What Can Be Done About Skyrocketing Drug Prices?

The American government and even major insurers actually have a lot of levers they can pull to lower drug costs – but do politicians, insurers, and employers have the courage to try?

The drumbeat of overpriced-drug stories has been continuous in America of late, from Martin Shkreli’s 5400% price hike last year, to the recent price hike and subsequent backpedaling of Mylan with respect to the EpiPen. With growing outrage over skyrocketing drug prices, it’s worth asking – what can be done about it? Drug pricing is not subject to typical market forces since a new drug often has exactly 0 direct competitors – enabling a drug company to set virtually any price. New cancer drugs often start list pricing at $300,000 per year, while groundbreaking new Hepatitis-C treatments like Gilead’s Sovaldi started out at $84,000 for a short term (curative) course of treatment. Insurance companies (and major employers) have been unwilling to say no, swallowing each hike and passing it on in higher premiums. Medicare, Medicaid, the VA, and other public entities have been banned from negotiating prices, leaving them powerless to get a better deal for those receiving care through their programs. Here are a few ideas on how to break the logjam, in order of increasing potential savings:

1. The Anti-Monopoly Approach

Making drugs, and in particular so-called small molecule drugs, is actually both inexpensive and easy. The primary protection that drug makers use to enforce their monopoly position on new drugs is the patent system. While this arguably makes sense for new drugs, what about long-generic drugs? In recent years certain drug companies (e.g. Valeant) began specializing in buying up the manufacturers of old drugs and immediately hiking prices. After gaining a monopoly position it became easy to hike prices by 50-100% per year and extract huge profits, while new entrants were stymied by
the FDA approval process required to certify the efficacy of their drug version. Why not streamline the FDA approval rules for generic drug manufacture? If a drug is tested and shown to be chemically identical, how much further testing is really necessary?

Alternately, the Department of Justice or FTC could bring suit to halt acquisitions which would leave zero competitors in the market for a generic drug. Special pharmacies called compounding pharmacies are also capable of making many drug compounds. Why not
allow compounding pharmacies to compete across all generic drugs, or specifically contract with them to make generic equivalents for the VA system or Medicaid system?

2. The “Title IX” Approach

Private American colleges and universities are not actually required by law to provide equity in women’s sports, or to follow any of a wide range of Department of Education edicts. The catch? In order to receive federal funding, institutions of higher education must comply with these rules. Since virtually all colleges make use of varying forms of federal assistance, they fall into line.

The American pharmaceutical industry does very little original research – most innovations originate in the university system, and most of the research funding (over $21B per year) comes from the National Institutes of Health [1]. The American government could utilize this lever to strongly influence drug pricing. Pharmaceutical companies might be required to adhere to certain pricing guidelines if they wished to license research originating from NIH funding.

Those guidelines might require drug makers to release drugs into the generic market on an accelerated timeline, for instance. Or the rules might require that drug makers adhere to a value-based pricing approach, as described further below. Drug makers could be required to pay a tiered tax on drug sales to fund NIH research – a tax of 25% on prices above $1000/patient/month and 50% above $4000/patient/month could simultaneously fund future research and encourage drug makers to keep pricing down. The advantage of the “Title IX” approach is that it preserves the liberty of drug companies – if they don’t want to conform with the rules, they can simply do their own basic research. Fiscal conservatives might find this approach palatable as it directly charges users (drug companies) for the government programs they use, and lowers the deficit in the process.

3. The Value-Based Approach

If insurers and government buyers (Medicare/Medicaid/VA) all insisted on paying for value, pharmaceutical companies might be compelled to go along. How do you define value? The UK’s NICE measures the efficacy of medical treatments by attempting to measure the number of “quality-adjusted life years” provided by that treatment. If a cancer drug postpones death by 2 years on average, and has mild side effects, then it can be said to provide 2 years of QALY. The NIH takes this a step further by quantifying how much it will pay per QALY (currently around 25,000 pounds per year), and it sets prices
on drugs using this approach.

American buyers could emulate this approach by offering to pay for measured improvements in outcomes. If a new cancer drug extends life by 2 years, but existing cancer drugs extend life by 1.5 years, then the value of the new drug is an additional half-year of life. Drug buyers could offer to pay a premium for the new drug based on this degree of improvement, and no more. Buyers could also use this as a way to foster competition between older and newer generations of drugs. The older drug is 75% as effective, so it can be placed into competition with the new drug, but at a discount. Express Scripts took this approach in the Hepatitis-C market and was among the first buyers to find a way to push back against Gilead’s $1000 per-pill asking price for Sovaldi.

