Economic output is the result of combining land, labor, and capital into goods and services that people purchase. What policy changes would increase the productivity of those factors and thus allow real incomes or leisure to increase? Let’s examine the factors in order.
The supply of land cannot be increased, but the intensity with which land is used can be. Scholars increasingly agree that zoning regulation prevents those with high school educations who currently do not reside in urban areas from moving to them and increasing their wages. High school graduates in cities with many college graduates make more than college graduates in cities with relatively few college graduates. For example, high school graduates in Boston average $62,000 per year, which is 44 percent more than the $44,000 made by college graduates in Flint, Michigan (Moretti 2014).
Migration to higher-wage cities is now much more difficult than in the past. From 1880 to 1980, incomes across states converged at the rate of 1.8 percent per year. Since 1980, that convergence has stopped. From 1980 to 2010 there has been a large reduction in low-skill migration to those states with a high share of bachelors’ degrees, but no change in high-skill migration to the same states. The explanation is housing supply constraints created by zoning in urban areas (Ganong and Shoag 2013).
The obvious conclusion from this research would be to eliminate zoning or modify it to reduce the effect of neighborhood opposition to more housing (Hills and Schleicher 2011) and allow housing markets to respond with new supply, which would occur whenever the marginal costs of new construction were less than the price of existing housing (Glaeser and Gyourko 2002). But earlier work in urban economics concluded that the funding of local public services through a property tax in the absence of zoning would lead to a never ending cycle of households seeking to pay less in property taxes than the cost of local public services that they consume. From this perspective zoning is a second best policy that converts the property tax into an efficient user fee (Fischel 1985 p. 302). Thus to be efficient and growth promoting, zoning reform also would have to be accompanied by the much more conceptually and politically difficult task of local public service payment reform. And even if that occurred, the economic growth rate would increase only temporarily until all the gains from moving to urban areas had been achieved.
Increasing labor supply would seem to be a good thing but growth in real GDP per labor hour is inversely related to labor supply growth in the U.S. over 20 year time periods since 1839. That is when labor supply growth through immigration or increased female and teenager participation occurs, labor productivity goes down. Rapid growth in real GDP per labor hour in the U.S. has occurred when immigration was severely limited 1930-1965. The slowdown in productivity from 1970-1990 occurred when first teens and women and then illegal immigrants flooded the service sector (Gordon 2004 pp. 25-26).
Increasing labor quality through improved educational outcomes seems to be full of intellectual dead ends (Heckman 2011). For example charter high schools on average have no effects (Cullen et al. 2013, p. 144). But from Fryer (2011, p. 2) we learn that intense specialized charter schools that implement what he refers to as a “no excuses curriculum” erase the black-white achievement gap in math and halve it in reading after four years and implementation of a similar curriculum in Boston eliminated both achievement gaps (Cullen et al. 2013, p. 144). But scaling up such a “Herculean model” may be very difficult because of the limited amount of teaching and principal talent available. For example, to implement the program on a limited basis in Houston public schools required interviewing 200 candidates to hire 9 principals (Cullen et al. 2013, 144-46).
At the college level the problem is the lack of increase in college graduation rates despite a dramatic increase in the premium paid to college graduates relative those with a high school degree. Caroline Hoxby has concluded that high-achieving low-income students can be induced to apply and attend selective colleges through application fee waivers and financial aid. The College Board is implementing her recommendations (Leonhardt 2013). The City University of New York has implemented a program of additional financial aid and individual advising at a cost of $3,900 per student per year to improve the graduation rate at its community colleges. In a random-assignment trial 56 percent of the first two cohorts of more than 1,500 students have graduated, compared with just 23 percent of the control group that received no extra help (Kirp 2014).
If the savings rate increased, future incomes would be higher although each increment of additional savings would have decreasing returns. But additional savings would increase the rate of growth in output only temporarily because the larger capital stock also would depreciate and have to be replaced (Bosworth 1984, pp. 44-46).
Many believe that decreased entitlements would increase the savings rate. The entire growth in the ratio of consumption to GDP between 1988 and 2000 (roughly 2 percentage points) can be explained by increases in medical care expenditures (Lusardi et al. 2001). “Consumption has increased simply because social programs are in fact assumed to be paying for the additional expenditure.” (Guigolin and La Jeunesse 2007, 510)
But Avner Grief (2013, 537) argues that the development of social welfare institutions can promote economic growth by reducing resistance to economic change that enhances productivity at the expense of current jobs. English counties that had more poor relief had more patents and fewer food riots during the period 1650 to 1830. An analogous modern example is the deal that allowed the shift from manual unloading of ships and its associated labor violence to the use of containers that could be simply loaded by large cranes onto rail cars or trucks (Kagan 1990). After 1960 dockworkers ended their resistance to productivity enhancing mechanization in return for higher guaranteed wages. “From 1958 to 1988, longshore wages in West Coast ports more than doubled, increasing 240 percent in constant dollars. But unit labor costs declined by 80 percent-from $16.98 per ton in 1958 (in 1988 dollars) to $3.31 per ton in 1988.” (Kagan 1990, p. 52)
Effect of Taxes on the Supply of Labor and Capital
Surely lower taxes increase economic growth. 1986 tax reform lowered marginal rates quite substantially but also eliminated many deductions. The net effect was revenue neutral. Even though the top marginal rate decreased from 50 percent to 28 percent, economists Joel Slemrod and Alan Auerbach concluded that the policy change altered the composition of national income rather than increase growth. “The aggregate values of labor supply and saving apparently responded very little.” (Auerbach and Slemrod 1997, 627).
