THE AMERICAN CENTRIST

First, a word of explanation for my long silence.  I was away for a month, attending my 50^th Harvard Business School Reunion, then a vacation on tour to Portugal and Northern Spain, which was delightful.  Although I had good intentions, it proved impossible to write and publish, with no available time for concentration.  I hope to get back to publishing one post per week.

Despite the title of this post, I wish anyone reading this, a Happy Fourth of July.  It is our nation’s 241^st birthday, and that in itself is a good reason to celebrate.  We have a wonderful country, a blessing for all its inhabitants.  No other nation on Earth today or any time in the history of humanity, has been as dedicated to the principles of liberty, equality under the law, opportunity, advancement, assimilation of newly arrived immigrants, generosity, and progress as the United States of America.  We have had our problems and issues: we still do and we always will, as perfection is impossible.  But we address those problems and issues in a democratic way, and sooner or later, arrive at solutions and move on.

So, why have I titled this posting, “(Un) Happy 4^th of July”?  We all know.  The Republicans have elected a President who is decidedly un-Presidential.  The Democrats are still in a state of shock, disbelief, and constant protest.  We, the electorate, were presented with a choice of two unappealing candidates.  The White House is at war with the media, and it’s ugly on both sides.  Although the Republicans control both houses of Congress, they are not a unified party, and the far right Tea Party faction makes progress extremely difficult.  The President’s limited travel ban is in court, reform of the Health Care law (ACA or Obamacare) is stalled, tax reform is in a state of delay.  No one can be pleased with the current state of affairs.

Even if we had a more conventional, less unpredictable President, our current state of divisiveness would still obtain.  The two parties, Democratic and Republican, are increasingly controlled, or at least strongly influenced, by their party’s extreme wing.  And the extreme wings are both ideologically driven, unwilling to consider any compromise, and totally lacking in the historical American pragmatism.  These fundamental problems would remain if President Trump were gone—replaced by Vice President Pence, or even if Secretary Clinton had won.

At my Business School Reunion, among other speakers, we heard from Professor Michael Porter, renowned business strategist, and author of many books and articles on competition.  He is doing research now on the political “market” in terms of competitive analysis, and is finding that both parties are competing, but as an oligopoly, effectively preventing any third party from entering the marketplace.  He did describe a strategy being discussed, called “the Senate Fulcrum”.  Since the Senate only has 100 voting members, and it is usually split between the parties in a ratio no higher than 55/45 (with a few exceptions that have gone to 60/40), a centrist bloc of only 4 or 5 senators could have power way beyond their numbers.

I am beginning to see increasing editorials and opinion pieces stating the need for a third, centrist party, or for the centrist wings of both parties to unite temporarily to pass specific pieces of “bipartisan” legislation.  Since the two major parties have worked deliberately to exclude third parties, forming a new party will be exceedingly difficult, and will require a patient, long term and determined effort.  But it can be done, and I believe it needs to be done.  It will never succeed if it is based solely on a charismatic leader deciding to run for President, during the year before the general election.  It can only be done by a group of citizens, working over many years to develop a party at the grass roots, winning seats in the House, the Senate, and Governor’s mansions, building an organization, raising money, all before a Presidential election candidate is backed.  Remember, when Abraham Lincoln won the Presidential election in 1860 as the first Republican victory, the party had been formed in 1853, seven years prior to the election.

I love our country, and would rather be right here, right now, than in any other country or in any other time in history, despite our current discomfort.  We all need to work to preserve that status as a truth for me, for you, for all of us, and for the generations to follow.

Before we discuss taxes again, I want to get rid of the elephant in the room.   It may be obvious to some readers that these blogs don’t concern themselves heavily with the news of the day, with the strange and different behaviors and remarks of the current Administration.  Here is why.  This blog is about trying to give voice to a very large segment of Americans for whom a centrist policy makes sense, who share a willingness to compromise to get things done.  It is trying to provide an alternative to Tea Party and fundamentalist Republicans, and hard left Progressive Democrats.  The current Administration is neither.  I believe it is an anomaly, brought on by a Republican primary with 16 candidates and no party leadership, by an uninspiring and tired Democratic candidate, and a large sector of the voting public that feels it has been ignored for too long.  Criticizing and questioning the Administration, which is an easy shot, would pull this blog off-message.

In the prior post on taxes, we eliminated most federal options other than wealth taxes and income taxes.  One important point I left out concerning so-called “sin” taxes, is that when they get too high, they encourage criminal smuggling and violent cartels.

