Can Anyone Spare $150 billion?

The trade-off between equality and efficiency mentioned in Sargent’s 2007 Berkelee commencement address generated a surprising amount of commentary online (surprising to me anyway). Much of the online posts were directed at dispelling the existence of this trade-off.  Matt Yglesias described it as “one of the big myths of our time.” Noah Smith argued that there might be important opportunities to improve equality and efficiency. Several other commenters pointed out that nations with relatively high per capita GDP have relatively more equal income distributions and so on.

Instead of arguing these points one by one (and yes, they’re basically all either wrong or practically wrong), I thought that perhaps it would be more constructive to present a realistic policy option that might actually make an impact on income inequality in the U.S.  I want to make clear at the outset that I am not necessarily endorsing this policy.  I’m just presenting it as a device to make the trade-offs and policy options clear.

Before I begin, let me mention a few facts so we can appreciate the issue a bit.

The U.S. labor force is roughly 156 million people and the U.S. population is 314 million people.

U.S. Gross Domestic Product (GDP) is currently roughly $17.15 trillion though it should probably be higher. As most of you know, GDP is total annual income.  If we divide by the population we get income per person or GDP per capita.  U.S. per capita GDP is approximately $54,600.  (If you didn’t know about the extent of income inequality in the U.S., for a family of four people you might expect a yearly pre-tax income of almost $220,000).  Typical household income is nowhere close to this however. Median household income is only $52,000.  (The median household is the household that would be exactly in the middle if I lined up all households from lowest income to highest income.)  The reason for this discrepancy is that there are a small number of extremely wealthy households who get enormous incomes.  To be fair, there are many households with only one person (singles) and this is comforting to an extent.  Don’t fool yourself though.  There are many, many households with 4, 5 or more people who take home a combined income that is well below $50,000 per year.

The minimum wage law under consideration (increasing the minimum wage from $7.25 to $10.10) would provide a transfer of $6,240 for every full time worker earning the current Federal minimum.  Unfortunately, if you earn $10.10 or more, you won’t get anything from the minimum wage.  If workers were evenly distributed between $7.25 and $10.10 then the average transfer would be $3,120.  That still sounds like a lot, however there are only about 4 million workers (about 2 percent of the labor force) currently at or below the Federal minimum wage. Also, many of these people are teenagers working part-time and living in middle class households.  Compare a teenager who works a minimum wage job flipping burgers with a worker who supports a family but earns $11.00 an hour as a waiter.  The minimum wage will transfer money to the teenager even if she lives in a family that is fairly well off.  The policy does nothing for the other worker.  How many examples like this are there?  Lots. About 30 percent of all workers earning the minimum wage are teenagers.

Suppose we wanted a policy that helped out a greater number of lower income Americans.  Specifically, let’s target the bottom 1/3 of all income earners.  Given the size of the U.S. labor force, this is approximately 50 million people.  50 million workers is a convenient figure.  To transfer $1,000 to each of one million workers would require $1 billion.  So, to afford an average transfer of $1,000 to the bottom 50 million workers, we would need $50 billion.  The proposed minimum wage policy transfers about $3,000 to each worker at the lowest end of the income scale.  If we wanted a policy that did essentially the same, we would need to come up with $150 billion dollars per year.  We could have the policy phase-out gradually as most transfer programs do. The very lowest earners could get a transfer of $6,000 and the workers at the top end of the phase-out would get nothing.

How would we achieve this transfer? I would suggest a wage subsidy with an explicit negative tax withholding feature.  If you get a job for $7 an hour, the government would subsidize the worker with by contributing roughly an extra $3 per hour and the wage subsidy would slowly phase-out.  Eligibility for the wage subsidy would be dependent on household income to avoid paying teenagers and focus instead on low-income primary and secondary earners (a teenager earning $7 per hour but living in a household that earns $150,000 would not get the subsidy).

Unlike the minimum wage law, this law would phase-out at around $20.00 per hour rather than $10.10 – this policy helps a large number of working Americans (50 million workers rather than 4 million).  Unlike the minimum wage, this policy encourages employment of low-income workers.

Now the bad news… Where do we get the $150 billion required to fund the program? Well one way of getting it would be a substantial tax increase on upper income Americans.  This is not entirely implausible.  The Piketty and Saez study shows that earners in the top 0.1 percent of the income distribution get roughly 10 percent of all income – roughly $1.7 trillion.  If we could get an additional 10 percent of their income in tax revenue we would have enough for this program just by raising taxes on the top 1/1000 of the working population.  Unfortunately, this is easier said than done and there are serious costs which would need to be carefully considered were we to take this path.  Among these costs are, first (1), introducing a new top marginal tax 10 percent greater than the current maximum tax rate would not be enough.  Much of this income is not taxed at the top marginal tax rate so the marginal rate would have to go up by more than 10 percent. [Note: currently, the top marginal tax rate is 39.6 percent. A 10 percentage point increase would make the top rate close to 50 percent (ouch).] Second (2), much of this income is capital income. Taxing capital income is not a very good idea since it compromises business expansion in the long run.  Third (3), these households will take steps to shield their income from the additional taxes.  Fourth (4), such a tax increase will reduce work for upper income Americans. Some working spouses will leave the labor force and stay at home.  Some workers will retire early.  Some businesses will shift operations overseas, etc.  Fifth (5), there will be significant administrative and enforcement costs associated with the policy.  These last costs could easily add another 10-20 percent to the overall cost of the program.

These costs (1-5) represent the tradeoff between efficiency and equity that Noah Smith, Paul Krugman and Matthew Yglesias want to de-emphasize (Yglesias seems to think they don’t exist). There are other options to getting this revenue. For instance, we could raise taxes on the top 1 percent rather than just the top .1 percent. We could cut spending in other areas, etc. In any case, this policy would require either cutbacks or heavy taxes or both to implement.

