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Abundance is overcapacity

Ezra Klein called it "supply-side progressivism". Derek Thompson called for an "abundance agenda".

If you hold liberal, progressive values and you want a better world, your project will be much easier when the economy is objectively delivering for people and opening up possibilities, rather than when politics seems like a zero-sum game and we are fighting to divide an inadequate pie.

I agree with Klein and Thompson, and applaud the impulse. Abundance is good per se, and it is also good for us in moral terms. Fascism subsists off of scarcity. The atrocities it demands are justifiable to human beings of ordinary virtue only as a matter of grim necessity, because it is us or them.

Klein and Thompson offer a variety of ideas about why abundance seems to elude us. There's a lot of emphasis on ways that public policy can hinder abundance. Permitting barriers thwart new housing and infrastructure. We sabotage industrial policy with "everything bagel" demands, asking firms we subsidize to offer union jobs and child care and other goods that, however laudable, are costly, and may undermine the core goal of building capable, competitive industries.

Promoting an "abundance faction", Robert Saldin and Steven Teles write

The state that America built in the 1960s and 1970s was, at its heart, regulative. From civil rights to environmental protection, its animating obsessions were things that it wanted to prevent from happening, such as racial and gender discrimination, nuclear disasters, highways through central cities, industrial accidents, dangerous toys, and environmental pollution. While much of this regulation was geared to private action, a great deal of it came to apply to the public sector as well. From the creation of compliance divisions inside of firms to the expansion of standing to sue to rules on public participation in government decision-making, the state that we created a half-century ago had the effect of displacing or slowing down the parts of organizations — public and private — focused on the delivery of goods and services. The aggregate effect of that state has been a widely diffused expectation that more or less everything that operates in physical space will take an extraordinary and unpredictable amount of time and be disappointing and uninspiring in its results.

All of these authors make excellent points, some of which withstand criticism, some of which I think do not.

But it is a bit dispiriting, 40+ years after the election of Ronald Reagan, that so often the explanation for Amerisclerosis boils down to "deregulation has never really been tried."

Really? If the Reagan revolution and its enthusiastic embrace by Democrats and Republicans under Clinton, Obama, and both Bush administrations were not sufficient to make deregulation great, is it plausible that a new deregulatory "abundance faction" is the best way forward?

Perhaps these ideas that first came into vogue in the late 1970s do not capture the whole story. Perhaps it is not, or not just, the public sector that thwarts the great abundance machine of American capitalism. Perhaps the machine is flawed. It thwarts itself. Perhaps its very design incorporates elements that promote scarcity rather than abundance.

If so, if we can understand how, we could tinker with that design, and fix the problem. We needn't overthrow capitalism, or socialize the means of production. There are many possible capitalisms. We could choose a better version.

Under capitalism, a firm can achieve pricing power — the ability to raise prices without losing customers — in a variety of different ways. It can produce at higher quality than its rivals, for example.

But how do whole industries achieve pricing power? If an excellent firm can command higher prices by virtue of quality, what defines the baseline price the firm gets to exceed?

In competitive industries with only variable costs, the cost of inputs provides a floor. But in industries that require expensive fixed capital, especially highly competitive industries, firms must tacitly coordinate.

They coordinate not to control prices, nor to restrict output that their factories could produce, but simply not to build so many factories. If there are too many factories — "overcapacity" in the lingo — competition will bring prices below what producers require to recover the cost of building the factories in the first place. This phenomenon of firms tacitly coordinating to limit total industry capacity has a name, "capital discipline".

Is "capital discipline" illegal? I don't know. I suspect it'd be hard to punish. It's one thing to prosecute a monopolist for refusing to produce at capacity, preferring to raise prices. It's quite another to prosecute a firm in a competitive industry for choosing not to invest, for not building a new factory, because the firm fears that if it does add capacity, prices might drop below what would allow it to recoup its costs. Prosecuting that seems like a stretch, even if the firm's existing factories are running flat-out and its goods are selling profitably.

Further, under our current capitalism, whether or not it is legal, capital discipline is necessary. Except in extraordinary circumstances, we expect firms to thrive or die on their own revenues, with no state subsidy. Yet firms are also supposed to compete vigorously and let price approach marginal cost. In high fixed-cost industries, the only way to reconcile these two admonitions is to ensure that capacity is constrained at an industry level. If we had an antitrust so stringent that it prosecuted capital discipline, every firm in every high-fixed-cost industry would go bust.

