# More on the Effect of Social Policy on Innovation and Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

My last post was on the false trade-off between social policies and growth. In particular, I took a shot at an essay by Michael Strain, but his essay is simply a good example of an argument that gets made very often: social policies will lower growth. I said this was wrong, and a number of responses I got questioned my reasoning. So this post is meant to spell out the logic more clearly, and point out why precisely I think that Strain’s argument (and others like it) is flawed. Consider this an uber-response to comments on the site, some e-mails I got, and the discussion I had with my neighbor (who probably won’t read this, but whatever).

First, we need to be clear that we have to distinguish the effect of social policies on innovation from the effect of social policies on growth in GDP. They need not be identical, which I’ll get too in more detail below. So to begin, let’s think about the effect of these policies on innovation, which is what Strain and others acknowledge is the source of improvements in living standards.

I’m an economist, so I think of the flow of innovations as responding to incentives. When the value of coming up with a new idea goes up, we get more new ideas. Simple as that.

What’s the value of an idea? That depends on the flow of net profits that it generates. The profits of owning an idea are

$\displaystyle \pi = (1-\tau)(\mu-1)wQ \ \ \ \ \ (1)$

where ${\tau}$ is the “tax rate”, and this tax rate is meant to capture both formal taxation and any other frictions that limit profits (e.g. regulations).

${\mu>1}$ is the markup that the owner can charge over marginal cost for their idea. ${(\mu-1)>0}$ is therefore the difference between price and marginal cost. The more indispensable your idea, the higher the markup you can charge. For instance, there are big markups on many heart medications because your demand for them is pretty inelastic. The markup on a new type of LCD TV is very low because there are lots and lots of almost identical substitutes.

${w}$ is the marginal cost, which here we can think of as the wage rate you pay to run the business that produces the good or service based on your idea. ${Q}$ is the number of “units” of the idea that you sell (pills or TVs or whatever). Together, ${wQ}$ represents “market size”. If the wage rate or quantity purchased go up, then your absolute profits rise. The effect of ${Q}$ makes sense, but why do profits rise when wages rise? Because of the markup. If your costs are higher, the price you can charge is higher too.

The profits from an idea are the incentive to innovate. So anything that makes ${\pi}$ goes up should generate more ideas. My issue with Michael Strain’s article, and others like it, is that when they think of “progressive social policy”, they think only of the cost ${\tau}$ of funding that policy. So there is a direct trade-off between funding these social policies and innovation (and possibly growth).

My point is that those social policies have direct, positive, effects on market size, ${w}$ and ${Q}$. Profits should be written as

$\displaystyle \pi = (1-\tau)(\mu-1)w(\tau)Q(\tau). \ \ \ \ \ (2)$

If we raise ${\tau}$ to pay for social policies that educate people or raise their living standards, there is a positive effect on market size. The wage goes up, either directly because we have higher-skilled workers, or indirectly because they have some kind of viable outside option.

Further, the size of the market increases because people appear to have non-homothetic preferences. That is, they buy a few essential goods no matter what. They only spend money on other goods once those essentials are dealt with. With non-homothetic preferences, the distribution of income matters a lot to the size of the market for your idea. If lots of people are very poor, or if the cost of essentials is very high, then they have little or no money to spend on your idea, and ${Q}$ is small. If you provide them with more income or make essentials cheaper, they have more income to spend on your idea, and ${Q}$ goes up.

To be clear, I think that the positive effects of ${\tau}$ on ${w}$ and ${Q}$ outweigh the direct negative effect of ${\tau}$. That’s what I mean when I say progressive social policies are good for innovation, and why I said that there is not a direct trade-off between funding social policies and innovation (and possibly growth).

That doesn’t mean that funding social policies is always positive. There is a Laffer-curve type relationship here, and if ${\tau}$ were too high the incentives to innovate would go to zero and that would be bad. But the innovation-maximizing level of ${\tau}$ is not zero.

