The Market Power of Technology (part 3)

March 13, 2024

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The last three chapters of Mordecai Kurz’s The Market Power of Technology contain his public policy recommendations. These are based on his conclusion that a capitalist economy left to its own devices will not produce the optimal, most efficient outcomes—the greatest good for the greatest number imagined by utilitarian philosophers. The accumulation of market power and monopoly wealth ultimately undermines economic growth and mass prosperity.

It also undermines democracy:

[I]n a democracy, the rich can shift society to an equilibrium favorable to them simply by putting together a winning coalition that establishes a free, laissez-faire economic policy. Capitalism then does the rest by enhancing their wealth and preserving their power at the expense of the rest of society. My conclusion is that, in the age of technology, democracy under unregulated free-market capitalism is an unstable economic system; it results in the decline of social cohesion and in a political progression toward plutocracy. For a capitalist market economy, a policy to contain market power is a necessary condition for both democracy and economic growth to succeed.

Reversing these negative trends will require a change of thinking on the part of policymakers and judges. They will need to stop regarding successful companies as so useful to society that their concentrated market power can be overlooked. While new technologies do increase productivity in general, the most profitable firms are not always as productive as they appear, or as they could be. Their high revenues create the appearance of producing great value at low cost, but those revenues also depend on high prices and profit margins.

Technological progress is necessary but not sufficient for strong, broad-based economic progress. Public policy must both restrain the expansion of market power and promote the general good by facilitating upward mobility and expansion of the middle class.

Restraining the expansion of market power

The goal here is to balance the need to reward technological innovation with the need to place reasonable limits on the market power of technology users. Kurz argues for a new principle of antitrust policy, “restraining an entity’s technological market power down to the level granted by patent law.” That is:

If its privately owned technology is entirely innovated by the firm itself (as distinct from having been acquired) and it does not take any actions to erect additional barriers to entry, its market power is then protected by patent laws.

The main way that big firms expand their market power is not by innovating for themselves, but by buying the innovations of smaller companies. Microsoft made 237 acquisitions between 1987 and 2020. Antitrust law should place limits on such acquisitions.

Another target of antitrust law should be large technology “platforms” such as Google, Facebook, and the Apple Store, which are able to extract monopoly profits from advertisers or developers. Kurz would like to see them regulated like public utilities.

Many European countries have gone beyond U.S. antitrust law to develop a concept of “abuse of dominant market position.” That makes it easier for European courts to take action against firms that erect barriers to free competition or raise prices to unreasonable levels. [That was the basis for the European Union’s $1.95 billion fine on Apple last week.]

Kurz has several recommendations for patent reform. He would tighten the requirements for granting patents, allow patents shorter than the standard twenty years, and cut the length of patents in half for those acquired through merger or acquisition.

Since firms with market power use it against workers as well as competitors, Kurz would strengthen protections for workers. He would target practices that restrict a worker’s right to seek the best wages and benefits, such as noncompete clauses for low-wage workers, long-term contracts classifying workers as independent contractors, or “no-poaching” agreements preventing one franchiser from hiring a worker from another. He would raise the federal minimum wage—now a paltry $7.25 an hour—and index it to the cost of living. He would facilitate the formation of unions, not just to increase wages, but “to develop cooperative institutions for addressing the social problems of workers.” That’s because labor’s falling share of the national income is associated with problems like family instability, lower morale, and drug addiction.

Taxation, public investments, and redistribution

The final policy chapter discusses ways to strengthen the economy by promoting the general economic welfare.

The first of these is a return to a more progressive personal income tax. Recent studies in economics support the idea that a higher top bracket rate can provide needed public revenue without reducing taxpayers’ incentive to contribute to society through valued work. (See, for example, my earlier post on this topic.) Higher tax rates did not stop the mid-twentieth-century from being a time of technological innovation and rapid economic growth.

Kurz is also in favor of corporate taxes, if they are carefully designed. Critics of corporate taxes complain that they tax savings and investment. But Kurz would tax only revenue in excess of the cost of materials, labor, and capital, thus taxing only monopoly profits, not investment. He would then use the additional tax revenue “to finance investments that promote long-term efficiency and growth, and for active antitrust policy to remove some of the distortion in factor prices.” Many multinational corporations escape U.S. taxes by moving profits to low-tax countries. Kurz would deal with that by apportioning taxes according to country of sale. If half of sales are in this country, half of revenue should be taxed here.

Kurz would like to see more of the national income going to benefit the lower half of the population. He does not, however, favor direct cash distribution programs, such as the frequently proposed Universal Basic Income. He believes that “the most decisive argument against them is that they do not address the main goal of all long-term egalitarian policies, which is to help individuals improve their skill and motivation to earn, on their own, income above poverty level and perhaps join the middle class.” He prefers health and education programs targeted at the children of low-income families, who he calls “the most wasted human resources in our society.” The evidence shows that such programs are more likely than tax cuts for the wealthy to pay for themselves in future tax revenue and reduced social costs.

