Economis and Government

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Ten Elements of Clear Ten Elements of Clear Thinking About Economic Thinking About Economic Progress and the Role of Progress and the Role of

GovernmentGovernment

Common Sense Economics

James Gwartney, Richard L. Stroup, and Dwight R. Lee

CommonSenseEconomics.com

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Some Questions to Consider:

• How does a democratic government really work?

• Is it a corrective device? Does it sometimes thwart economic progress?

• Will a policy supported by a voting majority be productive?

• What are the unintended consequences of well-intended governmental policies and programs?

• What is needed to reduce waste and direct governments toward productive activities?

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What Role for Government?

“A wise and frugal government, which shall restrain men from injuring one

another, which shall leave them otherwise free to regulate their own

pursuits of industry and improvements, and shall not take

from the mouth of labor the bread it has earned. This is the sum of good

government.”

-Thomas Jefferson

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Clear Thinking Proposition #1

Government promotes economic progress by:

1. protecting the private rights of individuals and

2. supplying goods that cannot be provided through markets.

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Government’s Protective Function

Government’s protective function includes the maintenance of a framework for security and order.

• Protect people and their property against aggressors through force if necessary.

• Enforce contracts.• Help avoid restrictions,

regulations and discriminatory taxes.

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"If men were angels, no government would be necessary.”

James MadisonFederalist Paper No. 51

1788

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Life, Liberty and the Pursuit of Happiness

Government promotes economic progress by protecting individuals rights to life, liberty, and the pursuit of happiness. It can use force to protect against loss of life, threat to liberty, and damage of property.

Individuals will use resources efficiently, invest and innovate if their rights to benefit from doing so are protected. Economic progress ensues.

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Government’s Productive Function

• Government’s productive function includes the provision of public goods – goods that cannot be provided easily in private markets.

• Public goods – Are available to others once

provided to an individual. – Are difficult to provide only to

paying customers.* National defense* Flood control projects

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The Case for Public Goods

The legitimate object of government is to do for a community of people whatever they need to have done, but cannot do, at all, or cannot, so well do, in their separate and individual capacities.”

~ Abraham Lincoln

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Clear Thinking Proposition #2

Government is not a corrective device. It can

and does fail!!!!

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A Democratic Government

A method of social organization where individuals make and carry out choices collectively.

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In a Democratic Government

• Decisions are made at the margin. Voters, elected officials and lobbyists support those proposals from which they expect to derive net benefits.

• Too often the secondary effects of political actions are ignored and/or pushed into the future when the elected officials are out of office.

• So there is no assurance that governmental actions will be productive.

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 Building a Road or Civic Center

Tax Payment

Voter Benefits Received Plan AEqual Tax

Plan BTaxed Proportionate to Benefits

Adams $15.00 (30% of $50) $12.00 $18.00 (30% of $50)

Brown $15.00 (30% of $50) $12.00 $18.00 (30% of $50)

Green $15.00 (30% of $50) $12.00 $18.00 (30% of $50)

Jones $ 3.00 (6% of $50) $12.00 $ 3.60 (6% of $50)

Smith $ 2.00 (4% of $50) $12.00 $ 2.40 (4% of $50)

TOTAL $50.00 in total benefits

$60.00 $60.00

CSE Table 3. Benefits and Costs of a Hypothetical Government Project

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A Democratic Government:Some Important Points

• Policies proposed by the government may or may not be productive.

• Policies favored by the voting majority do not necessarily promote economic progress.

• The benefits and costs faced by voters belonging to different interest groups are often disproportionate.

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Unlike Democratic Governments, When Markets Are Competitive • Producers can not force

consumers to buy their products.

• They have incentives to undertake only productive activities.

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Let’s Compare Democratic Governments

and Markets1. The government can use coercion to

tax and subsidize. Markets can not.

