Naked Economics: Undressing the Dismal Science pdfdrive com

regulation inspired by good intentions. At worst, regulation can become a
powerful tool for self-interest as firms work the political system to their own
benefit. After all, if you can’t beat your competitors, then why not have the
government hobble them for you? University of Chicago economist George
Stigler won the Nobel Prize in Economics in 1982 for his trenchant observation
and supporting evidence that firms and professional associations often seek
regulation as a way of advancing their own interests.
Consider a regulatory campaign that took place in my home state of Illinois.
The state legislature was being pressured to enact more stringent licensing
requirements for manicurists. Was this a grassroots lobbying campaign being
waged by the victims of pedicures gone terribly awry? (One can just imagine
them limping in pain up the capital steps.) Not exactly. The lobbying was being
done by the Illinois Cosmetology Association on behalf of established spas and
salons that would rather not compete with a slew of immigrant upstarts. The
number of nail salons grew 23 percent in just one year in the late 1990s, with
discount salons offering manicures for as little as $6, compared to $25 in a full-
service salon. Stricter licensing requirements—which almost always exempt
existing service providers—would have limited this fierce competition by
making it more expensive to open a new salon.
Milton Friedman has pointed out that the same thing happened on a wider
scale in the 1930s. After Hitler came to power in 1933, large numbers of
professionals fled Germany and Austria for the United States. In response, many
professions erected barriers such as “good citizenship” requirements and
language exams that had a tenuous connection to the quality of service provided.
Friedman pointed out that the number of foreign-trained physicians licensed to
practice in the United States in the five years after 1933 was the same as in the
five years before—which would have been highly unlikely if licensing
requirements existed only to screen out incompetent doctors but quite likely if
the licensing requirements were used to ration the number of foreign doctors
allowed into the profession.
By global standards, the United States has a relatively lightly regulated
economy (though try making that argument at a Chamber of Commerce

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meeting). Indeed, one sad irony of the developing world is that governments fail
in their most basic tasks, such as defining property rights and enforcing the law,
while piling on other kinds of heavy-handed regulation. In theory, this kind of
regulation could protect consumers from fraud, improve public health, or
safeguard the environment. On the other hand, economists have asked whether
this kind of regulation is less of a “helping hand” for society and more of a
“grabbing hand” for corrupt bureaucrats whose opportunities to extort bribes rise
along with the number of government permits and licenses required for any
endeavor.
A group of economists studied the “helping hand” versus “grabbing hand”
question by examining the procedures, costs, and expected delays associated
with starting up a new business in seventy-five different countries.
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The range
was extraordinary. Registering and licensing a business in Canada requires a
mere two procedures compared to twenty in Bolivia. The time required to open a
new business legally ranges from two days, again in Canada, to six months in
Mozambique. The cost of jumping through these assorted government hoops
ranges from 0.4 percent of per capita GDP in New Zealand to 260 percent of per
capita GDP in Bolivia. The study found that in poor countries like Vietnam,
Mozambique, Egypt, and Bolivia an entrepreneur has to give up an amount equal
to one to two times his annual salary (not counting bribes and the opportunity
cost of his time) just to get a new business licensed.
So are consumers safer and healthier in countries like Mozambique than they
are in Canada or New Zealand? No. The authors find that compliance with
international quality standards is lower in countries with more regulation. Nor
does this government red tape appear to reduce pollution or raise health levels.
Meanwhile, excessive regulation pushes entrepreneurs into the underground
economy, where there is no regulation at all. It is hardest to open a new business
in countries where corruption is highest, suggesting that excessive regulation is a
potential source of income for the bureaucrats who enforce it.
India has over a billion people, many of whom are desperately poor.
Education has clearly played a role in moving the nation’s economy forward and
lifting millions of citizens out of poverty. Higher education in particular has
contributed to the creation and expansion of a vibrant information technology
sector; however, a recent shortage of skilled workers has been a drag on
economic growth. So it’s no great economic conundrum as to why a
pharmaceutical college in Mumbai would seek to use empty space in its eight-
story building to double student enrollment.
The problem is that this action turned the college administration into
criminals. It’s true—the Indian government imposes strict regulations on its

