Pissing Down Your Leg

Thoughts on Economics and Economic Policy

The Relationship Between Marginal Tax Rates and the Top 1%

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Over the last (almost) 100 years the United States has had widely different approaches to very high income in its tax code. In 1913 the top marginal tax rate was only 7%. By 1918 it was 77% before falling in the Roaring 20s down to a low of 24% in 1929. The Great Depression lead to another steep increase and the top marginal tax rate never dipped below 63% until the Reagan Revolution in 1982. For much of the 1950s it was over 90%. Now, the top income level to which the tax applied was much higher (especially in real terms) than it is now. But during the strong growth of the 1950s we asked our richest individuals to fork over $0.90 of the last dollar they earned.

At the same time, we have seen widely different shares of wage and salary income going to the top 1 percent of earners over those (almost) 100 years. According to Piketty and Saez, it reached a pre-Depression high of 18.4% in 1928. That fell fairly steadily down to a mere 7.7% in 1973 before returning to 18.3% in 2007 (it has dipped slightly during this Lesser Depression).

Putting these two measures on the same graph makes it look a lot like they are closely related.

The correlation is -0.61. When the tax rate goes down, the share of income going to the top 1% goes up, and vice versa. Is it possible that one is causing the other? Or that there’s something else causing both? On the other hand, is it possible that they aren’t related at all?

Assuming there is some sort of causal relationship at work, I can think of a few possible explanations. Deciding which one is correct is not so easy.

  • Rich people don’t work as hard (or as much) when marginal tax rates are high, reducing their income.
    • This is certainly possible. If I had to pay 90% of my last dollar to the government, I would definitely consider not working quite so much.
    • And this is one argument against high marginal tax rates. It reduces the incentive to work and therefore will hurt overall economic growth.
    • But there doesn’t seem to be any relationship between higher top marginal tax rates and economic growth. In fact, if there is any relationship, it looks like it is positive, at least until you get to about 70%.
  • Rich people hide more of their income from the IRS when marginal tax rates are higher.
    • I’m told that there was evidence of this in the 1950s and 1960s. And again, I’m sympathetic. 90% is a lot of money to hand over to the government on that last paycheck.
    • But one question then is how much they hid, and how much they stopped hiding when marginal tax rates came down. Specifically, was it enough to increase federal revenue?
    • The answer seems to be maybe. There is almost no relationship between Federal tax revenue as a percent of GDP and the top marginal tax rate.
  • Very high marginal tax rates serve as a signal about what society views as acceptable top incomes.
    • This is fairly speculative, but the idea would be that a top marginal tax rate of 90% says to CEOs and finance professionals that we don’t think anybody should earn above a certain amount.
    • So if we set the highest marginal tax rate at $10 million (or $20 million, or $50 million), then we’re saying that there’s no point in having an income higher than that. After all, going from $10 million to $100 million in gross income only increases take-home pay to $19 million.
    • I think the interesting question is what this would do to everybody else’s salaries. Would they fall due to lower economic growth? It doesn’t look like it. Would they increase? I’m not sure.
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Written by Liam C Malloy

November 3, 2011 at 9:55 pm

Posted in Uncategorized

The CBO Makes the 99%’s Point: They’re Eating Our Pie!

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The CBO very thoughtfully made what I believe is the main point of the OWS protesters. The main income growth over the last 30 years has gone to only the top 1 percent of the income distribution, leaving everybody else only marginally better off than we were three decades ago.

The growth in (after-tax!) income by quintile is striking:

Growth in Real After-Tax Income from 1979 to 2007

Source: Congressional Budget Office

The first four quintiles have seen less than 50% growth over 30 years, or less than 1.4% per year. And as you can see that’s much smaller for the bottom 40% who have seen income grow less than 1% per year. Meanwhile the top 1% has seen after tax income grow by 270% over the same time period, or 3.6% per year.

That means that every group except the 1% have seen their slice of the American pie shrink between 1979 and 2007.

Shares of Market Income, 1979 and 2007

Source: Congressional Budget Office

I’m just glad that the 99% is finally waking up and demanding that we do something about it. So while I’m no protester (I’m much to soft and squishy), here are a few suggestions:

  • Increase the marginal tax rates, especially on the top 1% (my next post will expand on this).
  • Put a Tobin tax on financial transactions, say $0.05-$0.10 per share (or the equivalent).
  • Pass a constitutional amendment that says all federal elections are to be financed with only public funds.

