The Becker-Posner Blog

Warren Buffett on Taxing the Wealthy More Heavily—Posner

Two weeks ago Warren Buffett made waves with a brief op-ed piece in the New York Times of August 15 entitled “Stop Coddling the Super-Rich.” In it he says that very rich people are undertaxed, but he would leave the federal income tax rates of 99.7 percent of taxpayers unchanged and only raise the tax rates of taxpayers who report more than $1 million of taxable income a year; if they report at least $10 million a year they would pay an additional surcharge. But he doesn’t say what the increased tax rates on either group should be. He also wants dividends and capital gains taxed at the same rate as ordinary income but does not say whether he thinks the uniform tax rate should be the present income tax rate (except for those earning over $1 million a year and therefore liable for the lesser or greater surcharge) or perhaps a lower rate because it have a bigger base. 

Buffett’s piece is short, and really the only thing of interest, besides the celebrity of its author, is his claim, based on his extensive personal knowledge of wealthy investors, that increasing  the taxes on the wealthy would not cause them to invest less. He may be right but he does not discuss the distinct issue of whether they would invest differently. 

The growth of the federal deficit, which is growing from a very high level at a rate of well over $1 trillion a year, cannot be arrested without more tax revenues. The alternatives are spending cuts and rapid economic growth. They are attractive to many conservatives but will not cut the mustard. The needs of government preclude the kind of drastic spending cuts that would curb the growth of the federal deficit without any need for additional federal revenues. Diehard opponents of increasing tax revenues even by closing loopholes without raising tax rates argue that the federal government is too large and can only be made smaller by reducing its income. But this argument contains two mistakes. One is to think that the federal government can finance its activities only by taxation. Not true; it can finance them with borrowed money, as proved by the Bush tax cuts, which did not lead to a reduction in the scale or spending of the federal government, but merely to an increase in borrowing. Of course, as the federal government approaches bankruptcy, the pressure to curtail federal spending is great and an increase in tax revenues would alleviate the pressure, but probably only slightly because the feasible scope for such an increase is very limited.

Second is a confusion between size of government and amount of government spending. The federal government is not too large in the sense of having too many employees or even too many functions. We need a large military, and we need regulatory agencies that are well staffed—regulatory laxity was a major contributing factor to the financial crisis of 2008 and the broader economic crisis that it triggered. What we can’t afford is not federal employees (including soldiers) but careening entitlements. But the administration of vast entitlement programs is not particularly costly. A small government can transfer immense amounts of wealth among its citizens. The problem is the entitlements themselves, not wasteful expenditures on administering them—indeed the Medicare program would probably be more efficient, and, specifically, less susceptible to fraudulent and other overbilling and approval of unnecessary or marginal medical treatments, if the Medicare administration had more staff. 

Military spending cannot be cut significantly without endangering national security. Of course there is “waste” in military spending as there is in most activities, but bureaucratic and political imperatives, as well as the inherent uncertainty of threats to national security, place limits on economizing on military spending. Most of the other discretionary spending of the federal government (that is, spending that Congress must approve every year) is likewise justifiable, including spending on domestic security, infrastructure, the environment, basic research, and disaster relief, as well as regulation. Discretionary federal spending can and will be cut if the deficit cannot be reduced by other means, but it probably cannot be cut a great deal without inflicting costs greater than the benefits. 

Anyway the real threat to the solvency of the federal government doesn’t come from military expenditures, which would be leveling off even if there were no budget crisis, or other discretionary spending, which if it cannot be greatly cut can nevertheless be kept in bounds without great hardship. The real threat to federal solvency comes from the entitlement programs—Medicare, Social Security, Medicaid, and many others—not because they are huge, though they are, and certainly not because they are costly to administer, but because their outlays are growing rapidly, especially Medicare and Social Security outlays because of the aging of the population and the rising costs of medical technology as a byproduct of technological advance. Political resistance to cutting these programs, or at least to cutting Medicare and Social Security, is fierce. The programs may be cut some despite their sacred-cow status, but not enough to reduce the rate of increase of the deficit to the rate of economic growth. 

So can economic growth be increased, then? In the near term, the combination of poor economic leadership and management by the Administration with the economic radicalism of congressional Republicans makes it unlikely that the government will do anything to stimulate growth before the 2012 Presidential election and the seating of a new Congress in January 2013. Eventually the economy may rejoin its long-term trend of an annual growth rate of GDP of a little under 3 percent; whether there is a set of economically and politically feasible policies that would increase that rate seems doubtful. 

Which leaves increased tax revenues as a seeemingly indispensable weapon against the soaring deficit. Indispensable—but not ideal. Any increase in tax revenues would be counterproductive in the present depressed state of the economy, because it would take money out of the private economy at a time when the government can finance its debt cheaply by borrowing at very low interest rates. The increase in tax revenues would have to be phased in gradually and meanwhile the deficit will be growing. 

Merely increasing marginal income tax rates, even on the millionaires and multimillionaires and billionaires, is likely to be counterproductive. Unless the percentage increase is substantial, it will not generate much revenue. And if the increase is substantial, it will induce a flight to loopholes. (Buffett would close only two of them—dividends and capital gains—and there are many more.) Only if increased rates were joined with a thoroughgoing reform of the tax system that would eliminate virtually all deductions and exemptions would the increased rates generate substantially increased revenues by preventing a flight to loopholes. The reform would have to be precise, leaving very little for regulatory adjustments by the Treasury, and represent an unshakeable congressional commitment, eliminating all uncertainty so that taxpayers would know exactly where they stood. Meaningful tax reform along these lines, though falling far short of what was, and today is much more urgently, needed, was achieved during the Reagan Administration; there is no reason, other than interest group pressures and other political forces, why it can’t be achieved today. But those pressures and forces are great.

