Taxing the rich is harder than you think

In this post on Ed Broadbent's suggestion for a 6 ppt increase in the income tax rates faced by people earning $250k or more, I mentioned that some serious econometric work had to be done before this could be treated as a meaningful proposal. It soon occurred to me that there very likely had been some work done on this topic, and that I should try to track down some of the literature. It turns out that prospects of using the tax system to counter the trend towards higher concentration of incomes at the top end of the income distribution are limited, and the chances of generating perverse outcomes are large.

The best place to start is this delightful paper written by Alan Blinder back in 1981, when the expression "Laffer curve" was still relatively new in public policy circles. Blinder makes it clear that the notion predates the famous table napkin, and indeed follows from Rolle's Theorem of calculus. If 100% tax rates generate zero revenues (and this doesn't seem to be a point anyone seriously disputes) then there must be a point where tax revenues are maximised, after which increasing tax rates results in lower total revenues.

Suppose for now that an increase in taxes has no effect on wages. A bit of manipulation (Blinder's equation 3 without the last term) yields that the tax rate that maximises revenues is τ* = 1/(1 + η), where η is the elasticity of the supply of labour. As the labour supply elasticity increases, the value of τ* declines.

So the debate is not whether or not the Laffer curve exists; it does. The question is an empirical one: what is the elasticity of the supply of labour? More specifically for the case at hand, what is the elasticity of the supply of labour for people with high incomes?

There are two recent studies that address this question. In a study using US data, Jon Gruber and Emmanuel Saez summarise their results as follows:

[T]axpayers who have incomes above $100 000 per year ... have an elasticity of 0.57, while for those with incomes below $100 000 per year the elasticity is less than one-third as large. Moreover, high income taxpayers who itemize are particularly responsive to taxation. Our estimates suggest that optimal tax structures may feature tightly targeted transfers to lower income taxpayers and a flat or even declining marginal rate structure for middle and high income taxpayers.

The finding that high-income earners are most sensitive to changes in taxes is probably not surprising. In a study using Canadian data, Mary-Anne Sillamaa and Mike Veall also find that people at the top of the income distribution have higher elasticities. Moreover, they find that the elasticities are higher than those found in other studies: 1.32 for those earning more than $75,000 in 1986, and 1.67 for those with incomes higher than $100,000 (this corresponds roughly to the top 1% of the 1986 income distribution). An elasticity of 1.32 corresponds to a value of τ* = 0.43, and the revenue-maximising tax rate for the top 1% would be 0.37.

Sillamaa and Veall take care to note possible explanations for why their results are so much larger than in other studies, and suggest that "it is possible the estimation is picking up at least in some degree an intertemporal response that is larger in the short run than in the long run."

Long-run effects may offer a partial explanation for the differences between the Sillamaa-Veall and the Gruber-Saez results, but that's not a reason to discount them. Indeed, the long-run effects are precisely what matter most for tax policy. In the short run, workers are stuck with the human capital they've accumulated. But in the long run, human capital is endogenous, and higher tax rates reduce the returns on education. In a recent blog post, the never-to-be-sufficiently-praised Chris Dillow puts it this way:

[P]ut yourself in the shoes of someone on, say, £100,000 a year facing [a] higher tax. He might well figure: "I’ve got an ex-wife and kids to support: I’ve got to keep  earning. And I’m not qualified to do anything else anyway. But I hear that some senior partners are thinking of retiring now they have to pay more tax. If I work hard, I might be able to get one of the jobs they leave."

But now, think of a university student. He figures: "I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead."

Now, in the short-run - which might be many years - the £100,000 a year man’s response is the most important one. But in the very long-run - decades - it’s the student’s response that determines our macroeconomic fate.

See also this paper for some evidence on how students' education choices depend crucially on their perceived prospects in future labour markets.

If we interpret the Sillamaa-Veall estimate of 1.67 as a (possibly conservative) estimate for high earners' long-run elasticity, then the peak of the Laffer curve occurs at a tax rate of 37% - which is lower than the top marginal tax rate in all Canadian provinces. In other words, available evidence suggests that we are already on the wrong side of the Laffer curve. Increasing tax rates at the top end to finance a transfers to low-income households will actually reduce the amount of money available for redistribution.

Now let's relax the assumption that wages don't react after a change in the tax rates. If workers reduce their supply of labour after a tax increase, then wages will increase as we move up the demand curve for labour. The new tax rates will now be applied to these higher wages, and Blinder notes that this effect pushes the peak of the Laffer curve well to the right:

[U]nless the elasticities are quite high, we can only be over the Laffer hill only when marginal tax rates are extremely high... [I]t is very unlikely (though not totally impossible) that the peak in the Laffer curve comes at a tax rate that anyone might seriously entertain.

This condition is unlikely to be met: labour demand elasticities are generally very small. Indeed, part of the story behind the concentration of incomes at the very top end of the income distribution almost certainly involves labour demand elasticities that are extremely inelastic. Workers who face perfectly inelastic labour demand curves are pretty much asked to name their price. Instead of withdrawing their labour, top-end workers are more likely to obtain increases to their gross wages that keep after-tax incomes at their previous levels.

