Only Leadership Will Get Americans Out of This Dilemma

A variety of structural crises threaten America’s economic and social health.  Massive stimulus has mortgaged the nation’s future in exchange for a temporary boost in national income and employment.  Its inevitable withdrawal now threatens to hold down future growth.  Government deficits and debt are reaching new highs.  In the short-term this is largely because of the recession and efforts to counteract it.  However, the long-term threat stems largely from a long pattern of promising government benefits but not setting aside the funds needed to pay for them.  As a result, pensions and health care benefits on the federal, state and local level have reached unsustainable levels.

Two things are needed for long-term recovery.  The first is a readjustment of government spending to match government revenue.  In the private sector this is usually accomplished by the renegotiation of contracts, either voluntarily or through bankruptcy.  This process can be helped by a series of broader policy initiatives that increase economic growth.  Worthwhile policies include devoting a large share of public and private spending to investment rather than consumption, tax reform, and the elimination of unnecessary regulation.  So why can’t we accomplish these reforms?

The problem is that progress on each of these area is made nearly impossible because current laws contain a morass of special provisions that benefit one group of Americans at the expense of everyone else.  The vast majority of these policies lower national wealth in two ways.  First, they divert productive effort away from beneficial activities and into those activities that the government has chosen to favor, that is unless the current beneficiaries can also get the government to pass laws that protect them from competition.  Second, the government’s use of this arbitrary power encourages large investments in attempts to influence its decisions.  These investments include lobbyists, campaign contributions, personal gifts, and outright graft.  Mancur Olson wrote that stable societies were in danger of facing sclerosis as the gradual growth of special interests skewed incentives and limited innovation.

The the crux of this problem can be understood if we look at how an individual might choose between four alternative states of the world and how government policy might or might not affect their incentives to act on these preferences.  In evaluating an area such as tax policy, each individual faces four alternatives which we will call winner, social cooperation, social loss, and sucker.  The situation that the individual faces is determined by whether he retains those government policies that specifically benefit him and whether the rest of society retains the benefits that favor them.  It is important to realize that, while an individual has some ability to choose whether to give up his benefits, she takes the choices of others as given.

Most individuals probably rank their preference for each outcome in the following order:

  1. I win you lose.  I get to keep my special tax breaks but we repeal yours in order to get faster growth.
  2. We all cooperate.  Everyone gives up their tax breaks.  This allows benefits society the most.
  3. No one cooperates.  We all keep our special privileges.  This comes close to the status quo.
  4. I am a sucker.   I give up my tax break in order to improve public policy, but no one else does.  We are stuck with basically the same system, but I am worse off.

From the point of view of society as a whole, the proper ranking should be; 1) we all cooperate, 2) I win, you lose (because only one special tax break exists), 3) I am a sucker, and 4) no one cooperates.   Given this, how can we productively look at issues such as tax reform?

The first thing to notice is that we are largely stuck in the system where no one cooperates.  The tax code is riddled with special provisions benefiting one group or another.  There is a growing consensus that the complexity of system as a whole imposes large burdens on Americans and that few of the tax provisions can be justified on policy grounds.  Most people think that comprehensive tax reform, similar to the 1986 reforms would make the country better off.

If the average taxpayer would prefer universal cooperation (which in this case would mean everyone giving up their individual tax provisions) why is it so difficult to enact reform?  Largely because, without leadership,  each person or group takes the actions of others as largely given.  The  choice they face is not between we all cooperate and no one cooperates.  It is beween  no one cooperates and I am a sucker.  If homeowners voluntarily step forward to give back  the tax deduction for home mortgages, the oil industry is unlikely to follow their lead.  The extra revenue will be divided among everyone else or, worse, be used to give a new tax break to another group.  In this case, the homeowners have indeed become suckers, sacrificing their interests for the sake of others but not achieving the social benefits that would come from broader reform.

The role of government in this situation is to craft a comprehensive agreement that allows the parties to effectively chose broader social cooperation.  It is to frame the debate in terms of the status quo or full cooperation (or close to it).  Groups are more likely to cooperate if their sacrifices can be made conditional on the cooperation of others.  Bringing more groups into the agreement increases the total social gains that each group realizes in return for its cooperation.  This argues for bold and comprehensive reforms like the 1986 act.  But it also means moving toward simplicity rather than complexity in the way laws are drafted.  Unwieldy reforms such as health care reform, climate change legislation, and financial reform add further layers of special privileges onto an already burdened system, reducing the public’s trust that true reform has been achieved.

But even if comprehensive reform is enacted, the government’s role is not done.  Social cooperation is never a stable outcome because each group has a higher preference: that it gets its special provision added back while others are cooperating.  Having achieved cooperation, they now want to win.  These changes deliver large benefits to the targeted group and, although they reduce total national income, the burden felt by others is often minor.  The problem is that every group wants this outcome and success by one only encourages other attempts.  Thus government must remain ever vigilant in protecting the broader agreement against special interests that attempt to undermine it.  This requires policymakers to forswear the power to dole out special favors, even in cases where there is a good policy argument for using it.

There are strong indications that Americans see the benefits of comprehensive reform and are ready to make sacrifices to achieve it.  Putting America back on course could be this generation’s contribution to posterity.  But few people are willing to give up their own benefits unilaterally.   Unfortunately, they are losing faith in their elected leaders who seem largely uninterested in giving up the discretion to benefit some at the expense of others and who shrink from the leadership needed to craft bold reforms.

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