Industrial Policy Fails

President Obama has proposed another $50 billion for infrastructure, full deductions for investments in capital goods during 2010 and 2011, a permanent tax credit for research. These measures will do little to revive the economy.

The new infrastructure spending would be small, relative to the size of the economy. If a bridge here and a road there need repairing, then do it, but not to create jobs or stimulate the economy. These projects pull resources away from other activities, and they take some time to plan and implement. The government has already spent billions of dollars for stimulus, and unemployment is still high, and growth sluggish.

If the economic problem is lack of demand, why have the budget deficits of over a trillion dollars not provided sufficient demand? Because the problem is not a lack of demand. The government of Japan tried for a dozen years after 1990 to stimulate demand, and the economy remained flat.

Business can already deduct the cost of investments from their tax liabilities, so a full deduction just moves the tax deductions from the further future to the nearer future. That will provide a little help to business, but they will not expand so much if other taxes rise and reduce their profit.

The tax credit for research, experimentation, and development, is rather selective. Some types of research, such as new applications for programmable devices, are not eligible. Credits for particular activities are an example of industrial policy, in which government seeks to push economic activity in particular directions. But the chiefs of government cannot know which types of investment will be the most productive for the future. Industrial policy ends up distorting the economy and creating waste by arbitrarily subsidizing some activities and penalizing others.

Tax credits for research do little to reduce unemployment, because few workers are involved in such activity. Tax advantages for capital goods skew the economy against labor. When a company hires more labor, it is slapped with payroll taxes and medical costs, whereas if they buy machines, they get lower taxes. Thus it pays for firms to substitute capital goods for labor. The US government’s industrial policy pushes firms into labor-saving investments. If the goal is to reduce unemployment, this industrial policy is senseless.

The best policy for employment and economic growth is permanently low or zero marginal tax rates, and no subsidies. A “marginal tax rate” is the tax rate on additional income. The top marginal tax rate on dividend income is scheduled to rise from 15 percent to 39.6 percent in January 2011. The capital gains rate will jump from 15 to 20 percent.

So with one hand the government provides tax credits and deductions for particular activities, but with the other hand it takes away more of the profits from enterprise and investment. Some firms which have had profits in 2010 are paying these to the shareholders in dividends in 2010 when they would have used the funds for research and investment. It makes financial sense to pay the dividends now, before their steep rise in 2011. But it may have made greater economic sense to invest the funds if not for the tax increases.

The chiefs of government today seem to have a bias against low marginal tax rates for higher incomes. To get revenue, they could have proposed taxes on pollution or land value. They don’t seem to believe that the law of demand applies to the rich. They think that they can just take income from the wealthy with little economic impact. But that is not the way the world works.

After the transition, taxes on land value would have no economic burden, because by lowering the price of land, the tax would replace the mortgage interest that would otherwise be paid. The government seeks high taxes on the rich, which they then rebate implicitly with the rent generated by governmental infrastructure and rebate, but with a deadweight loss on the economy.

Not one in a million persons, and not one in a thousand economists, understand that much of taxation is at the expense of land rent. Production has a surplus that gets paid in land rent. Taxes reduce the surplus, as taxed enterprise bids down the rent. So taxes already take land rent, but in an indirect and hidden way, with a deadweight loss punch to the economy.

Once you understand the tax cat, you see that the current tax policy and tax proposals are economic madness. But the chiefs will not let the cat out of the bag.