An interesting example of this sort of phenomenon is being played out in the market for soccer players in Europe. Elite soccer players in both France and Spain pay lower taxes than do other employees, and the governments of both countries want to eliminate this special treatment. Probably the most disinterested people in this story are the players themselves, who know that their take-home pay won't be affected no matter what happens. If they have to pay higher taxes, they know that market forces being what they are, they will be able to extract the appropriate pay increases to compensate.

This would seem to be a happy ending, then: high-income workers keep working, and they pay higher taxes on their (increased) wages. But the analysis doesn't end there. Once we introduce both supply and demand effects, we have to look at the incidence of the increased tax on high earners. The burden of the tax does not necessarily fall on the people who actually pay the tax.

We can be pretty sure that if there's one group of people who won't be paying the tax, it is the high-income earners themselves - the reason for the increase in wages is to compensate them for the higher tax bill. And if we're talking about a small open economy whose capital markets are highly integrated with the rest of the world - and in the case of Canada, we are - then we also know that the tax will not be borne by owners of capital.

If neither high-income earners nor investors are paying those increased taxes, then they must be being taken from workers further down the income distribution. And as we move down the income distribution, workers' bargaining power diminishes: demand for labour becomes more elastic, and supply becomes less elastic. We could even have the perverse result of a tax on high incomes having regressive effects.

(Note also that imposing a wage cap just puts us back to being on the wrong side of the Laffer curve.)

So here are the possible outcomes:

1. If wages don't adjust after the tax change, then we are very likely already on the wrong side of the Laffer curve for high-income earners: increasing the tax rates on high-income earners will reduce total revenues.
2. If wages do adjust, the gross incomes of high-income will rise so that their after-tax incomes are the same. Extra revenues will be generated, but the burden of the tax increase will be borne by those below the top end of the income distribution.

The reality is likely to be more nuanced,  but we can pretty much rule out the naive scenario in which there are no behavioural responses. And the existing literature suggests that those responses will generate effects that are almost exactly the opposite of the what we want to see happen.

Once again, we're back to the main message of my previous post. The tax system is at best a clumsy instrument for redistributing income, and there are simply too many possibilities for generating unintended perverse outcomes. If you want to reduce poverty and inequality, focus attention instead on setting up a well-designed system of transfers. It's effective, and it's also the strategy used by all successful social democracies.

Comments

[Patrick]

Seems to me that it matters what the wealthy do with their money. If you have a Scrooge McDuck who sits on his hoard of cash, that's really bad. If you have a someone buying Cristal, big houses, and expensive Italian sports cars, that's not really much better. What we really want is wealth to be productively invested so that it creates jobs.

[Adam P]

But doesn't buying big houses employ house builders and buying Italian sports cars employ Italians?

[Marc]

Interesting analysis, Stephen. One other factor to consider is that extremely high top mtr's will divert some compensation into in-kind income, like more secretaries, plusher carpets, tickets to hockey games, more use of the corporate jet, etc.

Overall, though, Broadbent's 6 ppt increase would be mostly swallowed. The numbers you point to are mostly capturing intertemporal variations, likely due to the timing of exercising stock options (that's a well-known empirical finding). Sure, we would see LR changes if we tried to set the top marginal tax rate at 70% or higher, but Broadbent's 6 ppt increase is extremely likely to be on the "good side" as far as revenues go.

For those of us who find such grotesque inequality at the top end unpalatable, what policies would you suggest? Massive inheritance taxes, a wealth tax, a tax on financial transactions, increasing moorage fees, eliminating the deduction for corporate boxes?

[Andrew F]

So, a high tax on consumption, a 'regressive' (declining rate, or at least flat) income tax regime, compensated by transfers to the poor. Sounds like the middle class might have a hard time swallowing that, even if it is better for society.

[Patrick]

Adam P: Yeah - I admit that I'm going on intuition here so it may not pan out ... I'm thinking there's a sort of declining marginal utility at work i.e. we'd all be better off if the rich guy lived in a 3000 sq. ft house instead of 12000 sq. ft. house and drove a Lexus instead of Maserati and took the money he didn't consumer and invested it in some clever engineer's start-up company which will create jobs which ultimately mean more growth and a higher standard of living more generally. His individual utility maximization heuristics (i.e. ego) might be telling him he's better off with the giant house and the Maserati, but society would prefer that, at some point, he forgo consumption and instead invest.

[Adam P]

Patrick, I don't know. Doesn't a 12000sq.ft house provide 4 times more income for construction workers than the 3000sq.ft house? I'm not sure, haven't really thought much about this but seems like we don't care how much they consume or invest, interest rates and prices will work out all the allocations of capital and the consumption/investment split.

Perhaps it's best to tax consumption instead of income and then just transfer the money to the poorest? (Isn't that what Stephen basically endorses?)

[Nick Rowe]

Stephen "...the tax rate that maximises revenues is τ* = 1/(1 + η).."

That formula is neat. I had never seen it before.

