Monday, April 29, 2013

Is the SEC headed for collapse?

A little over a year ago, Congress passed the Jumpstart Our Business Startups (JOBS) Act, a bipartisan effort to boost employment by helping startups gain access to capital. The most talked-about provision in the Act is Title III: Crowdfunding, which was a real coup for entrepreneurs who want to be able to sell shares in their startups through crowdfunding platforms online. Although it made headlines, the reality is that Title III is rendered pretty useless by the details of the law. The much more promising provision is Title II: Access to Capital for Job Creators. It is also the part that could destroy the Securities and Exchange Commission.

Before I get to why the SEC's days are numbered, a pop quiz: Which of the following scenarios are illegal?
  1. A popular deli has a placard on the counter that reads: "We are looking for investors to help us expand! Inquire with management for details."
  2. A local TV commercial advertises a chance to buy shares in a renovated movie theater that plays classic films.
  3. You meet a couple of software coders at a bar who tell you that they are looking for investors to help fund the next Facebook.
If you answered "all of the above," you are correct. Generally speaking, it is a federal crime to advertise unregistered securities to strangers unless you already know that they are "accredited investors."

The reason Title II of the JOBS Act is so revolutionary is that it is intended to lift this advertising ban. Sales will still be restricted to accredited investors, but issuers will be able to solicit those investors openly instead of relying on networks that favor the well-connected. If the law is enacted as intended, advertisements like those I described will become commonplace.

Admittedly, that is a big if. Until the SEC finalizes the rules (it is nearly a year overdue already), nothing is certain. For instance, the SEC may place such strict limitations on the advertising that it will be useless to entrepreneurs. The SEC can still save itself! But if advertising is truly permitted, I do not see how the situation will be tenable. 

Consider that every advertised offer will come with the following proviso: "Accredited Investors only." What is an "accredited investor"? Most people have never heard the term. Chances are it is unfamiliar to you, too. Simply put, an accredited investor is someone who has a million dollars (not including their home) or makes over $200,000 per year. 

Imagine their reaction when people see ads like those described above and discover that they are not eligible to invest, even if they can easily afford it. It is against the law, they learn, because investing in private securities is too dangerous for regular people. Do you think they will find that policy acceptable? Or do you think they will demand the same rights enjoyed by the top one-percent? As far as I can tell, that possibility hasn't even crossed the mind of anyone at the SEC.

The status quo works because only the insiders know about it. The advertising ban preserves its own secret. Once the ban is lifted and people learn the truth about the accredited investor exemption, you can't put that cat back in the bag. I don't think people will stand for it. It will be exemption for all or exemption for none.

So which will it be? Exemption for none would be beyond catastrophic. The whole system of private capital is built on the accredited investor framework. But exemption for all would be the end of the SEC, as there would no longer be a distinction between public and private securities.

In my next post I will discuss what I think we should do if that happens.

Saturday, April 13, 2013

Arizona Film Tax Credit: Yes or No?

Should Arizona adopt a film tax credit in order to spur a movie industry in the Valley of the Sun? No. Let me explain why.

Think "Subsidy"

The proposed refundable tax credit would work as follows: production companies that spend at least $250,000 producing entertainment in Arizona would receive a 20% "rebate" on their state tax returns. The "refundable" part means that if the tax credit exceeds the liability, then the state pays the difference in cash (see SB1242 section 43-1075 E).

The term "rebate" implies that investors are are merely getting back the tax revenue they paid on the production, but that is not the case (nor would it be any better, but that's for another post). The term "tax credit" is lipstick on a pig. The more appropriate term, "subsidy," invokes the usual conservative skepticism, and with good reason.

Think "Product"

Most arguments for the tax credit are based on the idea of fostering a fledgling industry. Make our film industry attractive to outside investors, the logic goes, and that will bring outside money into the state. Sounds good, right?

The proposition is less attractive when we substitute the term "fledgling industry" with the term "product," which is equally accurate. Why is exporting production services any different from exporting airplanes or microchips or anything else? We are right to be prejudiced against subsidizing specific products.

