by James A. Dorn
Chinese officials have been highly critical of the U.S. debt buildup and the political wrangling in Washington that has failed to resolve the debt crisis.
But China could well turn that leery eye inward to find policies that are preventing financial markets from functioning in a healthy manner — and which may yet spread the next serious malady to global financial markets.
One problem is that China is the largest holder of U.S. Treasury securities, with more than $1 trillion invested. Without China's large appetite for U.S. debt, Congress would have been more constrained in its deficit spending, and U.S. growth would have been more robust.
The challenge for both China and the U.S. is to restore the balance between the state and the market — to maximize freedom and minimize coercion.
China now holds more than $3 trillion in official foreign exchange reserves, the result of large trade surpluses and inward foreign investment. However, China is a net exporter of capital via the purchase of Treasuries and other government securities. The large accumulation of dollars is the result of an exchange-rate policy designed to undervalue the yuan.
Which brings us to the second major problem: if the Chinese currency were allowed to freely float, there would be no massive buildup of official reserves. Traders, not communist party members, would determine the exchange rate. Adjustment would occur spontaneously via voluntary decisions, not via central plans.
A more flexible exchange rate and a fully convertible yuan would increase the range of choices open to people, expand the private sector, and increase popular pressure for political reform.
The legacy of central planning still haunts the banking sector. Lending, interest rates, and the major banks themselves are all controlled by the state. Even more ominous is that most of the lending is to state-owned enterprises. Investment decisions are therefore heavily politicized, and corruption is rampant.
Stimulus spending allowed China to escape the 2008-09 global financial crisis, but the rapid expansion of bank credit, as well as off-balance sheet lending, has led to excess money growth and an inflation rate of more than 6 percent. UBS data show that China's bank credit, including off-balance sheet loans, now stands at about 180 percent of GDP, up sharply from 2008.
If the economy slows, nonperforming loans could swell. The excess credit could turn into a debt crisis. That crisis could be compounded by a bursting of the Treasury bond bubble, once the Federal Reserve begins to increase interest rates, or once markets think the Fed will inflate and reduce the real debt burden.
China needs to tame domestic inflation and further liberalize its economy. Yet, there is strong political pressure to continue to peg the yuan at an artificially low rate and "sterilize" the newly minted yuan — that is, drain off excess yuan by selling central bank bills, increasing reserve requirements, and setting tighter lending quotas.
Price controls and capital controls are also being used to suppress inflation and to limit private choices. But as long as China is trapped in its export-led development model, with financial repression, the hoard of foreign exchange reserves will grow and most of those reserves will be lent to the U.S government, not to private enterprise.
The reality is that both China and the U.S. are growing the state sector at the expense of the private sector. Crony capitalism, not market liberalism, is now the norm.
James A. Dorn is vice president for academic affairs and a China analyst at the Cato Institute in Washington, D.C.
More by James A. Dorn
For China to become a global financial center and achieve financial harmony, there must be privatization of the banking system, capital freedom, flexible exchange rates, market-based interest rates, and a rule of law that assigns responsibility to private individuals, not the state.
The mispricing of credit/risk and monetary manipulation plague both China and the U.S. Beijing is right to criticize U.S. policymakers for creating fiscal and monetary uncertainty. But what Beijing wants is more, not less government control, while the solution to the problem of creating economic and social harmony is less government.
With a rule of law and limited government, voluntary exchanges in private free markets would increase individual sovereignty and wealth, while promoting the general welfare. That concept of spontaneous order is now foreign to most politicians. Politics and "legal plunder" have trumped what the great French liberal Frederic Bastiat called the "law of liberty."
The challenge for both China and the U.S. is to restore the balance between the state and the market — to maximize freedom and minimize coercion. Rebalancing can then be market-directed, economic relations normalized, and politics put in its proper place.
Why Taxing the Rich Is No Solution
Obama’s Folly: Why Taxing the Rich Is No Solution
During the last three decades the wealthy in America have become wealthier yet. American capitalists today are richer than virtually any other group in any country at any point in history. At the same time, the United States is experiencing record deficits, which threaten to bring the economy to its knees.
It is therefore hardly surprising that the solution proposed by some is to raise taxes on the rich. President Obama has proposed doing so. Investing giant Warren Buffett made the case for taxing the wealthy this week in the New York Times.