Kurz proposes a National Fund for Equity and Democracy that would invest in markets through an index fund, but use the earnings to support a flow of workers into the middle class. For example, it could provide scholarships for low-income students to attend college or technical school, or pay the moving costs for families to move to places with greater economic opportunity.

Several proposals address the continued need for technological innovation. One calls for reversing the decline in public support for basic research, which has dropped dramatically as a percent of GDP over the past forty years. (Recall that publicly-supported basic research is a major source of technological innovation.)

Kurz is also concerned about the impact of technology on jobs. Giving low-income children more skills will be futile if the economy has no jobs for them to do. Machines that are designed to replace workers can create private gain, but they come with a high social cost. However, many smart machines are intended to be used by smart humans! “A policy needs to be crafted that encourages innovations that promote partnership of workers with machines and enhances the productivity of the unskilled rather than replaces them.”

All these proposals are consistent with Kurz’s general argument. The best formula for prosperity is the one that characterized the mid-twentieth century—a technological revolution yes, but also egalitarian policies to curb the power of the few to monopolize the benefits, and to provide avenues of upward mobility for the many.

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Posted by Ed Steffes

An Economic Case for Building Back Better

May 3, 2021

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Last week, in his first address to Congress, President Joe Biden defended the three legislative initiatives in his “Build Back Better” program. So far at least, the response from the public has been mostly positive. Yet Congressional Republicans seem united in their opposition, leaving the fate of two of the proposals in some doubt. Here I will give a brief overview of the plans, describe how the President intends to pay for them, and discuss some of the pros and cons of implementing them. On balance, I think that the proposals would help rather than hurt the economy.

The Biden plans

The American Rescue Plan is the $1.9 trillion COVID relief and stimulus package that President Biden has already signed into law. It passed Congress very narrowly, without Republican support. Senate opponents could not filibuster the bill because it qualified for passage under budget reconciliation rules.

Included in the plan are direct stimulus payments to households, extended unemployment benefits, a continued moratorium on home evictions and foreclosures, an increased child tax credit (fully refundable for families too poor to pay income taxes), assistance to state and local governments, assistance to schools trying to reopen, and subsidies for COVID vaccination and testing.

The American Jobs Plan is a $2.3 trillion plan to improve infrastructure and create jobs. Some of it relates to infrastructure in the traditional form of roads, bridges, airports, railroads and waterways. It also addresses “community infrastructure”—such things as new schools, VA hospitals, affordable housing, clean drinking water, broadband access for all communities, power grid modernization, and support for energy efficient homes and new sources of energy like wind turbines and charging stations for electric vehicles.

The plan also addresses manufacturing and workforce development, including government investments in research and development, which Biden noted has declined from 2% of GDP to less than 1%. It would also support new jobs in the area of home and community-based care for the elderly and disabled.

Biden defended the plan as an exercise in “public investment,” doing things that only government can do. Private firms will do what is profitable, but they don’t do as good a job providing goods and services that benefit the entire society without regard to ability to pay, such as public education or clean water. The low wages and shortages of eldercare workers suggest a public need greater than the private market can meet.

The American Families Plan is a $1.8 trillion plan to address the health, education and wellbeing of families. It includes $800 billion in tax cuts, especially an extension of the rescue plan’s child tax credit for four additional years. This is intended to cut child poverty in half.

The plan also enables each child to obtain four more years of free public education, two in the form of free preschool and two in the form of free community college. It subsidizes high-quality affordable child care, with payment caps for parents adjusted for income level. It finally does what other industrial countries do, moving from unpaid to paid family and medical leave. The plan makes changes to the Affordable Care Act, lowering deductibles and prescription drug costs, and allows Medicare to negotiate lower prescription drug prices with pharmaceutical companies. As it is, American often pay more than people in other countries for the same drugs, at least partly because the power of large drug companies is not challenged by the countervailing power of government.

Whether they pass Congress this year or not, these plans represent a fundamental reversal of the trend to disparage and reduce the role of government in the economy and society. Although the current national situation is not as dire as the Great Depression, the proposals are already being compared to those of Franklin Roosevelt and the New Deal.

Economic costs and benefits

The goals of these plans are fairly popular. Most of the debate over them concerns their economic implications. Democrats say they will help the economy, while Republicans claim they will hurt the economy. Who has the better argument?

The American Recovery Plan is very different from the other two plans because of its obvious benefits and costs. It is responding to a national emergency, but since it is not paid for with new taxes, it does add to the federal deficit, a potential burden on future taxpayers. Last year’s deficit was already $3.1 trillion, or 15.2% of GDP, the largest percentage since 1945.

However, I am not losing too much sleep over that, for two reasons. By its very nature, emergency spending is mostly temporary. But also, deficits and debt normally rise during economic contractions and fall during economic expansions. At the end of World War II, the deficit was 21% of GDP, and the accumulated public debt was 106% of GDP. By the early 1960s, the deficit was down to zero—the budget was balanced—and by 1974 the public debt had fallen to 23% of GDP. The postwar economic boom had boosted GDP and tax revenues, and made the debt relatively smaller and more manageable. Similarly if less dramatically, economic growth in the 1990s eliminated what had been a 5% deficit and brought public debt down from 48% to 32% of GDP. Deficits and debt do matter, but so do economic stimulus and economic growth.