Growth in GDP per capita comes from the entire economy. It comes from businesses competing for your dollar and coming up with new products and better ways to make old products. It can be strong when the top marginal tax rate is 90% (as it was in the 1950s) or when it is 39% (as it was in the 1990s). It can come when the top 1% is getting 7% of the national income and when it is getting 15% of the national income. We simply have to choose which world we want to live in.

I believe the three suggestions above will slow the growth of the top 1 percent’s income, reduce the size of the financial sector, and make the government more accountable to voters rather than those who donate. That’s the world I want to live in.

Written by Liam C Malloy

October 27, 2011 at 9:45 am

What Do Unions Do?

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Public unions have been taking a lot of heat from the right recently, while private sector unions continue to diminish in importance in the United States. I think it’s useful to think about what unions actually do in order to think about whether they are harmful or beneficial (or neutral) to economic performance. In order to do that, I want to do a little thought experiment.

Imagine an employer and a potential employee. While there is some doubt about how productive the worker will be at this particular job, the expectation is that there will be some value created by the match. That is, for every employer-employee combination, the worker creates a certain amount of value added for the firm. If the firm decides to hire this worker, the next step is to figure out how much to pay her.

The firm will not pay more than the value of that the worker can provide. If it did, it would lose money every day. The worker, on the other hand, will have some reservation wage below which she will choose not to take the job. It could be equal to the value she places on leisure or it could be the value of her next best job offer. If the firm offers to pay her less than this reservation wage, she will politely decline and go to her next best option.

So let’s call the reservation wage r and the value that the job creates v. In a search type model (a la Mortenson-Pissarides) we throw these numbers into a Nash-bargaining black box and come up with some equilibrium wage. But there could be a large number of possible equilibria. It depends on the bargaining power of both the firm and the employee which in turn depends on the tightness of the labor market for the employee’s particular skills.

In general, most workers have significantly less bargaining power than the firms that want to hire them. Therefore wages tend to much closer to r than to v. There are, of course, exceptions. NFL quarterbacks, CEOs, and airline pilots spring to mind. But for factory workers, clerical workers, retail workers, and most of the rest of us, the firm generally has the upper hand in bargaining over wages and can make take-it-or-leave-it offers. While some industries may pay efficiency wages above their workers reservation wages in order to reduce efficiency, many do not.

Firms then, are often able to capture much of the surplus that is created by each employer-employee match. When we see corporate profits increasing while labor income is stagnating or decreasing, this is evidence that firms have been successful in reducing the amount of the surplus that goes to labor. That we have seen this recently in the United States is no surprise because we have also seen the power of labor unions fall.

For what do labor unions do? At least when it comes to wages, they are able to increase the bargaining power of labor. This allows workers to capture more of the surplus created by these employer-employee matches and push wages closer to v. This will reduce corporate profits and increase the share of revenue that goes to labor. This is what we saw in the 1940s and 1950s, the heyday of union growth in the U.S.

But the question remains whether this is good or bad. We have seen a number of industries that seem to have given away too much to labor. leading to a loss of profitability and competitiveness and even bankruptcy. The answer to this question is, unfortunately, far from clear. First of all, increasing the bargaining power of labor is definitely good for (currently-employed) workers in the short term. It will increase their wages (and other forms of compensation). Of course, by raising the cost of labor, it will likely lead to fewer jobs in that particular firm/industry. Firms have a downward sloping demand curve for labor, so when the price goes up, they will employ fewer workers.

That doesn’t necessarily mean that it is bad for the economy. Increasing the share of income that goes to labor (as opposed to profits), leads to increased consumer spending and higher demand for firms. In the end, it may lead to more total employment in the economy or it may simply be neutral. Certainly the economy of the 1940s-60s was no worse than the economy of the last 20 years and it may have been healthier.

But what of the long-term consequences? If firms that are profitable now give away too much to the unions, they may find themselves uncompetitive in the future, needing to cut jobs or even declare bankruptcy. Certainly the U.S. auto industry seems to be in this position and unions have had to give back a fair amount of what it won in the past in order to keep the big three auto companies afloat.

