Monday, July 14, 2014

Incentives and Economics

A few years ago I went to Norway and had a great time. In this post I described how expensive everything was in Norway due to their highly valued currency (tied to oil riches) combined with the relentless decline of the US dollar (tied to ZIRP and other dubious economic moves). In the simplest terms, a fast food meal or a beer in Norway cost over $20 USD which is complete madness.

Business Insider discussed the Scandinavian economic experiment, where high taxes are applied to goods and services in order to fund a vast social safety net. From the article:
In Norway, a burger and fries at a fast food joint will set you back $23. A six-pack of warm grocery-store beer is nearly $30.
These hefty price tags are due, in part, to high wages for low-skilled service jobs. But high taxes play a role too.
Most products have a 25 percent value-added tax, which means that $5.50 of the cost of that burger goes to fund Norway’s generous social programs.
As a visitor, you get little for the added price. But, as a resident, your daily spending helps to fund an expansive package of benefits, including health care, child care, high-quality education, pensions, and unemployment insurance.
Some are now proposing this high-cost method, with large taxes embedded in everyday prices, as a solution to the inequity in incomes and wealth that is discussed widely in politics and economics today.

From the perspective of someone who is highly interested in economics and tax policy, my two rules of thumb are:
1) that the tax policy raise the money that it intends to raise
2) that the tax policy not significantly distort economic activity

Any society that implements high taxes such as Norway needs a comprehensive surveillance model in order to collect these taxes. It is difficult to avoid taxes that are broadly assessed on fast food, for instance, because each corporate location will set up cash registers and controls to remit these taxes onto the state. The same types of processes can be installed in liquor stores, formal bars and nightclubs, grocery stores, and restaurants.

In a less-homogenous society such as the USA, we already have major problems with tax evasion on cigarettes and likely liquor, and these are in responses to our sales taxes. The problems would be compounded if we placed value added taxes on all goods at a higher level and on services such as restaurants, hair care, etc... Smuggling would become rampant and informal or barter methodologies would increase in size and scope. These sorts of costs would have to be applied across the USA or some areas would become uncompetitive and see an out-migration of economic activity, starting with incremental additions (no one has opened a new manufacturing plant in Illinois in years, for instance) and eventually leading to the lock, stock and barrel out migration of existing industries (such as the exodus of car manufacturing out of the midwest and California to the American South).

On a broader level, however, the question is - "what do these taxes incent, and how does it make us economically stronger?" These taxes would encourage a broad "welfare state", with a large safety net, huge numbers of governmental employees to track spending and provide services, and make doing business a "high cost" effort.

For employees, high taxes on consumer goods and services would encourage them to stay home and cook as well as garden and do things by themselves rather than hire someone else, since the incremental costs are so high. It would also reduce incentives to work in the first place (if the disability net was cushy enough), since the differential between working and not working isn't as great after the incremental costs are applied.

Depending on how taxes are structured, if the tax rate is high on consumed goods and services and is not progressive on income (i.e. when you earn more, you pay a higher percentage of your income), this could remove one of the blockages to incremental effort, a high marginal tax rate. However, these sorts of schemes are often linked to "progressive" tax rates which also discourage work beyond a certain point. I did a bit of research on Norway and the taxes do not seem to be too progressive but they reach such a high rate (>50%) on high earners it likely accomplishes the same disincentive effect. Sweden does implement a progressive system so this compounds the situation instead of mitigating it.

It is ridiculous for the USA to copy this model because Scandinavia is not a competitor to the US. Norway is awash in oil and can set up any sort of scheme and remain rich, and is a model citizen compared to the massive distortion found in countries like Saudi Arabia (where locals basically do next to nothing except reproduce and are a massive burden on the state). The other countries like Sweden are smaller than some US states and are homogeneous and can continue to work and thrive based on their high level of overall education, modest expenditures on defense, and bountiful natural resources. US industries have little to fear from the Swedes in terms of product and service competitors.

Our actual competition, today and tomorrow, comes from China, other Asian countries, and perhaps India and South America if they can get their act together. These countries have a completely opposite model, with a focus on investment, high technology, commodity resource extraction, limited to no "welfare state" functions, and growth. Of all the elements dis-incented by the "high tax" model, growth is most dis-incented because high taxes continually steal profits throughout the chain to pay for a vast government which turns around and spends it on salaries and processes that do not increase competitiveness. Every day you would be siphoning off private sector capital and sending it to state and local capitals to feed this net.

In the short or medium term, the relative competitiveness of your economy doesn't matter; you can live off the educated people who don't want to uproot and part ways and businesses for whom the cost of re-locating is prohibitive. Or if your entire economy is based on physical location (i.e. a tropical island), you could apply high costs and pass them on to tourists until it reaches a point that they pack up and suntan elsewhere.

For all others, it is necessary to build competitive industries to have a high quality of life and to provide the goods and services needed for a modern society. Unless you are completely self-sufficient, you must pay for imported goods, services and commodities and if your economy isn't competitive you soon will find yourself unable to pay for these goods and services. During the 2007-8 crash parts of Greece went without medicine and heating fuel; the international markets are no joke and merciless if you don't have the wherewithal to pay. Today Venezuela doesn't have much in the way of air service and Argentina has little in the way of imported goods - this is the market at work when all the local stopgap measures run out, and stripping companies of their ability to compete through government fiat finally comes home to roost.

In the USA, the issue is the "relative" cost of living - perhaps NYC or San Francisco could pull off high local costs because so many services / arts / investment / technology people want to live there - but the rest of the country would see an exodus over time with these sorts of policies, moving to friendlier locales to do business until they ended up like the industrial wasteland in Detroit, Cleveland, Baltimore, Camden and lots of Chicago.

On a theoretical not practical level, the plan of a wide "nanny state" and paying people high wages for entry level jobs just won't play out well for many Americans. They don't want vast governmental involvement in their lives and don't want to pay the immense taxes needed to subsidize those jobs. In addition, businesses would rapidly automate their way out of these high cost models and just shed low skill jobs entirely.

Everything goes in waves and the post WW2 lessons with socialism have been forgotten. Unions took the UK down to its knees in the 1970's and socialism stunted the economy of China for decades. It was once reflexive that free markets and free economics powered America, especially when we faced a cold war against the USSR. However, dodgy economic schemes have become commonplace, powered by the Keynesian idea that "all spending is good spending" and somehow consumer spending is the root of economic power, rather than efficiency, productivity, and investment. Today it seems that the majority of the work force is de-facto run by the state - schools, universities, hospitals, insurance, "straight" government, cartel businesses like beer distribution, as well as a melange of non-profit organizations of all sorts.

"Raw" economics comes to the fore in times of trouble or shortages; we can't always count on debt to bail us out and we can't always assume that we will have a high standard of living if we don't have a productive and thriving private sector. Comparing ourselves to "old Europe" and their straightjacket economic policies won't prepare us for competing with the Chinese and other rising economies.

Cross posted at Chicago Boyz

1 comment:

Carl from Chicago said...

There is a good discussion thread on this topic over at Chicago Boyz.