In National Review, Kevin Hassett, the former Chairman of the Council of Economic Advisers, asks Ed Conard to defend conservative free market capitalism and how it promotes entrepreneurial risk-taking that has grown middle-class incomes faster than Europe.
Five Questions for Ed Conard
National Review Online
August 21, 2020
1) Many liberals claim capitalism no longer works for the middle and working class. Is it true?
No. According to the Congressional Budget Office, prior to the pandemic, middle-class incomes had grown 60 percent more than inflation since 1980. The income of the poorest 20 percent had doubled. Those increases don’t include the full value of innovations such as cell phones, cleaner air, more-effective cancer treatments, fewer automobile accidents, and less crime.
In 1995, America’s middle-class incomes were 19 percent larger than Germany’s — the most prosperous economy in Europe. Today, America’s middle-class incomes are 28 percent larger than Germany’s. They are 65 to 70 percent larger than Southern Europe’s (wages less taxes plus government services).
These large differences significantly understate the true superiority of America’s economy. With three to four times as many low-skilled workers per high-skilled worker as in Northern Europe, America would be significantly richer if we enjoyed Northern Europe’s distribution of talent. And Europe would be poorer if it weren’t freeloading off America’s disproportionately large contributions of innovation, defense spending, and health-care profits.
Europe has contributed shockingly little innovation. Apple alone is worth more than the 30 largest companies in Germany. America is producing five times as many billion-dollar startups. U.S. productivity, as measured by GDP per hour worked, has grown 50 percent faster than Northern Europe’s since 2000, and three times faster than Southern Europe’s with demographics similar to America.
Growth increases wages when the supply of workers is constrained. Otherwise, it increases employment. Despite employment growth that has been twice as fast as Europe’s since the 1980s, Americans still enjoy higher and faster-growing incomes. Unlike Europe, America isn’t cannibalizing its competitive advantage in the long run to produce higher incomes in the short run.
We shouldn’t take America’s success for granted. Liberalism has greatly diminished the vibrancy of Europe’s economy and slowed the growth of its middle-class incomes relative to America. The cost of liberalism is hidden by ignoring the enormous difference between America and Europe.
Despite claims that inequality is rising after accounting for government benefits, taxes, and investment, the amount consumed by the rich (the 90th percentile) — the most relevant measure of inequality by far — has barely increased relative to the poor (the 10th percentile) since the 1960s. Most studies of wealth inequality ignore the value of Social Security and Medicare, which substantially increase the consumption of retirees. Including the value of this consumption, in effect, triples the wealth of the bottom 80 percent from 15 percent of the wealth to 45 percent.
Nor has America’s middle class been hollowed out. Although the Pew Research Center claims America’s middle class has declined from 61 percent of the population in the 1970s to 50 percent today, seven percentage points of the eleven-point decline came from families whose income moved upward. And Hispanic immigrants account for three of the four points of the decline. So native-born Americans have enjoyed a seven-point upward shift in income offset by a single point of decline. A recent Brookings study finds the share of working- and middle-class families falling from about 80 percent of families in the late 1960s to 50 percent today, with the entire loss coming from families with rising incomes.
2) If higher taxes slow growth, why wasn’t growth slower in the 1990s, in California today, and in the 1950s?
The internet was commercialized in the 1990s. It was like creating the telephone. It increased the payoffs for successful risk-taking more than the Clinton administration’s tax increase reduced them. Higher payoffs increased entrepreneurial risk-taking. Successful risk-taking produced innovation that accelerated growth and raised middle-class incomes.
Similarly, Silicon Valley increases the payoff for entrepreneurial risk-taking more than higher California state taxes reduce them. Higher payoffs increase entrepreneurial risk-taking.
Even though marginal tax rates were higher in the 1950s, with loopholes, investment incentives, and 25 percent marginal tax rates on business income and capital gains, the average tax rate paid by the top 1 percent was almost the same then as it is today. There was also much less regulation and income redistribution. Nor does history provide evidence that high marginal tax rates in the 1950s didn’t gradually slow growth. Innovation-driven productivity growth fell from 3.5 percent a year after World War II to less than 0.5 percent a year by the 1980s before it gradually accelerated after the Reagan tax cut.
