General Interest

Category: General Interest

The Federal Income Tax is Both Horizontally and Vertically Inequitable

In today’s Economix blog, Bruce Bartlett argues that our Federal income tax burden violates two fundamental economic principles. Although the tax system on average is progressive (in the sense that households in higher income groups pay on average proportionately higher tax rates than those in lower income groups), it violates both horizontal and vertical equity. Horizontal equity requires that people with the same income and circumstances should pay the same tax rate. Vertical equity usually is interpreted to mean that those with greater ability to pay (higher income and all else equal) should pay higher tax rates. As the chart below, taken by Bartlett from the Annual Report of the Council of Economic Advisors Report for 2012, shows numerous inequities exist.

The chart should be read horizontally. For those in the middle quintile (40-60% levels) of income, the average income tax rate ranges from 1.7% to 23.5%. For those in the top 1% bracket, the range is from 8.7% to 34.6%. Clearly horizontal inequity exists within each quintile and vertical inequity exists across quintiles, since many in higher quintiles pay a lower rate than many in lower quartiles.

These results arise because different incomes are taxed differently. Those whose incomes are attributed to labor face higher rates than those whose income can be attributed to capital. This is especially pertinent for investment fund managers who are paid in capital gains rather than salary. Not only do they pay a lower income tax rate than those with the same level of income but they also avoid some payroll taxes assessed against wages and salary income.

Any serious attempt at tax reform should directly confront these inequities not only for “fairness” reasons but because the income tax system provides strong incentives that distort the allocation of labor and human capital toward favored categories, many of which benefited greatly over the past decade.

Man vs. the Machine. Man is Losing

This week many of you are reading Brynjolfsson and McAfee’s book Race Against the Machine. The authors make reference to a September 28, 2011 Wall Street Journal article by Kathleen Madigan entitled “It’s Man vs. Machine and Man is Losing.” Madigan provides the chart below to illustrate the relative growth of equipment and software in comparison with payroll employment since the trough of the recession in June 2009.

As I have previously argued here and here, Madigan notes how the relative price of labor compared to capital is consistent with the pattern shown in the above chart. Again, job creation clearly is quite difficult if the incentives are perverse.

Keynes, Cowen, Brynjolfsson, McAfee & Capitalism

Here’s the update from the reading group.

On the subject of big, fat profits in the financial sector, you might consider visiting some of these pieces. On the subject of big, fat incomes in the financial world, Cowen offers up a simple theory on why so many smart young people go into finance, law, and consulting. Adding fuel to this fire, “Mr. D” sends me this helpful blog post from Ezra Klein, arguing that Ivy Leaguers head to the Street because that’s where they get their “real” education. Do you buy that? And, in a similar vein, “Mr. P” wants to know why Americans don’t elect scientists.

We left off yesterday with the open question of what the best-case scenario is for market economies moving forward. Where are the big productivity gains going to come from? What type of work is to be done? Is manufacturing dead or alive, or does it even matter? (See Professor Finkler’s previous post). Has John Stuart Mill’s concern about the inevitable decline in radical breakthrough inventions finally come home to roost?

And, this opens the door for next week’s book, Brynjolfsson and McAfee’s Race Against The Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy. There are a couple of secondary sources on this, as well, including pieces from The Economist and The Wall Street Journal.

By all rights, this term’s 391 DS reading group should be titled Keynes, Cowen, Brynjolfsson, Backhouse, Bateman, McAfee, and Capitalism, but that doesn’t quite roll of the tongue, does it?

Nor would it fit on your transcript.

Manufacturing Matters or Does It? Two Democratic Former CEA Chairs Battle it Out

In his State of the Union Address, President Obama highlighted the importance of providing special treatment for U.S. manufacturing through tax breaks and other forms of direct support. In a February 4^th op-ed piece in the New York Times, Christina Romer, the first Chair of President Obama’s Council of Economic Advisors (CEA) finds the arguments for such special treatment less than compelling. In response, in a February 10^th New York Times Economix blogposting, Laura D’Andrea Tyson, the Chair of President Clinton’s CEA, makes the case for why manufacturing deserves such support. This blog posting summarizes their arguments. Read the full articles for yourselves and respond by indicating which argument you find more compelling.

