Tag: inequality

A Different Look at After-Tax Income Inequality

Every presidential candidate promises to “reduce income inequality” by raising tax rates on the rich and increasing transfer payments (including tax credits and in-kind benefits) for the middle class.  Yet the widely-used flawed data from Thomas Piketty and Emmanuel Saez exclude both taxes and transfers.  Income measures that exclude taxes and transfers cannot tell us whether taxes or transfers are high or low, and cannot be directly affected by higher taxes on some or higher transfers to others (because such policies are ignored in the data).

A simple table adapted from the 2017 Consumer Expenditure Survey, from the Bureau of Labor Statistics, may be sufficient to show how crucial it is to take account of taxes (including refundable tax credits), and also to adjust average income for the different number of people and workers per household.

After Tax Income by Quintile

Incomes are shown by fifths (“quintiles”), with the lowest 20% on the left and highest on the right.

The second row shows the “lower limit” of pretax income needed to counted be in each quintile.   The next two rows show mean (average) income before and after taxes.  

The column at the far right shows a ratio of highest to lowest income, called the 80/20 ratio, which a common gauge of inequality.    It shows that the highest 20% earned 16.5 times as much as the lowest 20% before taxes, but only 12.5 times as much after taxes.  

But simply adjusting household income for taxes is not enough.  Average incomes cannot be properly compared between the highest and lowest quintiles because there are three times as many people per consumer unit (household) in the highest 20% as there are in the lowest.   And there are four times as many workers in the highest 20% as there are in the lowest.

By adjusting for different household size, we find the highest 20% earned only 6.5 times as much after-tax income per person as the lowest 20%.  

But income is likely to be higher in households with two or more workers than it is in households with no workers or only one.  So, that last row measures average after-tax income per worker in the highest and lowest quintiles (and those in between).

By further adjusting for the different number of earners, the highest 20% earned only 3 times per worker as much as the lowest 20%, after taxes.   

Properly understood, the facts about U.S. after-tax income distribution and growth are insufficiently alarming to justify the political misuse of questionable pretax, pretransfer income statistics as a false argument for redistributing after-tax income.

Punitive Marginal Tax Rates and A Partial Appeal to The Economics Literature

Alexandria Ocasio-Cortez hit headlines last week for advocating marginal income tax rates “as high as 60% or 70%” on those earning $10 million plus per year. Under her plan, revenues from such a policy would be put towards funding a “Green New Deal.”

Matt Yglesias, Paul Krugman and Noah Smith were quick out of the blocks to defend the idea of massive marginal tax hikes on high earners as simply sensible, mainstream economics. They appealed to the work of economists Peter Diamond, Emmanuel Saez, Thomas Piketty and others, who have set out the case for very high marginal tax rates on top incomes in academic journals over the last two decades.

These economists have indeed recommended the optimal marginal tax rate for the top 1% of income earners in the U.S. should be a combined (federal, state and local taxes) rate of 73 percent or higher – designed with the aim of maximizing revenue from top taxpayers.

But their recommendation is not analogous to jacking up marginal federal income tax rates on very high earners in our current code. Furthermore, their result depends on highly contentious philosophical positions and economic assumptions.

Labor’s Share of GDP: Wrong Answers to a Wrong Question

A recent paper by David Autor of MIT, Lawrence Katz of Harvard and others, “The Fall of the Labor Share and the Rise of Superstar Firms,” begins by posing a mystery: “The fall of labor’s share of GDP in the United States and many other countries in recent decades is well documented but its causes remain uncertain.”  They construct a model to blame it on U.S. businesses that are too successful with consumers.  

Five broad industries, they found, became more dominated by fewer firms between 1982 and 2012: retailing, finance, wholesaling, manufacturing and services. But those aren’t industries at all, much less relevant markets: they’re gigantic, diverse sectors. Is all manufacturing becoming monopolized? Really? Census data ignores imports, but why ruin this bad story with good facts.

Noah Smith at Bloomberg ran an audacious headline about this tenuous paper: “Monopolies drive down labor’s share of GDP.” Smith writes that, “The division of the economy into labor and capital is one place where Karl Marx has left an enduring legacy on the economics profession.” He goes on to claim that “at least since 2000 – and possibly since the 1970s – capital has been taking steadily more of the pie.” Yet, Jason Furman and Peter Orszag found “the decline in the labor share of income is not due to an increase in the share of income going to productive capital—which has largely been stable—but instead is due to the increased share of income going to housing capital.” Depreciation and government, they noted, also gained an increased share (i.e., grew faster than labor income.) 

