Economics for politicians

It's become a cliche to bemoan the fact that politicians are disproportionately Oxford PPEists. This is odd, as there's not much evidence that they read much E. Here are seven basic principles of economics that don't seem to be wholly grasped by the main parties.  

1. Tax incidence. The burden of a tax doesn't necessarily fall upon the people who hand over the money. For example, stamp duty helps to lower house prices - which means that Labour's proposed cut for first-time buyers might just raise prices and so not help FTBers much. Similarly, a Mansion Tax would reduce the price of Mansions. That's a double blow for owners of mansions now, but it means that future owners won't be hurt; although they'll have to pay a tax, they'll buy their mansion cheaper. Also, in an open economy (pdf), it's likely that taxes on companies - in the form of a higher corporate rate or those unspecified anti-avoidance measures the parties like - will fall partly on labour insofar as the tax reduces investment.

However, incidence doesn't just matter for taxes. There's also benefit incidence. Housing benefit is in fact landlords' benefit because it raises rents. And welfare benefits help some firms as much as claimants: where do those benefits get spent?

2. Productivity growth matters. In the long run, it determines GDP growth. A party that was serious about wanting to improve living standards would therefore have a policy to raise productivity growth.

3. The knowledge problem. Any serious policy - in politics and in fact in life generally - must begin from the question: what do we really know? Politicians commonly overstate their knowledge. This leads to promises to cut government borrowing, even though this might not be feasible if economic growth slows. And it also closes off some interesting policy options such as the provisions of services through cooperatives rather than hierarchies.

4. The paradox of thrift. Efforts to save more or borrow less can be collectively self-defeating. To put this another way, falling government borrowing requires increased private sector debt. Oddly, the main parties don't seem keen to point this out.  

5. Factor price equalization. Yes, foreigners might be forcing down British wages. But they don't need to migrate here to do so; international trade can bid down unskilled wages. The notion that immigration controls are sufficient to raise wages greatly is just wrong.

6. Deadweight costs.Labour wants to spend more on immigration controls.For a given (overly tight) fiscal policy, this is money and people diverted away from where they could do more good. That's a deadweight cost.

Another important deadweight cost is that of tax complexity; it leads to people looking for loopholes and gaming the system rather than doing proper work. Tax simplification (and benefit simplification too) should be a higher priority than it is.

7. Supply and demand. If you want to make houses more affordable, you do one thing: build more of them. Lefties might stress the importance of state action, righties the importance of liberalizing planning, Both, though, should agree that demand-side policies such as Help to Buy or cutting stamp duty are just daft.

I don't pretend this is an exhaustive list. I've confined myself to ideas on which economists broadly agree but which the main parties seem to reject. There is a big gap between politicians and economists.      

Comments

[pablopatito]

So could a new political party, based on these sound principles, gain any popularity? You could call it the Stumbling & Mumbling Party. I'd vote for them.

[Matt Moore]

+1000. The overlap in belief between economists of the left and right is much greater than the overlap between either wing and their respective political brand.

I'm still agnostic on the paradox of thrift, but otherwise I couldn't agree more. If I had but one wish in the world, it would be that each one of these points was fully and widely understood.

I wrote a letter to the Times once, after they gave a Tory backbencher space to promote the idea that sellers instead of buyers should pay stamp duty. They couldn't find space for my letter. That man is supposed to be a professional policy-maker.

Do you think politicians are really ignorant? Or are they just-hyper aware of the (rational) ignorance of the electorate?

I would definitely add 8) comparative advantage -free trade is beneficial for both parties even if one is absolutely more productive at everything

[JP]

I blogged on the tax simplicity thing a year or two back - there's a link in there to World Bank/PwC research aligning economic growth more closely to cuts in the tax admin burden than cuts in the tax rate: http://blogs.accaglobal.com/2013/11/12/the-way-less-travelled/

[trebots]

In what sense can international trade bid down my neighbourhood plumber?

[Phil]

"Labour wants to spend more on immigration controls."

To be fair, I think what Labour wants is to get back some of the working-class support that bled away to UKIP as soon as they started looking like a credible option, and to do that they need to make the right noises on immigration. It's not pretty, though.

[Matt Moore]

@trebots... The cost of a plumber is at least partly determined by the need to bid the labour away from other industries (a barber does the same job as four hundred years ago, but it's paid more because the productivity of his alternatives has risen).

[Keith]

Sadly I think most of this is not ignorance by the political class but moral evil. Surprising when they all study Philosophy as part of that PPE degree! Policy around land and property is a failure from the moral point of view as the net effect of restricting supply while increasing demand for housing reduces the standard of living of the majority by reducing the disposable income of tenants and house buyers. And reducing quality and choice. It is an example of an economic policy driven by the desire to create a system where land and buildings are expensive monopoly tokens in a game of musical chairs which enrich the existing class of owners and provide security for banks to lend money to people using the security of an asset whose value is never going to fall as every Government policy is designed to keep prices high. Capital is misallocated and living standards reduced so an arbitrary group can make a untaxed capital gain. This constitutes an enormous negative externality for society deliberately created by the state. The debts created risk periodic breakdowns in the economy as they are so large a part of bank lending. Most of the failures of policy if you examine them in detail are probably also driven by dubious political aims involving preferential treatment for key social groups and the ideology of profiteering that passes for economics in contemporary developed societies.

[Cres]

All of these points are indeed now covered by the current Oxford PPE economics syllabus (speaking as a recent grad - may not have been the case 20 years ago).

[George Carty]

Matt Moore: "I would definitely add 8) comparative advantage -free trade is beneficial for both parties even if one is absolutely more productive at everything."

WRONG!!