Buffett and a Better Tax System-Becker

In my blog post last week on inequality I expressed sympathy with Warren Buffett’s concern that the share of the income paid in taxes by the very wealthy is considerably smaller than the shares paid by many middle class Americans. But I am troubled by what he proposes to do about it.

He suggests that the 12 member congressional panel set up to cut current and future federal deficits leave tax rates unchanged for 99.7 percent of taxpayers, and only raise rates on the approximately 250,000 households who make more than $1 million. Simple calculations show that a tax increase on such a small number of households, even a very large tax increase, would have a negligible effect on total tax revenue, and hence on closing the budget deficit. As we will see, there are more sensible ways to improve tax revenue.

Warren Buffett has persuaded 68 other billionaires to follow his example and promise to give at least half their wealth to charities. But why hasn’t Buffett proposed also that the very rich make large gifts to the federal government to offset what he considers ridiculously low taxes on their incomes and wealth? My guess is that he and the others who pledged to give away their wealth to charity would have little confidence in how the government would spend such gifts. Buffett, for example, is giving most of his wealth to the Gates Foundation, not to the federal government, and is relying on how this foundation will spend his vast gift. Given this reluctance to make large gifts to the federal government, why should anyone have confidence that the federal government will spend additional tax revenue in a sensible way?

Still, I agree with Buffett that the American income tax system makes no sense from an equity viewpoint, nor does it make sense from its effects on the efficiency of the American economy. Of course, it makes great sense from a political economy perspective since special treatments of all sources of income- whether it be capital gains, gifts to charities, or deductibility of interest on home mortgages- are in the tax code not by accident, but are there due to the political power of builders and home owners,ethanol producers, universities and other non-profit organizations, and other special interest groups. However, perhaps with the present concern by voters over present and future deficits, it may be possible to get serious tax reform by overcoming the political power of important interest groups.

From a efficiency perspective, the ideal tax system would replace all income taxes with a flat percentage tax on total consumption of each household, as in a flat inclusive value added tax (VAT). A tax on consumption instead of income has the advantage that it would avoid the double taxation of saving. The present income tax structure first taxes incomes, and then another tax is imposed on the income earned from any of the original income that is saved (although some savings, like in IRAs, may avoid any taxation until they are spent after retirement). A tax on consumption also avoids the double taxation of corporate income. Under the present system corporate income is taxed, and then taxed again when dividends are paid or capital gains realized. A consumption tax also eliminates the complicated calculations about depreciation on capital that are necessary to arrive at the taxable net incomes of businesses.

Of course, the consumption tax rate would have to be pretty high if it were to replace all income taxes. I would guess that a VAT on all consumption of no more than 25% would be adequate to raise the revenue needed to balance the budget, even without the desirable reductions in federal spending. Since the economy would become more efficient with such a tax, real income would expand, perhaps by a lot, which would lower the burden of a consumption tax.

Two objections are commonly raised to replacing all income taxes with a flat consumption tax. One is that it is unfair for the poor to pay the same tax percent on their small amounts consumed as the rich pay on their greater consumption. One way to introduce progressivity into a consumption tax is to impose a lower tax rate on goods more heavily consumed by low-income households, such as bread, cheap apartments, over the counter drugs, and the like. A less arbitrary way is for the government to give monetary transfers to poor households. Households that qualify for such transfers would report their incomes and savings, with consumption measured by the difference between incomes and savings. It is easier for most families to know what their income and savings are than to keep track of their consumption.

Many small government advocates agree that a flat VAT type tax is efficient, and that is what bothers them. For they are concerned that opposition to raising the tax rate of a flat VAT tax would be weak precisely because the tax is efficient. The more efficient a tax, the smaller the cost to taxpayers from higher rates, and so the more willing they are to accept higher taxes. Casey Mulligan and I develop the theory behind these concerns, and also provide evidence that efficient taxes, such as the VAT, may start low but rise over time (see our paper, “Deadweight Costs and the Size of Government” in the Journal of Law & Economics, 2003). Although some other studies have not found such strong empirical effects of efficient taxes, the argument about the greater incentive to raise tax rates from efficient taxes makes a great deal of common sense as well.

Still, no tax system is ever going to be perfect. Taking everything into account, reliance on a flat tax on aggregate consumption rather than income taxes with different tax rates and various exemptions seems to be a worthy goal to strive for. I say “strive for” since the interest groups that have favorable treatment from the tax code will not meekly go away, but will have to be fought constantly to have real hope of meaningful tax reform.

 

Deserving and Undeserving Inequality–Becker

 

During the past 25 years, inequality in the world has greatly declined mainly because of the rapid growth in incomes in large poorer nations, especially China, India, and Brazil. This led to enormous declines in worldwide poverty as hundreds of millions of families were pulled above poverty thresholds, such as having to live on $1 or $2 dollars a day. At the same time, however, inequality between families grew rapidly within many countries, especially the United States and other Anglo-Saxon countries, China, and India. Although attitudes to inequality differ across cultures and countries (see, for example Alesina, Di Tella, and MacCulloch, “Inequality and Happiness: are Europeans and Americans different?”), in every society these attitudes depend on whether the inequality is considered to improve efficiency and to be deserving – the difference between “good” and “bad” inequality.

