Austian vs. The Chicago School; M. Skousen

The Chicago School, Part III by Mark Skousen "Those [ideas] that are better tend to prosper and survive. Those that are worse tend to recede and vanish [like Austrian capital theory]." -Sherwin Rosen, University of Chicagol A t every Mont Pelerin Society meeting, a debate develops between the two schools of free-market economics: the Austrians (followers of Ludwig von Mises) and the Chicago school (followers of Milton Fried man). I've discussed their similarities and differences in various columns (see, for ex ample, the February, March, and April 1995 issues of The Freeman). At this year's program, held in Vienna, Austria, the discussion centered around how much (or little) Austrian economics has been absorbed into the mainstream "neoclas sical" model. At the end of the discussion, Professor Rosen made an interesting obser vation: the competitive free market of ideas tends to weed out bad economics from good economics. Good economics "passes the mar ket test," he claimed, bad economics doesn't, and is discarded. Therefore, concluded Pro fessor Rosen, if some Austrian concepts have not been absorbed by the "neoclassical"

model, they are probably "useless" and need Dr. Skousen is an economist at Rollins College, Department of Economics, Winter Park, Florida 32789, and editor of Forecasts & Strategies, one of the largestinvestment newslettersin the country. The third edition of his book Economics of a Pure Gold Standard has recently been published by FEE. not be pursued. He cited Austrian capital theory as an example. It was almost as if Professor Rosen was suggesting that a student need not bother with actually studying Austrian capital theory; one could simply dismiss it on the grounds that it was not being taught by mainstream econ omists. Does the Market Guarantee Good Economics? I first encountered this odd view of eco nomic progress while reading a paper by Professor William Baumol (New York Uni versity) about college economics. Baumol, a textbook writer, boldly declared, "there is absolutely nothing wrong with the current state of economics," because, he claimed, the mainstream economic approach "is a superb machine for grinding out theorems.,,2 In other words, the competitive process works in economic research. Through trial and er ror, economists sift and test theories, acquire good ones, and discard bad ones in a never ending upward spiral of academic progress. In short, the science of economics marches on ward and upward to its current advanced stage of knowledge and wisdom.

Based on this rather complacent view, Professor Baumol dismissed my criticisms of mainstream economics in Economics on Trial by reiterating, "I am totally unrepentant. There is absolutely nothing wrong.... ,,3 I offer two criticisms of this distorted view of the market of ideas. First, I question the 836 AUSTRIANS VS. THE CHICAGO SCHOOL, PART III 837 competitive market process in academia. As Professor Peter Boettke (New York Univer sity) notes, the economics discipline, like most social sciences, is a market of fashion, not the free and equal exchange of ideas through a rigorous scientific method. Philosopher Thomas Kuhn made this point forcefully in his classic work, The Structure of Scientific Revolutions (University of Chicago Press, 1962). Kuhn pointed out that the history of science typically works very differently. Once a central paradigm is established, very little testing or sifting is done until a series of failures or anomalies emerges. Only when a "crisis" arises does the profession seek out a new paradigm, and there is no assurance that the next paradigm will be more correct than the previous one.

The Keynesian revolution is a case in point. During and immediately following the 1930s, most economists incorrectly concluded that free-market capitalism caused the Great De pression. Throughout the fifties and early sixties, Keynesianism triumphed in the aca demic world, and the free-market schools of Vienna and Chicago were dismissed out of hand. Granted, free-market economics has made a huge comeback, thanks to the efforts of Friedman, Buchanan, and Hayek, and the turn of world events-most notably, the col lapse of Soviet communism in 1990. But let us not fall into the trap of thinking that economic errors automatically are eliminated in the classroom, or that deeply flawed ideas cannot be resurrected. Murray Rothbard calls this progressive view of history the "Whig Theory" because nineteenth-century Whigs maintained that things were always getting better and better. He states, "the consequence [of the Whig theory of history] is the firm if implicit posi tion that . . . there can be no such thing as gross systemic error that deeply flawed, or even invalidated, an entire school of eco nomic thought, much less sent the world of economics permanently astray.,,4 Rothbard rejects the Whig theory. In writing his history of economic thought, he concludes that "there can ... be no presumption whatever in economics that later thought is better than earlier."

