The Economics of Creative Destruction, Part III

Time for Part III in my series on the economics of creative destruction (here’s Part I and Part II).

We’ll start with this clip from a recent trans-Atlantic interview.

As you can see from the discussion, I openly acknowledge that the progress enabled by free enterprise can produce economic pain.

This is why I’ve called creative destruction the best and worst feature of capitalism.

For instances, millions of jobs are destroyed every year. But (assuming politicians aren’t causing too many problems) more jobs usually are created.

And, over time, our incomes grow and our living standards increase (with some countries doing better than others for obvious reasons).

For today’s column, let’s look at some additional evidence.

We’ll start with some findings from a 2019 study published by the Australian Bureau of Statistics. The researchers found that failure is a necessary feature of a market economy.

Here are some excerpts from the abstract.

We examine the components of this productivity growth by estimating the contribution of entry, exit, within-firm growth and re-allocation to productivity growth in Australia in the period 2002- 2013. We use an experimental linked dataset of 10 million workers across 1.5 million firms. …We find that firm entry and exit are by far the largest contributors to productivity growth across all industries. In general, firm exit contributes positively to productivity growth whereas firm entry generally contributes negatively. This would suggest that policies which facilitate firm entry and exit are likely to help achieve increased productivity gains. Policies which provide large advantages to incumbent firms are likely to detract from productivity growth.

That final sentence is key. It shows why politicians should not coddle big business with handouts, bailouts, subsidies and protectionism, and other forms of cronyism and industrial policy.

That’s a recipe for zombie firms and stagnation. This is why it is good news that the vast majority of Fortune 500 companies in the U.S. lost ground over a 60-year period.

Let’s now look at another study, this one published by the National Bureau of Economic Research. James Feigenbaum and Daniel P. Gross looked at how the economy adapted after massive job losses in the telephone industry.

Using panel variation in the local adoption of mechanical switching and population outcomes from complete count census data from 1910 to 1940, we show that dial cutovers presented a large negative shock to local labor demand for young, white, American-born women, with the number of young operators dropping by upwards of 80%—a near-total collapse in entry-level hiring in one of the country’s largest occupations for young women—and accordingly around 2% of jobs for this group being permanently replaced by machines, essentially at the flip of a switch. These 2% of jobs represented entry-level opportunities for several times as many young women, and the fear was that its automation might choke off future generations from the labor force. We find that this shock did not reduce future cohorts’ employment rates. It appears that comparable middle-skill office jobs and some lower-skill service sector jobs absorbed future generations of young workers workers, and did so fairly quickly, with women of only the youngest ages on average ending up in lower-paying occupations than they would have been in otherwise. The adverse consequences of automation were concentrated in incumbent telephone operators, who were subsequently less likely to be working, and conditional on working, more likely to be in lower-paying occupations—but even then, the magnitudes of these impacts were relatively modest.

In other words, “creative” generally outweighs “destruction.” Which was one of Joseph Schumpeter’s main points when he explained the concept last century.

Speaking of which, let’s close by looking at Professor Richard Ebeling’s column about Schumpeter.

Schumpeter…defined “the entrepreneur” as the central and dynamic figure of the market process who introduces transformative innovations that radically change the forms and directions of economic activity. …Looking over the nearly century and a half from the start of the nineteenth century to his own time…, Schumpeter pointed to the dramatic increase in the output of goods and services, including new and better goods that were not available to even the wealthiest of kings and princes in, say, 1790 or 1810. …In doing this, capitalism was also serving as a great “leveler” that was raising the economic well-being of all, while also narrowing the differences in the quality of life between “the rich” and the rest. …The “culture of capitalism,” Schumpeter said, also had eliminated political privileges and favoritism and had increasingly fostered equality before the law for all, including women and religious and ethnic minorities. Capitalism replaced primitive tribal and social collectivism with an ethic and a politics of individualism that established the ideal of individual rights, private property, and human association based on freedom of contract. …Fortunately, even in the face of the regulatory and redistributive state, the market economy has still possessed enough competitive openness and profit-earning opportunity that continuing prosperity has been a reality.

By the way, Schumpeter was actually pessimistic about the survival of capitalism. He feared that it was just a matter of time before supporters of statism would get the upper hand.

For all intents and purposes, he was describing the tension in my 16th Theorem of Government. In other words, will politicians give the economy enough “breathing room” to deliver more prosperity?

Read Full Post »

The Economics of Creative Destruction, Part II

I’ve referred to “creative destruction” as the “best and worst part of capitalism.”

This short video from the Fraser Institute is a good tutorial on the topic.

The core message is that entrepreneurs improve our lives by coming up with new ideas, new technologies, and new products.

That’s the good news.

The bad news is that this process unavoidably can have a very negative effect on sectors of the economy that get displaced.

That being said, the bad news for people like blacksmiths and carriage makers hopefully is only temporary since the economy creates other jobs.

This is a point I’ve made when looking at global trade, but the lesson would apply even if the United States was the world’s only nation.

For today’s column, I don’t need to provide any additional analysis. Instead, I’m simply going to share four tweets that illustrate the power of creative destruction.

