Coordination Problem

The French Riots Explained...

I found it on the net a few days ago, but forgot to save the link and can't find it anymore. Apologies to the author.

After the Nordic, the Teutonic

As I discussed earlier in a post on the MMP system in Germany and New Zealand, the recent election in Germany has delivered a difficult situation (see also here). Last week, in an article on the new coalition government, The Economist described the challenges ahead for Angela Merkel. In my opinion, the German situation is to be watched for at least two reasons:

• There is a greater likelihood for policy reforms in Germany than in France or in Italy for instance. I suspect a good chunk of the German population understands that the rise of union power, and the implementation of nation-wide collective bargaining and other labor-market regulations over the last twenty years, have taken their tolls on the German economy (for a very good paper on this topic, see “The Rise and Fall of the German Miracle” by Wolfgang Kerber and Sandra Hartig published in Critical Review in 1999).
• The impact of German reforms on Western Europe would be considerable. If Germany were to implement the reforms needed, the French, but also the Italians, the Belgians, and many others in the EU who have resisted most reforms, could not hide their heads in the sand anymore. German reforms would be a catalyst for the rest of Europe – and more so, in my opinion, than reforms in France or Italy would.

As The Economist explains, the recent policy decisions taken by Merkel and her coalition are not very promising. Germany, like France and Italy, badly needs a reform of its labor regulations and tax system, but these ideas have been postponed to a later date. For now, the government wants to reduce the budget deficit by raising the value-added-tax (VAT) from 16% to 19% (in addition to some small spending cuts). Moreover, it plans to implement an “impulse program” of spending in the amount of €25b over the next four years.

The increase in the VAT rests on the idea that taxing consumption is less damaging for investment and growth than taxing income or capital. The VAT, being largely self-enforcing, is one of the preferred tax instruments in the EU. VAT rates throughout the EU have often been very high (even above 30% for some “luxury” goods in the 1970s and 1980s - see here for current rates). This is possibly because the tax-free zones at the bottom of the respective income tax schedules are larger (i.e. a bigger fraction of the population is not tax-liable on its income) in Western Europe than elsewhere (e.g. New Zealand does not have a tax-free zone, but it is an exception).

Considering the size of the VAT base and that the rate is already high, a three-percent increase will have negative consequences on economic activity. How much is hard to say. Moreover, controlling budget deficits via tax increases is almost always a bad idea. Also, it is not true that one can tax consumption without affecting other choices individuals make. At the end of the day, there is only one tax base (i.e. the income derived from market exchanges), but different taxes will offer different avoidance opportunities.

Germany may become a very important laboratory for reforms in the coming months and this would have a huge impact on the EU. I am excited about it, but I don’t hold my breath.

Scandinavian Economies and Corporate Tax

Following my post on Sweden, someone commented that another reason why Scandinavian economies fare well compared to some of their European counterparts is because of their low corporate marginal tax rates. KPMG publishes a list of world-wide corporate marginal tax rates every year. While the January ’05 figures are not available on the net, I found those for January 2004 (see here).

In its report, KPMG explains that the trend is towards lower corporate tax rates world-wide, especially in Europe where many countries now have rates around 30% and a few much below that threshold (e.g. Portugal and Ukraine are below 20%). The idea that Scandinavian countries have relatively low corporate marginal tax rate seems true: Finland’s marginal rate is 29%, while Sweden’s and Norway’s rates are a notch lower at 28%. This is below the EU average of 31.3%. It also compares favorably with the US Federal corporate tax rate of 35%.

As Israel Kirzner argues in Taxes and Discovery: an Entrepreneurial Perspective, taxation reduces the likelihood that unnoticed opportunities will be perceived. In other words, taxation not only affects the incentives to pursue an already-known alternative, but it also affects the incentives to adopt a not-yet-known course of action. This is because taxation reduces pure profit, which is the lure of entrepreneurial discovery. Doing so makes an unnoticed opportunity less likely to be noticed.

Marginal corporate tax rates are only part of the picture; other policies are necessary to obtain sustained prosperity. However, all the talk about Ireland cannot detract from the fact that the country dramatically lowered its corporate tax rate in the last twenty years. It now stands at 12.5% and this annoys EU bureaucrats and other European tax-addicts who see upward harmonization of tax rates as the preferred path. Low taxation is underrated in the world of policymaking. Even in New Zealand, where a “broad-base, low-rate” tax policy was adopted early on, the marginal tax rates have not gone below 33% (this is still hotly debated, see here for instance). In fact, David Lange fired Roger Douglas from his post for proposing a 23% income flat tax in late 1987. This was regrettable considering the enormous economic benefits of low taxation.