Professor Romer makes the following points in arguing that special treatment for manufacturing is unnecessary.

No market failure specific to manufacturing exists.
Innovation takes time to commercialize, thus special treatment makes sense; however, innovation is far from limited to manufacturing.
National defense needs must be met but such needs do not map easily onto manufacturing. The problem, of course, becomes identifying in some objective way which industries (firms?) are essential to the national defense.
Manufacturing industries have not been great job creators, as the share of employment tied to manufacturing has declined markedly in the past 30 years. Technology and rapid productivity growth have led to not only a reduced need for workers but an increased need for more high skilled workers.
Improved income distribution is not well served by a specific focus on job creation in manufacturing. It is better served by direct attention to policies that will raise the skill levels of the population in a way that matches the needed capabilities.

Professor Tyson begs to differ. She highlights the recent increase in manufacturing jobs as well as the need to strengthen U.S. competitiveness in manufacturing. Specifically, she makes the following points:

The U.S. economy needs to be rebalanced towards export production, and manufacturing goods make up 60% of the exports of goods and services.
Manufacturing jobs are highly productive and provide relatively high compensation to workers; thus, we should encourage such job creation as a way to raise the average level of worker compensation.
Manufacturing companies play a key role in innovation. They employ the majority of scientists and engineers in the U.S. and cover 68% of business R & D (research and development) dollars.
Increased manufacturing activity will assist in keeping R & D in the U.S. rather than see it outsourced along with lower skilled employment.

Both Romer and Tyson support extension of the R & D tax credit and efforts to improve the skills of the American workforce. Clearly, they disagree, especially given current and prospective budgetary pressures, how narrowly focused these policies should be. With whom to you agree?

GDP Growth vs. Employment Growth

At last, the level of real GDP has rebounded past its previous peak in the fourth quarter of 2007. Clearly, the trough for employment was both much deeper and trailed that for GDP. In contrast, the recovery for real GDP has been more rapid as well. Financial repression (extremely low interest rates) must be part of the story behind this chart. Clearly, an increased cost of labor relative to capital induced a capital intensive recovery.

Low Interest Rates: the Addictive Policy Drug of Choice

Satyajit Das, in today’s Financial Times, argues that low interest rates generate a variety of economic distortions that expand rather than address structural problems in economies (whether those of the U.S., Europe, or elsewhere.) These effects are especially pernicious when real interest rates (that is market interest rates minus the expected inflation rate) are negative. He provides a laundry list of “side effects” to this economic drug of choice.

1. Encourages the substitution of capital for labor. Is it any surprise that employment has been slow to respond eventhough GDP is now higher than it was at the beginning of the last recession?

2. Encourage the substitution of debt for equity funding

3. Discourage savings, especially when real rates are negative. Of course, if households have a particular wealth target, low rates could induce additional savings.

4. Create a funding gap for defined benefit pension plans (which means either reduced benefits or attempts to increase returns through more risky financing)

5. Feed asset price inflation through the purchase of risky assets (related to point 4)

6. Reduce the cost of holding money (which inhibits the flow of capital to worthwhile activities)

7. Allow banks to borrow cheaply (from depositors) and achieve their income targets through purchase of governmental securities rather than through lending to the private sector

8. Distort currency values as deviations in interest rates across countries is one of the drivers of short term capital flows

9. Induce a reliance on low interest rates to continuously fuel aggregate demand

For the most part, those who argue for extended periods of low interest rates believe that aggregate demand drives aggregate output. They tend to underplay the importance of structural change in the economy (such as labor market, regulatory, or tax policy reform); such change cannot be addressed by replacing depressed elements of aggregate demand with policy induced aggregate spending. The day of reckoning is just extended, not cancelled. Just ask the Europeans.

The Informant

U.S. Exports. Where is U.S. Comparative Advantage?