First, I’ve explained that big companies can get toppled. This tweet shows have fast it can happen.

Mar 1998: "How Yahoo! Won the Search Wars" (Fortune)
Sep 1998: Google founded

Feb 2004: Facebook founded
Feb 2007: "Will MySpace ever lose its monopoly?" (Guardian)

Jun 2007: iPhone released
Nov 2007: "Nokia. One Billion Customers—Can Anyone Catch the Cell Phone King? (Forbes) pic.twitter.com/uGKcovNSvO

— Alec Stapp (@AlecStapp) July 29, 2020

Sticking with the topic of companies, here’s a remarkable tweet capturing the dynamism of the American economy.

Things that didn’t exist on Christmas 20 years ago:

iPhone
Facebook
YouTube
Instagram
Twitter
TikTok
Android
Bitcoin
Tesla
iPad
Gmail
Netflix streaming
Amazon Prime
Slack
Reddit
Etsy
WhatsApp
Messenger
Google Maps
Snapchat
LinkedIn
Pinterest
Chrome
Zoom
Skype
Spotify
Airbnb
Uber

— Jon Erlichman (@JonErlichman) December 25, 2022

Next, you don’t need to be my age to remember ubiquitous Blockbuster stores. At one point, there were nearly 6,000 in the country.

But look what happened as new technologies gave consumers better options.

Animated map shows the rise and fall of Blockbuster Video stores in the US from 1986 to 2019. Fascinating to view. Source: https://t.co/WH4fY6ZBxo pic.twitter.com/ivDVVxnZMT

— Simon Kuestenmacher (@simongerman600) June 29, 2020

Now let’s travel back in time. Here’s a job that disappeared because of technological improvements.

knocker-up profession disappeared in 1920s as alarm clocks became cheaper and more reliable pic.twitter.com/UbZDOJxSsA

— Vala Afshar (@ValaAfshar) July 29, 2020

The moral of the story is that the rise and fall of different industries, different companies, and different professions can be messy.

But the long-run result is much higher living standards for families. As I explained in this video, even the children and grandchildren of people who lost their jobs because of creative destruction are much better off.

P.S. Understanding creative destruction also helps to explain why industrial policy is so misguided, along with protectionism. Politicians and special interests are motivated by a desire to save jobs in declining sectors. Instead, they should adopt policies that lower barriers to investment and entrepreneurship. That’s the recipe to hasten the creation of new jobs.

Read Full Post »

The Best and Worst States to Create a Small Business

Americans can see how their states rank for overall economic liberty.

• Economic Freedom of North America.
• Freedom in the 50 States.
• Report on Economic Freedom.

They can also see how states rank for fiscal policy.

• State Business Tax Climate Index.
• Fiscal Policy Report Card on America’s Governors.

Today let’s look at how various states rank based on whether they are good places to create a small business.

Unsurprisingly, having no state income tax helps, but that is just one variable. It is also very important to have modest fees.

The top three states are Wyoming, Florida, and South Dakota.

Here’s some discussion of the ratings, including methodology.

Brand new research conducted by small business advice company Venture Smarter reveals the best and worst states to startup an LLC. The experts have indexed all 50 U.S states (plus DC), ranking each against six factors necessary for starting up an LLC, to receive a score out of 100. …Rankings are based on factors including LLC annual fees, LLC filling fees, average LLC agreement bid costs (from professional in States required to have one), advertising and publishing costs, tax climate index scores, and number of small businesses per 100K residents.

And which states are worst?

California is in last place, followed by New York and Delaware.

I’m somewhat surprised to see a very bad score for Delaware.

The state is famous, after all, as a tax haven for companies. I wonder if this is a case of the state charging high fees because it actually provides high value?

Read Full Post »

New Academic Study: Payroll Tax Burdens Stifle Entrepreneurship

When I write about Social Security, I normally focus on two serious deficiencies.

1. The program was never properly designed to deal with demographic change, which means there’s a gargantuan long-run budgetary shortfall of $44 trillion.
2. The program is a very bad deal for workers (especially minorities), offering a paltry retirement benefit compared to what could be obtained with private savings.

I’ve neglected to explain, though, that there’s also an economic cost. All government spending is a burden since resources get diverted from the productive sector of the economy. Moreover, the associated payroll taxes have an adverse impact on incentives for employment.

Those taxes also have a negative effect on entrepreneurship, according to new research from three economists. Here are some excerpts from their study, which has been published by the National Bureau of Economic Research. We’ll start with a look at the methodology.

Entrepreneurship plays a central role in modern economies. In the US, for example, new businesses account for 20% of total gross job creation. While entrepreneurs can be very successful…, entrepreneurship remains one of the most economically risky lines of activity and can result in large wealth losses. …the marginal value of resources for entrepreneurs can be substantial, given how cash-constrained they often are. Therefore, mandating social insurance, while reducing risks,could significantly affect entrepreneurial activity. …In this paper, we…exploit quasi-experimental variation in the amount of social insurance contributions and…administrative data on the full population of Finnish entrepreneurs to address this question. …We use a standard differences-in-differences strategy and exploit a reform in 2011 that changed the ownership share rule from 50% to 30% to assess how relaxing the social insurance mandate affects entrepreneurial activity. …Overall, we find that social insurance contributions are reduced by an aver-age of 19% for the treatment group, which has more discretion over insurance contributions after the reform. This reduction represents a large cash windfall, equivalent to, on average, a 5 percentage-point reduction in corporate taxes.