As an aside – there are plenty of costs that comparies or innovators have to pay that would have no direct benefit for wages or ${Q}$. Think of useless red tape regulations. I’m all for getting rid of those. But getting rid of red tape is not something that requires us to sacrifice social policies. It does not cost anything to remove red tape.

But wait, there’s more. The speed of innovation in an economy – ${g_A}$ – is going to be governed by something like the following process

$\displaystyle g_A = \frac{R(\pi,H)}{A^{\phi}} \ \ \ \ \ (3)$

where ${R(\pi,H)}$ is a function that describes how many resources we put towards innovation, like how much time is spent doing R&D, or how much is spent on labs. That allocation depends on profits, ${\pi}$, which dictate how lucrative it is to come up with an innovation. But it also depends on the stock of resources available to do innovation, and here I think specifically of the amount of human capital available, ${H}$. Social policies can not only raise ${\pi}$ indirectly, but can directly act to raise ${H}$. Education spending is the obvious case here. But policies that lower uncertainty (income support, health care coverage) allow people to either undertake risky innovation projects themselves, or work for those who are pursuing those projects, because they don’t have to worry about what happens if the risk fails to pay off. Social policy can act directly to raise ${H}$. Which means that social policies can, for two reasons, raise the growth rate of innovation, ${g_A}$. Even if the effect on profits is zero, innovation can still rise because the stock of innovators has been increased.

Aside: The term on the bottom, ${A^{\phi}}$, is a term that captures the effect of the level of innovation, ${A}$, on the growth rate, ${g_A}$. If you are of the Chad Jones semi-endogenous growth opinion, then ${\phi>0}$, and this means that the growth rate will end up pinned down in the long run, and social policies will have a positive level effect on innovation. If you are of the opinion that ${\phi=0}$, then policies have permanent effects on the growth rate. It isn’t important for my purposes which of those is right.

What does this mean for GDP growth? I said in the prior post that it isn’t clear that GDP growth is the right metric. We really want to encourage innovation, not necessarily GDP growth. Why? Because growth in GDP, ${g_Y}$, is just

$\displaystyle g_Y = g_A + g_{Inputs}. \ \ \ \ \ (4)$

If we raise ${g_A}$, then what happens to ${g_Y}$ depends on what happens to ${g_{Inputs}}$. We might imagine that ${g_{Inputs}}$ remains constant, so ${g_Y}$ rises when ${g_A}$ goes up. But there is no reason we couldn’t have ${g_{Inputs}}$ fall while ${g_Y}$ remains constant. What if we take advantage of innovations to only work 30 hours a week? Then GDP growth could remain the same, ${g_{Inputs}}$ falls, and yet we’re all better off. Or if innovation allows us to dis-invest in some capital (parking garages?) while still enjoying transportation services (self-driving cars?). GDP may not grow any faster, but we’d be better off by using fewer inputs to produce the same GDP growth rate.

The point is that the right metric for evaluating the effect of social policies is not GDP growth per se, it is the rate of innovation. It is ${g_A}$ that dictates the pace of living standard increases, not ${g_Y}$. In lots and lots of models, we presume that growth in inputs is invariable, but that doesn’t mean it is how the world actually works.

Strain completely ignores the possible positive impacts of social policies on the growth of innovation, and that is what I’m saying is wrong about his essay. We can have a reasonable discussion about what the right level of ${\tau}$ is to maximize the growth rate of innovation, but that answer is not mechanically zero. There is no strict trade-off between innovation growth and social policies. Which means there is even less of a strict trade-off between GDP growth and social policies.

## 6 thoughts on “More on the Effect of Social Policy on Innovation and Growth”

Let me start by saying the argument of whether we should be arguing for growth or innovation is kind of pedantic. OK, the innovation may lead to leisure or something not captured in GDP. My reading of Stain is he would not disagree, indeed he wrote that we “must be on guard not to genuflect with too much reverence before the altar of national income statistics.”

