Defining Ideas

The Free Market Way To Help The Poor

Tuesday, December 1, 2015

Editor’s note: The following essay is an excerpt from the new Hoover Press book, Inequality and Economic Policy: Essays in Memory of Gary Becker.

Inequality is not an issue that policy should address. Some have argued that policy should redistribute income away from the highest earners. This view is counterproductive, as it does not sufficiently recognize that our top earners create enormous surpluses for society. Bill Gates at Microsoft, Steve Jobs at Apple, Fred Smith at FedEx, Sam Walton of Wal-Mart, and many others who started new businesses have directly and indirectly created millions of new jobs, created new industries, and transformed our society. And these individuals have received only a tiny fraction of the economic value that they have created.

Society, however, should care about creating economic opportunities for the lowest earners. I therefore will focus this essay on expanding opportunities and raising the productivity of these workers. I want to focus on the lowest earners for two reasons. One is because for the last thirty to forty years, workers with low levels of human capital have been swimming upstream against technology. My work with economists Per Krusell, José-Víctor Rios-Rull, and Giovanni Violante, and the work of economist Kevin Murphy and others, indicates that technological improvements over this period are complements to highly skilled workers, raising their marginal productivity, but are substitutes for low-skilled workers, reducing their marginal productivity. This means that increasingly sophisticated technologies that keep making capital goods better and cheaper will continue to place downward pressure on the wages and opportunities of the lowest earners.

The second reason I will focus on the lowest-income workers is that many of our policies toward lower earners are schizophrenic. On the one hand, we have policies now that provide much larger transfers to the lowest earners today than they did in the past. For example, a family of four at the poverty level has about $22,300 per year of pre-tax income. Consumption for that same family of four on average, however, is about $44,000 per year, which means that their consumption level is about twice as high as their income. But consider the relationship between consumption and income among poverty-level families prior to Lyndon B. Johnson’s Great Society initiatives in 1964. At this time, a family of four at the poverty level was consuming only about 10 percent in excess of their income. We’re certainly providing many more resources to low-earning families today. But on the other hand, we have policies in place that either limit economic opportunities for low earners or distort the incentives for those earners to achieve prosperity.

I’m going to focus on K-12 education and immigration policy as areas of reform that in my view would expand economic opportunities for low earners as well as increase their productivity and skills.

I will focus on introducing competition into K-12 education as an important reform for increasing student skills and performance. I will begin with some statistics on student math achievement, which have been produced by Eric Hanushek of the Hoover Institution. The statistics are grim and paint a dismal picture of how we are preparing many US students for careers, particularly those from low-income households. The Organization for Economic Cooperation and Development (OECD) administers the Program for International Student Assessment test (PISA). It’s given to about half a million students between fifteen and sixteen years old, in forty-four countries. Thirty-four of those are OECD countries, which are advanced, high-income countries including Canada and the countries of Western Europe.

The United States does not perform well in this assessment. US fifteen- and sixteen-year-olds rank thirty-fourth out of all forty-four countries, and the US is twenty-seventh out of the thirty-four OECD countries. Our proficiency rate in math is only 32 percent. Only five states have a proficiency rate of 40 percent or higher: two large states, Massachusetts and New Jersey, and three small states, Kansas, North Dakota, and Vermont. Proficiency in California is just 24 percent, which is worse than Kazakhstan. New York’s proficiency is at 30 percent. The US proficiency rate is particularly low for minorities. It is 11 percent for African Americans and it is 15 percent for Hispanics.

Low US performance is not simply due to the fact that our student population is more heterogeneous than some other countries. Comparing the top achiever in this international assessment, which is Shanghai, China, with our best state, which is Massachusetts, shows a difference in math achievement that is equivalent to two full years of education. American students on average clearly do not have sufficient math aptitude.

