Great Britain and Laissez Not-so-Faire Economics

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I recently finished State, Economy, and the Great Divergence by Peer Vries. It’s a comparison of the activities of the state in Great Britain and China in the period running up to and including the Industrial Revolution, roughly 1650-1850.

Vries critiques the standard view on the role of the state and the divergence between these two places, encapsulating that view in the following:

In the Smithian interpretation of British economic history, that fits in quite neatly with the Whig interpretation of Britains overall history, the primacy of Britain and its industrialization are by and large regarded as the culmination of a long process in which Britains economy increasingly became characterized by free and fair competition and in which government increasingly tended to behave according to Smithian logics.
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For those who endorse them, the predicament of imperial China, that it did not industrialize, has always been quite easy to explain. They only need to refer to the fact that China was characterized by some kind of oriental despotism. This notion has a long pedigree whose beginnings can be traced back at least to Marco Polo.

The alternative that Vries proposes is that China is far more “Smithian” than Great Britain in this period, in the sense that it operated a very hands-off government that mainly served to provide some subsistence insurance to its population, while Great Britain had a relatively large, intrusive, and active government managing its economy and actively interfering in the process of industrialization. With regards to the idea that Great Britain enjoyed a meaningful advantage in institutions (re: property rights) after the Glorious Revolution, Vries has this to say:

I, moreover, see no concrete direct links between changes in property rights and the emergence of modern economic growth during industrialization in Britain, or rather I do not see any major changes in that respect just before and during take off. In several respects property rights in Britain after 1688 were not better protected, as a strengthened central government had acquired more power to interfere with them on the basis of national interest. More in general, one has to realize that, as will be discussed later on, the history of Western Europe was not exactly lacking examples of expropriation and that well protected, entrenched property rights including patents can also be an obstacle to growth.

Vries then spends a good portion of the rest of the book laying out the evidence on government expenditures, taxes, employment, and transfer payments to support the idea that Great Britain had a much more intrusive state than China in this period.

I’ll leave you to the book for the full details, but here are some essential highlights. Taxes per capita in Great Britain were approximately 20 times higher than in China. As a percent of GDP, the figure depends on exactly your preferred source for GDP data, but taxes were again much higher in Great Britain (3-5 times higher depending on the measure). Further, taxes were rising in both per capita and percent of GDP terms over this entire period in Great Britain, while they were essentially flat in China. Finally, the government in China never ran deficits in this entire period. If you are familiar with the history of Great Britain, then you know that government debt as a percent of GDP was essentially zero in 1689, right after the Glorious Revolution. From there it rose steadily, reaching a peak of almost 250% of GDP after the Napoleonic wars. It wasn’t until after 1850 that debt fell back below 100% of GDP. In terms of the number of government officials, Vries cites data that China had between 20,000 and 30,000 civil servants in the 18th century. Great Britain had an equal amount, for a population roughly 30 times smaller. Great Britain spent a much larger fraction of GDP on welfare and poor relief than China ever did.

Drawing on the excellent War, Wine, and Taxes by John Nye, Vries also talks about the attitude of Britain towards free trade:

In the 1820s, for example, the average tariff rate for imported manufactured goods was between 45 and 55 per cent. It was only after 1850, and even then only quite temporarily, that Britain really became a free-trading nation. Overall, its tariffs in the first half of the nineteenth century were so high, higher for example than in France, and continued to be high for so long that any explanation of the first industrial revolution by reference to the existence or emergence of a free-trade economy is extremely improbable. When Britains economy took off, the country definitely was not a free trader in matters of international trade.

Compared to Britain, China was much closer to a free trade nation, declining to interfere or promote imports or exports actively.

Vries wraps up his argument with

This book maintains that the historical evidence now is so heavily in favour of industrial and military policies successfully encouraging long-term economic development in England, admittedly through far more complex means than simply setting tariffs to encourage domestic manufactures, that the burden of proof falls on neoclassical economics, not on the historic record.