Since the 1950s, we have transitioned from a more command-and-control manufacturing economy with faster productivity growth to a harder-to-manage decentralized service economy with slower productivity growth. We also enjoyed a large one-time increase in productivity growth from saturating the population with education.
Decades of risk-taking have gradually built American institutions, such as Google, that can successfully mine the technological frontier. This exposure trains workers, spins off valuable ideas, and raises the expected payoffs for risk-taking that produces innovation. With greater rewards, talented Americans have gotten better training, worked longer hours, taken more entrepreneurial risk, and produced a lot more innovation than their counterparts in Europe. Lack of access to companies like these greatly diminishes the motivation and productivity of Europe’s talent. Europe is surprisingly unproductive despite its abundance of talent relative to America.
Researchers who underestimate the gradual growth-draining effects of high marginal tax rates concede that estimates “should reflect not only short-run labor supply responses but also long-run responses through education and career choices.” They nevertheless assume the long-run effects are nonexistent despite growing differences between America and the rest of the high-wage world.
Nor can economists specify optimal tax policy independent of the expected payoffs for risk-taking. Tax rates high enough to discourage risk-taking may have costly consequences when expected payoffs are high, as they appear to be in America, and have little, if any, consequences when expected payoffs are low, as they appear to be in Europe. Lacking good ideas, Europeans may not take risk no matter the tax rate. Analysis that considers the long-term effect of tax rates on innovation and growth derives revenue-maximizing marginal tax rates of 30 percent or less.
3) Why do Bill Gates and other billionaires need to earn so much?
It’s true that billionaires such as Steve Jobs and Bill Gates earned a lot more money than they expected to earn when they initially took risk. Unlike in Europe and Japan, their outsized success motivated an army of talented risk-takers to follow in their wake. The success of that army produced higher and faster-growing middle-class incomes and employment than in all other high-wage economies.
A small amount of innovation bubbles up unexpectedly from large pools of failure. We don’t need payoffs to motive success; we need them to motivate failure. It’s hard to find improvements and nearly impossible to get rich. Some liberal pundits insist the rich are merely lucky, but luck is the flip side of risk. If people knew what worked, it would already be invented. No one has a clue.
This is the core problem with liberalism. Liberals are certain their ideas are good ideas. Ideas are overwhelmingly byproducts of mistaken analysis of a world that is too complex to analyze. The rare good idea largely emerges unexpectedly from fiercely competitive survival of the fittest, a process the leviathan of government need never endure.
Ultimately, liberals and conservatives want the same thing: to maximize middle- and working-class incomes, pay for retiring baby boomers, and protect America from the risk of a rapidly growing China. They just disagree on how to achieve it. Even liberal economists agree that investors must produce $5 of value for others — customers, employees, and suppliers — to earn a dollar for themselves. With half the share of high-scoring workers as Northern Europe, America must squeeze more value out of its talent to remain competitive. We can discourage growth by confiscating more of the 50 cents that business owners keep after taxes, or by maximizing incentives for risk-taking by restraining the never-ending increase in the share of the economy consumed by government.
With America’s current tax system, only the most productive workers pay more taxes than they consume in government services. To succeed, America must maximize the number of net taxpayers and motivate them to take risk. With talent and good ideas constraining growth, we must train more high-skilled risk-takers if we can, or recruit them from abroad if we can’t.
Unlike Einstein, who pursued science to “escape from everyday life with its painful crudity and hopeless dreariness,” the most productive workers distinguish themselves by earning money, power, and fame by embracing the unrelenting demands of serving customers more effectively than their competitors do. Were status merely relative, Europe’s economy would be as competitive as America’s. Money motivates.
Every investor knows that returns are disproportionately earned by a handful of home-run investments. With unlimited upside, venture capital and other private-equity investments have scarcely outperformed public markets. Capping returns significantly diminishes expected returns. Lower expected returns diminish risk-taking and the demand for training, which gradually slows growth.
And why discourage innovators such as Jeff Bezos from creating large companies, like Amazon, by limiting how much money they can earn? Large companies are more competitive. They are more productive, invest more, pay higher wages, and spin off valuable ideas that grow the economy faster — all characteristics we want America’s economy to achieve.
4) How big of a role has rising cronyism played in the success of the 0.1 percent?
