Modeled Behavior

Andrew Sullivan is smitten

A simplified tax code, consisting of a two-bracket income tax with a large standard deduction and a business consumption tax, would pay for a means-tested safety net, and a system of tax credits, risk pools and low-income subsidies would underwrite a free (or, well, somewhat freer) market in health care. In other words, Ryan would balance our books by shifting away from programs that shuffle money around within the middle and upper-middle classes — taking tax dollars with one hand and giving health-insurance deductions, college-tuition credits, home-mortgage deductions, Social Security checks and so forth with the other — and toward programs that tax the majority of Americans to fund means-tested support for the old, the sick, and the poor.

Paul Ryan is my new hero.

There is a lot about Ryan’s proposals to like: incentive based, progressive and in the long run, cost containing. Yglesias and Klein have focused on some of the downsides from a liberal perspective.

There is a potentially large libertarian downside as well: the  creation of extremely high marginal tax rates at low income levels. Ryan suggests that we means test everything. From the point of view of a household though, means testing is no different from marginal taxation. Every extra dollar you earn reduces the amount of government benefits you receive and so the return from working or investing is muted.

Means-testing can be particularly sinister because the tax rate is not obvious. The result is that effective marginal tax rates could climb to 100% or more. I tend to think that the elasticity of labor supply is pretty low and so the effects of marginal taxation can be easily exaggerated. Still, marginal rates approaching 100% are going to have serious incentive effects.

In addition, even more reasonable but very high marginal tax rates can have strong disincentive effects for the poor. High enough effective marginal tax rates and entering the underground economy becomes profitable, investing in education becomes unprofitable, etc.

Mechanically, means-testing lots of credits is little different than giving everyone the credit and then paying for it with high income tax rates. In some ways explicitly high tax rates are preferable because they are transparent.

Further still, there is not much difference between a tax credit and a voucher system. There can be technical details between means tested credits, universal credits funded by marginal taxation, and universal vouchers funded by marginal taxation but the basic incentive effects are all the same.

Under a Ryanesque approach the accounting will show that government spending is smaller and taxes are smaller. Under a universal voucher approach the accounting will show that government spending is huge and taxes are huge. But the basic economic effects are exactly the same. We should not get lost in the accounting and think that we have done something special because we get different numbers for “taxes” and “spending.”  What matters is the effect government has on the economy.

The New York Times is reporting that Wall Street is sending more cash to the GOP this year than Democrats. It seems that at least one branch of the East Coast Elite is having second thoughts. Perhaps Nancy Pelosi should send them a gentle reminder on the 2008 TARP vote.

Pretty quickly, it seems. According to a new study, schools spent 38% of their stimulus money in the ‘08-’09 school year, 48% this year, and have 14% left over for next year. From a Keynesian perspective, that seems like a pretty decent pace to spend $100 billion. Some states, in fact, managed to spend 100% of their education stimulus money “immediately”. Even better, some of the money that was tied to reforms, like the $4.3 billion Race to the Top program, will probably pay many future dividends as well.

The downside of spending the money so quickly is many states and districts are once again facing a budget crunch, this time without stimulus money to bail them out. If there’s going to be another stimulus bill- oh wait, I’m sorry, that’s “jobs bill”- then it seems like education money tied to reforms could provide good short-term and long-term returns.  How about instead of $4.3 billion out of $100 billion conditional on reforms, the next round could be 100% conditional on reforms. What kind of reforms could $3 billion per state buy?

Over at The Atlantic Business Channel, Daniel Indiviglio tells Virginia Postrel that just because marginal costs of producing e-books is close to zero does not mean that the price should be close to zero. He correctly points out that price only equals marginal cost when markets are perfectly competitive, and the book market is not perfectly competitive. But Postrel didn’t claim price should equal marginal cost, which you can see in her discussion of the importance of demand:

The other side of the equation is consumer response: How many more copies will people buy if the price goes down? Or, in economic lingo, what is the price elasticity of demand?

Her point is that since price elasticity is large the price should be closer to the marginal cost, because you sell a lot more books by lowering the price. What Inviglio seems to miss is that if Postrel thought that the market were perfectly competitive, she wouldn’t be discussing the price elasticity of demand, since in perfectly competitive markets producers are price takers, i.e. the price is set by the market, which means that from the book sellers perspective the price elasticity of demand would in fact be infinite.

Inviglio’s point about price not being equal to marginal cost is an important one to remember though. Even if books could be made at a no cost, the authors would write them for the publishers for free, and there were no uncertainty about which books would be popular,  the price of books would not equal zero.

From Arnold Kling:

Take a look at the top ten countries in the economic freedom index. Then look at the top ten countries by population. The United States is the only country in both lists, and at the rate things are going we will not be in the top ten in terms of economic freedom much longer.

My reading is that there are serious diseconomies of scale in governance. The larger the polity, the worse the ability to govern.

What do the citizens of the state of Massachusetts gain by being a part of the United States? My guess is that the sovereign nation of Massachusetts would greatly outperform the U.S. in policy and economic growth.

In previous post on the efficient market hypothesis, I sympathized with Scott Sumner’s overly demanding definition of identifying a bubble, because his definition prevents people from taking credit for spotting a bubble an implausible number of years before it popped. The example I gave was Dean Baker, who I recalled as predicting the current housing bubble in 1948. Dean corrected me in the comments, reminding me that it was in fact 2002 when he “called” the bubble, and he links to the paper where made the call.

I strongly suggest that anyone who harbors a notion that Dean called the bubble read his paper, from August of 2002, and consider whether he was calling the housing bubble that popped in 2006, or whether he was calling a housing bubble that hadn’t begun in any appreciable way.

Why don’t I think Dean actually called the bubble? First, in his paper Dean specifically refers to the period of time before we can expect prices to fall as “months”. In his conclusion, he sums up his predictions like this:

..it is likely that the HPI will follow the rent index in the months ahead, first showing considerably slower growth. In later months, it is likely that that the HPI will fall in real terms, and possibly in nominal terms, until it is back near its pre-bubble position relative to the rent index.

He is referring here to slower growth in the “months ahead” and a fall in the house price index in “later months”. In fact, house prices didn’t peak until the second quarter of 2006, four years or 48 months after Dean wrote this paper. From his choice of words here he makes it pretty clear that he did not have anything like that in mind.

Another problem is that national house prices are still above where they were when Dean spotted a “bubble”. According to the most recent Case-Shiller house price indices, the U.S. national house price average is now where it was in late 2003, a year after Dean claimed that house prices were going to fall 11% to 22%. Prices falling well below where they were when you cried bubble is a bare minimum requirement for calling a bubble. Dean has not met this very minimal requirement.

You might think prices are going to fall another 25% and prove Dean right, but prices would need to fall much more than that. If Dean was correct that there was an 11% to 22% bubble in 2002, then after the huge buildup in housing supply that occurred from 2002 to 2006, you’d expect the eventual fall in prices to bring us much lower than 11% to 22% below the 2002 price level. To put it simply, if I said “the supply of gold right now is too high to support the prices we are seeing, prices are going to fall 10% from here”, and then the supply of gold quadruples, prices need to fall more than 10% to prove me correct. This is even more true when you consider that the popping of a huge housing bubble is more destructive than the popping of a small housing bubble, so prices should be lower than Dean forecast due to a much larger destruction of wealth than he expected.

Dean’s a nice guy and all, but I think it really is inaccurate to characterize him as having called this bubble.