Mercantilism, as practiced throughout this period in Great Britain, was not simply a fascination with collecting gold. The British government actively looked to strengthen manufacturing (of imported raw materials) and used military and naval power to open markets with that purpose in mind. To do this it taxed heavily, borrowed heavily, and spent heavily.

What to make of this? There is no necessary link between strict laissez-faire policies and growth. The first industrial nation in the world was anything but laissez-faire, and it intervened far more deeply into its economy than China, which functioned in some sense as the idealized “night watchman” state of Adam Smith. There is little to no evidence that government “just getting out of the way” leads to development. The interventions Great Britain did make certainly resulted in massive monopoly rents to small groups of people at times. So let’s not go overboard in the other direction and conclude that massive state interventions are necessary or optimal. But it is valuable knowing just how un-laissez-faire Britain was during this period.

Why did Britain take off even with all this government interference? Vries doesn’t say this explicitly, but I think his answer is partly that large-scale industrialization has big fixed costs. I want two things before I undertake big fixed investments: a large market and low risk. The British government used the high taxes to fund a military that could ensure large markets around the world, and could ensure that those markets remained open so I could earn enough to pay off my fixed cost. That military (directly or by proxy) could also actively ensure that other markets did not develop competitive industries, again ensuring that I could earn enough to make the fixed costs worth it. Without the market size and low risk, maybe British capitalists are not willing to create the large-scale industries that drove the IR. In that sense, the large size of government was necessary to the industrialization of Britain.

Why I Care about Inequality

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“Inequality” is a term that has been tossed about quite a bit. The Occupy movement, to Piketty’s book, to debates over the minimum wage, to Greg Mankiw‘s defense of the 1%. Just today Mark Thoma published an op-ed on inequality. A few days ago John Cochrane had a post about why we care about inequality.

One of Cochrane’s main points is that the term “inequality” has been used in so many contexts, and to refer to so many different things, that it is ceasing to lose meaning. I’ll agree with him on this completely. If you want to talk about “inequality”, you have to be very clear about what precisely you mean.

There are three things that people generally mean by “inequality”:

1. The 1% versus the 99%. That is, the difference in average annual income of the top 1% of all households versus the average annual income of the bottom 99%.
2. The stagnation of median real wages and those below the median.
3. The college premium, or the gap in earnings between those who finished college and those who did not (or did not attend).

When I say I care about inequality, I mean mainly the second – the stagnation of median wages – but this is going to take me into territory covered by the first – the growth in top 1% income. There are things to say about the college premium, but I’m not going to say them here.

Why do I care about the stagnation of median wages?

• Because I’m going to be better off if everyone shares in prosperity. I want services like education, health care, and home repairs to be readily available and cheap. The way to achieve that is to invest in developing a large pool of skilled workers – teachers, nurses, electricians, carpenters. Those at the bottom of the distribution don’t have sufficient income to make those investments privately, so that requires public provision of those investments (i.e. schools) or transfers to support private investments. You want to have an argument about whether public provision or transfers are more efficient? Okay. But the fact that there is an argument on implementation doesn’t change the fact that stagnant wages are a barrier to these investments right now.
• Because people at the bottom of the income distribution aren’t going to disappear. We can invest in these people, or we can blow our money trying to shield ourselves from them with prisons, police officers, and just enough income support to keep them from literally starving. I vote for investment.

One response to this is that I don’t care about inequality per se, I care about certain structural issues in labor markets, education, and law enforcement. So why don’t we address those fundamental structural issues, rather than waving our hands around about inequality, which is meaningless? Because these strutural issues are a problem of under-investment. The current allocation of income/wealth across the population is not organically producing enough of this investment, so that allocation is a problem. In short, if you care about these structural issues, you cannot escape talking about the distribution of income/wealth. In particular, you have to talk about another kind of inequality, the 1%/99% kind.