Conclusion

As long insurers are happy to pass rising costs along in the form of higher premiums, and American politicians remain beholden to the pharmaceutical lobby, nothing will change. But the ideas outlined above show that America doesn’t need European style price controls to break the drug price spiral – a combination of relatively small policy changes and insurers’ willingness to negotiate are all that is required.

 

[1] This article investigates the breakdown of basic pharmaceutical research in detail, and concludes that big pharma companies contribute less than 25% of research dollars in the US, with most of the balance coming from the NIH.

Gun Control And Mass Shootings: Would Lives Be Saved?

An analysis of every US mass shooting over the past 30 years shows that two small policy changes, restricting high-capacity magazines and introducing stringent background checks, might have saved over 500 injuries and deaths, reducing total casualties in mass shootings by 50%.

Various proposals have been set forth since 2012’s numerous mass shootings, ranging from much stricter gun regulations to arming more individuals in public spaces. Starting from Mother Jones’ list of US mass shootings over the past 30 years, I analyzed the potential impact of two proposals in particular: would a ban on high-capacity gun magazines have reduced casualties, and would stringent background checks of gun purchasers have reduced the number of shootings? I researched the incidents surrounding each shooting to determine whether each proposal would have had any impact. The data are summarized in the table below, with the full research spreadsheet available here.

