Moore And Laffer May Not Have All The Answers, But Krugman Has None Of Them

Keith Naughton | Public Affairs Consultant

I’ll let you in on a secret about economic studies: They can be anything you want. There is no universal standard for economic analysis. Economists debate which variables to use, how to weight them, data sources and even statistical technique. A skilled economist can manipulate his/her econometric formulae to give you the conclusion you are paying for. Even the best, least biased studies will include judgment calls and points of contention.

And that brings us to the current food fight between tax cutters Steve Moore/Arthur Laffer on one side and big tax, big regulation Paul Krugman on the other. While Moore/Laffer overstate the tax cut case, Krugman is just plain wrong. Lower taxes are a contributing factor, albeit among many while high taxes and regulations are not the fount of growth for California and New York – it’s just price gouging.

All three combatants acknowledge that many factors including regulation, housing costs, quality of education, local amenities, availability of capital and climate, are all important factors (and then go back to arguing over taxes). After all, what good are low taxes when your business is choking on regulation, the school system is terrible and it rains every day? The fact is that many of the low tax states also have low regulatory burdens.

The Moore/Laffer study “Rich States, Poor States” goes into these issues in some detail. Moore and Laffer rank Texas and Tennessee, two no-income tax states, 13th and 19th, respectively – a decent showing, but behind several income tax levying states. This is the real story. When the government promotes economic freedom and lower burdens (both regulatory and tax), economic performance can be expected to improve.  States need to take a holistic outlook.

What is incontrovertible is the failure of the Krugman big tax, big regulation model.

To see how weak the tax and regulate argument is, all one has to do is look at California. The big government crowd loves to cite the Golden State as a prime example of how tax-and-regulate policies lead to prosperity. California is a very wealthy state and has had significant job growth recently, but it’s not taxes and regulations that are the cause.

The fact is California’s job growth and fiscal health are due to industries that are location-dependent and price insensitive. In other words, Silicon Valley is location-dependent due to its intense social, financial and research interconnections, which makes it virtually impossible to pick it up and move it to Kansas City. Additionally, the incredible wealth generated allows Silicon Valley entrepreneurs to be less concerned about taxes and other costs. The same can be said for the entertainment industry.

Meanwhile, location-flexible and price sensitive industries have been leaving. From manufacturing, to agriculture to corporate headquarters, California has been hemorrhaging jobs that don’t have to be in California. Even Silicon Valley and Hollywood are not immune. Manufacturing has long left Silicon Valley. A great deal of movie and television production has relocated, forcing California to respond with economic incentives to retain a portion of that work.

Further undermining Krugman is that both of these industries came to be located in California during its earlier incarnation as a low regulation, low tax state.  Silicon Valley entrepreneurs found a region in the 1950s and 1960s that was a blank slate, where they could create their own environment and culture.  They escaped the hidebound financial system of the east coast, reinventing venture capital to incredible effect.

Southern California became the home of filmmakers because of the climate and to escape the East Coast cartel controlled by Thomas Edison. As with Silicon Valley, the new studios entered a region with no regulation and light taxation. They also similarly created their own culture, financial institutions and regulatory system to serve the industry.

So, the two industries propping up the California economy exist in the state due to the growth factors cited by free market economists.

To be fair, California has invested in important public goods. The state has a world-class university system, an extensive freeway network and vital water delivery system – all critical to the state’s growth over the years. But these investments are legacies from past investment, not funded by the current high tax regime. Not only that, the state has actually been cutting back on university funding and barely maintaining its infrastructure. The only big-idea project receiving funds is the absurd high-speed rail boondoggle, which is attracting no additional investment and will never be completed.

California’s high tax, high regulation environment is not designed to promote economic growth. It is price gouging by a state government that is secure in the knowledge that its high technology industry and entertainment industry are very difficult to move. Entrenched interests, venal politicians and a myriad of squawking pressure groups have been getting a free ride on the backs of the wealth creation of a few, while segments of the state’s economy that can’t afford the price have cut back or are leaving. And who works in the price-sensitive segments of the economy? The blue collar workers and middle class that Krugman and other liberal economists claim to represent.

The fact is that Krugman and the big tax, big regulation, big government advocates are definitively wrong. When their arguments are subjected to rigorous examination, they become as bankrupt as Solyndra. States and local governments that follow their prescription will find themselves in a world of trouble. Very few industries are as rooted in place and price insensitive as the high tech industry in Silicon Valley, the entertainment industry in southern California or high finance in New York.

The California price gouging model is far more likely to result in wheezing basket cases like Rhode Island. Interesting that we never hear Krugman talk about the high tax, high regulation failures. Perhaps that is why he left Princeton – to gain the freedom of dishonesty.

Tags : california paul krugman stephen moore
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