Visible Subsidies and Invisible Destruction

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Schumpeter’s "creative destruction" describes how the free market’s new and more efficient industries push out old ones, creating economic growth. The state’s perversion of this process we may call uncreative destruction. The state overtly subsidizes some industries and groups (including itself and its employees), while covertly it destroys society’s overall wealth and well-being, lowering economic growth and welfare.

The state’s magic act and trickery consists in attracting attention to the subsidies of its right-handed spending while obscuring the even greater destruction of its left-handed taxes and regulations. As French 19th century economist Bastiat wrote, in his essay That Which Is Seen, and That Which Is Not Seen, there are two effects of the state’s actions: the visible and the invisible. The state points to the economic activity of fixing real and imaginary broken windows (the subsidies), while avoiding all mention of the windows it breaks, the houses it bulldozes, and the people diverted from building new and better houses (the destruction.)

The state, for example, advertises the stimulative effect of wartime spending, which subsidizes all those businesses producing war matériel and supports all those working in war industries. But its taxes to pay for the war are extracted from a broad swath of the population who experience their wealth diverted and destroyed. The destruction does not end there. With lower wealth, people’s capacities to save and invest in human and physical capital are decreased. Innovation is stifled in the butter industries as production to meet demands is curtailed and shifted to waste. Economic growth declines.

All state spending is like spending on wars in diverting production away from what people want and value (the invisible) and into what people do not want and do not value. And all of it causes destruction in more ways than one. With more wealth going to guns and less to butter, people go unemployed in the butter industries. People’s lives and plans are disrupted. They must travel and seek different employment elsewhere. Social and family relations are disarranged, imposing heavy psychic costs on human beings. Meanwhile, the state’s takings make obsolete, divert, and destroy all forms of capital: physical, human, and social.

We know that the destruction effects exceed the subsidy effects simply because the taxes are coerced. And because the destruction includes not only the immediate diversion of wealth away from goods people favor (butter), but also the destruction of investment and innovation, the destruction of preferred social arrangements, and the imposition of psychic costs on those forced to alter their preferred living arrangements, we can be sure that the destruction far exceeds the subsidy benefit. We can be sure that the net effect of subsidy and destruction is net destruction.

All state programs have the same sorts of net negative impacts upon society. A Social Security program, for example, is highly destructive. In this case, a favored group of elderly is subsidized while an unfavored group of employed taxpayers foots the bill. Saving, investment, and innovation are stifled broadly throughout the entire society. Growth and progress diminish. The many and varied negative social and economic impacts on family, work, and attitude add to the negative total.

How large is the state’s uncreative destruction? Very large. Rothbard suggested that all of the state’s spending was waste. How can we get an idea of the extent of the net destruction? As a lower bound, we can consider the long-term changes in the efficiency of American industry, and we can consider the tax bite taken from taxpayers.

In the 1880′s, American industry (in real terms) produced a 7 percent rate of return on invested capital. Today, the figure is 4 percent. Suppose that firms retain all of this return and reinvest it. Then they will grow at a 7 percent rate in 1880 and at a 4 percent rate in 2007. Although industry does not retain all of its earnings, the large drop in profitability suggests that a vast slowdown in the growth rate has come about because of the state. Changes in taxes coincide with this slower growth and confirm it. Suppose that the tax rate in 1880 was nil, and that the tax rate today is 30 percent. Then the after-tax return of a 7 percent rate today is reduced to 4.9 percent. A 40 percent tax rate reduces the return to 4.2 percent. As the state absorbs returns and diverts that wealth to waste, both taxes and slower growth reflect that diversion.