The great majority of people in different cultures do not object to someone who has made lots of money when they have superior abilities and talents, and they work hard at producing what are considered useful goods or services. Actors like Tom Hanks or Jennifer Aniston earn millions of dollars per film, yet they are admired as stars rather than condemned for being millionaires because films are a popular form of entertainment. Bill Gates, Steve Jobs, and others who became billionaires by creating innovative companies that provide highly valuable goods and services to millions of individuals are widely admired as the business equivalents of rock stars rather than attacked for their great wealth. Leading transplant and other doctors who become successful and very wealthy through extensive education and superior skills are recognized for their valuable contributions to extending the lives of very sick individuals, and few object to their high earnings.

On the other hand, when hedge fund managers become rich by using arbitrage activities to narrow the spreads in interest rates and other prices between different regions (most hedge funds do not only engage in arbitrage) they produce useful services, but the value of what they do is not so apparent as the businessmen who make successful products. It is still harder for many to understand the usefulness of “speculators” who do well financially by successfully shorting shares of companies or commodities, such as oil, because they believe correctly that their prices will fall in the future. Their activities add value by smoothing out the prices of these shares and commodities over time, but few people like individuals who bring bad news, or who profit from anticipating bad news.

Other forms of behavior are objectionable because they both add to inequality and lower economic efficiency. These are the most dangerous sources of inequality, and they create negative attitudes toward the wealthy, and even at times social unrest. One illustration is the arbitrary use of government power to give or take away wealth. Some individuals become very wealthy because of the political favors they receive, while others lose much of their wealth because of unjust governmental treatment. Examples include Carlos Slim and the Russian oligarchs who gained big economic advantages by receiving monopoly positions in industries like telecommunications when they were privatized, and the officials of Fannie Mae and Freddie Mac who became wealthy by using their political connections to acquire a dominant position in the US residential mortgage market. A highly publicized recent example is the Indian businessmen who obtained special privileges in telecommunications and other industries because of corrupt government officials.

Arbitrary taking of property through eminent domain and other government power without proper compensation is a major source of discontent. Chinese farmers objected, and some even rioted, when governments took their land to build infrastructure or factories. Governments in the United States sometimes use eminent domain powers to take the land and housing of families in order to build public and private redevelopment projects. In these and related examples, people object partly to the forced transfers of property to governments, and partly to inadequate compensation to small property owners, at least inadequate in the eyes of those losing their properties and their neighbors.

Since earnings is the biggest contributor to income for the great majority of families, the considerable inequality in earnings has been extensively dissected. During the past several decades, technological advances that favored highly skilled workers raised the earnings of college graduates by a lot relative to those with lesser education in the United States, Great Britain, China, India, and many other countries. This sharply higher relative earnings of the more educated has been accepted for the most part since it contributes to greater productivity. Criticized are the various obstacles that prevent able boys and girls from acquiring a college education, such as broken and poor families, and inadequate schools. These obstacles lead to bad and inefficient inequality that sometimes causes frustration and discontent among those affected.

Attractive public policies encourage the good earnings inequality and attack the bad inequality through laws, taxes and subsidies, and in other ways. For example, charter schools, vouchers, merit pay for good teachers, Head Start programs, and student loans help more able students from disadvantaged backgrounds enter and finish college.

Public policies can also help overcome inefficient sources of inequality in other types of income, although these policies often run into powerful political opposition. Privatization and other sales of government properties should be auctioned off, not given away to favored businessmen. Governments should be allowed to use eminent domain and similar laws to take property from individuals only in sharply constrained circumstances with very high benefit/cost ratios. Regulations should be based on rules rather than discretion, so that the regulators cannot easily get “captured” by the industries they are regulating, including capture through corruption of government officials.

I agree with the argument by Warren Buffet in a recent New York Times op-ed piece that it is neither fair nor efficient for highly wealthy individuals like himself to be paying a smaller fraction of their incomes in taxes than middle income and many lower income persons. However, the way that inequity is corrected can make an enormous difference to economic efficiency as well as to the degree of inequality. The best way to reduce these inequities is to substitute for the present tax mess an inclusive equal percentage tax on all incomes, where the income base would be greatly widened by eliminating deductions on mortgage interest payments, restraining the tax-deductibility of charitable contributions, and eliminating special subsidies, such as the generous ones to ethanol producers. With a flat broad equal percent tax on all incomes, capital gains and other sources of income that currently have special tax treatment should then be taxed at the same flat rate as earnings and other incomes.

Income Inequality and Envy—Posner

The position one occupies in the distribution of income and health is largely a matter of luck—the luck of the genes, the social and economic standing of one’s parents, accidents of upbringing, the match between one’s abilities and demand for particular goods and services, and so forth—though there is an element of choice, since people are motivated by nonpecuniary as well as pecuniary factors. But that is more a matter of some people who could earn high incomes choosing a career less remunerative but more productive of nonpecuniary income. A person who lacks the ingredients of financial success can “choose” to become rich but won’t get anywhere. 

Utilitarians believe that, other things being equal, income equality maximizes utility because of the diminishing value of income—an extra $100 confers more utility on a beggar than on a millionaire. So utilitarians are apt to condone inequality only if it increases average incomes substantially—which doubtless it does, within limits at any rate, at least in a society not riven by envy. (In highly envious cultures, a person may start a fire that will destroy both his and his neighbor’s barn, provided his neighbor’s barn is worth than his and is not insured.) 

Hence Becker properly emphasizes the importance of distinguishing between economic inequality that promotes, and economic inequality that retards, the creation of social wealth. And in a commercial society such as that of the United States, a political-economic system that allows able people to make and keep large fortunes produces powerful incentives to create wealth. I call the wealth they create “social” because it benefits other than just the creator of the wealth. Successful producers of goods and services create consumer surplus and pay a disproportionate share of taxes. 