Here are the key results, which show that payroll taxes have a decidedly negative effect on new firms.

…we observe a larger than average decrease in social insurance contributions by the owners of younger firms. The cash saved from the lower contributions is channeled into their firms, as we observe an increase in both employee compensations and other input costs, and an increase in turnover after the reform. …entrepreneurs in younger firms are more liquidity-constrained and have access to better growth opportunities than more mature firms. …Figure 2 shows the effect of the 2011 reform on business activity for young firms that are equal to or younger than five years old. …we estimate a 9.9% increase in turnover and a 6% increase in employee wage costs. Overall, these results imply that firms use the saved cash to pay for additional intermediate inputs and labor in order to increase turnover, and suggests that these firms might be facing liquidity constraints.

Here’s the aforementioned Figure 2, showing the both sales and wages are higher when social insurance taxes are lower.

The bottom line is clear.

…our findings imply that the social insurance mandate…crowds out business activity for young firms… the social insurance mandate for entrepreneurs has heterogeneous efficiency costs. Efficiency gains could be achieved by…lower social insurance contributions.

What is meant by efficiency gains?

That’s simply economic jargon for faster growth and higher living standards. And those results occur because entrepreneurs play a key role in driving innovation.

P.S. This issue is timely and important since politicians such as Bernie Sanders and Alexandria Ocasio-Cortez are pushing “Medicare for All” and other schemes that would require huge increases in payroll taxes.

P.P.S. Other Democrats, such as Barack Obama and Hillary Clinton, have urged higher payroll taxes that would deliberately target entrepreneurs, investors and business owners.

P.P.P.S. You can enjoy some Social Security cartoons here, here, and here. And we also have a Social Security joke if you appreciate grim humor.

Read Full Post »

Higher Tax Rates ==> Less Innovation ==> Less Prosperity

If the goal is higher living standards, then higher levels of productivity are necessary. And that requires entrepreneurship and innovation.

But bad tax policy can be an obstacle to the economic choices that create a better future.

I’ve already shared lots of research showing how punitive tax rates undermine growth, but it never hurts to add to the collection.

Let’s look at a new study by Ufuk Akcigit, John Grigsby, Tom Nicholas, and Stefanie Stantcheva. Here’s the issue they investigated.

…do taxes affect innovation? If innovation is the result of intentional effort and taxes reduce the expected net return from it, the answer to this question should be yes. Yet, when we think of path-breaking superstar inventors from history…we often imagine hard-working and driven scientists, who ignore financial incentives and merely seek intellectual achievement. More generally, if taxes affect the amount of innovation, do they also affect the quality of the innovations produced? Do they affect where inventors decide to locate and what firms they work for? …In this paper, we…provide new evidence on the effects of taxation on innovation. Our goal is to systematically analyze the effects of both personal and corporate income taxation on inventors as well as on firms that do R&D over the 20th century.

To perform their analysis, the economists gathered some very interesting data on the evolution of tax policy at the state level. Such as when personal income taxes were adopted.

By the way, I may have discovered an error. They show Connecticut’s income tax being imposed in 1969, but my understanding is that the tax was first levied less than 30 years ago.

In any event, the authors also show how, over time, states have taxed upper-income households.

They look at 20th-century data. If you want more up-to-date numbers, you can click here.

But let’s not digress. Here are some of the findings from the study.

We use OLS to study the baseline relationship between taxes and innovation, exploiting within-state tax changes over time, our instrumental variable approach and the border county design. On the personal income tax side, we consider average and marginal tax rates, both for the median income level and for top earners. Our corporate tax measure is the top corporate tax rate. We find that personal and corporate income taxes have significant effects at the state level on patents, citations (which are a well-established marker of the quality of patents), inventors and “superstar” inventors in the state, and the share of patents produced by firms as opposed to individuals. The implied elasticities of patents, inventors, and citations at the macro level are between 2 and 3.4 for personal income taxes and between 2.5 and 3.5 for the corporate tax. We show that these effects cannot be fully accounted for by inventors moving across state lines and therefore do not merely reflect “zero-sum” business-stealing of one state from other states.

Here are further details about the statewide impact of tax policy.

A one percentage point increase in either the median or top marginal tax rate is associated with approximately a 4% decline in patents, citations, and inventors, and a close to 5% decline in the number of superstar inventors in the state. The effects of average personal tax rates are even larger. A one percentage increase in the average tax rate at the 90th income percentile is associated with a roughly 6% decline in patents, citations, and inventors and an 8% decline in superstar inventors. For the average tax rate at the median income level, the effects are closer to 10% for patents, citations, and inventors, and 15% for superstar inventors.

At the risk of understatement, that’s clear evidence that class-warfare policy has a negative effect.

The study also looked at several case studies of how states performed after significant tax changes.