If I understand it correctly, that formula assumes the labour demand curve is infinitely elastic (wages are fixed). There must be an equivalent formula in the more general case, which solves for the revenue-maximising tax rate as a function of both labour supply and labour demand elasticities. I expect I ought to get out pen and paper and calculus and figure it out.

Intuitively, by analogy with the revenue-maximising monopolist case, the revenue-maximising tax rate ought to be where the elasticity of something (tax base with respect to tax rate?) equals (minus) one.

[Robert McClelland]

Doesn't a 12000sq.ft house provide 4 times more income for construction workers than the 3000sq.ft house?

No. A construction worker will earn the same weekly income regardless of whether they're working on a 3000sq.ft house or a 12000sq.ft house. The latter does require more hours of labour, but that isn't really much of an issue these days.

[Stephen Gordon]

Nick: Alan Blinder derives the more general expression in the 1981 paper I linked to in his equation (5).

[Adam P]

Robert, most people don't wait 4 times as long for for their house if it's 12000sq.ft. Someone that rich probably wants it even faster, I was suggesting the builder employs 4 times as many workers. (I said "4 times more income for construction workers", plural on workers.)

[Adam P]

I guess I should have said "doesn't a 12000sq.ft house employ 4 times as many workers?"

My bad.

[Nick Rowe]

Stephen: thanks.

[Patrick]

Adam P: No, there are economies of scale, but they would fill it with more stuff I suppose.

"interest rates and prices will work out all the allocations of capital and the consumption/investment split"

Recent experience suggests it doesn't always work that well - at least when finance runs amok. But then, if finance goes haywire I suppose all bets are off anyway.

[Matthew]

Stephen,

You say that the tax system is not a good way to re-distribute income and we should focus on well-designed transfers.

What is the mechanism for financing the transfer of wealth from X to Y, if is isn't through the tax system? Or perhaps you are using "transfer" in a different sense than I am.

[MattM]

Matthew, he doesn't mean that financing shouldn't come through the tax system.

The simplest example of what Stephen could be proposing would be a flat tax financing a fixed per-person annual payment.

[travis]

"But now, think of a university student. He figures: "I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead."

Now, in the short-run - which might be many years - the £100,000 a year man’s response is the most important one. But in the very long-run - decades - it’s the student’s response that determines our macroeconomic fate."

Ouch, an inadvertent argument for taxing the rich regardless of whether it raises tax revenue or not.

[Naive]

Why then does Canada have less doctors per capita then countries which pay less and where PITs are higher?

[Andrew F]

Doctors are a regulated profession in Canada, and the government determines the supply, while also (in the past, at least) having the notion that fewer doctors means fewer people to drive health care costs, paid for by government. There are as many doctors as our university system will allow.

[jeremy]

i guess the 12000 sq. ft. house might be more intricate in design making some parts more time consuming. The rich guy might want the workmanship to be above perfect which could be mean more do overs, so more spending on materials, and the workers might be able to charge more because of their greater skills...

[RSJ]

If the goal is to change income distribution, then you *want* to be on the right hand side of the Laffer curve for top incomes, and on the left hand side for everyone else.

The purpose of these policies is not to raise tax revenue, but to shift the payoffs in such a way as to discourage windfall-seeking. This is part of a bargain in which the government agrees to stabilize revenues for the business sector across the cycle in exchange for top earners agreeing to limit their take of the revenue.

When the U.S. had high surplus profit taxes on corporations as well as 90% marginal rates, this was not done to raise money, but to prevent certain types of salaries from being paid, thereby making median salaries "cheaper" in relation to those of top management. Otherwise, the bargaining power/disorganization effects will put downward pressure on median wages and upward pressure on the wages of top decision makers.

And this worked quite effectively in the U.S. -- In fact, the U.S. experienced its peak productivity and GDP growth period under this regime, and median incomes rose along with GDP. As soon as those top rates began to be cut, median wage shares began to decline, and aggregate debt began to balloon, and real investment declined as well.

So there are three separate issues here, which seem conflated in your post:

1. Helping the "poor" with transfer payments -- great idea, but does nothing for the middle class.

2. Raising revenue -- from whom? The revenue can be raised from the middle class, from business, and from top earners. You want a world in which most of that revenue is raised from the first two categories because their incomes are rising along with GDP. You don't want the rich to be rich enough so that you need to soak them in order to suppress demand.

3. Supporting the middle class so that their incomes increase 1-1 with national incomes -- here you need a suite of reforms, but the centerpiece of these needs to be extremely high (e.g. 70% or higher) marginal rates on incomes and surplus profits that we as a society deem to be excessive as part of the stabilization bargain.

[Andrew F]

"If the goal is to change income distribution, then you *want* to be on the right hand side of the Laffer curve for top incomes, and on the left hand side for everyone else.

The purpose of these policies is not to raise tax revenue, but to shift the payoffs in such a way as to discourage windfall-seeking."

So, make everyone worse off, rich or poor?

[Nick Rowe]

What Andrew F said.

And in case anyone missed it, let me spell it out slowly.

