Obamonics

David Leonhardt in today's Times on Senator Obama's economic views:

Mr. Obama praised the Clinton administration for reducing the deficit and setting the stage for the ’90s boom. But he said Mr. Clinton had failed to halt a long-term increase in income inequality that had left the middle class feeling squeezed.

If elected, Mr. Obama said he would to try to forge a popular mandate for policy changes that could reverse a generation of slow wage growth and outlast any one administration. At the top of his list would be shifting the tax burden more toward the wealthy and making investments—in health care, alternative-energy research and education—that would cost a significant amount of money but could ultimately lift economic growth.

Leonhardt's is a high-level and laic overview, but it provides a good preview of what to expect: Lots of spending. Among themselves, the Democrat candidates differ very little, but the article goes for drama:

But the two candidates offer strikingly different strategies for achieving their economic agendas.

To be sure, where Senators Clinton and Obama do differ is nontrivial. Senator Clinton's proposal to freeze interest rates for five years, for example, is politics-over-policy to the point of being dangerous; Senator Obama's plan is much more sensible. Perhaps the biggest difference is Clinton's preference for small, directed tax cuts (microcuts in response to microtrends) compared to Obama's favoring of simple and broad measures that have a decided Chicago School feel. As Austan Goolsbee, Obama's senior economic adviser, described the heterogeneity:

Clinton is offering "a collection of relatively narrowly targeted tax credits," he said, while Obama "has a pretty significant middle-class tax relief."

The Illinois senator's preference, Goolsbee said, is for what he called "iPod government," which he described as "simple to use, easy for people, makes their life better."

This "spirit of simplicity is in a bunch of policies," he added.

Their policy distinctions, however, are more than just packaging; Senator Obama's economic plans are worth much more than a sound-bite. Simple, broad, and market-based always wins over complicated, narrow, and directed. Moreover, there are real economic concerns with tax credits and deduction.

My first problem with targeted tax credits is that they distort behavior. If a choice is bad without a tax credit, commonsense suggests its likely also the wrong preference with a tax credit. Note this is not a refutal of Pigovian taxes, such as a carbon tax, which price-in otherwise-unpriced negative externalities. The goal of a carbon tax is to incorporate the costs of carbon emissions—pollution—into the price of carbon. The goal of a directed tax credit is to encourage people to make choices that, presumably without the credit, were suboptimal or inefficient. Enter deadweight loss.

In reality, however, most of Senator Clinton's proposed tax credits won't cause huge changes in behavior because folks are already making the choices she hopes to encourage. Thus, the net result is to reward existing behavior (cf. the mortgage interest tax credit) at the expense of Federal revenue. In other words, a second issue with tax credits is that they pay people to do things they would do anyway. And in the rare examples where this is untrue, tax credits distort behavior. You cannot win with these things, even if you are the Clintons.

A third complaint with tax credits is that they are complicated, and both compliance and administration is costly. A simpler tax code is a better tax code and given that we already have a horribly-complicated tax system, sprinkling myriad small credits and deductions around is the exact opposite of the tax simplification for which we should aim.

The fourth and final problem with tax credits is also the most important: Unlike tax reduction through cutting of marginal tax rates, tax credits yield no incentive to increase work—in fact, they act as a disincentive. A decrease in your marginal tax rate is like an increase in your wage: Your income goes up and thus your consumption rises. A tax credit's effects are similar, but the credit differs vis-á-vis the marginal cut in one important way: A credit does not increase the marginal utility of work but the marginal rate cut does, thus the rate cut encourages work and makes leisure more expensive. A tax credit does not make leisure more expensive with-respect-to work, but it does increase its recipient's income. Some people, happy with their old consumption level but unhappy with their labor-leisure balance, might respond to the tax credit by working less. Certainly, unlike with a marginal rate cut, folks won't work more.

Put another way, a revenue-neutral replacement of tax credits in favor of marginal tax rate cuts will increase productivity. Our policy preference should be for marginal tax rate cuts, targeting the middle-class if that is the goal. In fact, it would be a great exercise to tally up the cost of every tax credit and deduction, ditch them all, and decrease marginal tax rates accordingly.

Of course, Senator Clinton (or at least her advisers) know all this. But telling seniors that they get a tax credit for robot insurance and beat farmers that they get a deduction for subsurface agriculture, while bad economics, is good politics. Identify the microtrend and provide the microcarrot—I get it, I read the book. Those who rise higher, to do not what is popular but to do what is right, those who don't capitulate to uneducated demands but instead aim to raise the level of public debate, they are the politicians who deserve your vote.

I largely judge presidential candidates based on their economic and foreign policy advisers. This approach is approximate—who knows who will be around in two years, let alone who has the President's ear on the first—but it gives a good idea about the ideologies and theories that will craft the policies in any given administration. To that end, Dr Goolsbee is good. As is Senator McCain's senior economic adviser, Douglas Holtz-Eakin.