wedding receptions at home rather than in a hotel or club. So they build bigger as well, and that shifts the frame of reference for others below them, and so on, all the way down the income ladder.
There's no other way to explain why the median new house built in the U.S. in 2007 had more than 2,300 square feet, almost 50 percent more than its counterpart in 1980. Certainly, it's not because the median earners are now awash in cash.
Virtually all families in the middle of the earnings distribution aspire to send their children to a school of at least average quality. (We'd think ill of any parent whose aspirations were lower.) The rub is that the best schools tend to be located in more expensive neighborhoods. In the US, that's partly because school budgets are often funded by local property taxes. But because of peer effects in the classroom, it's also true in countries in which school budgets are everywhere identical. The upshot is that to send its children to a school of even average quality, a family must outbid half of other similar families who are pursuing the same goal. And that's become dramatically more expensive because of the growth in median house size, which was in turn caused by higher spending at the top.
Similar expenditure cascades have occurred with celebrations to mark special occasions. When a CEO spent $10 million to stage a coming-of-age party for his daughter in New York City a few years ago, he probably had no attention to harm others. But by staging such a lavish party, he raised the bar that defines how much others must spend to mark similar occasions. There's no other way to understand why the average American wedding now costs more than $28,000, almost three times as much in real terms as its counterpart in 1980.
These changes are problematic because they confront middle-income families with a painful dilemma. They can match what their income peers spend on housing and celebrations; or they can spend only the lesser amounts on those items that they can comfortably afford. If they choose the former option, they must go into debt and risk bankruptcy. But if they choose the latter, they must send their children to inferior schools or court the impression that they failed to understand the importance of the social milestone they were celebrating.
Without ever intending to, then, top earners have harmed others by spending in ways that force them to choose between such options.
You're a proponent of a progressive consumption tax. What's that, and how does it differ from a flat tax?
Frank: A flat tax is roughly the same as a sales tax. Unlike the current progressive income tax, which imposes a higher tax rate on the next dollar you earn as your income rises, a flat tax levies a single rate on every dollar earned. In contrast, a progressive consumption tax is simply a progressive income tax with an unlimited savings exemption. You'd report your income to the IRS as before, but you'd also report your savings, much as you would for an IRA or a 401(k). The difference between those two numbers -- your income minus your savings -- is the amount you spent during the year. That amount less a large standard exemption -- say, $30,000 for a family of four -- is your taxable consumption. Rates on taxable consumption would start very low, so for families in the bottom half of the spending distribution, total tax bills would be as small as or smaller than those under the current system. But rates would rise steeply as taxable consumption rises. That would not discourage savings and investment, as higher marginal income tax rates are often said to do. On the contrary, higher marginal consumption tax rates would actually encourage savings and investment.
How is a progressive consumption tax like the effluent taxes you describe, and how would it discourage spending that causes harm to others?
Frank: Just as an effluent tax discourages the discharge of harmful pollutants, a progressive consumption tax would mitigate expenditure cascades that cause harm to middle-income families. Consider, for example, how the tax would affect a wealthy family that was weighing whether to build a $2 million addition onto its mansion. If the marginal consumption tax rate at the highest levels was 100 percent (meaning that if the biggest spenders spent another $2 million, they'd also have to pay another $2 million in taxes), the family would have a strong motive to scale back its addition. That simple fact reveals the fiscal alchemy implicit in this form of tax: If this family and others like it all built additions only half as big as they'd planned, the smaller additions would serve them just as well as the larger ones would have. Beyond some point, after all, it's relative, not absolute, mansion size that matters. And when they spend less, others just below them would spend less, and so on all the way down.
But wouldn't such consumption reductions be bad for the health of the economy?
With the economy still in the midst of the deepest downturn since the Great Depression, now would be a terrible moment to impose a progressive consumption tax. But if we passed the tax into law now and scheduled it for gradual phase-in once the economy recovered, we could kill three birds with one stone. First, by committing ourselves to a measure that would increase revenue in the long run, we would reassure those who rightly fear that endless additions to the federal debt are unsustainable. Second, by phasing the new tax in gradually, we would gradually shift the composition of total spending toward investment and away from consumption. Such a shift would cause no change in total spending at first, so employment levels would not be threatened. But in the long run, greater investment would mean greater productivity and income growth. Finally, the announcement that the tax was coming would stimulate families who were thinking of building additions to their mansions at some future point to accelerate their projects, thereby to escape the tax. We'd get hundreds of billions of dollars of desperately needed economic stimulus right away, without the government having to spend an extra nickel.