In many respects, this policy option is a lot like the Earned Income Tax Credit (EITC). The EITC requires a budget outlay of roughly $50 billion per year. The above proposal would differ in a couple of ways.  First, the EITC is targeted to low income workers with children while the proposal outlined above would transfer to all low income workers regardless of family size. Second, the EITC is a smaller program.  It is fairly generous to very low income workers with children but the phase-out occurs much faster.

Ignoring the problem of income inequality is not an option (that said, the minimum wage policy is one way of taking a passive stance to inequality to put off dealing with the problem directly).  If we really want to make a noticeable dent in U.S. inequality, we will need to get aggressive and we will need to be prepared for policies with serious price tags.  There are real costs to achieving a more equitable distribution of income.  Exactly how costly, is up to us.

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40 thoughts on “Can Anyone Spare $150 billion?

  1. “Unlike the minimum wage, this policy encourages employment of low-income workers.”

    This is wrong. Productivity is just one factor that influences wages, another is political economy and bargaining for rents. Whenever a company sells its output in an imperfectly competitive market it gains rents and how these rents are distributed among labour and capital depend upon the politcal power of each. Obviously the power of unions has declines whereas the power of capital has increased during the last four decades.
    So an increase of the minimum wage does not per se lead to a reduction of employment. The empirical literature on the subject also shows ambiguous results.

    About taxing the top 0.1%, many of them are heirs or CEOs. The former got their money from daddy so no incentive effects at all (unless you think that daddy will spend more of his wealth if you increase capital or wealth taxes but this is highly unlikely and even if it would occur it would just a minor disincentive effect upon saving … and last time I checked the macro problem is that investment is low while savings are high) and the latter extract rents from the company they work for due to corporate governance problems (asymmetric information, principle-agent problem and so on plus plain bad corporate governance laws.
    Good luck in trying to argue that the pay of a CEO who wrecked a company and nonetheless gets massive bonuses reflects productivity.

    About capital tax rates, what matters are not tax rates but decent law enforcement. There is an institutionalized tolerance of capital tax evasion with rich folks getting their wealth out of the country they live in. And this has obviously nothing to do with the disincentive effects of capital tax rates; the tax rates are on a historical low and yet wealthy people nonetheless play this game.

    Your key error is the ignorance of rents and implicit assumption that pay always perfectly reflects productivity.

    • While I agree with you, the right question in my opinion is succinctly showing that the reason wages are low for low-income workers is not productivity but rather something else. Distributionally, in a zero-sum wage allocation game, if one’s productivity is being overcompensated, then by consequence other’s is being undercompensated, but a zero-sum wage allocation game is too static and unrealistic, as well as unpersuasive when contrasted with the incentive effects argument.

    • If you mean increasing VAT as a way of financing the wage subsidy, that would offset some of the egalitarian effects of this policy, since VAT is a regressive tax…

  2. Chris, great blog and an interesting reflection on pro-egalitarian public policy design. I think you make an effective argument as to why it would be more effective in excluding a certain class of minimum wage workers from the benefits of rises in the minimum wage. That said, I think that you ignore the following points, which I’d be grateful if you could try to reply to:
    1) Your analysis suggests that the only ones affected by a minimum wage increase are those earning at or below the new proposed minimum wage. However:
    a) Isn’t it the case that rises in the minimum wage will exert upward pressure on all wages, or at least those in the proximity of this wage?
    b) In further detail, it seems implausible that the minimum wage equalises wages for all those earning at or below the minimum wage? This might be a logical conclusion if you accept the neoclassical assumption that wages equal productivity, however intuitively the worker earning $9/hour will probably still earn a higher salary than the worker earning $7/hour. This would mirror an adaptation of your assumption i.e. that relative wages equal relative productivity (which is still inaccurate in my opinion but nevertheless more accurate than wages equal productivity).
    2) While transfer payments (such as your wage subsidy) are not original as a policy instrument, in-work transfers have fallen under criticism as government subsidy of cheap labor i.e. allowing private companies to continue to practice wage suppression at the expense of the taxpayer. I understand your proposed means of finance would still grant distributive justice, but I’m not sure you account for the expenditure of political capital for this policy relative to the expenditure of political capital for raising the minimum wage. (I guess the relative values of political capital expended by each of these policy options could be calculated, I’m just not convinced yours has a lower cost in political capital.) But moving beyond the plain ethical concern, there is a moral hazard for it eliminates the risk involved in sustaining low wages.

    Sorry for the long comment.

    • On (1) you are completely correct. The policy will affect more than those just at the min wage. At the very least, workers with wages between the 7 and 10 $/hr will be affected. Other workers might also be influenced. In particular, the minimum wage might raise labor demand for high wage workers to the extent that it decreases employment of low income workers (I would guess that they are substitutes to some extent — if they are compliments then labor demand will fall for both).

      Your point in (2) is absolutely a key point. The main thing the min wage has going for it is that it is politically popular (mainly I think this is because it sounds effective even though it really isn’t and the costs are somewhat obscured). The policy I sketched above would be very difficult to get passed particularly in the polarized environment we have today. So, yes, I would think it would require a lot of political capital.

  3. “Second (2), much of this income is capital income. Taxing capital income is not a very good idea since it compromises business expansion in the long run.”

    That’s not true. God, are you an idiot, or just dishonest? Or both? Capital follows profitable opportunities, and profitable opportunities are generated by demand. Shielding capital income from taxes encourages useless financial manipulation – for example, high-frequency trading, leveraged buyouts, credit default swaps, and a host of other wasteful and damaging practices. Taxing capital income does nothing to discourage sound business expansion because sound business expansion carries with it the promise of continuing gains.

    “Fourth (4), such a tax increase will reduce work for upper income Americans. Some working spouses will leave the labor force and stay at home. Some workers will retire early. Some businesses will shift operations overseas, etc.”

    No, such a tax increase will reduce work *by* *some* upper income Americans. And first, it’s good if a tax increase reduces work for upper income Americans, and if working spouses leave the work force and stay at home. If people have enough choices that a tax increase will cause them to reduce the amount they work, great. If the work is worth doing, the jobs won’t go away, and if the people you are talking about vacate the jobs, other people will step in to do them.

