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The Effect of Tax Increases and Spending Cuts on Economic Growth

Veronique de Rugy — Wed, 22 May 2013 15:07:02 -0400

Publication

Good morning, Chairman Murray, Ranking Member Sessions, and members of the committee. Thank you for the chance to discuss the effect of tax increases and spending cuts on economic growth. I appreciate the opportunity to testify today.

Last week the Congressional Budget Office released a revision of its budget outlook for FY 2013.[1] According to CBO, our short-term outlook seems to be improving, at least on a superficial level, with this year’s deficit now expected to be $642 billion. That is $200 billion lower than projected in February, which would make it the smallest deficit since 2008.

There are many reasons for continued pessimism, however. At 76 percent, the debt-to-GDP ratio is still much higher than the 2008 level of 36 percent. Unfortunately, even under the new projections the debt- to-GDP ratio will still be around 74 percent at the end of the decade. And that’s assuming Congress doesn’t overturn sequestration and all of CBO’s assumptions hold true. In CBO’s alternative scenario, debt will be above 83 percent of GDP by the end of the decade.

The explosion of spending from programs such as Social Security, Medicare, and Medicaid will trigger even higher levels of debt in the years outside the 10-year budget window. Unfortunately, high debt levels are problematic. As CBO explains,

Such high and rising debt later in the coming decade would have serious negative con- sequences: When interest rates return to higher (more typical) levels, federal spending on interest payments would increase substantially. Moreover, because federal borrowing reduces national saving, over time the capital stock would be smaller and total wages would be lower than they would be if the debt was reduced. In addition, lawmakers would have less flexibility than they would have if debt levels were lower to use tax and spending policy to respond to unexpected challenges. Finally, a large debt increases the risk of a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates.

In other words, a brief dip in the deficit is no reason to be complacent. The federal government should continue to work on addressing its long-term debt problem. However, in the pursuit of debt reduction, it is important to remember that the type of fiscal adjustment that we implement is more important than its size.

In theory, debt reduction can be achieved by cutting spending or by raising taxes, or by adopting a mix of spending cuts and tax increases.

When anti-austerity policymakers or critics talk about austerity without even alluding to this distinction in how deficit reduction is achieved, they do a disservice to the clarity of the issues at hand, since different types of austerity measures produce very different results.[2]

This testimony is based on a paper I wrote with Harvard University economist Alberto Alesina, called “Austerity: The Relative Effects of Tax Increases versus Spending Cuts.” As we explain in detail in that paper, the consensus in the academic literature is that the composition of fiscal adjustment is a key factor in achieving successful and lasting reductions in the debt-to-GDP ratio. The general consensus is that fiscal adjustment packages comprising mostly spending cuts are more likely to lead to lasting debt reduction than those composed of tax increases.

There is still significant debate about the short-term economic impact of fiscal adjustments, but some important lessons have emerged. First, fiscal adjustments and economic growth are not incompatible. Second, while fiscal adjustments may not always trigger immediate economic growth, spending-based adjustments are much less costly in terms of output than tax-based ones. In fact, when governments try to reduce their debt by raising taxes, the policy is more likely to result in deep and pronounced recessions, possibly making the fiscal adjustment counterproductive. Finally, there is some evidence that expansionary fiscal adjustments are more likely to occur when they are accompanied by growth-oriented policies, such as policies liberalizing both labor regulations and markets for goods and services, in addition to a monetary policy that keeps interest rates low.

These findings are key to designing proper policies for the United States. They also suggest that the budget plans proposed by both President Obama and Chairman Murray are unlikely to reduce the country’s debt and may also slow economic growth if implemented as proposed.

1. How To Reduce Debt-to-GDP Ratios

The United States is not the first nation to struggle with a worrisomely high debt-to-GDP ratio. The evidence suggests that the types of fiscal adjustment packages that are most likely to reduce debt are those that are heavily weighted toward spending reductions, not tax increases.[3]

One of the difficulties of studying the impact of large fiscal adjustments on both debt and economic growth involves the definition and identification of successful and expansionary episodes. For a long time, the identification criteria were based on observed outcomes: a large fiscal adjustment was one where the cyclically adjusted primary-deficit-over-GDP ratio fell by a certain amount (normally at least 1.5 percent of GDP). Following the approach pioneered by University of California, Berkeley, economists Christina Romer and David Romer,[4] IMF economists suggested a different way to identify large exogenous fiscal adjustments: a large fiscal adjustment is an explicit attempt by the government to reduce the debt aggressively and it is unrelated to the economic cycle.[5] This new approach was meant to guarantee the “exogeneity” of the fiscal adjustments.

The authors also suggest that a difference in the way fiscal adjustments are measured would change the overall results. However, the difference in the way fiscal adjustments are defined does not change the overall result. A 2012 study by Alberto Alesina and Goldman Sachs’s economist Silvia Ardagna shows that spending-based adjustments are more likely to reduce the debt-to-GDP ratio, regardless of whether fiscal adjustments are defined in terms of improvements in the cyclically adjusted primary budget deficit or in terms of premeditated policy changes designed to improve a country’s fiscal outlook. [6] Similar results with more advanced technical tools using the IMF episodes are also reached by Alberto Alesina and Bocconi University economists Carlo A. Favero and Francesco Giavazzi.[7]

Other research has found that fiscal adjustments based mostly on the spending side are less likely to be reversed and, consequently, have led to more long-lasting reductions in debt-to-GDP ratios.[8] Beyond showing whether spending-based adjustments or revenue-based ones are more effective at reducing debt, the literature has also looked at which components of expenditures and revenue are more important. The results on these points are not as clear-cut, partly due to the wide differences in countries’ tax and spending systems. With that caveat in mind, successful fiscal adjustments are often rooted in reform of social programs and reductions to the size and pay of the government workforce rather than in other types of spending cuts.[9] Results about which type of revenue increases contribute to successful fiscal adjustment are much less clear.[10]

Also, while successfully reducing the debt-to-GDP ratio is possible, a majority of historical fiscal adjustment episodes fail to do so. Data from studies by Alesina and Ardagna and by Andrew Biggs and his colleagues show that roughly 80 percent of the adjustments studied were failures.[11] One explanation is that even (or especially) in a time of crisis, lawmakers are driven more by politics than by good public policy. Countries in fiscal trouble generally get there through years of catering to pro-spending constituencies, be they senior citizens or members of the military industrial complex, and their fiscal adjustments tend to make too many of the same mistakes. As a result, failed fiscal consolidations are more the rule than the exception.