You often hear business commentators opine that an industry "needs to consolidate", for "efficiency". If you ask, those commentators will usually say it's because there are technical economies of scale that smaller firms cannot fully exploit.

But technical economies of scale exhaust themselves long before the degree of consolidation that is common and considered "efficient" in the contemporary United States. What people really mean by "efficient consolidation" is an industry sufficiently consolidated that its firms, competing vigorously, can survive full business cycles without going bust for failing to cover their high fixed costs. Efficiency, in this sense, is managed scarcity.

You can see, then, that there might be some tension between this version of capitalism and an abundance agenda. So long as the economy we imagine is one in which unaided, purely private firms are expected both to vigorously compete and to survive, then high-capital industries must engineer scarce capacity.

Yes, yes, those bastards. Perhaps they overengineer scarce capacity. They do have shareholders to please, executives to enrich.

But even if they did not, even if firms' goal was to just barely recoup fixed costs, they would have to engineer scarce capacity. Then we wonder why this great machine of American capitalism fails to yield "abundance".

What do we even mean by "abundance"?

We don't mean "glut". Glut is when firms produce more goods than customers will buy, and see them collect dust as inventory. That's not what we're after. Sure, for some critical goods, we might want a buffer stock. But then we'd pay to buy and store the goods, like the Strategic Petroleum Reserve.

I'd posit that when we ask for abundance, what we want is inexpensive price elastic supply. We don't want more goods produced than are demanded for purchase. But we do want new demand to be accommodated with an expansion of quantity, rather than rationed with an increase in price. We don't want excess goods. We want spare, slack, production capacity.

In other words, we want the resting state of American industry not to be just enough capacity, efficiently used. We want excess capacity, inefficiently unused. The cost of this "inefficiency" is overcome by a benefit both private and social — the ability of firms to ramp up production at stable prices should conditions change.

The core of an abundance agenda, I posit, would be to reshape American capitalism so that overcapacity, rather than capacity nearly fully employed, becomes the norm. At desirable overcapacity, the marginal cost of a new unit would sit approximately at the minimum of firms' marginal cost schedule, well below the level where costs meaningfully rise.

Firms can't do this on their own. Under capitalism, the means of production are in private hands, but production is always a public-private partnership. That firms use public roads and rely upon public regulation does not render our economy socialist.

An abundance economy should rely upon private firms competing aggressively, pursuing pricing power through quality and innovation, rather than by engineering scarcity. But if we want industries to eschew capital discipline, if we want firms to deploy capacity at levels that would undo the pricing power scarce capacity yields, the public sector will have to subsidize capital deployment.

The public sector should do just that.

draft by Steve Randy Waldman
2024-09-17 @ 04:55 PM EDT

Another man's poison

  • This post was meaningfully revised at 2024-09-13 @ 12:15 AM EDT. The previous revision is here. (See update history.)

I don't think a sovereign wealth fund is a thing one can intelligently be "for" or "against", generically. That's like being asked to take a position on chlorine. I'm against chlorine if the proposal is I should breathe it. I'm for chlorine as part of a water purification process. You really do need to be more specific. There are versions of social wealth funds that I'd oppose, others about which I'd be enthusiastic. I did a talk on the subject several years ago, if you have an hour to kill.

I think people focus too much on the asset and benefits side of social wealth fund proposals, and too little on the effects of how the funds might be financed. In an American context, much of the reason to want a social wealth fund is to divert financial flows from where they would otherwise go.

For example, here's Tyler Cowen:

It is true that the expected rate of return of the US stock market is higher than the US government’s borrowing rate. But what matters is the net social increase in investment value, not the nominal returns on the government’s portfolio. If the government buys some of my mutual funds, for instance, and it earns the 7% return that I would otherwise have earned, there is no net increase in social value. On paper, the sovereign wealth fund looks like a big success, but the government has simply issued more debt and redistributed some equity returns away from the citizenry and toward itself.

Cowen elides questions of distribution. Who is this "citizenry"? To whom do equity returns actually go?

While much of the public owns some shares, fully the majority of US stock market wealth, in dollar terms, is owned by the richest 1%. Only 7% is owned by the bottom 90%.