    God, do you not understand this?

    How is a tax on individual income doing to cause businesses to shift operations overseas? The businesses aren’t going to be paying the tax.

    Anything that increases wages at the bottom end by taking money from people at the top end increases efficiency, because the people at the bottom end will immediately spend the entire increase, and the people at the top end will reduce their wasteful financial manipulation.

    I can understand how your costs 1-5 are ignored by people with more integrity than you have, but why do you ignore the efficiency gains promoted by higher consumer demand?

    Economics is supposed to be a science? All you do is to promote an observation-free orthodoxy. You teach economics at a university?

    God!

  4. Unless you are keen to publish to get a tenure in a university, real world policy makers are better off to ignore what R. Lucas or T. Sargent has said about macroeconomics.

  5. And I forgot my “second” to your (4). If upper-income jobs will in fact disappear because of a tax increase, those jobs didn’t need doing, so we gain efficiency by eliminating useless jobs in favor of supporting wages that will be immediately spent.

    Now, to your (1):

    first (1), introducing a new top marginal tax 10 percent greater than the current maximum tax rate would not be enough. Much of this income is not taxed at the top marginal tax rate so the marginal rate would have to go up by more than 10 percent. [Note: currently, the top marginal tax rate is 39.6 percent. A 10 percentage point increase would make the top rate close to 50 percent (ouch).

    Wow. We’re talking about the top 0.1% of income, so actually essentially all of their income is taxed at the marginal rate. (Limit of X+A as X approaches infinity). Second, going from a 39.6% rate to a 50% rate is a 26% increase, not a 10% increase.

    You teach at a university?

    God!

    • Mike, I’m guessing that your comments are just trolling but in the off chance that you are actually serious let me make two simple points. First, the marginal rates apply only to income above the marginal rate threshold. The threshold is actually quite high so they have a lot of income taxed at lower rates. Also, most of these people itemize deductions which excludes a lot of income from taxation.

      As to your second point, we need an additional 10% of their pre-tax *income* — not 10% of their initial tax revenue.

      And, yes I teach at a university. And no, I’m not god.

      • Whether I’m trolling (that is, presenting opinions with which you disagree and facts you would prefer not to acknowledge) or not is irrelevant; what’s relevant is the soundness of my arguments and whether they vitiate your analysis. The marginal rate threshold is not high when evaluated from the perspective of the top 0.1% of the income distribution, especially as one moves up within that distribution. Deductions start phasing out well below that point too.

        As I said, the limit of X+ A as X approaches infinity is X.

        You said this: “Among these costs are, first (1), introducing a new top marginal tax 10 percent greater than the current maximum tax rate would not be enough.”

        OK, I understand now that what you wrote didn’t clearly express what you were thinking.

        And do you really not understand what “God!” means in this context? Or are you just trolling your own blog?

  6. What many right-wingers (and make no mistake, House might wear a centrist mask but he is a right-winger as this post as well as the factually wrong post in which he claimed that Krugman said some lunatic things but failed to back it up with facts in order to make the “centrist” point that left-wingers and right-wingers are equally crazy) do not want to be known is that increasing the top marginal income tax rates has positive effects upon efficiency. It makes rich heirs actually work for real instead of spending their money to undermine our democracy like the Kochs do and it might reduce the rent extraction of CEOs which comes at the expense of shareholders (standard incentive arguments, they can keep less of their “booty” so they work less hard to get some of it).

    This is just theory though. About empirics, q quick glance at the nasty communist Eisenhower under whose reign top marginal income tax rates have been far above 90% and GDP growth rates respectively employment numbers show that the supposed negative incentive effect that right-wingers often warn about (OMG, !50 billion dollar !!!) is absent.

    • Way to bore, Funky, with your harping on the Krugman thing.

      And your assertion is incorrect. Proportional taxes on income are inefficient, because they reduce the amount that any person, irrespective of income gets from work. This makes them more readily amenable to substituting to leisure. This is common in economic models across the spectrum (left, right, whatever). This is not House’s idle thoughts. This is decades of modelling by many people smarter than you.

      If you don’t buy it, and you are of course free not to, write a model that offers something different, get it published, sell it on the seminar circuit, change the orthodoxy and then maybe your comment will have more than no value.

      • Hahaha, it doesn’t matter how many decades of modeling there are unless one of predictions one of the models yields is compared to reality.

        Pay attention to what Funky is actually arguing, please. (Here’s a hint – not all “work” is valuable, and reducing “work” that’s not valuable doesn’t reduce efficiency). Being so sloppy and inattentive doesn’t reflect well on you.

  7. Plenty of models capture aspects of reality. Theoretically and empirically. If you don’t know or get that, you are out of your depth. Way out of your depth.

    My point is you don’t like the way things are modeled, write an alternative model. If you think an assumption is unrealistic, write a model that relaxes that assumption. It takes a theory to beat a theory. Until then, you and Funky got nothing.

    • Hahahahahahaha, if a model says that it’s sunny between 11 PM and 5 AM I don’t need to develop a model of my own to point out that it’s dark.

      • Huh? So models aren’t necessary? In a complex world, how do we know what mechanisms cause what effects? How do we understand the effects of changes in policy? That is why we need models. To create something far simpler to better understand the complex world in which we live.

        If you don’t like some aspects of a model, change them and see if the outcome changes. See if that particular assumption matter. Guessing from the aggregate data is no use because their is too much going on to be able know what affects what. And while you might have a mechanism in mind, your writing is confused, so I suspect you are confused also. Put some rigour into it beyond just raving and you may not be as useless as you seem.