2. Fiscal Adjustments and Economic Growth

While there is little debate over the fact that sound fiscal balance and restraints in government spending have a positive impact on GDP in the long run, the question of whether, in the short term, budget cuts shrink or expand GDP is far from settled.[12] This is an especially important question for countries where government spending as a share of GDP is close to or above 50 percent. A few uncontroversial points have emerged, however, despite the differences in approaches and in the definitions of successful or expansionary episodes.[13]

First, expansionary fiscal adjustments are not impossible. There is now a long trail of academic papers that have studied and documented the impact of fiscal adjustments on economic growth. The first in the series was by Francesco Giavazzi and Marco Pagano in 1990.[14] It was followed by a large literature, which was reviewed in depth by Alesina and Ardagna in 2010.[15] However, today the question is not whether expansionary fiscal adjustments are possible, but whether in the current circumstances it is possible to design fiscal adjustments with as little cost as possible to the economy, given that monetary conditions will provide little additional help. It is perfectly possible that fiscal adjustment today might be on average more costly than in the past, but this does not mean that the medicine is not necessary.

Second, while not all fiscal adjustments lead to economic expansion, spending-based adjustments are less recessionary than those achieved through tax increases.[16] Moreover, when successful spending-based adjustments were not expansionary, they were associated with mild and short-lived recessions, while tax increases were unsuccessful at reducing the debt and associated with large recessions.[17] These findings hold even when using the IMF definitions of fiscal adjustments.[18]

In fact, these findings are consistent with IMF studies themselves.[19] For instance, IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori study 173 fiscal consolidations in rich countries and find that “nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending.”[20]

Third, successful and expansionary fiscal adjustments were those based mostly on spending cuts rather than tax increases.21 Also, these adjustments lasted slightly longer and were associated with higher growth during the adjustment. Using data from [21] Organisation for Economic Co-operation and Development countries from 1970 to 2010, Alesina and Ardagna find that successful fiscal adjustments on average reduced the debt-to-GDP ratio by 0.19 percentage points of GDP in a given year. GDP grew by 3.47 percentage points in total, which is 0.58 percentage points higher than the average growth of G7 countries. Successful adjustments lasted for three years on average.[22]

How can we explain the fact that spending-based adjustments can result in lower output costs for the economy than tax-based ones, or in no output costs at all? IMF economists Prakash Kannan, Alasdair Scott, and Marco Terrones argue that this difference in outcomes is not a result of the composition of the fiscal adjustment packages, but rather a result of the business cycle having picked up because of other forms of government interventions, such as expansionary monetary policy.[23] However, Alesina, Favero, and Giavazzi’s work shows that taking the business cycle and monetary policy into account does not change the main finding.[24]

If the difference between tax-based and spending-based fiscal adjustments is not the result of the business cycle or of monetary policy, what explains it? The standard explanation is that lower spending reduces the expectation of higher taxes in the future, with positive effects on consumers and investors. In particular, there might be a boost in the confidence of the latter—as Alesina, Favero, and Giavazzi have shown. But there is more. As is often the case, the devil is in the details. Studies by Alesina and Ardagna and by Roberto Perotti have noted that fiscal adjustments are multiyear rich policy packages.[25] Austerity measures are often undertaken at the same time that other growth-enhancing policy changes are made, and, as such, there is much to learn by looking into the details of each successful episode.

One important lesson is that several accompanying policies can moderate the contractionary effects of fiscal adjustments on the economy and enhance their chances of success.[26] For instance, spending-based fiscal adjustment accompanied by supply-side reforms, such as liberalization of markets for labor, goods, and services; readjustments of public sector size and pay; public pension reform; and other structural changes tend to be less recessionary or even to have positive economic growth.[27]

Such reforms signal a credible commitment to more market-friendly policies: less taxation, fewer impediments to trade, fewer barriers to entry, less labor market and business regulation. And, of course, with enhanced economic freedom, unit labor costs fall and productivity improves, making an expansionary fiscal adjustment more likely than a contractionary one.

Germany’s fiscal adjustment of 2004–2007 provides a good example.[28] First, the country implemented a stimulus by reducing income tax rates. This reduction was part of a series of supply-side-oriented reforms implemented between 1999 and 2005, including a wide-ranging overhaul of the income tax system that was meant to boost potential growth but that did not have much effect until 2004. In addition, significant structural reforms to tackle rigidity in the labor market were put in place, as well as changes to the pension system to relieve demographic pressures. These reforms included “an increase in the statutory retirement age, the elimination of early retirement clauses, and tighter rules for calculating imputed pension contributions.”[29] Finally, Germany adopted large expenditure cuts to the fringe benefits in public administration (such as ending Christmas-related extra payments) and also serious reductions in subsidies for specific industries, including residential construction, coal mining, and agriculture.[30]

Sweden provides another example of successful adjustment. The data show that after the recession Sweden’s finance minister, Anders Borg, not only successfully implemented reduction in welfare spending but also pursued economic stimulus through a permanent reduction in the country’s taxes, including a 20-point reduction to the top marginal income tax rate. At the same time, Sweden benefited from a very aggressive monetary policy followed by strong export revenues and firm domestic demand. The country’s economy is now the fastest-growing in Europe, with real GDP growth of 5.6 percent, which has helped the country to rapidly shrink its debt as a percentage of GDP over the past decade.[31]