The Jobs Plan and the Families Plan are in a different category, because the President proposes to pay for them by undoing some of the Trump tax cuts on corporations and the wealthy. To the extent that we do that, the plans have the potential to stimulate growth without adding to deficits and debt. Biden would increase the corporate tax rate from 21% to 28%, which is still lower than the 35% rate before the 2017 tax cut. He would also impose a 15% minimum rate to stop corporations that have been using tax loopholes to avoid taxes altogether. The Biden plan would go back to taxing personal income over $400,000 at 39.6%, the top-bracket rate before Trump reduced it to 37%. That would affect only the richest 1% of taxpayers. Finally, the plan includes a higher capital gains tax for millionaires. The tax cuts of 2017 did not turn out to be very popular, and a majority of Americans support these increases.

A principal economic argument for these two plans is that the increased spending will stimulate the economy and create more jobs than the 2017 tax cuts did. Government purchases of goods and services boost GDP directly because they are a component of national spending. They also have a multiplier effect, where each dollar spent grows the economy by more than a dollar. Tax cuts, on the other hand, only increase the demand for goods and services to the extent that the increased disposable income is spent rather than saved. As Krugman and Wells say in their macroeconomics text, “In general,…a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP.” Furthermore, the tax cuts that are in Biden’s plans put money in the hands of ordinary families who are more likely to spend it, rather than wealthy families who are more likely to add it to savings. Increasing the child tax credit should boost GDP more than cutting capital-gains or inheritance taxes.

In addition to short-term economic stimulus, the Biden plans are investments in future growth. Addressing our neglected infrastructure, our research and development needs, and our transition to new sources of energy should be good for the economy in the longer run. So should the investments in human capital through wider access to preschool and college education. Addressing parental needs with paid leaves and subsidized child care makes it easier for people to combine parenting with paid employment, adding to the nation’s economic output and income.

Opponents of the plans are almost forced to argue for some form of “trickle-down” or “supply-side” economics. They must claim that low taxes on the wealthy are better for the economy than the proposed government spending. In theory, low taxes on corporations and the wealthy can stimulate the economy from the supply side by making more money available for private investment. Then the benefits trickle down to the rest of us. But that is a tough argument to support when the wealthy are already riding high and the interest rates on funds for investment are already at historic lows. There seems to be no shortage of funds to invest; what is lacking is business confidence because of sluggish growth and weak economic demand. That’s probably why trickle-down economics has not been working and the Trump tax cut was such a fizzle. The tax revenue that we lost by cutting taxes on the already-rich could be better spent “growing the economy from the middle out,” as President Biden said.

Another objection to the plans is that they could produce too much demand-side stimulus and runaway inflation. That is not impossible, and the day may come when we need to cool the economy by raising interest rates or cutting spending. But such policies seem premature when 6% of the workforce is unemployed, many others have dropped out of the labor force, and the economy is running below capacity. Turning from government stimulus to austerity prematurely was the mistake the US and many other countries made back around 2010, when we were still recovering from the last recession.

The Republican alternative

This section can be brief, since Republicans are proposing very little except to keep taxes low and avoid increases in domestic spending. In the official Republican response to the Biden address, Senator Tim Scott rejected all three of Biden’s initiatives, but based his position on worn-out slogans rather than economic arguments.

Senator Scott characterized the American Rescue Plan as a “partisan bill,” ignoring the fact that it is supported by about three out of four Americans. He suggested that it wasn’t needed because Biden had inherited an improving situation from his predecessor. America had already “rounded the bend” on the pandemic and the associated recession.

Scott described the American Jobs Plan as mostly “big government waste,” since only a small part of it involved traditional transportation infrastructure. Either Republicans believe that broader objectives like power-grid modernization and broadband access are a waste of money, or they think the private market will do the job alone. As for the taxes to pay for the plan, he called them “job-killing tax increases,” refusing to acknowledge that the additional tax revenue would be used to create jobs. Republicans want us to believe that tax cuts for the wealthy grow the economy more than spending to address majority needs, but the economic evidence does not support that. Basing policy proposals on facts is not something that Republican leaders have excelled at lately.

Scott dismissed the American Families Plan as an effort to put “Washington in your life from cradle to college.” I wonder how many of today’s struggling families would rather keep the government out of their lives than accept free preschool and community college, affordable child care and paid parental leave, not to mention more established programs like Social Security and unemployment compensation.

Having dispensed with Biden’s proposals with a few derogatory remarks, Senator Scott turned to pleasing the Republican base by arguing that America is not a racist society, and that Republicans really support making it easier to vote, just not to cheat. He didn’t explain why cheaters are so much harder to find than eligible voters standing in long lines in poor urban precincts.