The Market Produces Goods and Bads I offer another objection to Professor Rosen's viewof the free market. He notes that in a free market bad musicians don't sell very many records. True enough, but one must distinguish between what is technically com petent and what is morally deleterious. Cer tainly, Hollywood produces technically ad vanced films, with special effects, skilled acting, and superior photography, but it also makes filmswhose contents are often morally bankrupt. In short, the market does a great job in producing both "goods" and "bads." Austrian Capital Theory, Again Finally, a comment about Austrian capital theory, as developed by Eugen B6hm Bawerk, Ludwig von Mises, and Friedrich Hayek. Admittedly, it is not currently part of the mainstream. But is it "useless"? Hardly. In fact, I frequently depend on the Austrian stages-of-production model in analyzing the economy and financial markets. Because it is usually ignored by the establishment, I can more easily use the Austrian model in pre dicting economic trends and developing fi nancial strategies.5 The unpopularity of Aus trian capital theory does not make it wrong or useless. [] 1. Sherwin Rosen, "Austrian and Neoclassical Economics: Any Gains from Trade?", Proceedings of the Mont Pelerin Society Meetings, Vienna, Austria, September 9, 1996.

2. William Baumol, "Economic Education and the Critics of Mainstream Economics," Journal of Economic Education (Fall 1988), pp. 323-4. 3. See the paperback edition of Economics on Trial (Burr Ridge, Ill.: Irwin, 1993). 4. Murray N. Rothbard, "Introduction," Economic Thought Before Adam Smith (London: Edward Elgar, 1995), p. ix. 5. See my work, The Structure ofProduction (New York: New York University Press, 1990), and Austrian Economics for Inves tors (London: Pickering & ChaHo, 1996).

Letters to the Editor: The Flat Tax To the Editor: In his article "The Flat Tax: Simplicity Desimplified" (The Freeman, October 1996), Roger Garrison implies that those who favor the flat tax do not care about the size of the tax bur den. Since the vast majority of flat-tax support ers are big advocates of lower taxes, and since all the major flat-tax proposals include a signif icant tax reduction, this claim is somewhat con fusing. Moreover, evidence from the states shows that single-rate tax systems make it hard er for states to raise taxes. As such, adoption of a flat tax presumably would impose limits on the growth of taxes on the federal level (primar ily because politicians would have a harder time using divide-and-conquer tactics). Garrison argues that the tax system cannot be simplified. Given that the flat tax eliminates all the most difficult and confusing aspects of the current system, this assertion is quite puzzling.

No longer would individuals or businesses have to worry about capital gains, depreciation, estates and gifts, alternative minimum tax, for eign tax provisions, inventory accounting, phase-outs, itemized deductions, and so forth. It is certainly true that there is no free lunch, but there certainly are ways to reduce the cost of the lunch, and tax reform provides those effi ciencies. Garrison also claims that huge problems would be created as taxpayers reclassify W-2 income as business income in order to take advantage of business deductions. The incentive to play that game, however, depends on the tax rate. Since the tax rate will come down under a flat tax, there actually will be less income shifting. Perhaps the most glaring error is Garrison's claim that income from savings is not taxed under a flat tax. Even liberal economists admit that the core principle of the flat tax is to tax income only once. This means either taxing once when the income is first earned, but then leaving the returns alone (the Hall-Rabushka approach), or not taxing income that is saved, but taxing the interest and principal when spent (the IRA approach). Liberals admit that doing neither is double taxation, but justify it on pure income-redistribution grounds. It is difficult to imagine why anyone who believes in markets would adopt that position.

Garrison envisions a tax scam where employ ers give employees money to buy bonds, the interest to which would be nontaxable. He for gets, however, that the money provided to the employees under the flat tax would either be considered income to the worker (and thus tax able) or a fringe benefit (and thus taxable at the firm level). Either way the compensation is taxed (but not double taxed, since the interest properly is left alone). Garrison believes that one rate has little to do with simplicity. In reality, one rate is critical if we want to tax all income at the source. One rate, for instance, allows us to tax AT&T one time on their income at the single rate of 17 per cent. This is vastly preferable to tracking down all 2.2 million shareholders and imposing sepa rate tax rates depending on their total income. The same thing with interest income. Not only will the single rate eliminate the one billion 1099 forms in the economy, it will also elimi nate income shifting designed to have income declared to the low-tax person and deductions attached to the hightax person.