…case studies provide particularly clear visual evidence of a strong negative relationship between taxes and innovation. When combined with the macro state-level regressions, the instrumental variable approach and the border county analysis, the results overall bolster the conclusion that taxes were significantly negatively related to innovation outcomes at the state level.

Here’s the example of Delaware.

For what it’s worth, we have powerful 21st-century examples of the consequences of bad tax policy. Just think New Jersey, California, and Illinois.

But I’m digressing again.

Back to the study, were we find that the authors also look at how tax policy affects the decisions of people and companies.

We then turn to the micro-level, i.e., individual firms and inventors. …we find that taxes have significant negative effects on the quantity and quality (as measured by citations) of patents produced by inventors, including on the likelihood of producing a highly successful patent (which gathers many citations). At the individual inventor level, the elasticity of patents to the personal income tax is 0.6-0.7, and the elasticity of citations is 0.8-0.9. …we show that individual inventors are negatively affected by the corporate tax rate, but much less so than by personal income taxes. …We find that inventors are significantly less likely to locate in states with higher taxes. The elasticity to the net-of-tax rate of the number of inventors residing in a state is 0.11 for inventors who are from that state and 1.23 for inventors not from that state. Inventors who work for companies are particularly elastic to taxes.

And here are additional details about the micro findings.

…patenting is significantly negatively affected by personal income taxes. A one percentage point higher tax rate at the individual level decreases the likelihood of having a patent in the next 3 years by 0.63 percentage points. Similarly, the likelihood of having high quality patents with more than 10 citations decreases by 0.6 percentage points for every percentage point increase in the personal tax rate. …We find that a one percentage point increase in the personal tax rate leads to a 1.1 percent decline in the number of patents and a 1.4-1.7 percent decline in the number of citations, conditional on having any. …the likelihood of having a corporate patent also reacts very negatively to the personal tax rate… A one percentage point decrease in the corporate tax rate increases patents by 4% and citations by around 3.5%. The IV results are of similar magnitudes, but again even stronger. According to the IV specification, a one percentage point decrease in the corporate tax rate increases patents by 6% and citations by 5%.

Here are some of the conclusions from the study.

Taxation – in the form of both personal income taxes and corporate income taxes – matters for innovation along the intensive and extensive margins, and both at the micro and macro levels. Taxes affect the amount of innovation, the quality of innovation, and the location of inventive activity. The effects are economically large especially at the macro state-level, where cross-state spillovers and extensive margin location and entry decisions compound the micro, individual-level elasticities. …while our analysis focuses on the relationship between taxation and innovation, our data and approach have much broader implications. We find that taxes have important effects on intensive and extensive margin decisions, on the mobility of people and where inventors and firms choose to locate.

In other words, the bottom line is that tax rates should be as low as possible to produce as much prosperity as possible.

P.S. If you check the postscript of this column, you’ll see that there is also data showing how inventors respond to international tax policy. And there’s similar data for top-level entrepreneurs.

Read Full Post »

Entrepreneurship, Growth, and Capital Gains Taxation

I wrote last month about a new book from the Fraser Institute about demographics and entrepreneurship.

My contribution was a chapter about the impact of taxation, especially the capital gains tax.

At a panel in Washington, I had a chance to discuss my findings.

If you don’t want to watch an 11-minute video, my presentation can be boiled down to four main points.

1. Demographics is destiny – Other authors actually had the responsibility of explaining in the book about the importance of demographic change. But it never hurts to remind people that this is a profound and baked-in-the-cake ticking time bomb.

So I shared this chart with the audience and emphasized that a modest-sized welfare state may have been feasible in the past, but will be far more burdensome in the future for the simple reason that the ratio of taxpayers to tax-consumers is dramatically changing.

And it goes without saying that big-sized welfare states are doomed to collapse. Think Greece and extend it to Italy, France, Japan, and other developed nations (including, I fear, the United States).

2. Entrepreneurship drives growth – Capital and labor are the two factors of production, but entrepreneurs are akin to the chefs who figure out news ways of mixing those ingredients.

For all intents and purposes, entrepreneurs produce the creative destruction that is a prerequisite for growth.

3. The tax code discourages entrepreneurship – The bulk of my presentation was dedicated to explaining that double taxation is both pervasive and harmful.

I shared my flowchart showing how the American tax code is biased against income that is saved and invest, which discourages entrepreneurial activity.

And then showed the capital gains tax burden in developed countries.

The U.S. is probably even worse than shown in the above chart since our capital gains tax is imposed on inflationary gains.

4. The United States need to be more competitive – Last but not least, I pointed out that America’s class-warfare tax policies are the fiscal equivalent of an “own goal” (soccer reference for World Cup fans).

And this chart from my chapter shows how the United States, as of mid-2016, had the highest combined tax rate on capital gains when including the effect of the capital gains tax.

That’s the bad news. The good news is that the Trump tax cuts did produce a lower corporate rate. So in the version below, I’ve added my back-of-the-envelope calculation of where the U.S. now ranks.

But the bottom line is still uncompetitive when looking at the tax burden on investment.

And never forget that this ultimately backfires against workers since it translates into lower pay.

P.S. The Wall Street Journal produced an excellent description of why capital gains taxation is very destructive.