Some of you might answer industrial machines. Not a bad answer. That’s #3 at $37B for the first 11 months of 2011. Others might answer civilian aircraft. Again, this has been a traditionally strong export industry. Guess what, it comes in at #10 with $27B for the first 11 months on 2011. How about engines for civilian aircraft? #15 on the list at $21.6B. The correct answer, believe it or not is petroleum products at $87.5B, more than twice the amount for #2, pharmaceutical preparations.

As the Bureau of Economic Analysis puts it:

Fuel exports, worth an estimated $88 billion in 2011, have surged for two reasons:

1. Crude oil, the raw material from which gasoline and other refined products are made, is a lot more expensive. Oil prices averaged $95 a barrel in 2011, while gasoline averaged $3.52 a gallon — a record. A decade ago oil averaged $26 a barrel, while gasoline averaged $1.44 a gallon.

2. The volume of fuel exports is rising. The U.S. is using less fuel because of a weak economy and more efficient cars and trucks. That allows refiners to sell more fuel to rapidly growing economies in Latin America, for example. In 2011, U.S. refiners exported 117 million gallons per day of gasoline, diesel, jet fuel and other petroleum products, up from 40 million gallons per day a decade earlier.”

The United States has become a net exporter of fuel for the first time since 1949.

Top 15 U.S. Exports, January-November 2011

Rank	Export Category	Jan.-Nov. 2011 (millions)
1	Petroleum products	$87,543
2	Pharmaceutical preparations	$37,547
3	Industrial machines, other	$37,456
4	Semiconductors	$36,898
5	Chemicals-organic	$32,514
6	Plastic materials	$30,219
7	Telecommunications equipment	$29,885
8	Electric apparatus	$29,147
9	Nonmonetary gold	$27,821
10	Civilian aircraft	$27,179
11	Medicinal equipment	$26,591
12	Computer accessories	$26,520
13	Chemicals-other	$24,150
14	Industrial engines	$23,246
15	Engines-civilian aircraft	$21,648

Even Some Keynesian Economists Appreciate Milton Friedman

Brad DeLong, UC Berkeley economist and ardent Keynesian, wrote an obituary for Milton Friedman when he died in 2006. DeLong requires that his introductory economics students read Free to Choose, authored by Friedman and his wife Rose. Why does ardent Keynesian DeLong impose this burden on this students? Here’s his answer based on a statement made by John Stuart Mill:

“Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength.”

For every left-of-center American economist in the second half of the twentieth century, Milton Friedman (1912-2006) was the incarnate answer to John Stuart Mill’s prayer. His wits were smart, his perceptions acute, his arguments strong, his reasoning powers clear, coherent, and terrifyingly quick. You tangled with him at your peril. And you left not necessarily convinced, but well aware of the weak points in your own argument.

He concludes his piece with the following point.

For right-of-center American libertarian economists, Milton Friedman was a powerful leader. For left-of-center American liberal economists, Milton Friedman was an enlightened adversary. We are all the stronger for his work. We will miss him.

I encourage you to read the entire obituary. It’s worth your time.

“Made in China.” What Does It Mean?

The U.S. has been running large trade deficits with China. Many view this result as arising from the excessive purchase of goods that carry the “Made in China” label. Hale and Hobijn, in a recent Federal Reserve Bank of San Francisco Economic Letter, provide evidence to the contrary. They use data from several U.S. governmental sources to answer three questions:

What portion of U.S. consumer spending comes from goods labeled “Made in China” and what portion from goods “Made in the U.S.”?
What part of the cost of goods labeled “Made in China” comes from valued added in China in contrast with what portion arises from valued added by U.S. economic activity?
What part of U.S. consumer spending comes from direct purchases of goods imported from China or from intermediate inputs that came from China?

Their answers are as follows:

2.7% of U.S. personal consumption expenditures come from goods labeled “Made in China” and 88.5% come from goods “Made in the U.S.”
Of the 2.7% noted above, approximately 1.2% reflects the direct cost of imported goods. in other words, 55.6% of goods labeled “Made in China” can be attributed to services added in the U.S.
The total imported content of personal consumption expenditures that comes from goods and services imported from China equals 1.9% of which 0.7% can be attributed to intermediate inputs from China.

