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Nobel Laureate Economist James Heckman

Making a Bigger Pie

The perils of unintended consequences, the importance of flexibility, the ultimate value of ideas: In this exclusive interview, Dr. James Heckman focuses on the keys to a successful economy.

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Making a Bigger Pie

By Isabella Wu
From CommonWealth Magazine (vol. 376 )

Taiwan’s economic development stands at a point of transition.

As the gap between rich and poor expands in Taiwan, how should the government plan social welfare to ensure both fairness and continued growth? The Nordic model has produced Norway, with the highest concentration of millionaires in the world, and Finland with its resounding success in high tech. Is it worthy of emulation?

And as neighboring Hong Kong and Singapore aggressively slash taxes to attract capital, what should Taiwan’s response be?

In July of this year, James Heckman, the 2000 recipient of the Nobel Prize in economics, visited Taiwan to lecture at the invitation of the Academia Sinica and the Far Eastern Group. He also graciously granted an interview with CommonWealth Magazine.

While not a specialist on Taiwan, Dr. Heckman offered keen insights into adopting a successful economic strategy, warning against simplistic allegiance to a single model, and extolling the pursuit of incentives that promote excellence.

Following are highlights from the interview.


Q: These days the Northern European economic model, with its more equal distribution of wealth, has become a hot topic. You have looked at it very closely. Is there anything that people are missing?

A: The question is whether or not the whole Swedish model or the whole Finnish model should be taken. I think it’s a mistake to say, “Here’s a successful model, we’ll take it.”

Every society has its run. The question is what features have allowed certain societies longer runs than others?

Ireland is an economy that is very successful. It’s small—much smaller than Taiwan, only about five million Irish—but they opened themselves to world trade in a way they didn’t before. They educated their workforce through compulsory schooling laws. One generation ago, people in Ireland had very little education. They suddenly made it free – no tuition fees anymore – made it much more accessible. All Irish capital stock goes up. At the same time, Ireland opens its way to incentives— it has very low taxes on capital.

But, I don’t think we want to follow the Nordic countries, or the Austrian countries, or any country in particular. I think what we want to do is look at the structure of incentives in place and realize that it’s been the incentives that have mattered, wherever they apply. The best part of the Irish system is the open trade. They have very low export taxes, very low taxation on capital. A lot of foreign companies are in there repatriating profits. So the difference between the GDP and the GNP is enormous. But they’re creating jobs, and definitely increasing welfare for Ireland.

Can we break out of the mentality of seeking a model we should adopt? I would be the last person to say that any country should adopt the American system. There are a lot of problems with the American system. Likewise, The Nordic model has features that are good, but the features aren’t all uniform.

Q: I think maybe part of the reason people like to talk about the Nordic model is because equality. People feel the society has more equal opportunity.

A: It’s true, the Nordic model measures a much smaller gap between the rich and the poor. On the other hand, the incentives for people to go to college are lower, the incentives for people to produce are lower, and you’re getting this rising trend where more of the younger people are learning to take advantage of the welfare system.

But you’ve got to somehow preserve the incentives for people to acquire skills. You want to think broadly; those very things you like about inequality reduction may have negative effects in terms of creating the next generation of people. So if I am protected against having to work – I don’t have to work, I don’t have to be skilled to make a good job – I won’t. And that’s what we see happening.

Now, the younger generation is saying, well, why should I work when the older people will pay for me? They then start creating a two-tier system. Some of the immigrants would come in and say, “I can get these benefits – why should I work?”

In our own country – I don’t know if you’ve visited any of these inner city areas in Chicago, New York, Los Angeles – but what happened was that very poor people, primarily African-American – not always though, there were poor whites – were essentially given housing, benefits. The idea was that you would improve their well-being, and if you gave them income, that would improve the next generation, they would have higher income. It didn’t work that way. It created a group of people who generation after generation were on welfare. And so it created a class of people who were separated from the larger society.

There was a term coined by a famous sociologist at Columbia, Robert Merton Sr. – “the unintended consequences of social policy.” Welfare was one of them. Same thing is true of minimum wage—what could be more beneficial than giving people more money? Go to work, get a higher income, that’s better, good for you. The trouble is, there might be fewer jobs.

To a company, it makes it more costly for them to do business. That means then that some companies might go out of business altogether. Some companies might relocate to other countries. And so what that leads to is a structure where even though initially the people who get a higher wage are better off, it ignores the fact that a lot of people might not get jobs. That’s an unintended consequence.

Q: It seems very difficult to devise a sustainable model or system. So should we revisit our model?

A: You revisit the model, but its not saying we can’t protect people. You can protect people, but there are better ways to protect them.

