Uneasy Money

A couple of weeks ago, and again last week, I suggested a reason why, despite the general proposition that non-lump-sum taxes are distortionary, reduced marginal tax rates since the 1980s could have slowed down US economic growth. In illustrating how this might have happened, I focused mainly on the growth of the financial sector, hypothesizing that investments by financial firms in “research” and in devising trading strategies are socially wasteful, because the return on those investments stems from trading profits reflecting not additions to output but transfers from other less knowledgeable and sophisticated traders.

An article (“AOL Strikes $1.1 billion Patent Deal with Microsoft”) in today’s New York Times gives another illustration of this phenomenon, a difference in the social and private value of information, except that the difference between the social and private value of information in the AOL/Microsoft patent deal results not so much from the information as such, as from the creation of property rights in ideas, i.e., intellectual property, especially patents.

AOL agreed on Monday to sell a portfolio of over 800 patents, and license about 300 more, to Microsoft for $1.056 billion, amid an arms race within the technology industry over intellectual property.

Under the terms of the transaction, AOL will retain a license for the patents it is selling, while Microsoft will receive a nonexclusive license for the technologies AOL is retaining.

It is the latest big deal for patents, at a time when tech companies are amassing intellectual property rights as ammunition against competitors. Last year, Google purchased Motorola Mobility for $12.5 billion, largely for its patent portfolio.

And scores of companies, including Apple, Samsung, Facebook and Yahoo, are clashing in courtrooms over claims to technology underpinning some of the basic functions of smartphones and social networks alike.

The deal will also provide AOL with some sorely needed cash as the struggling Internet company continues its attempt to refashion itself as a media content provider.

AOL began shopping around the patents in the fall, in what it said was a “robust, competitive auction.” The results of the sale may be surprising to some analysts. Two weeks ago, an advisory firm estimated that the sale could yield as little as $290 million.

“The combined sale and licensing arrangement unlocks current dollar value for our shareholders and enables AOL to continue to aggressively execute on our strategy to create long-term shareholder value,” Tim Armstrong, the company’s chairman and chief executive, said in a statement.

The company said it would distribute a “significant portion” of the proceeds to restive shareholders, who have been awaiting positive results from the turnaround campaign from Mr. Armstrong.

Among those investors is Starboard Value L.P., which currently owns a 5.2 percent stake. In a letter on Feb. 24, the investment firm wrote that it remained disappointed in AOL’s progress, and announced a slate of candidates for the company’s board.

Shares in AOL leaped 35.6 percent, to $24.98, in premarket trading on Monday. They had fallen more than 8 percent over the last 12 months.

AOL was advised by Evercore Partners, Goldman Sachs and the law firms Wachtell, Lipton, Rosen & Katz and Finnegan, Henderson, Farabow, Garrett & Dunner.

Microsoft was advised by the law firm Covington & Burling.

The benefits from inventive activity are systematically overstated.  Take for example a classic argument by George Stigler, in his book The Organization of Industry (Chapter 11: “A Note on Patents”). Stigler posed the following question:

The main theoretical question posed in the production of knowledge . . . is how to bring about the correct amount of resources in the search for new knowledge. Does our present [published in 1968] patent system with its 17-year grant of exclusive possession of the knowledge bring forth approximately the right amount of research effort?

To which Stigler offered a further question and a tentative answer:

We normally give perpetual possession of a piece of capital to its maker and his heirs. The reason is simple: the marginal social product is the sum of all future yields of the piece of capital, and if capital is to be produced privately to where its marginal social product equals its marginal cost, the owner must receive all future yields. Why not the same rule for the producer of new knowledge?

The traditional formal answer, I assume, is that the new knowledge is usually sold monopolistically rather than competitively. The inventor of the safety razor does not have to compete with 500 equally attractive other new ways to shave, so he may charge a monopoly price for his razor. . . . Thus with a perpetual patent system too many resources would go into research and innovation.