However, comparing corporate marginal tax rates on paper is not always useful. A rate that appears high on paper may not be applied in practice. A better comparison should use effective marginal tax rates. Though, the effective marginal rate will often vary from company to company. Using effective marginal tax rates makes cross country comparisons all the more difficult.

As far as Scandinavian countries are concerned, the idea that Sweden for instance has two economies running side by side (one export oriented and the other one domestic) is reasonable. The existence of a 28% corporate tax rate reinforces the idea that the Swedes know the price of the welfare state. Sweden, like other social democracies, faces the following problem: capital is highly mobile, and if it doesn’t go to Sweden, it will go somewhere else. Taxing capital less than labor seems, in these conditions, rational. However, this creates other issues, for instance with regard to the capital-labor boundary. Some individuals (especially sole-entrepreneurs and artisans) may characterize part of their labor income as capital income to benefit from the lower taxation of capital. This is good for the economy but was not intended by the legislators.

This example is a reminder that the distinction between labor income and capital income is an illusion. All income is the result of human action. Taxation of corporate income is, fundamentally, taxation of the returns on the savings of those who invested in the company's equity.

At the end of the day, while having different marginal tax rates for income and capital helps countries such as Sweden stay afloat, it opens the door to lobbying and complexity. Differential and progressive taxation cannot “properly” (i.e. according to the canon of optimal tax theory) be achieved by governments because the information necessary for its implementation is not available. Moreover, altruistic social planners are not part of this world. The result is that taxation should always and everywhere be simple and the marginal rates should be low. From Hong-Kong to Ireland, it has consistently delivered good results.

Meet the New Boss, Same as the Old Boss?

I just returned from the Southern Economic Association meetings.  I have not missed a SEA meeting in close to two decades.  The wow factor is rarely there, but there is some good work being done.

Glen Whitman and Mario Rizzo are engaged in a research program tackling the new paternalism that results from behavioral economics.  The old paternalism contended that the State knew more about what was good for you than you knew so they would step in and serve as your boss, the new paternalism is slightly different, you know what is good for you, but you will not do it because of problems of self-command so the State will serve as your boss since you are incapable.  Whitman and Rizzo show that behavioral arguments are difficult to hold on to when actors are viewed as in the process of learning and discovering their life project, and also when the problems in terms of knowledge and incentives that the State would have to face in accomplishing its paternalistic policies.

While Rizzo and Whitman are addressing the paternalist policy implications of behavioral economics in a transcendent manner, my colleagues Bryan Caplan and Scott Beaulier are engage in an immanent critique of the paternalistic policy prescriptions of behavioral economics, and in the process show that behavioral economics can in fact bolster the case of laissez faire policy in issues involving self-command, etc. 

Neither Whitman and Rizzo nor Caplan and Beaulier address the demand for the State as a parent that James Buchanan has recently focused on, and is also what so concerned Tocqueville and later Hayek and Vincent Ostrom as we lose our ability to be self-governing individuals in our quest for security and safety and to escape from the 'cares of thinking and the trouble of living' as Vincent Ostrom puts it. When the State oversteps its bounds and constrains our chooses for us, we loose the capacity to live a self-governing life.  Both the Whitman/Rizzo type and the Caplan/Beaulier type critiiques of the meddlesome state are necessary components in the battle against an overzealous government, but we also must address the fear of freedom that too many individuals possess.

On Microfinance Again

Two weeks ago, The Economist published a special survey on microfinance (MF). I also recommend the audio discussion with Tom Easton, New York Bureau Chief of The Economist.

While no accepted definition of MF exists, The Economist sees MF as formal financial services for the poor. Indigent people could have access to formal financial services just like those who live in the developed world. Many billions of people (perhaps up to 5) potentially constitute this market. Banks have discovered in the last decade how profitable this market could be – at least if MF's costs could be reduced.

The formal financial services the poor could benefit from are deposits, savings, insurance, loans, and fund transfers. Remittances, a fast growing business worth $225b a year according to the World Bank, could represent the entry point in the MF market for many big banks. In other words, MF used to be a quasi-charity, but it is now slowly moving into mainstream banking. Global and local banks are becoming more interested in this potentially huge market.

However, there is another aspect to MF, which The Economist’s survey only partially addresses. This is the idea that MF, especially group-lending (as practiced by Grameen banks), is a silver bullet to poverty. While MF gives access to financial services to millions of poor, it is primarily a source of funds for entrepreneurs who otherwise would have no funding. Through MF, people can finance small business ventures, lift themselves out of poverty, and eventually graduate in the formal economic world establishing business relationships with established banks.