Read Full Post »

It’s a Bird, It’s a Plane….It’s Super Entrepreneur!

When writing about economic growth, my usual approach is to point out that more output is a function of increases in the quantity and quality of labor capital.

This is a helpful way of thinking about growth since it becomes easier to understand why certain policies are bad (such as redistribution programs that discourage labor supply) and other policies are good (reducing double taxation to encourage more saving and investment).

But labor and capital are only part of the story. Those two “factors of production” are the ingredients for growth, but who decides how those ingredients are combined?

As I point out in one of the Powerpoint slides I often use, there needs to be a “chef.”

This is why entrepreneurs are so important. They are the innovators who often figure out better and smarter ways of mixing labor and capital, leading to the “creative destruction” that characterizes dynamic and prosperous economies.

Entrepreneurs make mistakes all the time, of course, but there’s a feedback mechanism in a private economy called profit and loss. And that rewards good choices and penalizes bad choices. By contrast, when politicians play “chef,” you get cronyism, inefficiency, and corruption.

To understand the critical role of entrepreneurship, I strongly recommend a great two-part series, authored by two Swedish brothers, Tino Sanandaji and Nima Sanandaji, published by Cayman Financial Review.

In Part I, published in January, they share some good news about the state of entrepreneurship in America compared to Europe.

Entrepreneurship matters. And the rate of entrepreneurship differs across the Atlantic. Of the 100 largest public companies in the U.S., 31 were founded by an entrepreneur during the post-war era. In Europe, the corresponding figure is only seven out of the 100 largest firms. While these new firms in the U.S. created over four million jobs, those in Europe created about a million. A slightly different measure is the 500 largest global firms listed by the Financial Times. Amongst the U.S. firms on the list 29 percent were formed after 1950. This compares with merely eight percent in Europe.

But they make a valuable observation that entrepreneurship and self-employment are not necessarily the same thing.

In fact, the U.S. has a lower rate of self-employment than most other industrialized countries. Self-employment is the highest in Greece, Turkey, Spain, Portugal and Italy, countries with low rates of innovative entrepreneurship. Within the U.S., the self-employment rate in Silicon Valley is half that of the average of California. Clearly, the concept of entrepreneurship is very much different from that of self-employment. …When asked directly, four out of five business owners would not even define themselves as entrepreneurs. And approximately nine out of ten of the self-employed report that their firm does not engage in any innovative activity. So while a percentage of self-employed are true or potential entrepreneurs, not all of them are.

So the Sanandaji brothers decided to create a new measure based on “SuperEntrepreneurs.”

…we have worked on constructing a measure of high-impact entrepreneurship. The basis of our analysis is the comprehensive work that Forbes Magazine annually does when compiling the list ‘The World’s Billionaires’. We build upon Forbes’ work by distinguishing the individuals who have amassed a billion dollar fortune through entrepreneurship.

Their findings are fascinating.

The richest individuals in capitalist market economies to a surprisingly large extent appear to earn their wealth by creating new value, rather than inheriting it or acquiring it illegitimately. …the difference between both sides of the Atlantic is significant. In Western Europe 42 percent of the billionaires are self-made entrepreneurs, with most of the rest having inherited their wealth. In the U.S., 70 percent of billionaires are self-made entrepreneurs. In countries such as China that have only recently opened to capitalism, virtually all billionaires are self-made entrepreneurs. This indicates that the American Dream – the notion that it is possible for individuals to rise to the top through effort, luck and genius – is still alive. Self-made billionaire entrepreneurs have created millions of jobs, billions of dollars in private wealth and probably trillions of dollars of value for society.

And that value varies by region.

The number of SuperEntrepreneurs varies significantly across countries. Hong Kong has the most, with around three SuperEntrepreneurs per million inhabitants. The second highest rate of entrepreneurship is found in Israel, where there are close to two SuperEntrepeneurs per million inhabitants, followed by the U.S., Switzerland and Singapore. …When comparing large regions, the gap in super-entrepreneurship can be clearly seen. The U.S. is roughly four times as entrepreneurial as Western Europe and three times as entrepreneurial as Japan. The same relations hold regardless of whether we look at our measure of SuperEntrepreneurs, large firm founders or venture capital investment as a percentage of GDP.

But why does SuperEntrepreneuship vary by regions?

In Part I, the Sanandajis note that there seems to be more success in the Anglosphere (i.e., nations that got their legal system from England).

In Part II, published in April, they dig deeper and identify the policies that make a difference.

They start with property rights.

One institution that has a direct and positive link to entrepreneurship is the protection of private property. …Property rights matter because individuals will rarely invest the massive amounts of time and money needed to creating an entrepreneurial company if there is an imminent risk that their firm will be taken from them in the event it becomes valuable. In economies with weak protection of property rights and corrupt states, firms tend to stay small and informal. This of course inhibits high growth entrepreneurship. …In our study, we find a clear link between property rights – as measured by the International Property Rights Index – and the level of SuperEntrepreneurship per capita around the world. The countries which have the strongest property rights tend to have more high-impact entrepreneurs.

They also find taxes make a difference.