The government "[r]edistribut[ing] equity returns from the citizenry and toward itself" has another name. It's called a tax. It's a tax that falls almost entirely on the rich, but is experienced painlessly, in the form of returns foregone relative to a counterfactual. The rich find themselves with just a bit less opportunity to get richer.

I wrote about precisely the phenomenon Cowen describes in 2018:

A sovereign — er, social — wealth fund is a taxation machine. It is an automatic taxation monster. It takes the miracle of compound growth that capitalists are always on about and turns it into a miracle of compound taxation, effectively taxing wealthier cohorts (those who would otherwise own the SWF assets) an ever increasing share of income year after year without requiring any new legislation, and with minimal distortion of investment behavior.

To see how this works, let’s imagine that we want to simulate the flows of an SWF+UBD. We’ll imagine a very simple scenario. Let’s define a “notional” SWF. The SWF is going to be financed by a tax enacted just once, which will yield $1T in Year 0. The tax take will grow with nominal GDP, which we will model as growing at 5% annually. Beginning at the end of Year 1, the SWF will make payouts. For simplicity, we will base payouts and returns on the end-of-prior-year balance. That is, we are conservatively assuming that the taxes we collect within a year are unavailable until the year following. We will assume a constant rate of investment return of 8% per year. Echoing Bruenig’s proposal, we will have the SWF payout 4% of the prior year balance each year.

However, instead of actually forming the SWF, let’s say that the government were to decide that there’s no need to intervene in the miraculous private sector with actual state ownership, that the assets can remain, um, efficiently managed in private hands but the government will simply use the tax system to reproduce the flows an SWF would generate. As it would if it actually formed the SWF, in Year 0 it would enact a tax, which would raise $1T. At the end of Year 1, it would have raised an additional $1.05T from the same tax. The notional SWF would have enjoyed the same $1.05T as new contribution. However, the notional SWF, if it had actually been constituted, would have also earned $0.08T as investment returns. In order to simulate the SWF flows, the state would have had to adopt a new capital tax of $80B. In Year 2, we have the same effect again. The originally enacted tax now raises $1.1025T, and the new Year 1 tax brings in $84B (assuming that both grow in line with GDP), for a total intake of $1.1865T. However, investment returns on the prior year SWF balance of $2.09T would have yielded $167.2B, which when added to the same take of $1.1025T from the initial tax, yields an inflow of $1.2697T. So, to bring the total inflows in line with what an SWF would have done automatically, the government would have to impose a new tax of $83.2B.

And so on. Each year, to reproduce the same net flows from private capital holders as would “naturally” have occurred had there been a SWF, the state would have to enact a brand new tax, in addition to still collecting the taxes enacted in prior years. Under our assumptions, each year’s new tax is slightly smaller as a share of GDP than the prior year’s, but in reality, that would depend upon investment returns, gdp, and dividend payouts. Whenever investment returns net of dividend payouts exceed GDP growth, the effective new tax that would need to be imposed on capital holders becomes larger as a share of GDP than the prior year’s tax. (Here’s the little Mathematica simulation the numbers in this section are drawn from: [pdf][nb])

We can all, as Mike Konczal put it on Twitter, “spitball” about politics. But I think it fair to say that it would be difficult to sustain the political will to cumulatively impose new taxes on capital holders, every year, year after year after year over a period that might span decades. But the “gimmick” of actually using the proceeds from a single tax, enacted once and continued indefinitely, to purchase capital assets, generates the same effect as this compounding tax schedule in a way that seems natural and inevitable and legitimate under the norms of present-day capitalism. If we accept that other capital holders get to enjoy the miracle of compound returns, why shouldn’t a fund owned in equal shares by all citizens get to enjoy the same? Actually constituting a SWF delivers a regime of effective taxation that, I think it is fair to say, ordinary politics simply could not.

If you think it is a good thing to let the "miracle of compound growth" cumulate endlessly in wealthy private hands — creating permanent, ever-expanding gaps between the rich and the less rich, entrenching a system of wealth-stratified caste — then yes, you should oppose the state "[r]edistribut[ing] equity returns from the citizenry and toward itself".

If, however, you think letting compound growth continually expand the advantage of the already wealthy is not great, if you dislike living in a society whose economic, political, and cultural life is increasingly vandalized and held for ransom by mad billionaires, then perhaps it would desirable to divert equity returns away from "the citizenry" and towards purposes whose benefits will be much more widely shared.