President Obama’s Council of Economic Advisers, under Jason Furman, nonetheless worried that the 50 [!] largest firms in just 10 “industries” (if you can imagine retailing and real estate to be industries) had a larger share of sales in 2012 than in 1997 (using Census data that excludes imports). They concluded that, “many industries may be becoming more concentrated.” Noah Smith, Paul Krugman and many others have suggested that this nebulous “concentration” allowed monopoly profits to rise at the expense of the working class, supposedly explaining labor’s falling share of GDP during the high-tech boom. A quixotic search for even one actual example of monopoly soon morphed into advice about using unconstrained antitrust to constrain Amazon, which is apparently feared to have monopoly profits invisible to the rest of us.  

Research that starts with such a meaningless question as “labor’s share of GDP” was never likely to lead us to any profound answers. Workers do not receive shares of GDP – they receive shares of personal or household income.   

Contrary to popular confusion, dividing employee compensation (wages and benefits) by GDP does not measure how a capitalist private economy (e.g., “superstar firms”) divides income between labor and capital. Most obviously, the government makes up a huge share of GDP, including nonmarket goods like defense and public schools. Nonprofits also account for a lot of GDP, with no obvious payout to labor or capital. Less obviously, depreciation makes up another huge share of GDP, including wear and tear on public highways and bridges as well as private equipment, homes, and buildings. The “imputed rent on owner-occupied homes” is another large piece of GDP. Asking if labor is getting a fair share of defense, depreciation and imputed rent is a truly foolish question. Net private factor income would be a better gauge than GDP, for the purpose at hand, but still flawed.  

The ratio of compensation to GDP uses the wrong numerator as well as an untenable denominator. Labor income must add the labor of self-employed proprietors.

When people say “labor’s share is falling,” they surely mean income people receive from work has not kept up with income people (often the same people) receive from property: dividends, interest, and rent. But, that crude Piketty-Marx labor/capital dichotomy ignores another increasingly important source of personal income: namely, government transfer payments from taxpayers to those entitled to cash and in-kind benefits.  

Shares of Personal Income

The first graph shows shares of income from labor, property, and transfers. The property share peaked at 21.1% in 1984-85, as the Fed kept interest rates very high, but averaged 19.3% and was 19.4% in 2016 (after dropping to 17.8% in 2009).  The labor share averaged 66.5% but was 63.3% in 2016 even though property owners’ share was virtually flat. What went up? Transfer payments. Transfers rose from 11.7% of personal income in 1988 to 17.4% in 2016. Personal income that has been growing persistently faster than income from work has not been income from property (since the 1980s), but income from Social Security, Disability, Medicare, Medicaid, EITC, TANF, SNAP, SSI, UI, and so on.

Some might object that personal income leaves out retained corporate profits. But profits not paid out as dividends add to people’s income only if they are reinvested wisely enough to lift the value of the firm and thus generate capital gains. Personal income excludes capital gains because national income statistics measure flows of income from current production, not asset sales. That is also true of GDP, adding another reason to discard GDP as the basis of comparison.

However, Congressional Budget Office reports on the distribution of income do include realized capital gains when assets are sold (turning wealth into income). 

CBO Shares of Household Income

The second graph shows that labor’s share of household income is highest in deep recessions (77.5% in 1982, 76.2% in 2009) and lowest at cyclical peaks (70.6% in 2000, 68.3% in 2007). The higher labor share in recessions does not mean recessions are good for workers, of course, but that they are even worse for business and investors. Those who equate a higher labor share of income (e.g., during recessions) with higher real income for workers are making a basic and very large mistake. 

Capital income was highest in the early 1980s because the Federal Reserve kept interest rates very high, and capital income (dividends, interest, and rent) has shown no upward trend since then. Dividends and rent are up, but interest income is down.

Capital gains rose at specific times, but there has been no upward trend. There was a spike in capital gains in 1986 because the tax on gains jumped to 28% the following year. Realized gains also rose for four years after the capital gains tax was brought back down to 20% in 1997, and again after the capital gains tax was cut to 15% in mid-2003.

