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As I analyzed how the further economic reactions to the policy
would unfold, I began to realize that these reactions would lead to
consequences much less desirable than those at the first stage, and
I began to waver somewhat.
"And then what will happen?" Smithies persisted.
By now I was beginning to see that the economic reverberations
of the policy I advocated were likely to be pretty disastrous”and,
in fact, much worse than the initial situation that it was designed
to improve.
Simple as this little exercise may sound, it goes further than
most economic discussions about policies on a wide range of is-
sues. Most thinking stops at stage one. In recent years, former
economic advisers to presidents of the United States”from both
political parties”have commented publicly on how little thinking
ahead about economic consequences went into decisions made at
the highest level.1 This is not to say that there was no thinking
ahead about political consequences. Each of the presidents they
served (Nixon and Clinton) was so successful politically that he
was re-elected by a wider margin than the vote that first put him
in office.

Incentives and Consequences

Thinking beyond stage one is especially important when consider-
ing policies whose consequences unfold over a period of years. If
the initial consequences are good, and the bad consequences come
later”especially if later is after the next election”then it is always
tempting for politicians to adopt such policies.

Herbert Stein and Joseph Stiglitz.

For example, if a given city or state contains a number of pros-
perous corporations, nothing is easier than to raise money to fi-
nance local government projects that will win votes for their
sponsors by raising the tax rates on these corporations. What are
the corporations going to do? Pick up their factories, hotels, rail-
roads, or office buildings and move somewhere else? Certainly not
immediately, in stage one. Even if they could sell their local prop-
erties and go buy replacements somewhere else, this would take
time and not all their experienced employees would be willing to
move suddenly with them to another city or state. Nevertheless,
even under such restrictions on movement, the high taxes would
begin to have some immediate effect.
Businesses are always going out of business and being replaced
by new businesses that arise. In high-tax cities and states, there is
likely to be an increase in the rate at which businesses go out of
business, as some struggling firms that might have been able to
hold on longer, and perhaps ride out their problems, are unable to
do so when heavy tax burdens are added to their other problems.
Meanwhile, newly arising companies have options when deciding
where to locate their factories or offices, and cities and states with
high tax rates are likely to be avoided. Therefore, even if all exist-
ing and thriving corporations are unable to budge in the short run,
the high-tax jurisdictions can begin the process of losing busi-
nesses, even in stage one. But the losses may not be on a scale that
is large enough to be noticeable.
Then comes stage two. Usually the headquarters where a business'
top brass work can be moved before the operating units that have
larger numbers of employees and much equipment. Moreover, if the
corporation has other operating units in other cities and states”or
perhaps overseas”it can begin shifting some of its production to
other locations, where taxes are not so high, even if it does not im-
mediately abandon its factories or offices at given sites. This reduc-
tion in the amount of business done locally in the high-tax location
Politics versus Economics 7

will in turn begin to reduce the locally earned income on which
taxes are paid by both the corporation and its local employees.
Stage three: As corporations grow over time, they can choose to
locate their new operations where taxes are not so high, transfer-
ring employees who are willing to move and replacing those who
are not by hiring new people. Stage four: As more and more cor-
porations desert the high-tax city or state, eventually the point can
be reached where the total tax revenues collected from corpora-
tions under higher tax rates are less than what was collected under
the lower rates of the past, when there were more businesses pay-
ing those taxes. By this time, however, years may have passed and
the politicians responsible for setting this process in motion may
well have moved on to higher office in state or national govern-
More important, even those politicians who remain in office in
the local area are unlikely to be blamed for declining tax revenues,
lost employment, or cutbacks in government services and ne-
glected infrastructure made necessary by an inadequate tax base.
In short, those responsible for such economic declines will proba-
bly escape political consequences, unless either the voters or the
media think beyond stage one and follow the sequence of events
over a period of years”which seldom happens.2

There is another sense in which multiple stages must be taken into account, which may be easier
to explain by analogy. Imagine that a dam can be emptied into a valley and that calculations show
that this would fill the valley with water to a depth of 20 feet. If your home is located on an elevation
30 feet above the valley floor, it should be safe if the water is slowly released. But if the floodgates are
simply flung wide open, a wave of water 40 feet high may roar across the valley, smashing your home
and drowning everyone in it. After the water subsides, it will still end up just 20 feet deep, but that
will not matter as far as the destruction of the home and people are concerned, even though both are
now 10 feet above the level at which the water settles down. A Nobel Prize”winning economist has
argued that economic policies suddenly imposed on various Third World countries by the Interna-
tional Monetary Fund have ignored the timing and sequence of reactions inside those countries,
which may include irreparable damage to the social fabric as economic desperation creates mass riots
that can topple governments and make foreign investors unwilling to put money into such an unsta-
ble country for years to come.

New York City has been a classic example of this process. Once
the headquarters of many of the biggest corporations in America,
New York in the early twenty-first century was headquarters to
just one of the 100 fastest growing companies in the country With
the highest tax rate of any American city and the highest real es-
tate tax per square foot of business office space, New York has been
losing businesses and hundreds of thousands of jobs. Meanwhile,
the city has been spending twice as much per capita as Los Ange-
les and three times as much per capita as Chicago on a wide variety
of municipal programs. By and large, spend-and-tax policies have
been successful politically, however negative their economic conse-
In short, killing the goose that lays the golden egg is a viable po-
litical strategy, so long as the goose does not die before the next
election and no one traces the politicians' fingerprints on the mur-
der weapon. Looking at it in another sense, when you have agents
or surrogates looking out for your interests, in any aspect of life”
political or otherwise”there is always the danger that they will
look out for their own interests, which do not always coincide with
yours. Corporate managements do not always put the stockhold-
ers' interest first, and agents for actors, athletes, or writers may sac-
rifice their clients' interests to their own. There is no reason to
expect elected officials to be fundamentally different. But there are
reasons to know what their incentives are”and what the economic
realities are that they may overlook while pursuing their own polit-
ical goals.
Such one-stage thinking is not peculiar to the United States or
to tax issues. On the other side of the world, an Indian writer ob-
served the same phenomenon as regards education reform:

