There is something of a debate about why people make more money in cities, and whether at the individual level it’s wisest to make more money in a higher-cost city or less money in a lower-cost city. Emily Badger has an excellent piece on economist Rebecca Diamond’s work on the growing educational/economic divide across American cities. Diamond found (unsurprisingly, if you’ve ever compared Boston and Detroit) that places with more college graduates are expensive, but tend to be nicer and to offer higher-paying jobs. In short, even after you account for the higher cost of living big, well-developed cities tend to come out ahead. That doesn’t surprise me, but this did – places with higher concentrations of college graduates tend to pay college graduates more!
This suggests that the urbanist case is actually right – that people are more productive in cities than rural areas. There are two countervailing forces that could act on the wages of highly-skilled workers in areas with many of them, greater supply and greater productivity. We should expect to see lower wages for college grads in cities with lots of them, and the fact that the opposite holds true suggests that there are in fact quite substantial productivity benefits gained by embedding in a local economy with more specialization and more opportunities to apply specialized skills.
Urbanization is a positive feedback loop of productivity. Urban workers produce more – while they have to pay more in housing costs, there is a positive net social benefit that increases the more people take up the opportunity. This is actually the opposite of a collective action problem, a situation where everyone is incentivized to take actions that make everyone else better off. Even better, this generates surplus income that can be taxed to make rural residents better-off, something the state does now through taxing income and spending on services/infrastructure in rural areas. The main thing standing in its way is structural constraint, namely the limited housing available in the densest and richest urban areas.
Arguably, by preventing development rich urban landholders are extracting rents from the rest of the country. Certainly from the rest of their states.
As a way to encourage private investment in clean energy research, the Department of Energy has extended loan guarantees to many private companies involved in renewable energy development. While conservatives seem to believe that they are all Solyndras, in fact the portfolio is doing remarkably well. And that’s a problem. As Michael Grunwald says, the whole point of this program is to bankroll promising technology that offers high rewards, but is too risky for the private sector to invest in. If almost all the loan recipients are paying it back, that means the government is not only not investing in promising-enough technologies, but is actually crowding out private investment in the sector.
The political economy of public-private research partnerships are less promising than they seem initially. They are justified as offering lower costs than direct government sponsorship by risk-sharing, which is hypothetically true. However, it carries with it the inherent risk of Goodhardt’s Law – when a measure becomes a target, it ceases to be a good measure. The key measurement here is default rate – the government can hypothetically monitor the riskiness of its program by monitoring the default rate and making adjustments accordingly. However, the default rate in a loan guarantee program is actually the only visible metric available, and it is a natural rule of organizations that you manage to what you can measure. Even without the political pressure applied, it seems like one would naturally expect these types of programs to be managed to generate maximum return of capital rather than maximum investment in promising technology.
There are better ways to structure public investment into research. The simplest is to fund public research, which has been used plenty successfully in the past. There’s no monetary recovery, but it’s also not set up in such a way as to encourage it – and if the money is well-directed, the social benefit can far outweigh the accounting cost. There are also tax incentives for R&D, which are a bit less well-directed towards basic innovation but can be relatively cheap. There are public innovation prizes, which are likely underutilized and are a generally neat solution. But none of these face the perverse incentives of public loan guarantees. They’re a clunky policy tool that emerge from the contradictory desire to keep the government out of something while still using policy to drive it.
Piketty may have published at exactly the wrong time, since there is some question about his famous formulation “r > g”. That stands for “the rate of return on capital is greater than the rate of growth”, meaning that capital tends to accumulate in fewer hands in capitalist systems. The NYT reports on what has been going around in finance circles for some time – the general return on assets has been falling rapidly since its peak at the depths of the financial crisis. It’s somewhat unclear how exactly this is possible, though many theories have to do with central banks buying up assets as part of quantitative easing. There are other schools of thought – either that too much money is being saved or that there are too few investment opportunities, which are kind of the same idea phrased differently. This might be a moment that passes quickly, but at least at this moment in time it appears that the returns to capital are falling quickly. I think it’s worth stepping back for a moment and wondering about the changes to American political economy if in fact r < g.
Most big institutions – though not the federal government – are in big trouble. Universities in particular will likely suffer, because they can no longer rely on healthy returns from endowment investment. Pension funds are similarly in trouble, because they generally rely on fixed returns from their investment funds. For both, there will likely be serious downsizing of future promises as the reality sinks in. Businesses will likely also face issues as well, because they will have few opportunities to productively deploy their profits. Leadership in the business world will become less stable, because profitable businesses won’t have as much of an opportunity to develop an economic moat. In general, institutions will be less stable and competition amongst them more volatile. The same will apply at the individual level – investments will either be low-return or pushed further out the risk curve, and wealth will be less durable. We would expect a flattening of the income distribution and greater social mobility.
