The Agenda

James Capretta on SOTU 2012

My Economics 21 colleague James Capretta argues that President Obama failed to make a compelling case for the connection between steep increases in taxes on capital income, increased public spending, and wage growth for the middle class:

There’s no question that the president’s populist, tax-the-rich rhetoric resonates with a segment of the electorate that has struggled economically and is all-too-willing to accept the simplistic explanation that the blame for their troubles lies with the so-called “rich.”

But what President Obama didn’t explain last evening — indeed, has never really explained — is how a tax hike on higher income households will help the struggling middle class.

Because it’s not at all obvious it would.

For starters, if, as the president proposes, the rich are taxed at higher rates but the government’s main entitlement programs remain entirely unreformed, the government’s deficit and debt problems will not be solved. According to the Congressional Budget Office (CBO), spending on Social Security, Medicare, and Medicaid was just 6.0 percent of GDP. In 2030, spending on those programs plus ObamaCare is expected to reach 15.2 percent of GDP (using assumptions about health cost growth that is slightly more realistic than current law). That jump in spending is the real cause of our fiscal problems. If, as the president proposes, the Bush tax cuts are allowed to expire for those with incomes above $200,000 ($250,000 for couples), that might raise revenue by about 0.4 percent of GDP per year. That’s not nearly enough to cover the explosion in entitlement spending that will occur over the coming two decades.

Moreover, there’s strong evidence that higher taxes will hurt growth and job creation, despite the claims of the president to the contrary. Among economists, it’s really a debate about how damaging higher tax rates will be to growth and job creation. There’s no real debate that such taxes are neutral in that regard.

This is a fair characterization in that virtually all economists believe that there is some harm associated with higher tax rates, but I’d recommend reading Arpit Gupta’s recent guest post on labor supply on taxes. Microeconomists like Peter Diamond and Emmanuel Saez have called for steep increases in the top rate of marginal tax, as they believe the impact on labor supply will be negligible. In contrast, research that factors in the extensive margin (i.e., whether or not one participates in the formal labor market) as well as the intensive margin suggests that the impact of taxes on labor supply is in fact quite large. 

But even setting aside the likely damage that would ensue from higher taxes, the president has never articulated a coherent theory about how a presumably larger government would bring about higher paying jobs for the middle class. Because there’s no evidence whatsoever that the middle class or anyone else will be better off if the government increased spending on items that the president likes to call “investments.” The president is not calling for stimulus spending to raise aggregate demand in a Keynesian sense. He long ago abandoned that line of argument. No, what he proposed last night is simply more spending on certain programs finance by higher tax collection. Thus, any benefit to the middle class would have to come from the quality of the government’s “investments.”

Unfortunately for the president, there’s no evidence that more governmental spending will lead to better jobs for anyone.

There is evidence to believe that more governmental spending will lead to better jobs for some nontrivial number of public employees, but of course much depends on (a) what we think of as “better jobs” and (b) whether we conceive of the public sector as a program designed to create employment or as a vehicle for the efficient delivery of public service. One definition of a “better job” could be a job in which once receives a higher level of compensation, even as underlying work effort remains unchanged. People tend to get better jobs, according to this definition, in tight labor markets. Yet another way to secure a better job is to secure higher compensation levels in the public sector than one might receive in the private sector. As it turns out, this proved to be a significant part of the labor market picture during the 1990s and 2000s, as local school districts dramatically reduced student-teacher ratios, in the process diluting the teacher talent pool and potentially creating a mismatch between compensation levels and underlying skill levels. 

If we believe, as I do, that the public sector should in fact be a vehicle for providing high-quality services at the lowest cost to the taxpayer, channeling public spending in this way doesn’t seem like a wise or sustainable course of action. Regardless, it is politically attractive for the coalition that is most tightly aligned with the interests of current public employees. The president made reference to layoffs of teachers and other public sector professionals; it is also true, however, that jurisdictions in which local school districts were given the ability to unilaterally revise the terms of employment were far less likely to lay off employees that those that were not. The president has been sharply critical of giving local governments this ability.

He mentioned against last evening that job training is a central component of his program. But federal job training efforts have a four decade record of failure, and the president’s speech gave no indication that his administration has found a way to deliver services in ways that will lead to better results.

James Heckman and Pedro Carneiro’s contribution to Inequality in America: What Role for Human Capital Policies? is instructive on this front. Tellingly, Heckman and Carneiro were engaging Alan Krueger, who offers a modest defense of job training programs. Suffice it to say, I think Heckman and Carneiro have the stronger argument. 

After the deep recession of 2008 and 2009, what the country needs more than anything else is a period of robust economic growth. That’s the only remedy that will truly help the American middle class.

This sounds right. So the key question regarding the various SOTU proposals is whether or not they will prove growth-enhancing. My initial impression is that dramatic increases in capital income taxation and a series of new targeted tax breaks, sharp increases in public spending with relatively little regard for increasing public sector productivity (the caveat applies to an effort to consolidate agencies that subsidize small and medium-sized corporations, which may improve the productivity of a part of government that arguably undermines the allocative efficiency of the economy as a whole), and the strategic disfavoring of the oil and gas industry will not prove growth-enhancing, but of course we can’t say anything for sure.  

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