Stephen Daley and I published a Mercatus Policy Comment earlier this year on MF in the Philippines. Steve conducted a series of field studies in Manila (see picture – click on it) and came back with a wealth of data and interviews of people involved in MF. The aim of our research was to understand, by talking to people on the ground, whether MF is indeed the silver bullet against poverty. We mostly focused on group lending, which is a common form of MF in Manila. Here are the conclusions of our field work research:

• Many of those who receive MF loans do not graduate into the formal economy – even successful entrepreneurs;
• The relationship with moneylenders is often very valuable to the client because of the strong ties that exist between them – and MF recipients prefer to maintain strong ties with moneylenders than loose ties with unknown bankers (which is why they stay in the informal economy);
• The institutional environment is crucial to the way moneylenders operate. In Manila for instance, Mumbais (local moneylenders) operate in an environment which is not conducive to the development of formal financial relations with their clients.

Overall, the Philippine case shows that while MF provides financing to many small entrepreneurs, it is unlikely to become the silver bullet against poverty because graduation into the formal financial world is limited. At best, it is a band-aid solution to poverty. Based on the evidence we gathered in the Philippines, we believe that institutional changes would have a greater effect on poverty than MF loans as practiced by Grameen banks.

For instance, allowing Mumbais to hold property and set up financial businesses could lead to a development of the financial system from the bottom up. Titling of real property would also improve the situation of many would-be entrepreneurs. We also found that who funds MF loans matters to the incentives recipients face. In this regard, the involvement of governments in MF is not good news. MF must remain a private endeavor, either driven by charitable concerns or by profits. As The Economist puts it: “Good banking is, in the end, no match for bad government” (p. 13).

At the end of the day, the emergence of MF as a mainstream banking business is good news for the world poor, but it remains to be seen whether this phenomenon (at least the group-lending side of it, which we studied) alone will have beneficial effects on poverty levels.

A Dictator's Dilemma -- at least one of them

Writing in Knowledge and Decisions (1980, p. 132), Thomas Sowell argued that "The incumbant leader of the Soviet Union at any given time could make himself more popular by liberalizing government restrictions or be reducing military spending and allowing the people's standard of living to rise accordingly.  The immediate dangers to his own regime during his own term of office could be minimal, yet the larger danger to the internal and external goals of the Communist party could well be sufficiently serious to cause that party to depose the leader for even trying to initiate such reforms."

Twenty-five years later in, of all places, the Monthly Review a Chinese anthropology graduate student at U of Chicago, Yiching Wu, writes: "The path of marketization begins as the passive strategy of the ruling class for self-preservation and political appeasement, yet eventually it turns into their end-game or exit strategy—their massive self-transformation from power-holders to capital owners."

Andrei the Great

Bob Subrick at the Stationary Bandit reports on the new study which tracks the most cited economists over the past 10 years (1995-2005).  Andrei Shleifer tops the list with roughly 3000 citations to his studies in behavioral finance, Russian privatization, law and finance, and political economy.  Students of my generation grew up on the work of Joe Stiglitz and Robert Lucas --- both brilliant individuals no doubt.   But consider how much more we learn from the work of Shleifer that is relevant to the real-world than we do from that work of the 1970s and 1980s.  As my students have been hearing for the past 10 years, it is my opinion that Andrei Shleifer is the most important mainstream economists for students of market process perspective to study.  It turns out that he is not only important for market process economists to study to learn about how to address problems in the real-world, but for everyone doing economics and political economy as the citation pattern demonstrates.  Congratulations to Andrei and his team of co-authors (who show up on the list as well).  Time for market process economists to pay attention to the work pattern and style of research that Shleifer and his team follow.  If we want to have an impact on professional opinion, perhaps there is something important for us to learn in terms of topics to study and research output expectations.

Riots in France: Policy Responses Will Determine France’s Future

The Economist this week has two very good articles (here and here) on the riots in France. As I emphasized myself earlier this month (here), The Economist sees the source of the rioting in (a) “mass unemployment that persists in a welfare system supposedly glued together by ‘social solidarity’” and (b) “ethnic ghettos that have formed in a country that prides itself on colour-blind equality.”

Some French commentators explain that discrimination and the failure of social integration are the sources of the problems. The policies of the last 30 years have not gone far enough. More is needed to achieve the dream of a perfectly integrated society. Others have been quick to draw a line between radical Islam and the French riots (see for instance Mark Steyn’s article in the Chicago Sun-Times). The Economist also believes radical Islam is an issue in France, which boasts Europe’s biggest Muslim population. However, The Economist doesn’t see Islam as the source of the riots. Instead, it offers unemployment, the failed welfare system, and the ghettoization of some suburbs as the main culprits. They are right.