Another key factor influencing the rate of high-impact entrepreneurship is taxes.  …Taxes are therefore a necessary evil. The need to balance the need for revenue and the damaging impact of taxes on the economy is perhaps the biggest challenge of modern welfare states. …Entrepreneurial success is a fabulous prize that motivates many to try, for a few to succeed. If taxes diminish the value of this prize, fewer individuals will make the effort and take the risk to win. … If taxes eat away a sizable part of the return from the rare cases of great success, the calculus between these choices is changed. …high taxes can make a previously profitable investment unprofitable. …Research has consistently shown that business owners reduce their output more in reaction to taxes than workers; they are, in the terminology of economists, more responsive. This is likely due to a combination of entrepreneurs having more control over their reported income, more control over effort and being more responsive to economic incentives. …In our study, we indeed do find a clear relation between taxes on profit and the share of high-impact entrepreneurs in our list. The nations that have the highest tax rates tend to be the same that have the lowest rates of entrepreneurship.

And they explain that regulatory burdens also are important.

The third institutional factor that is strongly linked to the rate of SuperEntrepreneurship is regulation.  …Each individual regulation may seem reasonable in out of itself… Taken together however, these well-meaning regulations can grow exponentially and inhibit business startup. This is especially true as startups do not have the resources to hire full time employees to deal with regulations like large firms. Regulations can also inhibit the rate of growth, take energy from the entrepreneur that could instead be used to develop the venture and can also force the firm to make poor business decisions in order to comply with some rule or regulation. …in many countries regulations arise not in order to ensure desirable social outcomes, but in order to facilitate government control and even corruption….we rely in our work on the World Bank “ease of doing business” index… We find that countries with a heavy regulatory burden have fewer entrepreneurs per capita. The findings are replicated when using an alternate regulatory index for the OECD countries. Even when controlling for tax rates and per capita income, more regulation is associated with fewer SuperEntrepreneurs.

I’m only skimming the surface on what’s included in the two articles.

But here’s the bottom line, as illustrated by this table from Part II.

And their conclusion emphasizes why it’s important to have genuine free markets so highly productive people seek success by serving the needs and wants of consumers. In a cronyist economy, by contrast, people seek “success” through government favoritism.

Another aim is to distinguish between crony capitalists and constructive entrepreneurs. Our preliminary analysis shows that countries with free market policies are dominated by individuals who become rich by creating even greater value for society at large. Countries with high levels of state involvement and weak market institutions on the other hand encourage individuals to gain wealth at the expense of others. In all systems, individuals are motivated by wealth.

Now let’s close by looking at the issue from a more US-centric perspective.

Liya Palagashvili of George Mason University writes in U.S. News and World Report that entrepreneurship seems to be waning in the United States.

And government deserves the blame.

What exactly are the factors leading to the decline in business activity in the United States? And what can be done to revive the American entrepreneurial environment? Economists identify the costs imposed on entrepreneurs by the regulatory environment as one of the most important influences on business dynamism. Where regulations make it difficult to start and operate businesses, entrepreneurs have a difficult time bringing new ideas and innovations to fruition. Promising entrepreneurs who face burdensome regulations might opt out of doing business or decide to take their ideas to countries with more favorable business climates. Burdensome regulations such as credit and labor-market regulations, business taxes and start-up costs – like the number of procedures, payments and minimum capital requirements to start a business – all influence individuals’ decisions to engage in entrepreneurial activity. Is it costly to start a business? Am I even allowed to start a business? Will my business entail high labor costs? Can I easily fire bad or redundant workers?

Unfortunately, while government deserves the blame, the rest of us will bear the costs.

These trends pose a long-term problem. If a favorable entrepreneurial environment is eroding, what will become of economic prosperity for future Americans? …People living in the United States and much of the developed world today experience significantly higher standards of living because entrepreneurs continuously introduce and improve market products – not only items such as personal computers and cell phones, but new medicines, better clothing and other technologies that improve ordinary people’s daily lives. New technological improvements are sparked when entrepreneurs are able to reap the benefits of their innovations, and business entry is high when start-up costs are low.

So we have yet another piece of evidence showing the superiority of free markets and small government.

P.S. At the start of the month, I defended religious liberty laws based on the libertarian principle of freedom of association. Simply stated, the government shouldn’t have the power to force you to do business with people you don’t like, even if you have repugnant motivations.

Well, that principle is a two-way street. Check out these excerpts from a recent news report out of Colorado.

Last week, the Colorado Civil Rights Division ruled that Denver’s Azucar Bakery did not discriminate against William Jack, a Christian from Castle Rock, by refusing to make two cakes with anti-gay messages and imagery that he requested last year. …Silva told the civil rights agency that she also told Jack her bakery “does not discriminate” and “accept[s] all humans.” Jack told the civil rights agency the bakery treated him unequally and denied him goods or services based on his religious creed, Christianity. He said he found this “demeaning to his beliefs.”

I’m glad the Colorado Civil Rights Division ruled in favor of the bakery, though its legal reasoning is laughable. The bakery unambiguously discriminated.

But it’s not the role of government to force people to like each other or do business with each other, whether the issue involves some Christians preferring not to do business with some gays or some gays (or gay sympathizers) preferring not to do business with some Christians.