2. Markets can charge high prices but can not force people to pay. Governments “can” and “do”.

3. Unconstrained political democracy is a system of majority rule, while market allocation is based on proportional representation. In markets, consumers buying one commodity will not interfere with the ability of others to buy a different one.*

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What Is Needed to Encourage Democratic Governments To Be Productive?• To reduce the likelihood that

people can participate in government projects without paying, it is important to link benefits proportionately to costs.

• A democratic majority vote does not guarantee the passage of productive proposals.

• Supermajority support (75% of the voters) will increase the likelihood of passing productive projects.

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Clear Thinking Proposition #3

The costs of government are not

only taxes.

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Which of the following is true of taxes?

a. Taxes increase the volume of mutually advantageous exchanges.

b. Tax increases are the primary cause of inflation.

c. Business taxes generate government revenue without imposing a burden on consumers and households.

d. Taxes drive a wedge between what buyers pay and what sellers receive.

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3 Types of Costs Incurred

1. The loss of private sector output that could otherwise be produced

2. The cost of resources expended in tax collection and enforcement of government mandates

3. The cost of price distortions caused by taxes and borrowing

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Costs of Collection & Enforcement

• Government expenditures plus compliance costs and mandated private spending represent more than 1/2 of GDP.

• Preparation, monitoring and enforcement of tax law and regulatory legislation require time, talent and money.• These resources could be used elsewhere. • People will use resources to avoid taxes.

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Let’s Review How To Measure Government’s Share of Total Output

• Government expenditure’s share of total U.S. spending on goods and services produced represents approximately 35% of total GDP.

• When the costs of regulations are added, this share rises to over 50% of GDP.

• Government is big in the U.S.!

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Government Can Distort Prices

• Taxes alter consumption and production incentives.

• Consider supply and demand. Taxes increase what consumers pay and reduce what sellers receive. They reduce the volume of exchanges and squeeze out some of the gains from trade.

• Some exchanges will not occur because the tax wedge makes them disadvantageous.

• Deadweight loss of taxation adds 9-16% above the costs of compliance and regulation.

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Taxes in a Nutshell

• Taxes distort prices.• Taxes transfer income from

individuals to the government. – Businesses do not pay taxes.

Instead, they collect taxes from customers, employees and shareholders.

• Politicians want to conceal the tax costs of their programs and make you “think” businesses are paying!

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Do you agree or disagree? Explain.

“Taxing is much like plucking a goose. It is the art of getting the greatest number of feathers with the least amount of hissing.”

~ Senator Bob DoleWall Street JournalDecember 16, 1983

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Clear Thinking Proposition #4

Unless restrained by constitutional rules,

special-interest groups will use the democratic

process to fleece taxpayers and

consumers.

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A Democratic Government• Can contribute to economic

progress when it fills its protective and productive roles.

• However, more than a majority rule and popular vote is needed to assure that it restricts itself to those roles.

• Why? Incentives matter! Consider the following three examples.

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1. Democratic Government Incentives

“Government regulators and legislators may be heavily influenced by lobbyists and the possibility of securing highly paid jobs after leaving government, and so they may focus on the interests of the regulated party rather than citizens.”*

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The Power of Special Interests

• Special interest groups will help politicians get elected through donations and getting workers to vote.

• While the majority of unorganized voters is harmed, there is little incentive to act in opposition.

• In varying degrees, all politicians cater to special interests.

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2. Democratic Government Incentives

“If a small but organized group cares a great deal about a certain government policy, while the majority is unorganized and apathetic, then the special interest often prevail.”*

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Consider This “Sweet” Example

• In 2000, the sugar lobby contributed $13 million to politicians.

• The government restricts sugar imports into the U.S. through quotas.

• The average U.S. consumer pays $20 per year in higher sugar prices while sugar growers gain about $1.9 billion.

• IS THIS A SOUND GOVERNMENT PROGRAM? DISCUSS.

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3. Democratic Government Incentives

• Log-rolling: implicit vote trading among legislators

• They vote for programs that benefit the districts of other legislators in exchange for votes for their pet projects.