The political economy of this is moderately concerning – there will be a great deal of pressure for the government to do things to increase the rate of return on capital. The currently powerful don’t like the institutional foundations of their power eroded away, and so juicing r will be a key political goal for institutions, the wealthy, and their representatives. Some of this will take familiar forms – capital gains tax cuts, more anti-labor laws, and perhaps more implicit or explicit investment subsidies. But this is pretty unusual – for the most part, a general glut of savings has not been a problem of the modern era, because there have been plenty of avenues for extensive and intensive growth via deploying capital. I’d probably be prepared for things to get strange when it comes to policy.
More strangely, the elite political pressure for quantitative easing will probably only grow. At this point, ending quantitative easing will deliver a massive hit to financial asset prices. QE presents a novel form of a traditional finance problem, the tradeoff between upside and capital preservation. Even if QE is eroding the realized return on asset prices, central banks’ purchasing actions are propping up the prices of assets and thus preserving capital for current capital holders. Ending QE might make greater investment returns possible, but it’s unlikely those gains will accrue to those who are currently holding large amounts of financial assets, who will take large hits in the process. This suggests that there’s a potential for a positive feedback loop here in QE and decreases in r: more QE decreases r, but generates more pressure to keep QE going.
In short – the political economy of r > g is well-understood, but the political economy of r < g is much less well-understood. If this is a general feature of the future financial landscape, we can probably expect to see some novel political phenomena emerging.
Massachusetts is in the news today, as the locally dominant Partners Healthcare prepares to gobble up more hospitals. Partners began in 1994 with the merger of Mass General and Brigham and Women’s Hospital, a merger that granted the new entity substantial market power. Unsurprisingly, Partners immediately began abusing said power by demanding higher prices of insurers and threatening to lock them out if they didn’t pay. Insurers couldn’t very well lose Boston’s biggest and best hospitals and hope to retain their customers, and so they have caved and Massachusetts healthcare prices began their long and unstoppable climb ever since.
In a seemingly unrelated story, in the early 1880s there existed a grocery store in Memphis, in a neighborhood called “The Curve”. It was the only grocery store in the Curve and run by a white man named Barrett. Barrett was a nasty customer, and exploited his position as the only store within walking distance to charge higher prices to blacks. This was before the formalization of Jim Crow, but of course nobody was about to file an FTC complaint about it! So some members of the Memphis black community formed a rival, which they called the “People’s Grocery”, which broke Barrett’s local monopoly and charged fair prices to everyone.
This seems like the proverbial invisible hand of Adam Smith in action, but there’s not a happy ending here. Barrett was an influential man in the community, and white besides – so he had some friends stir up some trouble at the People’s Grocery. When the clerks had to act in self-defense, they were arrested and set off a wave of mob violence against the black community. In the resulting chaos, a large proportion of Memphis’s black population fled. Of those who remained, many had their property expropriated. The logic of competition had little force compared to the fundamentally corrupt nature of government power in the Old South, which kept the region in poverty for many decades more.
In the larger question of what actually affects people, the best-known problems of national political economy matter little compared to the injustices and failures at the local level. Most monopolies aren’t national monopolies, and weren’t even before the Sherman Anti-Trust Act. They are mostly at the local level – the water, power and cable companies that we deal with every day and the hospital groups that dominate many metro areas. And anti-competitive measures aren’t generally stemming from the US Congress, but from the Barretts of the world and their friends in local government. In fact, a great deal of the impetus behind Jim Crow came from local businessmen and planters realizing that they could use their local governments to expropriate African-American property. The Massachusetts story is less dramatic, but also cautionary – Massachusetts politicians that approved the 1994 merger created a monster with the economic clout to improve its market power and the political power to yank their successors around.
Local political economy is probably under-studied.
America’s corporate tax rate has two problems – it is too high and too low. Too low in that it collects very little revenue, through a combination of factors – loss harvesting, special tax exemptions, and booking profits overseas. Too high in that its statutory rate – 35% – is extremely high, driving a lot of this behavior. As a result, while the United States has one of the highest corporate tax rates in the developed world (as conservatives fixate on), its effective tax rate is one of the lowest in the developed world. It could be reasonably argued that the United States is on the wrong side of the Laffer Curve, at least with regards to corporate taxes. Conservatives like to use this to argue that the United States could reap huge rewards in terms of economic growth by lowering corporate taxes. This is wrong – but even so, there’s a solid political economy argument that the Democrats should move to lower and reform corporate taxes. Why? So the Republicans don’t get there first.