Second, you really need to stop revising his argument to being one requiring NO social programs. This is a 180 degree contradiction to what he wrote. He specifically stated we should pay for education, adequate nutrition and preventing bankruptcy due to catastrophic medical emergencies.

Stain’s argument for growth was pretty much a non-economists’ version of your wQ. We need economic growth in part to provide what he refers to as the “money to make targeted spending programs possible.”

A few other clarifications. First, as I commented on the last post, education spending doesn’t intrinsically do anything for innovation. Cost effective education does. These are not the same things.

An economist could make an extremely convincing argument that there is no long term benefit to preK education programs, and that we are pouring way too much money into bureaucracy, ineffectiveness and rent seeking gone wild in the primary, secondary and college education categories. Sander’s recommendations can be argued to lead to even more waste, inefficiency and privilege seeking, and could lead to lower innovation, not more.

In other words, you just assume the goal of the program is achieved by spending more on it. How does this stand up to scrutiny?

Next, you lay out an argument on the value of reduced uncertainty and risk and how that can stimulate growth. Great points, all. But you do realize that safety nets also can discourage innovation by reducing the need to innovate or work for innovators? I am not sure why you are ignoring this side of the issue. In addition, the safety nets don’t have to be publicly funded. Again, you just assume this.

The key is not more social policy spending. The key is optimal social policy spending directed in such a way as to maximize long term wellbeing. And again, that is exactly what Stain argues FOR.

Third, you waive away “useless red tape regulations” as obviously something you don’t support. But let us again go back to the Socialist in question and Bernie Sander’s actual platform, which is the target of Stain’s ire. Do you really think we are going to socialize medicine, education, reduce free trade, increase corporate and individual taxes, create a government jobs program, double the minimum wage and strengthen the cartel powers of unions in a way which does not lead to bureaucracy, waste, inefficiency, administrative overhead and thousands of pages of confusing red tape?

Are you familiar with how difficult it is now to start a business, expand a business or even just run a business in some of our more (over)regulated states*? Do you not recognize that expanding social programs present a threat to this in terms of endless red tape, barriers to entry, barriers to change, and rent seeking activities (especially for larger incumbent competitors) of every stripe?

Are you familiar with how, once you create hundreds of pages of (often contradictory) regulations and various regulatory agencies, that the nature of the competitive game shifts from innovating solutions for improved cost effective consumer solutions, and shifts to winning the regulatory chess match? Optimal profits now come from regulatory gaming or influence. You lay off the R&D team and hire a dozen more lobbyists and lawyers and strategists who can obey the letter of the regulation and yet find loopholes which generate profit by capitalizing on the inefficiency created by the regulation.

I am going to suggest you actually spend more time in the world of business and see exactly how well we are stimulating constructive novelty. Then perhaps read more Public Choice literature on the discrepancies between intentions and outcomes in government agencies.

For the record, as a retired entrepreneur, I generated profit through true constructive innovation (improving products, services, efficiency or price discrimination) and I also generated profit by out-competing other companies at weaving through inefficient regulatory bureaucracy. We hired the ex-regulators, and we used barriers and restrictions to our advantage (though we usually lobbied against it, once we had it in place we made the best of it). My efforts in the latter added little or nothing to human welfare. They detracted from the efforts at true innovation directed at improving the welfare of my customers.

• I don’t see how anecdotal experiences in a system from which Bernie Sanders would like to move away from are supposed to count against the system he’d like to move towards.

For your every anecdote, I can personally raise a counter-anecdote. I’m a native of one of the supposedly “socialist” countries that Bernie Sanders admires, and a business owner in that country. I completely fail to see where the overregulation and the red tape is which you are implying me to suffer from. When I founded my business, I had to fill in one (1) form three (3) pages long, pay a nominal fee, and wait a couple of weeks – because they had to check that the name of my business did not violate the intellectual property rights of any existing businesses.