The state, of course, is corrupt as fuck. But in its worst corruption, nothing that the state does at scale results in benefits as lopsidedly plutocratic as the dollar distribution of investment returns when they compound in private hands.

Update 2024-09-13: For the record, I would not support a social wealth fund that was financed by the state issuing debt or money to buy up stock in ordinary times, despite the (fragile unless state-supported) claim that "the expected rate of return of the US stock market is higher than the US government’s borrowing rate". That would create windfall profits for the bloated and parasitic finance sector, and it would give back some of its distributional benefits by bidding up the price of equities which, for the forseeable future, would remain primarily in the hands of the privately rich.

I would support an equity-holding social wealth fund financed from progressive new taxation. Taxes that kick in only at high income brackets divert flows that would otherwise have been devoted almost entirely to purchasing portfolio assets. A social wealth fund financed with such flows thus represents a rotation of demand for these assets from the private to the public sector, rather than a new bid that would accelerate increases in the price or rate of issuance of financial assets.

Under rare circumstances, I might support debt-financed purchase of securities into an SWF, at collapsed prices and excellent forward-looking valuations, as a component of macrostability interventions. There are always devils in details, but here there are also devils in suits, Wall-Streeters who'd love to use the Federal government as a gigantic source of dumb money, to earn commisions from, and to offload crap to. Overall I treat suggestions to use new debt issuance rather than taxation of private-sector financial asset purchasers very cautiously.

draft by Steve Randy Waldman
2024-09-12 @ 02:30 AM EDT

Income driven repayment of fixed capital

High-fixed-cost industries are difficult to reconcile with competitive capitalism. Under competition, price falls toward marginal cost, which excludes the cost of fixed capital. Firms earn at least the incremental cost of producing an additional unit, but they don't recoup the cost of building the factory that made it possible, absent some form of pricing power.

In introductory economics textbooks, pricing power is imagined to result from firms exiting the market until industrywide capacity constraints bring marginal cost above average variable costs. For industries whose fixed costs derive from durable capital, this story doesn't actually work, because built capital survives firm exit and remains exploitable by new (or bankruptcy-reorganized) firms.

Industry pricing power derived from limited capacity is also just undesirable. It leaves society without the option to expand production quickly when circumstances or preferences shift, like after a pandemic.

In an uncertain world, option value is real value. We want our industries in a state of "overcapacity", so they inexpensively expand production when demand increases, rather than price-ration constrained supply.

Unfortunately, our collective, social interest is quite opposite firms' private interests. The invisible hand gives us the finger.

Social option value derives from our economy's capacity to expand quantities produced, with minimal price increases, under unexpected demand. But to firms, "excess" capacity is a cost. Should demand spike, producers profit more if constrained capacity forces price rationing and high markups rather than elastic new supply. Firms gain private option value precisely by destroying social option value.

So, industries will coordinate and consolidate to prevent overcapacity, if we tolerate it. Their pricing power — both under baseline conditions and during demand spikes — becomes the public's cost. If they gain pricing power in excess of what is necessary to cover the cost of fixed capital, the result is rent extraction by producers and deadweight loss from demanded goods never supplied. For important goods — products that might become necessary promptly in the event of a public health emergency or (God forbid) a military conflict — the deadweight cost of constrained capacity might be existential.

It is efficient, then, to subsidize capacity and the social option it creates, rather than to subsidize incapacity by tolerating industry consolidation and pricing power.

But how?

I propose we offer the subsidy, as China does, in the form of underpriced finance. Like in China, our subsidy should take a form that overcomes the incompatibility between high-fixed-cost industries and vigorous competition. Our high-fixed-cost industries should have tens of competing firms, rather than collapse into "Big 3" oligopolies with pricing power and negative social option value.

Unlike China, I propose we offer this underpriced finance openly, via transparent instruments whose embedded subsidy we all understand and acknowledge. Here's how it would work.

In strategic industries, firms would be able to petition the state for loans to build production capital. But rather than have a fixed repayment schedule, the payment due over any time period would be a function of the number of units sold.

Should goods sell briskly, firms might fully repay the loan, including interest at the agreed rate. Should goods sell slowly, the firm might never fully repay the loan. When a pre-agreed depreciable life of the purchased capital expires, any unpaid balance on the loan would be forgiven. Firms would be required to produce and offer goods for sale for the full depreciable life of the capital in order to enjoy loan forgiveness.