A Net Loser

The key to thinking about this issue is to understand that subsidies do not materialize out of thin air. They are transferred from one party to another, and therefore a subsidy to one is always a tax to another. Of course a subsidy to one industry can help drive up exports in that industry, but the correlative tax will drive down exports in those industries that bear the burden. The question is whether the situation is a net gain or a net loss.

In the case of the film tax credit, the gains to that product will be acutely large and apparent, whereas the dispersed increase in taxes on everyone else will be spread thinly throughout the economy and hard to measure directly. Yet we can be confident that the overall losses will be greater than the gains.

We can be confident in that assessment for the same reason that the subsidy is needed in the first place: the product cannot compete without it. The Arizona film industry does not enjoy a comparative advantage that can justify its existence in the marketplace. Consider that there is a cost to produce a good or service and a price that it will fetch in the market. If the price is higher than the cost, you call the difference "profit." If the price is lower, you call the difference "loss." A 20% subsidy implies that the market price for the product is 80% of the cost. Every dollar's worth of input that our film industry supplies fetches only eighty cents. A 20% loss, in other words.

In fact, 20% is an understatement. The film tax credit requires that only a portion of the total production budget be spent on Arizona goods and services. I don't know the details off-hand, but suppose only half of the qualified production expenditures actually go to Arizonans. In that case the effective subsidy is actually 40%! Having put together a film budget myself and looked carefully at state film tax credits in the past, I am confident that a production could spend less than half of its total budget in a state and still qualify for the full credit.

So if the subsidy is actually a loss, who loses? In order to fund the subsidy, we must tax the profits of other exports. We can't tax unprofitable exports because those don't pay taxes, so we know that we are transferring money from exports that yield a net profit to an export that yields a net loss. Even though we will never be able to measure the impact of a film tax credit on the rest of the economy because the effects are spread so thinly, we can be certain that the flow of resources from productive areas to unproductive areas is a net loser for the state economy.

The Externality Game

Advocates of the Arizona film tax credit argue that boosting our film industry will provide collateral benefits to the state. Most of these are pretty easy to brush aside:
  • It will provide training. Why do we want to subsidize training in a field that needs a subsidy to exist?
  • It will provide jobs. And cost jobs elsewhere. The effect on employment will be the same as the effect on the economy overall: a net loser.
  • Film crews spend money. So do tourists, yet we tax hotels and resorts rather than subsidize them.
  • A film industry is good for our state image. The requirement of any marketing budget is that it generates more money than it costs. How much additional business do you expect Arizona to receive because people see our skyline in the back of the next action movie?
I'm sure people can come up with many more nice things to say about having a film industry, but we need to be careful when talking about externalities. Every industry has both positive and negative externalities, and most are hard to quantify. A transfer from one industry to another will increase some externalities and decrease others. Why should our film industry have an advantage over colleges, startups, hotels, high tech, or anything else? If a product is profitable, the externalities are icing on the cake. Advocates try to justify subsidies by adding up all the positive externalities, and somehow the math always reaches the conclusions they want. The key insight to have is that when our elected officials play the externality game, we lose.

Free Things that Will Make a Difference

The film tax credit is a bad idea, but that doesn't mean there is nothing we can do to support the film industry in Arizona. Aside from keeping the state a low-tax, low-regulation environment that is attractive for all businesses, there are a couple of other ideas we should consider.

As someone who put an insane amount of effort into planning a movie production that ultimately fell through, I know firsthand some of the roadblocks that producers face. In my opinion, the most galling are 1. the laws that make it nearly impossible to raise money from investors, and 2. the unions.

These problems are way too complicated to go into in detail here, so I'll just give the prescriptions I would suggest. Right now we are waiting on the SEC to write new rules regarding how entrepreneurs (including film producers) can acquire investors for their projects. If you want to know a little more about that, I wrote about it here. Overall these changes should be a good thing, but it is quite possible the SEC will bungle it. If they do, then Arizona can give itself a huge competitive advantage by revising the rules on "general solicitation" with respect to Reg D Rule 504 securities offerings. We do not have California's investor networks, so in order to compete we need to relax the rules allowing filmmakers to connect with potential investors.

