Image by Josh Hallett CC 2.0 via Flickr

This is an edited extract of a Crawford School event with Professor Vito Tanzi, former Director of the IMF Fiscal Affairs Department. The event was co-hosted by The Tax and Transfer Policy Institute and the Development Policy Centre.

Miranda Stewart is the director of the Tax and Transfer Policy Institute; Stephen Howes is the director of the Development Policy Centre; Roger Bradbury is a Professor at the National Security College; and Peter Whiteford is the director of the Social Policy Institute.

Podcast: Complexity in Governments and Markets

Lecture by Professor Vito Tanzi

This lecture addresses questions of complexity and inequality. About 12 years ago, I wrote a chapter in a book called ‘Complexity and Systemic Failure’, in which I tried to identify how complexity can lead to failure. And to my surprise, after the financial crisis came, I looked back at my chapter and there was a prediction of the financial crisis in it – that the financial system had become so complex that nobody understood it anymore and so the possibility of having a financial crisis had increased.

Let me cover some historical background before returning to the issue of complexity. The distant past, if you go back to the 1920s, was the age of laissez faire. Laissez faire was easy to understand: there was not much to be understood! Then came the period between the two World Wars, when laissez faire was challenged and competed ideologically with theories of governmental economic planning. In that period, one could mention two very famous economists. One was Hayek, who in 1941 wrote The Road to Serfdom. He feared that planning which had become very popular in many countries and was implemented in the Soviet Union in Russia, would spread and contaminate all the countries – Germany, Italy, Spain, and in some other places. The other was Keynes, who wrote a famous pamphlet at the time called The End of Laissez Faire, arguing that laissez faire was not producing what people had expected it produce and so the government needed to intervene more in the economy.

World War II was accompanied, and followed, by the New Deal, the creation of welfare states. Many countries decided that the government should do much, much more than it had been doing up to that point. In many European countries they created the welfare state. In other countries, like Australia or New Zealand, they expanded the role of government without going all the way to creating a welfare state. The bottom line is that the role of the state grew dramatically after WWII for the next two or three decades until the decade of the 1970s.

There had been various views that the government should intervene to eliminate most of the evils of society. The Beveridge Report of 1942 set the design for the welfare state that was introduced in the UK. There was a question Keynes asked in an essay in 1925. This was a situation, a time, very similar to ours in terms of income distribution, in terms of complexity and so forth. Keynes said that we need new wisdom and new policies, and he asked: what kind of policy? This really is the $24,000 question.

The period immediately after WWII was one of great optimism. People became very optimistic about what you could do with the economy, both central planners and market economists. The central planners thought they had seen the future. They were taken on visits to Russia to state factories and farms and so on. They came back to England, to France to Italy and to other places with a view that central planning could be made to work. The market economists thought that they had discovered nirvana in Keynesian stabilization policy.

I was at Harvard in the early 1960s and really, it was the view that we knew everything that we needed to know about how to stabilize the economy. Professor Charlie Shulz made a speech in which he said students should not waste their time anymore in studying microeconomics. Let them concentrate on industrial organization he said. Market economists realized that there was market failure but they felt it could be corrected. The point is that there was really a lot of optimism about the future.

When my book on Government Versus Markets was published in 2011, I had written a concluding chapter in that book dealing with complexity. One of the editors of the Financial Times wrote a review in which he called attention to this chapter he asked whether complexity would destroy civilization.

Mechanical economics or social systems in principle can be simple, that is you understand them easily, and you can predict behavior. Or it can be complicated, and difficult to build, but still predictable in their outcomes to experts. If you want to go to the moon, or to build a modern jet, or a power plant, clearly this is very complicated and you need experts. But experts, once they build them, can duplicate them. They can more or less can predict the outcome. Obviously, if you build something with thousands of parts, a part may fail occasionally and you could have a disaster.

On the other hand, systems can be also complex and are difficult to fully understand and are less predictable in their results. In other words, it’s very difficult to understand exactly how they operate, and also difficult to really know what results will happen.

The financial system, as I mentioned a few minutes ago, is one of these systems. It becomes so complex that almost nobody full understands it. And if you don’t understand something, then it’s possible that you could have a disaster not anticipated. Over the last decade some government operations and some social systems became not only complicated but complex and less predictable. The same thing happened to private markets, which were easy to understand in the past and which became much more complicated.