The effect of this proposal is to eliminate fixed capital costs, and instead convert them to marginal costs.

Note this is quite different from, say, renting capital goods, or using ordinary borrowing to finance them. These traditional approaches help space out the burden of capital costs. But those costs are still invariant to later production choices. Firms have to make payments regardless of whether they sell. If firms have excess capacity, they benefit relative to not selling if they produce and then sell for just over marginal cost, even if that price cannot cover the cost of fixed capital.

Under the proposed new instrument, firms only have to pay the capital cost allocated to a given unit if and when they actually sell the unit. Capital costs are not invariant to their production choices. Firms only produce and sell when their anticipated sales price covers not only the marginal production cost, but also the capital repayment burden they incur only with the sale.

This reasoning would be mistaken if the repayment burden was so high, relative to expected sales, that firms would end up repaying the loan in full with near certainty. If that were the case, there'd be no subsidy in the loan (assuming a market interest rate). It would be something like a bank line-of-credit with less discretionary repayment terms.

But the point of this proposal is to finance capital goods beyond the level that industries would otherwise privately choose to invest. The full repayment point would be set at a level that could be achieved only with a pace of sales substantially brisker than a typical firm would anticipate — even with prices aggressively disciplined by competitors — under baseline demand conditions. At an industry level, the state would offer these vehicles to many contending firms, under terms where the average firm would not quite fully repay them. So, for most firms, repayment avoided from eschewing an underpriced sale becomes a genuine economic gain, not a mere rejiggering of the timing of payments.

Firms would retain incentive to compete on quality, even as the competitive environment renders them very close to price-takers. The highest quality firms would sell to their full capacity, and so would fully repay their loans, and then enjoy pricing power set by the increment in marginal cost these repayments impose upon more typical firms. Selling past the full repayment threshold converts part of the industry price to economic profit above and beyond covering the cost of fixed capital. For a relatively few big winners, the market awards a trophy even though the state provides no subsidy.

More typical firms, the firms that are not big winners, do not go bankrupt. They do not exit. They survive, earning ordinary accounting profit, near-zero economic profit, providing spare capacity. They become institutional embodiments of social option value, for whose survival the state pays a premium — the portion of the loan that will ultimately be forgiven.

It may be desirable, as a matter of market discipline, to arrange that the lowest quality producers do in fact go bankrupt and exit. We can get this effect by funding fixed capital with a mix of our "income-driven repayment" vehicle and traditional amortizing loans. Holding constant the aggregate capital financed and the number of firms, the more we use amortizing loans, the more market discipline we impose, but the less capacity we endow in expectation. 1

To emphasize, this new financing vehicle is not intended as a firm-level arrangement. It is intended to be provided at the level of industries that we consider strategic, for which there is important social option value in maintaining competitive domestic capacity. We would provide it to tens of firms in industries we target, not to one or two favored incumbents.

I have recently argued that we should learn from China's economic model, but adapt it to Western institutions and values. This proposal represents a means of providing the subsidy at the heart of that model — payment of the premium on valuable social options.

But our mechanism is open and straightforward. It does not rely upon loans that become overvalued on effectively fraudulent balance sheets of banks and local government financing vehicles.

"Income-driven repayment of fixed capital" would constitute a transparent means of providing subsidized finance to strategic industries in a manner that encourages competition, capacity, and quality.

  1. Given the low expected profitability of typical firms, the share of any amortizing loans in the financing mix should be low, if we intend for Mistress Market to cull only the worst perfomers. All of these loans would be secured by the capital goods purchased. Failed firms would surrender the capital goods back to the state, which would not offer them cheaply to new entrants, but either scrap them or offer them to new firms on comparable repayment terms, in order to maintain cost parity and the terms of competition established.

    ↩
draft by Steve Randy Waldman
2024-09-04 @ 12:50 PM EDT

No which tax on tips? Let it be FICA.

Both Donald Trump and Kamala Harris have promised "No Tax On Tips". Tax experts generally argue it's a bad idea. Whatever rules you invent to cabin what counts as a nontaxable tip, people will work pretty cleverly to reclassify their own income as that to avoid paying taxes.

"No Tax On Tips" is intended to help lower-income service workers — waiters and bartenders, perhaps manicurists and hairstylists — not, say, hedge fund managers who are arguably also in a "service" occupation. Yet, in the discussions I've encountered, the presumption is the "tax" referred to is the income tax.