The Swedish example raises the question of the appropriate role of monetary policy in successful fiscal adjustments. For instance, there is some evidence that at times exchange rate devaluation (induced by an accommodating monetary policy) can help to boost a country’s exports as the country becomes more competitive and, as a result, can compensate for a previous slowdown in domestic demand.[32]

Economist Scott Sumner has made the case that the best way to get austerity and growth simultaneously is to increase “[nominal] GDP and budget surpluses—the Swedish way.”[33] To be sure, monetary policy in Europe—or in the United States, for that matter—could increase the effectiveness of spending cuts and structural reforms (a little like the water you drink to help the medicine to go down). But it is a mistake to oversell it, and it certainly will not achieve our long-term goals without serious reductions in government spending. In particular, the devaluation of a country’s currency is neither a necessary nor sufficient condition for success, as shown by Alesina and Ardagna.[34]

There is growing evidence, however, that private investment tends to react more positively to spending- based adjustments. The data from Alesina and Ardagna, and Alesina, Favero, and Giavazzi, for instance, show that private-sector capital accumulation increases after governments cut spending, which compen- sates for the reduction in aggregate demand due to the fiscal adjustments.[35]

The good news is that it is possible to design a fiscal adjustment that could both reduce the deficit and have a minimal or even, in some cases, positive impact on the economy. It requires austerity based mostly on spending cuts. This can be accomplished without hurting the least advantaged in society. As Alesina wrote in November 2012,

But if we cut spending, do we necessarily hurt the poor? Not in such countries as Greece, Portugal, Spain, and Italy, whose public sectors are so inefficient and wasteful that they can certainly spend less without affecting basic services. Even in countries with better-functioning public sectors— such as France, where public spending is nearly 60 percent of GDP—there’s a lot of room to economize without hurting the poorest and most vulnerable. And even in America, public spending is about 43 percent of GDP, a level common in Europe not long ago, and up from 34 percent in 2000.[36]

In other words, Western governments can save money and avoid inflicting injury on lower-income earners or the poor by improving the way welfare programs are targeted; scaling back programs such as Medicare that use taxes raised in part from the middle class to give public services right back to the middle class; and gradually raising the retirement age to 70. The same holds true for Social Security. What is more, lots of savings could be achieved by cutting subsidies going to businesses—which are often large, well-established, and politically connected firms, such as gas and oil companies, farms, automobile manufacturers, and banks.[37]

Conclusion

Economists disagree a lot when it comes to fiscal policy. For instance, there is no consensus about the size of the spending multiplier or where on the Laffer curve most countries are situated. However, a consensus seems to have emerged recently that spending-based fiscal adjustments are not only more likely to reduce the debt-to-GDP ratio than tax-based ones but also less likely to trigger a recession. In fact, if accompanied by the right type of policies (especially changes to public employees’ pay and public pension reforms), spending-based adjustments can actually be associated with economic growth.

Fortunately, successful fiscal adjustments are possible when based mostly on spending cuts and accompanied by policies that increase competiveness, as we have seen in the case of Germany, Finland, and other more recent examples, such as Estonia and Sweden. However, it is important to refrain from oversimplifying these results since fiscal adjustment packages are often complex and multiyear affairs. Also, many of the successful (i.e., expansionary and debt-to-GDP-reducing) fiscal adjustments in this literature are ones where the growth is export-led during times when the rest of the global economy is healthy or even booming. While there has been some recovery in the midst of the recession, we should recognize that it may be much harder today to achieve export-led growth when many countries are struggling.

The cost of well-designed adjustments plans will not be zero, but will be relatively low. Besides, it is not clear that the alternative to reducing spending is more economic growth. In fact, the alternative for certain countries could be a very messy debt crisis.

See footnotes as a PDF

Patient Protection and Affordable Care Act; Health Insurance Market Rules; Rate Review

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:52:48 -0400

Regulatory Report Card

This proposed rule would implement the Affordable Care Act’s policies related to health insurance premiums, guaranteed availability, guaranteed renewability, risk pools, and catastrophic plans. The proposed rule allows health insurance issuers to vary premium rates for health insurance coverage in the individual and small group markets based on a limited set of specified factors: (1) whether the plan or coverage applies to an individual or family; (2) rating area; (3) age, limited to a variation of 3:1 for adults; and (4) tobacco use, limited to a variation of 1:5. The proposed rule also defines catastrophic plans to include preventative coverage.

The Patient Protection and Affordable Care Act, and Standards Related to Essential Health Benefits, Actuarial Value, and Accreditation

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:06:44 -0400

Regulatory Report Card

This proposed rule provides details of standards for health-insurance issuers consistent with Title I of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively referred to as the Affordable Care Act). This proposed rule outlines exchange and issuer standards related to coverage of essential health benefits and actuarial value. This proposed rule also proposes a timeline for qualified health plans to be accredited in federally facilitated exchanges and an amendment that provides an application process for the recognition of additional accrediting entities for purposes of certification of qualified health plans.

Energy Conservation Program: Energy Conservation Standards for Standby Mode and Off Mode for Microwave Ovens

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:14:21 -0400

Regulatory Report Card

Per the requirements established in the Energy Policy and Conservation Act (EPCA), which prescribes energy-conservation standards for various consumer products and commercial and industrial equipment, and the Energy Independence and Security Act of 2007, the DOE proposes energy-use standards for microwave ovens in the standby and off modes. Specifically, the rule would prescribe the maximum allowable energy use when a product is in standby or off mode. For microwave-only ovens and countertop combination microwave ovens the maximum allowable energy use will be 1 watt. For built-in and over-the-range combination microwave ovens, the maximum allowable energy use will be 2.2 watts. DOE estimates a 0.06 percent reduction in projected household energy use as a result of the proposed rule.