You've said the tax code should be simplified, including how folks determine what their taxable income is. What is your proposal?
Frank: The current tax system is not complex because it has multiple income brackets, each with a different rate. It's complex because of the myriad deductions, exemptions, and other loopholes in the 3.4-million word IRS code that must be factored in when computing your taxable income. Once you've computed that number, you just look up how much you owe in the tax tables. To simplify the tax code, we must thus do away with many of these deductions, exemptions, and loopholes. Consider the mortgage interest deduction, whose effect is to give taxpayers an incentive to build larger, more expensive houses. Unless you think the main problem confronting the American economy is that our houses are too small, there's no reason the tax system should provide a costly incentive like that.
Do you think it's wise, or even possible, to change the tax code in the current economic and political conditions?
Frank: Wise? Yes. Possible? No. With the six Republican members of the Congressional supercommittee having signed a pledge never to approve any new tax under any circumstances, there's virtually no chance that the change I recommend will be adopted by the current Congress. Their having signed that pledge, of course, means that balancing the budget will be impossible. No one who understands the numbers believes that balance can be achieved in the absence of additional revenue. An economic trainwreck looms.
How viable in your opinion are some of the tax plans floated by various GOP presidential candidates, such as Herman Cain's 9-9-9 plan, Rick Perry's flat-tax proposal and Mitt Romney's 59-point plan that would include lowering the corporate tax rate and eliminating the estate tax?
Frank: These flat-tax proposals surface reliably every campaign season, then just as reliably, sink without a trace. They're generally sold as a change that would enable taxpayers to file their returns on a postcard. But they'd do nothing of the sort. The complexity of the current system, as noted, results from the difficulty of computing taxable income, which you'd also have to do under a flat tax.
A flat tax would also greatly exacerbate the growing income disparities we've seen in recent decades. The nonpartisan Tax Policy Center estimated that Herman Cain's 9-9-9 plan, for example, would reduce taxes on the top one-tenth of one percent of households by an average of almost $1.4 million, while raising the tax bill of the median household by more than $4,000. Other flat tax proposals have similar adverse distributional effects. That's why none of those plans will ever be adopted.
What's the single most important factor (or set of factors) that need to happen for the economy to sustainably strengthen?
Frank: We're in a classic demand-shortfall recession. The unemployment rate remains high because total spending remains too low to generate jobs for all who want them. Ever since the Great Depression, economists have known that demand shortages tend to persist in the wake of severe financial crises like the ones that happened in 1929 and 2008. Consumer spending won't increase because many people still have big debts to pay down, while others are fearful they may lose their jobs, if they haven't already lost them. Firms, for their part, won't invest much any time soon, because they already have the capacity to produce more than people want to buy.
The only other major actor in the economy with the capacity to remedy the spending shortfall is government. There is no shortage of genuinely urgent work to be done in the public sector. The American Society of Civil Engineers, for example, recently issued a report card on American infrastructure that identified $2.2 trillion of desperately needed repairs -- ranging from unsafe roads and bridges to failing water systems, dams and sewage systems. People who know how to do this work are currently unemployed. The required equipment is also largely idle. Materials are cheap in world markets. Interest rates are at record lows.
There is no debate about whether these projects need to be done at some point. Nor does anyone deny that if we wait, they will become far more costly. Doing them now would not only be cheaper, it would also put idle people and machines back to work. If we wait, we'll have to bid them away from other useful tasks. Doing the work now would produce an immediate boost in tax revenue. It would cause an immediate decline in social safety net payments. Multiplier effects would further boost spending and tax revenue. In short, tackling these projects right away is a no-brainer.
Yet misguided rhetoric about deficits has created political roadblocks that have rendered government completely paralyzed to act. Deficit reduction is important, yes. But that's not a reason to postpone these projects. Doing them right away will make long-run deficits smaller, not larger.
Future historians will describe the current Congress' failure to put people back to work by authorizing these projects as an act of gross political malpractice.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions. Follow Paul on Twitter. Image at top by Red Frog from the Vetta collection via Getty Images.