Given these results, why is it the common perception that a much larger portion of goods consumed in the U.S. come from China. The answer can be inferred from Table 1 in the report, which indicates that 35.6% of clothing and shoe expenditures bear the label “Made in China” and 20.0% of furniture and household equipment bear the same level. These two categories, however, only account for 3.4% and 4.7%, respectively, of U.S. personal consumption expenditures.

These data suggest that our concern with the purchase of imports from China is overblown and that a tariff on Chinese goods will have modest, if any, effect on aggregate U.S. personal consumption.

Our Macroeconomic Future: A Chaos Theory for Investors.

Neel Kashkari, managing director and head of global equities for PIMCO, has recently posited an array of possible scenarios for America and Europe and employs a simplified version of chaos theory to sort through the results. Kashkari was Secretary of Treasury Hank Paulson’s assistant; he worked directly with implementing the Troubled Asset Relief Program (TARP.) He plays a significant role in Andrew Ross Sorkin’s book Too Big to Fail. The movie, starring William Hurt, does a nice job reflecting the book.

Western economies (mostly governments and households) have loaded themselves with debt that under most scenarios is not sustainable. Kashkari indicates the following five options policy makers have as well as the potential consequences for investors. Check out his analysis.
1. Austerity and deflation
2. Explicit default
3. Mild inflation
4. Runaway inflation
5. Miraculous growth

Which scenario do you think is most plausible? Least plausible? Do your answers differ for the U.S., Europe, and Japan? Why or why not?

Is Capitalism Sustainable?

During the winter term, we will focus on visions of the world economy and the role of economics. The Backhouse and Bateman book puts these topics in sharp relief. This discussion continues questions raised by Schumpeter, Hayek, Keynes and many others. In a recent Project Syndicate article, Kenneth Rogoff, co-author of This Time is Different, argues that some version of capitalism will continue to exist because there are few viable alternatives. Furthermore, he argues that European welfare state versions and the Chinese authoritarian version have yet to prove their sustainability. Of course, the contemporary version of capitalism will need to make some serious adjustments to be sustainable. Rogoff posits the following:

In principle, none of capitalism’s problems is insurmountable, and economists have offered a variety of market-based solutions. A high global price for carbon would induce firms and individuals to internalize the cost of their polluting activities. Tax systems can be designed to provide a greater measure of redistribution of income without necessarily involving crippling distortions, by minimizing non-transparent tax expenditures and keeping marginal rates low. Effective pricing of health care, including the pricing of waiting times, could encourage a better balance between equality and efficiency. Financial systems could be better regulated, with stricter attention to excessive accumulations of debt.

“Economics is what economists do”

As I was preparing for Econ 100 for next term, I came across a piece by Roger Backhouse and Steven Medema on the definition of economics. Or, to put it more bluntly, what exactly is economics anyway?

Backhouse and Medema run through a bunch of textbook descriptions of what dismal scientists spend their time thinking about, and offer up a few choice quotes. The first candidate is from the indefatigable Paul Krugman and Robin Wells from their intro textbook: “Economics is the study of economies, at both the level of individuals and of society as a whole.”

That seems pretty accurate, but I don’t think economics is nearly as exciting as they make it sound. ;-)

Here’s another from David Colander, a man who knows a thing or two about The Making of an Economist. He says “Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.”

Coordination, indeed. For us market types, scarce resources are generated and distributed via market forces (e.g., prices), and there are all sorts of “agents” running around maximizing this and that — utility, profit, market share, Facebook friends, etc…

Harvard’s Greg Mankiw simply says “Economics is the study of how society manages its scarce resources.” Pithy, to the point, possibly accurate, and consistent with what Robert Heilbronner tells us in The Worldly Philosophers. More on that later.

Or perhaps try the more pro-market friendly Gwartney and Stroup et al.: “[E]conomics is the study of human behavior, with a particular focus on human decision making.”

Couldn’t that describe psychology?

Scarcity, choices, allocation, behavior, decision making — not exactly narrowing down our subject here, are we?

So, for the punch line, here is the classic Jacob Viner quip, “Economics is what economists do.”