What about the effect of higher taxes in Europe? Their effect has been to reduce the labor supply and hours worked but increase the productivity growth of those that remain in the labor force: fewer and more productive jobs. From 1973 to 2000 the annual average growth in real GDP per labor hour was 1.37 percent in the U.S. and 2.4 percent in Europe (Gordon 2004 table 1).
After land, labor, and capital what is left? Economists call what is left multifactor productivity. What is it? Greg Mankiw, commenting on a paper summarizing the growth accounting literature, said, “Long ago, some economist-I believe it was Moses Abramovitz- called multifactor productivity “a measure of our ignorance.” That is, we account for changes in capital, labor, labor quality, and the many other determinants of output we can measure, and the changes in output left unexplained are called “multifactor productivity.” But that is really just giving a fancy name to something about which we are pretty clueless.” (Mankiw 2007, 143). “Statements about multifactor productivity are of limited use for either forecasting or policy analysis. Measured ignorance is probably better than unmeasured ignorance, but it would be a mistake to confuse it for real knowledge.” (Mankiw 2007, 144)
Innovation is a component of our measured ignorance. Is policy optimally encouraging innovation? Burk argues that our system of intellectual property is premised on the belief that the social cost of the market power created by patents is less than the benefits created by the inventions that result. But there is surprisingly little data to support or refute this belief (Burk 2012). Bell and Parchomovsky (2014) propose to end the one-size-fits-all patent monopoly and its accompanying economic distortions (excessively high prices and reduced output) with a menu of options that would charge inventers more for longer patents with greater rights to sue infringers and less for shorter patents and fewer rights. Their basic insight is that we charge too little now for the monopoly rights we grant and thus have too much intellectual property.
The literature is not very supportive of claims that simple changes in policy would improve productivity and real incomes. For every common argument about a simple policy change that would increase the productivity of land, labor, capital, and everything else that matters I have found compelling contrary or at least complicating evidence.
What advice can I offer? Good policy offers sound remedies for those market failures that really exist. And to the extent that government redistributes it needs to think carefully about the incentive effects of guarantees and the rate at which subsidies are reduced as market incomes increase. Of the policies I examined zoning, low-income college student assistance, and patent reform seem to offer the most promising, though limited, gains.
Alan J. Auerbach and Joel Slemrod, “The Economic Effects of the Tax Reform Act of 1986,” Journal of Economic Literature, Volume 35 (June 1997) pp. 589-632.
Abraham Bell and Gideon Parchomovsky, “Reinventing Copyright and Patent,” SSRN no. 2399998 (February 2014).
Barry P. Bosworth, Tax Incentives and Economic Growth (Brookings Institution, 1984)
Dan L. Burk, “Law and Economics of Intellectual Property: In Search of First Principles,” Annual Review of Law and Social Science,Vol. 8 (2012) pp.397-414.
Julie Berry Cullen, Steven D. Levitt, Erin Robertson, and Sally Sadoff, “What Can Be Done to Improve Struggling High Schools?” Journal of Economic Perspectives 27 (Spring 2013) pp. 133-52.
William A. Fischel, The Economics of Zoning Laws (Johns Hopkins University Press, 1985)
Roland G. Fryer, Jr, “Injecting Successful Charter School Strategies Into Traditional Public Schools: A Field Experiment In Houston,” NBER Working Paper no. 17494, October 2011.
Peter Ganong and Daniel Shoag, “Why Has Regional Income Convergence in the U.S. Declined?” SSRN no. 2081216 (March 2013).
Edward Glaeser and Joseph Gyourko, “Zoning’s Steep Price,” Regulation (Fall 2002) pp. 24-30.
Robert J. Gordon, “Two Centuries of Economic Growth: Europe Chasing the American Frontier,” NBER Working Paper no. 10662, August 2004.
Avner Greif and Murat Iyigun, “Social Organizations, Violence, and Modern Growth,” American Economic Review, Volume 103, no. 3 (2013) pp. 534-538.
Massimo Guigolin and Elizabeth A. La Jeunesse, “The Decline in the U.S. Personal Savings Rate: Is It Real and Is It a Puzzle?” Federal Reserve Bank of St. Louis Review, Volume 89 (6) 491-514.
James Heckman, “The American Family in Black and White: A Post-Racial Strategy for Improving Skills to Promote Equality,” NBER Working Paper no.16841, March 2011.
Roderick M. Hills Jr. and David Schleicher, “Balancing the ‘Zoning Budget’ ” Regulation (Fall 2011) pp. 24-32.
Robert A. Kagan, “How Much Does Law Matter - Labor Law, Competition, and Waterfront Labor Relations in Rotterdam and U.S. Ports,” Law & Society Review Volume 24, Number 1 (1990) pp. 35-69.
David L. Kirp, “How to Help College Students Graduate,” New York Times, January 9, 2014 A21.
David Leonhardt, “A Nudge to Poorer Students to Aim High on Colleges,” New York Times September 26, 2013 A20.
Annamaria Lusardi, Jonathan Skinner, and Steven Venti, “Saving Puzzles and Saving Policies in the United States.” Oxford Review of Economic Policy 17 (Spring 2001), pp. 95-115.
N. Gregory Mankiw, “Comments on ‘Explaining a Productive Decade’ ” Brookings Papers on Economic Activity (Spring 2007) pp.81-152.
Enrico Moretti, “Are Cities the New Growth Escalator?” SSRN no. 2439702 (May 2014).
The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.