"Arguing in My Spare Time," No. 5.02
by Arnold Kling
January 26, 2002
Are tax cuts good or evil? What government policies are best for the economy? These sorts of questions can be answered from the perspective of what I call The Growth Doctrine.
In the previous essay, I quoted this statement of the growth doctrine:
Ultimately, long-run economic growth is the most important aspect of how the economy performs. Two major factors determine the prosperity and growth of an economy: the pace of technological advance and the capital intensity of the economy. Policies that accelerate innovation or that boost investment to raise capital intensity accelerate economic growth. -- Brad DeLong, Macroeconomics, p. 89
Taking the growth doctrine as our guide, we can evaluate economic policy by asking two questions.
For example, consider the case of a tax cut. It has the following effects:
It lowers government revenue, so that the government has to borrow more. This reduces national saving. Therefore, it reduces investment in productive capital.
It increases after-tax income in the private sector. Some of this income will be saved, which increases investment in productive capital.
Many taxes have punitive effects on economic activities that we want to encourage. For example, the social security system places a tax burden on work and on thrift. To the extent that taxes provide disincentives to productivity and investment, cutting taxes enhances growth.
Of these three effects, it is likely that crowding out is the strongest. However, in practice, there is a tendency for the government to adjust its spending to the level of revenue. That gives us two more effects to consider.
Suppose that a $100 billion tax cut is matched by a $100 billion cut in spending on programs that do nothing for economic growth. Then the crowding-out effect is zero.
On the other hand, suppose that a $100 billion tax cut is matched by a $100 billion cut in funding for scientific research and other pro-growth programs. The net result is to reduce economic growth.
On the whole, the effect of a tax cut cannot be sorted out without answering questions like these:
To believe that tax cuts are positive for growth, you have to believe that the government will spend less than it would otherwise, and that the reduced spending will come primarily in "feel-good" programs rather than from scientific research or other social investments. For what it's worth, my amateur opinion happens to be that tax cuts in fact will reduce spending on "feel-good" programs more than they will reduce government surpluses or spending on social investments.
I am inclined to believe that the government affects the economy more profoundly with rules and regulations than it does with its budget. Rules and regulations also affect the level of investment, because the incentive to invest depends on property rights and regulatory policy. Moreover, rules and regulations affect the climate for adoption of new technology.
New technology creates losers as well as winners. Would-be losers use political power to retard progress. For example, as farming becomes more productive, we need fewer farms and fewer farmers. In every country, presssure from farm interests leads to government policies that attempt to protect unproductive farms, often by restricting imports.
Government can set rules and regulations that encourage the adoption of new technology. However, government can have the opposite effect. Interest groups can influence government to adopt rules that restrict the ability of new technologies to compete. In fact, in their book Barriers to Riches, authors Parente and Prescott argue that the uneven distribution of income and wealth across countries can only be accounted for by the ability of interest groups in some countries to keep out the best technology.
In the United States, we are fortunate to have many government agencies that encourage and promote new technologies. For example, the Internet was fostered by the Department of Defense. It was developed further under the auspices of the National Science Foundation.
An emerging example of the role of government and interest groups in economic growth concerns the regulation of the radio wave spectrum. That is the set of frequencies used for military communication, cell phones, television, and radio.
In the United States, the FCC regulates the spectrum. Based on the state of technology in the twentieth century, the FCC treated different frequencies as property to be owned by different segments. One band of frequencies went to AM radio, one band to FM radio, other bands went to television stations, and so forth. Within each segment, individual companies own the licenses to use specificl frequencies within certain geographic areas.
The twentieth century allocation of spectrum was designed to keep different signals from interfering with one another. However, interference is not a given. Interference depends on the technology employed. In fact, one might say that
Interference is in the ear of the receiver.
As we add computational power to the receiving equipment, we can use spectrum more efficiently without the artificial boundaries set up by the FCC. Instead of saying that frequency X is for a television station and frequency Y is for a radio station, we should open up all frequencies to anyone who follows a set of standards and protocols.
We can use the Internet as an analogy. If the Internet were regulated in the FCC-like manner, different networks would be allocated for email, web browsing, music swapping, and so forth. You would not be allowed to send email over the web network, for fear of causing "interference."
(As an aside, there are engineers who believe that the Internet needs this type of segregation. For example, some have argued that streaming video requires a special category of high-priority transmission.