That is not to say that the income of wealthy people is carefully proportioned to their contribution to social wealth. A person who wins a fortune in a lottery does not increase the size of the economic pie, but merely gets a big slice for himself. But lotteries are an effective method of tax collection (they are voluntary taxes), and windfalls are an essential element of the method and therefore have a legitimate social function. 

These points are not familiar to the general public, so it is a puzzle why there is so little envy in our society. There is of course local envy—envy of a neighbor or coworker who one thinks has enjoyed undeserved good fortune—but that is different from envy of the rich as a class. Inequality has grown significantly in recent decades and has been magnified and dramatized by the continuing economic crisis; high un- and underemployment coexists with widely publicized lavish partying by billionaires. One reason for the lack of envy is that the only inequality that is noticed is inequality between middle and upper class people—the poor are invisible—and the middle class is well off by international and historical standards. Another reason is that there is already a good deal of redistribution of income and wealth through the entitlements programs, and further redistribution, involving significantly heavier taxes, is generally opposed, as no one knows whom the burden of the heavier taxes will actually fall on. Still another factor is the domination of campaign financing by the wealthy, which discourages legislators from left as well as right from waging “class warfare.” Also, America is a classless society in the sense that the wealthy do not flaunt a superiority of culture or manners (think of the vulgarity of a Donald Trump); they do not, typically, attend the very best prep schools and colleges; they are not, for the most part, rentiers, living off inherited wealth; they are not considered “better” than other people; they just have more money. And America remains an open society. Children of privilege have advantages, but the talented who start with no advantages face no obstacles to rising. 

Equality of opportunity, a salient American cultural characteristic, actually guarantees inequality of income, because an opportunity is just a chance. Equality of opportunity is related to individualism and competitiveness, which are also American traits, related to the diverse origins of its large population. Ties of community are loose, and altruism outside the family circle limited. 

Inequality could reach a point at which a relatively small group controlled such a large fraction of the nation’s wealth that a political movement could rally support for dispossessing them of their wealth. At present, however, such a movement does not exist.

The English Riots—Posner

Marches and other peaceful demonstrations are conventional forms of urban political activity in democratic societies. They compensate for the fact that votes do not register the intensity of the voter’s political preferences. Because demonstrating involves a much greater time cost than voting, it provides better evidence of intensity. It also provides the demonstrators with self-expressive utility (people like to express their views, especially publicly) and enables people to meet and form relationships with people having similar views to theirs, so it is a form of social networking. One expects more demonstrations in times of economic distress, because with unemployment and underemployment high, the time cost of demonstrating is reduced, and because distress causes people to want political change urgently, without waiting for the next election, and a demonstration is a kind of voting. 

When a demonstration imposes real costs, as by blocking traffic, and when it becomes violent—becomes a riot—destroying property and sometimes even injuring or killing people, it conveys a stronger political message by demonstrating greater commitment, but it also arouses greater opposition. The most effective demonstration, however, is the peaceful demonstration violently repressed, with demonstrators arrested, prosecuted, injured, or even killed, for that both demonstrates commitment and arouses sympathy. When burning the American flag was a crime, the flag burner demonstrated his commitment by courting arrest and prosecution. After the Supreme Court held that burning the American flag (provided it is your own property) is constitutionally protected activity, flag burning disappeared, as it no longer signaled commitment to whatever cause the flag burner was trying to promote. 

Riots in a democratic society will almost never represent majority opinion, and so it might seem—given their destructive effects—that they would never be effective in changing policy. But that is not true. It may be cheaper to remove the grievance that spurred the riot than to create and administer an effective machinery of repression. So a riot and its repression may be forerunners of reform. Reform in such circumstances is appeasement, and appeasement can beget further violence, as we know from the efforts in the 1930s to appease Hitler, but that is just to add another cost to the calculus of response to riots and other aggressive behavior. 

There is finally to be considered the consumption aspect of riots. Even if the organizers and most—or even all—of the rioters are rioting because of grievances, the rioting may include looting, because the rioters may greatly outnumber the police, making for easy pickings. Moreover, the grievance that sparked the riot may have been over high food prices or other economic hardship, in which case looting might seem a natural or even justifiable component of the riot. But it is unlikely that many riots are motivated by simple thievery. It would be odd for a thief or other criminal to think that a profitable form of criminal activity is organizing a riot, since his share of the loot obtained by rioters would be very small yet his punishment (as ringleader) if he were caught would be great. A riot degenerates into looting even if no economic grievance sparked it because the rioters see opportunities for quick gain or because persons who have no interest in the political goals of the rioters free ride on the opportunities that a riot creates for easy thieving. 

Britain and America are nowadays quite similar in culture, political institutions, economic policies, and racial problems, yet it seems unlikely that we will experience contagion from the recent English riots. We have a large young black urban population that has suffered more in the current economic depression than the rest of the population, so it might seem that conditions are ripe for urban rioting with looting—we have had many such riots in the past. Riots need a spark, but a police killing of a black is a typical spark of an urban race riot (as apparently it was in London), and such killings are not infrequent in the United States. Riots in the Middle East (riots that are depicted in the West as heroic) and in Greece and now England have been well publicized and the human animal is imitative. Social networking facilitates organizing strangers into demonstrations and other mass actions. 

But our long history of race riots—there were serious such riots in northern cities during the Civil War—may have provided a measure of inoculation against them and thus made them less likely to occur nowadays than in England, which until recently had a racially and ethnically homogeneous population. We have learned the importance of such preventive measures as a well-trained, racially heterogeneous police force, and the cultivation of and communication with leaders of urban minority communities. The race riots that followed the assassination of Martin Luther King in 1968 operated as a wake-up call and ever since our domestic security apparatus has been wide awake. It helps that the President is black (actually half black, but unlike the people of many other countries, such as Brazil and South Africa, Americans don’t distinguish mixed from “pure” races). 