That’s it!

Thanks to Mr. T for the tip. You can read the full piece here.

And here is the citation: Roger E. Backhouse and Steven G. Medema. 2009. “Retrospectives: On the Definition of Economics.” Journal of Economic Perspectives, 23(1): 221–33.

Backhouse, by the way, is one of the co-authors of our ECON DS-391 and Econ 601 books. So we’ll be hearing more from him in the coming weeks.

See Euro Future

Here’s Charlie Calomiris from back in 1999, predicting a bad end to the Euro.

I predict that the euro will be a weak currency (one that will not retain its value against the dollar), and that it will not be a permanent currency. Ultimately, the euro will most likely be remembered neither as a textbook example of the social gains of properly defining the optimal currency area nor as the harbinger of global exchange rate stability, but rather as an illustration of the importance of fiscal discipline for monetary credibility, and as a monetary example of the tragedy of the commons.

European union will likely strengthen the attraction of the dollar as a numeraire and a store of value. Countries outside of Europe will continue to peg their exchange rates to the dollar. And when the European Monetary Union ultimately collapses, it will itself provide a positive shock to the real dollar exchange rate that will hurt countries that have pegged to the dollar. All of this is unfortunate from the standpoint of global macroeconomic stability—an example of how political constraints that limit rational policy and encourage public profligacy make the global economy less stable than it otherwise would be.

I picked that up from Marginal Revolution, where Tyler Cowen points out that economists from Paul Krugman to Milton Friedman were pessimistic on the long-term prospects.

Here’s Freidman:

I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them. Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time.

If we look back at recent history, they’ve tried in the past to have rigid exchange rates, and each time it has broken down. 1992, 1993, you had the crises. Before that, Europe had the snake, and then it broke down into something else. So the verdict isn’t in on the euro. It’s only a year old. Give
it time to develop its troubles.

The snake?

At any rate, Cowen’s point is that economists may have whiffed the financial collapse, but they seemed to hit the ball on the Euro.

Johnson on Stigler on Regulation

Simon Johnson is the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, which we wrote about here. This week, Russ Roberts interviews Johnson on EconTalk, and a summary of the interview. Here’s a taste:

On Regulatory Capture: Prof. Johnson says he is a follower of George Stigler, who made the point that when you regulate industry, industry will attempt to capture the regulators. Bankers are able to capture the regulation and get themselves huge commissions to take on risk. We witnessed one of the most sophisticated episodes of regulatory capture in the history of humankind.

On who benefitted: The benefit of this kind of rent-seeking accrues to executives in the bank – and not to shareholders.

Interesting point, that we also brought up here.

Economics Department Read, Winter 2012

We have been sponsoring a reading group (DS-391) in the economics department over the past four terms, and we will continue that with two books during the winter term. If you have some spare time in the next five weeks, you might try getting a jump on these.

The first is Roger Backhouse and Brad Bateman’s Capitalist Revolutionary: John Maynard Keynes. The authors’ names might sound familiar from a couple of posts ago where I briefly discuss their op-ed in the New York Times about the need for economist as “worldly philosopher” rather than “dentists” (Keynes’ term) honing in on the intricacies of the little picture. Indeed, the book portrays Keynes both as a deep thinker and an accomplished technical theorist.

The second is Tyler Cowen’s brief yet epic e-book, The Great Stagnation: How America Ate All The Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better. This is one of the most thoroughly reviewed pieces I have ever seen, with scholars and bloggers and otherwise lining up to weigh in. There is plenty to talk about with this one.

Both books should be accessible to economics students at any level.

The Economics of Black Friday

Is Black Friday a day to give thanks for low prices, or a symbol of the gross excesses of retail capitalism? Robert Frank discusses:

In recent years, large retail chains have been competing to be the first to open their doors on Black Friday. The race is driven by the theory that stores with the earliest start time capture the most buyers and make the most sales. For many years, stores opened at a reasonable hour. Then, some started opening at 5 a.m., prompting complaints from employees about having to go to sleep early on Thanksgiving and miss out on time with their families. But retailers ignored those complaints, because their earlier start time proved so successful in luring customers away from rival outlets.