The US has never had a wealth tax.  It could theoretically raise a very large sum of money.  But there are several serious problems with it.  First, people have never had to declare all their assets, and if they were forced by law to do so, with a tax impending, there would be massive and flagrant cheating by non-reporting and under-reporting.  Unlike income, which is reasonably well documented by W-2 forms, 1099 forms, reports by banks and brokerage firms, vast amounts of data on assets are not in IRS hands, or even in the hands of institutions like banks who can be forced to produce client data.  Second, wealth would soon flee the country, to be invested or hidden offshore.  No longer available for investment in the US, we would find our capital stock and investment declining, leading to an anchor on our economic growth and resulting improvements in standard of living.

That leaves income taxes, both business and personal, as the only practical and meaningful way for the government to raise the money it needs to function.  Income taxes have several advantages.  First, they are progressive, not regressive, i.e., those who earn more pay more (even with a flat percentage tax), and can better afford to do so.  Second, a great deal of documentation concerning earnings and profits is well documented, leading to much higher voluntary (and involuntary!) compliance.  That’s the easy part.  The hard part is how much, and who pays, what deductions, if any, are allowed, whether investment income is taxed differently from wage income, etc.

Let’s look at the easiest part first, corporate income taxes.  It makes no sense that we have one of the world’s highest stated corporate income tax rates, but with numerous deductions and carve-outs because of lobbyists, campaign contributions and influence.  We also lose headquarters of companies through “inversions” where they acquire a foreign-based company and change their headquarters to that nation because it has lower tax rates.  It also makes no sense that we are one of the few nations that taxes repatriation of earnings from foreign subsidiaries of multi-national corporations, even though they have already been taxed by the nation the sub resides in.

We should drop the corporate rate to 20% (not the lowest, but clearly competitive), and allow repatriation of earnings with a cheap amnesty, 5-10% tax rate if done within one year.  We should also, in one clean sweep, get rid of special incentive reductions of taxes, whether for favored industries or not.  Oil companies don’t need depletion allowances any longer; solar companies shouldn’t get tax deductions or rebates.  And we need to end the double taxation of foreign earnings on repatriation.  I believe that we will get as much or more tax revenues on an ongoing basis, gain a one-time windfall on repatriation of the trillions of dollars now offshore, and see greater investment in the US through the productive use of those dollars.  The people who will be hurt most are lobbyists.

Similar principles should apply to individual income taxes, with a few exceptions that will be made clear.   But everyone should pay taxes, and no one who earns money or gets transfer payments should be excepted.  Everyone needs to have a stake in paying for the services they demand.  But clearly, graduated rates are in order, as the rich are better able to pay a larger percentage than the poor.

Here are some suggested rates:  2% on the first $25,000 of earnings, 10% on earnings between $25,000 and $60,000, 20% on earnings between $60,000 and $150,000, 28% on earnings between $150,000 and $400,000, and 35% on all earnings above $400,000.  While these brackets may seem arbitrary, there is some logic to them.  Even someone earning $7.50 an hour in a full time job would earn $14,625 (after SSA deductions) and pay a tax of $292.50 even if they did not take a standard deduction, less if they did.  They will now care how tax money is spent, and whether the spending will lead to tax increases.  At the other end of the spectrum, I believe that somewhere above 1/3 of a person’s incremental wages going to the government results in a loss of incentive for more work, extra efforts at legal (or illegal) tax avoidance, and a stinginess toward helping those who really need help.  Obviously, the rate at which one or more of these negative behaviors kick in, will differ for different people, but clearly the higher the rate, the more people hit the point where their behavior changes.  There is nothing magic about the brackets or rates I suggest, they are all open to debate, but I think they are close to right.  The table below illustrates the amounts and average rates that would be paid.

Annual Income            Taxes Paid       Marginal Rate             Average Rate

$10,000                             $200                   2 %                                2%

$25,000                             $500                   2%                                 2%

$50,000                             $3000                 10%                               6%

$100,000                           $12,000             20%                               12%

$200,000                           $36,000              28%                               18%

$500,000                           $127,000            35%                               25.4%

$1,000,000                        $302,000            35%                               30.2%

Deductions also should be curtailed, if not eliminated.  I believe a deduction for charitable contributions should be allowed, but it could be capped at 20% of income.  Deduction for interest on a home mortgage should be limited immediately on more than one home, and phased out for all new mortgages over a period of five years (existing mortgages at the time the tax law passes should remain deductible for one residence).  All other deductions should be eliminated, although phasing out of some might be wise, and should be looked at. Thousands of pages of regulations could and should be eliminated.