Shooting Deaths Injuries Lives Saved Injuries Prevented Weapon Legally Acquired? Notes
Totals: 459 481 250 324 Legal in 58 of 63 cases 54% of deaths and 67% of injuries might have been prevented with the policies analyzed.
Newtown, CT Sandy Hook Elementary 27 2 17 0 Yes – legal weapons in same household The shooter’s rampage was stopped by a quick police response. If the shooter had to reload 3 times as often, he would hit many less victims, as he fired on each victim multiple times.
Minneapolis, MN Sign Company 6 2 1 0 Yes The shooter reloaded at least once during the shooting, and initially struggled with victims.
Oak Creek, WI Sikh Temple 6 4 3 2 Yes In a public setting with many adults, it’s possible shooter would have been stopped while attempting to reload, or would have retreated outside more quickly if he had less capacity.
Aurora, CO Theater 12 59 12 59 Yes A lucky form of weapon capacity control prevented a larger disaster, as the shooter’s weapon jammed and he was only able to fire roughly 1/3 of the 100 round magazine. A properly integrated background check system might have stopped the incident entirely.
Seattle, WA Cafe 5 1 0 0 Yes It’s not clear that the gunman ever needed to reload, and though he had a history of mental health problems, he was never treated and never convicted of a felony.
Oakland, CA – Oikos University 7 3 7 3 Yes HCM limit would have no impact here, but the shooter was expelled from school for behavioral issues, which might have been caught if this data were submitted to a comprehensive background check system.
Atlanta, GA – Health Spa 4 0 4 0 Yes HCM limit and background check would have no impact here
Seal Beach, CA – Salon 8 1 3 0 Yes The shooter reloaded during the shooting per police reports, so lowering weapon capacity would likely have lowered casualties.
Carson City, NV – IHOP 4 7 2 3 Yes The shooter fired over 30 rounds per eyewitness accounts – lower capacity would have constrained him.
Tucson, AZ – Giffords shooting 6 13 4 9 Yes Shooter was tackled and stopped while he tried to reload – direct evidence that lower capacity would have decreased the toll.
Manchester, CT – Beer Company 8 2 4 1 Yes Shooter used two weapons and fired multiple rounds at many victims – had he been limited, he would have run out of ammunition earlier
Lakewood, WA – police officer shooting 4 0 0 0 No Capacity limits might not have helped, as the shooter fired on four victims seated at one table, and hit all of them with his initial salvo.
Ford Hood, TX – army base 13 29 9 19 Yes Shooter reloaded many times, and 30 round magazines enabled him to fire roughly 170 rounds before being shot himself by military police. Multiple soldiers attempted to charge the shooter – if he had only a 10 round magazine, it’s entirely possible that he would have been tackled and stopped upon initial reload.
Binghamton, NY – civic association 13 4 9 3 Yes Shooter fired 99 rounds in total – this would likelybeen reduced if his weapon capacity were 1/3 as large
Carthage, NC – nursing home 8 3 0 0 Yes Since shooter used multiple weapons and never reloaded, it’s unlikely capacity limits would have mattered.
Henderson, KY – Atlantis Plastics 5 1 0 0 Yes Shooter did not use a high capacity weapon
Dekalb, IL – Northern Illinois University 5 17 5 17 Yes This incident’s casualty count is quite low because the shooter first fired with a very low capacity weapon, his 6-round shotgun – enabling many students to escape the classroom. Shooter also had a long, documented mental health history.
Kirkwood, MO – City Council 6 1 0 0 Yes Shooter used low-capacity revolver initially, and took a higher capacity weapon from a victim (police officer).
Omaha, NE – Westroads Mall 8 4 5 3 No Shooter appears to have emptied one magazine and then taken his own life.
Crandon, WI – sheriff’s rampage 6 1 0 0 Yes Shooter used a service weapon, so proposed rules/limitations would have had no effect.
Blacksburg, VA – Va. Tech 32 23 32 23 Yes Shooter reloaded many times, and used multiple weapons. Mental health check would have prevented weapons acquisition.
Salt Lake City, UT – Trolley Square 5 4 5 4 Yes Shooter did not use high capacity weapons
Nickel Mines, PA – Amish School 5 5 2 2 Yes Once shooter started firing, sheriffs approached – he killed himself as they arrived, and likely would not have had a chance to reload.
Seattle, WA – Capitol Hill 6 2 6 2 Yes Shooter had a weapons-related felony charge, which was reduced to a misdemeanor.
Goleta, CA – postal shooting 6 0 6 0 Yes Shooter had a previous history of mental illness
Red Lake, MN – high school 9 5 3 2 Yes Shooter possessed a gun in his bedroom despite being treated with Prozac. Since he was an adolescent, and his parents/guardians chose to give him a gun, background checks would be ineffective. Shooter shot his grandfather who was a police officer, and took his weapons.
Brookfield, WIChurch group 7 4 2 1 Yes Shooter suffered depression, but had no mental health or criminal records.
Columbus, OH – concert 4 7 0 0 Yes No HCM used, and no medical or criminal record. Nearby police stormed the concert and shot suspect
Meridian, MS – Lockheed Martin 8 7 4 3 Yes Shooter used military-style weapon with high-capacity
Melrose Park, IL – Navistar 4 4 4 4 Yes Shooter used military-style weapon with high-capacity, and was also a convicted felon
Wakefield, MA 7 0 5 0 Yes Shooter used high-capacity weapon and also had a history of mental illness, but with the mental illness far in his past and no criminal record, even stringent checks might not have denied him weapons. Shooter stopped firing at an arbitrary point and sat calmly til arrested. If he had lower capacity weapons, stopping to reload multiple times might have caused him to sit and wait for arrest earlier.