The result was that some recent crises and some outcomes were not anticipated, for example the Global Financial Crisis of 2007-2008 had been really unanticipated (although some people argued later on that they anticipated it). The growth of income inequality in the past decade probably had also not been fully anticipated. If you had stated in the 1970s that income inequality would get worse in the next two or three decades, people would probably not have believed it. The rise of populism may also be one of these unanticipated developments. And probably, I could add the election of President Trump was totally unanticipated.


Miranda Stewart: In your books Government Versus Markets, and Public Spending, it seems to be your view that some countries are taxing too much. You seem to argue that tax levels were too high by a measure of efficiency, sustainability or wellbeing, or perhaps relative to some theoretical concept of what is the right tax level. Are you more ambivalent about that question today? Do you still have a view about whether we are taxing too much and if the 1980s aim of reducing taxes and spending got that right?

Vito Tanzi: I clearly am much more concerned about income distribution now than I was at that time. I didn’t realise that income distribution would bring the kind of populism in the result. I see this as a very dangerous development. I also have become aware of data in the U.S. of which I was not completely aware before. For example public health, and life expectancy, if you take some counties in the U.S., say Mississippi, and you take counties like New York, you find the difference in life expectancy average is 18 years. This is larger than anything you have in the world between the richest and the poorest countries. These kinds of worries have brought me to another point

Maybe I have become more sympathetic to universal problems. But that brings me to another question, which is whether governments are capable of introducing programs. I have no problem with Denmark which collects more taxes than any other place in the world and uses the taxes well. It collects taxes which are very simple, and doesn’t give much scope to lobbyists and so forth. So I’ve become more sympathetic to that, but I’m not sure that the U.S. would ever be able to adopt that kind of approach to the problem given ethnic differences. The bottom line is that I’m much more pessimistic now.

Miranda Stewart: Do you think the US is really an outlier? It’s a very big country and of course a lot depends on context. The inequality that you see there, do you think there is something unique about that?

Vito Tanzi: Let me give you one piece of data. Of all the OECD countries, the tax burden of the U.S. has grown the least in the last 50 years. It’s still not much different from what it was 50 years ago. Yet if you talk to most Americans they think they are over-taxed. President Trump can win the election saying they are paying too much tax. Clearly the U.S. is an outlier.

We turn to Professor Roger Bradbury to discuss the issue of complexity

Roger Bradbury: Vito, your talk got me thinking about whether complexity is to blame for the problems, or do the problems cause the complexity: which way does the causation flow. One of the issues we’re dealing with when we look at governments and when we look at economies and institutions and regulations, reminds me very much of that old cosmology of some ancient tribe. The cosmology had it that the world was sitting on the back of a turtle. A Western anthropologist asked, ‘What does the turtle sit on?’ And the Indigenous people looked at the anthropologist and said, ‘Well, on another turtle – there are turtles all the way down’. The analogy is that there is complexity all the way down and all the way up.

We can take a solar system or a galaxy and understand them to some useful degree with relatively few parameters. We don’t capture all the intricacy, but we capture enough to try and understand it. So one of the things to think about it is that we’ve got a theory of economies but we don’t have a theory of the layer of the onion outside that, the broader institutions and government. We can’t capture that in the same way that we can capture an economy. We have layers we can understand and then we have layers we don’t understand.  It makes for very difficult prediction and for very difficult extension and extrapolation and learning how to link these things together.

That said, complexity scientists have been making some reasonable strides in the last couple of years in being able to predict some of these difficult behaviours. One of the problems we have in any complex system occurs if the system reaches a tipping point and then suddenly changes its state. Economies, interactions between nation states, financial systems and the internal behavior of individuals all tend to have stabilities of one sort or another. Then, suddenly they can change. An individual can have a psychological crisis, an economy can melt down, nations can suddenly go to war, or we see the Global Financial Crisis. These sudden transitions in state have for a long time been one of the most profound problems in understanding complex systems.

In the theory of complex systems, we are now getting to a point where we think we have some tools that could predict the arrival at what’s called the tipping zone. This doesn’t necessarily mean the system will tip, and that it will change state. But it means that it has moved to a state where it can move into a zone where it is much more likely to change state than it was before. The probability of the system changing states suddenly spikes before the change of state occurs, it’s a leading indicator. That is a tremendous improvement from where we were before the Global Financial Crisis. These results have only come out in the last two or three years. So we are getting to a state where we gradually have more control and understanding of the different layers of the onion.

