Sunday, October 22, 2017

Public Policy Suffers when Price Theory is Ignored

Jason Furman and Larry Summers weighed in this week about the quantitative amount that labor can benefit from a capital-income tax cut.

It soon became clear that they had failed to carefully use price theory in coming to their conclusions.

Furman and now Krugman (update: and now Summers) are admitting that simple supply and demand vividly contradicts what they said/say about taxes, but assert that the world is more complicated. I agree.

But they are dead wrong to further assert, without evidence (and I suspect without thinking), that adding complications will overturn the simple supply and demand conclusion or at least weaken the contradiction contained in their original proclamations.

(So far, Summers has wisely refrained from trying to defend his mistake.  Update: he replied 2 hours after I posted this -- see the update at the very end of this post.)

Supply and demand can do more than I have already shown.  Supply and demand also:

  1. can give quantitative answers.  Greg Mankiw writes "I must confess that I am amazed at how simply this [quantitative formula] turns out. In particular, I do not have much intuition for why, for example, the answer does not depend on the production function."  Supply and demand can answer his question, without any algebra.
  2. can deal with complexities, such as "imperfect competition."  The simple supply and demand model assumes perfect competition, but that assumption can be and has been modified.  Guess what?!  Making that modification shows that even the simply supply and demand model, let alone the proclamations of Furman-Summers-Krugman, understates the wage impact of capital-income taxation.
    [Hints: what new rectangles appear when the factor-renter is selling his product for more than marginal cost? What determines the equilibrium size of those rectangles?  Why should we use the corporate tax to rather than the DOJ to fight monopoly?]
  3. can deal with complexities, such as debt finance.  Having uneven taxation of different types of capital tends to reduce the denominator of the Furman ratio more than it reduces the numerator.  i.e., Furman still has it even more backwards than I thought (update: Summers too).
  4. explains why horizontal capital supply is not an "extreme" caseGary Becker and I explained why capital supply probably slopes down somewhat in the long run (thanks Kevin M. Murphy for reminding me about this -- not to mention for teaching so many of us about price theory!)
  5. shows you how to process the economic data.  Furman and Krugman make evidence-free proclamations about the elasticity of capital supply.  Supply and demand shows what economic data is needed to measure that elasticity (spoiler: it's not complicated, and shows a very high elasticity).

I will post on these individually next week (week of Oct 30). In the meantime, you may be interested in a previous instance when, with important public-policy issues at stake, Krugman failed to appreciate what supply and demand really says.

Update: 2 hours later Summers posted a reply that reiterates the "it's complicated," "monopoly profits," and "debt finance" excuses for ignoring what the simple model says.  See my points 2 and 3 above.

He also hopes that you forget that he referred to CEA's result -- which is generally in agreement with the simple supply and demand model -- as "unprecedented in analyses of tax incidence."

Regarding Summers' other replies, see here.

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