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An Educated Public Is Democracy's Biggest Asset

March 9, 2009

An Educated Public Is Democracy's Biggest Asset

OK, I feel like I'm harping on the Obama Administration, and I really don't mean to. But Laura D'Andrea Tyson has an op-ed piece in today's Wall Street Journal that perfectly illustrates why democracies need an educated public. Ms. Tyson sits on the President's Economic Recovery Advisory Board.

Read this statement from her article and see if you can tell why it's misleading:

"Critics charge that President Obama's tax rates for high-income earners will strangle small business and stifle economic growth. Such claims are misguided or disingenuous. A full 97% of small businesses will see their rates unchanged or enjoy additional tax benefits under the Obama plan."

Here's the problem: Incomes for both businesses and individuals are distributed according to a power law, like the famous "80-20 rule" that serves as a good general guide for how customer profits are distributed. The 80-20 rule, also known as the Pareto Principle, means 20% of your customers will usually generate about 80% of your profit. Mathematically, incomes and revenues are almost always distributed according to a power law, but there's nothing really special about 80-20. Different types of distributions could be 90-10, or 70-30.

But power laws like this go on and on with the same kind of distribution. So if your customer profits are distributed according to an 80-20 power law, then 20% of your top 20% of customers will produce 80% of that 80% of profits, i.e., the top 4% of your customers will do 64% of your business, and the top 1% of your customers will do about half your business.

In 2004 the top 5% of tax payers earned 31% of all the income, and paid 58% of all personal income taxes. This corresponds roughly to a 77-23 rule for income taxes paid, and that ratio will increase with higher marginal rates on higher incomes. The distribution of jobs created by small businesses will follow a similar power law.

So what's misleading about Ms. Tyson's statement is that while it may only be 3% of small businesses that see their taxes raised, this top 3% are almost certainly responsible for more than a third of all small-business jobs!

The arguments for and against the President's budget proposals are serious issues that deserve intelligent consideration, and Ms. Tyson's article presents many of them very well. But as an economist herself, she surely knows that her statement about small-businesses is seriously misleading.

Shame on Laura D'Andrea Tyson. The President's own economic advisor simply shouldn't engage in this kind of distortion. A more educated public wouldn't fall for it, and a more objective news media would call it to our attention.

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