For the last forty years, Republicans have been promoting the same one-size-fits-all economic policy. Always cut taxes, in good times and bad; and always call for domestic spending cuts, even if the actual cuts suggested are too unpopular to be passed. Blame the resulting deficits on “tax and spend” Democrats, not on “don’t tax but still spend” Republicans. Offer few constructive proposals for addressing national problems. Instead, deny the problems or blame them on vague conspiracies, trust the markets, and claim you are saving America from the tyranny of liberal elites and the Deep State. Our politics and policies have served the few better than the many, left the economy with sluggish and erratic growth and the worst inequality since the Gilded Age, and neglected many pressing national needs. The case for a new national direction is strong.

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Posted by Ed Steffes

Taxing the Rich

January 16, 2019

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Paul Krugman, “The Economics of Soaking the Rich,” The New York Times, 01/05/2019.

Peter Diamond and Emmanuel Saez, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations.” Journal of Economic Perspectives, Vol. 25, #4 (Fall 2011): 165-190.

The resurgence of the Democratic Party in the 2018 elections is encouraging more discussion of some progressive policy ideas. One of those is a more progressive income tax, as some Democrats advocate higher taxes on the wealthy in order to fund liberal programs like early childhood education and assistance for college tuition.

Paul Krugman’s column calls attention to both the political debate over progressive taxation and the relevant economic research, in particular the work by Peter Diamond and Emmanuel Saez. They make a strong case that a higher top tax rate is in the public interest.

The problem

The top federal bracket is now 37%, which applies to income over $510,300 for individuals and $612,350 for married couples filing joint returns. Is 37% too low, too high, or about right?

Advocates for a higher rate argue that once people reach a certain level of wealth, no one derives much benefit from their additional consumption. Society would benefit from some redistribution of wealth from those who have enough to those who have too little, either through direct spending on the needy or general spending on public goods like good roads or good schools. On the other hand, advocates for a low rate argue that high taxes reduce people’s incentive to earn income by making useful contributions to the economy. When taxes get too high, public revenue can actually drop because the tax base shrinks.

The optimal tax theory presented by Diamond and Saez acknowledges the effects of taxes on both social welfare and personal incentive. Optimal taxation requires some trade-off between the two.

Social welfare is larger when resources are more equally distributed, but redistributive taxes and transfers can negatively affect incentives to work, save, and earn income in the first place. This creates the classical trade-off between equity and efficiency which is at the core of the optimal income tax problem.

The social welfare effect

The idea that money received by very high earners could be put to better use through taxation and public spending is based on the “marginal utility of consumption.” That is the idea that how much you value an additional dollar you get to spend depends on how many dollars you already have. Each increment of income matters more to a poor person than a rich person, and so the marginal utility of consumption declines dramatically as income increases. Taxing the highest incomes in order to spend for the benefit of the less affluent majority should contribute positively to the general good.

The potential positive effect of taxing the rich can be easily calculated by first computing the tax revenue obtained from the highest bracket. For example, if the highest bracket begins at $500,000, and the average taxpayer in that bracket makes $1.5 million, then $1 million is taxable at the highest rate. A 37% rate raises an average of $370,000 from each top-bracket taxpayer, in addition to whatever is collected from the income falling into lower brackets.

The potential effect on the public good is offset by the loss to rich people of their benefit from private consumption. But since the marginal utility of consumption declines so dramatically as income increases, this offset is very small. Diamond and Saez ignore it in order to simplify their mathematical presentation, but make an adjustment for it before they are finished. One estimate is that marginal utility for people in the top 1% is only 3.9% of the marginal utility of the median-income family.

The potential social welfare effect of taxing the rich is only achieved if the revenue is spent usefully, as opposed to foolishly or wastefully. But that is more of a political problem than a problem of economic theory.

The behavioral effect

How much do high taxes reduce incentives to earn high incomes? That depends on what the authors call “behavioral elasticity,” which they define as the “percent increase in average reported income…when the net-of-tax rate increases by 1 percent.” If the tax rate is r, then the net-of-tax rate is 1-r, the portion of top-bracket income you get to keep. The more you get to keep, the greater incentive you should have to earn.

The paper’s formulas and charts are confusing for us non-economists, so here’s a concrete example with simple numbers. Let’s start with the average wealthy taxpayer described above, earning $1.5 million and paying top-bracket rates on $1 million (the portion falling over the $500,000 threshold). Say that a future Congress is considering raising the top bracket rate from 40% to 45%. If income remained the same, that would generate additional revenue of $50,000 (5% of $1 million) per wealthy taxpayer. But now income goes down some because of reduced incentive, in response to the change in the net-of-tax rate. Reducing it from 60% to 55% is a percentage decline of 5/60 or 8.3%. Research on behavioral elasticity has found that the effect on income is about one-quarter of the percentage change in the net-of-tax rate, in this case about 2.1%. So the estimated decline in income is 2.1% of $1.5 million, or $31,500, leaving $1,468,500 to be taxed, $968,500 of it at the top rate. Top-bracket tax revenue from this taxpayer still goes up, but only from $400,000 (40% of $1 million) to $435,825 (45% of $968,500). The behavioral effect is significant, but it is not enough to offset all the additional revenue from the tax hike.