Comparative advantage theory actually says that both countries can benefit if balanced trade takes place with each country exporting whichever product has the greater relative advantage.

What FREE trade actually results in though, is the more productive country exporting BOTH products though, in exchange for the importing country's IOUs. This benefits the exporting country at the expense of the importing country (which finds itself saddled with higher debt and/or higher unemployment).

[Donald]

Perhaps there are some benefits to cutting stamp duty for first time buyers. The cut in stamp duty should increase house prices by less than decreases relative prices for FTBs.

Typically FTBs are at a disadvantage compared to people already on the housing ladder. So, arguably*, the distributional benefit will be positive. Although, perhaps better achieved by increasing stamp duty for everyone else?

*The increase for everyone else probably includes renters. Speaking of which...

I think something similar could apply to Labour's (widely panned) plans to cap rent increases. A landlord's monopoly power increases once a tenant has moved in because it costs tenants to move. At the same time a tenant’s monopsony also increases because it costs the landlord to find a new tenant. If the increase in the landlords monopoly power is greater the change should benefit renters. They should also benefit from reduced risk.

[Luis Enrique]

"What FREE trade actually results in though, is the more productive country exporting BOTH products though, in exchange for the importing country's IOUs."

the UK is more productive that China. Are we exporting to China whilst China accumulates debt? No. Oh you want to say that exchange rates work so that buying stuff made in China is cheaper? And might exchange rates be part of the theory of how a less productive economy can trade with a more productive economy? I think it might.

[Anders]

Re: tax incidence - this presumably means that tax credits actually benefit corporates, rather than workers.

With this in mind, what taxes should progressives favour that won't just get pushed on to the poor or to workers in general? Just a Georgist land tax?

[Luis Enrique]

Anders, more likely the benefits are shared by both. Here is some evidence from the US, where if I understand correctly EITC is like our tax credits:

"Work by UC Berkeley’s Jesse Rothstein suggests that for every $1 of transfer to workers using the EITC, post-tax income rises only by $0.73 because of employer capture."

from here:
http://arindube.com/2015/04/19/public-assistance-private-subsidies-and-low-wage-jobs/

this doesn't account - as far as I can see - for any impact on the number of people employed (one would have thought, positive) over and above how much they earn. Nor does it account for possibility that even if they are able to hire workers more cheaply firms may partially pass that on in lower prices rather than retain higher profits.

[reason]

"7. Supply and demand. If you want to make houses more affordable, you do one thing: build more of them. Lefties might stress the importance of state action, righties the importance of liberalizing planning, Both, though, should agree that demand-side policies such as Help to Buy or cutting stamp duty are just daft. "

AT LAST, somebody else who gets it. (Although, another possibility is to invest in infrastructure so that there are more attractive places to build. But liberalizing planning is tricky, also for right wing parties. Their core voters are NIMBYs.)

[reason]

"Re: tax incidence - this presumably means that tax credits actually benefit corporates, rather than workers.

With this in mind, what taxes should progressives favour that won't just get pushed on to the poor or to workers in general? Just a Georgist land tax?"

I thought one Georgist conclusion was that ALL taxes altimately come out of rents.

[Anders]

Thanks Luis. Why would a profit-maximising firm want to pass cost savings (from hiring cheaper workers) on to its customers?

[Luis Enrique]

Anders,

well it wouldn't want to - a profit maximizing firm would love to be a monopolist. Those who aren't, face competition, and may cut prices to win market share. We know from casual observation that as inputs get cheaper, prices often fall too (see: get clothes made more cheaply abroad => Primark)

[Anders]

Luis - I agree that certain industries have seen input cost deflation and also cut their prices. But surely one should analyse these separately. Perhaps Primark wanted to gain market share so it cut its prices, and it was able to realise cost savings around the same time, preserving its unit margins.

To understand the economic effect of a tax credit, it seems to me you need to hold as much as possible constant. If a tax credit is introduced, it will surely make the corporate sector more inclined to grow employment at the margin, but there is also a second effect for existing employees. In other words, corporates would like to immediately cut the wages of those qualifying for the tax credit. If wage stickiness makes this unfeasible, the corporate sector would still postpone wage increases for a long time - compared with the counterfactual where there were no tax credit.

I can't see why the corporate sector _as a whole_ would respond to a tax credit by passing on the lower input costs to customers.

[Luis Enrique]

Anders,

if you want to understand the economic effects of a tax credit, why ignore some effects? This is exactly why economist attempt full general equilibrium analysis.

The extent to which lower wages would be passed on in lower prices would no doubt vary from industry to industry, and over time. I don't know what that means about the corporate sector "as a whole". But in general and in the long run we do not tend to think the rate of corporate profits is driven by input costs do we? To turn it around, do you think rising inputs costs would have a long-run negative impact on rate of corporate profits, or do you think they'd pass them on? If you have in mind an asymmetric models whereby increases are passed on but cuts not, that would ratchet up profits, but as Chris has shown many times on this blog the profit rate is pretty flat.

[Anders]

Luis -

I thought this website and its regulars were sceptical of GE analysis. At any rate, I have in mind a simple first-order effect of a transfer from the government to the corporate sector. Any second-order effects would stem from the worse/better balance sheet positions of the two sectors, respectively.

My model of profit-seeking would say that business always seeks to maximise prices where it is commercially feasible to do so, irrespective of its input cost environment. This is what I see in my day job as an equity investor. There may be some research which shows that firms seek to defend, but not grow, their margins, but this wouldn't resonate with how I see businesses being run. In any event, Chris' piece below seems to show a fairly choppy aggregate profit rate.

http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2010/04/the-tendency-for-the-rate-of-profit-to-rise.html