The second thing we could do is find a way to undermine the unions that have a monopoly on talent. The SAG Ultra Low Budget Agreement is a wolf in sheep's clothing that deceives naive independent filmmakers into casting SAG talent only to discover later that they can never turn a profit under the terms of the contract. If at all possible, the State should forbid the union from punishing Arizona actors who go "financial core" in order to perform in non-union films.

Another angle to press would be to try to achieve through legislative means a "99 seat rule" like the one that exists in Los Angeles. In LA, small theaters are able to cast union actors in plays without the ordinary union constraints. The stage actors union (AEA) is essentially joined at the hip with SAG/AFTRA and they largely contain the same pool of actors, so anything that improves the situation for stage actors will also benefit the film industry. By making Arizona a less restrictive place for professional actors to do alternative theater and independent film without fear of reprisal from the unions, we will help develop the talent that will ultimately bring larger productions. 

In my view, these changes would be a larger comparative advantage than a tax credit, and they would cost us nothing - except perhaps the ire of the talent unions. Assuming the ideas I propose are legally doable, why not scrap the subsidy and do the free things that will make a difference?

Wednesday, April 10, 2013

Paretian, Libertarian, or Utilitarian?

I haven't been able to find a straight answer to this question: does the concept of a Pareto improvement by definition ignore competitive harms? My guess is that yes, it must, because otherwise I don't see how you could get a Pareto improvement in a situation where there is competition and scarcity. Think about it: a "Pareto improvement" is a situation in which at least two parties gain and no third party is made worse off. But suppose A has money and needs a car, and both B and C have cars to sell. If A buys a car from B, both A and B are better off, but arguably C is worse off because their opportunity to sell to A is gone. You might say that B did competitive harm to C by offering a better car at a better price. Does it therefore fail the test of being a Pareto improvement?

Because pretty much every transaction will have the feature described above, I assume that Pareto improvements ignore competitive harm. If I'm correct, then being run out of business by competition does not constitute a harm as far as Pareto improvements are concerned.

Regardless whether I'm right about the precise definition of a Pareto improvement (maybe third party effects aren't factored into the Pareto improvement analysis at all), I think it's only useful if we think about it that way. So what does make a third party worse off? Well, if money is taken from A and given to B, then A loses and we don't have a Pareto improvement. Therefore if we wanted to run a system that produces Pareto improvements, uncompensated transfers would be ruled out. Furthermore, we may safely assume that parties only agree to transactions in which they gain, so we would want to permit voluntary transactions and prohibit coerced ones. Of course, if a party enters into a voluntary transaction based on false information, that may not produce a Pareto improvement either, so we would want to outlaw fraud, too. And finally, we might also want to outlaw certain kinds of voluntary behavior that still leaves third parties worse off, such as cartels and monopolies. With those few prohibitions in place, all transactions are likely to be Pareto improvements and the situation looks remarkably similar to the standard Libertarian universe.

It seems to me that a strict Paretian is very similar to a strict Libertarian. But I can see at least one difference. For a strict Libertarian, the prohibition against force and fraud is a moral imperative, whereas for the Paretian it is more like an imperfect screening mechanism. Suppose A and B don't want to trade with each other even though they would both gain from the transaction. They are just being irrational. The strict Libertarian would never force the transaction, whereas the strict Paretian might force A and B to trade in order to get the Pareto improvement. For the Paretian, the prohibition against force need not be absolute. We might call a Paretian a "consequentialist libertarian," as opposed to the more hardcore "deontological libertarian."

Now where does Utilitarianism fit in? If you accept that a rapid series of Pareto improvements is likely to produce more utility than anything else, then there will be a lot of overlap between Paretians and Utilitarians. The difference, I believe, has to do with figuring out whether it is ever appropriate to permit or even force transactions that do make a third party worse off. In such a situation the gains may exceed the losses even if it is not a Pareto improvement.

A simple example of this would be the transfer I described above in which you take money from A, who is rich, and give it to B, who is poor. A is made worse off, but B may gain more utility from the money because money has diminishing marginal utility. That is, a thousand dollars means less to a millionaire than it does to a homeless person.