If you are over the top of the Laffer curve for the rich, you could cut tax rates on the rich, and gain more revenue to give to the poor. Which would help both the rich and the poor.

[RSJ]

Andrew F,

I guess you have a hard time explaining the data then.

It is not making everyone worse off at all, but is changing the rules of the game so that you can have robust sustainable growth in which everyone is better off in line with GDP growth, but some are not fantastically better off at the expense of overall system stability.

[RSJ]

Nick,

You are addressing point 1, not points 2 and 3. The world contains not only the rich and poor, but a middle class. It is the welfare of that center that determines the success or failure of the economy. The poor can be funded by everyone else -- sure. There is no reason to support a fantastically wealthy top 5% in order to "raise funds" to help the poor.

[travis]

And Stephen just stop with this canard that PITs in the Nordic countries are low they are not they hit 60%.

Sweden’s Tax rates

Corporate Tax Rate: 28%

VAT: 25%, general rate; 12% for food and hotels; 6% for culture.

Personal Income tax rates: 29-35%; above 327,600 SEK (approx 50,ooo CDN) another 20 – 25% (max 60%).

Capital Gains: 30%

Source:

http://www.isa.se/upload/english/factsheets/taxes_in_sweden.pdf

[Patrick]

Brethren, be not children in understanding!

This is an empirical result. It's the world as it really is. All the hand waving in the world doesn't make it any less so. It make no sense to make everyone worse off because you prefer a make believe world to reality.

And to be clear, rent extraction is clearly a problem, but not all high income earners are rentiers. But we aren't talking about multi-gazillionaires here. A senior engineer or star salesperson can easily earn >100K. And certainly a small business owner who meets with any success is going to pay herself in the 100K range. Do we really want them to be withholding labour because we're beating-up on them with taxes? How many people area waiting in the wings to do the work they will withhold?

[RSJ]

Dear Patrick,

There is no empirical evidence that high marginal rates make "everyone worse off" -- that is a political fairy tale taught to children in order to justify windfall seeking. There is *no* *supporting* data.

No one is being made worse off with high marginal rates. When the U.S. had high marginal rates, we were:

* more productive
* had faster GDP growth
* had a growing middle class

Even now, nations with high marginal rates deliver a better life to more people.

That is an empirical fact. Another empirical fact is that those nations with an increase in top income shares are more likely to see increases in household debt/GDP.

You can shout "wages are equal to the marginal productivity of labor" until you are blue in the face. You can equate the well-being of the top 5% with the well-being of everyone else. You can *pretend* that the top incomes have the same marginal propensity to consume, and therefore can pile up huge financial claims on everyone else without plunging the economy into debt. All of these beliefs are wrong and easily refuted if you look at the flow of funds, the survey of consumer finances, and census data.

You can ignore this data all you want, but nonetheless putting caps on windfall seeking is an economically beneficial thing. Only by the most psychopathic measures does this constitute "making everyone worse off". It makes the nation as a whole richer, more stable, more productive, and less demand constrained.

Do not let your ideology get in the way of understanding this.

[Declan]

Some good points already by RSJ, Travis and others, a few points of my own:

1) I agree that expanded transfer programs will help the poor. We've already proven this pretty conclusively with seniors.

2) If you believe that 'nice guys finish last' and much of the wealth/income at the high end of the distribution is obtained by measures which reduce rather than increase overall well-being (e.g. taking big bonuses for growing bank revenue in the short term by lending to people who can't repay in the long term), then discouraging this group of people from acting is a positive, not a negative.

3) If the costs from inequality (perversions of the political system, perversion of the media, positional externalities, etc.) are high enough, then again, discouraging top earners from earning so much is again a positive, not a negative. I know it's hard for economists to accept that more isn't always better, but its true - externalities and market failure are pervasive.

4) I'm not convinced that studies of income elasticity are measuring elasticity with respect to the level of marginal taxation as opposed to elasticity with respect to changes in the level.

Minor points:

5) I'm not sure why you bolded the comment about being on the right side of the Laffer Curve when your own post suggest we're not and it was just a few posts ago you were complaining (rightly, in my opinion) about how reducing the GST caused a structural deficit.

6) The example of the soccer players doesn't make sense to me. Say we raised taxes on all NHL activity such that the amount of money left over after the taxes were paid was the same as that raised by the AHL. NHL player salaries would be unaffected? Huh?

7) I for one, seriously dispute that 100% tax rates would lead to 0 revenue. In an economy where your choices were to work for the government and receive room and board in return or starve to death, people wouldn't work? Huh?

[Andrew F]

If you're working for the government for room and board, you're receiving a salary of $0, so there is nothing to tax.

[Declan]

"so there is nothing to tax."

What's taxed is whatever you created with your labour.

[reason]

travis
I'm sure Paul Krugman wrote a post recently that showed that the more bright people there are in finance, the greater the likelihood of problems.

