Feb 16, 2009

Tales from the Mouth of the Fraser


With the BC budget just 27 hours away, in today’s Vancouver Sun, you can find my pre-budget oped. Alas, as often happens, I am paired with the Fraser Institute for the Economically Insane.

In today’s edition, Neils Veldhuis and Milagros Palacios act as yang to my yin. Their pre-budget oped seems strangely distant from the day-to-day reality of a recession that is unfolding in BC and elsewhere. Their response could have been written two or five years ago: the solution is to cut taxes and spending, and all will be good because cutting taxes increases the incentive to work, invest and save. Just don’t ask why, after eight years of tax cuts federally and provincially, work is disappearing, businesses are pulling back on new investments, and savings have plummeted.

Even in good times, these supply-side incentives do little to enhance prospects of productivity or economic growth. Their prescription is based on a flawed understanding of how economies work. More importantly, the current problem is on the demand side: a fall in incomes and employment. In these circumstances, businesses will not make new investments or hire new workers due to the weak outlook. Households are reining in their spending, and if anything are wanting to reduce their debt loads. Most households were not saving to begin with; only high-income households can afford to save. This is why governments need to focus their efforts on actions that will increase employment and incomes, particularly for low-income families who will go out and spend any additional income they get.

The Fraser case for tax cuts is further undermined by the fact that the specific tax cuts outlined by Veldhius and Palacios – eliminating the top income tax bracket, major cuts to corporate income tax rate, and increasing the small business income tax – are only of benefit to the very richest British Columbians, precisely the folks who would be least likely to spend their tax cuts. It is hard to believe that actions aimed at such a small group of people are going to turn the economy around. Their case is ultimately an ethical one: the rich are deserving of their riches (inherited wealth, anyone?) and any attempt to use the state to change that is morally wrong.

Not to be totally negative, I should give Neils and Milagros credit for this:

[W]e must dispel the notion that balanced budgets are the be-all and end-all. How the government chooses to finance its spending (whether through taxes or deficits) has little impact on real economic activity.

This is a major departure from the orthodoxy as practiced by the Fraser during last month’s federal budget, when their call was for both balanced budgets and massive tax cuts, measures that would have lopped off one-quarter of federal expenditures, and would have guaranteed a hard landing of the Canadian economy.

Alas, just a few paragraphs later we get this claim:

There is a wide body of academic research supporting the idea that the size of government matters with respect to economic performance. According to this research, the size of government in British Columbia is significantly larger than that which maximizes economic growth and social progress. Simply put, B.C. still has too much government intervention in the economy.

A wide body of academic research? I wrote a whole paper summarizing the literature, including the sources used by Neils and then-partner Jason Clemons, a few years back, for those who want the full meal deal. In short, the notion that there is an optimal size of government that maximizes economic growth may be an intriguing concept but any factual claims about Canada or any other country are simply bogus.

The pioneer of this research is Gerald Scully, of the National Center for Policy Analysis, a Dallas-based think-tank with a market fundamentalist perspective similar to the Fraser Institute (one-third of Clemens and Veldhuis’s references are papers by Scully). He developed a simple model designed to derive an optimal size of government, but this model is too simple — it states that economic output is merely a function of the tax share of GDP and nothing else. Technically, Scully sets up a Cobb-Douglas production function, but instead of using capital and labour as the factors of production, he uses the public sector and private sector shares of output. Scully assumes what he wants to find, and does not bother controlling for any additional factors apart from the raw size of government that might influence economic growth.

Most of this “research” is based on a single country, the United States, and (surprise!) finds that it is in need of a smaller government. Clemens and Veldhuis cite only one study looking at Canada, by Fraser Institute fellow and former Reform Party MP, Herb Grubel. Interestingly, it was a classmate of mine from grad school who crunched the numbers in that paper, but he felt uncomfortable publishing the results. Apparently Grubel had no objections to putting his name on it.

I personally do not mind right-wing arguments. They add to a healthy debate about the balance needed between individuals and society. But most often the available evidence contradicts the moral positions taken about the wonders of low taxes and minimal government. What is troubling is that Clemens and Veldhuis misrepresent research. That is, they claim that studies support their position but if one actually digs the study up, the finding is more nuanced or even the exact opposite.

Topics: ,