Stigler’s answer is correct, as far as it goes, but it doesn’t go very far. There is another, perhaps greater, problem with treating knowledge like a piece of physical capital than the one addressed by Stigler:  it presumes that new knowledge created at time t would not have been created subsequently at any later date, say, time t+x. If the knowledge created at time t would, in any case, have been created subsequently at time t+x, then giving the inventor a perpetual right to the invention overcompensates him inasmuch as he contributed only x years, not an infinite length of time, to society’s use of the invention.  The analysis is further clouded by the fact that every inventor faces uncertainty about whether he or some other inventor will obtain the patent for the invention on which he is working.  The existence of patents creates countervailing incentives to engage in inventive activity.

But the AOL/Microsoft patent deal illustrates another, wholly insidious, result of the explosion in intellectual-property enforcement, which is that patents have become weapons with which competitors in high-tech industries engage in a zero- (or even negative-) sum game of legal warfare with each other (“an arms race within the technology industry”). The resources devoted to the creation and protection of intellectual property are largely wasted, making it very questionable whether the benefits from encouraging investment in inventive and innovative activity that the patent system is theoretically supposed to encourage are now, in fact, greater than the value of resources wasted in the process of obtaining and using those right.

In his seminal 1959 article on the Federal Communications Commission – how many people know that it was in this article, not the better known “The Problem of Social Cost” published the following year, that the Coase Theorem was first stated and proved? – Ronald Coase made the following incredibly important observation at the end of footnote 54 on p. 27.

A waste of resources may result when the criteria used by courts to delimit rights result in resources being employed solely to establish a claim.

So it seems that the current intellectual property regime is causing a substantial, perhaps huge, shift of resources from inventive activity, i.e., creating new and better products or creating new and less costly ways of producing existing products, to establishing claims to intellectual property that can then be used offensively or defensively against others (“amassing intellectual property rights as ammunition against competitors”).  Such gains as are being generated from this kind of activity are, I conjecture, going disproportionately to those earning high incomes from intellectual property rights established through this costly process.  The corresponding losses associated with creating intellectual property rights are probably distributed more evenly across individuals than the gains, so that the net effect is to increase income inequality even as the rate of growth in aggregate income and wealth is slowed down.

In an oral argument before the Supreme Court on Tuesday March 27 in the case Dept. of Human Services Et Al. v. Florida Et Al. about the Constitutionality of the individual health-insurance mandate, Justice Anthony Kennedy made the following statement expressing deep skepticism that the power claimed by the Obama administration to compel individuals to purchase health insurance against their will is a power compatible with our traditional understanding of the relationship embodied in the common law and our jurisprudence between an individual citizen and his or her government.

JUSTICE KENNEDY: But the reason, the reason this is concerning, is because it requires the individual to do an affirmative act. In the law of torts our tradition, our law, has been that you don’t have the duty to rescue someone if that person is in danger. The blind man is walking in front of a car and you do not have a duty to stop him absent some relation between you. And there is some severe moral criticisms of that rule, but that’s generally the rule.

And here the government is saying that the Federal Government has a duty to tell the individual citizen that it must act, and that is different from what we have in previous cases and that changes the relationship of the Federal Government to the individual in the very fundamental way.

Following Justice Kennedy’s pronouncement, the Justices and the lawyers kept referring to the existence or the non-existence of a “limiting principle” that would prevent the government, if its power to impose an individual mandate were granted, from exercising an unlimited power over the economic decisions of individuals under the “commerce clause.”  By all accounts, Chief Justice Roberts, and Justices Scalia and Alito expressed similar concerns to those of Justice Kennedy.  Justice Thomas, as is his wont, remained silent during the oral argument, but he has already written skeptically about the extent to which the “commerce clause” has been used in earlier cases to justify government regulation of private economic activity.

A few days later in the case Florence v. Board of Chosen Freeholders of County of Burlington Et Al., Justice Kennedy, writing for a majority (Chief Justice Roberts, and Justices Scalia, Thomas, and Alito) of the Court, upheld the power of jail officials to strip search detainees arrested for any offense at their own discretion, regardless of whether there was probable cause to suspect the detainee of having contraband on his person.  According to press reports, a nun arrested at an anti-war protest was subjected to a strip search under the discretionary authority approved by Justice Kennedy and his four learned colleagues.  Here is an excerpt chosen more or less randomly from Justice Kennedy’s opinion.