There is a real question whether a different scale of taxation for capital gains on investment should be included.  It does favor people who can invest (i.e., the more well-to-do), but it encourages investment, which is necessary to provide the means to increase GDP and standards of living.  In fact, a case could be made for extending the holding period needed to take advantage of the lower rates, say two years to reduce the tax rate by 20%, three years to reduce it by 40%, all the way down to 5 years and beyond, being taxed at only 20% of the applicable rate for ordinary income for the individual payer.  It would certainly increase long-term investment over mere trading.

All of these should be run against models to show how revenues would change, and rates modified to meet the needs.  I don’t have access to the necessary computer models, but it should be tested both by static and dynamic models, i.e., if nothing changed in the economy as a result, and if the economy grew by different reasonable percentages.

The main conclusions in this rather lengthy post are that we are not that far today from what should be done in individual taxation, where the goal would be mainly to simplify, but that competitive changes in corporate rates would bring more money back to the US, and keep company headquarters here.

In an interesting opinion piece in Wednesday’s Wall Street Journal by William Galston, he asks “Why did wages flatline?”, and cites Bureau of Labor Statistics that since 2010 hourly wages, corrected for inflation, have risen at only 0.5% per year.  Unfortunately, he does not contrast this with what he claims were greater gains in most earlier periods.  However, I do believe his thesis that the gains have been smaller in recent years.  He also cites falling unemployment, falling unemployment duration, but notes lower employment participation.  He then hypothesizes that unions are weaker, the population is aging, and with corporate profits up, managements aren’t sharing gains with workers.  Standard progressive fare.

Then there is our President, who asserts that the good jobs have been lost to China.  Unfair currency manipulation, government subsidies, theft of intellectual property, all under the auspices of a government taking advantage of US workers has been the villain.  Pretty standard reactionary fare.

So where does the truth lie?  While everything on both sides has some element of truth, some minor contribution to the problem, the elephant in the room, that no one discusses, is automation and instantaneous global communications.  More jobs, especially higher paying manufacturing jobs, have been lost to automation than anyone is talking about.  So is protectionism the answer—trade barriers, including tariffs, restrictive quotas, our own currency hijinks?  Or is it training and retraining individuals out of work with new and different skills, those now needed by the ever-changing economic landscape?

Simple economic theory teaches comparative advantage, that everyone is better off if each nation does what it is best at, and sells to other similar nations the goods and service in which they excel, and buys what their trading partner excels in.  The visible problem is this, however.  As a hypothetical (my numbers are not grounded in research, but are not totally fanciful), because Apple manufactures in China, everyone can buy an IPhone for $200 less than if it were manufactured here, and let’s say 4 million of them would be sold per year.  That’s good, right?  But if they were to manufacture here, there would be an additional 20,000 people employed at an average salary of $25,000 per year plus benefits.  This might be offset by less sales of our exported products to China, but let’s not even worry about that. So the employed are better off by $500 million and the buyers collectively are worse off by $800 million.  The 20,000 people without jobs hurt more and are more visible, even though the nation as a whole has a net benefit.

So what do we do?  The answer has to be to make a meaningful investment in training and retraining.  There are many overlapping and inefficient government programs for training, so why not drop them, and use the money elsewhere.  Employers know best what skills they need, so let the government reimburse them for training.  For example, if a company were to hire a worker to fill a job where he did not have the requisite skills, the government could reimburse the trainee’s pay, one month wages if he was still on the payroll at the end of a year, a second month if he were still employed at the end of a second year, and a third and final month if he was still on the payroll after 36 months.  Of course there would have to be safeguards to eliminate the possibility of companies cheating, but that shouldn’t be onerous.

Unions could be required to put a small fraction of union dues paid each month into building up a reserve for re-training laid-off members.  Teachers, generally off work in the summer months, could be paid for adult education in those months, to bring up reading and math skills among the educationally-deficient unemployed, who could be incentivized to attend classes by the prospect of losing benefits if they did not attend.

So a good centrist position here is not to cut off our nose to spite our face by dampening trade.  Nor is it to rail against “greedy” capitalists, but to invest in our people, upgrading and modernizing their skills.  There are always numerous job openings, often going unfilled, because the necessary skills can’t be found.

As everyone knows, the second round of French elections yesterday put Emmanuel Macron in the Elysee Palace as the President, replacing socialist Francois Hollande.  Hollande was a decent man, and tempered his socialist views when in office.  But that’s not the news or opinion that matters, it’s the defeat of Macron’s rival, Marine Le Pen of the French National Front, that is significant.

