Saturday, January 31, 2009

The reason WHY trickle-down tax cuts don't work

The theory behind trickle-down tax cuts is that, if the rewards to certain very talented businesspeople is increased, they will then be incentivized to create even more economic activity.

The problem with this picture is that it completely misrepresents what businesspeople can do. In certain very rare instances and environments, a very small number of businesspeople with very specific talents can build large enterprises. Usually these environments occur when a new industry either initially begins or when an old industry drastically restructures.

In those very short moments of opportunity (historically, they rarely last more than a few years), a handful of businesspeople with incredibly specific skills, talents, connections, personalities, etc. can build up enormous business firms, employing huge numbers of people in a very short space of time. But once that moment of opportunity closes, often there is no new moment of opportunity in that industry for many decades (or even longer).

Thus, once that moment of opportunity had closed, the resulting Bill Gates or Andy Grove or Ray Croc is very wealthy indeed. But Gates or Croc's skills and experiences are very focused on the single opportunity they exploited. It has almost never happened that a single businessperson built two successful industry-dominating firms from ground up in two different industries (in fact, I can't recall a single example of this).

Further, a businessperson of this caliber in the very special environment we're talking about is largely unaffected by comparatively small changes in his tax rate. The opportunity presented to him is so unique and compelling that he would do the same things for much less money, and would do them for much more money.

Thus, when you increase the reward to the ALREADY successful entrepreneur (i.e., he has already made a big pile from his entrepreneurship), you don't actually encourage him to do anything new. He can't, he's ALREADY done the one single great thing he could do. The firm he already built up dominates his industry, and he will be extraordinarily unlikely to be able to do it again. All you end up doing is giving him more money to give to his kids.

4 Comments:

Blogger dave said...

The bigger the prize, the more people play the lottery. exponentially.

in capitalism, the increasing lottery-pool of gains-to-the-winner is an engine of innovation. this is a question of incentives.

12:49 AM  
Blogger Alex said...

David,

There's simply not much evidence of moderate changes in tax policy as the central driver of the creation of new large business enterprises (note: we're not so much interested in this discussion in innovation perse, but only in innovations that lead to large numbers of people being employed in new industries).

Incentives matter, but the resulting question is: what are incentives? The theory of trickle-down assumes that the largest incentive by far is comparatively small changes in monetary compensation.

But we know the opposite, in fact: one of the greatest events in economic life was the United States, Germany and Japan far surpassing the UK in the new industries of the late nineteenth century: internal combustion engines, chemicals, electricity and so on. The pre-WWI tax policy of the UK was not much different than the US and Japan and was lighter than in Germany. The tax policies generally provide very little insight into how the respective economies performed.

Instead, as Chandler and then Lazonick/Elbaum I think correctly deduced, is that it was primarily institutional/social problems that led to the UK's comparative underperformance. It was not that England's entrepreneurs were under-incentivized under the UK's tax policy, it was that a combination of social, institutional, educational, economic and other factors hindered British entrepreneurs (and there were many who were more technically innovative as any in the US, Germany or Japan) from turning their innovations into large surviving business enterprises.

11:03 AM  
Blogger dave said...

Alex,
Much appreciated and excellent comments.

The below goes on a bit, often on tangents, but I don't have it in me to linearize at the moment. Apologies. Feel free to pick only relevant bits for further discussion.

"new large business enterprises" - who needs them? I suppose it depends on your definition of large. wouldn't a series of small businesses that offer small gains amount to the same thing? your focus on 'employment' as a distributor of gains seems shortsighted. which is more productive - jobs created that add 1 million dollars to the system distributed amongst 20 people, or products sold at cheaper costs that distribute 1 million dollars in gains to 200,000 people? I don't dispute that the employment of individuals matters, but as to macroeconomic effects, it's a wash.

I'm interested in making sure that incentives to innovation aren't hampered by tax policy. Innovation (and growth) are good because they produce wealth transfers across time to future generations (my historical long view constrains my socialist impulses because I'm concerned about producing compound growth that can improve concrete material conditions).

Essentially, I think that trickle-down is silly because it fails to have the (claimed) intended effect. To create growth (and hence innovation) one needs the money 'returned' to the system by tax cuts to be put to better use than the government, and I see macro policy as more effective when pursuing a trickle-up policy, since a greater percentage of money given to the poor makes its way up by virtue of increased aggregate demand -- which create gains along the way to a broad spectrum but still consolidates money, in the end, in the hands of capital.

I think boom-bust can in large part be attributed to this addition and withdrawl of actual money from the money supply, which can be counteracted by the extension of credit (virtual money). Artificially low interest rates of the Greenspan variety create enough virtual money to cover up the consolidation of real money at the top. Low interest rates, then, can be a form a class warfare. The problem with virtual money is that beyond certain epistemological limits on the nature of risk (see: the work of Nassim Taleb) it is unsustainable. Much of the present crisis is the result of extending virtual moneys without understanding the level of disconnect between virtual and real - i.e. of being able to accurately quantify risk, within a range of uncertainty.

I don't, at core, really think that the US is anywhere near the point where tax disincentives to riches outweigh the gains to the economy as a whole, but I want us (and also the broader political 'us') to keep this point in mind when addressing tax policies. Future generations depend on the gains from the present Unternehmergeist. It wasn't that long ago that everyone was either one drought away from starvation, or a thief.* The extension of decreased starvation-uncertainty is slow but observable, and is definitively the product of capitalist growth.**

* and by thief I mean Nobleman.
** not the only way to get there, to be sure, but one that's proven to work - in a limited way, at least, but broader and faster than any form of wealth distribution otherwise enacted. One can disagree with the structural composition of capitalism's power-money dynamic while hoping to preserve the compound efficiency of markets as an allocator of resources in the general case (if not all the specific ones).

1:15 AM  
Blogger Alex said...

David,

I'm not certain where you're disagreeing with me.

There are many other problems, both theoretical and empirical, with trickle-down theories of tax cuts, but I'm focusing here solely on why tax-cuts on entrepreneurs income streams don't seem to have a large effect upon those entrepreneurs' behavior. We generally don't see (indeed, we almost never see) very successful entrepreneurs going on to create additional new large enterprises. They seem to have only one great company within themselves. Thus, the tax-cuts don't seem to incent the behavior we're looking for.

Further, if we take a look at the amount of entrepreneurial activity across economies, we don't see much correlation between the economic activity within large companies (i.e., not entrepreneurial activity) and income tax codes. The US has a generous tax code for individual entrepreneurs, but a very high percentage of the population working for large enterprises, and a very high percentage of economic activity captured by large enterprises, compared with other nations who have much less favorable tax codes towards entrepreneurs, yet more entrepreneurial activity.

A potential conclusion is that other factors, and not tax incentives, are what drive entrepreneurial activity. Obviously, if the tax rates are extremely high, the tax rates can then be a major factor. Other than within the condition of "tax rates = astonishingly high", it doesn't seem to be a major factor
across some rather wide varibilities in tax policy.

2:39 PM  

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