All believers in limited government agree that the tax burden should be reduced to the maxi838 mum extent possible. This goal is not in con flict, however, with the idea of making sure whatever level of taxes is collected is taken in the least destructive, least intrusive manner pos sible. -DANIEL J. MITCHELL McKenna Senior Fellow The Heritage Foundation Washington, D.C. Roger Garrison replies: Dan Mitchell's challenging remarks, particu larly his reference to a "glaring error" concern ing the tax status of saved income, provide an opportunity for dealing with a common point of confusion. I take Robert Hall and Alvin Rabushka's Flat Tax (2nd ed., Hoover Institution Press, 1995) to be ground zero for the modern resurgence of interest in simplifying our tax system. Hall and Rabushka leave little doubt about the status of saving in their proposed sys tem: Here is the logic of our system, stripped to the basics: We want to tax consumption .... We can measure consumption as income minus invest ment. A really simple tax would just have each firm pay tax on the total amount of income generated by the firm less that firm's investment in plant and equipment. (p. 55) Saving, then, which stands in contrast to con sumption and underlies investment, is not taxed.

Hall and Rabushka' s only significant departure from this "really simple tax" is one that exempts some consumption: the part of the firm's (gross) income that is paid out in wages is untaxed until it is in the hands of wage earners, each of whom is allowed a generous personal exemption. This provision causes a substantial amount of con sumption to go untaxed and gives a progressive character to average tax rates, but it does not bring saving into the tax base. Given the ex post macroeconomic identity between saving and investment, Hall and Rabushka could hardly fail to recognize the nature of their proposal: "Our proposal is based squarely on the principle of consumption taxaLETTERS TO THE EDITOR 839 tion. Saving is untaxed.... " (p. 54). Yet the authors themselves are at least partly responsi ble for the current confusion. At critical points, they misleadingly write "income" instead of "consumption," and sometimes they write as if there were no difference between these two magnitudes. Although there are many such instances, I will cite just two: "The business tax . . . is carefully designed to tax every bit of income outside wages but to tax it only once"

(p. 61). In fact, it is actually designed, as Hall and Rabushka had already stipulated, to tax only income net of investment, effectively convert ing the income tax to a tax on consumption. And virtually guaranteeing confusion, the authors explicitly affirm their "goal of taxing all income once at a common, low rate and achieving a broad consumption tax" (p. 63). This compound goal is simply at war with itself. Consumption and income are not the same thing; they differ precisely by the amount of income saved. The confusion that has its roots in the original Hall and Rabushka proposal has caused Mr. Mitchell and undoubtedly others to see my exposition as involving a "glaring error." Some supply-siders leverage the confusion by insist ing that "consumed income" is, in fact, what "income" actually means. Others offer the all too-facile claim (not supported by Hall and Rabushka' s basic logic) that saved income (or, alternatively, the yield on saved income) has already been taxed. These and other confusing claims stem from their using the rhetoric about taxing income once and only once in defense of a consumption tax. It is consumption, not income, that (beyond the generous personal exemptions) is taxed once and only once.

Several other points of disagreement raised by Mr. Mitchell are resolved once the tax status of investment (and hence saving) is established. For instance, there undoubtedly would be efforts in the private sector to disguise part of the (taxable) net income as (nontaxable) invest ment as well as efforts by the government to counter such attempts at tax avoidance. Mr. Mitchell points to the vulnerability of our 840 THE FREEMAN· DECEMBER 1996 current system to the "divide-and-conquer tac tics" of politicians trying to raise tax rates but fails to acknowledge that Hall and Rabushka's generous personal exemption, which converts flatness into progressivity, would seriously weaken taxpayer solidarity and expose their proposed system to those same divide-and-con quer tactics. Remaining differences between Mr. Mitchell's views and my own are matters of per spective and judgment. Yes, some-maybe most-supply-siders would prefer tax reduc tions, but their willingness-even eagerness-to propose revenue-neutral or revenue-enhancing reform suggests their priorities lie elsewhere.

And yes, given the complexities of the current system, there is plenty of room for reform in the direction of tax simplification. TANSTAAFL does not deny that some lunches are cheaper than others; TANSTAABST (There ain't no such thing as a big simple tax) should be interpreted analogously. My arguments do suggest that a tax system involving (1) postcard-size tax forms and (2) the transferring of hundreds ofbil lions of dollars from the private sector to the public sector is (not-so-unhappily) outside the realm of possibility. -ROGER W. GARRISON Professor of Economics Auburn University We will print the most interesting and provocative letters we receive regarding Freeman articles and the issues they raise. Brevity is encouraged; longer letters may be edited because of space limitations. Send your letters to: The Freeman, FEE, 30 S. Broadway, Irvington-on-Hudson, New York; 10533; fax (914) 591-8910; E-mail: freeman@westnet.com.