Let me be very clear about this too, because I don’t want anyone to think I’m trying to be clever and hide something. I would take some of the income and/or wealth from people with lots of it, and then (a) give some of that to currently poor people so they can afford to make private investments and (b) use the rest to invest in public good provision like education, infrastructure, and health care.

Would I use a pitchfork and torches to do this? No. Would I institute “confiscatory taxation” on rich people? No, that’s a meaningless term that Cochrane and others use to suggest that somehow rich people are going to be persecuted for being rich. I am talking about raising marginal income tax rates and estate tax rates back to the archaic levels seen in the 1990s.

Why do I not feel bad about taxing rich people further?

• Because rich people spend their money on useless stuff. Not far from where I live, there is a new house going up. It will be over 10,000 square feet when it is complete. 2,500 of those square feet will be a closet that has two separate floors, one for regular clothes and one for formal wear. If that is what you are spending your money on, then yes, I believe raising your taxes to fund education, infrastructure, and health spending is a net gain for society.

  Don’t poor people spend money on stupid stuff? Of course they do. Isn’t the government an inefficient provider of some of these goods, like education? Maybe. But even if both those things are true, public investment and/or transfers to poor people will result in some net investment that I’m not currently getting from the mega-closet family. I’m happy to talk about alternative institutional settings that would ensure a greater proportion of the funds get spent on actual investments.

• Because I’m not afraid that some embattled, industrious core of “makers” will decide to “go Galt” and drop out of society, leaving the rest of us poor schleps to fend for ourselves. Oh, however will we figure out how to feed ourselves without hedge fund managers around to guide us?

  This is actually a potential feature of higher marginal tax rates, by the way, not a bug. You’re telling me that a top tax rate at 45% will convince a number of wealthy self-righteous blowhards (*cough* Tom Perkins *cough*) to flee the country? Great. Tell me where they live, I’ll help them pack. And even if these self-proclaimed “makers” do stop working, the economy is going to be just fine. How do I know? Imagine that the entire top 1% of the earnings distribution left the country, took all of their money with them, and isolated themselves on some Pacific island. Who’s going to starve first, them or the remaining 300-odd million of us left here? The income and wealth of the top 1% have value only because there is an economy of another 300-odd million people out there willing to provide services and make goods in exchange for some of that income and wealth.

So, yes, I care about 1%/99% inequality itself, because I cannot count on the 1% to privately make good investment decisions regarding the human capital of the bottom 99%. And the lack of investment in the human capital of the bottom part of the income distribution is a colossal waste of resources.

Taxes and Growth

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William Gale and Andy Samwick have a new Brookings paper out on the relationship of tax rates and economic growth in the U.S. [Apologies to whichever blog/site led me to the paper, I can’t remember.] Short answer, there is no relationship. They do not identify any change in the trend growth rate of real GDP per capita with changes in marginal income tax rates, capital gains tax rates, or any changes in federal tax rules.

One of the first pieces of evidence they show is from a paper by Stokey and Rebelo (1995). This plots taxes as a percent of GDP in the top panel, and the growth rate of GDP per capita in the lower one. You can see that the introduction of very high tax rates during WWII, which effectively became permanent features of the economy after that, did not change the trend growth rate of GDP per capita in the slightest. The only difference after 1940 in the lower panel is that the fluctuations in the economy are less severe that in the prior period. Taxes as a percent of GDP don’t appear to have any relevant relationship to growth rates.

The next piece of evidence is from a paper by Hungerford (2012), who basically looks only at the post-war period, and looks at whether the fluctuations in top marginal tax rates (on either income or capital gains) are related to growth rates. You can see in the figure that they are not. If anything, higher capital gains rates are associated with faster growth.

The upshot is that there is no evidence that you can change the growth rate of the economy – up or down – by changing tax rates – up or down. Their conclusion is more coherent than anything I could gin up, so here goes:

The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

The effects of tax cuts on growth are completely uncertain.