As another example, suppose A has a piece of land that he is not developing. B could make that land highly productive by putting a farm on it, but A irrationally refuses to sell it to B. In this instance, the Utilitarian might exercise eminent domain and simply take the land from A and give it to B to develop. Again, it's not a Pareto improvement because A is worse off, but it does increase total utility. 

To review: Libertarians, Paretians, and Utilitarians will all use standard prohibitions against force, fraud, and conspiracy as their starting point. Libertarians will seek Pareto improvements whenever they can be achieved voluntarily, but they will stop short of coercion even if that means accepting a Pareto inferior outcome. Paretians, on the other hand, will coerce transactions in order to achieve a Pareto improvement, but they will not force transfers that leave one party worse off. Utilitarians will seek Pareto improvements whenever possible, but they will also force transactions that are not Pareto improvements in order to maximize utility.

Which one is best? Well, that depends on what you value most. The Libertarian values liberty highest, whereas the Utilitarian values utility highest. To the Libertarian, it is never morally permissible to violate another's individual autonomy no matter how much utility is at stake. The obvious problem with that position is a hypothetical like the following: Suppose you have fifty people dying of thirst and one stubborn person with a well who is unwilling to share. Should we not coerce the person with the well to save the lives of the other fifty?

The Utilitarian, on the other hand, believes that liberty should be considered only in terms of its utility. But how do you measure the utility of liberty? Strict Utilitarianism has the impossible task of measuring the unmeasurable. Furthermore, how does the Utilitarian deal with moral quandaries like the following: Suppose a dying, penniless virgin rapes a prostitute. If the rape provides the dying, penniless virgin more utility than it costs the prostitute, is it therefore permissible?

In reality, the examples of the man with the well and the penniless rapist illustrate that real people are not absolute Libertarians or Utilitarians. I think even strict Libertarians will allow that there are categorical situations where force is admissible, and even strict Utilitarians will allow that there are categorical situations where interpersonal comparisons of utility do not apply. In the well situation we are all Utilitarians, and in the rape situation we are all Libertarians. Those hypotheticals help us stake out the parameters of the philosophies.

What about the Paretian? Well, the Paretian is a kind of made-up figure, because nobody really regards the Pareto improvement as an end in itself. Rather, we like Pareto improvements because they produce a lot of utility by making all parties better off and none worse off. However, as demonstrated before, Pareto improvements neither guarantee liberty nor maximize utility. The values are liberty and utility.

Strict Libertarians makes no attempt to measure the utility of liberty, and therefore their position is relatively straightforward and clear. To them, individual liberty is simply a moral absolute above and beyond utility.

The Utilitarian faces a much more difficult problem. In theory, an omniscient Utilitarian can know every individual's utility function and therefore they will use force only when necessary to maximize utility. But nobody is omniscient, so how do you manage that in the real world?

The strength of the Paretian position is that it provides a highly pragmatic, workable approach that mitigates the excesses of both strict Libertarianism and strict Utilitarianism. The Paretian says that you can force A and B into a transaction if and only if they both benefit from it. How does that translate into the real world? Essentially, it is the eminent domain clause in the Constitution: "nor shall private property be taken for public use, without just compensation." Without that provision, a single holdout could block the building of, say, a railroad by refusing to sell their parcel of land. Eminent domain says that you can force the Pareto improvement as long as you provide "just compensation" so that everyone is better off and nobody is worse off.

But what about transfers that increase overall utility even while making some parties worse off? Here again we have the problem that there is no such thing as an omniscient Utilitarian. The danger of Utilitarianism is that when you try to make ad hoc utility comparisons you might get it wrong and decrease rather than increase utility. The nice thing about the Pareto improvement constraint is that Pareto improvements are always positive sum. In fact, when you can't get a Pareto improvement and must force the transaction, that is a good sign that the transaction is likely to be negative sum.

Remember the example I gave of the Utilitarian taking fallow land from A and giving it to B who will put a farm on it? The question that arises is: why not give it to C, who would put an oil derrick on it? Or D, who would put a mall on it? How do we know which will raise utility the most?