For the rule's Regulatory Impact Analysis, go to Regulations.gov.

If The IRS Bothers You, So Should The FSOC and CFPB

Hester Peirce — Wed, 22 May 2013 11:29:03 -0400

Expert Commentary

The recent revelations about the goings-on at the Internal Revenue Service have gotten a lot of attention. When the patina of government impartiality shows itself so disturbingly thin, people of all political stripes sit up and take notice. The hard lessons drawn from the IRS experience should inform the broader policy debates about regulatory structure and oversight.

When the IRS activities came to light, the president expressed his disapproval and cited the agency's independence. As others have pointed out, the IRS is actually not-as agencies go-particularly independent. It is part of the Treasury Department, an executive agency that answers directly to the president, and the head of the IRS serves at the pleasure of the president. Nevertheless, the president's mention of independence reminds us of the importance of accountability in government-a government official who does not answer to anybody else can do quite a bit of damage without anyone noticing, let alone stopping her.

Our elected officials ought to be taking steps to ensure that other agencies do not follow the IRS's lead. If, instead, they refuse to subject regulatory agencies to basic accountability measures, they will help to clear the way for the next agency misdeed.

The need for accountability is relevant to a number of ongoing debates. The Senate is moving closer to a vote on the president's nomination of Richard Cordray to head the Bureau of Consumer Financial Protection. He is already serving in that capacity by virtue of a recess appointment that has been legally challenged, but Senate confirmation would give him a full five-year term in office.

Dodd-Frank intentionally made the CFPB super-independent and put all of its powers in the hands of one person, the director, who does not have to answer to anyone-not to congressional appropriators, not to House and Senate oversight committees, not to the American consumer, not to the chairman of the Federal Reserve (where the Bureau is technically housed), and not to the president. The president may remove the director, but only "for cause." Before the Senate votes to lock in Cordray's autonomy, it ought to ensure that Congress has the necessary tools to monitor him and hold him accountable. Otherwise, the president may one day be citing the director's independence as the reason that agency misdeeds went unnoticed and unstopped.

This week's hearings on the Financial Stability Oversight Council's annual report present another opportunity to incorporate the lessons from the IRS. The council is made up of the heads of the other financial regulators. With so many cooks in the kitchen, it is hard to know whom to hold accountable for the council's decisions-decisions that could fundamentally reshape the financial sector. The hearings offer an opportunity to explore ways to remake the council so that its actions are transparent, its members represent their agencies' views rather than their own, and its staff is properly supervised.

As it functions now, it is difficult to know who is making decisions at the council and on what basis those decisions are being made. The Government Accountability Office and others have noted this lack of transparency. The members of the council are the agency heads, rather than the agencies themselves, which increases the potential for conflicting signals coming from the council and the other federal financial regulators.

It would also be worth thinking about how the council's sister agency, the Office of Financial Research, can be made accountable. Its director serves a six-year term and, like the CFPB director, sets his own budget and answers only to himself. The OFR is a data collection agency, but the IRS incident is a reminder that even data requests can be wielded in a way that disproportionately burdens certain entities.

Our elected officials should use this moment to reconsider the design of the CFPB, the FSOC, and the OFR. These agencies must be accountable, transparent, and balanced so that the American people understand what these agencies are doing and why they are doing it. We can't eliminate government lapses of judgment through regulatory redesign, but we can make it less likely that they will go undetected and unpunished.

The Film Tax Credit Farse

Antony Davies, James R. Harrigan — Wed, 22 May 2013 10:10:22 -0400

Expert Commentary

Everyone loves a good movie, but with an average cost of more than $8, most Pennsylvanians have to choose carefully what they will spend their money on. Too bad we don't have that same luxury with our tax dollars, which subsidize the film industry to the tune of $60 million a year. If lobbyists for the “film tax credit” have their way, this will increase to $100 million in short order.

The debate over whether to increase the credit clouds the real issue: The debate should be whether the credit should exist at all. Simply put, it should not.

The credit, we are told, is an “investment” in Pennsylvania. By offering this credit we entice out-of-state productions to the state, which creates jobs and increases the tax base. Everybody wins! But if you really want to see who wins, look at who is pushing for the benefit. Filmmakers win. Taxpayers will be left holding the empty popcorn bag.

The film industry claims that the tax credit creates 18,000 jobs and innumerable others benefit as out-of-state money filters through our economy. What is casually omitted from this rosy scenario is the money lost by businesses that are already here.

When people are taxed to subsidize one industry, they have less money to spend the way they want. Some people win, but a lot of others lose. Politicians are simply picking the winners and losers.

Proponents say that our taxes aren't really going up because the $60 million is a credit. Out-of-state film crews don't pay taxes in Pennsylvania, so enticing them here with tax credits means only that they still won't be paying taxes in Pennsylvania. But this ignores the fact that they will be using state services: police and fire protection, public schools, roads and — notably — unemployment benefits when their movies wrap up. We taxpayers will be footing the bill for these services.

According to the nonpartisan Tax Foundation, every independent study of film tax credits has found that the credits are money-losers for the states. Arizona's Department of Commerce calculated that Arizona made back 28 cents in tax revenue for every $1 it “invested” in film tax credits. Connecticut's Department of Economic Development estimated that the state earned 7 cents in tax revenue for every $1 it lost. State agencies in Massachusetts, Michigan, New Mexico and even Pennsylvania's Legislative Budget and Finance Committee found that state coffers received less than 30 cents for every dollar they paid out in film tax credits.

If film production is such a great cash cow, why aren't venture capitalists lining up for a piece of the action? The problem is that the film industry wants special treatment. It wants someone else to shoulder the risk of investment while it keeps the profit for itself. No investor would agree to such a deal, and that is why the film industry has turned to our state government.

Filmmakers know the state can force taxpayers to invest in something taxpayers would never choose on their own.