Tampa, FL – hotel 5 3 5 3 Yes Shooter was arrested for assault only a few months earlier, and bought weapon at a gun dealer
Honululu, HI – Xerox 7 0 3 0 Yes Shooter acquired a large number of weapons long before mental issues began.
Fort Worth, TX – Wedgwood Baptist Church 7 7 2 2 Yes Shooter committed suicide after emptying three magazines – but he had six more loaded. Has the magazines been 1/3 smaller, that would have lowered the toll proportionally.
Atlanta, GA – Day trading 9 13 0 0 Yes The shootings happened in multiple separate incidents, making it less likely that HCM limits would have had an impact. Barton was suspected but never charged in earlier murders, so background checks would have had no impact.
Littleton, CO – Columbine High 13 21 6 10 No Shooters used a high capacity Tec-9 and standard capacity 9mm, so avg capacity is used here. Details of the shooting indicate that in many cases shooters fired at the same victim multiple times – if limited in capacity, this would have reduced their ability to fire on additional victims.
Springfield, OR – Thurston High 2 24 1 19 Yes Shooter was tackled and stopped when he first tried to reload – a clear indication that lower capacity would have further limited casualties.
Jonesboro, AR – Westside Middle School 5 10 2 3 Yes Shooters ran away after firing 30 rounds – lower capacity might have reduced total rounds fired.
Newington, CT – Lottery worker 4 0 0 0 Yes Shooter chose specific victims and fired relatively few rounds, so capacity limits make no difference here.
Orange, CA – Caltrans 4 2 3 1 Yes Shooter entered shootout with police shortly after initial incident, lower capacity might have shortened his attack
Aiken, SC – RE Phelon Co 4 3 0 0 No Standard capacity weapon (illegally acquired) used
Fort Lauderdale, FL – city employee 5 1 0 0 Yes Standard capacity weapon used
Corpus Christi, TX – Walter Rossler Co 5 0 0 0 Yes Standard capacity weapon used
Fairchild AFB, WA – hospital 5 22 5 22 Yes Shooter possessed only one 75 round drum magazine – so he would never have to reload. Military police arrived quickly and killed perpetrator.
Aurora, CO – Chuck E Cheese 5 0 0 0 No Shooter fired less than 10 times, executing each victim, usually with a single shot
Garden City, NY – LIRR 6 19 2 6 Yes Shooter emptied two 15 round magazines and was tackled while reloading with a third magazine. Total rounds fired would have been decreased by 1/3 were magazine capacity limits in place.
Fayetteville, NC – Luigi’s Restaurant 4 6 2 3 Yes Shooter used a high capacity rifle, shooting was stopped by nearby police
San Francisco, CA – 101 California St office building 8 6 4 3 Yes Shooter used a 32 round Tec-9 in the shooting, and fired hundreds of rounds
Watkins Glen, NY – office 4 0 0 0 Yes Shooter killed four intentional targets with relatively few shots, and then waited for police to arrive – perhaps less than 10 shots total fired.
Olivehurst, CA – Lindhurst High School 4 10 0 0 Yes Shooter used two weapons and fired relatively few shots, so high capacity weapon limits would have no effect here. Shooter also had no prior criminal or mental history.
Royal Oak, MI – postal 4 6 4 6 Yes Shooter had his concealed weapons permit revoked on concern of mental illness. Shooter also used high-capacity magazines with his rifle and fired scores of rounds according to police.
Iowa City, IA – Univ of Iowa 5 1 0 0 Yes Did not use a high-capacity weapon, and did not display sufficient signs of mental illness prior to shooting to warrant attention
Killeen, TX – Luby’s Cafeteria 20 24 8 10 Yes Used high capacity pistols and reloaded multiple times – capacity limits would have enabled more victims to escape, as many escaped by exiting the restaurant.
Jacksonville, FL – GMAC plant 9 4 9 4 Yes Shooter had a history of violence and convictions, and yet legally purchased multiple weapons. Used a high capacity weapon in shooting
Louisville, KY – Standard Gravure Co 8 12 8 12 Yes Shooter used high capacity weapon, emptying its magazine and committing suicide with his second weapon. Shooter also had a lengthy psychiatric history including hospitalization
Stockton, CA – schoolyard 5 29 5 29 Yes Shooter had a lengthy arrest history and had served time in jail as an accomplice to armed robbery, and yet was allowed to buy weapons.
Sunnyvale, CA – ESL Co shooting 7 4 7 4 Yes Shooter was able to purchase guns while under a court restraining order
Palm Bay, FL – shopping center 6 14 6 14 Yes Shooter used a high capacity .223 caliber rifle, and killed two police officers during the shooting – one of them as the officer was trying to reload. Perhaps if the shooter’s capacity were lower, the officer might have himself fared better. Gunman also had prior assault conviction.
Edmond, OK – USPS 14 6 0 0 Yes Shooter was in National Guard and would have had access to weapons. Though he was referred to as “Crazy Pat”, he had no history of crime or treated mental illness
San Ysidro, CA – McDonalds 21 19 14 13 Yes Shooter used a high capacity weapon, Uzi, pinning down a quick-responding officer with 30 rounds of fire before re-entering restaurant
Dallas, TX – nightclub 6 1 0 0 Yes Shooter used an unknown handgun, emptying it into crowd and then rushing out – unclear that capacity limit would have any impact here.
Miami, FL – welding shop 8 3 8 3 Yes Shooter did not use a high capacity weapon, but purchased his weapons one day after failing a psychiatric exam ordered by his employer, the school district, and after incidents in which he appeared to be a threat to students
Birchwood, WI – hunting altercation 6 2 3 1 Yes Shooter fired 20 rounds at other hunters – if he had a lower capacity, it’s likely that another hunter would have been able to respond with fire