In the first round election, two weeks ago, those two emerged as the largest vote-getters, eliminating Melenchon and Fillon, who represented the socialist wing and the establishment, respectively.  The important news for centrists, is that Macron was their candidate.  Had Le Pen, a fairly extreme nationalist won, France might have followed Britain in exiting from the Euro economy, and that could well have been the death knell of that important coalition/organization.  And the victory was substantial, a 2 to 1 victory;  in the U.S. a candidate with that kind of margin would declare “an incredible and never-before mandate!”

Macron has his work cut out for him, with the country’s economic malaise, youth unemployment, over-regulation, non-assimilation of immigrants, and a host of smaller problems.  His youth and inexperience will not help him, and we wish him well in his endeavors.  But again, the important thing for us, is that after Brexit, after the Trump election, after the rise of nationalist parties in Hungary, Greece, and elsewhere, after Putin’s nationalist hold on Russia, a center party was able to win, and win significantly.  Just as socialists in one country applaud the victory of socialists in another, nationalists in one feeling strengthened by the victory of nationalists in another, we centrists (assuming you are with me), should feel both relief at Macron’s victory, and increased hope that our views can prevail here in the United States of America.

Why do we need taxes of any kind?  No matter how much someone hates government, even if a libertarian, he must admit we need some government services that have to be paid for.  We need a military and homeland security, we need embassies, we need a justice system, etc.  One can logically argue about how much government we need, but not whether we need one, must pay for it, and therefore raise money.

Since the Trump Administration has proposed a new tax plan to be detailed and voted by Congress, the topic is timely.  The aim of this post is not to critique either the Trump plan or Speaker Ryan’s plan, but to examine possible sources of revenue, comment on their desirability or lack thereof, and suggest improvements from where we are today.

Federal sources of revenue could include tariffs (or border adjustment taxes) on imports, sales tax or VAT (Value Added Tax), income taxes, wealth taxes, property taxes, luxury taxes, estate taxes, wage taxes, “sin” taxes (cigarettes, alcohol, possibly marijuana), and others I probably haven’t thought of.  Effects on state and local taxes must also be balanced in, and they have typically been income, wage, sales, and property taxes.

Tariffs discourage world trade, and trade is generally a good thing.   Tariffs are favored by the domestic industries which have difficulty competing profitably with foreign based companies. However, they raise prices for consumers, and invite retaliation by those foreign nations, hurting our exporting industries.  Workers in non-competitive industries can get hurt if they are not protected by tariffs, but that is the collateral damage of what Schumpeter called the creative destruction of capitalism.  There are other ways to handle the damage done to those workers, and we can deal with those in a later blog post.  The problem becomes the voices of the many who are helped slightly by lower prices or better quality are not as loud as the few who would benefit by hurting overseas competitors.

If tariffs are not appropriate, it is hard for me to see how a “border adjustment tax” is helpful.  I am not privy to the models and assumptions used by economists who say that a naturally occurring phenomenon of currency depreciation will smooth everything out, but I have trouble believing that as a panacea.   First, all industries will not benefit or suffer equally, second, the currency theory is untested and may not work as forecast, and most importantly, we cannot know how foreign nations whose industries may be hurt will react.  A trade war, where many nations erect tariff barriers to our exports, or devalue their currency, is in no one’s long term interest.  I am very skeptical of this idea.

Sales taxes are one of the primary sources of state and local revenues.  They are already in the 5% to 9% range for many locations.  Everyone will agree, I believe, that they are regressive, hitting poorer people proportionately harder than more well-to-do.  All in all, probably not a good source of Federal revenue.

Many European nations use a VAT, or Value Added Tax, which taxes goods at every level, for the value that producer added.  For example, if a steel producer sold $100 of steel, and it had $35 of iron ore it purchased and $11 of coal, the tax would only be on the difference of $54.  When the automaker used the steel, he would deduct its price to him from the sales price of the car, etc.  This tax, by any other name, is still a sales tax.  It increases the price of the products that all consumers purchase, and although it hides behind a maze, it is still a regressive tax.

Property taxes are used by almost all state and local governments.  If the Federal government were to begin taxing them as well, home ownership would be discouraged, and older people on fixed income might be priced out of living in a home they purchased years before.  Since we believe that home ownership helps society by giving people stability and a real stake in society, as well as a chance to enjoy gains in a growing economy and population, additional taxation at the Federal level is probably undesirable.

