Marginal Taxes on the Rich

In response to the opening sentence of my last post, Greg Mankiw asks:

Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?

I'll outsource the first part of the answer to "a student of economics," who comments on Greg's post via the comments section of my last post:

Greg asks the wrong question in an effort to get the answer he seeks.

The correct question should be, "would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

It's not clear that I would do anything different if all my options improved by the same amount. There are only so many hours in day. In fact, perhaps I would actually work less and play more if I were twice as rich (assuming, of course, all gov't services magically continued without cost).

I do recall once having two job offers at comparable pay, and I'm sure that, if the one I rejected had paid twice as much, I would have taken that one instead. But it's pretty obvious that has nothing to do with taxation; it has to with what other opportunities are available. If both jobs had paid twice as much, I would have made the same choice that I did.

Part-time opportunities are a separate issue. I don't have a clear memory on this point, but it's quite possible that I've turned down consulting work that I would have accepted if it paid twice as much (though again, if all opportunities paid twice as much, I'm not sure how the income and substitution effects would sort out). In my case, though, the example (if there is one) would make my second point: that the incentive effects of higher marginal tax rates are not all bad. If I did turn down an assignment, it would be a job in support of one side or the other in a legal case or an interest arbitration. Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high. In this case, the tax is Pigovian, and I'm confident that it's nowhere near high enough to equate the private rewards with the social value of such work. I've made a similar point before.


[UPDATE: Boy, my two sentences introducing a different topic are generating quite a large tangent. PGL at Angry Bear has this to say.]


UPDATE2: In a Update, Greg gets into the whole income and substitution effects business and argues that he is asking the right question because he is isolating the substitution effect, which is what matters for deadweight loss. But for most real-life examples, he's still wrong. It's fairly obvious in my example of having two job offers, but it's true in a lot of more subtle cases too, that one is not really making a substitution between labor and leisure; rather, one is substituting one labor opportunity for another. Usually, one doesn't have a firm offer for the alternative opportunity, but one has some reasonable idea of what opportunity may become available. If a job offer gets doubled, it becomes unrefusable simply because one will never get another offer so big.

It's true that, to the extent that one has marginal opportunities, as in my consulting example, there may be labor-leisure tradeoff, but even there to a large extent it may actually be an intertemporal tradeoff between different labor opportunities given a more-or-less fixed amount of total leisure over time. And I would reiterate my point that the taxes in these marginal cases are often Pigovian.


[UPDATE3: While we're on the topic, let me point back to this post in which I argue that progressive taxation (though not high overall taxation) can actually encourage entrepreneurial activity.]

Marginal Taxes on the Poor

I've always been skeptical of the importance of the purported bad incentive effects of high marginal tax rates on high income earners. (I won't go into the details now, but I don't think the incentive effects are very strong -- at least at tax rates close to current tax rates -- and I don't think they're all bad.) For some time, though, I have been concerned about the effects of effective marginal taxes on low income earners. The problem is not the taxes they pay to the IRS (which they mostly don't, anyhow) but the effective taxes they pay to various subsidizers, price discriminators, and assistance providers in both the public and private sectors.

It has worried me that there might even be some point on the lower part of the income spectrum where the effective tax rate is greater than 100%. That is, you get more income; you no longer qualify for various assistance and subsidies; you slide up the "sliding scale" of various vendors and service providers who (officially or unofficially) give discounts for the financially challenged; you pay more in FICA and state and local taxes (even if you still don't pay Federal income taxes, which you might); and you end up worse off (even leaving aside any reduction in leisure) than when you had less income.

It turns out this was more than a theoretical possibility. Jeff Frankel (hat tip: Greg Mankiw) quotes Jeff Liebman with a story about a woman who "moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more." In her case it wasn't until after the (apparently irrevocable) decision that she discovered what a bad deal it was to make more money, so maybe the incentive effect per se wasn't a problem, but even someone like me, dubious as I am about "justice" as a moral concept, has a sense that this woman has been cheated and that what happened is "wrong." And eventually we have to assume that the incentive effects will matter: presumably Abraham Lincoln was right that you can't fool all of the people all of the time. Moreover, the incentive effects will matter even when the effective tax rate is "only" 80% or 90%. And it can only get worse when we begin to attempt universal health care on a national level.

In theory the solution is to consolidate all forms of public (and ideally, private) assistance into a single, fairly large grant, which can then be taxed away via the income tax at a reasonably slow rate for people who don't need it. That obviously isn't going to happen, and I don't have any other solutions to offer, but Jeff Frankel notes in passing that Jeff Liebman is an economic advisor to Barrack Obama. Given that Senator Obama is now the (not quite odds-on, as of this morning) favorite for the next presidency, I'm heartened that at least one of his economic advisors is thinking about the problem.


[UPDATE: My next post deals specifically with the issue raised in the first two sentences about high income earners. I guess it's hopeless, though, for me to get people to break that thread here and post comments on that more relevant entry.]

The Economics and Politics of Trade

Paul Krugman (hat tip: Mark Thoma, as usual) says:

…I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.

Greg Mankiw asks:

But what if those who are worried about trade are protectionists? Should we still respect them?

Until Paul Krugman gives his own answer, I think we can presume that the answer is yes. Respecting protectionists doesn’t mean we are willing to give in to their protectionist demands, but it does mean that we appreciate their concerns and presumably that we are interested in finding some way of accommodating those concerns, short of actual protectionist policies.

It helps, I think, to separate the positive question from the normative question. The positive question is, “Who is helped by trade, and who is harmed?” The normative question, in the abstract, is, “How much weight should we give to the interests of the various parties that are helped and harmed by trade?” Twenty years ago, there was an easy answer to the first question: “Nearly everyone is helped in the long run, and in the short run, only people in a few specific industries are harmed.” That made the answer to the normative question irrelevant. Unless one wanted to give a ridiculously high weight to the short run interests of industries that were hurt by trade, the conclusion was always that trade was good, and protectionism was bad. And anyone who disagreed could be written off as either representing a special interest or misunderstanding the positive economics, thus not deserving our respect.

