Social Justice and Empty Pockets

Monday, January 23, 2012
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© Reuters/Carlos Barria

Economic problems have led to much soul-searching on both sides of the Atlantic. Neither Europe nor the United States will be able to extricate itself from their shared slump until the policies that led to this crisis are reversed. The needs are clear: a successful and sustainable political order requires stable legal and economic policies that reward innovation, spur growth, and maximize the ability of rich and poor alike to enter into voluntary arrangements. Limited government, low rates of taxation, and strong property rights are the guiding principles.

Unfortunately, many spiritual and economic leaders are working overtime to push social policy in exactly the opposite direction. At the top of the list are two prominent figures: Pope Benedict XVI and financier Warren Buffett.

Not long ago the pope was on his way to recession-torn Spain to lead a celebration of World Youth Day when he denounced those nameless persons who put “profits before people.” He told journalists, “The economy cannot be measured by the maximum profit but by the common good. The economy cannot function only with mercantile self-regulation but needs an ethical reason in order to work for man.” Ironically, these words mirror the refrains of countless Spanish socialists, whose relations with the pope have soured in recent years. Their shared premises help explain why Spain finds itself in such a sorry state.

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Warren Buffett’s face graces a fake dollar bill handed out at a recent Berkshire Hathaway shareholders’ meeting. Buffett wrote a much-discussed editorial that condemned the economic system that had allowed him to flourish as an extraordinary investor.

A COLLECTIVE MISUNDERSTANDING

Denouncing those who put “profits before people” may stir the masses, but it is a wickedly deformed foundation for social policy. Profits, like losses, do not exist in the abstract. Corporations, as such, do not experience gains or losses. Those gains and losses are passed on to real people: shareholders, consumers, workers, and suppliers.

It is possible to imagine a world without profits. Yet the disappearance of profits means that investors will be unable to realize a return on either their capital or their labor. Structure a system that puts people before profits, and both capital and labor will dry up. The scarcity of private investment capital will force the public sector to raise and allocate capital and labor, though it has no idea how these resources should be deployed to help the people, writ large. A set of ill-conceived public investments will not provide useful goods and services for consumers (who are, after all, people), nor will it provide sustainable wages for workers (who are also people). Poor investment decisions will lead to a massive constriction in social output that harms all people equally.

The proper response to these difficulties is to treat profits as an accurate measure of the cost of capital, rewarded to those individuals and firms that supply some desirable mix of goods, services, and jobs that people, acting individually and not collectively, want for themselves. The genius of Adam Smith, whose musings on the invisible hand are too often derided, was to realize that private markets (supported, to be sure, by suitable public infrastructure) will do better than a command-and-control system in satisfying the individual’s wants and needs.

The pope offers no serious answer to Smith’s point when the pontiff talks about an “ethical reason in order to work for man” and the “common good.” In both of these cases, he treats a collection of diverse individuals as though they form part of some harmonious whole. “Man” in the pope’s formulation is a grammatical singular but a social collective. The “common good” speaks of some aggregate benefit to a community that is not securely tethered to the successes and failures of the particular individuals in the collectivity.

Corporations, as such, don’t have gains or losses. Those gains and losses are passed on to real people: shareholders, consumers, workers, and suppliers.

Ordinary businesspeople speak of win/win transactions. In doing so, they show an intuitive understanding that statements about groups must be transformed into statements about the individuals that compose them. That common expression, “win/win,” is the distillation of sound economic theory, for the more win/win transactions a society can generate for its people, the greater its economic prosperity. Such transactions generate gains to all parties involved in the bargain.

The great advantage of competition in markets is that it exhausts all gains from trade, thus allowing individuals to attain higher levels of welfare. These win/win propositions may not reach the perfect endpoint, but they will avoid the woes that are now consuming once-prosperous economies. Understanding the win/win concept would have taken the pope away from his false condemnation of markets. Moreover, it might have led him to examine more closely Spain’s profligate policies, where high guaranteed public benefits and extensive workplace regulation have led to an unholy mix of soaring public debt and an unemployment rate of 20 percent.