[reason]

I think that underlying the disputes here is a bit of a fallacy of composition.
Now I don't accept that higher marginal rates actually in the long run change the propensity to work unless they are very high indeed. They may change timing, and they make change the way that income is taken (by increasing the return to tax avoidance), but I doubt that people voluntarily make themselves poorer because other people benefit as well (after all other people benefit from their work).

But lets assume that it true. Where the fallacy is ignoring that many markets are "winner takes all". If the top guy (say the top surgeon in a hospital) works less, it doesn't mean that all that forgone income disappears. Someone else will earn more. And that may be net gain, because it is also investment in human capital.

[reason]

The argument about investment in education is correct, and effects on investment in general worry me more than effects on incentives to work. But then surely the correct approach to that problem is to be more generous to investment in the tax system, or to even subsidise it. When pushed, in general, I favour a move towards some sort of progressive consumption tax, but I worry about creating a plutocracy and so some sort of wealth tax or inheritance tax is also needed.

[reason]

I actually wonder, thinking about it, if the studies on marginal propensity to work aren't biased by a pretty big income effect - the ability to afford early retirement. Early retirees, are almost certainly excluded from their sample, even though though are potential workers. Lower tax rates and people work more now, because they know they can retire earlier.

[Patrick]

RSJ:

Did you even read what I wrote?

I'm not talking about super gazilllionaires here. 100K is your family doctor or the engineer the designed the bridge I drive over to get to work. Do you really want believe these people are evil rent extractors plotting to make us all serfs?

The evidence is that at some point higher rates cause those paying them to withhold labor. This is entirely consistent with lower marginal propensity to consume. I never claimed otherwise.

When the US had high marginal rates, it was the only game in town. You can't seriously be comparing a small open economy in 2009 to a gargantuan super power at the height off it's power.

[Frances Woolley]

On the incentives to invest in education: right now medical and dental schools - indeed any program that gives one a decent shot at earning over $100,000 - are vastly oversubscribed. Talk to anyone who sits on a law school admissions committee! Would it be such a bad thing if these programs had fewer applications? But you might say, 'the smart people won't apply.' Well paid jobs are typically also more fun - you'd have to tax doctors a lot before people stopped wanting to go to med school.

Like Reason, I'm trying to put a face on these workers over $100,000 who have negative incentive effects from taxation. It can't be university professors since our pay is only very loosely related to hours worked and even more loosely related to hours worked on socially productive activities e.g. teaching. For the self-employed, it's very hard to measure net (as opposed to gross) income, and there's possibilities of income sprinkling, so you would have to have a really high income as a self-employed person before your taxable income was over $100,000. Lawyers? There's some interesting work by U Calgary law professor Alice Woolley (yes, she's my sister) on the incentive effects of billable hours. Lawyers having less of an incentive to work 80 hour weeks and bill accordingly might not be such of a bad thing.

So where are these incentive effects coming from?

Here's a story about why you might get these results: over the past 20 years we've seen a reduction in marginal tax rates and also a big increase in job insecurity and the competitiveness of the labour market in general. The latter would cause an increase in hours worked at the top end because everyone is desperately trying to cling to the few good jobs that the economy has to offer. The former gives us the correlation. The problem is it's really hard to do what you'd like to do empirically - a natural experiment/difference in difference methodology - because a change in marginal tax rates in, say, Ontario would tend to lead to internal migration of high income earners (witness Calgary head offices), so it doesn't give you a good estimate of the effect of coordinated increases in marginal tax rates.

[Too Much Fed]

What RSJ said and not what Andrew F and Nick said.

Poor people need a raise not a transfer.

[Too Much Fed]

Frances said: "Here's a story about why you might get these results: over the past 20 years we've seen a reduction in marginal tax rates and also a big increase in job insecurity and the competitiveness of the labour market in general."

Let's say it bluntly. Cheap labor outsourcing, cheap labor legal immigration, and cheap labor illegal immigration has the labor market mostly oversupplied.

So, how should a mostly oversupplied labor market be dealt with when most goods are also oversupplied?

[Jessica6]

The Laffer Curve has been thoroughly debunked if you simply look at the data since 1980. Tax cuts don't pay for themselves - burgeoning deficits prove that. But it sure did benefit some people which I suspect is the reason it's been so widely accepted.

http://shire.symonds.net/pipermail/sojolist/Week-of-Mon-20060102/001993.html

http://finance.yahoo.com/expert/article/economist/4065

[Patrick]

As a self identifying lefty/progressive I sometimes despair of my comrades.

RSJ: "wages are equal to the marginal productivity of labor". Oh God. Such raging right wing lunatics as Joe Stiglitz have made a pretty convincing case that wages are ABOVE marginal product. If they weren't, we'd have no unemployment.

Jessica6: Stephen is not saying tax cuts always pay for themselves. Clearly they don't (e.g. the GST cuts). I think he was just saying that the Laffer Curve exists, which it clearly does, and thus it becomes an *empirical* issue to pick the optimal point on the curve and collect the most revenue possible. That's all. Now, you might argue that there are valid reasons to pick a sub-optimal point, but you can't argue that the Laffer curve doesn't exist.