In one respect, Obama and Buffett are completely right. The rich do not “need” to pay lower taxes, and can certainly “afford” tax increases. If raising taxes on the rich would solve the deficit without hurting the economy, we would support the president’s tax policy in a heartbeat. It would certainly be a more equitable solution to lower the already astounding standard of living of hedge fund owners than to “cut some kids off from getting a college scholarship.”
If raising taxes on the rich would solve the deficit without hurting the economy, we would support the president’s tax policy in a heartbeat.
Unfortunately, the choices faced by America are not that simple. An economic strategy founded on raising taxes on the rich is based on two false premises. The first is that tax increases on the rich are a solution to current budget deficits. The second is the argument often put forward that there is “no evidence” that tax increases on the rich hurt the economy.
If you look carefully, President Obama has never explicitly stated that taxing the rich will bring in much revenue. Instead, the president has made sure to give voters the impression that the Republican refusal to tax the rich is the main cause of the deficit and thus the main obstacle to solving the fiscal crisis. For instance, Obama stated that “tax cuts that went to every millionaire and billionaire in the country” will “force us to borrow an average of $500 billion every year over the next decade.” This message has been widely repeated: Jon Stewart, for instance, has assured his impressionable audience that without the Bush tax cuts, future deficits would not be a major problem.
But how much revenue are we really talking about? According to the New York Times, the president’s plan to abolish the Bush tax cuts for those making more than $250,000 is expected to bring in merely $0.7 trillion over the next decade, or about 0.4 percent of Gross Domestic Product per year. As a comparison, the Congressional Budget Office estimates that the deficit over the same period is going to be $13 trillion, more than 6 percent of GDP per year.
The president’s plan to abolish the Bush tax cuts for those making more than $250,000 is expected to bring in merely $0.7 trillion over the next decade, or about 0.3 percent of GDP per year.
The rich in America obviously have lots of money, but there are simply not enough of them to fund the president´s preferred level of spending. For all the attention it has received, President Obama’s “taxing the rich” policy can best be described as symbolic in nature, a rounding error compared to the deficits in the president’s budget. Obama centers his speeches around tax hikes on the rich to lead voters into believing that hard choices on the economy can be avoided simply by taxing the rich at a higher rate.
Taxes and Entrepreneurs
Although the proposed tax increases will barely make a dent in the deficit, raising the top tax rates is likely to harm economic output. Many are convinced that tax increases have little or no damaging impact on the economy. We hear over and over again that notions of damaging effects from higher taxes are merely based on “trickle down” theory, which has been proven false.
This is not true. There exists robust empirical evidence that taxes impede economic activity. In conventional economics, only the magnitude of the negative impact of taxes on economic output is debated, not the existence of such an effect.
Let us focus on one such negative impact, the effect of taxes on the activity of business owners, an important segment of the economy. Business owners account for 40 percent of American capital, while firms with less than 500 employees employ half the private sector workforce.
We might like to believe that someone who is already a millionaire doesn’t care about obtaining even more money. But this does not appear to be how actual millionaires behave.
The argument that taxes do not negatively affect small and medium-size business tends to rely on a number of fallacies. One example is an article by Berkeley economics professor Laura Tyson, a member of Obama’s advisory board, which was published in the New York Times. In the article, she claims that “the relationship between tax rates and economic activity, even though it has superficial appeal, is not supported by the evidence.”
The most common fallacy repeated by Tyson is that taxes do not matter because the economy was booming during the Clinton years even though taxes went up. But tax increases are not the only economic event associated with the Clinton years, and therefore cannot be claimed to cause all events that took place in his presidency. The Clinton years also contained entry into NAFTA, welfare reform, and recovery from the 1992 recession. Most importantly though, the Clinton years included the IT boom, which dramatically raised productivity growth in the United States as well as in other developed countries. It would strain the imagination to believe that Clinton’s moderate marginal tax increase somehow caused the PC and Internet Revolution.
Instead of picking one historic event that happens to fit your preferred theory, a more reasonable approach is to investigate all historical periods where taxes increased or decreased. This has been done by former Obama advisor Christina Romer and her husband David Romer. They also take into account the causes of tax increases.1 They find that tax increases tend to reduce economic growth, stating that “tax increases appear to have a very large, sustained, and highly significant negative impact on output,” as “an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.” Similar results have been obtained by Harvard economist Alberto Alesina using a different methodology.2
Obama centers his speeches around the tax hikes on the rich to lead voters into believing that hard choices on the economy can be avoided simply by taxing the rich at a higher rate.