The white space at the top is important because it increases by four percentage points from 1990 (15.3%) to 2016 (20.3%) while labor’s share fell by 2.5 percentage points (from 75% to 72.5%). That white space is transfer payments: income from neither labor or capital. As the first graph showed, labor’s somewhat smaller share of income is not because of any sustained rise of capital income or capital gains. It is because of a sustained rise in the share of income from transfer payments and a sustained fall in the labor force participation rate.

Meanwhile, household income from owning a closely-held private business doubled since 1986: from 4% of household income in 1986 to 8% in 2013. That reflects the well-known shift of income from corporate to “pass-through” entities after 1986 as the top individual tax rate became even lower than the corporate tax rate (1988-92) or about the same dropped to the same as the corporate rate (35% 2003-2012)) or lower. That did not mean that “business” grabbed a bigger share at the expense of “labor,” but that a larger share of business income shifted from corporate to personal data.

The frequently repeated angst about “the fall of labor’s share of GDP in the United States” is based on a serious yet elementary misunderstanding of both labor income and GDP. “Labor’s share of GDP” is fundamentally nonsensical, because so much of GDP (depreciation, defense, etc.) could not possibly be paid to workers, and because the measure of labor income is too narrow (excluding the self-employed). 

Labor’s share of the CBO’s broadly-defined household income also fell (unevenly) because the share devoted to transfers rose, but also because the share moved from corporate to household accounts (and individual tax returns) also rose. Business income counted within CBO’s household income has increased its share of such income since the Tax Reform Act of 1986, but that just reflects a change in organizational form from C-Corporation to pass-through status.

Labor’s share of personal income fell mainly because the share devoted to government transfer payments rose. Labor’s share of GDP fell for other reasons (rising shares going to housing, government, and depreciation), but it is a fundamentally misconstrued statistic used to rationalize irresponsible remedies to an illusory problem of “monopolies.”

 

 

The Curse of Motivated Reasoning against Econ 101

Earlier this month, James Kwak penned an extensive critique for The Atlantic of the Econ 101 view that government-imposed minimum wage rates lead to job losses. There is a lot of muddled thinking in the article, not least that it constantly conflates poverty and inequality. But for the sake of brevity, here are 9 observations:

  1. The theoretical and empirical literature does suggest the minimum wage question is more complex than first imagined, and it should not surprise us that reality lies somewhere between the perfectly competitive model of the labor market and the monopsonistic one, depending on the time and sector analyzed.
  2. However, the bulk of the detailed empirical literature still supports Econ 101’s prediction that raising wages by government dictat reduces labor demand, particularly for certain groups (the young and lowest skilled). Of course, the “bite” of the minimum wage is significant. That an increase from $7.25 to $8 may not have a large effect on the labor market does not mean that a rise to $15 wouldn’t have a much bigger effect.
  3. Reductions in labor demand need not mean higher unemployment per se (and so tracking time series of unemployment against minimum wage rates is unhelpful.) It may affect hours offered, lower the quality of jobs as firms cut back on financing training, or lead to cuts to other employee benefits. More recent evidence also stresses the dynamism of the labor market – minimum wage hikes may not manifest themselves through immediate job cuts (not least because of redundancy costs and stickiness of contracts/orders), but can lower the propensity to hire in future and hence slow job growth.

Oxfam Counts Highly Paid Millennials with Student Debt Among the World’s Neediest

Every year, Oxfam releases a report meant to shock the public about the extent of income and wealth inequality. This year’s report claims that the eight richest people on Earth have as much wealth as the bottom half of the world’s population (3.6 out of 7.2 billion people). That’s certainly shocking. It’s also profoundly misleading. 

As others have pointed out, Oxfam reached that number with a questionable methodology, which also led them to several other absurd conclusions. According to their own graphs, more poor people live in North America and Europe than China (see the far left of the chart below). How can that be, given that traditional poverty measures show the opposite

Oxfam isn’t using a traditional poverty measure (such as the number of people with a purchasing-power-adjusted income of less than, say, $2 per day). Instead, they focus on something called “net wealth.” This is the sum of an individual’s wealth minus any debts. 

Of course, many people in rich countries carry debt due to university loans or a home mortgage, yet also enjoy high incomes and an enviable standard of living. 

Here are some illustrations of just how absurd it is to use net wealth as a measure of poverty. 