To learn more about this, I examined representative questions from the PISA test. There are six levels of questions. A representative level two question is recognizing that two-fourths and five-tenths are the same number within a one-sentence word problem. Twenty-five percent of US students are not proficient at level two math. PISA test developers define level two proficiency as being able to be self-sufficient in terms of being able to understand common transactions. Level three questions involve rank-ordering numbers with decimal points. Forty percent of US students are not proficient at level three. Just 2 percent of fifteen- and sixteen- year-old US students are proficient at level six. A representative level six question involves using the familiar distance/time/rate formula, within a sentence. For example, “Helen rode her bike five kilometers and it took her fifteen minutes. On the way home, she took a shortcut, which involved a four kilometer ride, and it took her thirteen minutes. Calculate the average speed on Helen’s trip.” Only 2 percent of our fifteen- to sixteen-year-olds can answer this question. This level of math proficiency is simply unacceptable, and current US performance statistics mean that many of our children will not be competitive for jobs involving quantitative and logical skills that extend beyond the most basic levels.

Low math performance by US students is not due to insufficient spending on K-12 education. In fact, we spend more per pupil than almost any country. Our spending per pupil is twice as much as the Slovak Republic, which outperforms us, as do Estonia, Vietnam, Slovenia, and the Czech Republic. These are all low-income non-OECD countries in the PISA assessment that do not spend nearly as much on K-12 education as the US.

Improving K-12 education requires introducing competition in this process, including teacher tenure reform, which will make it feasible to replace the worst-performing teachers. Nationwide, the dismissal rate for teachers is 0.1 percent. In California, the dismissal rate is even lower than that, with about two dismissals per year out of 275,000 K-12 teachers, which is about .0008 percent. To put this in perspective, dismissal rates across occupations range from about 3 percent to about 9 percent per year, depending upon age, education, and occupation.

Dismissal rates in K-12 are so low because the process can cost up to $250,000 per case due to costly litigation, and the dismissal process can take several years. Dismissal protection and seniority-based layoff procedures are endemic in teacher union contracts, and they substantially impact teaching quality by protecting the worst-performing teachers. A recent lawsuit filed by nine California schoolchildren, Vergara v. California, argued that many students are receiving deficient educations because of ineffective teachers. The court agreed, and found that seniority-based layoffs and teacher tenure were unconstitutional. The court noted that “the evidence on grossly ineffective teachers is compelling, and indeed shocking.”

Ineffective teachers are an important reason why some students are not able to succeed. Hanushek finds that if the bottom 8 percent of teachers were replaced with the average of the truncated distribution, then math and science scores in the US would rise substantially. He estimates present discounted value of about $100 trillion in increased national income. Others, including Raj Chetty, now at Stanford, have estimated similar gains.

A teacher who is one standard deviation above the mean in terms of effectiveness generates marginal gains of about $400,000 in present value of student earnings. If kids are lucky enough to have a ninetieth percentile teacher, they can expect about a

$900,000 PDV (present discounted value) gain in future incomes relative to having a median teacher. The value of a good teacher is enormous.

The second aspect of introducing competitive pressure in K-12 education is merit-based pay. Teacher salaries are typically set by rigid schedules that depend upon seniority and the number of degrees held by the teacher. Typically, there are no salary differences across teaching areas, and salary doesn’t depend on effort or performance. This salary policy distorts incentives and guarantees shortages by teaching areas like math and science. The Los Angeles Unified School District is estimated to pay about $500 million per year in salary to teachers with additional degrees that have zero correlation with improved teaching performance.

Union compensation policies are also distorting the incentives to become teachers and are resulting in fewer highly capable individuals pursuing teaching as a career. Caroline Hoxby of Hoover and Andrew Lee find that there has been a significant decrease in the number of high-ability individuals who enter teaching, as a consequence of wage compression and the lack of merit-based pay. They find that those in the bottom 25 percent of the SAT distribution now make up about 40 percent of K-12 teachers. And they find that much of this change in composition is due to wage compression, reflecting these types of salary schedules.