Wage taxes already exist in the form of FICA, or Social Security.  Since Social Security is headed for bankruptcy long term, we should look at increasing those taxes anyway, but that will not solve the problem of funding other government operations.  Actually, the solution to the long term Social Security funding issue is perfect for a Centrist.  The Democrats want to raise the arbitrary bar that only the first $105,000 of annual earnings are subject to the tax and to increase the tax rate, and to means test the payout, and the Republicans only want to raise the retirement age at which benefits begin and reduce the rate of increase in benefits paid.  There is such an obvious compromise available—do both, but to a smaller degree than if only one side was adopted—that only partisan ideologues would reject that compromise.

“Sin” taxes already exist—alcohol and cigarettes bear considerable tax, and if legalized, marijuana presumably will as well.  The taxes on those could be raised, even though as a sales tax, they are regressive.  However, there is some point where, as taxes, they become self-defeating, raising the price of the offending substance to the point that consumers buy less of it, reducing the taxes raised.

Luxury taxes have been tried, taxes on sale of yachts, private airplanes, mink coats, etc.  Of course, one man’s luxury is another’s necessity, and the makers of those products would scream.  The real problem is, that it would generate more heat than light; i.e., for all the screams, they would raise little revenue as their annual sales just aren’t that high.

That leaves income taxes (both individual and corporate), estate taxes, and wealth taxes as prime suspects.  They will be discussed in the next posting on this blog.

This post may turn out to be unsatisfying, because it will ask some questions to which there are no good answers.  We know that if we want something to improve, we have to measure it.  So we measure the nation’s GDP (Gross Domestic Product) and its growth (or shrinkage in a recession).  And if we divide the GDP by the population, we get GDP per capita.  If it is growing, we say that the standard of living is improving.

GDP is the sum of Consumption spending, Investment spending, and Government spending.  In the relatively short run, measurement of changes in GDP per capita are probably fairly accurate. There are some problems with it, because it measures dollars spent, rather than value received, but one year over another is probably not too far off.  The problem I see is over longer periods, where technological change may deliver far more value than just the number of dollars spent.  Let me give a few examples of what I mean.

If someone spends $40 per month on his cellphone service, and increases it to $50 per month, that will increase GDP by $10 per month.  But if another person, who had no cell phone, cancels a land line that costs $40 per month, and subscribes to a cellphone plan at $40 per month, there is no change in GDP.  However, the increase in value received is enormous.  Free long distance calls (up to some limit), and the mobility of communications all beat the static nature of landlines and extra charges per long distance call.  GDP measurements won’t show this.

If XYZ company had 10 million subscribers at $40 per month each, drops the rate to win new subscribers to $30 per month, and gains 2 million more subscribers here’s what happens.  Before the price cut, they had revenues of $400 million per month, and afterwards, only $360 million per month.  But there was an increase of 20% in the people using cell phones, gaining the value they provide.  GDP went down, value provided went up.

Other key statistics have problems, too.  We like to see a low unemployment rate, below 5%.  But that doesn’t measure the participation in the labor force, which may be dropping at the same time the unemployment rate is dropping, because people give up looking for a job, quit the labor force, take government transfer payments, and are no longer counted as unemployed.

As we know, the government can borrow money long term, and spend it today.  GDP may rise through increased government spending (unless it’s for transfer payments which aren’t counted in GDP).  But we increase today at the expense of the future, when our children or grandchildren have to pay the debt through taxes.  Some will argue that debt can always be increased, we won’t go bankrupt.  That is true only up to a point—remember the problems Greece had with a sudden inability to borrow as lenders lost confidence.

So, what, if anything, is the lesson here?  I think it is that no single statistical measure can really tell us how we are doing.  Several differing measures must be looked at simultaneously, to get a whole picture that is relevant.  Politicians tend to only cite the statistic that bolsters the argument they are making at any given moment.  Policies must be designed that truly make our situation better, not just a single statistic.  As Mark Twain said, “Statistics don’t lie, but liars can use statistics”.

As I write this, the nomination of Judge Gorsuch to fill a vacancy on the Supreme Court is the current battle in the war of the 3 deadly P’s—Partisanship, Polarization and Power.  It looks like the Republicans will win this battle, because it only takes a majority vote to change Senate rules to eliminate the filibuster against Supreme Court judges.  But as a famous general once said after a Pyrrhic victory, “One more such victory and we shall be destroyed”.

