A Modest Proposal: A Backdoor Implementation of Free-Market Industrial Policy
My piece on the East Asian Economic Miracle has gotten some attention. It’s time to follow up.
Noah Smith tweeted this:
I should note that Noah and I are friends. We’ve hung out together, and maintain a sporadic email correspondence which usually starts with me emailing him to call out something misleading he said on Twitter. It is in the spirit of this long-standing friendship that I say: come on, dude.
I reconsider my beliefs on a topic after everything I read about a topic. That’s the point! Political writing is full of kind of pathetic wishful thinking. You can always find books like The Gipper’s Still Got It: Why We Should Build A Realistic Animatronic Ronald Reagan — And Why He’ll Win In 2020 or I Take No Pleasure In Reporting This: Vladimir Putin’s Secret Plot To Trick Hillary Clinton Into Not Campaigning In Wisconsin. But real view should constantly incrementally shift around some modal value, with occasional step-function jumps.
Moreover, there’s a general point about beliefs here: you should only claim that you disagree with a viewpoint if you can articulate it well. I suppose the higher bar is: you can only claim to disagree with a viewpoint if you can explain that viewpoint well enough that people assume you switched sides.
The libertarian view of state intention in the economy is that it leads to waste, corruption, and poverty. This is overwhelmingly the case! Nigeria started building a steel mill in 1979 — it still isn’t done. Brazil tried to industrialize, had success in a few industries like aerospace, but still relies heavily on commodity exports. Russia built out an industrial base under Stalin, and millions of people died in the process — and it still didn’t work all that well. China industrialized with lots of state intervention, but that was after a period where they had more state intervention, mass starvation, and became the rare modern example of a country getting less urban over time.
East Asia from 1950 through about 1985 is an astounding, glaring exception to the rule, and it’s worth exploring why. What I learned was that the model is actually quite hard to copy — they started from zero, they had exceptional leaders, they benefited from demographic tailwinds. As I learned later there was a technological tailwind, too: containerization was basically a universal tariff cut, and the Vietnam War was an implicit subsidy to exporters — ships came to Vietnam full, and they’d make the return trip regardless.
Industrial policy is only advantageous when it produces a step-function improvement in some crucial part of the supply chain that allows other market actors to achieve good returns by building out the rest of the supply chain. That’s why heavy industry is a big part of it: you need some capital and a lot of labor, but once you have cheap local sources of steel and chemicals, you can build higher value-added products, and you don’t need a command-and-control approach to do so.
There are basically three ways to bootstrap a new supply chain: industrial policy, a monopolistic business that controls access to other parts of the supply chain, or a bubble. Importantly, all three have been associated with great successes but have also led to catastrophic failures. Since they tend to be historically unique — once you’ve built a globally-competitive industry in one place, somebody who copies it tends to get lower returns — we don’t exactly have a consistent scorecard for how to make each model work best.
The Modest Proposal
I felt that I ended the post with some nicely depressing conclusions: we don’t have the demographic tailwind that Taiwan, Japan, and Korea benefited from, and we certainly don’t have a highly effective civil service. As far as I can tell, most government jobs are basically welfare for conscientious zero marginal product workers. Ambitious people correctly avoid working for the government.
Solving the demographic issue is hard, but there is a possible way to solve the bureaucracy problem. We can’t impose the punitively rigorous civil service exams Japan and Korea used (both countries’ exams had a 2% pass rate for senior positions).
To have an effective trade policy, we’d need to find a group of hard-working, unusually smart people who relentlessly work every angle of every deal, and put them to work on increasing American exports. We’d need to find the kind of people who work in private equity, for example, and get them on the case.
Here’s how: we eliminate the tax advantage from using corporate debt. But we allow companies that were eligible for these tax benefits to receive them in the form of export credits.
For example, a company that pays $10m/year in interest saves around $2.5m in taxes by using debt rather than equity. We’d eliminate that tax saving, but make the company eligible for up to $2.5m in export credits.
The goal is not to rationalize the tax system, although there is much more progress to be made in that area. Instead, the goal is to take the private equity — which recruits the talented and ambitious, and compensates them well — and get them to focus 100% of their energy on maximizing American exports.
This would be terrible news for PE shops that focus on industries like retail, but it’s not ideal for the US if some of our best managers and analysts are focused on service industries with low productivity growth. It would also be tough on real estate operators, although they have plenty of other tax tricks to pull.
It would be great for manufacturers. It would basically lead to a two-sided talent show: America’s Next Akio Morita searches for America’s Next Sony.
This is, of course, not trivial to implement. One traditional and beloved tax structure for high-margin industries is to have a breakeven US subsidiary that does R&D, a lucrative subsidiary in a low-tax jurisdiction like Bermuda that owns the IP, and then a manufacturer that licenses the IP from the low-tax subsidiary.
But we can reduce the incentive for funky tax games by taking this poliy further: I mentioned that we should equalize the tax treatment of equity and debt. The most popular proposal for doing that is to eliminate the debt tax deduction. But that’s not ideal: a country that wants to improve its balance of trade needs to subsidize investment and tax consumption, and one way to do that is to dramatically lower corporate income taxes, while either taxing dividends as regular income or just shifting as much taxation as possible towards consumption rather than income.
This reduces income inequality; it does let the rich get richer — but only on paper. Lower corporate taxes could reduce consumption among rich people by raising their opportunity cost. The one kind of consumption it wouldn’t discourage is the tax-deductible kind: charitable donations. Moreover, it’s possible to impose a progressive consumption tax, as long as you implement it as a progressive income tax with savings fully tax-deductible.
I doubt that that would be politically feasible, but the interest-deduction-as-export-credits trick is both populist enough to pass a Democratic legislature and economic-nationalist enough to pass muster with the executive branch.
This policy suggestion is not driven by some abstract, grand theory. It’s entirely ad hoc. The US tax code happened to incentivize companies to lever up, and some firms specialized in doing the levering and reaping the rewards; the combination of broad economic growth and good returns to financial engineering has put those companies in a position where they hire a disproportionate share of the smartest and hardest-working people in the US. So, just due to a series of random historical contingencies, the way to get business elites to do something is to make it something the managers of heavily-indebted companies want to do.
The end goal of an aggressive trade policy is not to do whatever China and Japan did. That’s exactly backwards: it’s to get them to stop. Governments are bad at picking winners, and their largesse eventually leads to corruption. Even the successful systems in Japan, Korea, and Taiwan are showing their age — and let’s not even start with the catastrophic combination of financial leverage and demographic collapse facing China.
The best industrial policy for America is no industrial policy. The worst is an American industrial policy that’s made in Beijing. I propose that we pick the least-bad option: an American-flavored industrial policy designed to cost-effectively restore global equilibrium.