Certain words in American political discourse lose their meaning and are understood only as epithets. Calling someone a “socialist,” for example, is often understood to be a beyond-the-pale denunciation rather than an honest attempt to characterize the official’s policy views. Yet, policies are not created in a vacuum; they tend to be animated by a worldview or vision for how the economy works. This past weekend in Roanoke, Virginia, President Obama offered what finance professor Craig Pirrong described as a “collectivist vision” for how the economy operates:
There are a lot of wealthy, successful Americans who agree with me — because they want to give something back. They know they didn’t — look, if you’ve been successful, you didn’t get there on your own. You didn’t get there on your own. I’m always struck by people who think, well, it must be because I was just so smart. There are a lot of smart people out there. It must be because I worked harder than everybody else. Let me tell you something — there are a whole bunch of hardworking people out there. (Applause.)
If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business — you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.
The President is certainly correct that hard work and intelligence are not sufficient for someone to build a business and become a successful entrepreneur. What is also required is a willingness to take risks, and this willingness very much depends on government policy. As NYU economist Roman Frydman has said, “no one has become very rich by pursuing projects everyone knows to be lucrative.” Successful entrepreneurs see potential returns in projects that others do not perceive. But perceiving the opportunity is only the first step; the decision to pursue it depends critically on whether a premium exists to compensate the would-be entrepreneur for assuming the risk of starting a new venture.
Academic research has looked at differences in rates of entrepreneurship in the U.S. and Europe and found that employment and tax policies decisively favor the U.S. First, labor markets are much less flexible in Europe, with much greater job security, higher minimum wages, nationwide labor negotiations, and a greater role for unions in the development of work rules. A worker in Europe that enjoys “lifetime employment” with predictable wage increases with each additional year of service is giving up more to start an entrepreneurial venture. More significantly, an entrepreneur is less likely to find employees willing to leave an established enterprise for an uncertain venture. To further complicate matters, an inability to shed workers is likely to be a much bigger problem for new firms less able to accurately forecast sales revenue. Together, labor markets regulations reduce the probability of deciding to become an entrepreneur and create rigidities that make it less likely new firms will succeed.
Secondly, higher tax rates reduce the potential returns from entrepreneurship, which can be toxic given the non-diversifiable risk entrepreneurs must assume. Since most start-ups fail, it is puzzling why so many American households “willingly invest substantial amounts in a single privately held firm.” Expected after-tax returns on privately-held businesses have to compensate investors for the lower liquidity and reduced diversification relative to a stock market portfolio. For these reasons, entrepreneurial activity is likely to be extremely sensitive to higher marginal tax rates. Empirical research finds support for this presumption, as progressive tax rates discourage entry into self-employment and into business ownership.
The President’s vision is also fascinating because it reveals a deep distrust of labor markets. An entrepreneur’s success may indeed depend on tens of thousands of employees, for example, but he or she had to attract them to those jobs in a competitive labor market. Basic microeconomics suggests that, in equilibrium, factors of production earn their marginal product. This means that the successful entrepreneur has to pay wages commensurate to the revenue those employees’ work generates. The same logic applies to use of roads, bridges, and other infrastructure – there’s no reason to suspect that use of these facilities cannot be priced appropriately through user fees, gasoline taxes, and other revenue streams.
Academic work has made clear that “top incomes earners today are not ‘rentiers’ deriving their incomes from past wealth but rather are ‘working rich,’ highly paid employees or new entrepreneurs.” Workers with more skills like education, experience, or innate talent tend to generate more output per hour of work and earn higher wages as a result. These higher wages create incentives to invest in human capital, which boosts productivity and living standards. Although wage inequality is, in some respects, beyond the level that can be explained by differences in skill levels alone, as Edward Lazear demonstrated decades ago, competition for the highest-paying jobs can increase productivity across the firm and broader economy. If there is one position of “President” available in a firm, the outsized pay for that role could increase the effort of many “Vice Presidents” seeking the promotion. In this case, it is economically rational for the Vice Presidents to earn one-third as much as the President even if they have the same skill and education level because the “prize” of the Presidency’s differential pay is what incents the hard work. In these cases, of course there is a requisite education or skill level necessary for the worker to be in the mix for the “prize” in the first place.
Finally, the President’s statement helps to shed light on some of the other questionable decisions of the Administration. The Solyndra debacle and related loan programs reflected a distrust of the ability of private market participants to perceive and fund promising new investments. If entrepreneurial success depends on government support rather than innovative thinking and discretionary risk-taking, why shouldn’t the government help to decide which ideas get funded and which don’t?
Second, the Obama Administration’s decision to allow the large banks to leave TARP without resolving the issue of “too big to fail” apparently stems from a belief that the bonuses of bailed out bankers are no different qualitatively from the returns of an entrepreneur since both depend on government. As TARP inspector general Neil Barofsky explained, many people believed the implicit bargain of the TARP bailout was financial regulatory reform that addressed the risk large financial institutions pose to the economy. Instead, the Obama Administration institutionalized bailouts and fought for the creation of a consumer agency.
One does not need to ascribe pejorative terms to President Obama’s worldview to recognize that some of his policies are animated by a misunderstanding of economic development. Large and non-diversifiable risk is the most salient feature of entrepreneurship, yet the President seems to ignore it completely. Taking entrepreneurial activity for granted by assuming it is invariant to tax rates is the easiest way to slow creativity, innovation, and growth.