England is not, historically at any rate, a nation of immigrants, like the United States, or a forced-assimilation society like France (although France has had difficulty assimilating Muslims and experienced Muslim riots in 2005, about which Becker and I blogged then). It clearly was not prepared for widespread race riots. The police were insufficient in number and not well deployed or commanded and seem to have lacked, or been unwilling to use, anti-riot equipment such as tear gas, water cannons, and rubber bullets. 

The spark that caused the riot was the shooting of a black by police, but the riot that ensued appears to have been dominated by looters (many of them white) hoping to get away with their loot in the confusion of a riot. They seem not to have reckoned with England’s extraordinary network of surveillance cameras, or with the anger of the people (including the Pakistani storekeepers victimized by the looters), which has resulted in many arrests and the swift imposition of substantial prison sentences on the looters and now a movement to evict looters and their families from publicly subsidized housing. The evicted may be more prone to engage in criminal activity, but the hope is that the threat of eviction, and of collective punishment (family members along with the malefactor), will deter more riotous behavior than it encourages.

Riots-Becker

 

Riots must be due to basic forces underlying human and social behavior since they have happened throughout history in all parts of the world. Recent years have seen riots not only in Britain, but also in France, and China, to take only a few examples.  As Posner indicates, the United States has a long history of riots that date back to the revolutionary period in the 18^th century.  I will discuss a few ways to reduce the incidence and severity of riots, but the pervasive social behavior that cause riots will always be lurking in the background.

To understand riots it is useful to divide the population of any country or city into three largely distinct groups. Many men and women will basically obey the main laws under the vast majority of circumstances, no matter what others may do. A minority of individuals will engage in criminal behavior, such as theft, if the gains are large enough, and if they are not likely to be substantially punished. The third group comprises individuals who are law-abiding if people around them are law-abiding, but who can be triggered by events and the behavior of others into various acts of lawlessness.

The first group will essentially never participate in riots, while criminals will always participate if they see opportunities to steal and rob. Since riots are social phenomena, the third group of individuals forms the backbone of rioters since they may join in when others are rioting, and refrain from vandalism and stealing if others also refrain. The crucial point in understanding riots is that behavior dependent on what others do has an inherenly unstable component. This means that many overall outcomes are possible depending on various precipitating events. For example, since the willingness of some white families to live in a neighborhood may depend on how many white families live there, sales of some homes in the neighborhood to black families will encourage other white families to move out. Their departure in turn will encourage still other white families to move to other neighborhoods. The result is the well-documented phenomena of neighborhood “tipping” in a short time from having mainly white families to having mainly black families.

In the same way, riots develop when some events mobilize the social forces that attract some individuals to participate because others are. The English riots apparently started because London police shot a black male. Soon not only blacks but also many whites were rioting in London and a few other cities. The French riots in the fall of 2005 in Muslim suburbs started with the deaths of two Muslim teenagers outside of Paris indirectly blamed on the police, and soon engulfed many Muslim young men. Recent Chinese riots have resulted from the government’s confiscation of the property of farmers to use for the building of factories and infrastructure. Before long, many farmers with the same or other grievances against governments joined the rioting.

Fortunately, the behavior that induces individuals to join a riot when others are rioting is not immutable, but depends on many circumstances and on incentives. Rioters are mainly younger men, particularly those who are unemployed and have lots of time on their hands. The high unemployment rates of young French Muslim males who were not integrated into the French economy were a major factor behind the 2005 rioting there. The likelihood that many rioters will be apprehended and punished affects the willingness of many to participate in riots, especially individuals with much to lose from being arrested and punished. Police crowd control techniques and police efforts to address grievances in minority neighborhoods are also important in preventing some riots, or at least ending them more quickly once they have begun.

Since riots are the result of social behavior, it is no surprise that Facebook, Twitter, and other Internet-based forms of social communication played a part in generating the English riots. These social networks have been crucial in the “riots” against the autocratic governments of Egypt, Tunisia, Bahrain, Syria, and other Arab countries. These were political demonstrations against unpopular governments, but analytically they have similar behavioral structure to the economic and social riots in democratic countries. The ease of communicating over the Internet will surely lead in the future to greater group protests.

Since the social behavior that underlie riots are a fundamental part of human behavior, one cannot expect riots to disappear, especially given the growing power of social networks. However, reasonable steps can reduce their incidence and destructiveness. Firm but fair enforcement of laws by police and other government officials will reduce the likelihood of the sparks that often start riots, and will also raise the cost to those who use riots to steal and vandalize property. Good employment and education opportunities for the poor and minorities will increase their confidence that they can have a satisfying economic future if they obey reasonable laws and work hard. Democratic access to political protests and protection of personal and other property will improve respect for the laws.

Especially in the Facebook age, none of these and other sensible actions will eliminate riots. However, a good economic, social, and political environment will significantly cut down the incidence and cost of riots. That itself would be a major achievement.

The Challenge of Cyberwarfare and Cyberspying -Becker

 

In May 2010 the US military appointed its first four-star general to direct its defensive and offensive capabilities in cyber warfare.  China, Russia, and other major countries also have increased their skills in this new kind of warfare. All major banks and other companies, such as Google, continue to upgrade their protection against breaches of their information and computer network systems. The increasing dependence of both modern economies and modern weaponry on computer-based networks and online storage of information explains the rapid expansion of programs to repel cyber attacks, and to provide armies with significant offensive cyber capabilities.