The analysis above attempts to answer the question – what would have happened in these incidents had the proposed laws been in place? Of 459 deaths and 481 injuries in 63 shootings, I estimate that 250 deaths and 324 injuries (54% of deaths and 67% of injuries) might have been prevented with the analyzed proposals. Each proposal, its method of action, and the analysis approach is described further below.

High-Capacity Magazine Ban:

Definition: Sales of high-capacity magazines to and between private citizens would be completely banned, and imports of high-capacity magazines for private use would be banned as well. While many magazines would exist in private hands, a magazine buyback could then be used effectively, as magazines are relatively inexpensive.

Method of Action:

  1. In some instances, the shooter was disarmed by potential victims while trying to reload – smaller magazine size clearly would have limited total impact in these shootings.
  2. In some instances, potential victims fled during breaks in the shooting enabled by reloading – if a shooter has to reload 2 or 3 times as often, this effect is multiplied.
  3. In some instances, law enforcement arrived relatively quickly, and most damage in the shooting was done via the initial magazine – a smaller magazine would have limited impact in the shooting in these instances.
  4. In a few instances, victims attempted to rush the shooter immediately. If a shooter could only fire 10 shots instead of 20-50, it’s possible that he might be tackled quickly rather than be able to continue shooting.
  5. In most instances, the shooter committed suicide after doing a certain amount of shooting, but always before exhausting ammunition. Since each reloading represents a break in the act, some shooters would commit suicide after having fired fewer total rounds if they were capacity constrained.
  6. In a few instances, the shooter appeared to choose a specific weapon because of its high capacity. If high capacity magazines were not available, would the shooter still go forward with the attack?
  7. In 18 of 63 shootings, shooters fired relatively few rounds, chose a small number of specific victims, or used standard capacity weapons. In these instances the high-capacity magazine ban has no impact. 29% of actual mass shootings fell into this category.

Analysis Method: If the shooting fell into the last category above, then zero impact is noted in the analysis. Otherwise, the casualty count is reduced by the ratio of the shooter’s magazine size to standard magazine size – if the shooter used a 30 round magazine, then the casualty count is estimated at 2/3ds lower (rounded up) with a standard capacity magazine. This approach will tend to underestimate the effect of a ban in instances like 1,4, and 6 above, while providing an accurate estimate or an overestimate in instances like 2, 3, and 5 above. In aggregate, I think this approach is unbiased.

Stringent Background Checks:

Definition: Create a mandatory national database of all felons, mentally ill, and others posing threats (anti-terror lists, those who have made threats against schools or other institutions). Mandate that all firearms transactions for new and used weapons, in public and private transactions, be checked against this database, with instant results. This stands in contrast to the current background check system, which is done on paper and via telephone call, not electronically.

Method of Action:

  1. Out of 63 mass shootings over the past 30 years, only 5 have involved illegally purchased weapons. Some of the shooters had a history of mental illness or a criminal record – preventing a sale of firearms to these individuals would reduce the frequency of shootings.
  2. Many of the shooters with a history of mental illness had no criminal record – it’s unlikely that they would know how to obtain an illegal firearm.
  3. Some of the shooters purchased weapons in the days after making threats against a school or other institution – in these cases, a properly implemented stringent background check system would have prevented the weapon sales.

Analysis Method: Shootings were identified in which a shooter had a documented history of mental illness, a criminal record, or had made threats against an institution prior to buying a weapon. In these cases (17 instances total) it’s assumed that the casualty count is reduced to 0, as the shooter would have been unable to obtain a weapon. In reality a certain number of shooters would then try to acquire weapons illegally, and some might succeed. But a certain number of mentally-ill or former felons might never try to obtain a weapon if they knew they had no easy or legal means to do so, providing an offset.

Analysis of Assault Weapons Ban and Armed Civilian Presence

Two other proposals have been mentioned in the last several months – a ban on assault weapons and the placement of more armed guards or civilians in public places. On the question of assault weapons, the data from mass shootings shows that shooters preferred a range of semi-automatic weapons with high-capacity magazines. Weapon capacity makes a difference, but the type of weapon (handgun vs rifle) does not.

With regard to armed bystanders, in 9 of 63 shootings armed individuals (often police officers) were present. In several cases armed individuals became victims in the shooting, and the presence of armed individuals did not prevent the shooting from taking place. However, this analysis is by definition incomplete – this is an analysis of shootings that actually did take place, and doesn’t include data on shootings that were stopped by armed individuals. The evidence here suggests that the element of surprise may render concealed weapons somewhat ineffective, but this is not a conclusive finding.

The Simple Arithmetic of High Capacity Gun Magazines

In the wake of yet another mass shooting tragedy today, let’s examine the costs and benefits of high capacity gun magazines. I previously examined the cost-benefit of private gun ownership in the US, and noted at that time that the extraordinarily negative cost-benefit ratio might eventually become an issue for the pro-gun lobby (the industry generates economy-wide economic losses of over $15B/year) [1].