Regarding small business, Tyson claims that “98 percent of small-business owners will not be affected if the Bush tax cuts for these brackets expire.” This is true, but also irrelevant. The United States has more than 25 million registered firms and more than 10 million self-employed. Most registered firms have zero employees and virtually no revenue, and exist for tax or legal reasons. Similarly, most self-employed businesses are small scale and employ no one other than the owner. What we are primarily concerned about is the impact of higher taxes on the small number of economically important firms. These are firms that collect sizable revenue, employ others and have the potential to grow and hire more workers. The owners of such firms are obviously far richer than the typical self-employed person, and are far more likely to be hit by tax increases on higher incomes or on capital gains.
According to the “World Top Incomes Database,” 28 percent of the income of the highest earning 1 percent of Americans, the group targeted by the president’s tax hikes and the group most likely to own successful firms, is constituted by entrepreneurial income.3 This has implications for the wider economy. Following the 1986 tax reform, Princeton Professor Harvey Rosen and co-authors investigated the effect of the personal income tax of business owners on their hiring activity. Business owners who received larger tax cuts expanded their hiring more.4
This runs contrary to a common argument that taxes may matter for ordinary people, but not for the already rich or for entrepreneurs who care mainly about developing their company. Arianna Huffington, for example, has ridiculed the notion that the rich would care about and be affected by a few percentage points of higher taxes.
In fact, two groups that are consistently found to be more responsive to taxes than average are precisely the self-employed and high-income earners.5 Both groups can more easily evade taxes and tend to have more control over their economic behavior. Looking at historic American tax reforms, economists Jon Gruber and Emmanuel Saez demonstrate that increases in taxes reduce taxable income especially for high-income earners.6
Even if you don’t care about taxes, taxes care about you.
We might like to believe that someone who is already a millionaire doesn’t care about obtaining even more money. But this does not appear to be how actual millionaires behave. Even some billionaires actively attempt to lower their tax rates, for example by relocating to tax havens.
While excessive acquisitiveness (greed) is hardly a virtue, acquisitiveness and ambition might not be bad traits in entrepreneurs. Otherwise Steve Jobs, Sam Walton, and Warren Buffet might have cashed out and retired in Tahiti after making their first $100 million instead of staying on and developing their companies.
While it may offend an egalitarian worldview, top entrepreneurial talent is not easily replaced. “Super-Entrepreneurs” often tend to be extremely talented individuals with access to well-paying, comfortable jobs in already existing firms. In order to entice enough of them to take the risk, hard work, and uncertainty associated with entrepreneurship instead of opting for a safe and well-paying job, there must be a substantial reward associated with success.
One way to better approximate the behavior of innovative entrepreneurs is to study investments in the Venture Capital (VC) sector. VC plays a central role for high-potential firms. More than half of those entrepreneurial firms that were successful enough to make an IPO and become public had VC backing. Harvard researchers Josh Lerner and Paul Gompers show that VC fundraising in the United States is highly sensitive to capital gains taxes.7 Their results indicate that the cause for this is that lower capital gains taxes encourage more skilled individuals to become entrepreneurs.
The low probability of entrepreneurial success even for the talented is often forgotten in the tax debate. Sure, Gates and Walton might well still have created Microsoft and Wal-Mart for $25 billion instead of $50 or $100 billion. But for every such success, there are thousands of failures. Entrepreneurship is what economists refer to as a “tournament,” a process where many compete for a prize that only a handful will ultimately receive. If taxes reduce the value of the prize, fewer will enter the tournament, even assuming that the behavior of the winners doesn’t change. Economists William Gentry and Glenn Hubbard found that high marginal taxes reduce the probability that an individual will enter self-employment to begin with (although admittedly the data did not allow them to establish this definitively).8
Two groups that are consistently found to be more responsive to taxes than average are precisely the self-employed and high-income earners.