Another threat to the Internet is posed by vertically-integrated companies, such as AOL-Time Warner. They may be tempted to give priority to their own content, making other data more difficult to transmit and to receive. So far, however, the Internet remains fairly "pure" and egalitarian.)
In the twenty-first century, an opportunity is emerging to structure the airwaves like the Internet, in the sense that transmissions do not have to be segregated by frequency. As with the Internet, everyone could be allowed to participate as long as they adhere to the appropriate standards and protocols.
If the FCC were to re-engineer spectrum regulation to consist of a set of protocols rather than a set of licenses, there would be many losers. First of all, people with existing equipment designed to broadcast and receive over set frequencies would have to replace that equipment. For example, radio stations and car radios would have to change technology.
We are used to changes in technology. We have seen CD's replace vinyl records, and we are in the process of seeing DVD players replace tape VCRs.
However, re-engineering spectrum regulation creates losers of a different sort. The twentieth century approach treated spectrum licenses as property. This property has value, as indicated by the fact that companies paid billions of dollars for such licenses when they were auctioned by the FCC in the 1990's.
The value of spectrum licenses is bound to drop eventually. Technology is turning spectrum into an abundant resource rather than a scarce resource.
However, the value of spectrum licenses could drop to zero in an instant if the FCC were to adopt an Internet-style protocol-based model of spectrum regulation. It is a safe bet that existing broadcasters and communications service providers are going to fight any re-regulation that from their perspective is a confiscation of property.
In short, society might be better off if spectrum regulation were re-engineered. However, existing spectrum owners have a strong interest in blocking such innovation, because it would hasten the devaluation of their property. A compromise between confiscating their spectrum on the one hand or allowing them to block innovation, on the other, might be for the government to buy back the spectrum licenses. In any case, this is an issue having nothing to do with tax cuts that perhaps is more important relative to long-term economic growth.
The government handles innovation in education and medicine quite differently. I would argue that the approach in medicine is basically working, and the approach in education is not.
In medicine, the Food and Drug Administration requires private companies to undertake scientific tests of innovative medicines. Those that pass the tests are approved. Those that fail to pass the tests are not approved. Private drug companies undertake the cost of research and testing.
Under the FDA process, there has been measurable improvement in health care. Many diseases can be treated more effectively at less cost than was the case in the past. While the FDA process has flaws, and new developments in "bioinformatics" may make it appropriate to change the approval process, the basic framework of private development and scientific standards for approval is a good one.
In education, on the other hand, new methods are introduced by fiat, typically without rigorous testing. An agency just decides that a certain math curriculum is "better." We have had many instances in which new educational methods were dropped because after bitter experience someone finally bothered to examine the data. We have had other instances where adverse data was denied and ignored.
Also in education, we do not have private competition. The public school monopoly is not pressured to adopt the best approach to education.
Overall, compare the results in education to the results in medicine. In education, there has been no clear improvement in quality in the past half century. In fact, measures such as SAT scores show a decline. We have not eradicated any of the "diseases" of illiteracy, math-phobia, or ignorance of science, history, and geography.
It would seem that there is room for improvement by adopting a regulatory environment in education that is closer to that used in medicine. A government testing agency could set standards for the evaluation of new "treatments," such as textbooks, teacher training methods, and methods of classroom organization. Private suppliers of education services could undertake research, development, and testing. Over time, we would adopt innovations based on proven value instead of succumbing to trends and fads.
Traditionally, we look at government's role in the economy by using spending as an indicator of priorities. For example, in the traditional view, spending more money on health care is an indication that the government is doing more to promote health care.
Certainly, increasing capital investment in an area should lead to improvements. Capital is a component of economic growth.
However, the "new growth theory" stresses the role of ideas and the ability of society to sort out and adopt the best technologies. The examples discussed in this essay reflect the importance of ideas relative to capital.
The capital investment in the Internet represents only a small fraction of its overall value. Most of the value comes from standards and protocols that enable the Internet to function.
Re-engineering our use of the spectrum requires some capital investment. However, the biggest hurdle is making the regulatory decision to adopt the idea of doing away with segmented licenses.
I have argued that innovation in education is hampered not by financial considerations but by an unscientific process for choosing which innovations to adopt. If this is correct, then simply changing to a more scientific approach could lead to substantial progress.
The overall point of this essay is that when we try to assess whether government policies are helping to promote economic growth, it is not enough to "follow the money." Government affects growth by the way its rules and regulations set the framework in various endeavors. Better design of the regulatory framework has significant potential to improve the outlook for growth.