Miranda Stewart: Vito, do those concepts of tipping points from complexity theory assist you in thinking about fiscal policies and policy changes over time? Also, does growing inequality becomes a leading indicator of instability in our complex systems, not only an indicator of a more unequal distribution.

Vito Tanzi: We go back to Keynes’ observation that we need new knowledge to interpret what is happening. The financial system had this tremendous crisis but it is still there. And we are probably going to get another crisis at some point. But the system will in some way still be there. The same thing applies for tax systems. The problem is that we can no longer anticipate the cost of the crisis and it becomes more difficult to anticipate the crisis.

Tax systems are certainly becoming more complex. Again, to give the US example – today there are 70,000 pages of laws and regulation of the US tax system. There are many special provisions for interest groups. For example, there was a US family that managed to have three or four words inserted in a regulation, and they saved billions of dollars.

So this is the problem, that in the complexity we more or less still understand the system but we don’t understand the effect of parts of the system changing. This has consequences also for the income distribution.

Audience Question: What are the consequences of these issues for the populism which we might see unfolding?

Vito Tanzi: What worries me about populism is that many of these people don’t seem to reason the same way as I do. This doesn’t mean I’m always right, but they don’t seem to believe in science. They don’t believe in facts; they believe in alternative facts. I’ve never understood why global warming is a question of right versus left. One can believe or not believe it on a personal basis – I understand that, that some people might not believe it. But why is it that all the people who are conservative don’t believe it and all the people on the other side believe it?

What worries me is that populism will bring really bad policy.  Clearly there are these developments going on, these attacks against globalization, these attacks against taxes. This really worries me. For example, for some of the people who voted for Brexit, one main reason they gave was that the European Union had forced England to put signs on the road in meters and kilometers. When we reach this stage, I don’t know what to do about it!

Audience question: You said that complexity doesn’t just happen. Someone makes it happen. In that context I was just wondering if you have any thoughts on the role of technocrats in complexity. They seem to me to be a sort of double edged sword – on the one hand modern policy problems are often very complex like a carbon price for example but at the same time, any time you given some insider group some power you inevitably encourage them to develop a guild. I was wondering if you think there are any ways we can take the good parts of technocracy without sort of succumbing to these other problems.

Roger Bradbury: I agree with Vito. Why did climate change fall the way it did in terms of the left believing it and the right not believing it? It seems to me it could have easily gone the other way. Perhaps the left would have been vehemently opposed to it because the right accepted it. It’s weird the way these things become dichotomous.

To pick up on the technocratic point about complexity, it’s important to look at a lot of process phenomena that are occurring in the world as technology changes. Some of those things are trap-doors. That means that we can’t go back. We can’t go back to hunter-gathering now that we have agriculture, because we can’t sustain the population of the world in agricultural terms by hunter-gathering. So we are stuck with the technology at that point. Once more than 50 per cent of the population is urbanized, as it is now, we can’t go back to living on the land and we have to worry about ‘manspreading’ regulations in the New York subway because of the population density.

Technology drives a lot of those things. We can’t do it without experts: to keep the water clean, to keep the petrol engines running smoothly so that we can drive to work. We need the experts and we can’t un-need them.

We turn to Professor Stephen Howes to give us a perspective on development and governments

Stephen Howes: As a development economist, I suppose the good news is the developing economies. They are the economies that over the last 20 years have reduced poverty by taking hundreds of millions of people out of poverty. They increased life expectancy, reduced infant mortality, they got their kids into school. This occurred in China, India and more recently more broadly across Asia, and into Sub-Saharan Africa.

So the pessimism of Vito’s talk is, I suppose, more based on your lived experience in the United States and perhaps recent experience in Italy, rather than your experience in the International Monetary Fund when you were dealing with developing countries which have shown more progress.

But, from the developed country point of view, it’s hard to disagree with the pessimism we heard today. I wonder, however, as you suggested, is it really about complexity? Yes, the world is getting more complex but is that the driving cause of problems? Or, is it inequality, as you also at one point suggested? Even inequality is somewhat too abstract a term. I think we can describe the problem in more concrete terms – as shown by Peter Whiteford who has presented data on inequality in the United States for male workers, which shows for the bottom 50% over the last 40 years the average male worker has seen a decrease in their wage. It’s not the bottom 10% that is really the issue, it’s the bottom 50%. And if that is what your society is producing then it’s not sustainable. Sooner or later people are going to revolt. It might be different if there is a war, but if year after year you see your wages going down or not keeping up with inflation, even if there are good things happening like iPhones, technology, you are going to be very unhappy. So I would express the problem more concretely in those terms.

