The Unproven Tradeoff of Growth and Inequality

“How do you feel about paying such high taxes?”

“I think it is terrific. . . . I get a little bit angry because constantly in Denmark there’s this talk that we have to lower the taxes, lower the taxes, lower the taxes. And I can only say I’m very young, I am only 25 years old, and already the system has provided me with a great education and help whenever I need it. I have been able to go the library whenever I needed it. I have not been to the hospital many times in my life, but when I have been it has not been a problem. I mean, I think we are so privileged that it is so wrong to attack this system.”

That’s a Danish student on Planet Money’s latest podcast, around the 14:40 mark. That seems perfectly sensible to me. If you are getting services that you value from your government, then you are going to be more likely to favor a system with high taxes. Obviously not very many Americans feel this way; since the Reagan Revolution if not the 1970s, there has been an increasingly widespread belief that government spending is wasteful, and therefore people want to hold onto their money. But there’s nothing irrational or bizarre about thinking that high taxes and high benefits are good, and you don’t have to agree with her to see that.

But this is what Adam Davidson of Planet Money had to say about it: “David [Kestenbaum, the reporter on that clip], it’s like you went to Bizarroland, where everything is the opposite.”

I like Planet Money. I think they do a good job of presenting economic issues in an accessible, informative form, and they line up some great people for interviews. So I think it’s telling that on an issue as basic as this–is small government necessary for economic growth–they have internalized the economic orthodoxy so completely that Denmark becomes “Bizarroland.”

And I’m not just picking on one word. To prove that I’m not taking him out of context, here’s a much longer version of Davidson’s position, from around the 10:30 mark:

“This tradeoff–which I think is probably essential–between equality and stability on the one hand and economic growth on the other. More libertarian economists, more free market-oriented economists would argue, I think, that sure, if you have a real free market, there’s going to be more inequality, people with more skill, people who put in more effort, are going to get more on the other end, there is going to be a bigger disparity, there’s also going to be less stability, there are going to be booms and busts. But, over time, that free market economy is going to be so much richer, the pie is going to be so much bigger, that every slice is going to be bigger and bigger. . . . Quoting President Reagan, ‘a rising tide lifts all boats.’ And obviously, in Denmark, you  have economists who say, ‘well, wait a second, we’re willing to trade,’ and I’m sure there are many people in the United States who are willing to trade some degree of growth for stability and equality. Now I think over a short term almost anyone would trade growth, because each year growth is only 2 or 3 percent, and inequality and instability can be quite unsettling. I think what’s interesting, as we’ve explored in our economic history sessions, is, over a long period, over decades and centuries, that growth starts adding up, and you start seeing the phenomenal, unbelievable rise in the standard of living that you see in industrialized nations, that you don’t see in more centrally controlled economies. But of course, Denmark has benefited from that, so they really haven’t had to pay as much of the cost as maybe some libertarian econmoists would have thought they would have.”

I feel bad picking on Davidson, because (a) he does great work, (b) he’s just speaking extemporaneously here, and (c) Planet Money did just put together two great episodes on Denmark, land of high taxes, low unemployment, and low income disparity. But my point is not that he’s wrong; it’s that mainstream, centrist, reasonable people have these beliefs internalized like this. This tradeoff between equality and growth is a theory of Davidson’s “more libertarian economists,” but by the end of the passage (from “Now I think”), he’s assuming it’s true, and that to get the increased prosperity of capitalism you have to have a high degree of inequality and instability. This is the kind of thing you ordinarily hear from bankers like Brian Griffiths or Bill George; that so many people take it for granted is the problem.

First, it’s not obviously true that the more free your markets, the faster you grow. Denmark, for example, has a higher GDP per capita than the United Kingdom (though lower than the United States). Maybe that’s because of oil and natural gas, so I’ll just say that you’d have to do some real analysis to prove that point. Also, as Kestenbaum pointed out in the podcast, the United States had extremely high top marginal tax rates during a period of very high growth after World War II. It would not shock me if you could find a regression showing that smaller government correlates with higher growth; but it would also not shock me if you could find a regression showing that greater income disparity correlates with lower growth.

Second, it stretches plausibility to argue that more free markets and smaller government always lead to more growth–that the optimum is all the way at one end of the graph. In completely free markets, you end up with monopolies, which give you monopoly pricing and less innovation. You get tons of negative externalities. You get entrenched aristocracies (because the aristocrats own the monopolies) and a rigid social structure, which is bad for growth. You need to be somewhere between the two poles of “free markets” and “central control.” I think you want to be much closer to the former than the latter. But Denmark isn’t a centrally controlled economy. On that spectrum, it’s a capitalist economy that happens to be just a little bit further from the free market pole than ours. (In the previous podcast, they talked about how it is very easy for companies to fire people.) I don’t see any a priori reason to think that our point on the spectrum gives you higher growth than theirs.

Now, because otherwise someone would bring it up, there is an economic argument for why free markets are better than paying high taxes and letting the government manage things. In one sentence, the argument is that resources are better allocated if they are allocated according to individual buying decisions, because those decisions reflect people’s real preferences for different things. That argument is almost certainly right for many things, like toothpaste. It’s better for companies to try to figure out what kind of toothpaste we want, and for us to vote by buying toothpaste, than for us to all pay a $6 annual tax to the government and have it manufacture all of our toothpaste.

But the argument is almost certainly completely wrong (or its implications are normatively intolerable) for some other things, like national defense or police protection; could you really fund the military by asking people how much they are willing to pay for protection, and then not protect the people who didnt’ pay? And many people, including me, think it is wrong for many things that fall in between toothpaste and national defense.

We don’t need to get into those specific debates here. But there’s no a priori reason to believe that we in the United States have figured out the optimal size of government, where the government does everything it can do better than the private sector and vice-versa. (In fact, people on both sides of the argument would argue vociferously that we are not at that optimum.) It’s possible that Denmark is at a more efficient point than we are. And so there’s no a priori reason to assume that there is any tradeoff between the United States and Denmark. Maybe their system is just better than ours, across the board; maybe ours is just better than theirs, across the board (and maybe their positive results are due to other factors, like oil reserves, cultural homogeneity, and lower defense spending). If we had higher taxes, bigger government, and more redistribution, we might have slower economic growth. But we might not.

(PS: David, high domestic taxes may lead Denmark’s best soccer players to play in other countries, but that doesn’t affect their chances of winning the World Cup, because they remain Danish for soccer purposes even if they play in England or Spain. Almost all the top Brazilians, for example, play in Europe, but they still play for Brazil in international competitions. In fact, Denmark won the 1992 European Championship, although they did only sneak into the competition because Yugoslavia was excluded.)

Update: Marton points out that Danish players play in other countries not because of lower marginal tax rates, but because the clubs there have bigger fan bases and therefore can pay much higher gross salaries. In either case, they still play for the Danish national team–and the experience of playing in other countries with better leagues probably makes them better players.

About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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