Consider this. Oxfam claims a penniless, starving man in rural Asia or Sub-Saharan Africa is far richer than an American university graduate with student debt but a high-paying office job, a $2,000 laptop and a penchant for drinking $8 designer coffees. 

Let that sink in. 

(I must credit Cato’s Adam Bates for that example). 

Here is another example, courtesy of Johan Norberg. He points out that his daughter, a child with only about twenty dollars in her piggy bank, is richer than 2 billion people by Oxfam’s logic. If that were true, then the solution would surely not be to take away the humble savings of his daughter and redistribute them among those 2 billion souls, but rather to generate more total wealth, “enlarging the pie” so to speak. 

That’s the core problem with obsessing over “inequality.” If the goal is to further human wellbeing, then instead of decreasing inequality through redistribution, we should focus on decreasing poverty by creating ever more wealth. Happily, thanks to the wealth-creating power of market exchange, we’re doing just that. The trend lines all show that poverty (by any reasonable measure) is in retreat.

Capitalism, Global Trade, and the Reduction in Poverty and Inequality

Drawing on a new World Bank study, Washington Post columnist Charles Lane today notesa vast reduction in poverty and income inequality worldwide over the past quarter-century” – despite what you might think if you listen to Pope Francis, Bernie Sanders, and other voices prominent in the media.

Specifically, the world’s Gini coefficient — the most commonly used measure of income distribution — has fallen from 0.69 in 1988 to 0.63 in 2011. (A higher Gini coefficient connotes greater inequality, up to a maximum of 1.0.)

That may seem modest until you consider that the estimate’s author, former World Bank economist Branko Milanovic, thinks we may be witnessing the first period of declining global inequality since the Industrial Revolution.

Note that this hopeful figure applies to the world’s population as though every individual lived in one big country. When Milanovic assessed the distribution of income between nations, adjusted for population, the improvement was even more striking: a decline in the Gini coefficient from 0.60 in 1988 to 0.48 in 2014.

The global middle class expanded, as real income went up between 70 percent and 80 percent for those around the world who were already earning at or near the global median, including some 200 million Chinese, 90 million Indians and 30 million people each in Indonesia, Egypt and Brazil.

Those in the bottom third of the global income distribution registered real income gains between 40 percent and 70 percent, Milanovic reports. The share of the world’s population living on $1.25 or less per day — what the World Bank defines as “absolute poverty” — fell from 44 percent to 23 percent.

So maybe this is a result of all the agitation on behalf of a more moral or planned economy? No, says Lane, citing Milanovic:

Did this historic progress, with its overwhelmingly beneficial consequences for millions of the world’s humblest inhabitants, occur because everyone finally adopted “democratic socialism”? Was it due to a conscious, organized effort to construct a “moral economy” as per Vatican standards?

To the contrary: The big story after 1988 is the collapse of communism and the spread of market institutions, albeit imperfect ones, to India, China and Latin America. This was a process mightily abetted by freer flows of international trade and private capital, which were, in turn, promoted by a bipartisan succession of U.S. presidents and Congresses.

The extension of capitalism fueled economic growth, which Milanovic correctly calls “the most powerful tool for reducing global poverty and inequality.”

This is the good news about the world today. Indeed, it’s the most important news about our world. We hear so much about poverty, inequality, gaps, resource depletion, and the like, it’s a wonder any NPR listeners can bear to get out of bed in the morning. But as the economic historian Deirdre McCloskey says, this is the “Great Fact,” the most important fact about our world today – the enormous and unprecedented growth in living standards that began in the western world around 1700. She calls it “a factor of sixteen”: we moderns consume at least 16 times the food, clothing, housing, and education that our ancestors did in London in the 18th century. And this vast increase in wealth that began in northwestern Europe, mostly Britain and the Netherlands, has now spread to most of Europe, the United States, Japan, and increasingly to the rest of the world.

2016: the “Year of the 1%” or the Year Poverty Fell to a New Low?

This past weekend, The Economist uploaded and shared a short video to its Facebook page called, “The year of the 1 percent.” The video shows a graph superimposed over the Earth seen from space, while a voice narrates, “2016 is set to be a more unequal world than ever before. For the first time, the richest 1 percent of the population will enjoy a greater share of global wealth than the other 99 percent.” The video has been viewed more than one hundred thousand times.

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