The Top 3 Things I Learned at the Bitcoin Conference

Jerry Brito — Wed, 22 May 2013 10:03:57 -0400

Expert Commentary

This past weekend I attended the Bitcoin 2013 conference in San Jose, where over one thousand enthusiasts, developers, entrepreneurs, venture capitalists, and, yes, lawyers gathered to chart the future of the virtual currency. Here are the top three things I learned at the conference.

Bitcoin is about more than payments

Bitcoin is an even bigger deal than I thought. While the currency is best known as a censorship-resistant and somewhat-anonymous payments system, it has the potential to be so much more.

“Ultimately bitcoins are data, and you can use a data transit protocol to transit information other than just ‘I’m sending you bitcoins.’ It could be ‘I’m sending you a stock,’ or it could be ‘I’m sending you a bet,’” says Jeff Garzik, one of the six Bitcoin core developers.

Thought of this way, the Bitcoin network is a platform on top of which other layers of functionality can run, much like the Web or e-mail are protocols that run on top of the Internet’s foundational TCP/IP protocol. Bitcoin therefore has the potential to spawn any number of other services that are decentralized, and thus difficult to regulate or control.

One application for such an extension to Bitcoin would be decentralized electronic markets—whether for futures contracts, sports betting, or anything else.

J.R. Willett, author of a white paper proposing such a system, explains with a thought experiment: Suppose two parties, A and B, want to bet on the future price of Google stock, and there is a third party, C, that publishes the price on the network every few minutes. A thinks the price of Google will go up and publishes a message to that effect, while B thinks it will go down and publishes a message accepting the bet.

“Now, they’re interacting on a protocol layer above bitcoin; they’re using a currency that’s on top of bitcoin that recognizes these kinds of messages,” says Willett. “So they’ve actually both committed and there’s an agreement that everybody in the world can see.”

Others on the distributed network don’t know the identities of who placed the bet, but they can see that A said it would go up, and that B said it would go down, and they can see C publish the price of Google in the future.

“If the price goes up, then the whole protocol recognizes that A won that bet; the whole protocol recognizes that A now owns B’s coins,” says Willett.

And voila, welcome to a world of decentralized electronic futures markets. The predictions market Intrade, a darling of academic economists and political scientists, recently ceased operations after it was sued by the CFTC. Yet such a predictions market built as a peer-to-peer network on top of Bitcoin could not be easily shut down, nor would there be an operator that could run away with user’s funds, as it’s also alleged of Intrade.

And it’s not just markets. Treating Bitcoin as a protocol would allow for a vast number of other decentralized applications, including communications messaging and broadcasting, a decentralized domain name system, and much more.

The hobbyists give way to the pros

Bitcoin to date has been the domain of geeks, gold bugs, and cypherpunks, but sensing its disruptive (and profitable) potential, entrepreneurs and venture capitalists are pouring into the space.

Peter Thiel’s Founders Fund last week made a $2 million investment in merchant services firm BitPay, Google Ventures recently backed bitcoin exchange Ripple, and Fred Wilson’s Union Square Ventures has invested $5 million in the transactions platform Coinbase.

This transition from ideological enclave to professionalized financial network was on display at the conference’s exhibit hall. Row after row was lined with the booths of professional venture-backed businesses, while nestled in between were those of the Seasteading Institute and Antiwar.com.

It’s just like the late-90’s rush to commercialize the Internet once entrepreneurs recognized its revolutionary potential. And just like the late ‘90s, the early adopters are not all fond of the gentrification.

“A year or more ago there was very much an ‘Occupy’ type feel to Bitcoin, where this is the anti-establishment currency, and now the establishment is getting interested in Bitcoin,” says Garzik. “There is a tension and you definitely see the libertarian crypto-anarchist roots bang heads with the venture capital that’s coming in right now.”

One point of contention is mixing. As professional and regulated businesses enter, they are keen to tie real identities to transactions, and they are loath to touch bitcoins of unknown provenance. Many in the community rightly see this as a threat to Bitcoin’s fungibility.

“If someone says, ‘I will not accept these bitcoins over here because I think they are stolen funds,’ then their value is different from these other bitcoins that are not necessarily stolen funds,” explains Garzik. “And so some people of the crypto-anarchist, libertarian mindset feel it’s very important to mix because that preserves the fungibility of Bitcoin.”

Mixing is essentially laundering. It is combining bitcoins of different origins in a pool before handing them back to their owners in order to obfuscate who has which coin. Some even suggest that mixing should be built into the Bitcoin protocol itself. Businesses, to say the least, don’t like the sound of that. Everyone, however, will have to accept that Bitcoin is an open source project, and it’s ultimately consensus that will resolve the differences.

There’s no escaping regulation

Just two days before the conference, the Department of Homeland Security seized accounts belonging to Mt. Gox, the largest Bitcoin exchange (and a major sponsor of the conference), in what looks like the beginning of a criminal enforcement. You’d think this would have put a pall on the festivities, but in a way it only served to underscore the growing professionalization of the Bitcoin ecosystem.

Mt. Gox seems to have been operating without the requisite money transmitter licenses, and DHS alleges it lied about its status as a money transmitter in bank documents. In contrast, the new Bitcoin businesses that are springing up are working with state and federal regulators to cross every T and dot every I. And panelist after panelist on the conference’s “Legal and Regulatory” track explained to attendees how to comply with the law, as uncertain as it is. Dilettante time is over.

If the message wan’t clear enough, the Bitcoin Foundation—which helps organize Bitcoin’s development on the same model as the Linux Foundation—announced that it would be hiring a full time lawyer in Washington to represent the community’s interests. The thinking is that Bitcoin businesses and users are going to be regulated even if the protocol itself can’t be, so it’s time to engage the regulators and policy makers before they make any hasty moves.