[RSJ]

Patrick:

I, too, despair. Marginal product of labor is just a fiction in a complex economy. Wage *shares* are determined politically. There is no "innate" distribution of pay in a complex interconnected system, that specifies that an manager that reviews QA plans should 80,000/year, but an IT support person should 60,000/year, and a tech-doc writer should earn 40,000/year. You can run a market system just as effectively with these numbers permuted -- and in many countries they are permuted -- it just depends on how you set up the rules of the game. All three are needed to generate revenue for the business, and the distribution of pay for all three is decided by the institution, not by something inherently less important in using framemaker relative to using powerpoint. The results of these battles determines how much of output the median income can buy, and how much must be debt-financed or funded via transfers.

Demand-led recessions occur because median wages are too low -- people don't save irrationally -- they refuse to buy unwanted output because it is too expensive to purchase, relative to their wages. If it were cheaper relative to their wages, then they would buy the output. As wages are more sticky than prices, this refusal to buy is effective at bringing costs back in line with incomes, and in fact this is the only "market" mechanism that can fight institutional arrangements that tend to concentrate incomes. Obviously during the adjustment, falling demand leads to growing unemployment, but prices fall faster than compensation. At some point, they are low enough that purchases resume at the lower levels, and during the expansion median wage shares start to fall again.

This is why wage shares *rise* during contractions and *fall* during expansions. In the U.S., wage shares have been rising at a continuous rate of +3.3% during expansions and fall at a continuous rate of 2% during expansions. Prior to the post-war era, the ratio of expansions to contractions was roughly 3:2. A policy of preventing contractions, not matched by an income support policy, results in shrinking wage shares over time. There is just overwhelming data for this.

I would rather have both a policy that sustains demand during contractions as well as a policy to keep median incomes growing with output during expansions. Call it a social bargain; Eisenhower called it "The Fair Deal", and the purpose of high marginal rates, surplus profit taxes, and pro-union policies is to support median wages during expansions as part of that deal. And it worked -- for both large and small countries, including Canada, Australia, and the majority of the OECD, during the period 1945-1970. And those were peak years in terms of GDP growth as well.

Here is some OECD data on (primarily gross) median earnings as a share of output since that time. Note that some nations managed to sustain wage shares while others have not. There is a great deal of dispersion as a result of shifting income support policies.

http://1.bp.blogspot.com/_fevQMK7kLEI/SxiNi1NzwQI/AAAAAAAAAIQ/YimXLxN_16o/s1600-h/wage-share_dispersal.png

There is little relationship between wage shares and real output growth -- output will continue to grow in either case, regardless of who manages to seize how much of it. But it will grow in a more sustainable way if windfall-seeking is limited and those responsible for purchasing the bulk of output are able to do so out of their wages, rather than out of growth in personal debt or government transfers.

Here is the cts. rate of change of the previous time series, sorted by country:
http://2.bp.blogspot.com/_fevQMK7kLEI/SxiNje4a7tI/AAAAAAAAAIY/wEcMbx62Hgc/s1600-h/wage_share_changes.png

Note that there is no relationship between "small, open" and "must have falling wage shares". It just depends on the rules of the game set by each nation. There is also no requirement that trade must lead to falling wage shares, or that elevated unemployment must accompany constant or rising wage shares. Trade could lead to wage discipline of top earners just as much as it leads now to wage discipline of median earners -- it just depends on how you set the rules of the game.

But the main source of despair is the complete self-censorship regarding class and distributional issues, leading to mass delusion as to what real life is like or how the economy works. 100,000/year is earned only by the top 6% of Canadian families (in 2006). The top marginal tax rates are just under 140K, and only 2% of households earn 150K or higher. So the complete disregard for the fate of 94% of the country is appalling, as is the lack of concern at the fact that median Canadian (and U.S.) household income has gone nowhere in the last 40 years, in real terms, although GDP has grown throughout that period.

[reason]

RSJ
I think falls in rent are a large part of the adjustment mechanism in recessions. I only have anecdotal evidence, but it seems to me the biggest potential for cost savings lies there.

[Patrick]

RSJ:

Wage share increases during a recession because GDP falls but firms are reluctant to show everyone the door and loose knowledge, now-how, etc. only to have to go through the expense of finding it again 6 months down the road.

Fact remains that if you ignore Stephen's point, you end-up with less revenue than you would otherwise. But I gather you're more interested in grinding people down the 'rich' under the implicit assumption that if they earn more than 100K a year, by definition they are rentiers. I think that's wrong. If there are people who are poor through no fault of their own, there are people who are well off through honest hard work and brains.

In the example you give with the IT vs. tech write vs. etc. : Wages for those positions change from place to place due to local labor market conditions.

Anyway, I've never denied that there aren't institutional issues - non-owner 'professional' managers looting companies with the blessing of a completely dysfunctional governance structure is a biggie on my list. And I agree that rent extraction is a big problem (see the baselinescenario link I provided). But my take on growing inequality in Canada is that it is largely due to an increasingly complex and competitive world. That's OK in my books. I don't begrudge an Indian programmer his or her job. But it means we have to do a lot more to help people getting left behind, lest poverty be an inescapable trap. But to do things I think might actually help - like feeding school kids and universal free university education - we need money. And if Stephen presents convincing evidence that says "soaking the rich doesn't work" then I'm not going to advocate soaking the rich. I'd rather help the poor.