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technical colleges that protect against something as reckless and potentially
dangerous as using empty space to educate more students. Specifically, the law
stipulates that a technical college must provide 168 square feet of building space
for each student (to ensure adequate space for learning). That formula precludes
the Principal K. M. Kundnani College of Pharmacy from teaching more than 300
students—regardless of the fact that all the lecture halls on the top floor of the
building are padlocked for lack of use.
According to the Wall Street Journal, “The rules also stipulate the exact size
for libraries and administrative offices, the ratio of professors to assistant
professors and lecturers, quotas for student enrollment and the number of
computer terminals, books and journals that must be on site.”
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Thankfully, governments sometimes roll back these kinds of regulation. In
November 2008, the European Union acted boldly to legalize…ugly fruits and
vegetables. Prior to that time, supermarkets across Europe were forbidden from
selling “overly curved, extra knobbly or oddly shaped” produce. This was a true
act of political courage by European Union authorities, given that representatives
from sixteen of the twenty-seven member nations tried to block the deregulation
while it was being considered by the EU Agricultural Management Committee.
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I wish I were making this stuff up.
Let’s step out of our cynical mode for a moment and return to the idea that
government has the capacity to do many good things. Even then, when
government is doing the things that it is theoretically supposed to do,
government spending must be financed by levying taxes, and taxes exert a cost
on the economy. This “fiscal drag,” as Burton Malkiel has called it, stems from
two things. First, taxes take money out of our pockets, which necessarily
diminishes our purchasing power and therefore our utility. True, the government
can create jobs by spending billions of dollars on jet fighters, but we are paying
for those jets with money from our paychecks, which means that we buy fewer
televisions, we give less to charity, we take fewer vacations. Thus, government
is not necessarily creating jobs; it may be simply moving them around, or, on
net, destroying them. This effect of taxation is less obvious than the new defense
plant at which happy workers churn out shiny airplanes. (When we turn to
macroeconomics later in the book, we will examine the Keynesian premise that
government can increase economic growth by stoking the economy during
economic downturns.)
Second, and more subtly, taxation causes individuals to change their behavior

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in ways that make the economy worse off without necessarily providing any
revenue for the government. Think about the income tax, which can be as high
as 50 cents for every dollar earned by the time all the relevant state and federal
taxes are tallied up. Some individuals who would prefer to work if they were
taking home every dollar they earn may decide to leave the labor force when the
marginal tax rate is 50 percent. Everybody loses in this situation. Someone
whose preference is to work quits his or her job (or does not start working in the
first place), yet the government raises no revenue.
As we noted in Chapter 2, economists refer to this kind of inefficiency
associated with taxation as “deadweight loss.” It makes you worse off without
making anyone else better off. Imagine that a burglar breaks into your home and
steals assorted personal possessions; in his haste, he makes off with wads of cash
but also a treasured family photo album. There is no deadweight loss associated
with the cash he has stolen; every dollar purloined from you makes him better
off by a dollar. (Perversely, it is simply a transfer of wealth in the eyes of our
amoral economists.) On the other hand, the stolen photo album is pure
deadweight loss. It means nothing to the thief, who tosses it in a Dumpster when
he realizes what he has taken. Yet it is a tremendous loss to you. Any kind of
taxation that discourages productive behavior causes some deadweight loss.
Taxes can discourage investment, too. An entrepreneur who is considering
making a risky investment may do so when the expected return is $100 million
but not when the expected return, diminished by taxation, is only $60 million.
An individual may pursue a graduate degree that will raise her income by 10
percent. But that same investment, which is costly in terms of tuition and time,
may not be worthwhile if her after-tax income—what she actually sees after all
those deductions on the paycheck—only goes up 5 percent. (On the day my
younger brother got his first paycheck, he came home, opened the envelope, and
then yelled, “Who the hell is FICA?”) Or consider a family that has a spare
$1,000 and is deciding between buying a big-screen television and squirreling
the money away in an investment fund. These two options have profoundly
differently impacts on the economy in the long run. Choosing the investment
makes capital available to firms that build plants, conduct research, train
workers. These investments are the macro equivalents of a college education;
they make us more productive in the long run and therefore richer. Buying the
television, on the other hand, is current consumption. It makes us happy today
but does nothing to make us richer tomorrow.
Yes, money spent on a television keeps workers employed at the television
factory. But if the same money were invested, it would create jobs somewhere
else, say for scientists in a laboratory or workers on a construction site, while