Here, I believe, unions need to think more like the owners of the firms than as representing the interests of the firms’ most important input. The surplus value created by each employer-employee match is not fixed in stone. It will vary over the business cycle and it will vary over time as the competitive landscape of industries change. If labor unions understand this, they can bargain for contracts that accept this fact and that increase pay to labor when the firm is doing well and decrease it when the firm is struggling. This is often how the pay is structured for those workers that have more bargaining power to begin with (think CEOs).

The obvious solution, which has been proposed again and again in the history of labor economics, is some form of profit sharing and/or employee ownership. A Ford that has lower base pay for workers but that regularly shares its profits across the board will be a much more competitive firm than a Ford that faces a UAW intent on extracting as large a share of guaranteed pay as possible. Of course, in a world in which workers own a large percentage of each firm, it would be inappropriate to have industry-wide unions like the UAW which might see it in the interests of its members to reduce competition in order to increase profits and pay.

Public unions, in this scenario, represent a problem. After all, they do not exist in a competitive world trying to maximize profits. If they work for anybody it is the citizens of the country, state, city, or town. These citizens have an interest in having high quality service at a low cost so that taxes are held in check. Politicians, on the other hand, elected to negotiate with these workers often have their own agenda. They may be more willing to make concessions in the interest of labor peace, especially if the bill for those concessions won’t come due until they have been out of office for a long time (think defined-benefit public pensions now bankrupting states and municipalities across the country). Or they may be intent on breaking the unions for ideological reasons especially if they have been sent to office by business interests intent on lowering their own labor bill.

It is therefore very important that public-sector negotiations take place in as public and open a format as possible. For the most part, voters and taxpayers want to see their teachers, police officers, firefighters, and other public servants paid fairly. What they don’t want is to see promises made that are much more generous than the compensation they themselves receive, as the taxpayers will eventually end up footing the bill.

Written by Liam C Malloy

October 21, 2011 at 10:36 am

Posted in Uncategorized

Green Technology and Comparative Advantage

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When David Ricardo first developed the idea of comparative advantage in order to illustrate the gains from trade he used England and Portugal as examples. Portugal, he argued, had a comparative advantage in producing wine because of its warmer climate and more fertile soil. England, on the other hand, had a comparative advantage in producing wool because of its cooler climate and rockier terrain. That makes sense. England and Portugal, after all, can’t do anything about their climates and can’t do much about the quality of their arable land.

Let’s fast forward through the Industrial Revolution and look at the automobile market in the twentieth century. For the first half of the century, American car companies dominated the industry. Outside of perhaps Germany, American car manufacturers had a comparative advantage in producing cars. By Ricardo’s theory, other countries should allow the U.S. (and Germany) to produce cars and then export them around the world.

Instead, after WWII restrictions were lifter, Japan designated its nascent auto industry as key to economic recovery and growth and provided it with various protections from foreign competition. The result was a Japanese auto industry that eventually came to dominate much of the international market. South Korea followed a similar program and is now also a major international producer. China and India seem to be following the same path.

The story of the auto industry brings into question the theory of comparative advantage when applied to manufactured goods. After all, a factory can be built just as easily in cities in Japan, South Korea, China, or India as in Detroit or Montgomery. With the easy mobility of technology and capital, there is no reason to think that Chinese or Indian auto workers cannot become just as productive as their counterparts in the United States. That is, comparative advantage may fit well in a static situation in which things can’t change (like climate), but it doesn’t work well in a dynamic world in which technology, capital, and skill can change.

So what does this all have to do with green technology? Just about everything, actually. The current news is all of the U.S. solar companies that are either going out of business or moving production to China. In a static world there is little question that China has a comparative advantage in producing most manufactured goods. But if you think there is going to be a huge demand for these new green technologies (and I certainly do) and that China’s low cost labor won’t last forever (it won’t), then there is a strong argument for a U.S. industrial policy to support green manufacturers and try to keep those jobs in this country. The type of protection could be tariffs or quotas or subsidies. The protection could even be time limited (say 10 or 20 years). But if it’s successful it will allow U.S. manufacturers to develop the technology and skill that would allow them to compete globally.