[Patrick]

Clarification: Above I mean that the more complex, competitive world is ok. Not the inequality.

[RSJ]

Reason:

Prescott has done work here to show that durable goods take the biggest hit, but I would assume that real estate is included -- basically anything that people borrow to purchase should take the largest hit, obviously, but everything takes a hit to some degree.

Patrick:

re: output

I've already addressed this point. Nations with higher wage shares do *not* have lower output growth rates, so your premise is false.

http://3.bp.blogspot.com/_fevQMK7kLEI/SxnRexIADQI/AAAAAAAAAIg/6dSrYstoCuM/s1600-h/wages_vs_growth.png

You can look at similar data that compares Gini indices against output growth. So there is no data to support your view that high marginal rates, pro-union policies, and other wage-support measures reduce overall output. Some countries have these policies while others do not. Those that do deliver a higher standard of living to their population while those that do not have a more indebted populace with a shrinking middle class.

Why do you believe so strongly in something for which there is no data and which has no sound theoretical basis? This is a real problem with economics, which contains a strong ideological basis that was formed in the late 19th century, primarily to tell fables to those who were asking uncomfortable questions about income distribution. It is long past time to abandon these fables and start looking at how complex economies actually work.

Even historically, Canada, the U.S., and most of the OECD had rapidly growing output in the period 1945-1970, even though wage shares were rising rapidly at the same time and top marginal rates were high (in the U.S., they were 90%). How do you reconcile this historical record with your view? Do you really believe that the economies of Korea, Sweden, Germany, and Italy are "less complex" than the economies of Ireland or Canada? If not, how do you account for the huge difference in wage share growth rates when they have the same output growth rates?

But I think there is another a key point here:

The distribution of incomes does not reflect the distribution of output. When there is a divergence, this must be funded by financial claims. A growing divergence must be funded by a growing stock of financial claims. Having a growing stock of financial claims on a stagnant underlying income stream (the income of the purchasers) is a recipe for higher multiples and instability.

That is why, historically, periods of falling wage shares have been followed by banking crises and deflations. We have just finished a long period of falling wage shares in a large part of the industrialized world that has ended in a massive banking crisis. If you care about sustainable output growth, you must also address inequality. We have in the last few decades been tided over by managing to get the borrowing game re-started whenever a recession hit. We are close to running out of steam in this area, and at some point if median incomes do not start growing with output, then output will not grow either.

So there is a real risk of a Japan-style period of a few decades of stagnant growth and de-levering if these issues are not addressed. Hiding behind 19th century fairy tales to ignore the key issues is not helpful. Accusing me of wishing to subtract from total output is also not helpful. The only way we will manage to escape this cycle is to significantly boost median wages via institutional changes -- including high top marginal rates -- that discourage windfall seeking and counteract wage stagnation.

[Patrick]

RSJ: Gini measures inequality. Comparing it to output growth isn't going to tell us anything about how to collect the most taxes to support the welfare state while not stifling growth.

If you want to continue this conversation, you're going to have to stop attributing positions to me that I do not hold and have never claimed to hold. I just waste all my time setting you straight and not addressing the issue at hand.

"So there is no data to support your view that high marginal rates, pro-union policies, and other wage-support measures reduce overall output"

Never said this. I actually led a union drive a few years ago, and paid a hell of price for it - I've done my bleeding for the proletariat, what about you? And I've also run a small business. If you don't believe marginal product and taxation matters to incentives, employment and wages then you're living in a dream world.

Out of respect for our hosts I try to be civil or say nothing, but now you've kinda pissed me off, so I think I'll just tell you to take a flying leap off that soapbox of yours. Go ahead and willfully misrepresent my positions if it makes you feel better, and ignore the empirical evidence that challenges your Bolshevik world view. And go ahead and dismiss people like Stephen who have spent decades thinking about these problems. I'm sure you and your soap box will be very happy to continue to pontificate in the political wilderness with the rest of the irrelevant left. All sans the inconvenience of economists, data and evidence.

[RSJ]

Patrick,

I will let the readers of the thread decide who is making the better arguments here. If you are convinced that you've spend "years" of your life" "deeply thinking" about these issues, and yet have nothing more to bring to the table other than accusations of Bolshevism and Ayn Rand arguments about workers "withholding their labor" due to high tax rates, then you are not going to make a lot of progress in this discussion.

If you decide to bring some data to the table and make an argument that can stand up to a good cross country comparison, or a historical comparison, then that would be great. I haven't seen any of that here; the data is not kind to beliefs that aggregate output is sensitive to high top rates or high minimum wage rates. Perhaps you will find some beliefs that do have empirical support, in which case you can present them, or cite something, and then you be less frustrated and will make more progress.