• Federally funded dams, highways, housing projects, Veterans Administration hospitals, and job-training centers are often reflective of logrolling.

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Question: Restrictions that limit sugar imports, subsidies for the construction of sports stadiums, and federal spending on programs like the construction of an indoor rain forest in Iowa all provide examples of government programs that,

a. Are based on careful analysis of benefits relative to costs.

b. Are designed to redistribute income from the rich to the poor.

c. Reflect the political attractiveness of special-interest issues.

d. Promote the general welfare.

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Clear Thinking Proposition #5

Unless restrained by constitutional rules, legislators will run budget deficits and spend excessively.

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The Attractiveness of Deficit Spending to Legislators

• Budget Deficit: Government spending that exceeds revenues. Deficits are financed by borrowing.

• Spending is attractive to legislators because it allows them to take credit for programs that benefit voters.

• Taxes are unattractive because they impose visible costs on voters.

• Thus, legislators tend to spend more than they are willing to tax.

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The National Debt

• The cumulative effect of all past budget deficits and surpluses of the federal government.

• Check out the U.S. Debt. • The U.S. Treasury borrows

funds by selling securities like U.S. Treasury Bills, Notes, and Bonds.

• Borrowing makes the current cost of running the government less visible.

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Deficit Spending and National Debt

• Borrowing pushes the visible cost of running the government and policies into the future.

• Bottom line. Immediate benefits with deferred costs are politically attractive!

• Deficit spending and public debt appear to transfer costs into the future when current politicians are no longer office.

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Constitutional Changes That May Restrain Legislators

• Require the federal government to balance its budget like most states.

• Require a 2/3 or ¾ majority vote in both branches of Congress to fund deficit spending or increase its borrowing power.

• Require that Congress only spends an amount equal to last year’s tax revenue.

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Clear Thinking Proposition #6

Government slows economic progress when it becomes

heavily involved in trying to help some

people at the expense of others.

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Production or Plunder?• A neutral government can help make the

economic “production” pie bigger when it protects property rights and provides public goods!

• It shrinks the economic pie when it “plunders” the income of one group to satisfy the interests of another.

“Counterproductive, favor-seeking activities are a natural outgrowth of unrestrained democracy.” CSE, p97

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Clear Thinking Proposition #7

The costs of government income

transfers are far greater than the net

gain to intended beneficiaries.

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Income Transfers• It is difficult to improve people’s well-

being through income transfers when benefits are not attached to costs.

• The unintended consequences of secondary effects can get in the way.

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The Unintended Consequences of Income Transfers

1. Reduce incentives of both taxpayer and transfer recipient to earn income• “Free” income reduces work effort and

innovation among transfer beneficiaries.• Increased tax burdens stifle incentives to

produce and earn more among persons earning income and paying taxes.

2. Competition for transfers erodes most of the long-term gain of the targeted beneficiaries.• When qualification requirements must be

met, resources and potential production are wasted as individuals seek to qualify for the transfers.

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Income Transfers (cont.)

3. Protection from adversity arising from imprudent decisions makes people more likely to increase the likelihood of that adversity.• Consequences of adversity become

less severe.• Potential recipients have less

incentive to avoid adversity.4. If you subsidize something, you

get more of it.• Transfers directed toward the poor

unintentionally encourage high-risk lifestyles.

• Charitable efforts are crowded out.

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The “War on Poverty” Illustrates

These Points

0%

5%

10%

15%

20%

25%

30%

35%

1947 1959 1965 1975 1985 1995 2005

“War”

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Clear Thinking Proposition #8

Central planning replaces markets

with politics, which wastes resources

and retards economic progress.

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The “Man of System”

“The man of system is apt to be very wise to his own conceit. He seems to imagine that he can

arrange the different members of a great society with as much ease as the hand

arranges the different pieces upon a chess-board.”

