As an Economics professor, thinking about public policy is a big part of my job, both in teaching and research. The work of the ivory tower has given me some distance from the rough-and-tumble of daily political debate, but has called on me both to face the enduring dilemmas of public policy and to identify areas where technical solutions are available, but not generally understood.
As for areas where technical solutions are available but not generally understood, one of the most important is in stabilization policy. It does not seem to be generally understood that there is no shortage of powerful tools to revive both the U.S. economy and the world economy. This is true despite (A) short-term interest rates already being close to zero in the U.S. and many other countries and (B) most countries not being able to afford to add much to their national debt. I will post on this point soon.
Among the enduring dilemmas of economic policy the most important is the conflict between efficiency and equity. In calling myself a supply-sider I am saying that I believe the harm to the productive performance of the economy caused by taxes and regulations is serious (though seldom serious enough that a reduction in taxes would raise revenue). In calling myself a liberal, I am saying that in addition to an attachment to the liberty, limited government, constitutionalism, and rule of law emphasized by Classical Liberalism, I hold to a view based on both classic Utilitarianism and contested elements of modern economic theory that, generally speaking, a dollar is much more valuable to a poor person than to a rich person, and that therefore, there is a serious benefit to redistribution that must be weighed against the serious distortions caused by the usual methods of redistribution.
Economists have identified two numbers that are central in governing the size of distortions caused by taxes and the benefits of redistribution:
- Tax distortions are governed in important measure by the the consumption-constant elasticity of labor supply. The consumption-constant elasticity of labor supply measures how much less workers want to work when what they earn is taxed, but the tax revenue is recycled back to them in one form or another of government benefit they can get regardless of how little they work. Matthew Shapiro and I argue in our paper “Labor Supply: Are the Income and Substitution Effects Both Large or Both Small?" that the consumption-constant elasticity of labor supply is large. Even leaving aside the decision of whether to work or not and just focusing on how many hours to work, we found a consumption-constant elasticity of labor supply equal to one and a half.
- The benefits from redistribution are governed by what I will call the degree of inequality aversion. In a research project that began in 2005 but is still ongoing, Fumio Ohtake, Yoshiro Tsutsui and I put some extra questions on the University of Michigan Survey of Consumers (the survey behind the Reuters/University of Michigan Consumer Sentiment Index). We asked the people answering the survey first "It is often said that one thousand dollars is worth more to a poor family than to a rich family. Do you agree?” Over 90% of everyone agreed. Then we went on to ask them questions such as this: "Think of two families like yours, one with half the income of your family and one with the same income as your family. Which would make a bigger difference, one thousand dollars to the family with half your family’s income or four thousand dollars to the family with an income like yours?“ More than half of everyone answering the survey said that $1000 would make a bigger difference for the poorer family than $4000 for a family at their own income level. As analysis ably assisted by Daniel Reck and Fudong Zhang confirms, this implies a degree of inequality aversion above two. An inequality aversion of two would mean that if you double someone’s income the value of an extra dollar will drop to a quarter of what it was. So $4000 to the family with twice the income looks like $1000 did to the family with the lower income. The short summary is that most people believe that dollars are worth a lot more to the poor than to the rich when they are asked in a context not immediately connected to public policy. But the public policy implications of this belief are dramatic when coupled with a view that making a net positive difference in people’s lives overall (added up across people) is a legitimate goal of public policy.
Perhaps because of cognitive dissonance, it is common for people to either believe (a) that tax distortions are serious and redistribution is of questionable value OR (b) redistribution is valuable and the distortions induced by taxes are small. My belief is that (c) tax distortions are serious AND redistribution is valuable. That makes me a supply-side liberal.