Another common fallacy in the tax debate is that entrepreneurs do not care about taxes because they are motivated by intrinsic factors. Indeed, non-monetary rewards are important for entrepreneurs (although three-quarters self-report that they also care about monetary rewards). But taxes also matter for the ability to build a new company, even disregarding the personal wealth of the entrepreneur.
Profit taxes lower the amount of capital available for reinvestment. The negative effect of corporate income taxes on business investments has been confirmed by numerous studies, such as a recent one conducted by Harvard economist Andrei Shleifer and co-authors.9
Furthermore, the growth of new high-potential ventures depends not only on individual entrepreneurs, but also on the ability to attract talented employees. Like entrepreneurs, these workers often have high paying and rewarding jobs, and a career ladder that they must leave if they choose to work for the new company. Few early stage entrepreneurial firms can compete on wages, instead relying on option programs and promises of future reward. Such incentive mechanisms are made more costly by high taxes, which disproportionally target the small probability of great success.
With higher taxes, even entrepreneurs who do not care about personal gains will find it harder to grow through reinvestment, raising external capital, and attracting new talent. In short, even if you don’t care about taxes, taxes care about you.
What to Do about the Tax Code
Is the president willing to risk one of the last sectors in which the United States enjoys a comparative advantage, betting that less burdensome taxes have nothing to do with this competitive edge?
The United States still leads Western Europe in innovative entrepreneurship. For instance, each year venture capital investments per person are about four to five times higher in the United States than in Western Europe. Is the president willing to risk one of the last sectors in which the United States enjoys a comparative advantage, betting that less burdensome taxes have nothing to do with this competitive edge?
If the tax increases on capitalists proposed by President Obama would balance the budget, perhaps we should endure the damaging effect on economic output. However, as noted above, the impact on the deficit is symbolic in nature. Rather, the motivation appears to be political, a combination of resentment towards the rich and a reaction to excessively ideological supply-siders.
Currently, less than half of national income is included in the basis for taxable income. Instead of raising tax rates, we can close tax loopholes and broaden the tax base so as to raise revenue to its historic average, while controlling federal spending. This is preferable to increasing tax rates based on the faulty notion that raising taxes on the rich does not hurt economic output.
Tino Sanandaji is an affiliated researcher at the Institute of Industrial Economics and holds a PhD in public policy from the University of Chicago. Arvid Malm is chief economist of the Swedish Taxpayers' Association and holds a master’s in economics from the Stockholm School of Economics.
Tough Lessons for Business Leaders
The Atlanta Cheating Scandal's Tough Lessons for Business Leaders
As details of the Atlanta Public Schools (APS) cheating scandal continue to emerge, the city’s business leadership has come under fire for its unabashed support of former Superintendent Beverly Hall. The tough truth is that Atlanta’s business community is partly to blame, as it ignored one of the cardinal rules of true partnerships: effective ones are two-way streets. City business leaders ended up working for, not with, the city’s school district leadership.
Too often, local businesses wanting to get involved in their K-12 education systems fall into this trap. Eager to be seen as “partners,” they donate dollars first and ask questions later. But to be effective, business leaders must recognize that partnering with school districts or policy makers doesn’t simply mean carrying their water. It means asking tough questions and insisting on certain end results or operational targets in exchange for support.
In Atlanta, it seems that the business community was a little too eager to do Superintendent Beverly Hall’s bidding. Dazzled by her corporate background and emphasis on “data-driven decision-making,” prominent leaders lined up to give her their support. They backed Hall when some criticized her lavish bonuses in 2006, and they defended her again when articles in local newspapers raised questions about the sudden gains APS students were making in standardized tests. We now know that business, along with the rest of Atlanta, was taken for a ten-year ride.
It is crucial for the business community to remember that much of its influence rests on its credibility.
A bit of context may be helpful for those who haven’t followed the saga. In February 2010, concerns arose when a state analysis found suspicious erasure patterns in standardized tests from 58 of Atlanta’s public schools. The ensuing investigation lasted over a year. Last month, the results of the probe were finally released, revealing widespread and systematic cheating by 178 teachers and principals in 44 Atlanta public schools. Some of those caught in the investigation blamed the district leadership, namely Beverly Hall—who was named 2009 National Superintendent of the Year by the American Association of School Administrators—for creating a “culture of fear, intimidation and retaliation,” which led them to fudge test scores. Hall left the district after her contract expired in late June.