The Democrats are filibustering against the nomination of a perfectly acceptable candidate because they want to deny Trump his choice, and to get even with the Republicans for not allowing Judge Garland’s nomination by President Obama to even come to the floor for a vote.  But the Republicans did that because they didn’t want President Obama to get his choice (of a perfectly acceptable candidate), and they were getting even for Harry Reid and the Democrats  changing the filibuster rule for appellate court judges, and so on back to Judge Bork being denied.  I remember the late Bobby Kennedy, brother to and Attorney General for the late President Jack Kennedy saying, “In politics, don’t get mad, get even”.

Ever since the rift between Thomas Jefferson and John Adams caused the formation of two political parties, Partisanship has existed.  So this is not a new phenomenon in American politics, and to some extent we should accept this, and understand it is something we will survive.  But there is today something more destructive at work than we have seen since World War II.  Famously, Republican President Ronald Reagan and Democratic Speaker Tip O’Neill, were able to sit down and talk, and come to compromise agreements.

The political parties used to nominate candidates who were chosen for their ability to win elections and then to govern.  Ideology was real, but secondary.  Party platforms drafted at conventions were feel good statements, often ignored by candidates, at least some parts.  Not so today.  The process of nominating presidential candidates has moved from being at least somewhat under control by the senior and experienced pols in the party.  Now it is almost completely at the direction of the various state primaries, many of which have different and unique ways of granting votes to different candidates.

Who is active in the primaries, voting and getting like-minded people out to vote?  It is the activists in both parties, who are the most motivated, and they are motivated by the ideology formerly relegated to platform statements.  Now they are able to sway which candidate is chosen, and they choose the one whose expressed ideology most closely resembles their own. Thus, the rise of the hard left progressives for the Democrats, and the Tea Party conservatives for the Republicans. ( I regard the nomination and election of Donald Trump to be an anomaly.)

To these activists, people on the other side of the aisle are not just opponents, they are the enemy.  No tactic to defeat them is too low or devious.  Instead of merely about Power, and who gets it, the object is to discredit the enemy, either their ideas or their person.  The desire is to eradicate the opposition’s ideas from discussion and consideration, now and forever.

The object is not Power to move the nation forward together, but Partisan victory to impose Polarizing concepts or actions.  The result in a government of checks, balances, and elections is to create stalemate and the inability to move in any direction.  That is how we find ourselves today with Judge Gorsuch.

How can we break the cycle we are in, of action and retaliation in an endless downward spiral?  I can think of only two ways.  One way is if one of the two parties nominates a different kind of leader than we have had recently, one who is more pragmatic, yet has the charisma to carry the activists.  One who sees power as a means to reuniting the country and moving it forward, rather than favoring the narrower interests of the ideologues.

The other way is for the formation of a third party, that has a leader that naturally appeals to conservative Democrats and liberal Republicans.  The extreme wings will find themselves shrinking and increasingly irrelevant.  We can survive as a nation for some time without either of those two occurrences, but not happily, and not ever after.

I think we can agree that innovation is critical to an improving standard of living. Then the questions become what creates a culture of innovation, how does our economy measure against those markers, and how can we improve performance. The keys to innovation, I believe, are: creative insights, motivation, access to skilled labor, and access to capital.

Where do ideas and concepts for innovation come from? I believe they come from perceiving a need or a problem, and marrying that with a knowledge of how to fulfill or solve it. Clearly education, especially of creative thinking rather than rote memorization, will help with the latter. The perception of need or problem is aided by good communications and widespread dissemination of ideas, events, and issues. Creativity is also fostered by living in a culture which accepts change, and empowers individuals to believe they can create change.

Motivation is also key. For someone to devote the enormous amount of energy and perseverance, to take the risks involved, and to turn down other easier life options, there has to be a significant reward that goes to the successful. Not everyone is motivated by money. Some would create just for the sheer joy of creation, some for the advancement of scientific knowledge, but for most people the prospect of significant personal economic gain is extremely important. It is not an accident that the societies that have produced the most innovation are not communist or socialist economies.

Skilled labor is developed by a widespread and good education system, and not just for college graduates. Mechanical, electrical, metallurgical, and programming skills are all valuable. Labor mobility is also key, because startup companies have to be able to attract talent from more mature and stable ones. Labor mobility is partly cultural, partly motivated by rewards for the risk, but also is aided by an education that enables understanding of new visions.

Finally, availability of capital is critical, to fund startups, to compete against established giants. Investors who take the enormous risk of funding startups have to have a route to eventual liquidity and the possibility of significant rewards. An economic system that permits those rewards and established liquid markets for securities are essential, as is a taxation regime that does not confiscate too much of the gain.