The cost of such a program would be to hurt consumers of green technology and energy in the short run. We would all pay higher prices (for possibly inferior products) just as car buyers in Japan and South Korea did while those industries developed. But it would help U.S. workers (no small benefit in a world of 9% unemployment) and would likely change the long run equilibrium of where these products are produced in 20 years and beyond.

Written by Liam C Malloy

September 7, 2011 at 12:45 pm

Posted in Uncategorized

The Difference Between Being Pro-Market and Pro-Business

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As an economist, I’m generally pro-market. By that I mean I believe that the best way to produce most goods and services is with a free market system. Why? The profit incentive, combined with competition, generally is able to supply customers with what they want at the lowest cost. That is, the free market is generally the most efficient way to produce the stuff we want. Of course, there are times when the market fails. Sometimes there are fixed costs that are so large that competition is not possible (rail, utilities, etc.). Sometimes there are significant externalities (negative or positive) that mean the good or service is over or under produced. Sometimes there are information or bargaining asymmetries that lead to inefficient, or at least inequitable, outcomes. In those cases I believe it is the government’s job to come up with regulations that provide the correct incentives for market players, whether it is a pigovian tax (or surplus) or a cap and trade system, or whatever. On very rare occasions it makes sense for the government to supply or pay for the good itself (education and scientific research are two that come to mind. Oh, and national defense, of course).

But generally I’m pro-market. And as someone who is pro-market, I support policies that help the market function. One of the most important of these is anti-trust legislation. In order for the market to function effectively, there has to be competition. That’s why the justice department is correct in filing suit to stop the merger between AT&T and T Mobile. While mobile phone service will never be one in which there are hundreds or even dozens of firms due to the large fixed costs involved, consumers will end up paying significantly more if we go from four major carriers to three.

When most people think about economics and “the market” they think of business. After all, it’s businesses that compete in the market. And so one of the common misperceptions is that businesses are also pro-market. In fact, most businesses are not pro-market. As long as there have been “business interests” there have been businessmen (and union leaders) talking about “ruinous competition.”

Executives and managers basically have two goals: maximize profits and keep their jobs, not necessarily in that order. One way to do that is by constantly innovating, coming up with new products that customers want and new ways to make those goods more cheaply. But another (and perhaps easier) way of accomplishing those goals is to reduce competition by buying up competitors and keeping new entrants out of your market. If you can get tariffs to keep out foreign goods or legislation that limits competition, so much the better!

Pro-business policies, then, are rarely pro-market. If you limit competition you will increase profits for businesses, but you will do so by reducing choice for consumers and forcing them to pay higher prices. Politicians seem never to make this distinction, maybe because they don’t want to piss off their corporate donors. But it is not a terribly difficult distinction to make, and would be an easy way for Democrats to distinguish themselves from the “pro-business” Republicans. After all, we are all consumers, whether we are a factory worker, a school teacher, a police officer, or a farmer. Lower prices and better products are something we can all support.

Written by Liam C Malloy

September 1, 2011 at 10:24 am

Posted in Market, Policy

A Speech for the Tenth Anniversary of the September 11, 2001 Terrorist Attacks

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Ten years ago today we were attacked by a group of 19 men. These 19 terrorists, supported by a larger terrorist network, used our own airplanes as weapons of mass destruction and killed thousands of Americans and others. In the ten years since then we have fought two wars, one directly related to the attack, one much less so. We have paid the price for these wars in over 6,000 soldiers, sailors, airmen, and marines killed, tens of thousands more injured, and at a cost of over a trillion dollars.

By some metrics these wars have been successful. We removed the Taliban from power in Afghanistan and we killed or captured most of those responsible for the attack including the head of Al Qaeda, Osama bin Laden. In Iraq, we removed a dictator from power, reduced the sectarian violence that followed, and the Iraqi people now have a parliamentary democracy in place. To the men and women in our military, we owe more than we can ever repay. But one thing I wish to make perfectly clear is that we will never forget the fallen nor shall we ever abandon our veterans. They have done all that we have asked of them and more. Any mistakes in the wars have been ours, not theirs.