The last time Congress took up corporate taxes in 2004, it was to pass a “holiday” on repatriation – wherein corporations could bring home profits domiciled abroad without paying taxes on them. The problem? Well, it doesn’t provide any reason to pay taxes on the day after the holiday – and it in fact encourages domiciling profits abroad, because if Congress passes one holiday that’s an excellent reason to believe they might pass another. Indeed, right on cue in 2011 Congress took up this idea again until the Democrats killed it, pointing out that when this behavior is repeated it’s nothing more than a series of free giveaways to the wealthy, and effectively eviscerates the tax regime for anyone who can afford a decent tax lawyer.
The Democrats should move to permanently cut corporate taxes now, to head off Republicans passing a repatriation holiday when they retake Congress. Lowering taxes and perhaps providing a partial holiday would remove the gigantic stores of offshore profits that Republicans would point to when calling for a holiday, and the total amount of revenue recovered would be far greater. It may or may not result in the rational corporate tax system that everyone in Washington claims to want, but it’s surely better than the inevitable giveaway that will result when the Republicans retake Congress. And a corporate tax cut is one of the few policies the Democrats could propose that might make it through the GOP-controlled house.
I’m doing some guided self-study this summer, and today I read a very thought-provoking paper by David Wildasin on “fiscal competition”. Fiscal competition is most well-known at the local level, for example when two cities offer tempting tax breaks to corporations in order to lure their new factory. It’s extremely common at the state level as well – most notably, Texas just lured a new Toyota factory with 4,000 jobs for a whopping $40 million in incentives. However, Wildasin points out that there is another side to these fiscal incentives – subsidies must be paid for with taxes elsewhere, particularly in cities without the power to run large deficits. Since localities almost never charge income taxes, the main way this is done is via taxes on particular types of property. In his simplified model, there are four key results.
- Capital within a locality is fixed in the short run. A tax doesn’t affect the real resources available or real output, but it does reduce the rate of return to capital.
- In the long run, a local property tax can’t reduce the net return to capital because capital will leave or enter so as to equalize net returns to capital inside or outside.
- However, it does affect the owners of immobile resources within the locality, particularly landowners.
- The loss of income to the immobile resource owners exceeds the revenue collected, because of the deadweight loss of taxation.
An interesting extension to this reasoning is to consider what happens once the factory moves in. The move might well be popular, particularly if there are relatively more non-land-owning workers vs. landholders. It’s an obvious win for the politicians – and the net benefit to the community might be positive, depending on how savvy they were at negotiating terms. Here’s the neat thing about this, though: after Toyota comes in, the game changes. We’ve introduced a large new player to the game, one that controls a fairly large proportion of the capital available to the community. However, it has a characteristic that distinguishes it from the landowners, namely that its capital is more mobile. It thus can extract rents from the community, because it can threaten to relocate if its taxes go up and take the equipment with it to whatever new city offers it better incentives. We would expect that future tax increases will continue to fall mainly on immobile property and also that Toyota’s tax incentives long outlive their currently scheduled expiration date.
This actually has a fairly interesting and counter-intuitive empirical prediction – that we should see business incentives that are stronger, and possibly more long-lasting, the more mobile capital is. There is a spectrum here, and a Toyota factory is much more mobile than a farm but relatively immobile compared to a textile factory, and extremely immobile compared to a bank, insurer, or software company. The latter are extremely poor targets for taxes because they can relocate their capital extremely easily – whereas a city government might get a couple good years out of Toyota until a replacement factory can be built, or Toyota might decide to stay if relocation costs exceed the new tax. So we would expect the more mobile businesses to have firmer public incentives, and to extract more rent from the public.
This logic should make us pessimistic about the returns from higher taxes on the ultra-wealthy, by the way.
By “Detroit”, I don’t mean the Big Three, I mean the actual city of Detroit. It has some well-noted problems, not least of which that its ongoing collapse has devastated public finances. One of the big targets in its bankruptcy proceedings has been the pensions for its current and retired workers, which are extremely generous – and considerably more than the average income of city residents whose taxes pay for them. I was concerned that in the settlement of Detroit’s bankruptcy, the result would fall into one of two terrible extremes – either pensions would be completely looted, or the rest of the city government would be starved in order to prop up these unsustainable pensions. Instead, Detroit is adopting an interesting “hybrid” plan (that does involve small cuts to current retirees).
Hybrid plans will include both elements of new and old-style retirement plans. Detroit’s workers will still receive traditional defined-benefits plans, wherein the pension fund will invest money on their behalf and pay out once they retire. However, they will bear most of the financial risk associated with changing returns to the pension fund’s assets. It’s an intriguing plan, because it maintains attractive aspects of both types of plans. Like a traditional plan, it guarantees that money is diverted to savings and provides a high level of confidence that retirement benefits will be there. Like a defined-contribution plan (e.g., a 401(k)), it shifts most of the financial risk away from the taxpayer. It also doesn’t suffer from the horrible drawback of relying on workers to manage the money themselves, which sounds nice but is a complete disaster in practice.