What nations show the greatest innovation? I believe that the 18th and 19th century U.K., Germany prior to World War II, and today, the U.S. and Israel would head the list. The U.K. began the Industrial Revolution, Germany pioneered modern chemistry, engineering, and automobiles, and today the U.S. and Israel have the most patents per capita year in and year out. What do these nations have in common? A sound education system (compared to other nations at their time period), a free, capitalistic economy, and an emphasis on things scientific are characteristics in common.

How does the U.S. stack up, and where can we improve? First, on the motivation and risk/reward for entrepreneurs, we do pretty well. Our culture does respect and sometimes glorify them, and we are forgiving of failures. In this we are unlike several European nations where an entrepreneur who failed is branded by that for the rest of his life. Through the availability of pools of risk capital, we create the opportunity of creating something big, not just a shoestring, or small business. And with a reduced income tax on capital gains, we allow the entrepreneur to keep a large portion of potential gains.

For the generation of ideas and concepts, we provide excellent communications, between the wide variety and availability of Internet, television, and print media. On creative thinking abilities, I am not so sure. We seem to be falling behind other nations in rank on K-12 education, but our university system is the envy of the world. In part, universities make up for it, but only for those who attend universities. And our STEM Universities are excellent– schools like MIT, Stanford, Cal Tech, etc. are tops. On the other hand we are educating more young people in Gender Studies or Sociology than we are in Physics, or in welding, for that matter, and that is not a good sign for the future. Neither High School nor College has to be vocational training (though we could do more in this arena), but the education should prepare students to have the basic skills the job market desires.

Access to skilled labor is affected by some of the educational issues discussed above. We have a favorable culture toward labor mobility, as there is no shame attached to leaving one employer for an opportunity to advance one’s career, even job-hopping is acceptable for a while, and career changes are not infrequent. We could aid this further, by limiting non-compete agreements (as California has done), by passing laws to make health insurance fully portable, and making retirement plans vested on day one and fully portable.

We do quite well with access to capital, but again, we could do even better. Laws and regulations matter. In the late 1970’s, President Jimmy Carter tried to raise the tax rate on capital gains. Congress rebelled, and passed the Steiger amendment, drastically lowering that rate. Almost immediately thereafter, investable funds started to flow into the hands of Venture Capital firms, and from them to startups and young companies, unleashing a tide of entrepreneurs and innovation. We could consider a capital gains tax rate that encouraged patient investment by starting at 50% for investments held less than a year, and going down by 5% per year held, until a 10 year investment had its gains untaxed–or some variation thereof. Alternatively we could have a taxation scheme that favored direct investment into companies (including IPOs) as opposed to purchase in the secondary markets. We could give even more regulatory relief of Sarbanes-Oxley costly reporting requirements for small and newly public companies.

Another area we could do better in is fostering more scientific and engineering research. Our companies are pretty good at development of product, but much of it is enabled by prior pure research. Many of our innovations from the 1960’s through today were based on research in defense (DOD), space (NASA), or health (NIH) done through research universities and private laboratories. This is pure research high risk investing, not generally attractive to companies or venture capitalists. I’m in favor of reducing government spending, but not in this area.

A thought I have had over the years is to make a change in accounting rules to encourage companies to invest more in basic research in fields related to their endeavors. We could allow business to capitalize funded research (either done inside or contracted to a research university or laboratory) as an intangible asset while deducting the expenditure for tax purposes, as opposed to immediately expensing the sums on their income statement. They would only write off the asset against earnings if the project was abandoned as valueless; this might make basic research more attractive.

The most important two things we can do, however, are to improve K-12 education, especially in STEM subjects, and to make sure every law and every regulation is questioned as to whether it will help, hurt or be neutral to innovation.

Let’s assume that what we want in economics is first and foremost an improvement in our standard of living. We try to measure that by GDP per capita, or the total value of goods and services consumed, plus spending on investment, plus government expenditures, all divided by the population number. As we’ll explore in later posts, this is the best measure we can come up with, but it has some significant drawbacks. This post will try to demonstrate the fundamental importance that innovation has to the increase in standard of living, and the next post subsequent will explore why the U.S. is good at it, and what the government can do to encourage it.

