Thursday, 8 August 2019

The Market, the State and the Monkey in the Middle

Profit versus regulation

In Economics for the Common Good, Noble laureate Jean Tirole describes the efficient and effective running of the economy.  The market operates in order to make a profit; the state regulates the market in order to insure that the population is well served and, in particular, to avoid monopolies and price fixing in the market.  Pro-business conservatives will complain about and protest over-regulation, the interference of the state in the market, administrative red tape and taxation which stifle and hamstring businesses from innovating, expanding and making a profit. Pro-state socialists and liberals will complain about and protest under-regulation, the failure of the state to control companies who, in their greed for profit, damage the environment, break or corrupt the law, and undermine the health and welfare of the population.  


"Game theory" and "cognitive bias"

Tirole's claim to fame is the application of game theory to economics.  Game theory attempts to determine optimal strategies by anticipating the actions and reactions of players in the game or agents in the  economy.  Traditional economics worked on the assumption that agents acted in rational self interest.  History and experience show that logic is not always determinant.  Tirole describes illogical, counter-to- the-evidence-and-self-interest beliefs as "cognitive bias."

Ideology

In a similar but more conspiratorial vein, postmodernists explain individuals' acting in opposition to their own best interests in terms of ideology.  In Ideology: An Introduction, Terry Eagleton describes ideology as follows:
A dominant power may legitimate itself by promoting beliefs and values congenial to it; naturalizing and universalizing such beliefs so as to render them self-evident and apparently inevitable; denigrating ideas which might challenge it; excluding rival forms of thought, perhaps by some unspoken but systematic logic; and obscuring social reality in ways convenient to itself. Such `mystification', as it is commonly known, frequently takes the form of masking or suppressing social conflicts, from which arises the conception of ideology as an imaginary resolution of real contradictions (5-6).
Ideology can thus explain the historical phenomenon of women's opposing the right to vote being given to women.  In the historical context, some women felt that involvement in politics was "unfeminine" and even "unnatural." Similarly, ideology is invoked to explain how an impoverished American citizen in need of affordable health care will vote for a billionaire who opposes social welfare programs.  The disadvantaged voter adheres to the market ideology that "all will be well" if the state is run like a business.  Conversely, Tirole cites the statistic that 60% of Americans (including many of the poor) believe the poor are poor "because they are lazy or lack determination." A typical third example, even if the empirical evidence is conclusive that more lenient treatment of prisoners will result in reduced recidivism and a lower crime rate, the ideological notion that the purpose of prison is punishment will commonly prevail.

Is education the answer?

Tirole's perhaps wishful solution (and the purpose of Economics for the Common Good) is that we all need a better understanding of economics.  In particular, citizens need to understand that economics is focused on results based on historical, empirical and statistical evidence while considering as many variables as possible.   I desperately want to agree with Tirole that education is the answer, but I am all too aware of the Cassandra effect.  (Cassandra was condemned by the gods to know the future and always tell the truth, but whatever she said, no-one would believe her.)  Being right, having knowledge, ethics and honesty on your side are weak forces of social change compared to celebrity, wealth, propaganda, manipulation of mass media, ideology and cognitive bias.  The devolution of scepticism into cynicism is no help either.

Change requires consensus

You and I are the "monkeys in the middle" as the ball gets passed back and forth between the state and the market. (I'm assuming you've played the game of my analogy sometime in your life.)  As voters we can influence the state; as consumers the market.  However, our influence is entirely dependent on our ability to act collectively; as individuals it is virtually nonexistent.  Have you noticed that in an era when we have enormous amounts of information and data at our individual fingertips, the possibility of consensus has grown evermore remote?  Society at every level--global, national, local--has grown more polarized.   The media, which once had a decisive effect on both the state and the market, has become nigh on irrelevant as journalists have become news-readers, panelists, gossips, messengers of pre-packaged press releases and cheerleaders for the cognitive biases of their particular readership.

The Rules of "monkey in the middle"

Even "monkey in the middle" has rules.  The basic rule is that there must always be a distance between the players so that the "monkey" has a chance to catch the ball as it is thrown back and forth overhead.  This is the rule we all need to be concerned about.   For example, Tirole points out that there is a distinct "lack of enthusiasm shown by most economists toward industrial policy."  "Industrial policies"; that is, governments attempting to pick and choose winners and losers in the market through subsidies and tax breaks, frequently fail because "politicians and voters lack information about the technologies, sectors and businesses that will produce tomorrow's economic wealth."

The Separation of state and market

While the state has the obligation to provide conditions for thriving markets, its presumed objective is the wealth and welfare of the citizenry.  We are all too familiar with the scandals of companies and lobby groups which seem to have taken control of the government.  The risks of Western democracies devolving into oligarchies and plutocracies seem evermore imminent as we have all come to accept that elections are won by campaigns and campaigns are won with ever larger sums of money.  We are called upon to vote for candidates we have likely never met based on slogans and sound bites tailored to appeal to what some guru or algorithm has determined to be our cognitive biases.  The solution isn't revolution; it's more self-awareness, diligence, consciousness and conscientiousness.

Overcoming cognitive bias

Overcoming my own cognitive bias is a challenge.  I recognize that I am left-leaning and quick (perhaps too quick) to see signs of capitalist greed corrupting both the market and the state.  I would like to know more about the experiences of businesses dealing with the state.  In my online review of various sites dealing with "why small businesses fail," none of them mention problems with the state. However, whenever I read blogs or op-eds with a pro-business perspective, the ideological anti-state rhetoric seems consistently inflated.