Given our own deep interest in encouraging business leaders to play a smart and constructive role in K-12 schooling, we think that two important lessons deserve to be flagged. First, it is crucial for the business community to remember that much of its influence rests on its credibility. As a seasoned legislative staffer who champions business involvement in education told us, “It makes a difference when a business person …[tells us], ‘I don’t care what your [standardized test] scores or your [reports] say, the kids who come to work for us can’t read.’” This valuable reality check was compromised in Atlanta when the business community threw its influence behind Superintendent Hall regardless of results, just because, as one local paper reported, she was “fluent in the language of corporate America.”
Too often, local businesses are eager to be seen as partners; they donate dollars first and ask questions later.
When discussing effective business-education partnerships, the usual presumption is that education leaders are being scrupulous and forthright with their data. The Atlanta scandal shows that business leaders supporting local school systems would be wise to follow President Reagan’s advice and “trust, but verify.” The APS debacle underscores the fact that, for many years, communities have been taking school testing results at face value. Of all people, business leaders should be interested in the mechanisms behind the results—and in ensuring that these processes are reliable. Coca-Cola, for example, does not rely solely on vendor reports; rather, it employs protocols and audits to keep the books in order. By flagging potentially problematic practices, such as teachers being allowed to hold on to their students’ standardized tests for days before sending them in, business leaders can help educators guard against scandals like the one that has rocked APS.
That being said, it’s a lot easier for business to maintain credibility and keep a watchful eye on educational leaders if they actually know their stuff. When it comes to municipal zoning or state tax policy, business leaders know that effective advocacy requires a grasp of the particulars, compelling data, political muscle, and strong working relationships. Yet those same leaders sometimes treat K–12 schooling like a hobby, relying on homilies, good intentions, and an inexperienced staff. Equipped with expertise and a dab of skepticism, business leaders can avoid being sold a false bill of goods by educational leaders—even by those who know to say exactly the words business leaders want to hear.
Co-authors Frederick M. Hess, the director of education policy studies at the American Enterprise Institute, and researcher Whitney Downs have just published “Partnership Is a Two-Way Street: What It Takes for Business to Help Drive School Reform.”
Not Free to Choose
Not Free to Choose: The Reality behind Clean Energy Standards
Climate activists failed to achieve comprehensive greenhouse gas controls in the United States in the form of a cap-and-trade program. And while they pursue incremental greenhouse gas regulation at both the federal and state level, they have not given up on their Holy Grail of a comprehensive national regime to control greenhouse gas emissions. Instead, they have rebranded their campaign.
The current incarnation of the greenhouse gas agenda is hidden in the campaign for a national Clean Energy Standard, or CES. Other terms for this approach are Renewable Energy Standards (RES), or, even more obliquely, Renewable Portfolio Standards (RPS). While many states have already implemented such standards, the push now is for federalization. What they all come down to, at the end of the day, is a governmental mandate that energy utilities must buy and distribute a certain percentage of energy that comes from so-called “clean” sources, such as wind power, solar power, nuclear power, “clean coal,” and so on.
Here’s why Clean Energy Standards are a bad idea:
They are hidden energy taxes. Because the kinds of energy that qualify as “clean” to environmentalists are more expensive than conventional energy, forcing them into the energy mix will inevitably raise energy prices. It is never a good idea to overprice energy, which is a critical input to economic productivity, but it is a particularly bad idea to overprice energy when our economy is barely moving.
Hiking energy prices is also unpopular, which is why, in all likelihood, the costs will be hidden from consumers by forcing utilities to charge commercial users such as manufacturers, restaurants, and retailers higher rates, while subsidizing private households. This was a key element of previous greenhouse gas control proposals, such as cap-and-trade.
It is never a good idea to overprice energy, but particularly when our economy is barely moving.
They are hidden subsidies. A CES is a stealth subsidy for wind and solar power because it requires utilities to buy such types of “clean energy” regardless of their cost. Without mandated purchasing, conventional energy forms such as electricity from natural gas render wind and solar power non-competitive–they’re too costly and too unsustainable to win out as the “energy of choice” in a free market. Requiring utilities to buy wind and solar power, then passing that cost onto businesses and ratepayers is simply a hidden subsidy.