Our earliest, pre-modern ancestors discovered the first innovation, the division of labor. Nature had made some stronger and faster, and thus more adept at hunting, and others, without those attributes, became gatherers. Teamed together, they were more productive then if each individual tried to do it all. Tool-making was also a very early innovation to enhance productivity, whether of wood for spears to aid hunting, of bone to sew garments, or of stone to make other tools. About 400,000 years ago man discovered how to safely use fire, thus harnessing energy other than his own, which provided safety for campsites, warmth, the ability to cook food, and a host of later innovations.

The discovery of farming and the domestication of livestock, around 7-10,000 years ago vastly improved standards of living. The discovery that firing clay hardened it for pottery, and that weaving of reeds made baskets or ropes, improved productivity. The invention of the wheel and the harnessing of draft animals to it was an incredible boost to transportation, and thus trade. Trade led to improved division of labor and specialization. The discovery that firing certain ores led to metals– first copper, then bronze, then iron and still later, steel–made an incredible wealth of new and useful products available.

The standard of living has been increasing over the decades, centuries, and millennia. And the time spans where it did not improve, and may have gone backwards, occurred when generations forgot the innovations their predecessors had made. An example would be the Dark Ages in Europe, when people lost the engineering of the Romans in building aqueducts, bridges, housing, etc. Medical practitioners lost the teachings of Galen, and lives were lost prematurely for centuries. The lack of innovation in the Dark Ages and Early Middle Ages was a root cause of the stagnation of betterment in the standard of living in Europe in those years. Standards of living began to increase again with innovations in shipbuilding, sailing and navigating, leading to increased trade and cross-fertilization from Eastern cultures.

Think of the advances that came from inventing a steam engine to do work. Can we imagine life before the harnessing of electrical energy? What did we do before automobiles and air travel? Life today without telephones, computers, and cell phones might be quieter, but I think we can all agree they have increased standards of living. Many productivity enhancing innovations are technological, but some are not. Think of the business process innovation brought about by Federal Express.

The United States’ economy has grown enormously since the end of World War II. Yes, it started at a low baseline for comparison, because of the Great Depression which preceded it. And yes, it grew because other nations were far more weakened by the devastation of war. But there were other more important causes, as well, one of which was our innovation. The outpouring of innovation in the U.S. in the past 70 years is unmatched in human history.

Can the government create jobs? To listen to our President, past Presidents, and other elected leaders, one could be forgiven for thinking the answer is “yes”. I beg to differ.

First, there is an exception or two. If the Administration increases the size of the U. S. military, it has created jobs. If the government expands the number of civil servants, it has created jobs. But we need to recognize that these jobs are paid for either by increasing taxes or by borrowing. The former removes money from the economy now, thus neutralizing any positive effect on GDP. Borrowing money to pay the salaries, merely shifts the balancing reduction in GDP to the shoulders of our children.

So where does job creation come from? In the main, it is private industry that creates jobs–corporations, partnerships, proprietorships and non-profit organizations as well. Why do they create jobs? Not for the sake of improving our employment numbers, but because their decision-makers sense an opportunity to use the additional labor to further their aims and goals.

So, what the government can and should do, is to create the environment which encourages private organizations to take risks and expand. Thus, the government through its words and actions can be indirectly responsible for creating jobs, and over time, significantly so. The tools the government has to work with include tax policies, spending levels and choices, regulations, promotion of exports, trade deals, and generally expressed words that build or weaken confidence.

In their haste to take credit or place blame, politicians conveniently forget or remember (as it suits their personal PR machine)that the economy often works with substantial time leads and lags. Business cycles can be lengthy, and policy changes may take months or years to work themselves through the economy. Thus the great recession of 2008-2009 occurred under President Bush, but had at least some of its roots in the housing policy decisions of the Clinton administration. And the Obama recovery was fostered by some policy decisions made late in the Bush administration (by the way, I am not holding Bush blameless for the recession!). Part of Clinton’s brilliant economic record was the good fortune of serving during the Great Internet Revolution and after the Reagan economic expansion, and part of Jimmy Carter’s economic malaise was the result of the oil shock and the distortions of price controls from former Republican administrations.

On a humorous note, the Reagan tax cuts, which were partly responsible for the great growth of the 1980s and 1990s, were passed in about May, scheduled to take effect in October. I distinctly remember a well-known Texas Democrat wailing in August that the tax cuts were a rotten idea, because, “See, they aren’t working!”. It might help if the government had more individuals with real world business operating experience to balance the attorneys and community organizers.

To conclude this post, I’d say the government does not create jobs in a meaningful way directly, but has an extremely important indirect effect on whether or not private organizations do. Future Posts on the subject of economics will cover taxes, regulations, trade, and the interesting Keynes’ discussion of “animal spirits”.