But that's idiotic! Low-end tipped workers pay far more tax on their tips as FICA taxes — the employee portion of Social Security and Medicare taxes — than they do as income taxes. If the intention is to help low-end service workers, we should interpret the pledge as referring to Federal payroll taxes, rather than the income tax. This would not be welching on the promise candidates have made. It would fulfill the promise more completely, by offering more relief to the groups targeted than income tax relief would.

A "no FICA tax on tips" pledge does not entirely prevent gaming to avoid the tax. But, when combined with occupational limitations and penalties for fraudulent claims, it will prevent nearly all gaming of the proposal by higher income earners. At higher incomes, the vast majority of ones Federal tax burden is the income tax. The higher ones income, the lower the relative burden of the payroll taxes. High income people won't risk criminal liability for fraud to evade a small fraction of the taxes they face.

If the employee-side FICA tax on tips were simply eliminated, that would harm the solvency of the Social Security and Medicare trust funds, and reduce the benefits tipped workers could expect to receive. Fortunately, we've already addressed this problem on the employer-side, so we know what to do.

There is already a FICA Tip Credit that food-service employers can claim against the FICA taxes they pay on tips. (The credit was enacted as a means of increasing employers' motivation to ensure that tip income is reported.) The FICA Tip Credit is an income tax credit, granted after contributions have already been mad to the trust fund. So it does not affect trust fund contributions.

Suppose we do the following:

  1. Leave tips notionally taxable as they are.

  2. Enact a refundable, employee-side FICA Tip Credit for the full amount of Federal payroll taxes due on applicable tips.

  3. As we did with the expanded Child Tax Credit, have the IRS remit payments of the tax credit monthly. Funds would be disbursed directly to the Social Security and Medicare trust funds, on each employee's behalf.

  4. Do not withhold FICA taxes from tips.

Pay stubs would show total Social Security and Medicare taxes due, then the credit for FICA taxes on tips, reducing the total withheld.

Tipped employers would get paid the full value of their tips, without any Federal payroll tax deducted. If their incomes are high enough to be subject to income tax withholding, they would still suffer that. But that's small potatoes for lower income workers.

Overall, lower income workers would enjoy much bigger paychecks than they would have under a "no income tax on tips" interpretation.

Workers would experience no penalty in terms of future Social Security and Medicare benefits from the program.

And it just wouldn't be worth it for high-income workers to try to fashion themselves cosmetolologists for a small tax benefit and large risk of jail time.

draft by Steve Randy Waldman
2024-08-25 @ 07:50 PM EDT

Competition and the form of the subsidy

The virtues of a market economy derive largely from competition. But for many goods and services, it is almost incoherent to talk about competitive provision.

As J. W. Mason explains (ht Steve Roth):

The usual situation in a modern economy...is flat or declining marginal costs. Non-increasing marginal costs, nonzero fixed costs, and competitive pricing cannot coexist: In the absence of increasing marginal costs, a price equal to marginal cost leaves nothing to cover fixed costs. Modern industries, which invariably involve substantial fixed costs and flat or declining marginal costs at normal levels of output, require some degree of monopoly power in order to survive. This is the economic logic behind patents and copyrights — developing a new idea is costly, but disseminating it is cheap. So if we are relying on private businesses for this, they must be granted some degree of monopoly.

The problem is, once we agree that some degree of market power is necessary in order for industries without declining returns to cover their fixed costs, how do we know how much market power is enough? Too much market power, and firms can make super-normal profits by holding prices above the level required to cover their costs, reducing access to whatever social useful thing they supply. Too little market power, and competing firms will be inefficiently small, drive each other to bankruptcy, or simply decline to enter, depriving society of the useful thing entirely. Returning to the IP example: To the extent that copyrights and patents serve an economic function, it is possible for them to be either too long or too short.

One way or another, the answer to this conundrum of high fixed costs, low variable costs, is and always has been state subsidy.

What are copyrights and patents, really? Here's Dean Baker:

At the most basic level, we have to understand that patent (and copyright) monopolies are a way the government pays for things it wants. Instead of using government funds to pay drug companies to develop new drugs and vaccines, we reward them with a patent monopoly...

In the government’s accounting, we treat patent monopolies and spending very differently. The grant of a patent monopoly does not appear in the government’s budget, so we can award these monopolies as an alternative to direct spending if we want the deficit to appear smaller.