After ten years, it is time to bring these wars to a close. We are not a nation of war, but a nation of peace. It took us only four years to win the second world war in both Europe and the Pacific. At this point we risk becoming accustomed to a state of perpetual warfare, a result that I cannot and will not accept. Furthermore, there are no longer any concrete goals we can accomplish. Our military presence in both Iraq and Afghanistan is doing as much to foment violence as it is to eliminate it, leading to an uneasy equilibrium. Because of this, we will remove our remaining troops in Iraq by the end of the year as has previously been agreed upon with the Iraqi government. All of our troops will be taken out of Afghanistan by the end of 2012. Both of these countries must now learn to stand on their own.

But the events in the Middle East and Northern Africa this Spring show that this area of the world should not be abandoned. Indeed, today we have new allies in the people of Tunisia, Egypt, Libya, Syria, and others who have shown that the desire for liberty and freedom is universal and glows in the hearts of all men and women. But in most cases it will not be our role to directly intervene in these nascent democracies. Just as we would have resented France had it sent troops to Boston in 1776, so too would these new allies resent Marines or Army Rangers or Navy Seals showing up on the shores of Tripoli, Cairo, or Hamah. As we saw in both Iraq and Afghanistan, while our military was there to help these countries, its presence often generated as much hostility as goodwill, just as foreign troops in American cities would.

So instead of a policy of armed conflict, we will shower these new allies with sunshine. We will provide aid when needed and asked for, whether it be in the form of food, medical supplies, or advice and training. We will provide arms only when we think it will tip the balance and help those people who are struggling to throw off the yolk of tyranny and bask in the glow of liberty. We will no longer give these people a reason to hate us, but instead provide them every reason to love America as the beacon that shines for all people who desire to be free. I believe that this investment, which will cost us much less both in terms of lives and dollars, will nonetheless have a much larger return. And as we reduce the cost of our foreign engagements we will be able to focus on other priorities at home such as making sure that the unemployed are able to find jobs so that they can support their families.

Do not interpret this change in policy as a sign of American weakness. Events this year have shown that we can attack any place on earth either with our unequaled special forces or aerial assets. If we are attacked on our own soil or abroad, we will respond swiftly and decisively. There will be no place that is safe from our long reach. But it is my belief that this new policy will remove all support that terrorists enjoy from the population of some countries. And without that support, terrorists will find it much more difficult to attract recruits and hide from our reach.

Remember that we our Americans. And what makes America great is not the strength of our military but of our ideals. We would rather welcome people into our country as immigrants than be forced to kill them as enemies. We must make sure that our foreign policy is in line with those ideals. And when that is the case, then will we be the city on the hill that was envisioned by our founding fathers. By avoiding foreign entanglements we will be the America of which we can all be proud.

Written by Liam C Malloy

August 15, 2011 at 11:47 am

Posted in Uncategorized

Time to Rescue the World

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Well, the world is going to hell in a hand basket today. Stocks are down 5-6% in one day after a horrible week last week. The unemployment rate is stuck over 9%, GDP is barely growing at all, and the administration doesn’t seem to have a plan. So here’s a plan.

It’s time for a little international intervention. And not with bombs, but with bulldozers. Let’s start with Haiti. The country is still trying to recover from its horrible earthquake and is struggling to do even the most basic tasks such as clear away the rubble. My suggestion is that as we wind down the wars in Iraq and Afghanistan, we send a new army of construction workers and engineers to clean up and rebuild Haiti.

Imagine that we send 100,000 workers and the needed equipment. They would be paid by the federal government and could also hire local workers. Ideally, these workers would be pulled from the unemployed (there should be plenty of construction workers), and be hired for at least a year. The cost of labor would probably be around $10-20 billion. The cost of materials (although I’m no expert) would be another $20 billion (with the requirement that they come either from American or Haitian companies). This would provide stimulus (and jobs!) for the economy.

And we wouldn’t need to stop in Haiti. If we can make that a success, we could move on to other countries that need our support. The end goal would be three-fold:

  1. Jobs for Americans.
  2. Good will for America.
  3. Better infrastructure for our neighbors.
Of course, we could also do the same thing in this country. Many parts of our infrastructure badly need maintenance and/or upgrades. The key is that we need to provide this stimulus in the form of jobs. So far the stimulus provided has done little to nothing in providing work for the unemployed.
Would this be a massive undertaking? Yes, of course. But we have 14 million unemployed workers. We need to create millions of jobs. This is the best way to start.

Written by Liam C Malloy

August 8, 2011 at 6:50 pm

Posted in Leadership, Recession