The policy recommendation is straightforward. Introduce competition into K-12 education. Reform teacher tenure and adopt merit-based pay. Don’t protect the poorest performing teachers. Pay the best teachers very well. Pay teaching specialists, such as math and science teachers, according to relative scarcity. To improve student achievement, we need to reward the best teachers and provide incentives for highly skilled and ambitious individuals to enter the teaching profession. I anticipate that these reforms will significantly contribute to enabling our children to become skilled in math and logical thinking, and to develop the necessary quantitative skills to be competitive in a labor market that is changing almost continuously in response to advances in technology.

The second policy reform I will discuss is immigration reform. Reforming immigration for high-skilled workers and entrepreneurs is necessary to increase new business formation. As we all know, macroeconomic performance continues to be weak. The employment-to-population ratio is down by about 7 percent relative to its 2007 level, and business sector labor productivity growth, which has averaged 2.5 percent per year from the late 1940s until recently, is now growing at 0.9 percent per year since mid-2009.

I cannot overstate the importance and severity of this productivity growth shortfall. Historically, the United States doubled labor productivity in the business sector every twenty-eight years. At its current growth rate of 0.9 percent per year, however, it will take roughly seventy-two years to double. We need to increase business start-ups and entrepreneurship because new business creation is fundamental for job creation and for increasing productivity. The new business creation rate is down 35 percent from the 1980s, with much of this decline coming in the last ten years. The start-up rate in every state, even North Dakota, which is experiencing a boom in energy production, has declined substantially.

New businesses are a key factor in the process of economic growth because thirty years from now, the biggest employers will likely be the start-ups from today or from the recent past. Half of the Fortune 500 list of the biggest companies turns over roughly every ten years. This is a symptom of the fact that all businesses have a life cycle, in which even the most successful ultimately stop growing. This means that creating a persistently growing economy requires a persistent flow of successful new businesses. To get a sense of just how important start-ups are, note that in most years the economy actually loses jobs on net if you take out job creation by start-ups. In terms of gross job creation, start-ups and young, high-growth firms account for nearly two-thirds of job creation. And in terms of productivity growth, start-ups are responsible for many of our most important innovations, including the air- plane, automobiles, air conditioning, the computer, electrification, railroads, refrigeration, the telephone, and many Internet applications.

The question is: who’s going to be the next Intel, the next Microsoft, the next Amgen, the next Oracle, or the next Apple? There is no reason to think that our economy will improve significantly, or that opportunities for low earners will improve significantly, unless we increase the number of start-ups.

Immigration reform is important for developing more new businesses. US immigration restrictions make it difficult for skilled foreign nationals to stay here. We have many foreign nationals who are ambitious, skilled, talented people, and who would like to stay in the United States. But we make it difficult for them to remain. Half of all successful high-technology start-ups are founded or co-founded by an immigrant. Forty percent of the Fortune 500 were founded by an immigrant or by the child of an immigrant. Intel, Google, and Yahoo are recent examples.

In the high technology area, most immigrant start-ups are from China or India. And yet we have country-specific quotas on immigrants, some of which date back to the 1980s. The problem is so severe that there is a start-up incubator called Blueseed which was planning to purchase an ocean liner, have it docked twelve miles off of San Francisco port in international waters, and have it house about 1,500 entrepreneurs who would get in skiffs and come to Silicon Valley and stay as long as they can in accordance with immigration rules. Then they will go back to the Blueseed boat. This highlights the importance of restricting high-skilled immigration. By expanding high-skilled immigration, we will increase start-ups, which in turn will increase job creation and productivity growth, and expand opportunities for low earners.

The lowest earners need more human capital to increase their skills and productivity, and a healthier economy with more job creation. Reforming K-12 education policies through competition, and expanding new business creation by allowing immigrant entrepreneurs to remain in the US, will help our lowest earners succeed.