High capacity magazines [2] seem to have become a feature of virtually every recent mass-shooting in the US [3]. How many lives might have been saved by eliminating high-capacity magazines? Let us conservatively assume 10 deaths per year might be reduced through this policy (a rounding error compared to the roughly 10,000 annual gun homicides in the US). The economic value of 10 lives can be estimated at $80 million, while the annual sales revenue of high-capacity magazines might be less than $20 million (since gun magazine sales are a tiny fraction of gun sales, and magazines can be had for as little as $15) [4].

Measuring tragedy on an economic basis might seem crass, but it helps establish a key point: not only are high capacity magazines empowering individuals in mass shootings – but they are also provably hurting America as a whole, as they subtract value from our nation! An outright ban on possession of high capacity magazines is thus a reasonable step to limit further damage to America’s citizens and economy.

Let me address a number of potential criticisms here:

  • Would-be mass shooters will acquire weapons and high-capacity magazines illegally, so you are only affecting law abiding citizens. Actually, 75% of weapons used in mass shootings were acquired legally, and recent shooters acquired their weapons legally. Most of these shooters had no previous criminal record, so in the event high-capacity magazines were illegal, it’s unlikely that they would even know how to find them illegally.
  • Banning high-capacity magazines would have no effect on death rates, as shooters would simply reload. In the Gabrielle Giffords shooting, the gunman was stopped in his rampage once he stopped to reload. Reducing magazine capacity to 10 rounds reduces total firing capacity – this is simple arithmetic. In both of these shootings and many other incidents, lives would have been saved. For that matter, lives might be saved in incidents like drive-by shootings where the rapid fire of multiple rounds makes victims of innocent bystanders.
  • High capacity magazines are needed for self-defense. Even the police rarely find need to fire large numbers of rounds. Is there even one documented case of self defense where the potential victim needed more than 10 rounds to deter his attackers? There are outliers in everything, but I’d be surprised to hear of such a case.
  • I have a 2nd-Amendment right to whatever capacity magazine I like. The recent Supreme Court case upholding an individual right to a firearm also upheld the right to ban American citizens’ access to fully automatic weapons, grenades, tanks, and all other manner of military weapons. Even Justice Scalia admits that there are restrictions on the 2nd Amendment. Your right to purchase whatever weapon you like has long since been curtailed, and the government retains the right to enact reasonable restrictions on access to arms.

 

[1] Using more recent numbers on the economic value of human life at $8M per life, the gun industry may actually cause annual economic losses in the US of $200B per year (8M * 30k lives lost – economic value of gun trade). I republished the more conservative estimate above to remain consistent with the original analysis that I referenced.

[2] I am defining high-capacity magazines as those holding more than 10 rounds, as defined in the original assault weapons ban.

[3] Limiting gun capacity would have reduced casualties in a number of recent tragedies:

[4] Gun sales are estimated to have reached an annual rate around 12 million this year. If separate high-capacity magazine sales are in the neighborhood of 10% of all gun sales, and magazines cost around $15, then total annual revenue from this business might be 1.2M * 15 = $18M. This is an imprecise estimate, since gun sales are not tracked, but conveys the order of magnitude, and illustrates the tiny economic benefit supplied by this particular product relative to its cost in human life.

How High a Budget Deficit Can We Sustain?

The US can sustain a budget deficit of 5%, not 3% as commonly assumed, because 2.5% inflation and 2.5% real growth combine to keep the total debt/gdp ratio stable.

With both the financial crisis and European debt crisis having a root in excess borrowing, the American political debate has turned toward deficit reduction as well. If current budget deficits (averaging 10% of GDP since the financial crisis) are recognized as unsustainable over the long term, then what level of budget deficit is sustainable? At one extreme, politicians call for a balanced budget, and at the other extreme the budget deficit is considered a distant issue. Meanwhile, many economists set the sustainable deficit threshold at 3% of GDP, and EU rules formally set the budget deficit threshold at 3% as well. What is the basis for the idea of a “sustainable” budget deficit, and is the 3% figure too high or too low?

What is a sustainable budget?

Unlike individuals or families, a nation has an indefinite lifespan, and can therefore continually roll over its debt as long as markets deem it a worthy creditor. As long as a nation’s economy is growing, its capacity for borrowing grows as well. But if the debt grows at a rate faster than the economy, then it will eventually exceed the nation’s ability to repay it. The idea of a sustainable budget deficit is summarized by the chief economist of the Concord Seo Company Coalition, “President Obama’s fiscal commission set a goal of getting deficits down to about 3 percent of GDP within five years – 3 percent being the average annual growth rate of the US economy since World War II.”