P.P.S. Here’s another update on a previous column.

I wrote last year about how some gun control laws were imposed by racist state governments that wanted to disarm oppressed black Americans.

Well, fortunately those bad laws weren’t always successful. Here’s a blurb from a recent book that Tyler Cowen posted at Marginal Revolution.

…although nonviolence was crucial to the gains made by the freedom struggle of the 1950s and 1960s, those gains could not have been achieved without the complementary and still underappreciated practice of armed self-defense.  The claim that armed self-defense was a necessary aspect of the civil rights movement is still controversial.  However, wielding weapons, especially firearms, let both participants in nonviolent struggle and their sympathizers protect themselves and others under terrorist attack for their civil rights activities.  This willingness to use deadly force ensured the survival not only of countless brave men and women but also of the freedom struggle itself.

Another reason why Glenn Reynolds (a.k.a., Instapundit) is correct to call the 2nd Amendment a civil rights issue.

Or a human rights issue, as powerfully illustrated by Jews for the Preservation of Firearms Ownership.

Read Full Post »

The Miracle of Modern-Day Prosperity…and the Ideas and Policies that Made it Happen

Why are some nations rich and other nations poor? What has enabled some nations to escape poverty while others continue to languish?

And if we want to help poor nations prosper, what’s the right recipe?

Since I’m a public finance economist, I’m tempted to say a flat tax and small government are an elixir for prosperity, but those policies are just one piece of a bigger puzzle.

A country also needs sensible monetary policy, open trade, modest regulation, and rule of law. In other words, you need small government AND free markets.

But even that doesn’t really tell us what causes growth.

In the past, I’ve highlighted the importance of capital formation and shared a remarkable chart showing how workers earn more when the capital stock is larger (which is why we should avoid punitive double taxation of income that is saved and invested).

But that also doesn’t really answer the question. After all, if a larger capital stock was all that mattered, doesn’t that imply that we could get prosperity if government simply mandated more saving and investing?

There’s something else that’s necessary. Something perhaps intangible, but critically important.

Deirdre McCloskey, in a video for Learn Liberty, says that ideas and innovation drive growth.

This is a great video for many reasons, but two points strike me as very important.

First, Deirdre is saying that economic liberty matters, but that modern prosperity also was enabled by a change in the culture. People began to appreciate and respect entrepreneurs. You could call this a form of social capital (and I think such cultural norms are critically important for a thriving society).

And entrepreneurs are the innovators who figure out ways of mixing capital and labor in ways that generate ever-larger amounts of economic output, so they play a critical role in boosting prosperity.

Second, she reminds us that poverty is the normal human condition and that the modern era truly is an amazing change. Indeed, I was so shocked by her numbers that I had to investigate to see if she was exaggerating.

She wasn’t. Using the Angus Maddison data set, I looked to see if Deirdre was right about world prosperity resembling a hockey stick.

Sure enough, there was an amazing increase in prosperity beginning about 1800, just as she explained. Indeed, she could have said that people lived on less than $2 per day for much of recorded history.

Here’s the data for world per-capita economic output over the past two thousand years.

Wow. Unlike the make-believe hockey stick used by global warming alarmists, this one is real. And it shows that the economy definitely isn’t a fixed pie if the right policies – and the right attitudes – prevail.

So what’s the moral of the story?

Perhaps the most obvious lesson is that we should respect and appreciate entrepreneurs and other wealth creators.

Unfortunately, we live in an era where politicians would like us to believe that the economic pie is fixed and that it’s the job of government to re-slice the pie with class-warfare tax policy and lots of redistribution.

But when they re-slice the pie, they also change the size of the pie. And not in a good way.

Read Full Post »

A Funny Look at Obama’s You-Didn’t-Build-That Comment

I made a serious point the other day about how government plays a very important role in the lives of entrepreneurs.

But since I was talking about the staggering burden of red tape and regulation, I wasn’t being very supportive of the President’s assertion that government deserves a big chunk of the credit when a business is successful.

This cartoon makes the same point, but adds taxation to the mix.

As far as I recall (I sound like a politician under oath when I write something like that), this is the first Branco cartoon I’ve used, but I think it’s the best one in this post, so I’m looking forward to more of his (her?) work.

Regular readers know about Michael Ramirez, of course, and he has an amusing take on the you-didn’t-build-that controversy.

I’ve used lots of Ramirez cartoons over the past few years, and you can enjoy some of his work here, here, here, here, here, here, here, here, here, here, here, here, here, here, and here.

The Obama campaign has been complaining that the President’s words were misinterpreted, so this Eric Allie cartoon is quite amusing and appropriate.

You can laugh at more Allie cartoons here, here, here, and here.

Fortunately for Obama, he has some allies to help him out, as Lisa Benson reminds us.

More funny Lisa Benson cartoons can be seen here, here, here, here, here, here, here, here, and here.

Last but not least, we have another Allie cartoon. I think this is the first time I’ve used two cartoons by the same person, but I think you’ll agree they’re worth sharing.

This gives me an opportunity to end on a serious note. The Obama campaign is asserting that the President was simply stating that private sector prosperity is made possible by the provision of “public goods” such as roads and bridges.