The Rhetoric on "passive income"

 "Time Hasn't Taken The Sting Out Of Feds' Attack On Small Business" is a good example of the rhetoric.  At issue is the Canadian tax rate on "passive income."  "Passive income" is money that you earn without having to work for that specific amount; in other words, money earned by money invested in stocks, bonds, mutual funds, and so on.  In order to encourage small businesses the Federal tax rate on businesses with fewer than 100 employees is 10%.  The debate is about how profit should be taxed when it comes not from your business but from investments made outside your business.  Should your "passive income" be taxed at the same rate as everyone else's investment income (including pension income), or should this money be taxed at the lower small-business tax rate of 10%?  Up until 2017 when the Liberal Government changed the rules, the answer was that if you followed the right tax procedures (often described as "loopholes"), your passive income was taxed as if it was small-business income.

Context and comparisons

Let's put the issue in perspective.  If you are a full time, permanent employee at a MacDonald's, you probably earn around $26,000 a year (salaries at a MacDonald's franchise can go up to $75,000 for an Operations Manager).  The tax rate on your $26,000 salary will be around 15%.

If you own the MacDonald's, you are probably making $150,000 a year in profit.  That $150,000 is taxed at the small-business rate of 10%.  No-one is debating this difference in tax rate.  No-one is questioning the idea that the MacDonald's owner takes on risks and responsibilities that allow him to earn that profit while paying a lot of bills and employing people, and he therefore gets the additional reward of a lower tax rate than his employees'.

In fact, to get to the issue of "passive income" tax rates, you have to imagine someone significantly wealthier than your average MacDonald's owner.  In order for the new rules to apply, you have to imagine someone with more than a million dollars in investments.  So let's imagine that our MacDonald's man has 10 franchises.  He is therefore pulling in 1.5 million dollars annually and, as long as he has fewer than 100 employees, can continue to pay the 10% tax rate.  After a few years our MacDonald's man has 2 million saved up.  He invests the 2 million, and makes an annual 5% return on his investments; that is, 100 thousand dollars.  Finally, we have made it to the question of "passive income":  What tax rate should the MacDonald's man pay on this 100 thousand of passive income?"

How should passive income be taxed?

Should our hypothetical business man pay the small business tax rate of 10% on his 100-thousand of passive income?  The Conservative answer is yes.  This was the status quo until 2017.

Should our imagined MacDonald's owner pay the normal (what everyone pays) tax rate on this 100 thousand of investment profit?  Interestingly, no-one is suggesting this possibility.

The Liberal solution, which became law in 2017-18, is that the MacDonald's man will pay the 10% tax rate on the first $50,000 and the normal rate on amounts over $50,000.  This is the new regulation that is being described as the "Feds' Attack on Small Business."

Economics, finance and education

Okay, I haven't quite succeeded in overcoming my socialist cognitive bias.  I first encountered the issue of tax rates on passive income when some of my former students (none of them multi-millionaires) shared a a video on my Facebook feed of Conservative MP, Michelle Rempel, railing against this Liberal attack on farmers and small businesses.  My students, in their comments, shared Minister Rempel's outrage at this attack on farmers and small businesses.  How many farmers do you know with more than a million dollars invested in the stock market?  Tirole has got it right; we all need to learn a lot more about economics and finance.



5 comments:

  1. I have a Conservative bias but trying to understand what is really going on is like trying to see what's going on at the surface from 20 feet under water. So, I try not to take my beliefs or anyone else's too seriously. I do appreciate thoughtful discourse such as is always the case with your blog.

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    1. By the way, Ryan, kudos for your analogy. The idea that we (voters/consumers) are 20 feet under water trying to figure out what is going on between the state and the market is an apt representation of the point I was trying to make in this post.

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  2. My accountant friends have been telling me that the issues are a lot more complicated than I have represented here, but I'm waiting to hear exactly what I have gotten wrong. As always, thanks for reading and the comment.

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  3. The combined federal-Ontario income tax rate on passive investment income is about 50.17% (rather than just 10%). This has been the case - with minor variations - for many years for Canadian Controlled Private Corporations, whether or not they are "small businesses". The small business pays combined Ontario and federal income tax on its ACTIVE INCOME at about 12.5% - it has to separate what is ACTIVE INCOME from what is PASSIVE INCOME, and pays tax at the appropriate rate on each type of income. When a dividend is paid, then about 30.67% of the "50.17% passive income tax" is refunded to the corporation - this offsets the personal tax that has to be paid when the dividend is received. That's how it works, and, with slightly varying rates, has worked that way for a long time (new rules mean corporations pay more tax when their passive income exceeds $50,000 in a year). We're fortunate in Canada to have had a talented Finance Department for many years - this is a clever way to tax income in a corporation and integrate it with personal tax.

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    1. Thanks for the comment and additional information T. I don't doubt your numbers or expertise, but just so readers understand that I didn't pull my numbers out of nowhere, I think I should explain. My numbers refer exclusively to the federal tax under discussion and did not include any of the 12 different provincial/territorial rates. This is a typical summary which I have seen repeated in various sources (this one is from Realagriculture):
      With the new rules proposed in the budget, tax rates assessed directly to passive income are unchanged, but Canadian-controlled private corporations (CCPCs) would gradually lose the ability to access the small business tax rate when annual passive income exceeds $50,000.

      In other words, the amount of business income eligible for the small business tax rate shrinks as passive investment income grows.

      The current small business deduction limit allows the small business tax rate to be applied to the first $500,000 of business income in most provinces. This small business rate is set at 10 percent for 2018 and will be dropping to 9 percent in 2019, whereas the general corporate rate federally is 15 percent.
      https://www.realagriculture.com/2018/03/tax-treatment-for-passive-income-simplified-in-federal-budget/

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