-Adam Smith

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The “Fatal Conceit” of Central Planning

1. Central planning merely substitutes politics for market outcomes.a. Subsidies and investment funds

disbursed by planners are influenced by political considerations.

b. “Old” firms tend to be favored over “new”, growth-oriented firms.

c. “Pork barrel” projects are still pursued.

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The “Fatal Conceit” of Central Planning

2. The incentive of government-operated firms to keep costs low, be innovative, and supply goods efficiently is weak.a. Boosting efficiency or lowering

costs generate little political gain.

b. Per-unit costs rise as increased inefficiencies get built into the political allocation.

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The “Fatal Conceit” of Central Planning

3. Investors risking their own money will make better investment choices than central planners spending the money of taxpayers.a. Private investors bear the

consequences of poor decisions directly but central planners do not.

b. Private investors have a strong incentive to increase productivity and keep costs low. In contrast, political rather economic considerations are more important for central planners.

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The “Fatal Conceit” of Central Planning

4. There is no way that central planners can acquire enough information to create, maintain, and constantly update a plan that makes sense.a. Market prices generally channel

information quickly and accurately to both producers and consumers. On the other hand a political process, particularly one with checks and balances like those found in the U.S., will respond slowly and often in a contradictory manner.

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Clear Thinking Proposition #9

Competition is just as important in

government as in markets.

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Government & Competition

1. Leaders of public sector firms have little incentive to cut costs or boost performance when there is little competition.a. Inefficient programs are permitted

to linger.b. Failure to achieve goals is often

rewarded by increased funding. Consider increased funding in police departments with higher crime rates.

2. In the market economy, profits and losses register performance. Inefficient producers are weeded out and efficient ones are rewarded. There is no parallel in the centralized government.

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Government & Competition

3. Increased competition among decentralized government units or between the government and private sector creates incentives for government officials to work productively, seek efficiency, cut costs and innovate.

4. Citizens with differing preferences and views about government activities can vote with their feet in a decentralized system; a centralized system does not permit this.

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Clear Thinking Proposition #10

Constitutional rules that bring the

political process and sound economics into

harmony will promote economic

progress.

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Constitutional ChecksConstitutional Checks• The scope of

government must be limited.

• An unrestrained government results in the fleecing of citizens.

• Constitutional checks:– 10th Amendment

– 5th Amendment

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A Positive Program for Prosperity

• List the seven constitutional constraints presented by the authors.

• Explain the purpose of each constraint.

• Indicate why you think it will be either effective or ineffective.

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A Positive Program for Prosperity:

7 Constitutional Suggestions

1. No government shall use its regulatory powers to take private property, either partially or in its entirety, for public use without paying the owner the full market value of the property taken.

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A Positive Program for Prosperity:

7 Constitutional Suggestions

2. The right of individuals to compete in a business or profession and/or buy and sell legally tradable goods and services at mutually acceptable terms shall not be infringed by Congress or any of the States.[i]

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A Positive Program for Prosperity:

7 Constitutional Suggestions

3. Congress shall not levy taxes or impose quotas on either imports or exports.

4. A three-fourths approval of both Houses of Congress shall be required for all expenditure programs of the federal government. At least two-thirds approval of the legislative branches of state government shall be required for the approval of expenditures by state governments.

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A Positive Program for Prosperity:

7 Constitutional Suggestions

5. A three-fourths approval of both Houses of Congress shall be required before the federal government is permitted to borrow any funds to finance a deficit in its annual budget.

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A Positive Program for Prosperity:

7 Constitutional Suggestions

6. A three-fourths approval of both Houses of Congress shall be required for the federal government to mandate any expenditures by either state governments or private business firms.

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A Positive Program for Prosperity:

7 Constitutional Suggestions

7. The function of the Federal Reserve System (Fed) is to maintain the value of the currency and establish a stable price level. If the price level either increases or decreases by more than 4 percent annually during two consecutive years, all Governors of the Federal Reserve System shall be required to submit their resignations.