Suppose, however, that we start from a much higher initial rate, and consider increasing the top rate from 75% to 80%. Starting from the same taxpayer earning $1.5 million, the potential increase in revenue is the same, $50,000, but the effect on the incentive to earn is in theory much larger. With the net-of-tax rate for top-bracket income only 25% to begin with, taxing away another 5% has a greater proportional impact. The reduction from 25% to 20% is a percentage decline of 5/25 or 20%. The estimated effect on income is again one-quarter of that or 5%. The estimated decline in income is $75,000, leaving $1,425,000 to be taxed, $925,000 at the top rate. Top-bracket tax revenue from this taxpayer now goes down, from $750,000 (75% of $1 million) to $740,000 (80% of $925,000). Raising the top bracket further when it is already so high is counter-productive.

The optimal top tax rate

These examples demonstrate the general principle that when the top rate is relatively low, raising it can generate additional revenue to be used to enhance general social welfare. But when the top rate is already relatively high, trying to raise it further can be counter-productive.

Diamond and Saez use the same mathematical relationships to calculate the sweet spot where revenue is maximized. The optimal top rate comes out 73%. Rates below that sacrifice revenue and overlook an opportunity to increase the general welfare. Rates above that reduce revenue by reducing the incentive to earn high incomes.

Three additional points are worth noting:

  1. The analysis to this point does not take into account the loss of consumption utility for the wealthy taxpayer. However, the marginal utility of consumption for the rich is so low that incorporating it into the analysis only lowers the optimal tax rate by about one percentage point.
  2. The optimal rate should take into account all taxes based on income, not just federal income taxes. At the time the authors were writing, other taxes added about 7.5% to the total tax burden, after federal deductions for state taxes were considered. So a total top rate of 73% implies a federal top rate of no more than 65.5%.
  3. The case for raising middle-class taxes would be much weaker, because of their much higher marginal utility of consumption. The more that people are already spending their income on essentials, the less government can enhance the common good through taxing and spending.

The politics of taxation

The United States has been in a relatively low-tax era since the “Reagan Revolution” of the 1980s. From the 1950s to 1970s, the top federal rate was in the 70-90% range. Since the 1980s, it has dropped from 50% to today’s 37%. According to the Diamond-Saez analysis, 90% is too high, but 37% is far too low.

During this era, achieving lower taxes, especially for the wealthy, has been the highest domestic priority for Republicans. They have pursued this goal almost without regard for the fiscal consequences, advocating lower taxes whether they can be matched by spending cuts or just result in larger deficits. Their rhetorical arguments have gone far beyond what economists know, belittling the benefits of public spending and exaggerating the deleterious effects of high taxes on earning incentives and economic growth. They have become the party of hostility to government and affection for those who feather their own nests.

The public benefits of high taxes on the rich may–like climate change–be one of those inconvenient truths that too many of our leaders choose to ignore. Rather than dismissing advocates of higher taxes as lunatics, economist Paul Krugman would like us to base tax policy more on facts and reasoned analysis. For example, he points out that the economy grew at a somewhat faster rate during the postwar era of high tax rates than it has grown lately.

Republicans almost universally advocate low taxes on the wealthy, based on the claim that tax cuts at the top will have huge beneficial effects on the economy. This claim rests on research by. . .well, nobody. There isn’t any body of serious work supporting G.O.P. tax ideas, because the evidence is overwhelmingly against those ideas.

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Posted by Ed Steffes

Forty Years of Reaganomics

July 18, 2018

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When he was running for president in 1980, Ronald Reagan used to ask his audiences, “Are you better off than you were four years ago?” If they were tired of high gas prices, double-digit inflation, and the Iranian hostage crisis, then voters should choose him over the incumbent, Jimmie Carter.

Reagan’s primary domestic policy aim was to shrink the size of government by cutting taxes, spending, and regulation. If only the government would get out of the way, so the theory went, the private sector could flourish. Although Democrats haven’t always gone along with this agenda, Republicans have had their way often enough to bring about a new era of low taxes and limited government. Even Bill Clinton agreed that the era of Big Government was over. Despite all the talk about how Donald Trump is somehow less Republican or less conservative than his predecessors, his tax, spending and regulatory proposals are right out of the Reagan playbook.

Now that almost forty years have passed since the “Reagan revolution,” we may well ask, “Are we better off than we were forty years ago?” I would like to make a modest contribution to an answer by looking at some of the macroeconomic indicators I have been discussing in recent posts. In order to make it easier to compare statistics across the years, I will express the various indicators as shares of gross national income (GNI) when discussing income, or as shares of gross domestic product (GDP) when discussing expenditures. The difference between GNI and GDP is relatively small and should not create any confusion in this discussion. (See my previous discussion of macroeconomic indicators, especially part 2 and part 3.)