The answer to the positive question is no longer easy, and Prof. Krugman suggests that the answer now may be something like this: “Rich Americans and poor foreigners are helped, while typical Americans are harmed.” I think most American economists, including both Greg Mankiw and Paul Krugman, will agree with my answer to the normative question: “Since poor foreigners are much, much, much, much poorer than typical Americans, any reasonable notion of distributive justice, utilitarian optimization, or human charity requires that we give more weight to the interests of poor foreigners.” But that answer is unattractively convenient for American economists, since, whether or not they are personally rich, they fall into the functionally defined category of “rich Americans” that benefit from trade. As Archie Bunker once said, “It’s always good to be generous when it don’t cost you nothing.”

The ultimate answer may be even more convenient for Paul Krugman, because it justifies his prior political preferences. He advocates addressing the concerns of protectionists by means of (broadly speaking) redistributionist policies that benefit typical Americans (trade losers) at the expense of rich Americans (trade winners). That answer is convenient, but nonetheless, provided that Prof. Krugman can substantiate his positive conclusions, pretty convincing (though perhaps I’m not one to judge, since I tend to agree with his prior political preferences anyhow). Whatever ones initial preferences regarding equity-efficiency tradeoffs, a recognition of the politics of trade should shift them a bit to the equity side. Or, more precisely, if the marginal efficiency gains (and equity gains at the global level) from trade are first order and you are already at your domestic optimum for the equity-efficiency tradeoff, then, with the introduction of the political constraint, the envelope theorem requires that you revise that domestic optimum.

Health Care Problems Exaggerated?

I’m a bit confused by Greg Mankiw’s latest blog post on the subject of health care. He seems to be arguing that, aside from redistribution issues and the perception of rising prices, the problem is relatively minor. (“...the magnitude of the problems we face are often exaggerated by those seeking more sweeping reforms...”) I suppose Greg regards the actuarial insolvency of the Medicare system as a problem of smaller magnitude than those alleged by reformers, or perhaps as a purely demographic problem that is only nominally related to the health care issue. But it seems to me, if the government has made a commitment to pay for certain things, the fact that the prices of those things are rising rapidly – regardless of whether quality is rising faster than prices – is a big problem.

I agree with Greg’s contention (in his New York Times piece) that it can be perfectly rational to spend a larger and larger fraction of our income on health care, but that doesn’t change the fact that, under current institutional arrangements, figuring out how to pay for it is a big, big problem. To put my point a little differently, those “pundits of the left” who pretend to be concerned about the health care system but really have a redistribution agenda, they would seem to be holding some pretty good cards right now, given that the government has already promised more free health care than it will be able to deliver under current fiscal arrangements.

When Greg asks the question, “What health reform would you favor if the reform were required to be distribution-neutral?” it is impossible to answer without making an assumption about how the distributions will be worked out under the current system. One possible assumption is that the Medicare problem will be solved by means testing. If so, one objection I have to the current system is that it will distort saving incentives by means-testing away the wealth that people have saved. That is an efficiency problem, not a distribution problem, but it’s hard to think how one might address that problem in a way that is both distribution-neutral and politically feasible. I believe (though Greg may disagree) that taxing rich workers is more efficient than taxing middle-class capitalists, but clearly that change is not distribution-neutral. I also believe (and Greg will probably agree) that taxing middle-class workers is more efficient than taxing middle-class capitalists, but…like that’s gonna happen.

I suspect that Greg is wrong about the motivation of radical health reform advocates. Redistribution, I would argue, is not the reason for health reform but the way to sell it. Somebody’s going to have to pay for Americans’ future health care, and if you say you’ll make the rich pay for it, the non-rich majority will be more willing to listen to the rest of your ideas.

I also suspect that Greg is wrong about why Americans are unhappy with the current system. I personally don’t mind rising prices, but I am unhappy with the current system. What makes me most unhappy (and has ever since I graduated college during a recession and had to apply for individual health insurance because I didn’t have a job yet) is the insecurity of it. Group health insurance (which most Americans get through their own or their spouse’s employer) is expensive but not prohibitively so. Individual health insurance is on average somewhat more expensive, but the problem is not the mean; the problem is the variance. If you don’t have access to group health insurance, there is no guarantee that you can be insured for any price.

There’s a distributional issue that’s important to me, too, but it’s not the rich vs. everyone else distribution that Greg talks about. And it isn’t the poor (in general) vs. everyone else either: the poor already have Medicaid. The category of people that I worry about are those who are poor, or who become poor, specifically because they (or people in their families) are sick. In some cases, it is probably their own fault for passing up health insurance when it was available. In other cases, I imagine, they never had a chance to become insured, or their insurance was cancelled.

No doubt the breadth of both of these problems – the problem of insecurity and the problem of people who are poor because of large health expenses – is exaggerated in my mind, but they make me very uncomfortable with the current system. And I don’t sense that the virtues of the current system (compared to those in other industrialized countries) are sufficient to justify the existence of these problems.

Incentive Effects of Progressive Taxation at the High End

Does progressive (labor) taxation at the high end reduce the incentive to engage in high-value activities? It seems to me that (to the extent that highly lucrative activities really are high value) it actually increases the incentive. Most of the people with the highest compensation -- movie stars, star athletes, CEOs of large corporations, successful hedge fund managers, successful entrepreneurs, etc. -- have that high compensation not just because of decisions to engage in (ostensibly) high-value activities but because of a combination of an intentional occupational choice decision and unpredictable outcome of success in that occupation. The ones who made the same occupational choices but weren't so successful -- ordinary actors, minor league athletes, middle managers of large corporations, hedge fund managers without a lot of assets under management, entrepreneurs with limited or no success, etc. -- don't get that ultra-high compensation.