Of course, modern warfare still relies on large numbers of combat military personnel. But the architecture of the military has become increasingly computer-based, with online communications, information storage, and other essential components that use cyberspace, or can be disrupted through attacks from cyberspace. Countries at war would gain an enormous military advantage if they could shut down the computer-networks of their adversaries for even a few hours.

Larger companies in developing as well as developed countries rely increasingly on the Internet and computer networks. Valuable information can be stolen, privacy of customers compromised, and internal and external communication made much more difficult when these systems get breached.

Warfare and espionage against government and private targets are not just hypothetical possibilities. After gaining independence from the Soviet Union in 1991, Estonia became a technologically sophisticated nation where the great majority of Estonians had access to the Internet, and much business was conducted online. Estonia suffered one of the first cyber attacks on a whole nation for a couple of weeks in 2007. Computer robot networks seized control over huge numbers of computers from many other countries, and used them to attack different targets in Estonia. These attacks crippled activities by the Estonian government, banks, and other businesses. Suspicion focused on the Russian government as the source of these attacks, but this could not be conclusively proved.

Georgia suffered severe cyber attacks slightly before the Russian invasion of Georgia in 2008. The attacks hit government websites, the media, banks, and other businesses. Georgia was more backward than Estonia, so these attacks on Georgia did not cause as much devastation as the earlier ones on Estonia, but they still inflicted considerable harm for a while. The timing and other evidence suggested again that Russia was behind these attacks, but no conclusive evidence could substantiate this belief.

Almost every day another company admits that its computer and online security systems has been breached. Often the attackers turn out to be hackers who just enjoy showing they can defeat even top of the line security firewalls. The culprits are sometimes criminals who seek information, such as credit card names and passwords, which they can use for financial gain. The hackers may also be governments that spy on companies in the hope of acquiring valuable proprietary information.

This week the American cybersecurity company McAfee issued a report that claims to identify a single government perpetrator  (alleged to be China) of large numbers of cyberattacks on other governments, companies, and even the United Nations. So far their claims have not been confirmed.

Combating cyberwarfare and cyberspying faces several unique challenges. Since cyberspace is not owned by any nation, and is easily accessed by billions of individuals and companies, it is often very difficult to get clear evidence about who is responsible for cyberattacks, such as the attack last year on Google’s source code, or the earlier attack on Estonia. Are they from governments that are probing for state and business secrets, or from private hackers seeking publicity, or valuable information that they can use for financial gain? If the source of the attack cannot be identified with much confidence, it is hard to establish a credible system of deterrence.

A second major challenge is the intrinsic vulnerability of many Internet and computer network systems. It has long been recognized that foolproof security systems do not exist, whether they be vaults, safes, identifications for checking accounts, or other traditional forms of protecting valuable assets. Any security system that protects information will generate efforts to access that information, including sometimes efforts by individuals who helped design these systems.

Since security systems that protect information in cyberspace are even more vulnerable, continuing battles take place against public and private hackers who probe for weaknesses in these systems. No company or government can ever hope to have a cyber-based system that cannot be breached, but they can make breaching more difficult.

The development of clearer international law about hacking would help deter attacks in cyberspace by private individuals and groups. Cyberattacks on military targets might be also brought before international tribunals, but countries have to prepare their own responses. These responses include cyber and other retaliations against cyberattacks during both wartime and peacetime on vital military network and information systems.

The Challenge of Cyber Warfare—Posner

Becker identifies the principal issues presented by cyber warfare—the difficulty of prevention and the difficulty of identifying the attacker, which is essential to effective deterrence. 

In assessing these issues, one needs to distinguish beetween hacking data and destroying data. The essential vulnerability of online data to hacking lies in the fact that, since the data are not physically enclosed (like documents in a steel safe), they can be secured against copying only by encryption, and any code designed to scramble a body of electronic data to make it unintelligible can be hacked from anywhere in the world. Unless the code is changed constantly (maybe every few seconds), the indispensable defensive response is to detect the hacking promptly and change the code. 

But hacking is a relatively minor problem—more in the nature of an annoyance than a serious injury. In the national security setting, it is a form of espionage, and espionage rarely inflicts more than marginal harm, in part because it a too-way street. And this is true of hacking: foreign countries hack our national security computer communications and databases, but presumably we hack theirs. 

The greater danger is the danger of destruction of online data (i.e., sabotage versus espionage). It could paralyze our conduct of cyber warfare and could also gravely disrupt the national electrical grid, the financial system, and communications generally. There have already been cases of successful cyber sabotage, notably of Iranian nuclear facilities. 

So cyber warfare is a real danger. But in that respect it is no different from nuclear warfare, which the world has managed to avoid, mainly by deterrence (threat of retaliation) but also by the taboo status that nuclear warfare has attained in the imagination of most people, including national leaders, over the last three-quarters of a century despite the proliferation of nuclear weapons and the relative cheapness and simplicity of creating and deploying them.

The problem with deterring cyber warfare is partly the difficulty of identifying the source of a cyber attack, which need not even be a nation (it could be a terrorist group—though there is also a danger that such a group could procure and deliver nuclear or biological weapons), and partly the difficulty of a feasible, effective response. Suppose the United States is the victim of a very serious cyber attack by a nation that has nuclear arms. How do we retaliate? If we use nuclear weapons, we risk counter-retaliation by nuclear weapons. If we use cyber weapons to retaliate, they may prove to be relatively ineffectual, either because the enemy has better cyber security or because it simply is less dependent on online data and communications for the management of its economy than the United States. We are confident that no nation could defend itself against a U.S. nuclear attack, but we can’t be confident about our ability to devastate an enemy nation with a cyber attack. 