      • My writing is clear, I don’t know what on earth you’re talking about. You said “It takes a theory to beat a theory.” No it doesn’t. If a theory predicts that it will be sunny between 11 PM and 5 AM at 30 degrees north latitude, all I have to do to beat the theory is to point out that it’s dark. Your argument is just an effort to monopolize the conversation, to restrict it to specialists and to exclude the public at large. But if it’s dark it’s dark and the theory is wrong. I don’t need to come up with a theory to explain down to the second when it’s sunny and when it’s dark. It’s enough to say no it isn’t sunny it’s dark, and there’s something really really wrong with people who insist that it’s sunny in the middle of the night because they have a theory telling them it’s sunny.

        And oh yeah, you tell Funky he needs to “change the orthodoxy” for my comment to have value. The problem is that in economics, the orthodoxy doesn’t change to conform to observed reality. That bespeaks a problem with the orthodoxy, and with economists promoting it, not with those who challenge it.

        Chris above presents a hypothesis that predicts it’s sunny between 11 PM and 5 AM at 30 degrees north latitude. It isn’t sunny at that hour and that latitude, it’s dark. I have pointed that out, and have pointed out fundamental defects in his hypothesis. You seek to exclude me from the conversation, arguing, essentially, that only insiders are allowed to have their ideas considered.

        If it’s dark, it’s dark, and my being an outsider doesn’t change the fact that it’s dark. What you need to ask yourself is, what does it say about your and Chris’s integrity that you both keep insisting it’s sunny when it’s dark.

  8. I don’t know what your ‘sunny when it is dark’ obsession is all about. I have already directed you to my point that ‘Plenty of models capture aspects of reality’. Saying that they don’t is wrong. Saying that economic models predict it is sunny when it is dark is wrong. Plain wrong. Models are judged on their ability to match what we observe in reality. Any model that doesn’t is likely to be quickly re-worked, discarded or superseded.

    Don’t play the ‘woe is me, I am being marginalised card!’ That wilfully misunderstands the discussion to date. I am not seeking to exclude you from the conversation at all. In fact, the complete opposite. The complete opposite. I would like you to join the conversation in a way that is more meaningful (and civil) than saying ‘God, are you an idiot, or just dishonest?’.

    If you violently disagree with the orthodoxy, then work to modify the orthodoxy. Work to change things. Present an alternative. The orthodoxy is open to change. Economics always incorporated ideas from psychology, physics and other disciplines. I’m sure economists will jump on board with your idea too… if it has merit.

    Like all sciences, economics isn’t finished. It is evolving. And it is responding to some its blind spots. See here for a summary.

    http://noahpinionblog.blogspot.com.au/2014/03/how-macro-answered-its-critics.html

    • It’s not an obsession; it’s an observation, and not mine alone. I and countless others have observed that if an economic model predicts that it’s sunny, pointing out that it’s dark doesn’t seem to cause people to abandon the model (especially if the model promotes giving government money to bankers, or giving special tax advantages to financial manipulation that consists of borrowing money without paying it back.)

      “I have already directed you to my point that ‘Plenty of models capture aspects of reality’.”

      But you haven’t presented any examples, and I don’t accept your unsupported word. And this is irrelevant anyway, because I have directed you to your saying “it takes a theory to beat a theory.” I’m pointing out that it doesn’t (not in real science anyway). It just takes proof that the theory is wrong.

      “Saying that economic models predict it is sunny when it is dark is wrong.”

      No it isn’t.

      “Plain wrong.”

      No it isn’t.

      “Models are judged on their ability to match what we observe in reality.”

      Surprisingly (to a real scientist), no.

      “Any model that doesn’t is likely to be quickly re-worked, discarded or superseded”

      No they aren’t. For example, look at the tenacity with which Chris clings to the “reducing the income of high-frequency traders reduces efficiency” model. And look at Steve Levett ignoring over 65 years of experience with the National Health Service in favor of his idiotic thought experiment.

      “Don’t play the ‘woe is me, I am being marginalised card!”

      Of course I’m not, because you don’t control the conversation, much as you would like to. But putting forth “rules” like “it takes a theory to beat a theory” is an effort to make the refutation of idiotic and harmful theories more difficult than it should be.

      “If you violently disagree with the orthodoxy, then work to modify the orthodoxy.”

      I pointed out that it’s dark. In science, pointing out something like that causes orthodoxy to be abandoned.

      Like all sciences, economics isn’t finished. It is evolving. And it is responding to some its blind spots. See here for a summary.

      http://noahpinionblog.blogspot.com.au/2014/03/how-macro-answered-its-critics.html

      Yeah, I took a look. He got mauled in the comments. Lots of the “answers to critics” were on the order of “the critics were right but for the wrong reasons so we were still right”.

      Yeah it was so hard, it took such complicated calculations and modeling to figure out that traders given access to depositor money but not exposed to the harm caused by their activities, would do whatever most benefited them personally.

      Economists were stunned that removal of banking regulations would result in insolvency of banks.

      • Your previous post basically says no a few times and then talks about HFT and banking which don’t appear in Chris’ post. Did a big, bad banker hurt your feelings at one time or another? If you want to argue that HFT has adverse implications for efficiency, then I have some sympathy. But only because it is analogous to models of momentum trading. The model supplies some rigour and structure to the intuition. The model is akin to proof that holds under stylised conditions. Do changing the conditions change the outcome? That is what subsequent papers investigate and, slowly, a concensus is built.

        Your’ sunny when it is dark’ obsession is a bad example. I see what you are getting at. If the model predicts poorly, it should be discarded or re-worked. And I agree. And this is what happens to poor models. Why is it a bad example? Models are like saying ‘if…, then…’. The ‘sunny when it is dark’ example has no ‘if’. This is what I mean by a theory. Something we can use to deduce what will eventuate given a set of circumstances. So if a theory fails to predict what we observe, (ie is proved to be wrong), we still have no way of understanding what causes what. We are still lacking a positive, rigorous contribution that explains what drives what we are observing. I should have been more clear when I rather glibly wrote ‘it takes a theory to beat a theory’.