How could the tax code encourage people to undertake these activities? If people were risk-neutral, the progressivity wouldn't make much difference, since any increase in taxation of the high rewards for being successful would be offset by a decrease in taxation of the lower rewards of being not-so-successful. But economists usually assume that people are risk-averse. If so, progressive taxation encourages people to enter high-risk, high-value occupations, because it provides a form of insurance for people who choose to do so. If you're successful, you make gobs of money, and you have to pay a lot in taxes, but you still end up with gobs of money; if you're not so successful, you don't make so much money, but you get an insurance payment in the form of a reduced tax bill. If the government were explicitly providing an at-cost insurance policy for actors, athletes, business people, hedge fund managers, and so on, I don't think there would be much question that the policy would encourage, rather than discourage, entry into these occupations.

For Richer or Poorer

Robert Reich (hat tip: Mark Thoma) says that the weak dollar is going to make Americans poorer (except for those who are rich enough to hedge against the dollar’s fall) and that “the real worry isn’t inflation” but “our pocketbooks.” Reich’s scenario is indeed what you get from a comparative static exercise in a simple full-employment model: when the terms of trade shift against you, you end up worse off, and (provided nobody expands the money supply) inflation isn’t an issue because falling prices outside the tradable sector (like, let’s say, in housing) offset rising prices for tradables.

But real life is not a comparative static exercise, and everything else doesn’t get put on hold when we go from an old equilibrium to a new one. In the past, the overwhelming tendency has been for the US (as a whole, anyhow) to get richer over time, and I doubt that the terms-of-trade shock, by itself, will be enough to reverse that tendency over the next few years. The US may get a recession, and that may make the US temporarily poorer, but if we are heading for a recession right now, it is in spite of, not because of, the falling dollar. Aside from the possibility of a recession, the US capital stock will continue to grow as usual, technology will continue to improve as usual, and, provided that the terms-of-trade shock is not too precipitous, improving domestic productivity will offset the deteriorating terms of trade.

What if the terms-of-trade shock is too precipitous? Then the US will get poorer, temporarily, but the long-run improvement in productivity will continue, and after a few years, we should catch up again. But a precipitous shock would lead me to question Professor Reich’s assertion that “the real worry isn’t inflation.” A sudden deterioration in the terms of trade would (as I argued in my earlier posts about labor cost targeting) put the Fed in a difficult position. Given the stickiness of many domestic wages and prices, the diminution of living standards that Reich foresees would not happen without a fight, and the result of the fight would be either inflation or recession. I would be more worried about either of those possibilities than I would about the fact that some people will have to make modest reductions in their standards of living.

It’s also not unthinkable that the falling dollar could end up improving US living standards, paradoxical though that may seem. The overvalued dollar has pushed a disproportionate fraction of US resources into the nontradable sector. One has to wonder whether this imbalance has damaged productivity growth. It’s a lot easier to imagine productivity growth happening in tradable industries like manufacturing and Internet-based services than in, say, construction and mortgage finance. Surely real investment will make a much greater contribution to productivity if it goes into plant and equipment for export industries rather than into residential housing. And as one who believes that there is more slack in the US labor market than is generally recognized, I hold out the hope that the stimulus from a weak dollar will help us discover that slack and give the US a Keynesian free lunch to offset the rising cost of the French wine we’ll be drinking with that lunch.

Professor Reich also suggests that the weak dollar will have a regressive effect on distribution, but again I’m skeptical. The tradable sector is where most of the good working class jobs are (or were, and presumably could be again). Reduced foreign competition will also put workers in a better position to negotiate a bigger slice of the pie in industries where there’s room for negotiation. If it becomes relatively more economical to produce in America, that’s no net advantage for the world’s capitalists (who will lose, for example, on European production what they gain on American production), but it will be a big advantage for the American workers who are available to do the producing.

Having said all this, I want to point out that, while the prognosis for the dollar is certainly not good, reports that the dollar is already dead have been greatly exaggerated. Yes, the dollar is at a record low against the Euro, but this doesn’t mean that the dollar has crashed. It just means that the dollar’s general downtrend, which has been in place for five years, is continuing, and that we happen to have been in a declining phase of the variation around the trend. There is a good chance that the dollar will keep going down from here and that the general trend will accelerate. But that’s hardly a foregone conclusion. Anyone who remembers the fall of 2004 should know to be cautious in extrapolating the weak dollar into the immediate future.

More about Labor Cost Targeting

Several issues arise in the light of Mark Thoma’s post about my last post. First, there is the distinction between labor cost targeting and wage targeting. Mark brings up the general argument for targeting sticky prices and/or wages (in particular as presented by Michael Woodford). To the extent that wages are stickier than prices, the theoretical argument would call for targeting wages, if one wants a simple policy (although more generally it should be an index of most wages and some prices). The problem with targeting wages is that it makes the inflation rate less predictable by taking away its long-term anchor. If productivity grows quickly, a wage targeting policy would imply a very low rate of price inflation (possibly even deflation); whereas if productivity grows slowly, a wage targeting policy would imply a higher rate of inflation. Productivity growth is notoriously difficult to forecast over long horizons, so the details of the long-term inflation rate become a wild card. I’m not sure I have a theoretically sound argument, but something about having an indeterminate long run inflation rate makes me uncomfortable. Certainly it has the disadvantage of making it harder to price long-term bonds.

In contrast, targeting labor costs would only permit temporary variations in the inflation rate in response to external supply shocks or distribution shocks. For example, a large increase in import prices would cause the inflation rate to rise in the short run, but eventually the domestic price level will adjust, and the inflation rate will go back to its long-run path. It’s true that the relevant long run could be very long: for example, the inflation rate has been higher than the labor cost growth rate for most of the last 16 years, as the chart in my last post shows, because the distribution of income has been shifting gradually toward capital. We don’t know if that shift will continue or reverse or how much longer it might continue, but we can be sure it will end eventually, because income shares can only vary between 0% and 100%. (Historically, income shares have in fact been mean-reverting. Possibly we are in a new regime now in which there has been a permanent increase in capital’s share, but for practical purposes, even if we can’t be sure it will mean-revert, I think we can rule out a large permanent increase in capital’s share beyond its current near-record.)