This is a perfectly fair point, as I explain in this video about the Rahn Curve.

But what Obama conveniently overlooks is that spending on so-called public goods is only about 10 percent of the federal budget. The vast majority of government spending is for unambiguously harmful outlays on transfers, consumption, and entitlements.

Which is why the second Allie cartoon is so good. Even when government does something that is theoretically good, it causes a lot of collateral damage because of the excessive size and scope of the welfare state.

Read Full Post »

A Proposal for More Immigration that Should Have 100 Percent Support

On my recent trip to Colorado, I had dinner with Congressman Jared Polis, a Democrat from Boulder. He’s not exactly a small-government conservative, but he understands the importance of low marginal tax rates, free trade, and other important economic principles (whether he votes the right way is a separate question, of course, so I’m curious to see what he decides to do about Obama’s plan to increase tax rates on investors, entrepreneurs, and small business owners).

One of the topics we discussed was his proposal to create a special visa for entrepreneurs. I won’t pretend to be an immigration expert or legislative lawyer, so I reserve the right to quibble about the legislation if there are details I don’t like, but the concept is a no-brainer. America gets to bring in the best and brightest from around the world. We give a green light to people who will be creating jobs rather than people who might want to mooch off taxpayers. And we make it easier to retain job-creating foreigners who already are in the United States. What’s not to like? Am I missing something?

The Wall Street Journal has given this idea favorable coverage here and here, and here are some excerpts from an article at Businessweek.com.

A change to immigration policy could help create jobs and rev up economic growth. It’s a change that wouldn’t be hard to bring about. I’m talking about the establishment of a Startup Founders Visa program. The program would make it easier for those with great ideas and the desire to start a company to live and work in the U.S. The idea is simple, yet powerful. By letting in company founders, the U.S. would bring in risk-takers who want to create jobs and potentially build the next Google, Cisco Systems, or Microsoft. At the same time, a founder visa program could stem the tide of talented, tech-savvy foreigners who are leaving the U.S. to seek fortunes in their home countries, primarily China and India. …U.S. Representative Jared Polis (D-Colo.), himself a former entrepreneur, is developing legislation to make it easier for foreign founders of investor-backed startups to secure visas to remain in the U.S. On the other end of the political spectrum, even Newt Gingrich, the Republican former Speaker of the House, has blogged about the need to make the country “more accessible to skilled immigrants.” He wrote this after witnessing “the dynamic entrepreneurial and high-tech business culture in Tokyo, Beijing, and Seoul”—countries with which we are competing for top talent. Representatives of both ends of the political spectrum can agree on this issue. As things stand, we’re losing the battle to retain the immigrants who fueled the recent tech boom. We’re experiencing the first brain drain in American history.Other countries in Europe and South America are realizing the potential of attracting skilled immigrants and are putting together programs to snap them up.

Read Full Post »

Obama’s Class-Warfare Tax Policy Will Hit Small Business

Kevin Hassett and Alan VIard of the American Enterprise Institute have a column in the Wall Street Journal showing how Obama’s proposed tax hikes will impose significant harm on small business owners and other entrepreneurs. Higher tax rates are damaging for the obvious reason that business cash flow gets diverted to the IRS, but also because they alter the price (or tradeoff) between work and leisure and between consumption and investment. This means less productive activity, which is just another way of saying reduced national income. 

Vice President Joe Biden harshly rejected House Minority Leader John Boehner’s assertion that the hikes would harm small businesses, saying that “he has created this myth that a tax cut for millionaires is actually a tax cut for small business. There aren’t 3% of small businesses in America that would qualify for that tax cut.” House Speaker Nancy Pelosi flipped the number around, saying that the planned tax increases would exempt “98% of American families and about 97% of small businesses.” …The 3% figure, which is computed from IRS data, is based on simply counting the number of returns with any pass-through business income. So, if somebody makes a little money selling products on eBay and reports that income on Schedule C of their tax return, they are counted as a small business. The fact that there are millions of people in the lower tax brackets with small amounts of business income may be interesting for some purposes, but it is irrelevant for the assessment of the economic impact of the tax hikes. The numbers are clear. According to IRS data, fully 48% of the net income of sole proprietorships, partnerships, and S corporations reported on tax returns went to households with incomes above $200,000 in 2007. That’s the number to look at, not the 3%. …A pair of papers by economists Robert Carroll, Douglas Holtz-Eakin, Harvey Rosen and Mark Rider that were published in 1998 and 2000 by the National Bureau of Economic Research analyzed tax return data and uncovered high responsiveness of sole proprietors’ business activity to tax rates. Their estimates imply that increasing the top rate to 40.8% from 35% (an official rate of 39.6% plus another 1.2 percentage points from the restoration of a stealth provision that phases out deductions), as in Mr. Obama’s plan, would reduce gross receipts by more than 7% for sole proprietors subject to the higher rate. These results imply a similar effect on proprietors’ investment expenditures. A paper published by R. Glenn Hubbard of Columbia University and William M. Gentry of Williams College in the American Economic Review in 2000 also found that increasing progressivity of the tax code discourages entrepreneurs from starting new businesses.

Read Full Post »