Not being historians and not being centagenarians, great numbers of Americans are unaware that the American growth rate has slowed so noticeably. Even if they recognized the visible loss in the decreased growth rate, would they realize the tremendously huge wealth losses this entails? Probably not. As growth begins from any base amount, it compounds. With a 4 percent growth rate, the base grows more slowly and the increments are much smaller. With a 7 percent growth rate, not only is the growth rate higher but the increments are larger and larger. There is a substantial growth-upon-growth effect, which is exactly like an interest-upon-interest effect. One thousand dollars grows to $50,000 in 100 years at 4 percent. It grows to $868,000 in 100 years at 7 percent. Although the growth rate is 75 percent higher (7/4 = 1.75), the ending wealth is higher by a factor of over 17 or 1700 percent.

Add on to slower growth the less visible or invisible losses in terms of technical innovations, education, health care, population growth, longevity, and culture. Add to this the losses in quality of services provided by states when they replace free market services. Add to this the sheer waste when states force human activity into channels where it does not want to go. In total, the destruction must be even greater than a 75 percent drop in growth rate suggests. Below we assume that today’s rate of government destruction is greater by a factor of 125 percent than in 1880.

To view the two faces of government more concretely, we explicitly introduce the subsidies to some businesses (guns) and the destruction to others (butter.) Let the business product in 1880 be denoted BPAST. Suppose that in 1880, the effect of subsidies was to increase this by 20 percent or by 0.2BPAST, and suppose that the effect of destruction was to reduce this by 30 percent or by —0.3BPAST. The net effect on the 1880 economy is then —0.1BPAST. Taxes measure this, since in total at all levels of government, they were probably around 10 percent at that time. At 10 percent, the drag on the economy in 1880 was relatively small.

Fast forward to 2007. The state is far larger. Its subsidies are larger and its destruction is larger. Suppose that the subsidies have increased by 50 percent compared with 1880. That is, the effect on today’s product (called BNOW) is 0.2 x 1.5 = 0.3. Today’s subsidies are 30 percent of today’s product. Today’s destructions have also amplified, by an even greater factor; let us say by 125 percent. That means the destruction effect is now —.3 x 2.25 = —0.675 of BNOW.

The net destruction today on BNOW is then 0.3—0.675 = —0.375. This figure of 37.5 percent approximates the tax rate being paid to the state today. By supposing that the state’s destruction has gone up faster than its subsidies have (125 percent compared to 50 percent), we obtain a sensible numerical result that replicates several facts: (1) the reduction in business efficiency from 7 to 4 percent, and (2) the increase in taxes upon business (felt of course by individuals).

Suppose that the business sector in a free market can produce and grow at 7 percent, both in the past and today. Using the guesstimates, the real growth rate in 1880, after the state’s depredations, was 0.9 x 7 percent = 6.3 percent. Today, the real growth rate is 0.625 x 7 percent = 4.375 percent. These numbers are speculative, but their difference provides a sensible ballpark and lower bound estimate of the net effect of the state’s destructions over its subsidies. As taxes have jumped from low to high levels, the growth rate of the economy has dropped by about 30 percent, that is, the difference between 6.3 and 4.375 divided by 6.3.

Why does the state’s destructiveness rise faster than the subsidies it provides? There are several reasons. Economically, when the state taxes, it first draws funds away from the lowest-valued projects that businesses wish to invest in. Later it draws funds away from more highly valued projects. As they seek to fund these, they run into capital costs rising at increasingly higher rates. Another reason is that the state’s regulations accompany its subsidies and taxing, and these add whole new layers of destructiveness by hindering innovation, forcing companies to divert resources to evasions, and driving companies overseas. Third, the state introduces political uncertainty into the business equation. Fourth, there are network effects. As destructiveness spreads, it deteriorates and disrupts business inter-relations among different industries. Fifth, as businesses learn that politics is influencing their production, they seek out political favors so that favoritism and the concurrent destruction grow. Sixth, the state is able to capture industries to which it provides subsidies.

The state’s only creativity is in designing its tricks and fooling the public. We who are on the receiving end experience massive uncreative destruction.

Per Bylund [send him mail] works as a CIO / IT and Development Manager in Sweden, in preparation for PhD studies. He is the founder of Visit his website.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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