Which brings me to another point I wanted to make. Several people have objected that targeting labor costs would mean putting a limit on wage growth, potentially further shifting income toward capital. I would call this a “glass half empty” view of labor cost targeting. The “glass half full” view is that labor cost targeting would insist on wage growth (up to a point). Since we’re talking about nominal wages, it’s not clear to me that either of these two views really has much substance to it: no matter what happens to nominal wages, prices can still change in such a way as to render real wages either higher or lower.

It has been suggested that, if the Fed were programmed to react to large wage gains by tightening, that would give workers less bargaining power. But if you look at the past 15-20 years, it looks like the Fed might have been targeting inflation at around 2%; if instead the Fed had targeted labor cost growth at 2%, that means the Fed would have tolerated even larger wage gains than it actually did, so presumably workers would have had more bargaining power than they actually did.

I’m not inclined to give much credence to these kind of arguments about bargaining power anyhow, because the Fed would be targeting aggregate labor costs, whereas wage bargains are made in individual industries (or at individual firms, or, these days, more likely by individual firms dealing with individual workers). If, for example, auto workers are somehow magically able to bargain for a 20% wage increase, the Fed need not necessarily react, unless it expects workers in other industries to get the same wage increase. I don’t see how there is much loss of bargaining power.

It’s also important to realize that labor cost targeting does not necessarily mean reacting directly to labor cost growth in the short run. As I pointed out in my last post, the data in the short run are unreliable, and it wouldn’t be appropriate to put too much weight on recent data that could be revised or could be just a temporary blip. So even if everyone gets a huge wage increase, the Fed’s reaction might be delayed. In general, workers could probably expect enough delay in the Fed’s reaction to make them comfortable driving as hard a bargain as their particular circumstances seem to warrant, since the tightening might well come later on when employers are trying to raise prices instead of when the actual wage increases happen.

Furthermore, to some extent labor costs have a predictable business cycle pattern, and big increases in labor costs are more likely to precede a recession. Since the Fed would want to dampen rather than amplify the business cycle, it would not be well advised to tighten in direct response to a cyclical increase in labor costs. Rather, it should have a forecast of the cyclical behavior of labor costs, and it should tighten or loosen depending on what labor costs do relative to that expected cyclical behavior. Realistically, though, the forecast should also include a lot of other indicators, and the Fed would be concerned with the ultimate level of labor costs at some point in the future. Though unexpected cyclical behavior would be a reason to revise that longer-term forecast of labor costs, it might well be offset by other reasons relating to the other indicators involved.


UPDATE: Another point occurs to me, which sort of ties together some of the points above. With wage targeting, the "damaged bargaining power" school might have a stronger case, because wage targeting would attempt (though with only limited likely success over any short time horizon) to put a constraint -- one that could be anticipated in advance -- on the aggregate behavior of wages at any particular time. With unit labor cost targeting, there is no absolute intended constraint on wage growth, because the intended wage growth would depend on productivity growth, which (a) could not be known in advance, (b) would not be known with any reliable precision until quite a bit later, and (c) might well depend on other aspects of labor negotiations, or for that matter, on wages themselves.

Bad Wages

Dean Baker notes that the preliminary benchmark revision to US payroll employment data will mean lower productivity growth. Another implication, provided that there are no compensatory revisions in average hours worked or total compensation, is that average hourly compensation will be lower. For those who have been complaining about anemic wage growth, it looks like the situation may be even worse than they thought.

To Wage War

According to Paul Krugman in today’s New York Times (by way of Mark Thoma and of jurassicpark at Welcome to Pottersville, and thanks to Google Blog Search, since I’m not a Times subscriber right now):

The Dow is doing well largely because American employers are waging a successful war against wages. Economic growth since early 2000, when the Dow reached its previous peak, hasn’t been exceptional. But after-tax corporate profits have more than doubled, because workers’ productivity is up, but their wages aren’t — and because companies have dealt with rising health insurance premiums by denying insurance to ever more workers.

If you want to see how the war against wages is being fought, and what it’s doing to working Americans and their families, consider the latest news from Wal-Mart....

I have an immediate problem with this explanation for the rising stock market (which is not to say that I have a better explanation). If wages (and total compensation) are being kept down in the face of rising productivity, why isn’t competition keeping prices down as well? It seems to me that, to make his explanation complete, Prof. Krugman needs a story about reduced competition in product markets. Otherwise, there is no reason to expect that the markup of prices over wages should rise as wage bills decline. If wages are the only story, then at best the stock market is being short-sighted in not seeing the eventual effects of competition.

Prof. Krugman’s example, Wal-Mart, is an excellent case in point. Historically, Wal-Mart has reaped the benefit of reduced costs not by raising its margins but by cutting its prices and thereby increasing its market share. Wal-Mart’s profits have gone up, but its competitors’ profits have gone down. (More precisely, some of the competitors’ profits have gone up, but more slowly than they would have in the absence of Wal-Mart’s cost-cutting, whereas other competitors have stopped earning profits altogether and, in many cases, gone out of business.) Historically, Wal-Mart’s cost cutting has not obviously resulted in increased profits for the retailing business in general. Things may have changed now – Wal-Mart may now have such a large market share that it plans to grow by raising margins rather than cutting prices – but in that case, the story is not really a story about costs but a story about monopoly power.

As I said parenthetically above, I don’t have a good explanation for the rising stock market. My best guess as to why profits are so high has been that economic rents in certain industries (oil and software, for example) are puffing up aggregate profits. But this wouldn’t explain why the stock market is still going up. Of course, one doesn’t really need an explanation because we can always attribute stock price movements to changes in the required equity risk premium.