For Europe, if we see unemployment around 10% year after year and for young people 20% year after year, it also seems that’s not sustainable. Sooner or later people are going to vote for a candidate that offers something different. Especially when migration is at high levels; this may not be the correct diagnosis but it’s a pretty obvious diagnosis ‘it’s these migrants’ that are taking our jobs and keeping my wage low.

In contrast, in Australia somehow we have done well. We have had inequality go up, yes, but somehow we have managed to keep the real wage growing pretty much across the population and we have had relatively low unemployment. Maybe we’re just lucky, we have had China, we have the resources boom, we have had tourism and education. Or perhaps we have the policy settings better. I don’t think we understand enough about what is needed to get shared growth across the economy. That is where we need to focus our efforts.

Meanwhile, the people who have been elected on the basis of a protest vote don’t have very logical proposals. President Trump doesn’t even talk about inequality and yet has been elected as an outcome of inequality. Perhaps the optimistic reading is that this is the sort of shake up that was needed because what we thought was sort of a golden period was an unsustainable era and now we will see a shakeup and eventually a more sustainable pattern of growth emerge.

Vito Tanzi: Complexity raises questions about what you are doing with the taxes raised, and I go back to the Danish or Swedish examples. The question is, could you improve the situation of inequality we now see in the US, simply by increasing taxes. If you have already dramatically lowered the tax on capital incomes (Mitt Romney when he was running for president made his tax declaration and he had paid 12% tax, and Warren Buffet keeps repeating that the tax burden on him is lower than on his secretary or his driver), but you then increase taxes under those circumstances what do you get?

Audience question: I’d like to ask, what’s wrong with complexity? With public policy there are three problems: unintended consequences, the sheer cost of doing public sector things in a complex way, or third, that democracy can’t work in complex public policy settings because you’re asking people to vote on things they don’t and can’t understand. That to me is what brings in the populism problem.

Vito Tanzi: I agree with all three points. Complexity makes democracy questionable. To understand, you have to have a certain amount of sophistication that most people don’t have. Complexity makes it easier for people with more means to hire the experts. Complexity makes it more difficult to make choices. If a system is complex then it is difficult to distinguish the good choice from the bad choice.

Peter Whiteford: When I was in the public service, two of my colleagues wrote a history of the legislative changes to the Social Security Act in Australia. The first volume covered the 75 year period from 1908 to 1983.  That was a 120 page document. The second volume covered the period from 1983 to 2000. That was a 600 pages document. It was roughly a 25-fold annual increase in the rate of legislative change. I often think: what happened?

It was partly about the capacity of governments to change things. Their capacity to do these things increased. It was partly because we computerized the payment systems, so you could make changes in payments, much faster than before. Then there are also the politicians who like to be seen to be reformist in this area in Australia, so they change things in order to leave their mark on the system. Maybe some of the public servants do as well. Then there’s also a gap between short term and long term visions. So people keep changing things, thinking they are making incremental change, but they don’t have a long term vision of where the system is going. Maybe that’s the problem, that we don’t have that sort of long term vision built into politics.

Vito Tanzi: I consider the issue of welfare reform including the example of universal basic income in my forthcoming book, Termites of the State, I argue that when governments started worrying about income distribution after WWII, it would have made a lot of sense at that time to increase the level of taxation through universal taxes. It would also have made sense to take that amount of money and redistribute to everybody, rich and poor equally – a basic income. Such a policy at that time would have had a tremendous impact on the income distribution and may have been in place of other welfare programs. But today, much of the discussion of universal income is in addition to other programs and this is where I have the problem.

Miranda Stewart: A final question then is: Is it the economy that is unsustainable or is it the tax and welfare systems we have developed that are unsustainable? Do you have a response to that point that it’s not really complexity it’s inequality? Or is it not so much that increasing taxes and spending wouldn’t address the problem, it’s that we can’t get the right tax reform in the current environment?

Vito Tanzi: I have become more of a skeptic about what I believed earlier. Simply spending more money on programs funded by taxing more was the optimistic view I identified earlier which prevailed after World War II. When I was a student that was the view that prevailed, that government create programs that address redistribution. The statements of Roosevelt, Beveridge or Johnson in creating social welfare programs show that the objective was increased spending funded by increased taxes in such a way that those at the bottom gain more. I’m not sure in the present political environment that that is still possible.

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