In either case, we can let things lie there. I want to point out though that none of my arguments were intended to be against your personal character or life experience. And for the exact same reason, I don't believe you have earned any rights or credibility to make discredited arguments based on your own life experience, either. All that matters is the quality of the arguments, and I am only disputing the arguments, not your own life.

[reason]

RSJ
I don't think you understood my point. I was talking about relative price changes leading to recovery, not so much about what drives the fall into recession.

[Nick Rowe]

Steady guys!

Let me attack both of you!

RSJ: First, I think you must have some sort of typo(s) here:
"This is why wage shares *rise* during contractions and *fall* during expansions. In the U.S., wage shares have been rising at a continuous rate of +3.3% during expansions and fall at a continuous rate of 2% during expansions."

Second: The income from the sale of newly-produced goods must be sufficient to buy those newly-produced goods, by accounting identity. It can't be the case that people (and the governments who tax that income) can't afford to buy the goods they produce, but that they choose not to.

Third: I think you have an implicit assumption that the marginal (and/or average?) propensity to spend (on newly-produced goods) varies by source of income, and level of income? It would be good if you made those assumptions explicit. Then we could understand your argument better.

Patrick: In the Shapiro/Stiglitz efficiency wage model of unemployment, wages are equal to marginal product of labour, but above the marginal disutility of labour. (The equilibrium point is on the labour demand curve, but off the labour supply curve.)

[Nick Rowe]

By the way, RSJ, I think I recognise your argument on wage vs price stickiness as an equilibrating mechanism. I remember Luigi Pasinetti explaining it to me in 1981/2. If there is excess supply, prices fall more quickly than wages, so real wages rise, and the share of wages in income rises. Assume the marginal propensity to spend out of wage income is higher than non-wage income, so eventually demand rises to eliminate the excess supply. Is that your argument? And is Luigi the original source?

But suppose that theory is true. I'm not sure what it would imply about correlations between output growth and real wages (or wage shares). Because we would have to distinguish between exogenous shocks to real wages and endogenous responses of real wages to other shocks to demand. And that would take some simultaneous equation econometrics. (And that might be at the root of some confusion, apart from typos, over what that correlation should look like).

[Thorstein Veblen]

So, basically what this is saying is that if we tax all of America's CEOs more, they will all take two months vacation? But this is false, right -- high profile jobs in America do not get more than two weeks vacation, and I don't think vacation time is that elastic w.r.t. the tax rate. Most high-wage jobs are not hourly...

Let's do a thought experiment. Let's increase Peyton Manning's marginal tax rate to 70%. Poor Peyton, after endorsements, would only be making a paltry $10 million or so. So, Peyton responds to this by: playing only 10 NFL games a year instead of 16? Perhaps he does fewer endorsements, but endorsements have no net societal benefits. (Come to think of it, neither does football...)

I was just thinking, how many high-profile jobs really give workers the option of taking massive amounts of vacation time? Or is the only way to actually quit?

All of the studies you cite are almost certainly fatally flawed.

[Adam P]

Football has no social benefit? Next you'll be claiming hockey has no social benefit, absurd.

[Curtis]

Peyton could retire earlier. Or could work out/ study film less (presumably making him less productive) since there would be less incentive to excel and earn his next contract.

[Stephen Gordon]

Or he can negotiate a higher salary to cover his increased tax bill.

[Adam P]

Stephen last comment gets at what is really the point here, addressed in the second half of the post. Peyton, along with Tom Brady, is a duopolistic supplier of the sort of QB services that can throw for 49+ TDs in a season. Thus he can extract rents from the market to make up for the tax.

Likewise, the Colts become monopoly suppliers of the entertainment of watching that sort of super high quality QB services. So they happily pay Peyton extra knowing they can extract the difference from the fan base. The conclusion is that the fan base pays the tax.

[RSJ]

"The conclusion is that the fan base pays the tax."

Where will the fan base get the extra income to spend more? And why should they spend more on the same quality of performance that they are receiving now? Or are you arguing that Peyton has been slacking off up until now, and only when his taxes are increased will his performance improve so that the colts can raise ticket prices so that he will be able to earn even more for the team to make up for the tax?

Moreover, have we ever had a shortage of sports heros due to tax policy? Is performance of top earners determined by tax policy?

[Min]

This article is not exactly about taxing the rich, but about taxing people with high income. There is a correlation, to be sure, but how about discussing a tax on wealth? For instance, at a flat rate? Since the tax on existing wealth is independent of whether one is working or not, would not the wealthy have an incentive to earn money, if for no other reason than to pay their taxes? In addition, their marginal income tax rate would start at 100% and go down to the wealth tax rate as they earned more money. Wouldn't the effects of such a tax be radically different from those of an income tax?

[Stephen Gordon]

That point came up in the comments to the earlier post. My comment is here.

[Min]

Thanks, Stephen. :)

[Min]

Hmmm. I would still like to know about the different effects of a wealth tax vs. an income tax or a sales tax. Both of those tax economic activity, whereas a wealth tax would seem to encourage it, at least until enough is earned to pay the tax. Isn't that a point in its favor?