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also making us richer in the long run. Think about the college example. Sending
students to college creates jobs for professors. Using the same money to buy
fancy sports cars for high school graduates would create jobs for auto workers.
The crucial difference between these scenarios is that a college education makes
a young person more productive for the rest of his or her life; a sports car does
not. Thus, college tuition is an investment; buying a sports car is consumption
(though buying a car for work or business might be considered an investment).
So back to our family with a spare $1,000. What will they choose to do with
it? Their decision will depend on the after-tax return the family can expect to
earn by investing the money rather than spending it. The higher the tax, such as a
capital gains tax, the lower the return on the investment—and therefore the more
attractive the television becomes.
Taxation discourages both work and investment. Many economists argue that
cutting taxes and rolling back regulation unleashes productive forces in the
economy. This is true. The most ardent “supply-siders” argue further that tax
cuts can actually raise the amount of revenue collected by the government
because we all will work harder, earn higher incomes, and end up paying more
in taxes even though tax rates have fallen. This is the idea behind the Laffer
curve, which provided the intellectual underpinnings for the large Reagan-era
tax cuts. Economist Arthur Laffer theorized in 1974 that high tax rates
discourage so much work and investment that cutting taxes will earn the
government more revenue, not less. (He first sketched a graph of this idea on a
restaurant napkin while having dinner with a group of journalists and politicians.
In one of life’s delicious ironies, it was Dick Cheney’s napkin.)
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At some level
of taxation, this relationship must be true. If the personal income tax is 95
percent, for example, then no one is going to do a whole lot of work beyond
what is necessary to subsist. Cutting the tax rate to 50 percent would almost
certainly boost government revenues.
But would the same relationship hold true in the United States, where tax rates
were much lower to begin with? Both the Reagan tax cuts and the George W.
Bush tax cuts provided an answer: no. These large tax cuts did not boost
government revenues (relative to what they would have been in the absence of
the tax cut);
*
they led to large budget deficits. In the case of the Reagan tax cuts,
Mr. Laffer’s conjecture did appear to hold true for the wealthiest Americans,
who ended up sending more money to the Treasury after their tax rates were cut.
Of course, this may be mere coincidence. As we shall explore in Chapter 6,
highly skilled workers saw their wages rise sharply over the last several decades
as the economy increasingly demanded more brains than brawn. Thus, the

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wealthiest Americans may have paid more in taxes because their incomes went
up sharply, not because they were working harder in response to lower tax rates.
In the United States, where tax rates are low relative to the rest of the world,
supply-side economics is a chimera: In all but unique circumstances, we cannot
cut taxes and have more money to spend on government programs—a point that
conservative economists readily concede. Bruce Bartlett, an official in both the
Reagan and the George H. W. Bush administrations, has publicly lamented that
the term “supply-side economics” has morphed from an important and
defensible idea—that lower marginal tax rates stimulate economic activity—into
the “implausible” notion “that all tax cuts raise revenue.”
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When Senator John
McCain told the National Review in 2007 that tax cuts “as we all know, increase
revenues,” Harvard economist Greg Mankiw (who served as chairman of the
Council of Economic Advisers for George W. Bush) posed the logical follow-up
question on his blog: “If you think tax cuts increase revenue, why advocate
spending restraint? Can’t we pay for new spending programs with more tax
cuts?”
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If I sound rather emphatic in making this point, I am. The problem with
the tax-cuts-increase-revenue fallacy is that it confuses the debate over our
public finances by giving the illusion that we can get something for nothing. You
should recognize by now that this is not usually the case in economics. There are
a lot of good things about tax cuts. They leave more money in our pockets. They
stimulate hard work and risk-taking. In fact, the increased economic activity
caused by lower tax rates usually does help to make up for some of the lost
revenue. One dollar in tax cuts may only cost the government eighty cents in lost
revenue (or fifty cents in extreme cases), as government is taking a smaller slice
of a bigger pie.
Think about a simple numerical example. Suppose the tax rate is 50 percent
and the tax base is $100 million. Tax revenues would be $50 million. Now
suppose that the tax rate is cut to 40 percent. Some people work extra hours now
that they get to keep more of their earnings; a few spouses take second jobs.
Assume that the tax base grows to $110 million. Government revenue is now 40
percent of that bigger economy, or $44 million. Government has lost revenue by
taking a smaller percentage of preexisting economic activity, but some of that
loss is offset by taking a percentage of the new economic activity. If there had
been no economic response to the tax cut, the 10 percentage point cut in the tax
rate would have cost the government $10 million in lost revenue; instead, only
$6 million is forgone. (In the case of a tax increase, the same phenomenon is
likely in reverse: The increase in new revenues will be offset in part by some
shrinking of the economic pie.) Tax experts typically take these behavioral