Income Distribution and Monopoly Rents

Maybe I am a lefty. In any case I find this discussion of income distribution (by Maynard of Creative Destruction) rather compelling:

I think one thing that's going on with the income distribution is this. With the development of communication and computer technology and the greater reach of large corporations in the last several decades, our productive technology is increasingly characterized by scale economies (I haven't read Rosen's Economics of Superstars, AER 1981, in awhile, but I think my argument is related to his). Two examples. Microsoft dominates the "market" for operating systems because of network effects: the more people who use Windows, the more valuable it becomes for the marginal user. Tom Hanks gets paid an outrageous amount of money because the distribution of his movies has become so sophisticated. It costs next to nothing at the margin to distribute one more copy of the same movie, so he is able by dint of a slight advantage in talent over a performer that no one has ever heard of to dominate the market. This means that there are huge monopoly rents that are up for grabs across huge swaths of the American economy. In the old days when the economy was insulated to some extent from the rest of the world and workers were represented by strong unions, you might have seen workers take a big chunk of these rents. But in the present environment, the rents go to those in the strongest bargaining position, namely the executives at large corporations and institutions and the performers who always have the recourse to walk away from the next film (or music, or sports) deal. So Brooks is right that our "meritocracy" is rewarding people based on individual talents, those who are organized, self-motivated, and socially adept. But the talent that is being rewarded is the talent to extract rents, not the talent to produce a higher quality product than the competition. Rewarding that particular talent produces no benefits for society; there is no economic argument to justify such a meritocracy, no economic basis for opposing, say, a steeply progressive tax system that would counteract some of the forces pushing us toward greater income inequality.

In fact, progressive taxation is more efficient. People in the bottom half of the income distribution aren’t getting much of the rents. They’re being paid roughly their marginal product, and taxes would distort their labor/leisure decision. People near the top of the distribution are the ones who have succeeded in capturing rents. They are being paid much more than their marginal product, and taxes actually correct a distortion in their labor/leisure decision.

Note, however, that these arguments don’t apply to capital taxation. (Maybe I’m not a lefty, after all.) If an individual has a lot of capital income, it is probably because that individual had a lot of capital to invest, not because she is capturing a disproportionate amount of rents in her capital income. So there is no efficiency justification for progressive taxes on capital income.

Q2 Labor Costs, Revised

The big increase in US hourly compensation in the second quarter didn’t make sense when it was first reported. Now that it has been revised upward, it makes even less sense. The best explanation I’ve heard comes from Dean Baker, who suggests, based on the NIPA statistical discrepancy, that some capital gains (obtained, for example, via exercise of employee stock options) might be misclassified as compensation. (Conceptually, in the case of stock options, the compensation took place when the options were granted, not when they were exercised. Anything that happened to the value in the intervening time was a capital change rather than income, but the value of the options doesn’t show up on the income side of the national accounts until they are exercised.)

Why Jane Galt is Still Wrong

I'm willing to bet a fairly hefty sum of money that almost none of the lefty bloggers who linked to it originally will link to my attempts to rectify their misunderstanding.

So writes Jane Galt. I don’t think I’m one of those she had in mind, since I didn’t deal directly with Ms. Galt’s arguments in my earlier posts (and I wouldn’t willingly accept the term “lefty,” though it’s possible that the shoe fits, or that it appears to fit). Nonetheless, I can’t resist the challenge.

Her words again:

…my metaphor was aimed at a specific kind of redistribution: that which is less interested in making the poor better off, than in making the rich worse off, so that they don't make the rest of us look bad. Or as Brad Delong said:

Surely public policy should weigh the spite-generated utility the rich gain from their conspicuous consumption as worth less than nothing?

And in that case, the wealth hierarchy is precisely equivalent to the beauty hierarchy, morally speaking: it is a zero sum game in which a lucky few feel better only when the others feel worse. So to my mind, anything that applies to the enjoyment of wealth by the lucky few applies equally well to the enjoyment of endowments like beauty, athleticism, and intelligence. I am unable to construct a moral argument for cutting down the tall poppies of the income distribution that doesn't apply equally well to conspicuous flaunting of one's pulchritude, physical prowess, or brains.

But how is it that she misses the critical point? To wit: the creation of conspicuous wealth, by its very nature, uses up resources that could be used for other purposes. Indeed, wealth might be defined as the ability to command resources, and therefore, the more resources that are used to produce conspicuous wealth, the more effective it is. By contrast, the process of flaunting one’s pulchritude, etc., while it may use up some resources, is not inherently resource-intensive. And certainly, such endowments, to the extent that they are truly endowments, don’t require resources to create.

The beauty hierarchy is, as Ms. Galt states, a zero-sum game (roughly), but – because of the resources used up – the wealth hierarchy could very well be a negative-sum game. Using up resources is fine as long as the full social benefit of the product exceeds the cost of the resources. But with conspicuous consumption that is not necessarily the case. Because there are negative externalities – namely the unhappiness (mistakenly labeled as envy) generated among inferiors – associated with that consumption, there is no mechanism to insure that the social benefit from the resources used is at least as great as the cost.

Of course there are counterarguments. For example, as Ms. Galt points out, there are also positive externalities associated with the pursuit of wealth. But those positive externalities have had their day in court. It is not at all fair to brush aside the negative externalities that may be associated with the pursuit of wealth (even if they are more difficult to measure).

Enough with the Envy and Spite Rhetoric

(See my last post, and its many links, for background.)

The terms “envy” and “spite,” it now occurs to me, not only frame the debate in an unpleasant light: they are also fundamentally inaccurate characterizations of the issue involved. Envy and spite are emotions directed at people: “I am envious of Peter”; “I am spiteful toward Paul”. These emotions imply hostility, which in fact has nothing to do with the argument that people derive utility from relative wealth. Thus Tyler Cowen Alex Tabarrok can complain that he doesn’t like being envied, but here he is talking about the actual emotion of envy (with all the attendant hostility), not about the property of certain utility functions that has been labeled as “envy.”

To say that I get utility from my relative wealth is not to say that I have any particular feeling about those against whom I compare myself. The word “envy” (and similarly the word “spite”) exaggerates the degree of other-regard that is present. The “others” in this case are not concrete people about whom I have feelings, but abstract reference points against which I compare myself. It’s not that the poor are envious of the rich; it’s that the poor feel bad about themselves when they compare themselves to the rich (or more likely to a social average in which the rich are only one element). Similarly, it’s not that the rich are spiteful toward the poor, it’s that they feel good about themselves when they compare themselves to the poor (or to the social average).