If we let B, C, and D bid for the land, we may be reasonably certain that the highest bidder will be the one who can make the land most productive and thus maximize utility. In that case we will take the land from A and auction it off to B, C, and D. But what if A comes back and puts in the winning bid? What if the land is worth more to A because of its natural beauty than it is to B, C, or D? In that case, we maximize utility by selling it back to A. But then why did we take it from A in the first place? This problem never would have occurred if we had been required to provide just compensation to A before holding the auction. The transaction was bound to be negative sum from the start. Therefore the Pareto improvement constraint - in this case, enforced by the just compensation requirement - would have prevented the imperfect Utilitarian from making a costly mistake.

The issue with the land may seem unique, but it is actually the same problem we face with any redistribution scheme. We may think that A has too much money and B, C, and D have too little, so we want to confiscate A's money without compensation and redistribute it to B, C, and D. But how should we distribute it to the others in a way that maximizes utility? In reality, A's money is not like fallow land; A is already redistributing that money by lending it to a bank (which lends it to B), putting it in the stock market (which finances C), or buying things (which pays D's salary). Allocation by this method is likely to be far more efficient than if we just redistribute it at random. So again, the Utilitarian impulse to confiscate and redistribute turns out to be extremely haphazard, and the strict Paretian's simple rules are a prudent constraint for the imperfect Utilitarian.

If "Pareto Improvement" is the name of your game, you will ensure that all transactions are positive sum. If you run it perfectly, nobody can harm anyone else through force, fraud, or conspiracy. Because most people tend to act in their own self interest, you won't often have to force people to take deals from which they benefit because they will do those voluntarily. But sometimes you will have to exercise eminent domain and make people take a deal they do not want to take. By adhering to the Pareoto improvement principle, you may give up some positive-sum transactions, but you are much more likely to avoid deadweight losses that are more commonly the result of forced transactions.

If you think all that sounds abstract and unrelated to real life, try really digesting the ideas for a few days and then start applying them to different situations to see how they hold up. I think you'll find that a good Paretian rule of thumb will lead you to the right conclusion most of the time. Of course a strictly Paretian scheme might seem to leave out people who cannot participate in positive sum games, such as children, people with severe mental or physical disabilities, etc. Well, the simple answer to that is that there is nothing in the rules against force, fraud, or conspiracy that prohibit charity. People have the bad habit of grossly underestimating the amount of private charity in the world. But assuming charity is insufficient, the Paretian framework accommodates forced transfers whereby all parties benefit and none are made worse off. "Public goods" generally qualify as just compensation, and it seems reasonable to me that some measure of a social safety net may be construed as a public good as well. That is a dangerous game, though, and if you don't rule out transfers categorically it is difficult to tell where exactly to draw the line, so you really want voluntary charity rather than forced transfers to handle redistribution whenever possible.

Generally speaking, I think progressives tend to be Utilitarians with a bad habit of trying to make ad hoc utility judgments and screwing it up. If we have a little more humility about our own abilities as social engineers, we should appreciate that we will get a lot more utility from a strict Paretian approach than if we give ourselves too much discretion when it comes to using coercion. If we aim to increase the rapidity and volume of Pareto improvements, we are sure to do well. We should all be more Paretian.

When I started writing this I sure didn't expect it to go this long, but I guess I got a lot of thoughts out that were in my head.

Saturday, April 6, 2013

Causes of Autism

April 2nd was World Autism Awareness Day. If you're ever feeling down on humanity, just talk to a service provider for people with intellectual disabilities and your faith in the goodness of people will be restored.

On the issue of autism, are we right to be kind of freaked out by what seems to be a steady increase? Some possible contributing factors are easy to identify, like the fact that people are having children later in life. Certainly the biggest factor is just an increase in diagnosis due to improved detection at the margin of the spectrum. And there's something I heard called the "sexy nerd theory," which basically posits that as left-brained people pair up their offspring are at greater risk. But my understanding is that even when you adjust for the known factors, that still doesn't seem to account for the full increase; there seems to be an unknown factor. That's why people look at vaccines, pesticides, household toxins, and other environmental factors. You don't want to freak out about stuff without evidence, particularly in the case of vaccines which you really don't want to discourage. But I really wish we could figure out what's up. This kind of fundamental research is where you really do want more federal spending. Anyway, thought of the day.