However, all of this will be moot if the growth of pension fund assets falls far short of projections. The new plan assumes pension fund assets will grow at 6.5% a year, which is modest relative to benchmark returns the past few years but may prove difficult to reliably meet in practice. It’s much better than the ludicrous 7.9% per year prediction that got the city into such trouble, but the issue with compounding interest is that a few bad years can destroy a long-run plan. My suggestion here is to better align the incentives. I’m sure that Detroit paid bright consultants good money to come up with this plan – how about paying them with a security linked to budget shortfalls? If pension plan revenues come in below the bottom of their sensitivity analysis and Detroit needs to bail out the plan again, the consultants don’t get paid. Maybe more public-sector consulting ought to work this way.
Two years ago, Judge Ned Rakoff rejected a settlement between the SEC and Citigroup. The SEC had been prosecuting Citigroup over fraud in some securities offerings it put together, similar to many cases in the bubble-era financial world. As was standard in this situation, finally Citigroup had enough and agreed to settle the case in the standard manner – a fine of $285 million and not having to admit it did anything wrong. Sick of seeing Wall Street getting simple slaps on the wrist, Rakoff put his foot down:
Judge Rakoff said it was impossible for him to say whether it was “fair and reasonable,” let alone in the public interest, after the bank “neither admitted nor denied” the S.E.C.’s accusations nor otherwise revealed any of the facts in a complex mortgage fraud case.
Rakoff’s ruling was a feel-good moment for people tired of Wall Street’s excesses, and two years later it is being reined in by the powers-that-be. The New York Court of Appeals for the Second Circuit found that Rakoff had exceeded the bounds of his discretion. Regardless of the merits of this specific decision, the logic is troubling. One of the perennial issues facing regulators and the bureaucracy in general is the question of “regulatory capture”, when bureaucracies turn from impartial regulators of an industry to its defenders or advocate. The SEC as a whole is certainly not captured, or else it never would have brought such a case in the first place. However, there were no doubt certain elements within the SEC which were very happy to see the case disappear with the minimum of fuss and muss lest it impede the revolving door to Wall Street. The decision by the appeals court threatens to set general precedent for judicial review of settlement, sharply decreasing the power of the courts in overseeing regulatory disputes.
The courts are not perfect, but the political economy of the situation suggests there are benefits to a supervisory role for the courts in this area. The professional incentives for judges are much better than for the SEC, since judges aren’t gunning for Wall Street jobs. Most are aiming to advance in their judicial career, generally doing so by making good law. Courts can be capricious and produce poor policy, and there are structural incentives encouraging that – little accountability and a partisan nomination process. However, these structural factors might lead to systematically poor policy. but there are no reasons to believe they systematically create biased policy, unlike the structural incentives facing the regulatory bureaucracy. It actually does make sense to hand off a fair amount of regulatory oversight to the courts, if we’re interested in a more even playing field for public interests. The Court of Appeals’ decision is troubling in that regard.
So apparently the right has been slinging some stones over Hillary Clinton’s comments that she and Bill were “dead broke” when they left the White House. But not only is it true, it’s almost unbelievably true: the Clintons had a net worth of negative ten million dollars, mainly in unpaid legal fees. As Yglesias rightly points out, the mere fact that they could have that much debt indicates that they were in fact quite wealthy. A normal person could never rack up that amount of debt. And when you are wealthy, there are different rules – for example, you can take out a loan to buy up your own bad debts for pennies on the dollar. The reason that the law firms extended this sort of service on credit was pretty simple – that they knew that Bill Clinton had extremely high earning potential and could easily pay them back. In this light, it’s obvious that the Clintons’ negative net worth didn’t really mean they were poor, simply that they were running a negative current account balance and had a fairly high debt-to-assets ratio,
So there are at least two things that we might mean when we say “wealthy” – the net worth you report on your taxes, and the present value of your expected future income. Of course, there is more than just that. Even someone who scores relatively low (by elite standards) on both – for example, a Congressman with no plans to lobby, might still be quite wealthy in the favors he can bring in and the standard of living he can ensure his family. Connections, even when not monetized, are a pretty important form of wealth. The truly wealthy – for example, Bill Gates, are richly endowed in all of these areas. Interestingly, the net worth score does a much better job of capturing the wealth of the poor than it does the rich – because their future earnings tend to resemble their present earnings, and their connections are generally not very useful. Wealth becomes increasingly multidimensional and hard to measure the wealthier one is, and flatter and more unidimensional the poorer one is.
This is, to my mind, an argument for the progressive income tax – if not stronger or downright punitive income taxes. A flat income tax actually captures less of the income of the wealthy, since their cash compensation forms a smaller portion of the economic and uneconomic capital to their name. Accordingly, a greater portion of their cash income can be taxed away without doing more harm to their utility.