I doubt that Tyler Cowen Alex Tabarrok really gets significant disutility from being part of such an abstract reference point, but if he does, he seriously needs to chill. And his comparison of envy to homophobia is also “fruit of the poison tree,” since it derives from the original misuse of the word “envy.” The hatred that homophobes feel toward homosexuals is entirely other-regarding. Very much in contrast to relative wealth feelings, it has nothing (except at a deep psychological level) to do with what the homophobe feels about himself. Homosexuals have a legitimate complaint about being the objects of actual hate, rather than imagined envy.

In fact, when Brad DeLong brought the word “spite” into this discussion, he was conceding a point that he never should have conceded. The phrase “politics of envy” is used, by those who oppose redistribution, to frame the debate in emotional terms. The phrase may perhaps be a reasonably accurate characterization of the politics. To get people excited about redistribution – to get them to vote on that basis – you may have to make them emotional, literally “envious.” Rational arguments about their underlying preferences probably won’t do the trick. But Greg Mankiw let the term “envy” slip from the political argument into the economic one, where it becomes quite misleading. That, in my opinion, was a mistake that needs to be corrected before the discussion can proceed.

UPDATE: Oops, I referenced the wrong Marginal Revolution blogger (for this post).

Inequality, Spite, and the Game of Love

The debate du jour in the economic blogosphere seems to be about relative wealth – whether it affects welfare and whether public policy should take this possible effect into account. We have the usual dramatis personae, with Brad DeLong and Greg Mankiw in the leading roles, Jane Galt as the female lead, a cameo appearance by Chris Dillow, and Mark Thoma in the role of messenger (and let’s not forget Tyler Cowen…and now Gabriel Mihalache...and...and...and...never mind, I'm going to have to post this before I read every single blog). Most of the discussion concerns “envy” and “spite” – the supposed emotions of the poor and rich, respectively, which mediate the welfare effect of relative wealth.

I have a couple of points to bring up. First, from a utilitarian point of view, it doesn’t help Brad’s case that he points particularly to the spiteful rich rather than the envious poor. If the rich get pleasure from knowing they are better off than the poor, that, by itself, is a good reason to keep the income distribution unequal. Why not give the rich that extra pleasure of being relatively, rather than just absolutely, rich? The only utilitarian reason is that it (ostensibly) harms the poor, which is to say, in the terms of the discussion, that the poor are envious. Yes, I do understand that Brad is countering Greg’s comment about “making envy a basis for public policy,” but it seems to me that Greg's whole line of thought brings us into the realm of emotional, rather than rational, policy analysis. Greg casts redistribution in an unpleasant light by using the word “envy,” and instead of trying to cast it in a pleasanter light (“people like being equal”), Brad reflects back the bad light by using the word “spite.” In any case, it’s all mood music.

But I wonder why everyone (except Chris Dillow) thinks that the effect of relative wealth is merely subjective. As Chris points out, there are objective ways in which consumption by the rich may hurt the not-so-rich. I wonder why nobody has brought up what seems to me to be the obvious example: sexual competition. (For example, suppose you like tall redheads and you’re into spanking….OK, never mind.) I think particularly of competition among men, although arguments can also be made about competition among women. (My example also assumes, without loss of generality, that the men are heterosexual. And, oh, yes, back in the 80s I used to believe that stuff about men and women being roughly equal, so it didn’t matter who was chasing whom…but the 80s ended back in 1989, if I recall.)

In the area of beauty, evolution somehow seems to have failed the human male (well, most human males, anyhow: men are no plums, but they do contain the occasional Pitt). So men tend to compete for the attention of women not (like peacocks) on the basis of their natural endowment but on the basis of other things, which are often expensive. If I own a BMW and you buy a Jaguar, it hurts me objectively, because all the chicks that used to ride in my BMW will want to ride in your Jaguar instead. (In reality, it’s probably just as well that I drive a Saturn; my wife wouldn’t be too happy if I used the car to go cruising for chicks.) There’s no envy or spite involved here: just men who are competing rationally and women who like men with fancy cars. Although the competition has some benefit for the women involved, it’s easy to see that there’s also a deadweight loss. It’s a multi-player prisoner’s dilemma, and there is no mechanism to produce a cooperative solution.

UPDATE: Steve Waldman brings up another, much more important (but less sexy!) area in which objective competition causes relative wealth to have an impact: politics.

UPDATE2: I missed Alex Tabarrok’s important post, which might sort of provide a justification for Brad’s focus on spite. Also this other one by Gabriel Mihalache.

Depreciation and the Profit Margin Puzzle

Dean Baker provides (a small) part of the answer to my “profit margin puzzle” (although he doesn’t frame it in those terms). Gross profit margins (represented by the divergence between the GDP deflator and unit labor cost) partly had to rise to compensate for increased depreciation, to keep net profit margins from falling. In other words, if you know your capital will have to be replaced more often, you have to charge more for your products in order to make provision for that replacement. However, for the period I looked at (starting in 1991) depreciation as a fraction of GDP rose only from 12.1% to 12.9%. Since the GDP deflator diverges from unit labor cost by an average of more than 0.5% per year over 15 years, this roughly 0.8 percentage point difference just chips away at the puzzle (less than 2 years worth out of 15).

In Defense of Labor Cost Targeting

A week or two ago, I made the apparently heretical suggestion that the Fed should target unit labor costs. Brad DeLong picked it up with a link to my subsequent post. Several objections have been raised, and I want to deal with those objections here.

The main objection, coming from Dean Baker and kharris, is essentially – to use my own earlier words – that the unit labor cost series is “subject to revision, and volatile from quarter to quarter.” As I agued in the original post, “This would be a big problem for an intermediate indicator, but not so much for an ultimate target. The important thing is that the long-term trend be predictable…” Unit labor cost depends on compensation rates and productivity. I think the Fed is already pretty good at forecasting the trend in compensation rates. Productivity is more difficult, but this is a problem even if you target inflation.