The only contacts I have since had with the government in my capacity as a business owner is when I make the quarterly remittances of sales tax and withholding tax (including the contributions to the statutory retirement programme). Accounts? They amount simply to the bank statements of the sole bank account of my business. I’ve been in business for eight years, and so far nobody has ever asked to see them.

In fact the total amount of red tape I have suffered from as an entrepreneur is less than the suffering I have had from cold calls alone. I foolishly listed my private phone number on the one form I had to fill in, which made it a matter of public record; and I then found out that the phone numbers of businesses cannot be put on the do-not-call list in this country.

Oh, and I dropped out of the free college I attended, because the contacts I made while attending it led to there being such a high demand for my work that I founded my business in response. So I wouldn’t be a business owner today if college hadn’t been free to attend, even though I: 1) majored in a subject that had nothing whatsoever to do with my eventual field of business; 2) did not even graduate.

So, based on my own life experience:

“Do you really think we are going to socialize medicine, education, reduce free trade, increase corporate and individual taxes, create a government jobs program, double the minimum wage and strengthen the cartel powers of unions in a way which does not lead to bureaucracy, waste, inefficiency, administrative overhead and thousands of pages of confusing red tape?”

Yes, I do.

“Do you not recognize that expanding social programs present a threat to this in terms of endless red tape, barriers to entry, barriers to change, and rent seeking activities (especially for larger incumbent competitors) of every stripe?”

No, I don’t.

“I am going to suggest you actually spend more time in the world of business […].”

Sorry, I don’t have time for that; I’m already in the world of business practically around the clock.

• I don’t see how anecdotal experiences in a system from which Bernie Sanders would like to move away from are supposed to count against the system he’d like to move towards.

For your every anecdote, I can personally raise a counter-anecdote. I’m a native of one of the supposedly “socialist” countries that Bernie Sanders admires, and a business owner in that country. I completely fail to see where the overregulation and the red tape is which you are implying me to suffer from. When I founded my business, I had to fill in one (1) form three (3) pages long, pay a nominal fee, and wait a couple of weeks – because they had to check that the name of my business did not violate the intellectual property rights of any existing businesses.

The only contacts I have since had with the government in my capacity as a business owner is when I make the quarterly remittances of sales tax and withholding tax (including the contributions to the statutory retirement programme). Accounts? They amount to the bank statements of the sole bank account of my business. I’ve been in business for eight years, and so far nobody has ever asked to see them.

In fact the total amount of red tape I have suffered from as an entrepreneur is less than the suffering I have had from cold calls alone. I foolishly listed my private phone number on the one form I had to fill in, which made it a matter of public record; and I then found out that the phone numbers of businesses cannot be put on the do-not-call list in this country.

Oh, and I dropped out of the free college I attended, because the contacts I made while attending it led to there being such a high demand for my work that I founded my business in response. So I wouldn’t be a business owner today if college hadn’t been free to attend, even though I: 1) majored in a subject that had nothing whatsoever to do with my eventual field of business; 2) did not even graduate.

So, based on my own life experience:

“Do you really think we are going to socialize medicine, education, reduce free trade, increase corporate and individual taxes, create a government jobs program, double the minimum wage and strengthen the cartel powers of unions in a way which does not lead to bureaucracy, waste, inefficiency, administrative overhead and thousands of pages of confusing red tape?”

Yes, I do.

“Do you not recognize that expanding social programs present a threat to this in terms of endless red tape, barriers to entry, barriers to change, and rent seeking activities (especially for larger incumbent competitors) of every stripe?”

No, I don’t.

“I am going to suggest you actually spend more time in the world of business […].”

Sorry, I don’t have time for that; I’m already in the world of business practically around the clock.

• I don’t see how anecdotal experiences in a system from which Bernie Sanders would like to move away from are supposed to count against the system he’d like to move towards.