What makes cyber warfare particularly insidious is that it is extremely cheap. It requires no raw materials, like uranium, no processing, like enriching uranium, and no delivery vehicles, like missiles carrying nuclear weapons. In these respects biological warfare is similar, but it is indiscriminate—it is difficult to shield the attackers from contagion. That is not the case with cyber warfare. And to prevent the proliferation of cyber warfare capabilities is impossible, because they are inexpensive, requiring basically nothing more in the way of inputs than software scientists and engineers. An international convention with inspections by an international agency analogous to the International Atomic Energy Agency would be unworkable because the cyber “warriors” would not work in identifiable facilities and because cyber weapons are immaterial rather than material entities. Of course the cyber warriors use computers but the computers are multi-purpose—they don’t identify themselves as weapons. 

Although at present defense against cyber warfare is very difficult, and indeed seemingly ineffectual, a pooling of the civilized world’s computer expertise in an international effort to secure computer networks and databases against online espionage and (especially) sabotage, as well as to create redundancy in such networks and databases that would enable their essential functions to be maintained even after a large-scale cyber attack, would certainly be a worthwhile undertaking. There are indications of cooperation between the United States and close allies such as the United Kingdom and Israel. Let us hope that international cooperation in cyber defense is expanded and adequately financed.

The Depression, the Deficit Debacle, and the Debt-Ceiling Crisis—Posner

The economy faces a short-term problem, a medium-term problem, and a long-term problem. The short-term problem is the debt ceiling, the medium-term problem is the depression that the economy is still wallowing in (the orthodox description of it as a mere “recession” that ended in 2009 is misleading), and the long-term problem is entitlements for old people—Medicare, social security, and (to a lesser extent) Medicaid, which to a significant degree operates as medigap insurance for many old people. The three problems are intertwined. The third, the long-term one, may well be the most serious. 

The debt ceiling—a dollar limit on debt owed by the federal government, which can be increased only by Congress’s enacting a statute raising the limit—is a dysfunctional method of legislative control over government expenditures.  Without the ceiling Congress could still limit borrowing by the Treasury, but it would have to do so by passing a statute. The existence of the ceiling means that enacting a statute is necessary to permit borrowing above whatever amount was specified as the ceiling the last time it was raised by statute. It is harder to pass a new statute than to defeat a proposed statute, and so a determined legislative faction may be able to extort unreasonable concessions by threatening to block the enactment of a statute raising the ceiling. If the intended victims of the extortion balk, and a game of chicken ensues, the statute may not pass; and if as a result the debt ceiling is not raised, when as at present the government must borrow to have enough money to fulfill its expenditure commitments, very serious consequences can ensue. At present the federal government is spending about $300 billion a month, of which about $83 billion is borrowed. If it cannot borrow that amount any more, because every time it borrows (unless it’s just rolling over a loan) its debt rises, it will be unable to fulfill its spending commitments. It will not default in the technical sense because its tax revenues are sufficient to service the debt, but contractual debt (bonds and the like) is not the only unavoidable expense of the federal government: there are both the normal civilian and military costs of running the government and the huge entitlements on which a significant fraction of the population is dependent. Inability to pay these costs would be de facto insolvency. 

The drastic curtailment of federal expenditures if the debt ceiling were not raised would have a devastating effect on the current very weak economy, because $83 billion in monthly spending cannot quickly be replaced by private spending; it’s not as if $83 billion were being shifted from the government to the private sector. It would mean taking a trillion dollars a year out of the economy. Maybe private foundations would take up some of the slack, but if so they would be diverting money from other recipients of the foundations’ largesse rather than increasing the net amount of cash available for consumption, unless they diverted money from overseas recipients.

There would be some long-run benefits from eliminating further federal borrowing. The benefits would lie mainly in forcing governmental economies and reducing the annual interest expense of the government. Rational-expectations economists would argue that foreseeing lower taxes in the future would stimulate consumers and businessmen to spend more than now. But consumers, investors, and businesses might be held back by uncertainty; and certainly the short- and medium-run dislocation of an already weak economy could be catastrophic. The reduction in government expenditures could not be matched immediately by an increase in private spending, so overall economic activity would plunge. 

The current weakness of the economy cannot be overemphasized. Adjusted for inflation, GDP has fallen since 2007 by 0.4 percent. That means that per capita GDP has fallen significantly because of population growth and that current GDP is almost 10 percent below the GDP trend line of 3 percent a year. There is a better argument for the Fed’s stimulating inflation to reduce mortgage and other consumer debt in real terms than for Congress’s cutting government expenditures. 

An irony in the present situation (and a powerful argument against Republican proposals to lift the debt ceiling for only six months in order to force reductions in government spending that would be necessary to induce House Republicans to support a further increase in the ceiling at the end of that period) is that the actual proposals for debt reduction are meager and probably illusory. Under the deal tentatively agreed upon yesterday the initial cut will be just $900 billion spread over the next ten years, which would amount to only $90 billion a year, or less than 10 percent of the annual deficit in the federal budget. And this is on the assumption that the deficit won’t grow. But it is quite likely to grow. True, if the economy recovers, tax collections will increase because incomes will be rising, and even without increased tax collections the deficit as a fraction of GDP (which is what’s important—not the absolute size of the deficit) will fall. But against this is the likely rapid increase in entitlements, primarily Medicare and social security, as the over-65 population continues its relentless growth. The only measure to slow this increase that seems politically feasible at present is to change the formula for calculating annual social security cost-of-living increases. A sure sign of the phoniness of the rival Democratic and Republican plans to cut government expenditures was that both rely heavily on a crackdown in Medicare “waste and fraud.” 