Frank is in the “race to the bottom” crowd, and while even if the bottom is economically “efficient,” it seems to me that he would disagree with the distributional implications — low-income wage earners being exploited, crass consumerism running amok, dogs and cats living together, etc…

Champion of commercial culture, Tyler Cowen, counters:

This is portrayed as a zero-sum or negative-sum game, but I view the matter, at least in efficiency terms, more optimistically. The alternative to waiting in line and fighting the crush is to go shopping some other day, hardly a terrible fate. More analytically speaking, the average return in other endeavors limits how bad these rent-seeking games can get, otherwise just switch and stay home and read your blogs, as some of you perhaps are doing right now.

In fact it seems that early December has in general the cheapest prices of the year, not Black Friday.

Dare I suggest that some people like waiting in those lines with their thermos cups and stale bagels. You could try to argue they are “forced to do so,” to get the bargains, but in a reasonably competitive world each outlet will (roughly) try to maximize the consumer surplus from visiting the store, including the experience of waiting in line.

Whole thing here.

Contrary to popular belief, black Friday is not the day I turn in my grades. But now that the term is over, we will have some time to do some blogging!

The Cartoon Road to Serfdom

Speaking of The Road to Serfdom, here is a handy link to the Mises Institute’s reprint of the “cartoon” guide to the Hayek classic.

Over the past four terms, we have focused on books that focus on the dynamics of the capitalist system. We started with Schumpeter’s biography and followed that up with Capitalism, Socialism, and Democracy. These really gave us a 10,000-foot view of where Schumpeter thought the system might head coming out of World War II. Schumpter seems sanguine about the “inevitability” of socialism, while Hayek gives us a much different, quite chilling vision of the meshing of politics and the economic system. Certainly, I would attribute part of this to Schumpeter and Hayek’s respective views of the importance of the price system — Schumpeter asserting that it is overplayed, whereas Hayek underscores its importance.

Next term, we will continue to sponsor an economics read, though our focus will likely shift to the future of the system coming out of the current crisis. I will be posting those books shortly in the event that you want to get a head start over break.

Early Holiday Book Recs

Ah, Winter Break is almost upon us, which means that it is almost time to get to my pile of books. I’m not sure what came over me, but I just went out and bought a whole bunch more that I can’t possibly get to.

Here’s the latest in the queue:

Roger E. Backhouse and Bradley W. Bateman Capitalist Revolutionary: John Maynard Keynes. I picked this one up after reading this New York Times piece where the authors argue that contemporary economists are lacking in the “worldly philosophers” department (see also the previous post).

Douglas W. Allen The Institutional Revolution: Measurement and the Economic Emergence of the Modern World. A perfect little something for the New Institutionalist that has everything. Allen is an expert on transaction cost economics, co-author of some great work on agriculture contracts, and one of the funnier economists you are likely to ever meet. I will bet dollars to donuts that the book contains at least one example that you’ll be dropping at your next mixer (From the publisher: “Allen provides readers with a fascinating explanation of the critical roles played by seemingly bizarre institutions, from dueling to the purchase of one’s rank in the British Army”). It says available December 1, but I got my copy in the mail today.

Eugene Fitzgerald, Andreas Wankerl, and Carl Schramm. Inside Real Innovation: How the Right Approach Can Move Ideas from R&D to Market – And Get the Economy Moving. Schramm is from Kauffman, one of our recent visitors to the innovation class touted this as a must read, and I hear rumors that this will rear its head in Econ 405 next term. A convincing trifecta!

Michael Lewis Boomerang: Travels in the New Third World. If you read this blog semi-regularly, you’ve probably seen something about Lewis’ new compilation of economic disaster tourism writing. I was going to recommend this as an e-book, but it has an unusually awesome dust jacket. Great for the plane.

Gretchen Morgenson and Joshua Rosner Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. This was on my wish list and I no longer remember who tipped me off to it. Looks great, if a bit thick.

I have some course-related pieces that probably aren’t such fab holiday gift ideas, but I will get to them as I get to them.

Enjoy!

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