Proponents of income redistribution insist rich people earn their money unfairly. Were it true, we could redistribute income without slowing growth. But if America were misallocating resources, growth in America — the country with the greatest inequality — should be slowing relative to countries such as those in Europe with more equally distributed incomes. America’s growth is faster than Europe’s.
It’s true large companies are gaining market share, but they are more productive, invest more, and pay higher wages — the opposite of misallocated resources. Aside from the slow-growing automotive sector, America’s 200 largest companies are investing twice as much as their European counterparts in R&D. The U.S. economy is investing nearly 25 percent more in intangible assets, such as software and training, than Europe. America is investing about eight times more venture capital per dollar of GDP. Rising cronyism isn’t evident in any of these revealing comparisons.
Were cronyism rising, we should also expect to see an increasingly entrenched status quo. We see the opposite. The turnover of the Fortune 500, CEO tenures, and the Forbes 400 richest Americans have also increased. Of the 500 companies in the Fortune 500 in 1955, only 51 remain. Most of America’s growth is coming from technology, which has been in turmoil. Excluding Microsoft, the 15 largest NASDAQ technology companies at the peak of the internet bubble have lost almost 60 percent of their market value. Meanwhile, ten of today’s 15 largest NASDAQ companies, with a combined market capitalization over $4 trillion, were worth less than $100 billion in 2000.
Today, the Forbes 400 richest Americans are increasingly self-made entrepreneurs, not heirs. Fewer than 10 percent of the U.S. billionaires on Forbes’s list in 1982 are still on the list. Most of the top tenth of a percent are working-age owners of skill-intensive businesses that lose almost all of their profits when the owner retires or dies. That’s hardly evidence of unearned profits.
If crony boards were overpaying CEOs, we wouldn’t find CEO pay rising no faster than the pay of private-company CEOs, where board members own the company. Nor would we find CEOs recruited from outside the company being paid more than those promoted from the inside, or CEO pay rising no faster than the income of the rest of the top tenth of a percent. None of this evidence suggests crony boards are overpaying CEOs.
Nobel Laureate Joe Stiglitz claims we can pay CEOs less because they can’t work any harder. Investors don’t pay CEOs to work hard; they pay them to take prudent risks. Without that motivation, CEOs avoid risking their positions atop the status quo and deliver satisfactory underperformance — exactly what we have seen from the rest of the high-wage world — a world with lower incomes than America.
Oligarchical control of the government is obviously suboptimal. But long ago, de Tocqueville was attributed with recognizing that “the American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.” With a majority of consumers eager to consume income that would otherwise by invested by a minority of voters, and an uninformed electorate easily misled by propaganda, it’s hardly obvious that more influence by a minority of investors necessarily endangers democracy and threatens prosperity at the margin. It is true that lobbying is growing. But much of lobbying is like steroids in sports where competitors largely fight each other to a draw.
5) People are hurting. Don’t we have a moral obligation to help them?
Most everyone agrees that we should help those in need; and we do. But we shouldn’t do it blindly. People demand more spending without knowing how much we spend. Last year — not counting the $1.6 trillion the government spent on retirees — America spent $1.25 trillion helping the poor (welfare, Medicaid, and disability). That’s enough to give every person in the bottom 20 percent under the age of 65 $22,500, or $90,000 per family of four — 50 percent more than America’s middle-class family earns, which we’ve already seen is the richest middle class in the world by far.
Unfortunately, we don’t give a large share of that money to the poor. Instead, lawmakers use it to buy votes. Nevertheless, America spends more after tax helping the poor than the richest countries in Europe, who, unacknowledged by most, tax their poor with 20 percent sales taxes.
While most everyone agrees that we should help the poor, not everyone agrees that we need to increase government spending from 36 percent of GDP (including state and local government) — which is expected to rise to 41 percent of GDP as Baby Boomers retire — to do it. Countries that have increased government spending as a share of GDP have significantly smaller and slower-growing middle-class incomes.
Unfortunately, we can’t legislate prosperity. We have to earn it the old-fashioned way — with hard work, investment, good ideas, and entrepreneurial risk-taking. America’s Founders didn’t write the Constitution to protect us from capitalism; they wrote it to protect us from government.
Ed Conard is an American Enterprise Institute visiting fellow, a former Bain Capital partner, and the author of The Upside of Inequality: How Good Intentions Undermine the Middle Class.