We sometimes have literally gone this route of using a patent monopoly, or an equivalent grant of exclusivity, as a substitute to direct spending. In the case of prescription drugs, in order to get drug companies to do pediatric trials, the government will award a company a six-month period of exclusivity, beyond any patent duration, in order to pay for the trial. 

The government could just pay the money directly for the pediatric trial, but this would be a direct expenditure that adds to the deficit. If instead it adds six months to a patent, the company is paid by being able to charge higher drug prices for this period. In effect, the government is allowing the company to tax patients to cover the cost of the trial...

The idea of selling the ability to tax is not new. Centuries ago, it was common for governments to do tax farming, which effectively meant that it sold the right to impose a certain tax for a set period of time.

Suppose the government sold off the right to collect the estate tax for the next two decades for $1 trillion. The deficit hawks could all be very happy because our debt would now be $1 trillion lower, but anyone capable of logical thought would see that this has not relieved the burden of the debt on our children one iota.

It is the same story with patent rents.

And it's not just patents and copyrights.

The state could in principle operate a comprehensive and vigorous antitrust regime. In practice, the state purposefully tolerates varying degrees of consolidation in many industries. Why?

Corruption? Capture? Of course that's part of it.

But there is also the true fact, which policymakers do understand, that insisting on Econ-101-style "perfect competition" for high-fixed-cost industries can be a prescription for not having those industries at all. The pricing power regulators tolerate, the consolidation they even encourage, amounts to a state-granted license to impose an excise tax on consumers, just like patents.

Just like patents, this might be a good thing. If our counterfactual will be perfect competition, foreseeable failure to recoup costs might prevent these industries from existing at all. But just like patents, we have a hard time evaluating whether this taxing power that we are so tacitly and indirectly granting is too little, leaving valuable activity underfinanced, or too much, and then a license for predation and extraction.

Patents, copyrights, and tolerated market power are all means of subsidizing activities that could not thrive or even survive under Econ-101 perfect competition. But the function of competition is not only low prices. We want firms to vigorously compete because competition drives quality and innovation.

High fixed-cost, low-variable-cost industries require some form of subsidy to survive. Both in the West and in China, governments have hit upon politically convenient, off-balance-sheet forms of subsidy. When the government is going to give somebody a sweetheart deal, it is preferable, from the perspective both of government officials and of recipients, if those sweetheart deals are hidden, deniable, submerged. This might not, however, be preferable from the perspective of the general public! And it damages our forward-looking capacity for policymaking, because we end up underestimating the costs of current practices when we evaluate "expensive" proposed reforms.

China's tacit subsidies take the form of badly underpriced loans, which state-backed banks and local government financing vehicles pretend are good long after they are not, as well as government-directed venture capital. Subsidy gets smuggled through losses that nobody will recognize for a long time. This form of tacit subsidy has advantages over Western practices of tolerating insulation from competition and granting limited monopolies. The Chinese approach preserves the non-price benefits of competition. It leaves in place ruthless competition for share in vigorously contested industries. Firms compete on quality, and they compete to innovate, even though before long they are all basically price-takers. China finances its industry contestants like it finances its Olympic contestants. The state pays up to cover the costs of bringing them into the arena.

In the West we subsidize too, but the form of our subsidy deprives our industries of the benefit of vigorous competition. Our firms become complacent, less innovative, less careful to insure the very highest product quality.

I don't propose that we adopt China's approach to subsidizing high-fixed-cost, low-variable-cost industries. China's cautious and opaque political system can work out its bad loans with quiet bailouts to keep banks and local governments above water, and with discretionary "corruption" prosecutions, to ensure local officials compete not to be the lossiest within a cohort of investments that should be expected, on average, to make losses. If we tried China's approach in the West, we would have massive scandals over every failed loan and bitter fights about the injustice of the bailouts.

What I do propose is that we in the West acknowledge that our great industries are in fact subsidized, that they are not and they cannot be pure "free market" success stories. We should work consciously, intentionally, to develop new forms of subsidy consistent both with very vibrant competition and our more transparent political life.

We should move away from grants of monopoly power, whether tacit acceptance of consolidation, or overt enforcement of patent and copyright. Those tools do important work, but they have terrible side effects. We can do better.

draft by Steve Randy Waldman
2024-08-24 @ 07:30 PM EDT