The “common good” speaks of some aggregate benefit to a community that’s somehow distinct from the successes and failures of individuals.

It is tragic that papal economics mimic those of the church’s socialist opponents. The pope’s powerful but misdirected words will only complicate the task of meaningful fiscal and regulatory reform in Spain and the rest of Europe. False claims for social justice come at a very high price.

WHAT’S WRONG WITH WIN/WIN?

A similarly harsh verdict must be rendered against Warren Buffett, author of a much-discussed editorial that foolishly condemned the very economic system that had allowed him to flourish as an extraordinary investor. Rhetorically, Buffett’s editorial read like the confession of a man who had gotten away with raiding the cookie jar.

Buffett insisted that in difficult times the principle of “equal sacrifice” should guide collective deliberations. In good autobiographical fashion, he then admitted that the current tax system had allowed him to get away with paying just under $7 million in taxes in the past year, which worked out to 17.4 percent of his $40 million personal income.

In Buffett’s utopian world, higher taxes, including higher capital-gains taxes, magically generate the revenues needed to eliminate the current massive deficit. For this bold proposition, we had Buffett’s personal assurance that he had never seen large or small investors scared off by capital- gains rates approaching 40 percent. This is a simple case of sampling error, for those people who are scared off by high capital-gains taxes don’t beat a path to his doorway in the first place. It would have been better if Buffett had addressed the “lock-in effect” with respect to capital gains. People pay capital-gains taxes only when they sell their stock. Accordingly, investors are highly sensitive to the capital-gains rate, because why sell if the net proceeds from the sale are so small that they more than negate a higher rate of return from a shrunken capital base?

Under this logic, lower capital-gains rates generate more tax revenue for the federal government. Yet Buffett didn’t grasp the point:

In 1992, the top four hundred had aggregate taxable income of $16.9 billion and paid federal taxes of 29.2 percent on that sum. In 2008, the aggregate income of the highest four hundred had soared to $90.9 billion—a staggering $227.4 million on average—but the rate paid had fallen to 21.5 percent.

I’d take 2008 any day. In 1992, the country’s top four hundred earners paid a total of $4.9 billion in taxes, a nifty sum to come from so few. But sixteen years later, that amount had risen to about $19.55 billion, while also leaving those most successful investors with an extra $71 billion in cash to invest in new ventures that could promise greater returns. This is win/win with a vengeance.

Buffett acted as if the dual increases in tax revenues and private gains had nothing to do with the reduction in the capital-gains rates. It is a sign of his upside-down moral standards to regard a win/win change in the tax laws as a blunder just because the government had a smaller slice of the pie than before.

The more win/win transactions a society can generate for its people, the greater its economic prosperity.

Buffett should reflect more deeply on the systemic dangers of taxing all those millionaires and billionaires to make up for the government’s huge tax shortfall. No fixed group of individuals is permanently wealthy. In fact, the number of people in each of the supposedly elite categories of wealth—those earning $200,000 or more, $1 million or more, and $10 million or more—has fallen in recent years. With fewer individuals in these groups, lower incomes for those that remain in each group, and depressed stock prices, no wonder tax revenues have dropped to about 15 percent of gross domestic product. That outcome happened, moreover, without any reduction in tax rates in the upper brackets. When people at the top earn less, tax revenues drop precipitously.

The pundits of the left insist, like Buffett, that higher tax brackets do not diminish earnings. That point is surely overstated, especially for capital gains. Fancy bankers, doctors, lawyers, and venture capitalists may be happy to work for less, but the people who hired them in good times won’t keep on hiring them in bad times when the economy slows. When the other side of the market falters, the incomes of the rich slide as well, and in ways that future tax increases will only accelerate. The government will not find a treasure trove of revenues by raising taxes on former millionaires and billionaires.

So rather than heed the advice of the pope and Mr. Buffett, we should take our guidance from another public figure: the late Reverend Ike. Many years ago, he said, “the best thing you can do for the poor is not be one of them.” Government should give everyone at least that opportunity.