Granted, the long-term trend in labor costs is probably not (contrary to what I suggested in the original post) as predictable as that of inflation. This is a disadvantage, but it is (I would argue) far outweighed by the advantages, particularly the relative robustness to the effects of supply shocks. Under a price-based (rather than labor cost-based) targeting regime, a huge adverse import price shock (such as a major dollar crash or sudden increase in oil prices) would virtually force the Fed to induce a recession. (Indeed, the Fed may have induced a recession – yet to fully materialize – in response to the more gradual oil price increases of the past few years.) Under a labor cost-based regime, the price shock could feed through to consumer prices without necessarily having a large effect on economic growth or employment. In principle, why should a scarcity in one commodity (such as oil) automatically induce a scarcity in another commodity (money)? Doesn’t a currency “backed by the productivity of the US labor force” inspire more confidence than a currency “backed by the promise of price stability”?

As my thinking has evolved, I would also suggest that a labor cost target should have the form of a “price rule” rather than a “growth rule.” That is, the Fed should explicitly try to correct deviations from trend rather than establishing a new trend when the old one is broken. The “price rule” approach helps with the data volatility problem by letting the Fed allow temporary deviations while credibly promising to maintain the longer-term trend.

Another objection, coming from an avowed non-expert:

When I hear "targeting unit labor costs" what I also hear is "we don't want workers to make more money, ever." To a lay observer like me, the Fed (and its counterparts in Europe) seem determined to prevent workers' wages from rising.

Actually, when I wrote the original post, I asked myself, “Would this regime discriminate against workers?” Would it automatically “take away the punch bowl before workers get to drink?” I think the answer is no. A labor cost target would allow workers to take full advantage of productivity gains, something they have apparently not been able to do under the current regime. Of course, firms could take back that advantage by raising prices, but I’m not sure that’s such a bad thing. In a sense, the current regime has allowed firms to undertake “stealth price increases” by keeping wages down. Under the current regime, the Fed is like, “Oh, hey, we’re just controlling inflation,” and firms are like, “Oh, hey, we’re just trying to keep costs down.” Under my proposed regime, firms would have to own up to the fact that they are grabbing a bigger share of the pie. If there are legitimate economic forces that are granting them that bigger share, then so be it, but let’s bring this process out into the open air of consumer markets rather than burying it in the back room of compensation determination.

The Profit Margin Puzzle

Take another look at this picture. Something screwy is going on. Labor costs have risen at an average rate of 1.5% over the past 15 years, but prices have risen at an average rate of more than 2%. That means labor is really cheap today compared to what it was 15 years ago. Why isn’t somebody hiring that cheap labor and undercutting competitors by charging lower prices (bringing down the rate of price growth, or bringing up the rate of labor cost growth by bidding more for labor)? I consider several explanations, but none seems quite satisfactory.

1. Rising raw material prices. If the cost of non-labor inputs is going up, then firms could be forced to raise prices even when labor is cheap. When you look at oil prices today, this seems like a good explanation, but take a look at this chart, which Barry Ritholtz found in a St. Louis Fed publication. Profits have risen dramatically as a share of national income, while compensation has fallen. If raw materials costs were the problem, we would expect them to be cutting into profits. Clearly they’re not, at least not in aggregate.

2. Increasing cost of capital. When economists talk about the “zero profit condition,” they are careful to distinguish economic profits from accounting profits. Accounting profits have clearly risen, but perhaps these profits just represent a higher required return on capital, not an increase in economic profit. This explanation fits well with the observation of a very low savings rate, which makes capital scarce. However, it is not consistent with the observation of a low interest rate. Obviously capital is still cheap for high-quality borrowers like the US government. Why would it be so expensive for businesses?

3. Increasing price of risk. The capital that gets compensated by profits is necessarily high-risk capital. Possibly, even though generic capital is cheap, the risk premium for equity capital has risen: investors have gotten more timid. If we compare today to 2000, this is almost certainly part of the story. But if we compare today to 1990, this argument is less compelling. Overall, price-earnings ratios have risen over the past 15-20 years, and dividend yields have fallen, which suggests people are more, not less, willing to invest in risky assets.

4. Rising rents. Some of what is counted as profits may actually be rents, and those rents may be rising. For example, an oil company that owns mineral rights continues to account for depletion based on original cost, even though the economic value of those rights has risen, so the implied rental cost shows up as profit. You could also argue that firms like Microsoft that own valuable intellectual property are earning large rents on that property, and those rents show up as profits. This explanation is more promising than some of the others. It’s certainly consistent with the observed unevenness of profits across sectors.

5. Reduced competition. Maybe the zero profit condition doesn’t apply any more. It’s hard to think of examples, though.

6. Product and labor market disequilibrium. Over the course of the business cycle, labor costs tend to rise during booms and fall during recessions, whereas prices rise more evenly throughout the cycle and perhaps accelerate before the boom phase is reached. If the Fed’s anti-inflation policies have made recessions more common than booms (“taking away the punch bowl before workers get to drink”), this could explain a shift of income away from labor. If this explanation is right, it bodes badly for profits in the future, because disequilibria tend to get corrected in the long run, no matter what the Fed does.

7. Capital market disequilibrium. Economic liberalization has resulted in a large increase in the effective global labor supply. According to classical economic theory, this should result in a (possibly temporary) increase in the cost of capital, as scarce capital is allocated toward the newly available labor. As noted earlier, observed low interest rates are not consistent with this story, but perhaps allocating capital is more complicated in the short run. Suppose, for example, that firms have a limit on the number of investment projects they can undertake at a given time. Even if capital is cheap, they won’t be able to take full advantage, but those projects they do undertake will be located where the plentiful labor is – i.e., not in the US. Thus the required return for US investments could be quite high (hence high US profits and high prices relative to wages) even if the raw cost of capital is low.