It’s a little bit like this: You want to make sure that people try their best. So how do you do that? You give people very high incentive to succeed. That by itself creates an inequality. No question about it, because there’ll be winners and there’ll be losers. If the stakes are very high, there’s probably more inequality. On the other hand, if there is a real productivity gain from giving these incentives, there’s no loss for the whole society to do some taxation and do some redistribution. But you do it in a way that doesn’t create an incentive for people to lose.

Q: Things are changing a lot, and they are changing at an increasingly faster pace. So if policymakers want to devise a system for tomorrow, what are the key factors they should consider?

A: Well, I just think they should be more open to discussions of incentive effects in policies. People are always talking about inequality—you mentioned inequality. Inequality is a real issue. But all I would ask is that people recognize that some inequality is good, in the sense that it creates incentives.

Q: Can you give us some examples?

A: Typically the way the world really is, is that we produce goods by trading and interacting with each other. It’s not like we’re taking a fixed pie and dividing it – we’re creating a bigger pie.

Just imagine two societies – one society where everybody is at starvation level but fully equal, and another society where some people are much richer than the starving – the poorest person is, say, a thousand times richer, but the richest person is a million times richer. So it’s much more unequal, but everybody’s better off. Which society would one want to choose? I think it’s the society that would be offering more opportunity. So equality per se isn’t the issue. It’s really the level of well-being.

We know people are very diverse, so an equal society is going to get a lot of diversity. If you gave everybody equal chance, given how different we are, then there will be a lot of the inequality in the end, right? We all started with the same thing, we all were given the same chance, but some people choose to become a concert pianist, some people decide to be an economist. In the end, they may even be the same in terms of well-being, but they may earn very different incomes.

So yes, have more equality of opportunity, but don’t force equality of outcomes.

Q: Can you give us an example of how to devise incentives for creating a bigger pie?

A: Take the case of the earned-income tax credit. The minimum wage operates by raising the wage of somebody, say by 15%. Some people then lose their jobs because firms paying higher labor costs go out of business. Some people will have more money, so some people win and some people lose.

Let’s suppose you increased the prevailing wage, but you did it in a different way. What am I going to do? I am going to say, “If you work at this job, then I will make up the difference between your productivity and that wage.” What does that do? It gives the person work.

So it’s not like there is a class of people who don’t work, and other people who do. Poor or rich, everybody is in this boat, and it’s expected that you work as a part of it. And I think there is some benefit of inclusion that comes from it.

Q: Different stages of economic development require different resources. What do you believe will be the most important resource to drive the world economy in the future?

A: I think the ultimate resource is not going to be energy. I think it’s probably always what it has been – ideas and creativity. I think that’s the ultimate resource. Think of how societies have stagnated for centuries because they have been unable to produce, unable to organize themselves effectively. Think of the change that happened in the last 250 years because of the industrial revolution. That was idea-based. People came along with different ways of producing goods, creating technologies, creating opportunities. And that liberated people.

A claim has been made that the standard of living in the Roman Empire at 0 A.D. and the standard of living in Europe in the 1300s or 1400s was about the same – very stagnant, because ideas and social systems weren’t very well organized. What created the difference? I think ideas and mechanisms for putting those ideas in place.

Q: What country is best at putting ideas to work?

A: Many societies are successful in different degrees. In Finland, Nokia has certainly been very successful, and their technology is all around the world. Japan is extremely successful in building high-quality automobiles. The U.S. has been strong in computer science, traditionally. There are technological leaders all around the world. Again, I don’t want to say there is one particular country. But the feature has generally been that places that have a high standard of excellence – they create a culture of excellence – have generally been very successful societies.

I think Taiwan has been very successful in the past 50 years, it has moved towards being competitive, using native skills, talents and finding initiatives to compete, and the global economy has actually helped Taiwan a lot. Taiwan has helped create the global economy by producing new goods, new products. China now seems to be very filled with ideas, but it’s got a lot of problems, of course.

It’s not just having the ideas—you have to make them practical, that’s the issue.

Q: What is the role of education?

A: Education is important. Historically, you see that more educated economies have been more flexible. You can shift sectors. When one sector declines, another sector rises. Educated workers can shift in ways and respond flexibly. Less educated workers can do one thing usually very well, but it’s difficult to switch to new sectors. If anything, we know that with open economies, fluctuating trade and all the uncertainties in trading partners, we need flexibility. That flexibility is achieved by education.

Probably education has been more important in the modern world because there has been more change. Not only can educated people produce ideas, they can also respond more quickly in different situations.