Petitioner’s proposal―that new detainees not arrested for serious crimes or for offenses involving weapons or drugs be exempt from invasive searches unless they give officers a particular reason to suspect them of hiding contraband―is unworkable. The seriousness of an offense is a poor predictor of who has contraband, and it would be difficult to determine whether individual detainees fall within the proposed exemption. Even persons arrested for a minor offense may be coerced by others into concealing contraband. Exempting people arrested for minor offenses from a standard search protocol thus may put them at greater risk and result in more contraband being brought into the detention facility.

It also may be difficult to classify inmates by their current and prior offenses before the intake search. Jail officials know little at the outset about an arrestee, who may be carrying a false ID or lie about his identity. The officers conducting an initial search often do not have access to criminal history records. And those records can be inaccurate or incomplete. Even with accurate information, officers would encounter serious implementation difficulties. They would be required to determine quickly whether any underlying offenses were serious enough to authorize the more invasive search protocol. Other possible classifications based on characteristics of individual detainees also might prove to be unworkable or even give rise to charges of discriminatory application. To avoid liability, officers might be inclined not to conduct a thorough search in any close case, thus creating unnecessary risk for the entire jail population. While the restrictions petitioner suggests would limit the intrusion on the privacy of some detainees, it would be at the risk of increased danger to everyone in the facility, including the less serious offenders. The Fourth and Fourteenth Amendments do not require adoption of the proposed framework.

One can’t help but wonder what limiting principle these five honorable justices would articulate in circumscribing the authority to conduct a “reasonable search and seizure” under the Fourth Amendment to the Constitution.  But I really don’t want to go there.

My post last week about marginal tax rates has received a fair amount of attention on the web, being mentioned by Noah Smith last week and today by Andrew Sullivan and Kevin Drum.  (Drum, by the way, was mistaken in suggesting that I intended to link reduced marginal tax rates with the financial crisis; I was talking about a long-run, not a cyclical, effect.)  As a couple of commenters on that post noted, I didn’t fully explain why reducing marginal rates would have led to such a big expansion of the financial sector. Kevin Drum raised the point explicitly in his post. After quoting a couple of passages in which I explained why reducing marginal rates on income might have led to the expansion of the financial sector, Drum registers his conflicted response.

Count me in! I’m totally ready to believe this.

Except that I don’t get it. It’s certainly true that marginal tax rates have declined dramatically since 1980. It’s also true that the financial sector has expanded dramatically since 1980. But what evidence is there that low tax rates caused that expansion? Does finance benefit from lower taxes more than other industries, thanks to the sheer number of transactions it engages in? Or what? There’s a huge missing step here. Can anyone fill it in?

So Drum wants to know why it is that reducing marginal rates might have caused an expansion of the financial sector. Obviously multiple causes may have been working to expand the financial-services sector; I was focusing on just one, but did not mean to suggest that it was the only one.  But why would reduced marginal tax rates have any tendency to increase the size of the financial sector relative to other sectors?  The connection it seems to me is that doing the kind of research necessary to come up with information that traders can put to profitable use requires very high cognitive and analytical skills, skills associated with success in mathematics, engineering, applied and pure scientific research. In addition, I am also positing that, at equal levels of remuneration, most students would choose a career in one of the latter fields over a career in finance. Indeed, I would suggest that most students about to embark on a career would choose a career in the sciences, technology, or engineering over a career in finance even if it meant a sacrifice in income. If for someone with the mental abilities necessary to pursue a successful career in science or technology, requires what are called compensating differences in remuneration, then the higher the marginal tax rate, the greater the compensating difference in pre-tax income necessary to induce prospective job candidates to choose a career in finance.

So reductions in marginal tax rates in the 1980s enabled the financial sector to bid away talented young people from other occupations and sectors who would otherwise have pursued careers in science and technology. The infusion of brain power helped the financial sector improve the profitability of its trading operations, profits that came at the expense of less sophisticated financial firms and unprofessional traders, encouraging a further proliferation of products to trade and of strategies for trading them.