The Real Sustainable Deficit Target

There’s just one problem with the 3% target for a sustainable budget deficit – it’s too low! While GDP growth is measured in real terms, inflation also eats away at the value of the US debt over time. For instance, assume that the US has no future economic growth, but continues to have 2% inflation. Assume that we also manage to (magically?) balance the US budget. With no economic growth, does this mean that debt/gdp stays constant? Actually, inflation would cause the numerical value of GDP to continue rising, while the debt stays constant. This would cause the debt/gdp ratio to fall by around 2% per year.

In practical terms, this means that we have to look at the rate of nominal GDP growth to determine a sustainable budget deficit level [1]. To be conservative, let’s assume 2.5% real GDP growth (less than the 3% post-war average) and 2.5% inflation (within Americans’ comfort zone, and less than the 90’s and 2000’s average). Taken together, this means that if nominal GDP grows at 5% per year, a budget deficit of 5% can be sustained long term. The difference between 3% and 5% of GDP is big, over $300 Billion in 2012. As the federal budget and spending again enter serious debate after the November elections, it’s important that politicians understand the government’s true borrowing capacity – and neither the populist “balanced budget” nor the typical economist’s 3% magic number stand up to examination.

[1] Here’s the actual nominal GDP data from the Fed: http://research.stlouisfed.org/fred2/howtobcome/data/GDP.txt

Using this data, we see that nominal GDP has grown at a compound annual rate of 6.6% over the post-war period (since 1947, when the data series begins). Over the past 30 years, nominal GDP has grown at a compound annual rate of 5.4% – and this period excludes most of the late 70’s and early 80’s inflation spike. Even over the past 20 years, which are skewed downward due to the financial crisis, the nominal GDP growth rate is 4.7%.

Explaining the India – China Wealth Gap

As of 2011, China had a per-capita GDP (PPP) around $8400 per year while India’s per-capita GDP was  $3700. China has routinely exceeded 10% real annual GDP growth over the last two decades, and India’s GDP growth has been impressive, it has rarely exceeded 8%. China’s growth has exceeded India’s since its economic liberalization, but its turn towards capitalism also began earlier. China’s Deng Xiaoping began to liberalize China’s economy beginning in 1978, while in India P.V. Narasimha Rao and Manmohan Singh were not able to bring about serious economic reform until 1991. If India had liberalized at the same time as China, how much narrower would the wealth gap be? How much of the income gap between India and China is explained simply by timing?

Over the 13 years from 1979 to 1992, India’s per capita GDP (PPP) roughly doubled from $480 to $972, at an annualized per-capita GDP growth rate of 5% for the period. China’s economy averaged 10% growth over this same period! Since 2002, India’s per-capita GDP growth has averaged 9.5% on a PPP basis [1]. If India had grown at its more recent average of 9.5% per year over that period, per capita GDP would have risen to $1562 by 1992 – and India’s economy would be over double the size that it is today [2]. Fast-forward to the present, and this earlier liberalization would have led to a current per-capita GDP of $6000 in India, almost double current levels and in the same range (of middle income nations) as China [3]. One effect experienced in China has been an acceleration of growth post-liberalization – economic growth accelerated as reforms took hold. Had this occurred earlier in India as well, it’s possible that the 90’s and 00’s in India would have benefited from 9.5% GDP growth as well. If we use a 9.5% assumption for India’s growth from 1979 to present, then we get a present-day per-capita GDP in India of $8000 – not substantially different from China [4]!

Despite their huge differences, with China as an autocratic capitalist state and India as the world’s largest democracy, the two nations’ growth paths have not really been that different. All of the differences in government, corruption, infrastructure don’t really seem to have mattered that much, as a simple head start of 13 years drowns it all out. What a difference 13 years makes! The good news: India’s development was unnecessarily delayed, but is now well underway.

[0] All of this is based on the World Bank’s purchasing-power parity GDP per-capita data, as provided by Google’s public data service via http://crosscountrymovingcompanies.biz. This is GDP divided by mid-year population and adjusted for the difference in purchasing power in each country (normalized to US prices and quoted in dollars – this gives you a sense for how poor people in these nations really are).

[1] From the Google chart, 3582/1723 = India’s economy grew 2.08 times from 2002 through 2010. This equals a compound annual rate of growth of 9.57%.

[2] Take the 9.5% growth rate post-2002, and apply it to the 13-year period starting in 1979 at $480 GDP/capita (PPP). This gives you $1562 by 1992.