Education has to be less narrow and more flexible. It has to feature less specialization at the undergraduate level and probably more focus in abstract reasoning, even what is sometimes called liberal arts reasoning. You can train somebody to be a metallurgist or a dentist, somebody to take very narrow specialty, but what we know is that communication skills, mathematic skills, the ability to think generally are in great demand. In other words you have to be able to think outside the narrow niche, because these specialties change.

In traditional learning, people are memorizing multiplication tables and memorizing words. Now I think we need more abstract ideas and people thinking broadly, solving problems, emphasizing what psychologists call “fluid intelligence,” the ability to solve new problems.

Psychologists have made distinctions between fluid intelligence and crystallized intelligence. You want crystallized knowledge, which is knowledge, but it is fluid intelligence that allows you to solve new problems. And that gives you the ultimate source of creativity.

Suddenly I encounter something that I have never seen before. How do I solve this problem? You have a society that is able to do that, rather than follow old lessons very well- that’s a society that’s very successful.

Q: What is a good model for small countries the size of Taiwan?

A: I think the only way that Taiwan can be more successful is to be more open to change, to think about old problems in new ways.

Taiwan’s economy started initially very heavily socialistic. Everything was owned by the government, except agriculture, the land. That was finally given to private individuals, and that was kind of the source of the initial capital that produced the surge of the privatization of land, and wealth was created. If you look at Taiwan’s economic history, from 1951 when it was a relatively poor country, to 2001 when it became much richer, most of that was because new industries came in, and failing industries were cut out – government steel industries, shipyards.

Any society that is successful has to be open to change and experiment. So nothing should be sacred – nothing.

I would argue that monopoly generally is not a good thing. Whether it’s intellectual monopoly of an idea, intellectual monopoly for unions, monopoly for school teachers, monopoly for government-provided service, monopoly is generally a very bad idea. And even patents are a bad idea. Intellectual property protection can be very bad idea.

Open-source software is very successful because it creates very good incentive. Some bright young kid comes along with a piece of software, because its open source, that person really can’t patent, but he has to respect that there is an old program out there, and that person has improved that. They capitalize it and they sell it later, and sell parts of their fame and glory. They get recognized as individuals. Much better than having monopoly, which gives me incentive not to do anything with it.

There is a famous story about the steam engine in the English industrial revolution. James Watt had a patent on the steam engine. Somebody else had a patent on one of the components of the steam engine. So James Watt actually had to build an inefficient steam engine until the other patent ran out. The point is, it wasn’t until James Watt’s patent expired that the steam engine took off.

Competition was there, but when you created a monopoly, James Watt had no incentive to make anything better. If I’m the only show in town, why shouldn’t I just live a good life? That’s the rule of monopoly. In the US now with so much frivolous patenting, people patent trivial games, they patent minor replications. There’s a huge amount spent in just getting around another person’s patenting.

Bill Gates makes a living these days in patenting. He imagines what new technology would be, he patents things. And if the new technology is actually realized, he brings cases against these companies and gets huge settlements. That’s totally counter-productive.

Its not necessarily just putting a market value on things, it’s a question of creating the right incentives. I think it’s competition more than private property. If we are forced to be excellent, we generally are.

The only cost is, suppose we have somebody who is mentally impaired, has a very low IQ or a physical disability and they can’t succeed – those people probably should receive some insurance, for sure. But not so much protection that high IQ people with high potential find it much easier not to use their abilities than to use their abilities. That’s where it starts to become destructive.

Q: Tell us about long-term incentives vs. short-term incentives.

A: Capital is very mobile. If I charge a much higher price for capital in one place than in the other – suppose I say I am going to tax capital at 50 percent of its income in Canada, but 20 percent of its income in Taiwan – then a huge amount of capital would flow from Canada to Taiwan. But capital is one of the most mobile things in the world. So if you start taxing differentially in different countries, it’s going to flow.

But suppose you have no taxation of capital. What would happen? It sounds like a bad idea, it sounds like no revenue. But that’s not true, to the extent that the society gets a greater inflow of capital, as the total pie gets bigger. Without any taxation on capital, you could actually have a bigger pie and even higher tax revenue by essentially increasing the pie and then taxing the total bigger pie with less distortion.

Many economists have argued we should have a consumption tax rather than a savings tax. If I take the money and re-invest it, and don’t consume it, then I don’t get taxed. That gives me a huge incentive to reinvest the money. I am going to have more capital. More capital means more jobs, more employment, higher wages, and it improves the benefits of everybody in the society.

If you have a bigger pie, there are lots of things you can do with it. But you want to make sure that whatever you do, you don’t want to redistribute it so heavily that you lose the size of the pie. That’s the trade-off.

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