Taxes

National income can go to pay taxes, to consume goods and services, or to save, as expressed in the equation GNI = T + C + S. Tax cuts increase the disposable income available for consumption and saving. Generally, more of that increase goes into consumption than into saving. Since consumption is the largest component of GDP, tax cuts raise what is spent on production. That effect includes a multiplier effect as the increased GDP creates additional income and consumption.

[One technical note: In the national accounting system, the T stands for taxes net of transfer payments, which are payments from the government to its citizens. Payroll deductions for Social Security are taxes and count toward T, but Social Security checks are transfer payments and count against T.  The “tax cuts” discussed here could include some increases in transfer payments, but those too would increase disposable income.]

Before the Reagan election in 1980, taxes had been taking about 17-20% of national income. That includes all kinds of taxes—income, sales, payroll, property—and all payers, personal or corporate. Congress passed substantial tax cuts during the administrations of Ronald Reagan, George W. Bush, Barack Obama and most recently Donald Trump. The national tax rate dropped from about 18% to 16% by the end of the Reagan and Bush administrations (1992); then to 14% by the end of George W. Bush’s first term (2004). Then came the global financial crisis and the Obama stimulus package, which lowered taxes briefly to 10% of national income. Now the rate is 12%, which reflects the economic recovery and some initial effects of the Trump tax cuts.

The rate of consumption has risen accordingly, whether calculated as a percentage of GNI or of GDP. It was running about 60-61% of GDP before 1980, but it is up to 69% now. That is well above the rate of most wealthy countries. It reflects the fact that we have become a relatively low-tax nation, with a high priority on the purchase of private goods and services.

Some of that increased consumption has gone into imported goods. We were running small trade surpluses in the 1960s, but the higher price of oil helped produce trade deficits in the 1970s. In the era of lower taxes since 1980, imports have grown dramatically. The trade deficit as a percentage of GDP peaked before the global financial crisis of 2007, but has settled back to about 3% recently.

The federal tax cuts have also made the tax code less progressive, so that the wealthy have benefited more than the middle class. Lower taxes give business owners and managers more incentive to claim a higher share of profits for themselves, since the government lets them keep more of their gains. The distribution of both pre-tax and after-tax income has become more unequal during these years.

Government spending

Another goal of Reaganomics was to reduce government spending. That meant especially domestic spending, since military spending was to be kept high. That task proved to be more difficult and contentious.

Although cutting taxes and cutting spending may seem to go together in a program to shrink the size of government, they are quite different matters. Spending changes can actually have a bigger effect on GDP than tax changes, and the effect tends to be in the opposite direction. That’s because government spending has a direct positive effect on GDP. It counts as spending on productive economic activity. Then, by affecting income, it has multiplier effects on consumption as well. Spending cuts lower GDP, other things being equal. Tax cuts raise GDP, but only indirectly through the disposable income that goes into domestic spending rather than spending on imports or saving for the future.

Recall the equation: GDP = C + I + G + NX.
(Gross Domestic Product = Consumption + Investment + Government Spending + Net Exports)

Government spending is a component of GDP. But taxes only effect GDP through their indirect effects on consumption and net exports.

That means that if Americans are willing to incur an additional $100 billion in the annual deficit, increasing spending has a lot to be said for it instead of cutting taxes. The overall effect on GDP should be greater, and the mix of public and private benefits may add to the quality of life. Cutting taxes increases spending on private goods, but raising spending provides public goods (that’s what government spends on) and private goods too (through the effect on income and consumption).

In any case, Republicans wanted to shrink government, not expand it, and they had some success in cutting domestic spending. Before 1980, government spending was running at 21-24% of GDP, but now it is down to 17%. (Part of that drop, but only part, is a consequence of using percentages to measure the changes. If one component of GDP increases its percentage share, others must go down, other things being equal. Here C went up and G went down, but neither change was just a mathematical adjustment to the other.) We know from the increased deficit that taxes have been cut more than spending. And since consumption has risen substantially, it’s safe to say that the big tax cuts increased GDP more than the spending cuts lowered it.

Saving and investment

Another goal of Reaganomics was to increase saving and private sector investment. Tax cuts would give people more money to save as well as consume, and strong consumer demand would encourage the investment of those savings in business expansion. Economic growth should remain strong, since the rising investment component of GDP would offset the falling government component.

Some of the consequences of fiscal policy flow from well-established economic principles, such as lower taxes—>higher disposable income—>higher consumption. But higher investment does not automatically follow from lower taxes. It depends on whether businesses find the economic demand sufficient to justify expansion. For example, airlines will meet the demand for more air travel by filling empty seats before they will invest in new planes. Businesses invest more when they anticipate a strong market for their expanded production.

I do not see in the macroeconomic indicators a surge of saving or investment since 1980. Before then, saving was running at about 19-22% of national income, while investment was in the range of 16-18% of GDP. Reaganomics got off to an auspicious start, with saving up to almost 23% and investment up to 20% by the end of Reagan’s first term. But since then, saving and investment have generally been no higher than they were before. Saving is now at 19% of GNI, and investment is at 17%.