[3] If we then assume that India’s economy grew exactly as it did historically from  1992 – 2011 (growing 3.8x), and multiply this by 1562 (the new starting point in 1992), then we get a 2011 GDP/capita of $5946.

[4] Now assume that India simply grew at a 9.5% rate from 1979 on – the rate that it has managed from 2002-2011 (a period which includes the financial crisis). This would 1.095 ^ 31 = 16.67x growth. From a starting point of $480 GDP/capita, this would leave India at $8000 GDP/capita (PPP) by year end 2011.

P.S. In researching this post, I noticed that India’s growth rates compare much more favorably in PPP terms than they do in exchange rate terms. This might be explained in part by the fact that the Rupee has been much more volatile than the Yuan over time. While inflation is now rising quickly in both countries, particularly in metro areas, perhaps India has remained less expensive than China over time. Comparing these two graphs shows the difference when comparing unadjusted $ GDP/capita to PPP GDP / capita. I use the PPP measure as it more accurately reflects the quality of life experienced by someone living in either country, since cost matters just as much as income.

How High Would Soccer Scores Be With No Goalies?

I’m an American, and while following the World Cup has been interesting, I will admit freely that I mentally tinker with the game as I watch it, since it is so different from most American sports. The big three American sports (football, baseball, and basketball) have higher scoring and are chock-full of statistical record keeping, so that fans can assess their teams’ progress even when scores are low. While I am learning to appreciate the explosive joy that a goal can bring in a game with so few of them, I thought it worthwhile to ask a question: how many goals would be scored in World Cup-level soccer if there were no goalies at all?

According to FIFA, 2.2 goals have been scored per match thus far in the World Cup, though 1-0 has been the most common outcome thus far. While teams have combined for almost 28 shots per match thus far, they have managed only 10.2 shots on target per match thus far. By definition, total goals in a match would thus rise to at least 10 if matches were played without goalies.

But if there were no goalies, game play would be altered in a number of ways. Teams would be more likely to shoot, raising scoring further. Defenders would spend more time in the box as “armless goalies”, so that not all shots-on-target were converted. Even without goalies, the percentage of shots-on-target might not rise dramatically, since the presence of defensive players alters many shots. As an upper bound, assume that total shots per match doubled to around 56, with 35% of shots-on-target (same as today). This yields roughly 20 goals per match, with scores of the 12-8 or 11-9 variety quite normal.

While scores like 12-8 and 14-6 sound astronomically high to the die-hard soccer fan, these are still less than one-fourth of basketball scoring, similar to high scoring baseball games, and about double football scoring. With rules change governing the offside rule or otherwise floated as a way to increase scoring, it’s interesting to note that even a radical proposal would not turn soccer into basketball. It’s difficult to score in soccer, even if there are no goalies!

A Better Capital Gains Tax

Taxes on long-term capital gains have fluctuated in recent years, with rates as low as 0% (for lower income groups) and as high as 28%. At the end of 2010 capital gains rates will likely revert to 20% after being at 15% for several years. While long-term term capital gains enjoy a tax break, short term capital gains (on positions held less than one year) have long been taxed at marginal income tax rates. While dividends have more recently been accorded the same tax breaks as capital gains, interest payments continue to be taxed as marginal income.

Capital gains tax breaks are designed to encourage investors to invest in the economy for the long term, thereby promoting economic growth. As currently structured, the capital gains tax break doesn’t really achieve this, as it simply rewards investors that hold a position for more than one year. The law does not distinguish between investments in startups or IPOs and in purchases of existing equity shares. With regard to real estate, the law encourages the tax-free flipping of properties via 1031 transactions, but does not reward investors who improve their properties.

Rather than subsidizing investments in existing shares and property, shouldn’t capital gains tax breaks attempt to promote new investments? This could be easily accomplished by lowering the capital gains tax rate to 0% for all new capital investments, irrespective of investment duration. A new capital investment could be defined as an investment in which the target company directly receives the proceeds of the investment. Investments in IPOs, secondary offerings, startup companies (including angels and VCs), and real property improvements would qualify, while purchasing of existing shares and real estate would not.

A 0% tax rate on new investments would incentivize real investment in the economy, rather than encouraging simple tax-related shuffling of existing investments. In order to offset deficit impacts, traditional capital gains tax breaks could be reduced or eliminated. Moving to a system in which new investment is incentivized would tip American finance away from the casino mentality of recent years, and back towards its original purpose: investing in promising companies for profit.