        If you don’t take my word for the fat that plenty of models capture aspects of reality, then you are just closing your eyes and hoping for the world to be different when you open them. One example. Here’s a summary of a model which matches the data from the recent recession:

        http://noahpinionblog.blogspot.com.au/2013/05/dsge-financial-frictions-macro-that.html

        You are just gritting your teeth and hoping that if you insist, it will be so. But it will not. Because it is not. So, with your ‘no, it isn’t’ and ‘surprisingly, no’ rejoinders, you are just derping. You have a prior you are unwilling to let go of and you aren’t willing or unable to investigate more deeply into what actually happens in the study of economics.

        I’ll give you an example of models being re-worked or superseded when they have flaws. Kydland and Prescott present a model which hypothesises productivity shocks drive the business cycle. It doesn’t match what we know about the labour market (among other things, but I will focus only on the labour market progressions) all that well. Hansen comes along and augments the microfoundation of labour in the model. Better, but still not great. Next comes labour search models which bring the model much closer to what we observe in reality. Iteratively, things improve. Nonetheless, people are still working in the area trying to make advances.

        This is how academic economists earn their living. There are incentives to say someone is wrong (think of that kid at UMass that refuted the findings of Reinhart and Rogoff – he increased his profile immensely with that one publication). There are incentives not to build on incorrect work, because it will be eventually discarded with your contribution along with it. There are incentives to take someone’s work, if correct, a step further. And people actively capitalise on these incentives. By making refutations and advances and publishing. Some lead to big leaps forward, some lead to small steps. But the profession keeps on trucking.

        The idea that anyone can control ‘the conversation’ is absurd. I would like as many people with as many insights as possible to contribute to advancing economics. This is what Nobels are awarded for. Akerloff and asymmetric information. Kahnemann and behavioural insights. Nash and game theory. Economics jumps forward when people make observations and then substantiate them with models that show them to be more than just opinion and speculation.

        Besides, it is a bit rich that you are now trying to make out like you are the aggrieved party in the argument and people are trying to control you, when your first response to Chris’ post was an ad hominem attack, calling him ‘stupid’ and ‘dishonest’, trying to ridicule and abuse rather than reason the argument out of his post.

  9. I agree with essentially everything in this post, but I want to point out that efficiency cost of the higher marginal tax rate in the phase-out range could be very large, possibly comparable to or even higher than the cost of raising taxes on the rich to provide the funds for the subsidy.

    Even a slow phase-out that goes linearly from $3 to $0 per hour as the pre-tax wage goes from $7 to $20 per hour implies a rise of 23 percentage points in the marginal tax rate in that range. Given that the relevant marginal tax rate is already quite high for many people in this range due to all the phase-outs that already exist, it’s possible that we’re talking about effectively a rise from (say) a 35 percentage point tax to a 58 percentage point tax. Since the log wage distribution (whose density determines the efficiency cost of the local distortion) has a very high density near $20 an hour, the costs here are quite large, and I suspect the disincentive on the intensive margin here overwhelms any work incentive on the extensive margin from the wage subsidy (though this is empirically still up in the air).

    This is why there is a very large tradeoff indeed between equity and efficiency – if you’re trying to transfer to the bottom, not only do you have to raise the money at the top, you have to distort decisions for the lower middle and middle classes through phaseouts. (Classic Mirrleesian public finance tends to dispense with the distinction between “subsidy + phase-out” and “tax” altogether, of course, elegantly unifying them into a single retention function.)

    Governments have more-or-less stumbled their way into the same solution that many optimal tax simulations would recommend, which is to give large transfers at the bottom and then phase them out aggressively, resulting in extremely high marginal tax rates near the bottom. (This is less costly than spreading the phase-out over a larger range because the central Mirrleesian tradeoff is between the local distortion from taxation at the margin and the inframarginal revenue raised. At the bottom, the distortion is fairly unimportant in these simulations because the density isn’t that high and people aren’t earning very much anyway, whereas the inframarginal revenue-raising benefits are enormous, because essentially everyone makes more. Thus the optimality of extremely high marginal taxes at the bottom.) Occasionally you see policy wonks recognize this and argue that it needs to be fixed, but I’m not sure that they realize how catastrophically expensive it can be. If you lower the phase-out rate by 20 percentage points in the $0-25k income range, you need to raise it by 20 percentage points in the $25k-50k income range (with much larger distortionary consequences, owing to the higher log density of incomes in that range) just to keep the transfer at $50k the same – and *then* on top of that all you need to raise a lot more revenue to pay for the massive additional transfer you just granted to people in the $0-50k range, which peaks at $5k for the pretax $25k earners.

    It’s a very difficult problem, and you see why simulations tell us to push the high marginal tax rates to the bottom – and yet you also see why creating an underclass for whom work doesn’t pay might have social consequences not contemplated in these simulations. Anyone who doesn’t think there is a tradeoff between equity and efficiency isn’t paying attention.

    • Matt,

      This is an excellent point! Phase-outs often entail a hidden distortionary effect which catches policy makers off-guard. My original intention with this policy suggested above was to have the subsidy depend only on the wage paid by the employer per hour. This would mean that you could work many hours and earn a lot of income without influencing the subsidy. That is, the phase-out would be in terms of the wage paid rather than the income earned. Of course, issues like the one you raise will still frustrate the policy a bit. In particular the policy might be susceptible to “gaming” in which the employer falsely reports the number of hours worked to make it seem like the wage is really low when in fact the wage is much higher.

      In any event, your point is very well taken.

      • Ah, I missed the fact that it was supposed to depend only on the hourly wage. Interesting idea.

        Conditional on implementation being possible, that eliminates the phase-out distortion along the hours margin, although it keeps the distortion along other compensation-related intensive margins (effort, job choice, skill acquisition etc.). How much this helps depends on how important the hours margin is, relative to other margins, as part of the overall response to after-tax wages. Not clear whether anyone has a good sense of this quantitatively – for full-time workers the 40-hour standard is so well-cemented that I suspect that the hours margin (in the short term, at least) isn’t all that important, while for part time workers it certainly is a big deal.