I’m not sure why the desired surge of investment did not occur, but here are a few possibilities. Some of the increased consumer demand has gone to support foreign production, which made domestic expansion less necessary. The Federal Reserve has also been very quick to ward off inflation by raising interest rates whenever rising demand started to push up prices. Higher interest rates discourage borrowing for business expansion. And although new technologies have been emerging, how to utilize them productively and profitably in a largely service economy has remained a question.

Sector balances

The economy consists of three sectors, each with its own financial balance resulting from inflows and outflows. They are the government sector, the domestic private sector, and the external (foreign) sector.

Ever since the Roosevelt administration engaged in massive deficit spending to combat the Depression and fight World War II, government has experienced more budget deficits than surpluses. Before 1980, deficits were running about 2-4% of national income. Since 1980, deficits of 4% or more have been common, except during the Clinton presidency, which ended in a small surplus. The deficit rose again in the George W. Bush and Obama presidencies, first because of the Bush tax cuts, and then because of the global financial crisis and the Obama stimulus package. The deficit was 9% of national income in 2012, but is down to 5% now.

As I discussed in my post on sectoral accounting, one sector’s deficit is another sector’s surplus. When the government experiences an income shortfall by spending more than it receives, some other sector must experience an income surplus by receiving more than it spends. Before 1980, that other sector was the domestic private sector. Households and businesses were saving more than they spent either on consumption or investment in real assets, with the difference showing up as financial assets. But since the 1980s, we have had a balance of trade deficit (and a current account deficit, which is the balance of trade adjusted for other financial flows between countries). Now about two-fifths of our government deficit winds up as surplus dollars in the hands of foreigners. By running such a large deficit, government is enabling both Americans and foreigners to accumulate financial assets.

While our government has been enabling the accumulation of private financial assets for some time, it used to do it in a more egalitarian way, through public-sector job creation, wages and the expansion of public goods. Now we do relatively less of that, and more with tax cuts aimed at corporations and the wealthy. That’s another reason why the distribution of income has become more skewed.

Gross domestic product

To summarize the changes in component shares of GDP, the consumption share is up sharply, government spending is down, investment has remained about the same, and net exports have fallen as the trade deficit has worsened. In the era of Reaganomics, we have been relying primarily on tax cuts to grow the economy instead of on public spending, business investment, or global demand for our products.

How much growth has our fiscal policy helped to achieve? I used data on real (inflation-adjusted) GDP to compute the cumulative growth for two different periods, 1945-1980 and 1980-2016 (the last year in that data series). Then I calculated the annual growth rate that would yield, when compounded, the cumulative result.

For 1945-1980, GDP grew 191%, which implies an annual rate of 3.1% compounded.

For 1980-2016, GDP grew 159%, which implies an annual rate of 2.7% compounded.

This confirms what others have reported, that growth in the Reaganomics era has been on average slower than in the previous postwar era.

This slower growth has also come with other costs: some neglect of public goods and services such as infrastructure repairs, a larger national debt, a larger trade deficit, and greater inequality.

With regard to the inequality, Piketty has argued that slower growth itself contributes to it, since workers rely on economic growth for real wage increases. Big investors rely more on the rate of return on capital. As the rate of growth falls farther below the rate of return on capital, the share of income going to capital rather than labor goes up. This is in fact what has been happening, a trend Piketty describes as a “drift toward oligarchy.” I think the drift toward economic oligarchy is related to the current threat to democracy, of which Donald Trump’s authoritarian tendencies are only one manifestation.

Government fiscal policy is by no means entirely to blame for sluggish growth. Factors such as slower population growth, an aging population and the difficult transition from a manufacturing economy to a service economy are also involved. But going forward, we do need to think about what combination of public and private initiatives can help.

We have probably gone about as far as we can go with tax cuts as the way to prop up a struggling economy. And government spending cuts without tax cuts would almost certainly be worse. The question for economists and policymakers today is how to make the best use of government spending to give the economy what it really needs. Among the things it needs are enhancements to human capital to keep up with changing job requirements, development of cleaner energy sources, and a twenty-first-century infrastructure. And as Modern Monetary Theory advocates, creating public jobs for anyone who wants them is one of the most direct ways of boosting national output and income.

The anti-government philosophy that has dominated the Reaganomics era has outlived its usefulness. I think that Republicans will either have to change their tune, or tone down the anti-government chorus so that new music can be heard. Democrats need to convince voters that their proposals serve the common good and not just the needs of particular constituencies. Warrenomics anyone?

 

 

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MMT 3: National Income and its Allocation

July 5, 2018

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This is the third in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

Here we take a closer look at the economy from the income side, considering the various uses of income and how they interconnect.

Gross National Income (GNI)

Because the discussion centers on income received by residents of the United States, the focal point will be Gross National Product and income instead of Gross Domestic Product, as in the previous post. Don’t let the distinction concern you too much, since the two are very nearly the same, both around $20 trillion dollars a year. But to be precise, we need to adjust GDP by adding Foreign Net Income (FNI), including income that Americans earn from investments overseas and excluding income that foreigners earn here. Currently Foreign Net Income is positive, and that makes GNP a little larger than GDP.