Q2 Labor Costs

By most indications US labor costs rose rapidly (by recent standards) in the second quarter. But something is wrong with this picture. Ordinarily one would like to attribute an increase in the price of something (labor, in this case) to either a leftward shift in the supply curve (decrease in supply) or a rightward shift in the demand curve (increase in demand). In the case of labor, there is no evidence that either of these things happened; indeed, the evidence suggests that the demand for labor declined.

I have noted before the dramatic decline in help wanted advertising. It is not matched by the official data on job openings; the latter are roughly flat but certainly show no sign of increasing. New hires, however, did decline in the official data. And aggregate payroll employment growth slowed to an average of 112,000 per month (not enough to keep up with recent average labor force growth) from 176,000 per month in the previous quarter (which is comparable to the average for the prior two years).

This apparent decline in the quantity demanded might suggest that the labor supply curve shifted. That is, there were fewer workers available at any given wage, so firms both raised wages and reduced hiring. But the direct evidence does not support this hypothesis. Labor force participation actually increased throughout the quarter (and also in July, so one cannot reasonably attribute the increases in May and June to sampling error). There was no increase in the rate of unemployment due to voluntary quits. There was a slight decrease in the overall unemployment rate, but the decrease was reversed in July.

Another explanation for rising wages might be an increase in inflation expectations, or a correction for price increases that had already occurred. The argument, I suppose, would be that employers deliberately raised wages because they realized that, given higher prices or higher expected inflation, they would need to do so to retain their desired workforce. Absent an actual increase in quits, however, I find this explanation implausible. If employers were so scared of quits that didn’t actually happen, why did they simultaneously reduce their help wanted advertising? If they decided to spend less on recruitment, why would they be willing to spend more on wages?

My guess is that the increase in labor costs will turn out to be a statistical illusion. Aggregate compensation per hour is reported to have risen at a 5.1% annualized rate for the business sector, but this number is subject to considerable revision. The employment cost index, which corrects for shifts across industry and occupation, shows an annualized increase of 3.6%, still high by recent standards but not quite as troubling. When incentive-paid occupations are excluded, the increase drops to 2.8%, which is roughly the trend growth rate of productivity.

Who cares about wages?

David Altig of Macroblog argues (continued here) that we should just ignore wages and look at total compensation. Greg Mankiw agrees. Brad DeLong disagrees, but only because we don’t have good enough data on total compensation. I would suggest, however, that there are a couple of reasons we should care about wages for their own sake.

First, even though compensation is the theoretically correct variable that rational firms and workers should care about, their behavior in the real world may reflect rules of thumb that give precedence to wages over benefits. As a result, the behavior of the Phillips curve – the short-run tradeoff between inflation and output – may depend on the exogenous behavior of benefit costs. Recent increases in the real cost of health insurance have, in my opinion, had an inflationary impact. In principle, they shouldn’t: firms facing rising benefit costs should just keep wages down. In practice, I suspect this is often not what they do. I can’t prove it, but I believe that the weak wage growth in recent years has been the result of weak labor market conditions – conditions that would normally have been disinflationary – and not the result of increasing benefit costs.

At the place I used to work, I was there for 6 years, and every year, they would announce a 5% wage increase. I found it kind of amusing because the memo always said what the inflation rate was, but it never seemed to make any difference: we automatically got a bigger real wage increase in years when the inflation rate was low. Since our benefits included health insurance, we also got a bigger increase in total compensation in years when the cost of health insurance rose more rapidly. (That part wasn’t even in the memo.). Firms have to take benefit costs into account in making employment and pricing decisions, but when it comes to wage-setting decisions, I would guess that a lot of firms behave like my old employer.

The second reason has more troubling implications. Wages, I think, have a lot to do with the subjective sense of prosperity. “Honey, I got a raise!” sounds a lot better than, “Honey, they expanded our health insurance to cover several newly developed procedures!” Even though rising benefit costs largely reflect real improvements in the quality of health care, these improvements don’t make us feel richer. Unfortunately (this is the troubling part) they really represent an acknowledgement that we weren’t doing so well to begin with. There are all kinds of health problems we could get, and it’s a good thing when new solutions are developed, but for those who are currently healthy, it is much easier to ignore the potential problem when we don’t have to pay for a potential solution.

More about Compensation and Productivity

In my previous post I discussed the empirical relationship between compensation growth and productivity growth in the US. One way of looking at the relationship is to look at the changes in labor’s share of total product – that is, gross compensation divided by gross output. This chart shows the evolution of labor’s share, measured 3 different ways (all computed for the business sector and expressed relative to their 1948 levels). The purple line (continued with estimates in yellow) uses NIPA data and divides “compensation of employees” by “gross value added.” The dark blue line (corresponding roughly to Lazear’s results) uses BLS data and divides “compensation” by “current dollar output.” The light blue line (corresponding roughly to Calculated Risk’s results) uses BLS data and divides “real hourly compensation” by “output per hour.”



The NIPA (purple) results are probably misleading because they ignore the decreasing role of proprietors’ income in the national accounts: labor’s share increased during the 50s and 60s because more production was shifted to the corporate sector in which labor gets separate compensation.

The BLS “product wage” (dark blue) results show a relatively steady share, although one might argue that there is a slight downward trend over time. In terms of dollars, workers are getting an output share only slightly smaller than what they got in 1948.

The BLS “consumption wage” (light blue) results show a dramatically declining share for labor. In terms of what they can buy with the money (compared to what firms can buy with their share), workers are getting a much smaller share (down by a factor of .73) than they were in 1948.

This discrepancy points to a basic flaw in the broadly phrased argument that “if productivity is rising rapidly, then standards of living for workers will also rise rapidly.” For the kind of time horizons that we’re dealing with here, the premise has to be about productivity of consumer goods, not productivity in general. Since productivity of consumer goods has in fact risen (though not as rapidly as overall productivity) and is expected to continue rising, Lazear still has a case to make, but he hasn’t quite made the case yet.