        Since full-time workers are responsible for the majority of earnings overall, in general they tend to be the more important subpopulation, but this may not be as true for a $7-$20 phase out range. (And in general, the hours margin may be more important for the lower wage ranges, where the mapping between time spent and work accomplished is more direct, while other margins are more important at the top – meaning that if we are going to use hours somewhere in the tax-and-transfer system, your wage subsidy is probably the best place to do it.)

        Implementation, as you mention, is of course the main worry. In principle, PF theory suggests that knowledge of hours could be tremendously useful for designing optimal transfers (indeed, if the only margin subject to distortion is the number of hours worked, knowledge of hours can in principle take us to the first best!), but the informational burden here is high enough that a lot of people dismiss this as a viable tool. Of course, we do use hours in a handful of policies, like the minimum wage, but those tend to have a more favorable alignment of incentives for enforcement – for instance, ex post the interests of workers and employers on the minimum wage are at odds, so if they cheat and pay below the minimum wage there’s a risk that the workers will report them.

        I’m not sure that there is any comparable mechanism here, and indeed the incentives to misreport hours seem extremely strong. Suppose that the true wage is $20 an hour, where there is no subsidy. If the worker & employer inflate the number of hours by a factor of 2.86, enough to get the wage down to $7 an hour, then there is a subsidy of $3 on each of these falsely reported hours, which implies a subsidy of $8.57 on each actual hour worked. This misreporting strategy yields an increase in the post-subsidy hourly wage of 8.57/20 = 43%, which is large enough that I suspect firms and employees would find some way to grab it and divide the surplus.

        Another issue is self-employment. It would be unfair to deny the subsidy to self-employed individuals, but it’s almost impossible to imagine that you could get them to report their hours correctly. (Indeed, the self-employed seem to be able to misreport income in very precise ways – Raj Chetty gave a talk here a while back about how increasingly people were gaming the EITC to hit the maximum on the schedule. And income is much harder to fudge than hours.) We deal with this problem for the minimum wage simply by accepting that the minimum wage doesn’t apply to the self-employed, but I don’t think that there is such a solution here.

        So overall, I’m afraid that I’m skeptical of the viability of incorporating hours into the tax-and-transfer system. It would be nice to shut down the hours margin as a source of distortion (especially at the bottom, where it’s presumably a bigger deal), but the traditional arguments against it are pretty strong. (By the way, there is some brief but good discussion of this by Banks and Diamond in their chapter on direct taxation in the Mirrlees Review.)

      • Again, very good points.

        I think your concerns about intentional misreporting of hours / wages might indeed be a serious problem. Switching to an income based transfer alone would be easier to implement but wouldn’t be as effective. There are some tax/transfer schemes that can be designed which are “self-enforcing” (the VAT is an example I guess — to get the deduction, you need to report your purchases. If your purchases don’t “line up” with the declared sales of the previous firm then the IRS would know there was a problem…). I think it would be really valuable if we could come up with an aggressive transfer that would be a realistic option on the implementation margin.

  10. By the way, on a different note, a good simple rule of thumb that might be useful for the discussion above is that if the upper tail of incomes is distributed Pareto (as it approximately seems to be) with shape parameter alpha, then if the top tax bracket starts at $X, among people within that bracket the fraction of *income* made within the bracket is 1/alpha.

    As inequality has risen, the tail has fattened, and alpha has been declining, but excluding capital gains I believe that the current value is roughly alpha=1.65. Thus 1/alpha = 61%, meaning that if we create a new tax bracket starting at $X, we won’t touch at all 39% of the income of people who make more than $X.

  11. “If you want to argue that HFT has adverse implications for efficiency, then I have some sympathy. But only because it is analogous to models of momentum trading.”

    It’s frontrunning. It’s self-dealing by an agent at the expense of his principal. Your willful blindness to that fact tells us everything about you that we need to know.

    “If you don’t take my word for the fat that plenty of models capture aspects of reality, then you are just closing your eyes and hoping for the world to be different when you open them. One example. Here’s a summary of a model which matches the data from the recent recession:

    http://noahpinionblog.blogspot.com.au/2013/05/dsge-financial-frictions-macro-that.html

    Mauled in the comments.

    “There are incentives not to build on incorrect work, because it will be eventually discarded with your contribution along with it.”

    Evidently not. Look at Reinhart and Rogoff. Their policy prescriptions are still being followed, even though their work was proven to be lies. They published an apologia defending their work. Show me something written by a deficit scold who has changed his viewpoint based on the fact that Reinhart and Rogoff’s work was proven to be lies.

    “when your first response to Chris’ post was an ad hominem attack, calling him ‘stupid’ and ‘dishonest’, trying to ridicule and abuse rather than reason the argument out of his post.

    That’s not what “ad hominem attack” means. An ad hominem attack is an attack on the argument through an attack on the speaker. I reasoned through an analysis of the manifest defects in Chris’s argument that he is stupid or dishonest or both, because I identified at least two of his points as being risible, with (2) being so obviously false that it is difficult to believe it wasn’t a lie.

  12. Finally, a reply without the ‘sunny when it is dark’ gibberish. Even so, you are still confused. In some cases, I suspect deliberately so.

    I was saying I have some time for your arguments on HTF (models confirming the intuition), but you read it as ‘wilful blindness’? You don’t seem to process information well. Perhaps your neural pathways are so set that you just see what you want. That, and you must have bile ducts the size of the Pacific ocean.

    I neither case, was he ‘mauled in the comments’. I would consider it a ‘mauling’ if there was an uprising against the model. But in neither case did this occur – although there were a few valid critiques. Besides, being mauled in the comments is not a bad thing if you are getting mauled by trolls or derps or people who have an inflated and mistaken sense of their own ability to understand and critique the model. Being attacked by these people is like being flayed with a lettuce leaf.