Now although this story makes sense, simple logic is not enough to establish my conjecture. The magnitude of the effects that I am talking about can’t be determined from the kind of simple arm-chair theorizing that I am engaging in. That’s why I am not willing to make a flat statement that reducing marginal income tax rates has, on balance, had a harmful effect on economic performance. And even if I were satisfied that reducing marginal tax rates has had a harmful effect on economic performance, I still would want to be sure that there aren’t other ways of addressing those harmful effects before I would advocate raising marginal tax rates as a remedy.  But the logic, it seems to me, is solid.

Nor is the logic limited to just the financial sector.  There is a whole range of other economic activities in which social and private gains are not equal.  In all such cases, high marginal tax rates operate to reduce the incentive to misdirect resources.  But a discussion of those other activities will have to wait for another occasion.

I am about to venture slightly out of my usual comfort zone, monetary theory, history, and policy to talk about taxes. You guessed it, March is almost gone, and I still haven’t filed my income tax returns. But that’s not what I am going to write about. I am going to discuss an article by Eduardo Porter (“The Case for Raising Top Tax Rates’) in today’s New York Times Business Section which caught my eye. Porter gives a good summary of the sea change in tax policy that was inspired by a brash young economist with a Ph. D. from the University of Chicago working in the Nixon and then Ford Administration in the early 1970s. His name was Arthur Laffer.  Porter tells the (apocryphal?) story of how Laffer drew his immortal curve for his bosses (Donald Rumsfeld and Dick Cheney — once upon a time able public servants!) on a cocktail napkin showing that any feasible amount of tax revenue could be generated by two tax rates (one high and one low) except for the maximum total revenue achievable only by a unique rate. The Laffer curve became the inspiration for what became known as supply-side economics. Despite enduring much ridicule, the Laffer curve became the central plank in the platform on which Ronald Reagan won the Presidency in 1980. Cutting taxes became the unifying principle on which almost all Republicans could agree, becoming the central pillar of conservative and eventually Republican orthodoxy. It was not always so. Barry Goldwater voted against the Kennedy across-the-board tax cuts of 1963. His vote against tax cuts, cuts supported by his chief opponent for the Republican Presidential nomination in 1964, Nelson Rockefeller — the object of conservative revulsion and outrage to this day — did not evoke so much as a peep of protest by conservatives when Goldwater was carrying the conservative torch in his epic campaign for the GOP nomination.

But as Porter points out, it’s not just conservative and Republican views on taxes that have changed. There was bipartisan support for cutting rates in 1986 when the top marginal rate was cut to 28%. Although Democrats consistently want to raise the top marginal rate, President Obama has not proposed raising the top marginal rate even to 40%, 10% below the 50% top rate under the Reagan tax cuts of 1981.

Why this sea change since the 1960s in views about top marginal rates? Obviously, tax cutting has proved itself to be politically popular, and that may be all the explanation necessary to account for the change in the political consensus about how high marginal tax rates can be raised. But Porter also notes that there was an important economic component in support for keeping tax rates low.

For 30 years, any proposal to raise taxes had to overcome an unshakable belief that higher taxes inevitably led to less growth. The belief survived the Clinton administration, when taxes rose and the economy surged. It survived George W. Bush’s administration, when taxes were cut yet growth sagged.

Porter cites new research suggesting that the scope for tax increases is really a lot greater than had been thought. Not only could the government “raise much more tax revenue by sharply raising the top tax rates paid by the richest Americans, but it could do so without slowing economic growth.” To support this idea, Porter cites a recently published paper by Emmanuel Saez and Nobel Laureate Peter Diamond. They argue that raising the top marginal rate to 80% would NOT cause revenue to fall if the loopholes available to the rich were closed. One obvious problem with that proposal is that the rich have a huge incentive to spend money lobbying against any increase in rates that is accompanied by closing loopholes and against any closing of loopholes not accompanied by a reduction in rates. Guess what? Spending money on Congress works, so don’t hold your breath waiting for tax rates to rise while loopholes are closed. But Saez and Diamond also estimate that even without closing loopholes the top marginal rate could be increased to 48% before any further rate increases would reduce revenue.