The more government distorts energy prices with subsidies, the less efficient our economy and use of energy becomes. Again, that’s a bad enough idea when our economy is humming along: it’s a particularly foolish idea when our economy is in dire straits.
They are hidden greenhouse gas controls. When most people think of the word "clean" in an environmental context, it is a reflection of things they consider dirty. Previously, these were tangible, observable things such as particulates, ozone precursors, photochemical smog, lead, mercury, etc. They were things that could be shown to cause harm to human beings and property in ways that were intuitive and readily understandable. You could point to them, or make jokes about them. People from Los Angeles still can, such as when they pretend to be uncomfortable in clean air because it’s “hard to trust air that you can’t see.”
Requiring utilities to buy wind and solar power, then passing that cost onto businesses and ratepayers is simply a hidden subsidy.
But environmentalists have taken the word “clean” and used it as camouflage to cover their efforts to control greenhouse gases, which are far different from conventional pollutants. Other than a few classes (such as particulates and ozone, which are already regulated under the Clean Air Act), the greenhouse gases are not “dirty” in any conventional sense of the term. They are not health hazards and they do not produce visible environmental degradation. Nor do they damage physical structures, as, say, acid rain might. And while the warming potential of greenhouse gases is well-established (though, I believe, overstated by alarmists), claims of future environmental degradation and risks to human health are highly speculative, based on computer models riddled with innumerable assumptions, many of dubious validity.
They are hidden technology standards. In previous conflicts over pollution control approaches, conservatives have often argued that government should set a standard for, say, vehicle tailpipe emissions, but then let the market determine how to meet that standard. That level of trust in the market is anathema to environmental regulators, however, who have historically perverted this idea by putting forward “emission standards” that could only be met by a particular technology. As an example, consider the ostensibly technology-neutral vehicle emission standards put into place in California. California’s Zero-Emission Vehicle Standard could only be achieved by a single existing technology (battery electric cars), with no other possible rival on the radar for years. This was not an accident, it was a de facto technology standard by the California Air Resources Board.
The same will happen with Clean Energy Standards, which will pretend to be technology neutral and embrace everything from nuclear power to “coal with carbon capture and storage,” but in reality will only give full credit to things like wind and solar power. There is already jockeying over what kind of “partial” credits might be given to nuclear power, hydro power, “clean coal,” and so forth. In current thinking, credit “multipliers” will favor wind and solar power over nuclear power, natural gas, clean-coal power, and others. In other words, while pretending that all forms of energy are up for discussion, some forms are pre-selected for preferential treatment.
Because the kinds of energy that qualify as ‘clean’ to environmentalists are more expensive than conventional energy, forcing them into the energy mix will inevitably raise energy prices.
They decrease consumer choice. Consider what would happen to your household food budget if the government imposed an “organic food standard” forcing you to consume 80 percent of your household calories as certified “organic” foods (80 percent is the environmentalist goal for a Clean Energy Standard). If you maintained your spending limit, you’d be getting less food and less choice for your money, because organic foods are more expensive and only some foods are produced organically. To get the same quantity and diversity of foods you had without the standard, you would have to pay more.
The same is true of a CES: energy use is hard to reduce, whether by consumers or businesses. Because of that constraint, a larger share of one’s budget will go toward paying for energy, leaving less for paying other bills, or making other buying decisions.
They are Trojan Horse politics. As for who's talking "bullshit," Al Gore has it wrong as usual: environmentalists and environmental agencies have stopped speaking honestly about their motivations (greenhouse gas controls). Instead, they are using poll-tested words to hide their real agenda behind terms that traditionally refer to something entirely different. They no longer speak about offering consumers a “choice” to voluntarily buy green energy and green products. Instead they favor forcing the choice by implementing “standards” such as those for lighting, which are de facto bans on incandescent bulbs. They no longer offer consumers the choice to buy clean energy (which was largely rejected by the public), they want to force people to buy pricey green power whether they want to or not.
Trojan Horse politics is the antithesis of good policy making. Environmental activists should say what they mean, and mean what they say. Then, they should accept the will of the public, expressed through democratic action and freely chosen purchasing decisions. The new stealth approach to energy policy being pushed under the guise of a Clean Energy Standard is frankly dishonest.
Kenneth P. Green is a resident scholar at the American Enterprise Institute.
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