The deal tentatively agreed to calls for further cuts (or tax increases) of about $1.5 billion, also spread over the next ten years, to be proposed by a bipartisan commission and take automatic effect unless Congress acts—as it could do: it could decide to rescind the cuts. Alterations in social security have been taken off the table; and the only cuts in Medicare that the negotiators are permitted to order are reductions in reimbursement of hospitals and physicians—that will have only an indirect effect on the expense of Medicare, by lengthening waiting time for medical services, and that will create pressure to rescind the reductions. 

As with adjusting the social security cost of living formula, and the successful effort in the 1980s to raise the eligibility age for social security gradually, large-scale reductions in entitlements are feasible only if phased in gradually—which would have to be done anyway in order to avoid a serious jolt to the current weak economy. The problem is that Congress cannot make credible long-term commitments to reduce spending because it cannot bind subsequent Congresses. The problem is exacerbated by the fact that both political parties are much fonder of increased spending than of increased taxes, so there is built-in momentum for increased government debt. The Republican radicals in the House of Representatives recognize this problem and their frustration is understandable, but national insolvency is not an intelligent solution.

Immediate and Medium Term Debt and Deficit Problems-Becker

 

As Posner indicates, the US is facing an immediate debt problem, a medium term deficit problem, and long-term debt and deficit problems. We have discussed several times the long-term fiscal problems (see, for example, my discussions on 11/07/10 and 7/17/11), so I will concentrate here on the shorter-term deficit-debt issues.

With the sole exception of the mid-1990s, the federal debt ceiling has always been raised on time during the past 60 years to accommodate the growing level of the debt. Although little time remains to raise the ceiling I do not believe either party will risk the political fallout from not adjusting the ceiling before the government effectively defaults on its obligations. Certainly Republicans remember the political cost to them after the Gingrich-inspired shutdown of the federal government in 1995. So I would be quite surprised if a deal is not reached this time before the US government is forced to delay payment on some of its implicit obligations, such as Medicaid and Medicare payments.

Of course, an absolute ceiling on the debt that is just raised continually makes little economic sense. Clearly, the relevant size of government is not measured by the absolute level of its debt since large economies tend to have much more debt than do small economies.  Better metrics of the debt burden would be the ratio of debt to GDP, or the ratio of interest payments on the debt to GDP, or perhaps the share of interest payments in total government spending.

Even the ratio of government debt to GDP does not measure the size of the government’s impact on the economy. The present and future impact is better measured by the ratio of government spending to GDP, including any trend in this ratio, plus various harder to calculate measures of the magnitude and scope of government regulations in product, labor, and capital markets.

The major legitimate concern over the growing federal government impact on the economy comes from the rapid growth in the share of government spending to GDP during the past several years. Moreover, this share is projected to continue to grow in the future unless GDP grows by at least 3% per annum over the next 20 years and effective controls are introduced over entitlements for the elderly.

The share of federal government spending to GDP hovered between 18% and 21% from 1995 to 2007, when it was 19.5%. During the next three years, government spending took off and grew rapidly, GDP stagnated, and the ratio of federal spending to GDP reached 25% in 2009. This share is projected at about 25% in 2011. Some of the growth in federal spending was needed to fight the financial crisis, but much of the increase also reflected the desire of many in control of the federal government to increase its role in the economy.

In a Wall Street Journal op-ed piece by George Shultz, John Taylor, and myself on April 4^th (Time for a Budget Game-Changer”) we lay out a general strategy to gradually lower this share once again to 19.5% by 2021. This strategy reduces government spending by a mere $19 billion in 2011, or only by about 0.1 percentage point of total federal spending. It also allows nominal federal spending to grow on average by 2.7% per year from 2010 until 2021.

Our approach also assumes that nominal GDP will grow by 4.6% during this eleven-year period. Since GDP is assumed to grow considerably faster than government spending, the share of government in the economy is reduced by over 4 percentage points by 2021. If we assume (optimistically) an average inflation rate of 1.7% per year during the next decade, our analysis allows government spending in real terms to grow from its already high level in 2010 by 1% per year until 2021.

The assumed growth in real GDP (after adjusting for the assumed 1.7% annual inflation rate) is a little less than 3% per annum over this period, with about 1% growth per year due to increases in the American population. Three percent per year in real GDP is the long-term growth rate of the American economy since 1880. This is considerably below the usual growth rate of GDP in a decade after a major recession. This is why I believe three percent growth is achievable with tax reform (that would include some tax increases), and with major controls over the growth of spending.

Keeping real federal spending growth to 1% per year will be a huge challenge since entitlements, like Medicare, will grow much faster than that over the next decade without sizable entitlement reforms that greatly cut their cost to the government. Still, the spending growth rate is doable. A major start would be to cut back some of the sizable expansion of federal spending since 2007. That combined with serious reforms that cut government spending on Medicare, especially for the elderly with decent financial means, would go a long way toward keeping the real growth of federal spending in the range of 1% per year for a decade.

Added Monday: first reactions after news surfaced of the possible budget compromise.

The details of the compromise are not yet clear, but apparently Medicare and other entitlements will not be affected, with one exception. Payments to hospitals and insurance companies for the services they provide or finance will be cut, which will either lower the quality of services offered or induce greater waiting times for medical services.

The compromise seems at this point better than doing nothing. But much more will have to be done, rather than simply promised for the future, in order to limit the growth in real federal spending to not much more than 1% per year.