Moreover, in another study Saez, Slemrod and Giertz found that although the rich would respond to increases in marginal rates by trying to shelter more of their income, doing so would not cause economic growth to slow down. Porter explains:

That’s because a lot of what the rich do does not, in fact, generate economic growth. So if they reduced their effort in response to higher taxes, the economy wouldn’t suffer.

Porter adds:

The arguments are not the mainstream view. Some economists really dislike them. And they are not absolutely airtight. The calculations rely on estimates about how higher tax rates would discourage the rich from working or investing over a couple of years at most. But we know little about how they might affect long-term decisions, like whether to become a brain surgeon or a hedge fund manager. We do know that in countries with higher tax rates, like France, people work fewer hours than in the United States.

Is there any way of explaining why raising top marginal rates to very high levels would not cause a loss of real income? Here’s an idea. The era of low marginal tax rates in the US has been associated with a huge expansion in the US financial sector. Wall Street has consistently been paying the highest salaries and giving the largest bonuses ever since the 1980s, attracting the best and the brightest from each year’s new crop of grads from our elite colleges and universities. What has been the social payoff to this expansion of finance? I am not so sure. Over a century ago, Thorstein Veblen wrote his book The Theory of the Leisure Class, followed some years later by his essay “The Engineers and the Price System.” He distinguished between engineers who actually make things that people use and financiers who simply make investments on behalf of the leisure class, adding no value to society. This was a vulgar distinction, premised on the unwarranted assumption that finance is unproductive simply because it generate no tangible physical product. On that criterion, Veblen would have ranked pretty low as a contributor to social welfare. Mainstream economists felt pretty comfortable dismissing Veblen because he was presuming that only physical stuff can be valuable.

However in 1971, Jack Hirshleifer, one of my great teachers at UCLA, wrote a classic article “The Private and Social Value of Information and the Reward to Inventive Activity.” The great insight of that article is that the private value of information, say, about what the weather will be tomorrow, is greater than its value to society. The reason is that if I know that it will rain tomorrow, I can go out today and buy lots of cheap umbrellas (suppose I live in Dallas during a drought), and then sell them all tomorrow at a much higher price than I paid for them. The example does not depend on my having a monopoly in umbrellas; I sell every umbrella that I have at the rainy-day market price for umbrellas instead of the sunny-day price. The gain to me from getting that information exceeds the gain to society, because part of my gain comes at the expense of everyone who sold me an umbrella at the sunny-day price but would not have sold to me yesterday had they known that it would rain today.

Our current overblown financial sector is largely built on people hunting, scrounging, doing whatever they possibly can, to obtain any scrap of useful information — useful, that is for anticipating a price movement that can be traded on. But the net value to society from all the resources expended on that feverish, obsessive, compulsive, all-consuming search for information is close to zero (not exactly zero, but close to zero), because the gains from obtaining slightly better information are mainly obtained at some other trader’s expense. There is a net gain to society from faster adjustment of prices to their equilibrium levels, and there is a gain from the increased market liquidity resulting from increased trading generated by the acquisition of new information. But those gains are second-order compared to gains that merely reflect someone else’s losses. That’s why there is clearly overinvestment — perhaps massive overinvestment — in the mad quest for information.

So I am inclined to conjecture that over the last 30 years, reductions in top marginal tax rates may have provided a huge incentive to expand the financial services industry. The increasing importance of finance also seems to have been a significant factor in the increasing inequality in income distribution observed over the same period. But the net gain to society from an expanding financial sector has been minimal, resources devoted to finance being resources denied to activities that produce positive net returns to society. So if my conjecture is right — and I am not at all confident that it is, but if it is – then raising marginal tax rates could actually increase economic growth by inducing the financial sector and its evil twin the gaming sector — to release resources now being employed without generating any net social benefit.

UPDATE 9:39PM EDST:  I left out “not” (now in CAPS) in between “would” and “cause to fall” in the fourth sentence of the paragraph beginning with “Porter cites.”

UPDATE 9:46PM EDST:  I revised the final sentence of the same paragraph which had been unclear.