This willingness to lobby and work with regulators, however, was not well received by many of the old guard. As one exasperated Foundation member tweeted, “I got into Bitcoin to improve this miserable planet and ESCAPE the iron grip of privileged moneyed interests, not JOIN THEM!”

But the fact is that Bitcoin is growing up. Its revolutionary potential is greater than most have yet understood. Entrepreneurs and venture capitalists are seeking to professionalize and legitimizing the network, and to do that regulators will have to understand and accept it.

It’s true that Bitcoin could continue to operate even if it was outlawed outright, but then it would only serve as an underworld currency, and its development would not doubt be hampered. The more subversive path may well be to let regulators create their rules for what at base is an uncontrollable system.

Oklahoma City Supporter and Friend Lunch

Maurice P. McTigue — Tue, 21 May 2013 17:04:21 -0400

Events

Please join us for one of our special events and discussions with the Honorable Maurice McTigue. As a former New Zealand cabinet minister and now a Mercatus Center vice president, Maurice speaks from experience about solutions and reforms that can be made to address the serious economic issues our country faces.

The Mercatus Center’s clear-headed research is shaping the conversation on government spending, fiscal austerity, and financial market regulation. Come hear what the former New Zealand cabinet minister would do in this country to promote economic growth and fiscal responsibility.

This is not a fundraising event, and there is no charge to join us. We are pleased to have you as our guest to show our thanks and appreciation to our donors. Dress is business casual. Please invite friends or associates who might be interested.

Questions? Contact Elizabeth Leibundguth at 703-993-4967 or eleibundguth@mercatus.gmu.edu.

Tulsa Supporter and Friend Lunch

Maurice P. McTigue — Tue, 21 May 2013 17:00:58 -0400

Events

Questions? Contact Elizabeth Leibundguth at 703-993-4967 or eleibundguth@mercatus.gmu.edu.

Why Is There No Milton Friedman Today?

Tue, 21 May 2013 14:57:12 -0400

Expert Commentary

Imagine that someone with all the endowments of a Milton Friedman were born in the 1960s or 1970s. Is it conceivable that such a person would develop into a ‘Milton Friedman’ like we know the actual Friedman to have been, including his academic eminence and his eloquent and influential advocacy of classical liberalism? Here leading economists address the question: Why is there no Milton Friedman today?

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Why Government Aid Programs Aren’t the Best Way to End Poverty

Christopher Coyne — Tue, 21 May 2013 14:52:35 -0400

Expert Commentary

Based on the high standards of living enjoyed by their citizens, you might think that the governments of First World countries know how to create development. They don’t. Development isn’t created by anyone, not least well-intentioned politicians or development “experts”. The process of improving well-being only takes place in an environment that encourages constant innovation and experimentation.

Unfortunately, the state-led aid industry not only neglects the realities of development, but often takes actions that actively undermine it. For First World countries, development does not mean allowing other societies to go through the same messy process they did themselves. It entails top-down planning and grandiose promises that – this time – their plans will end poverty and suffering for good. Just consider the $9bn (£5.9bn) pledged to Haiti following its 2010 earthquake. Only a small portion was delivered, and even that has proven ineffective. Haiti’s President Michel Martelly recently concluded that aid “isn’t showing results”.

There are two reasons why state-provided aid cannot create society-wide prosperity. First, policymakers do not have access to the knowledge needed to allocate scarce resources to their best uses. In his critique of socialism in the 1930s and 1940s, Nobel Laureate Friedrich Hayek made this exact point, noting that even the most qualified and benevolent planners lack the knowledge to produce even the most basic items in a cost-effective manner.

Investor Thomas Thwaites recently embarked on a fascinating endeavour, the Toaster Project, which illustrates Hayek’s point. Thwaites tried to build a simple toaster from scratch. He quickly found the task was overly complex, involving hundreds of parts and materials from many locations. After much travel and effort to extract and process these materials, he constructed his (extremely ugly) toaster. Upon being plugged into an electric socket, it burned out within seconds. Thwaites realised that “the scale of industry involved in making a toaster is ridiculous, but at the same time the chain of discoveries and small technological developments that occurred along the way make it entirely reasonable.” No central planner determined the process, yet toasters are readily available. This is economic development.

The perverse incentives associated with aid are a second reason governments can’t create development. These exist both within the recipient and donor governments. For recipients, aid creates the incentive for already dysfunctional governments to remain ineffective. A cross-country study by Stephen Knack of the World Bank found that foreign assistance undermines the quality of political institutions in recipient countries through weakened accountability of political actors, more corruption, greater chances of conflict, and a weakening of the incentive to reform inefficient institutions and policies.

For donors, government agencies tend to focus on spending money as quickly as possible on observable outputs to signal their importance and the need for more money. In the absence of clear lines of accountability, money is often wasted. Consider that a recent report by the Special Inspector General for the Iraq Reconstruction (SIGIR) identified $8bn in funds that were either wasted or unaccounted for. When people are not held responsible for their actions, they tend to act carelessly. Aid efforts are plagued by similar issues.

Economic freedom, which requires general protections of person and property, avoids both of these problems. It does not fall prey to the knowledge problem that Hayek warned of because it recognises that attempting to micromanage economic outcomes is doomed to fail. Likewise, it avoids creating perverse incentives because it limits direct political interventions into voluntary interaction between people.

What can be done? Instead of looking to fix other societies, developed nations should focus on their own policies towards people living elsewhere. As the Toaster Project illustrates, increasing the extent of the market is the best means of delivering more and cheaper goods and services. If the desired end is to help the worst off, this provides a benchmark for judging policies: does it contribute to increasing the extent of the voluntary market? If the answer is “yes”, those policies will be most effective at improving living standards and removing suffering.

Renewable-Energy Subsidies and Electricity Generation

Veronique de Rugy — Wed, 22 May 2013 13:17:21 -0400

Publication

This chart uses data from the US Energy Information Administration to compare federal investments in green energy and the share of green energy in electricity generation.