Subsistence and Self-perpetuating Inequality

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It’s common in development or growth to think about subsistence constraints. From a macro perspective, we think of them as an explanation for the low income-elasticity of food expenditures, and therefore a cause of structural change away from agriculture. The idea has there in development for years. I don’t know the full intellectual history here, but my understanding of it goes back to The Moral Economy of the Peasant by James C. Scott. He says you can understand a lot about the peasant mind-set by realizing they face subsistence constraints, and that this makes them incredibly risk averse. Kevin Donovan has a recent paper that looks at the macro consequences of this risk-aversion for agricultural development.

I think the concept of subsistence constraints and risk aversion is useful for thinking about inequality in general, even outside of developing countries. In particular, it offers an explanation for why inequality will be self-perpetuating and how mitigating inequality will be growth-enhancing.

If there is some subsistence constraint in your utility function, then your risk aversion is declining with income. You can take my word for it, or if you’d like to see it more clearly, let utility be

and the coefficient of relative risk aversion is then

Risk aversion approaches infinity as income approaches the subsistence constraint, meaning people will refuse to take any gamble that might put them below . Risk aversion approaches 1 as income rises. The value 1 itself isn’t important, what’s important is that as people get richer, they are willing to accept bigger and bigger gambles with their income, because they are less and less danger of falling below . Richer people are more risk-tolerant.

Combine this conception of subsistence and risk aversion with the commonly understood relationship of risk and reward. In finance and entrepreneurship, we generally believe that those willing to absorb higher risks are able to reap higher rewards. Entrepreneurs earned that money by taking a risk in starting a company. Aside from entrepreneurship, big fixed investments in education — quitting your job to go back to school — are very risky moves that in turn have high expected rewards.

Together, subsistence and the risk/reward correlation imply that inequality will be self-perpetuating. Poor people will not take on big risks (starting a business) because they cannot handle even a small probability of failure that takes them below subsistence. So they stay in low-wage jobs and don’t undertake investments that might make them better off.

Well-off people are able to tolerate bigger risks, and so also earn higher rewards. They start businesses, get more education, or move across country for a new job. If it doesn’t work out, they won’t starve, so it’s worth the risk. And because they undertake big risks, they tend to earn high rewards. The rich can expand their incomes and/or wealth at a faster rate than the poor, because of their higher risk tolerance. This naturally acts to expand inequality over time.

The crucial point is that there is no pathology to the poor refusing to take big risks. With subsistence constraints, the poor don’t remain poor because they are lazy or stupid, but because they are rationally avoiding big risks that might push them below subsistence.

The conceit of people who espouse a “just deserts” theory of inequality (Greg Mankiw, Sean Hannity, et al) is that they would have been well-off regardless of where they start in life. They believe that they possess qualities — smarts, skills, work ethic — that make them valuable to the market, and that they are rewarded for that. But start them off in a truly poor household, one where the next meal is uncertain, and with 99.99% certainty they would not end up a professor at Harvard or, well, whatever Hannity is. There were big risks taken in their lives that had big payoffs. Risks they or their family would not have been able to conceive of taking if they were truly poor.

Subsistence constraints also imply that acting to mitigate inequality — whether by raising incomes of the poor or making their incomes less uncertain — would have a distinct positive effect on economic growth. Ensuring that people won’t fall to subsistence (or below) means that more people are willing to start a business, and we get more economic activity, more competition, and more innovation. If more people are willing to go for advanced training (college or vocational school) then we get a more skilled workforce. Acting to insure or support poor incomes has positive spillovers.

Won’t providing income support just incent all the poor people to stop working? Remember that most of the people screaming loudest about this – Casey Mulligan – are tenured professors who cannot be fired. Despite having no incentives whatsoever to continue working on research or provide more than perfunctory teaching, Mulligan continues to work. Why? Why does he not rationally show up to collect his check and then go home to eat Cheetos and watch Dr. Phil? If Casey Mulligan continues to work despite a guaranteed income, I’m fairly confident that the vast, vast majority of people will continue to work even if they are no longer at risk of falling into destitution.