Monday, April 6, 2009

Liberalism And The Danger Of First-Order Thinking

There are two basic ways to look at the spending priorities of a government institution.

The first is to examine the public's underserved needs to determine where money should be allocated. The second is to consider where the money comes from to pay for it all.

Both perspectives are critical, and both perspectives help to shape the impacts of government policy. But few who analyze policy spend much time on the latter view.

Spending time only on the first part of the equation is the basic flaw in liberalsm. I call it first-order thinking.

To a first-order thinker, the obvious way to meet a need is through spending money on it. This applies to everything -- health coverage, education and pensions to name a few.

Sadly, economics follows its own thermodynamic principal. And, aside from recent actions by the Federal Reserve, the government lacks the power to simply invent money out of thin air and then spend it. By and large, governments must raise money they want to spend through taxation, borrowing or both.

Both taxation and borrowing involve taking money from one set of people and allocating it to the government's spending priorities. Those whose money is taken or borrowed must then adjust their priorities accordingly. This is a second-order effect, and it is not one a liberal is likely to consider.

This effect is the basic reason why the New Deal did little to fix the Great Depression, and Obama's stimulus package will do little to help the present national economy.

In fact, most economists view the negative second-order effect of government spending as more harmful than any benefits derived from the spending itself. This is because those whose money was taken or borrowed probably would have invested it in projects aimed at profitability.

Such for-profit projects are the engine of a capitalist economy. When the government substitutes its judgment for that of the invisible hand of the market, a less efficient outcome is nearly always the case.

So, the stimulus package will probably delay the economy's recovery.

But this is a local blog, so I want to address another second-order effect that is unique to the layers of government below the federal level.

Few probably remember Prop 63, the Mental Health Services tax which passed some years ago. This initiative imposed a 1 percent tax surcharge on Californians whose incomes exceed $1 million per year. It raised the top income tax bracket to 10.3 percent -- by far the highest in the country.

While my income means I have not been burdened with this tax, I opposed it because I suspected its second-order effects would mean more harm than good would come out of it.

My reasoning was based partly on the concept of the Laffer curve -- which says that there is a point in taxation where raising the rate actually nets the government less in revenue. This is because high taxation crowds out profitable investment opportunities. This then lowers the total income of the society, thus lowering the amount of tax to be found.

For Prop 63, the effect is even more pronounced, because these "millionaire households" need only to move to another state to avoid this tax.

And move they have. Since the tax passed, more than 7,000 such households left Los Angeles County. This flight hurts government revenue at every level. It means these people probably sold their houses, depressing property tax revenue. The same kind of thing goes for sales tax revenue.

Worse yet, it means they now pay zero income tax to California. At least $100k in taxes per year per family is gone from the state revenue base. That's $700 million per year, assuming each household makes around $1 million a year, which is a conservative estimate.

What does this analysis mean for places like Oakland, where all three of property, sales and income taxes are at the highest levels in the country?

Well, it probably means tax revenue will continue to fall, in spite of efforts to pass tax after tax. And it means the blight will grow. Why would anyone in their right mind relocate to Oakland or start a business here, knowing the level of taxation they're likely to encounter?

What should the state and local governments do? Lower taxes, and accept the short-term consequences to spending priorities. Doing so will actually increase the long term revenue to the government by drawing in individuals and businesses seeking more reasonable taxation.

It's clear as day to me that if Oakland lowered its ridiculous business taxation, reduced its property tax level to a more normal 1.1 percent (from 1.35 percent) and declared itself willing to do whatever it takes to attract businesses and wealthier residents, every aspect of the city would fare much better over the next decade than it will under the present course.

The problem, of course, is there is no clear constituency to advocate for such policies. The public employee unions will always advocate for higher spending. The anti-gentrification and socialist elements will always clamor for taxing the rich (until they all leave). But who is left to advocate for the right course of action when the second-order effects dictate that higher spending will only leave us with less to spend in the future?

I encourage my readers always to think about second-order effects in any government policy. Don't just consider where the money goes. Consider also where it comes from.

Consider how people's behavior changes when the government takes a larger share of the economy. Don't just consider one side of the equation, because doing so leads to the sort of short-sighted policies which have sunk Oakland and are slowly drowning California.

Wednesday, April 1, 2009

To Drain The Cesspool, Legalize Drugs

An interesting phenomenon took place over the past two weeks, as our new president was pressed on the question of legalizing marijuana.

To his credit, his administration has reversed the policy of pursuing local pot clubs because they are violating federal law. To his discredit, he indicated that he did not favor legalizing drugs, as he did not expect it would assist the economy.

Sadly, nothing could be further from the truth. Keeping drugs illegal has been the single most effective policy in keeping inner cities poor and ensuring that ethnic minorities in America fail to rise to their full potential.

Nowhere is this phenomenon more obvious than in Oakland, where "cash crops" such as pot, meth, crack and heroin make up a significant portion of the local economy.

My understanding is that those who support keeping drugs illegal fear that legalizing them might cause a catastrophe, as millions of Americans who never touched drugs before start using them and become unproductive.

There's a simple solution to this fear -- change the law incrementally. That approach is exactly the one our president inscrutably rejected last week. One can only presume he did so because he knows that solution doesn't poll well.

In my opinion, prohibition has several effects, all of which are negative.

First, it spreads policing manpower too thinly, forcing them to arrest people for owning or consuming certain substances. Targeting these victimless crimes prevents the cops from enforcing laws which have a greater impact on the public at large -- those against burglary and murder, for example. It is well known that Oakland's police don't even really investigate burglary cases. Our "war on drugs" is a major reason.

Second, it discourages addicts from seeking treatment, and it decreases the amount of money allocated for treatment by funneling that money to police and prisons instead. Obviously, if someone knows he can be arrested for what he is doing, he is far less likely to seek treatment.

Third, it does little or nothing to decrease drug use. My evidence here is empirical. Drugs are trivial to obtain in the East Bay, despite heavy enforcement.

Finally, and most importantly, it ensures a large steady stream of money toward the least desirable types of people in society, including the drug cartels in northern Mexico which are carrying on a war against Mexican authorities at this very moment. Closer to home, most of the slayings in Oakland each year are drug related, and it is well documented that the profitability of drug dealing is what draws most young black men away from honest lifestyles and toward a life of imprisonment and violence.

Legalizing drugs would eliminate the money going to these gangsters. Ever noticed how you don't hear much any more from the gangs which ran alcohol during prohibition in the 1930s? The same thing would happen to our current crop of inner-city gangs.

Furthermore, drugs could be taxed, with that money applied toward treatment and education programs. I think it's quite likely that this diversion of resources could decrease the number of drug users below current levels.

But most importantly, doing so would change the face of poverty in America, providing people with a real incentive toward honest lifestyles rather than drug dealing and violence.