    And you miss the point on Reinhart and Rogoff (R&R). There is a difference between the ‘research’ and the ‘policy’. Reinhart and Rogoff do the ‘research’. Governments make the ‘policy’. I am making no comment on the ‘policy’. Only on the ‘research’, and the result is unequivocal. R&R were wrong. They were found to be so. Not only did an incorrect model hurt R&R’s reputations, but it made Herndons. Proving that the incentives are aligned with publishing correct and defensible work, because otherwise it leaves you vulnerable (especially when there are incentives for others to take you down).

    You missed the point of Chris’ argument and then you went ad hominem on him. You missed the point, sprayed some of your own theorising and then went negative. That is precisely what ad hominem is.

    • You said about High frequency trading:

      “If you want to argue that HFT has adverse implications for efficiency, then I have some sympathy. But only because it is analogous to models of momentum trading.”

      Do you think I’m unable to scroll back up to see what you actually said? You think you can pick out individual phrases and ignore others and make people believe you didn’t say what you said?

      You said that HFT has “adverse implications for inefficiency” ONLY “because it is analogous to modes of momentum trading.” You thus displayed willful blindness to the fact that it is frontrunning. It’s the cheating of clients by their agents. Cheating doesn’t “have adverse implications for inefficiency” only because of some way you can classify it or some analogy you can draw to it. It has “adverse implications for inefficiency” because it’s cheating. It damages confidence in the market. The fact that the banking industry engages in wholesale cheating damages confidence in the financial system. The fact that the government allows cheating to continue damages confidence in the government.

      You ignored the fact that high frequency trading is cheating. As I said, your willful blindness tells us everything about you that we need to know.

      “I neither case, was he ‘mauled in the comments’.”

      Hahahahaha, somebody named Joe said this:

      “Agh, this is such a frustrating debate. The reason why we had the Great Recession is not because of the financial crisis; it’s because of the demand that was lost from the housing collapse. There’s no logical reason why a financial crisis should destine a country to years of sluggish growth. Dean Baker has made this point like a thousand times: http://www.cepr.net/index.php/op-eds-&-columns/op-eds-&-columns/revisiting-the-second-great-depression-and-other-fairy-tales

      So why are the theoreticians drawing the wrong conclusion? We don’t need more financial frictions in macro models; we need the models to better monitor imbalances, so that we can prevent bubbles from occurring in the first place. Macroeconomists set the bar too low if the only thing they can do is predict a financial crisis right before the crisis happens.”

      Smith said this:

      “he reason why we had the Great Recession is not because of the financial crisis; it’s because of the demand that was lost from the housing collapse.

      Maybe Dean Baker is wrong?”

      !!!!

      Joe responded with this:

      “Where is he wrong? What is the mechanism that connects “financial crisis” to “five-year slump”?”

      And Smith never explained.

      I didn’t say “criticized” or “attacked”; I said “mauled.” A mauling is an effective attack – Merriam-Webster has it as “to attack and injure in a way that cuts and tears skin; to cause a bloody injury.”

      You can disparage people who don’t adhere to your orthodoxy as Untermenschen, calling them “trolls” or “derps” but that doesn’t alter the fact that these “trolls” and “derps” demolished Smith’s arguments in the comments.

      “And you miss the point on Reinhart and Rogoff (R&R).”

      No I don’t. Reinhart and Rogoff were lionized because they said what the deficit scolds wanted to hear. They’re still saying what the deficit scolds wanted to hear, and their reputation hasn’t been shaken by the people for whom they wrote the paper. Have they admitted they were wrong? Were they fired? Rogoff is still a member of the Group of 30. Being wrong doesn’t damage an economist’s reputation; being dishonest doesn’t damage an economist’s reputation; what damages an economist’s reputation is heterodoxy.

      I didn’t miss the point of Chris’s argument. He was saying (based on a number of false statements) that it would be inefficient to implement a particular mechanism for transferring money from wealthier people to poor people. Ad hominem is what I said it is; look it up. I didn’t undertake an ad hominem attack; I drew conclusions about Chris’s intelligence and his integrity based on the risibility of his arguments.

  13. You are a confused person. I think you are able to scroll back up and see what I said, but I also think you are unable to process and understand what I wrote. And you are unable to prosecute your argument on the terms with which we started and you have tried to move the goalposts. Basically, you are arguing something else now.

    My sympathy for HFT comes from the intuition being confirmed by models. So that what seems right and reasonable actually works when put together with other features of the economy. Models establish and prove the idea in a stylised context. That is my point.

    ‘Cheating’ You don’t understand the words you use! This isn’t a game. What gibberish! The activities of these traders are either unlawful or they are not. They are either illegal or they are not. But that is a legal argument. And different to the economic argument. The economic arguments centre on principle agent issues and price effects leading to distorted outcomes. Not ‘cheating’. I don’t think you are wilfully blind to this. I think you are genuinely blind to this and don’t understand the confusion in what you have written.

    Again, don’t conflate the research with the policy. Our debate was about the research. Not its use by those in policy. This is why I say you are shifting the goalposts to try to move the focus of our discussion. I am not ready to let you wriggle away and try to argue on different grounds until I persuade you our original argument.

    There is no one model. The model I showed you predicted and matched the fall. Other models, like the IS-MP model, for instance, that Krugman favours couldn’t predict the fall (because they don’t have a financial sector and were thus missing the trigger for the recession), but could tell us about what to do once we got into the Recession. That is Joe and Dean Baker’s point. ‘Now we are here, what are we going to do’. Their focus is correct. ‘Ok, we had the fall, but why are we still down here?’. And it is certainly interesting and a hotly contested debate. But it is about policy. Not the methodologies of research. And so it is a debate for another day. I will gladly argue policy with you another day, and we may not be too far apart on that. But our debate is about models, and their usefulness.