For your every anecdote, I can personally raise a counter-anecdote. I’m a native of one of the supposedly “socialist” countries that Bernie Sanders admires, and a business owner in that country. I completely fail to see where the overregulation and the red tape is which you are implying me to suffer from. When I founded my business, I had to fill in one (1) form three (3) pages long, pay a nominal fee, and wait a couple of weeks – because they had to check that the name of my business did not violate the intellectual property rights of any existing businesses.

The only contacts I have since had with the government in my capacity as a business owner is when I make the quarterly remittances of sales tax and withholding tax (including the contributions to the statutory retirement programme). Accounts? They amount simply to the bank statements of the sole bank account of my business. I’ve been in business for eight years, and so far nobody has ever asked to see them.

In fact the total amount of red tape I have suffered from as an entrepreneur is less than the suffering I have had from cold calls alone. I foolishly listed my private phone number on the one form I had to fill in, which made it a matter of public record; and I then found out that the phone numbers of businesses cannot be put on the do-not-call list in this country.

Oh, and I dropped out of the free college I attended, because the contacts I made while attending it led to there being such a high demand for my work that I founded my business in response. So I wouldn’t be a business owner today if college hadn’t been free to attend, even though I: 1) majored in a subject that had nothing whatsoever to do with my eventual field of business; 2) did not even graduate.

So, based on my own life experience:

“Do you really think we are going to socialize medicine, education, reduce free trade, increase corporate and individual taxes, create a government jobs program, double the minimum wage and strengthen the cartel powers of unions in a way which does not lead to bureaucracy, waste, inefficiency, administrative overhead and thousands of pages of confusing red tape?”

Yes, I do.

“Do you not recognize that expanding social programs present a threat to this in terms of endless red tape, barriers to entry, barriers to change, and rent seeking activities (especially for larger incumbent competitors) of every stripe?”

No, I don’t.

“I am going to suggest you actually spend more time in the world of business […].”

Sorry, don’t have time for that; I’m already in the world of business practically around the clock.

• Boursin,

My comments were about Sanders’ specific platform and the expected innovation consequences in the US. And only one part of the argument was on regulation, the other parts were on potential effects on the growth rate, again in the US.

Even my point was not even that these programs definitely WILL harm innovation, just that as Strain suggests, a serious argument can be made that they CAN harm growth in the US (indeed, in the world), especially if executed poorly.

I certainly have zero input on how well these types of programs work in small, high trust, Nordic countries drafting on the innovation of larger countries which spend the lion’s share of R&D. I am sure they work great and that I would love living there.

If Sanders wants to suggest socializing some state similar in size to a Nordic country and see how well it goes, I am all for the experiment. I support it wholeheartedly.

• You’re right the post wasn’t comprehensive. Let me try to offer a few more specific responses.

Strain isn’t against social programs, I agree. But he frames expanding them as coming at the cost of growth (either in GDP or innovation). My point was that expanding those programs may very well increase growth, not slow it down.

Yes, I’m pedantic about growth and innovation, as they are not synonyms. Strain is not the worst offender here, very true. Think of that as a response to Strains readers more than to him.

I may not have been clear enough, but I don’t think that any social spending policy is automatically positive. I can definitely design a social policy that costs so much the costs outweigh whatever benefits they may provide, if any. But that does not mean that all social policies are net negative for growth. Medicare is the most efficient health administrator in the US. Social security is the lowest cost retirement program out there (compare to expense ratios on 401k). SNAP administration costs are a tiny fraction of its total spending. It is totally possible to improve the social safety net without increasing red tape at all. In short, the size of spending on social programs is not correlated with red tape . You want to simplify the tax code (for example) while expanding those programs. Great, let’s do it.

Whether safety nets disincent people from work or innovation is an empirical question. I don’t deny it is possible, but I do deny that there is any evidence this effect is large enough to matter in practice. Again, safety net spending and regulation are different things.