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responses into account when projecting the effects of a tax cut or a tax increase.
In all but the most extraordinary of circumstances, there is no free lunch.
Lower tax rates mean less total government revenue—and therefore fewer
resources to fight wars, balance the budget, catch terrorists, educate children, or
do anything else governments typically do. That’s the tradeoff. The
bastardization of supply-side economics has taken an important intellectual
debate—whether we should pay more in taxes to get more in government
services, or pay less and get less—and transformed it into an intellectually
dishonest premise: that we can pay less and get more. I wish that were true, just
as I wish that I could get rich by working less or lose weight by eating more. So
far, it hasn’t happened.
Having said all that, the proponents of smaller government have a point.
Lower taxes can lead to more investment, which causes a faster long-term rate of
economic growth. It is facile to dismiss this as a bad idea or a policy that strictly
favors the rich. A growing pie is important—perhaps even most important—for
those with the smallest slices. When the economy grows slowly or sinks into
recession, it is steelworkers and busboys who are laid off, not brain surgeons and
university professors. In 2009, in the midst of the recession induced by the
financial crisis, the American poverty rate was more than 13 percent—the
highest rate in more than a decade.
Conversely, the 1990s were pretty good for those at the bottom of the
economic ladder. Rebecca Blank, a University of Michigan economist and
member of the Council of Economic Advisers in the Clinton administration,
looked back on the remarkable economic expansion of the 1990s and noted:
I believe that the first and most important lesson for anti-poverty
warriors from the 1990s is that sustained economic growth is a
wonderful thing. To the extent that policies can help maintain strong
employment growth, low unemployment, and expanding wages among
workers, these policies may matter as much or more than the dollars
spent on targeted programs for the poor. If there are no job
opportunities, or if wages are falling, it is much more expensive—both
in terms of dollars spent and political capital—for government
programs alone to lift people out of poverty.
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So, for two chapters now I have danced around the obvious “Goldilocks”
question: Is the role that government plays in the United States economy too big,
too small, or just about right? I can finally offer a simple, straightforward, and
unequivocal answer: It depends on whom you ask. There are smart and

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thoughtful economists who would like to see a larger, more activist government;
there are smart and thoughtful economists who would prefer a smaller
government; and there is a continuum of thinkers in between.
In some cases, the experts disagree over factual questions, just as eminent
surgeons may disagree over the appropriate remedy for opening a clogged artery.
For example, there is an ongoing dispute over the effects of raising the minimum
wage. Theory suggests that there must be a tradeoff: A higher minimum wage
obviously helps those workers whose wages are raised; at the same time, it hurts
some low-wage workers who lose their jobs (or never get hired in the first place)
because firms cut back on the number of workers they employ at the new higher
wage. Economists disagree (and present competing research) over how many
jobs are lost when the minimum wage goes up. This is a crucial piece of
information if one is to make an informed decision on whether or not raising the
minimum wage is a good policy for helping low-wage workers. Over time, it is a
question that can be answered with good data and solid research. (As one policy
analyst once pointed out to me, it may be easy to lie with statistics, but it’s a lot
easier to lie without them.)
More often, economics can merely frame issues that require judgments based
on morals, philosophy, and politics—somewhat as a doctor lays out the options
to a patient. The physician can outline the medical issues related to treating an
advanced cancer with chemotherapy. The treatment decision ultimately resides
with the patient, who will interject his or her own views on quality of life versus
longevity, willingness to experience discomfort, family situation, etc.—all
perfectly legitimate considerations that have nothing to do with medicine or
science. Yet making that decision still requires excellent medical advice.
In that vein of thought, we can present a framework for thinking about the role
of the government in the economy.