Wind energy receives the lion’s share of renewable-energy grants. The industry has received nearly $30 billion in federal subsidies and cash grants over the past 35 years, and Washington has promised another $12 billion in subsidies in the next decade.

Among the specific fuels and technologies, wind plants received the largest share of direct federal subsidies and support in fiscal year 2010, accounting for 42 percent of total electricity-related subsidies. From 2000 to 2010, federal wind subsidies grew by an average of 32 percent per year while subsidies for other energy sources remained relatively flat. Between fiscal years 2007 and 2010, annual wind subsidies grew from $476 million to nearly $5 billion almost tenfold.

While the data of the full amount of subsidies is not available, as of March 21, 2013 DOE’s 1603 program funded $18.2 billion in cash grants for renewable energy projects. Furthermore, according to the National Renewable Energy Laboratory, the wind industry has received $8.4 billion in subsidies through May 2012.

Wind energy is subsidized through dozens of different federal credits, grants, and loan guarantees. These programs give wind producers significant pricing advantages over other, more reliable sources of energy. Despite this advantage and the extraordinary federal investments in wind energy, wind energy produced only four percent of the entire US electricity generation in 2012, coming in a distant fifth place behind coal, nuclear, natural gas, and hydropower.

Taxpayers should not be forced to shell out billions of dollars on subsidies for such a low-value energy generator that has already been heavily subsidized for 35 years.

Data note: electricity generation data from the EIA were updated in May 2013; subsidy data were not. Therefore, we use the 2010 figures in order to compare total subsidies, support received, and share in total generation. Solar provided 0.02 percent of total electricity generation in 2010.

Current Good Manufacturing Practice and Hazard Analysis and Risk-Based Preventive Controls for Human Food

Michael L. Marlow — Mon, 20 May 2013 17:09:27 -0400

Publication

Introduction

The Regulatory Studies Program of the Mercatus Center at George Mason University is dedicated to advancing knowledge about the economic effects of regulation on society. As part of its mission, the program conducts careful and independent analyses that employ contemporary economic scholarship to assess rulemaking proposals and their effects on the economic opportunities and the social well-being available to all members of American society.

This comment addresses the efficiency and efficacy of this proposed rule from an economic point of view. Specifically, it examines how the proposed rule may be improved by more closely examining the societal goals the rule intends to achieve and whether the proposed regulation will successfully achieve those goals. In many instances, regulations can be substantially improved by choosing more effective regulatory options or more carefully assessing the actual societal problem.

Summary

The proposed rule revises the FDA’s current good manufacturing practice (CGMP) regulations regarding the manufacturing, processing, packing, or holding of human food in two ways. First, it adds preventive controls provisions as required by the FDA Food Safety Modernization Act (FSMA) that generally apply to facilities under the FDA’s current food facility registration regulations. It includes requirements for covered facilities to maintain a food safety plan, perform a hazard analysis, institute preventive controls for the mitigation of those hazards, monitor their controls, verify that they are effective, take any appropriate corrective actions, and maintain records documenting these actions. Second, the proposed rule updates, revises, or otherwise clarifies certain requirements of CGMP regulations, which were last updated in 1986. The FDA states that the primary benefit of this rule would be a decrease in the expected incidence of illnesses caused by the manufacturing, processing, packing or holding practices of human food.

My comment argues that the FDA has failed to conduct a thorough and quantitative analysis. The FDA admits it is unable to quantify health benefits derived from this rule. Instead, the FDA has developed a qualitative assessment that describes how implementing this rule would likely reduce the level of foodborne illness. The FDA estimates the “breakeven illness percentage” for each of three closely related regulatory options that are not developed within a model of optimal food safety. The FDA thus does not conduct an in-depth benefit-cost analysis of this major revision of our nation’s food safety regulations.

This rule is a Hazard Analysis Critical Control Point (HACCP) rule without calling it that. The FDA has two HACCP rules in place for seafood and juice that, by now, should have generated ample evidence as to how well these two rules have reduced the rate of foodborne disease. The most logical one to study is rule for seafood, as the FDA promised in the final rule to analyze it and determine if it had been effective, whereas the juice rule primarily moved raw fruit juice producers to either pasteurize their products or go out of business. The analysis for the seafood rule has not been done, but it should be done before implementing HACCP for all other foods under FDA’s jurisdiction. The measure of the seafood HACCP program’s success would be the first indicator of the likely effectiveness of this program for other foods.

Even before that the FDA needs a baseline risk assessment that attributes different pathogens and other contaminants both to specific food categories as well as to failures at the processing level, failures that this proposed rule is intended to address.

Finally, the FDA needs to consider a wider set of alternatives within a model of an optimal level of food safety that can be quantitatively assessed through conventional benefit-cost analysis.

Standards for the Growing, Harvesting, Packing, and Holding of Produce for Human Consumption

Michael L. Marlow — Mon, 20 May 2013 17:00:56 -0400

Publication

Introduction

The Regulatory Studies Program of the Mercatus Center at George Mason University is dedicated to advancing knowledge about the effects of regulation on society. As part of its mission, the program conducts careful and independent analyses that employ contemporary economic scholarship to assess rulemaking proposals and their effects on the economic opportunities and the social well-being available to all members of American society.

This comment addresses the efficiency and efficacy of this proposed rule from an economic point of view. Specifically, it examines how the proposed rule may be improved by more closely examining the societal goals the rule intends to achieve and whether this proposed regulation will successfully achieve those goals. In many instances, regulations can be substantially improved by choosing more effective regulatory options or more carefully assessing the actual societal problem.

Summary

The proposed regulation is designed to meet Section 105(a) of the FDA Food Safety and Modernization Act (FSMA) requirement that “not later than 1 year after enactment, the Secretary . . . shall publish a notice of proposed rulemaking to establish science-based minimum standards for the safe production and harvesting of those types of fruits and vegetables, including specific mixes or categories of fruits and vegetables, that are raw agricultural commodities for which the Secretary has determined that such standards minimize the risk of serious adverse health consequences or death.”