The riots find their deep roots in the fact that France is one of the last experiments of Western dirigisme (code word for ‘socialism’). The French must stop deluding themselves with the idea that they are different from the rest of the world. They need to understand that the problems on their hands are the result of decades of deeply misguided social policies. The best illustration of this state of affairs is the level of youth unemployment. As much as 23% of the young below 25 years of age are unemployed. Many of them are poor and belong to ethnic minorities. For these young people, the hope of finding a stable job is almost non-existent. And this is in spite of (I should say because of) an armada of social policies: the 35-hour week, high minimum wage, restrictive firing rules, RMI (minimum income for the unemployed), high unemployment benefits, etc.

Reforming the labor market is most urgent. In fact, it is a sine qua non of social change. As always, the example of New Zealand comes to mind. Kiwis deregulated their labor market relatively late in the reform process (they should have started as early as 1985). The Employment Contract Act (ECA) of 1991 was an attempt to restore freedom of contract – and it was very successful. Labor relations until then were based on centralized bargaining with an important role given to unions and the government. The impact of the ECA (in conjunction with other important reforms) has been huge. Unemployment fell from 11 % in the early ‘90s to less than 4 % today. Strikes (which are a daily event in France) almost disappeared from the social scene.

The French Government’s policy responses in the next few months are going to be crucial to the way France deals with her policy failures. As of now, the responses are inadequate. For instance, it is about establishing a “civil service”, giving more money to local associations, or legislating against discrimination (see here). Moreover, the influence of the populist right might increase (see CSM article here), which may entice the government to implement tougher immigration laws and order more expulsions of non-citizen rioters.

In spite of the riots, the necessary reforms still seem to be politically impossible. The Economist is right in saying that the “biggest lesson of the French riots is that more jobs are needed,” but this is to mean only one thing: less socialism, bad policies and French dirigisme; freer markets and a freer society.

As Subtle as it is Profound

In my Constitutional Economics class tonight we are discussing Vincent Ostrom's The Meaning of Democracy and the Vulnerability of Democracy: A Response to Tocqueville's Challenge (U of Michigan Press, 1997).  I haven't read the book cover to cover in 3 years, but as I returned to it for preparation for tonight's class I realized just how much I missed in my first reading of the work.  In my Constitutional class we have been reading Smith, Hume, Hayek and of course Buchanan.  These authors are surely on my short list of the most profound writers in the field of political economy.  But I think Vincent Ostrom might have a claim to be the most subtle of them all.  His style of reasoning is certainly unassuming and the topics he tackles are as profound as any in the field of political theory.  Ostrom states: "My effort is to deepen the foundations implicit in Tocqueville's analysis so that we might recognize the theoretical merit of Tocqueville's achievements and begin to explore potentials for crafting democratic societies built on principles of self-governance.  Our challenge is to create 'freer institutions' rather than to 'stretch ourselves at the feet of a single master'.  Democracies are viable only under limited conditions; and finding ways of meeting those conditions are the necessary means for achieving democratic ways of life." (p. 30)

"Democratic societies," Ostrom concludes, "are vulnerable to an unlimited pursuit of strategic opportunism when peoples are spared the cares of thinking and the troubles of living. ... If everyone were bent on the pursuit of strategic opportunities at the cost of everyone else, the cumulative result would be the trampling of civilization underfoot.  Problems of deception, self-deception, and strategic pursuits can only be alleviated by extended experience in coping with problems in artisanship-artifactual relationships.  If individuals can learn to become master-artisans capable of working with other master artisans in open artisanship-artifact relationships, they have the potential for becoming self-governing.  The challenge in democratic societies is to extend the horizons of knowledge and skills by learning to work with others in ways that enhance error-correcting capabilities, rather than fabricating patterns of deception and self-deception to tranquillize, tease, and terrorize the mind into states of helplessness." (p. 271)

Subjectivism and Law and Economics

James Buchanan has just published a paper that everyone should read -- "Cost, Choice and Catallaxy: An Evaluation of Two Related But Divergent Virginia Traditions," in Charles Rowley and Francesco Parisi, eds., The Origins of Law and Economics (Edward Elgar, 2005). Rowley organized a lecture series over several years which brought to GMU all the founding fathers of law and economics and the current leaders in the field.  These lectures are now published in this wonderful volume.

In his essay Buchanan seeks to explain the similarities and differences between himself and Coase with respect to the economic analysis of the law.  Coase is an opportunity cost thinker, as is Buchanan, but Coase according to Buchanan is an objectivist while Buchanan states that: "I have been, I hope consistently, almost throughout my whole career, a subjectivist, a stance that will not allow me to lay down normative criteria for courts or for anyone else."  Buchanan's position cuts at the core of the cost/benefit analysis that is crucial to standard law and economics.  As might be expected from Buchanan, he directs his subjectivist critique of cost/benefit and equilibrium analysis and argues instead for a subjectivist, process and constitutional perspective.