    Reinhart and Rogoff took a beating in academic circles (again, policymaking and the incentives policymakers face is an argument for another day). Their reputations amongst the people who review their stuff and ultimately employ them took a battering. Their next paper will be examined very thoroughly before it is accepted for publication. And most importantly, Herndon made his career by proving them wrong. Got a massive publication and became a name in the profession. So, yes, as I wrote, there are strong incentives to look at and rigorously appraise what is out there. And, yes, economics does jump forward when people bring new ideas and perspectives to it (as in the examples I provided before).

    I doubt your ability to draw conclusions from what Chris wrote. You didn’t understand his framework. You didn’t understand his terminology and confused it with your own. And you didn’t understand his point. And far from it being a rule, it wasn’t couched in absolute terms (as there are precious few rules without exception). Even if you had a good example, it doesn’t invalidate his example. Nor does it invalidate what he was writing. But you don’t get that and instead jumped straight to ad hominem.

    • No, you keep shifting the meanings of words. I think it’s because you have a poor grasp of the English language.

      “‘Cheating’ You don’t understand the words you use!”

      No, I understand the word perfectly.

      “This isn’t a game.”

      You’re engaging in a clumsy and dishonest slight of hand, pretending that I meant a different meaning of “cheating” than I meant. I meant, and it is clear that I meant, that high-frequency trading is the cheating of principals by their agents.

      “What gibberish!”

      “Gibberish” means “something the person referring to ‘gibberish’ doesn’t understand” There are lots of reasons for someone to fail to understand something, but one of the most frequently encountered reasons is that the person failing to understand is stupid.

      ” And different to the economic argument. The economic arguments centre on principle agent issues and price effects leading to distorted outcomes. Not ‘cheating’.”

      That’s more evidence that the current practice of economics is no good. There *is* no argument to be made that cheating of a principal by an agent is somehow justified or somehow increases efficiency. As I said, high-frequency trading, by breaching the duty of loyalty by an agent to a principal, decreases confidence in the market and in the system of justice. In addition, it contributes nothing of value. Having a whole industry devoted to the cheating of principals by agents misallocates resources and, of course, creates an immense moral hazard. The easiest work available is to cheat a principal, and so many people flock to high-frequency trading positions. There are many more such positions, and people filling them, than are needed, and since they provide no economic benefit, none are actually needed.

      “Again, don’t conflate the research with the policy. Our debate was about the research.”

      The research is no good; the fact that the research entertains the possibility that high-frequency trading provides some benefit is saying it’s sunny when it’s dark. The fact that people do such research and get results saying it’s sunny proves they’re dishonest.

      “There is no one model. The model I showed you predicted and matched the fall.”

      The model you showed me didn’t predict anything. Pre- means “before”. Showing me a model which was shown years later to match something is risible.

      And I was pointing to Joe and Dean Baker to prove that Smith was mauled. They pointed out evidence contradicting Smith’s analysis and all he was able to respond with was “maybe Dean Baker is wrong”. That’s like saying “Oh, running away, eh? Come back here and take what’s coming to you! I’ll bite your legs off!”

      “‘Ok, we had the fall, but why are we still down here?’”

      We had the fall because of the moral hazard created by separation of benefits from risks.

      “Their next paper will be examined very thoroughly before it is accepted for publication.”

      I don’t what model you are using that predicts that economists act with integrity, but I use the Larry Summers Model, which is “Insiders don’t criticize other insiders.” Rogoff and Reinhart are insiders. The haven’t been fired, their policy prescriptions are still being followed the fact that their paper was all lies hasn’t affected them a bit.

      “I doubt your ability to draw conclusions from what Chris wrote. You didn’t understand his framework. You didn’t understand his terminology and confused it with your own. And you didn’t understand his point.”

      I understand everything. I demonstrated that a number of the claims on which he based his argument were lies. That proves his argument was no good. It *does* invalidate what he was writing. Only in economics does one see arguments like the one you’re making – oh, you demonstrated that all the claims on which the argument rests are false, but that doesn’t mean the conclusion is invalid.”

      Yes it does. How can it not?

  14. Such a long post, and yet you avoided so much.

    They are your words. You used them. Imprecisely and erratically and impotently. Don’t throw a tantrum when people hold you to your words. It seems you think if you bleat about ‘cheating’ and ‘gibberish’, instead of engaging on the terms of the debate we started on, you increase the length of your post. I can see you liking that. ‘It’s long. It must be good!’. But it doesn’t work that way, pal.

    So now you are trying to claim the principle-agent perspective that I outlined earlier as your own? Did you read it and run away and research it for a few days and then come back and try to turn your ridiculous shrill ‘cheating’ rubbish into something vaguely resembling an argument? I am taking that as a win. Guess what? Shock horror! It has been shown by models! Oh no! Now, having agreed with me you are on the side of science and economic models!

    More sunny when it is dark guff! Ha! I have been waiting expectantly for you to trundle that little beauty out again. It is just so hard-wired into you. I laugh so hard when you bring it out.

    Out of sample predictions… Look that up. A simple metric of model performance. Look that up and come back and agree with me, why don’t you.

    You use the Summer’s Model? You know that it is a model, right? Or as well as chanting ‘sunny when it’s dark’, do you also mumble ‘no models good, summer’s models better’ as a mantra.

    Herndon. made. his, name. from. proving. R&R. wrong. He’ll get his first job at a good uni out of that paper. Third time now. Hope it sinks in.

    No. You demonstrated nothing. You rambled and made no points, then said some nasty things. You get no credit for that.

    • “So now you are trying to claim the principle-agent perspective that I outlined earlier as your own?”

      Yes, I said it first, in response to this by you:

      “If you want to argue that HFT has adverse implications for efficiency, then I have some sympathy. But only because it is analogous to models of momentum trading.”

      No mention by you of principal-agent.

      I responded with this:

      “It’s frontrunning. It’s self-dealing by an agent at the expense of his principal. Your willful blindness to that fact tells us everything about you that we need to know.”

      No mention by you of principal-agent before I brought it up.

  15. Pingback: Warren Buffet: Fighting Income Inequality with the EITC | Orderstatistic

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