Sunday, August 27, 2017

The power to change the world

By changing the tax code we could bring back Mom-n-Pop stores and put Walmart out of business. I'm not recommending it. But the tax code has power enough to make it happen.

At Digitopoly Joshua Gans takes a look at John Kenneth Galbraith's The New Industrial State, fifty years on.

Gans is one of those people who put conclusions first, without a fact in sight:

Galbraith’s book is worth revisiting, since its subject is back in the news. Like many people today, he was worried about unchecked corporate power. Yet with the benefit of hindsight, we can see his worries were largely wrong.

Largely wrong? Where did that come from?

The article had me screaming "NO" again and again -- each time reading on, to see if it backs up its assertions. In the end, Gans and I mostly agree. But we take very different paths.

There are two points Gans makes in the article that I want to consider. The first concerns corporate size:
You actually don’t have to read The New Industrial State to understand its story. Galbraith observed, as others had done before him, that ... key industries were dominated by few very large firms — and sometimes even just one...

Why were those firms so large? Galbraith’s answer was that they needed to be so because technology required large amounts of capital to be deployed — think your large auto assembly, oil refineries, and chemical plants.

Gans accepts Galbraith's answer and moves on immediately: "What did that mean? First, the owner-manager firms were not possible ..."

I don't move on with Gans. I scream "NO" and write a blog post.

"Why were those firms so large? Galbraith’s answer was that they needed to be so because technology required large amounts of capital to be deployed."

The economy didn't start there. It didn't start with "very large firms". Largeness developed over time. If largeness is the problem, then you can't start with largeness. You have to go back in time and consider the causes of the development of the largeness.

This is something economists fail to do all the time. They take the current situation as a "given" and move on from there. That's not how problems get solved.

"Galbraith’s answer was that they needed to be so because technology required large amounts of capital to be deployed."

But why did technology require large amounts of capital be deployed? Isn't that the key question?

Galbraith and Gans want us to accept the notion that technology simply required it. I don't believe that's true. In one of those Back to the Future movies they had a Mr. Fusion device on the Delorean. Mr. Fusion, like Mr. Coffee, small enough to fit on your kitchen counter or the trunk of your car. It's a great vision, one that offers hope for a better future where energy is cheap and accessible.

Do you think the future will turn out that way? I don't. If we ever get fusion working, we will end up with another "very large firm" that requires "large amounts of capital". It won't fit on your kitchen counter.

Kinda deflates the dream, doesn't it?

But if these companies didn't get "very large" they wouldn't require large amounts of capital. So the question is: Why do they get so big?

They get big because the tax code encourages it. The technology evolves to fit.

The second point I want to consider concerns economies of scale.
[Galbraith's] theory predicted that the most valuable companies would be those with the most revenue to spend on large capital investments and workforces. That turned out not to be the case. The winners today aren’t Galbraithian.

... We have not seen corporations grow in dominance as Galbraith predicted.

Thus the very foundation of The New Industrial State did not hold. But why? Here is my own conjecture: In 1967 the scale of the large, centrally planned U.S. corporation had largely reached its limit. After that point, growth required more than finding additional demand. Indeed, there is only so much you can get from modern marketing ... Eventually, further growth became more expensive, cutting into corporate profits.

Here, I agree completely with Gans. The large corporation had "largely reached its limit". Additional growth came at a higher cost. The "limit" reached was the limit set by economies of scale. It was no longer more profitable to get bigger. It was becoming less profitable to get bigger. And that was in 1967, when the economy was still good!

Back in the early 1980s, the late '70s maybe, I subscribed for a while to the Kiplinger Letter. I remember a fragment of one article where they were talking about agribusiness. They said agribusiness had "outgrown its economies of scale".

That was one of those things that strikes you, and it struck me so hard I still remember it today. How can a business grow beyond its economies of scale? Wouldn't it be better to split into two separate companies so both could grow more cheaply?

It would be better. It would be best for each company to be sized at its greatest economies of scale. That way each company would be most efficient and most profitable. A perfect world, so to speak. So why do businesses grow beyond the point that maximizes their economies of scale?

The tax code. The tax code encourages bigness.

No matter how big a business is, it can still reduce its taxes by sinking more of its profit into growth. When a business has grown beyond its economies of scale, the tax advantage for growth is still there, and the tax code subsidizes any inefficiency that results.

I agree with Joshua Gans and Kiplinger that businesses often grow beyond their economies of scale. I disagree with Gans and Galbraith that the technology drives business size. If a business by some magic was suddenly half its present size, and the tax code created the best advantage at this new smaller size, the firm would seek the technology best suited to that smaller size.

If most firms were most profitable at half their present size, they would split instead of merging, and technology would evolve to favor the smaller optimum size.

The tax code encourages bigness. It's a problem. In a perfect world, the tax code would encourage every business to reach its maximum economies of scale, and remain there. In this imperfect world the best we could do is let markets work: Eliminate the tax advantage for bigness, and let every business and every industry work out the size thing for itself.

1 comment:

The Arthurian said...

"By changing the tax code we could bring back Mom-n-Pop stores and put Walmart out of business."

Or the tax code could put Mom-n-Pop out of business, and create Walmart. Which is what happened.