No one bothers about education because results take a long time to
come. When a politician promises rice for two rupees (12 cents a
Politics versus Economics 9

pound) when it costs five rupees in the market (31 cents a pound),
he wins the election. N. T. Rama Rao did precisely that in the 1994
state elections. He won the election, became the chief minister, and
nearly bankrupted the state treasury. He also sent a sobering mes-
sage to Prime Minister Narasimha Rao in Delhi, who, according to
some observers, slowed India's reforms because he realized that
votes resided in populist measures and not in doing what is right for
the long run. Since the 1980s politicians have competed in giving
away free goods and services to voters. When politicians do that,
where is the money to come from for creating new schools or im-
proving old ones?
I became thoroughly depressed the day the Punjab chief minister,
Prakash Singh Badal, gave away free electricity and water to farmers
in February 1997. He had lived up to his electoral promises, but
twelve months later the state's fragile finances were destroyed and
there was no money to pay salaries to civil servants.

Like taxes, subsidies also have further repercussions that can
make the country as a whole worse off, even when the subsidies
are not paid for out of the government's treasury but are created by
having one good or service subsidize another. Subsidized train fare
in India, for example, are paid for by raising freight charges. No
doubt this wins more votes among passengers than the votes lost
among shippers, simply because there are likely to be far more
passengers. However, the economic result of these artificially high
freight charges, according to the distinguished British magazine
The Economist, is that "power plants in the south of India find it
cheaper to import coal from Australia than to buy it from Bihar."
Meanwhile, Bihar is one of the poorest states in India and could
very much use additional jobs in its coal industry.
Even when dealing with emergency situations, public officials
may think of themselves and their own political needs before they

think of the victims and their plight. According to Indian econo-
mist Barun Mitra: "The super cyclone that hit the coasts of eastern
Indian state of Orissa in November 1999, left more than 10,000
people officially dead. But unofficial reports continued to put the
figure at more than double that number. There were reports in the
media that the Central Government in Delhi was reluctant to seek
international help, because this in some way might be a reflection
on the competence of the national government. And this despite
the fact that even two weeks after the tragedy, many villages re-
mained cut-off without any information coming or relief reaching
the survivors."
What about the reaction of a market economy to such a disaster?
Few insurance companies could drag their feet like this and expect
to survive in a competitive economy, because people would switch
to buying the policies of some rival insurance company. But most
government agencies are monopolies. If you don't like the slow re-
sponse of a government emergency relief agency, there is no rival
government emergency relief agency that you can turn to instead.
Monopoly tends toward self-indulgent inefficiency, whether it is a
private monopoly or a government monopoly. The difference is
that monopoly is the norm for government agencies, while few
private businesses are able to prevent rival firms from arising to
challenge them for customers.
Those who think no further than stage one often regard the gov-
ernment's power to control prices as a way of reducing the costs of
various goods and service, thus making them more widely afford-
able. Such policies as "bringing down the cost of prescription
drugs" or making housing "affordable" often seem very attractive
when thinking no further than stage one. However, even in stage
one, there is a fundamental difference between truly bringing
down the costs of particular goods and services and simply forbid-
ding prices from reflecting those costs.
Politics versus Economics

A classic example of controlling prices without controlling costs
was the electricity crisis in California in 2001 and 2002. The costs
of generating the electricity used by Californians rose substantially
for a number of reasons. Reduced rainfall on the west coast meant
reduced water flow through hydroelectric dams and consequently
less electricity was generated there. Since the costs of running
these dams did not fall correspondingly, this meant that the cost of
generating a given amount of electricity rose. At the same time,
the costs of such fuels as oil and natural gas were also rising, so
that the costs of generating electricity in these ways was also in-
creasing. In the normal course of events, such rising costs would
have been reflected in higher prices on California consumers' elec-
tric bills, which would provide incentives for those consumers to
reduce their use of electricity. But California politicians came to
their rescue by imposing legal limits on how high electricity prices
would be permitted to rise. That was stage one.
While those who generated electricity passed on their costs
when they sold the electricity wholesale to the public utility com-
panies, which directly supplied the public, these public utilities
were forbidden to charge the public more than the legally pre-
scribed price. Thus when wholesale electricity prices were 15 cents
per kilowatt hour, the retail price remained at 7 cents per kilowatt
hour. As an economic study of the industry put it:

Wholesale prices signaled that electricity was increasingly scarce,
but retail prices told consumers that nothing had changed. Accord-
ingly, consumers demanded more electricity than was available.

Blackouts were the inevitable result. That was stage two.
Stage three saw California politicians scrambling to find some
way to stop the blackouts, which not only disrupted homes and
businesses currently, but threatened to drive some businesses out

of the state, which would deprive California of both jobs and taxes.
Worse yet, from the politicians' perspective, it threatened their re-
election prospects. Stage four saw California public utility compa-
nies going bankrupt, as they bought electricity from wholesalers at
higher prices than they were allowed to charge their customers.
The public utilities' lack of money and declining credit ratings
then led the wholesalers to refuse to continue supplying them with
electricity. Things were now truly desperate, so the governor
stepped in and used the state's money to buy the electricity that the
wholesalers would not sell to the financially strapped utility com-
panies on credit.
In the end, Californians paid more for their electricity”only
partly on their electric bills and the rest on their tax bills or in re-


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