The FDA argues that the proposed rule would establish science-based minimum standards for the safe growing, harvesting, packing, and holding of produce on farms. It would address microbiological risks from all agricultural inputs (people, agricultural water, biological soil amendments, and tools and equipment), from unsanitary conditions in buildings, and from contact with wild and domesticated animals during growing, harvesting, packing, and holding activities of covered produce, including sprouts intended for human consumption. The primary benefit of the provisions in this rule is an expected decrease in the incidence of illnesses relating microbial contamination of produce.

I argue that the FDA needs to conduct a more comprehensive analysis. There is insufficient effort to establish the current state of food safety practices and little to no connection is made between those practices and public health. The FDA has not even presented a careful economic modeling of what an optimal set of rules for food safety practices would look like. Rather, the FDA wants to impose a “shotgun” approach on all covered foods rather than one that focuses on those foods or farms that pose the greatest risks. The FDA has acknowledged that it is required by law, by the Food Safety Modernization Act, to pass these standards. However, it is also required by OMB guidelines to analyze options that are not currently legal so as to inform the President and Congress when there are more efficient ways of solving a particular social problem than Congress had envisioned. The FDA should rethink its proposed regulation since there is little to suggest that it is the most efficient or effective option to improve public health.

The Hidden Costs of Tax Compliance

Jason J. Fichtner, Jacob Feldman — Mon, 20 May 2013 16:48:20 -0400

Publication

The tax code, far beyond simply collecting revenue to fund the operations of the federal government, attempts to perform policy and political functions as well. This paper does not examine the normative value of these provisions, but instead examines the hidden costs of today’s tax code: time and money spent submitting tax forms, foregone economic growth, lobbying expenditures, and gaps in revenue collection. These problems grow larger as the Internal Revenue Code becomes more complicated and temporary.[1] Based on the studies reviewed in this paper, we estimate that hidden costs range from $215 billion to $987 billion and that the tax code results in a $452 billion revenue gap in unreported taxes. The economic costs are substantial relative to the $2.45 trillion in revenues raised by the federal government in 2012.[2]

The structure of individual and corporate income taxes in the United States— accounting for over 55 percent of total tax revenue—reflects policymakers’ agglomerated attempts to increase fairness, conduct social policy, encourage economic growth, and promote favored industries.[3] According to the National Taxpayer Advocate, between 2001 and 2010 there were 4,428 changes to the Internal Revenue Code, including an estimated 579 changes in 2010 alone.[4] To put this in perspective, it means the tax code averages more than one change per day. The complexity of tax code is largely responsible for the $67 billion to $378 billion of accounting costs incurred in the process of filing taxes. A simpler tax system with fewer deductions would assist in alleviating these costs.

Revenue collected by the government through taxes prevents economic transactions from occurring. The economic size of these purchases and business deals that do not occur is larger than the revenues collected by the government. Net estimates of foregone economic growth range from $148 billion to $609 billion (see table 3, page 13).

Along with accounting costs and economic costs, lobbying costs are a third cost of today’s tax code. Although we do not have an estimate of annual lobbying costs, between 2002 and 2011 lobbyists spent $27.6 billion petitioning federal, state, and local governments for policy preferences (see figure 2, page 14). More significantly for long-term economic growth, a tax code open to lobbyists incentivizes the pur- suit of rent-seeking careers, rather than innovation, to protect and expand tax advantages.[5]

Finally, although it is not an economic cost, the structure of the tax code affects the government’s ability to raise revenues efficiently and equitably. The United States has a tax-reporting compliance rate of 85.5 percent—leaving a revenue gap of $452 billion in unreported taxes. The government’s failure to collect revenues that are owed by law creates a social cost of inequitable tax burdens among similar taxpayers.[6] Policymakers intending to collect more revenues for the federal government will need to understand the risks/benefits taxpayers assume by not report- ing taxable income. One case study from Russia suggests that shifting the tax code toward a flat tax holds promise for reducing the revenue gap.[7]

The extent to which many of these costs could be quantitatively reduced by reforms is beyond the scope of this paper. The purpose of the paper is to use the relevant scholarly literature to document the cost of the US tax system. In section VI, we provide qualitative recommendations based on successful tax reform in Russia and on the 1986 Tax Reform Act. Tax reform today must negate the incentives for both legal and illegal tax sheltering. Curtailing the hidden costs of taxation will require a simpler tax code with lower rates.

The Federal Reserve Ignores Its Own Role in the Financial Crisis

Steven Horwitz — Tue, 21 May 2013 13:54:52 -0400

Expert Commentary

Since the financial meltdown in 2008, the Federal Reserve's range of powers have expanded, as have the kinds of financial institutions it monitors and regulates. Fed Chairman Ben Bernanke is now saying that the Fed's oversight has expanded beyond strictly financial institutions to wide swaths of the economy that might, in his words, provide evidence of "emerging vulnerabilities."

The justification for all of these new powers is that the Fed is best able to prevent a repeat of the 2008 meltdown by keeping in check the potential systemic problems revealed in that crisis. But the notion that the Fed is the firefighter standing by with the hose to douse any reignited embers of 2008 ignores its own role in creating those problems in the first place.

The Fed's own policy choices were central to the housing boom and bust and the associated financial crisis. In trying to soften the possibility of a post-9/11 recession, and then wrongly worrying about deflation, the Fed expanded the money supply, dropping interest rates to unsustainably low levels in the mid-2000s. The nominal Federal Funds rate was well below the benchmark of the widely-recognized Taylor Rule. Worse, the real Federal Funds rate (the nominal rate minus inflation) was actually negative for roughly two years. A negative interest rate means people are essentially being paid to borrow.