GNP = GDP + FNI

Using the components of GDP covered in the previous post (Consumption, Investment, Government Spending and Net Exports), we can also describe GNP this way:

GNP = C + I + G + NX + FNI

The combination of NX and FNI is also known as the Current Account Balance (CAB), which is the difference between money flowing into the country and money flowing out of the country, taking into account both trade and investment income. So it is also true that:

GNP = C + I + G + CAB

In macroeconomics, output equals income, and so Gross National Income equals Gross National Product.

GNI = GNP

These equations describe where the national income comes from, but where does it go?

Allocation of national income

Income can be used in three basic ways: to pay taxes, to consume goods and services, and to save.

GNI = T + C + S, in which:

  • T = Taxes net of transfer payments. That includes all sorts of taxes paid to government, minus any payments from government like Social Security checks or veterans benefits.
  • C = Household spending on goods and services, as before.
  • S = Private sector saving, whether by households or businesses. Businesses account for about three-fourths of it.

Consumer spending uses about 68% of GNI, about the same percentage it contributes to GDP. The next largest use is Saving (19%), followed by Taxes net of transfers (12%).

I have already been using the concept of Disposable Income, which is simply income after taxes and transfers, or GNI – T.

I have also discussed the Marginal Propensity to Consume (MPC or c), which is the portion of each additional dollar of disposable income that is devoted to Consumption. Its counterpart is the Marginal Propensity to Save (MPS or s). Although we are often interested in the average propensities for the economy as a whole, households at different income levels have different propensities. Wealthy households can afford to save more of each additional dollar, while poorer households need to spend more of it.

Leakage and injection

Although Gross National Income = Gross National Product, we have separate formulas for them whose equivalence is not obvious. Let’s see what happens when we try to reconcile the income side (GNI) with the spending or output side (GNP):

GNI = T + C + S

GNP = C + I + G + CAB

Well, C in the first formula is C in the second formula; that much is clear.

Let’s assume that T goes into G, since taxes go to the government.

Then we encounter an apparent discrepancy. We might like to think that all of Saving goes into Investment. But the Investment category in national accounting only includes real assets like plants, equipment and new inventory. Some of saving goes to acquisitions of financial assets (cash accounts, stocks, bonds) that are not financing new acquisitions of real assets. Currently S is about $4 trillion, but I is only about $3.4 trillion

Another difference is that the GNP formula includes the Current Account Balance (CAB), which is currently negative because Americans spend more on imports than foreigners spend on our exports. (Foreign Net Income from investments is positive, but it isn’t large enough to offset Net Exports, which is a big negative.)

So some of the national income in GNI isn’t showing up in national spending in GNP. The gap is about $1 trillion, attributable to the excess of Saving over Investment and the negative Current Account Balance. The text calls these “leakages” from GNP. In order for GNI to equal GNP anyway, there must be some offsetting “injection” of spending. That is, there must be some other form of spending going into national product and income, but not coming from national income. And of course there is; it’s the deficit spending by government.

What makes everything balance is that government spending exceeds taxation. G is greater than T by an amount equal to the missing $1 trillion. Most of that is the federal deficit, although G and T take into account spending and taxes at all levels of government. The sovereign government uses its unique position as the issuer of currency to create money when it spends, and that increases national output and income. The deficit spending helps drive the economy, accounting for about 5% of GDP and GNP.

The consequences of trying to balance the federal budget should now be even clearer. It would require some combination of spending cuts, which would reduce national output and income, and tax increases, which would reduce disposable income. Either way, consumption would be negatively impacted to a degree governed by the marginal propensity to consume. The negative impact would be compounded by the consumption multiplier discussed previously. After the multiplier effects ran their course, the economy would find a new equilibrium, but at a lower level of national output and income.

As long as hundreds of billions of national income are going into financial assets but not investments in real assets, and additional billions are going to buy imports instead of American products, the country relies on deficit spending by government to sustain national output and income. The alternative is recession. And in fact, the authors report that balanced federal budgets have usually been followed by periods of recession.

Paradoxes of thrift and spending

Most people consider thrift a virtue. In his classic The Organization Man, William H. Whyte described it as one of the three traditional values of the “Protestant Ethic.” (The other two were hard work and self-reliance.) But in the aggregate, too much saving can be a problem. Not all saving is matched by investment, and what isn’t is a drag on current GNP. Keynesian economists call that the “paradox of thrift.”

If all households would start being thriftier at the same time, consumption would drop, forcing businesses to scale back production and employment. Saving would increase, but not all of the increase would go into the acquisition of productive assets. In fact, investment would likely go down, since businesses see less profit in investing in new plants and equipment when consumer demand is falling. A lot of the new saving would go to buy financial assets, especially safe ones like cash accounts and bonds. The bottom line is that households would ultimately be punished for their thrift by a decline in their own incomes as the economy contracted.

On the other side of the ledger we have what we might call the “paradox of excess spending” (my term). What might be considered a vice on the individual level actually helps sustain or increase output and income on the aggregate level. The sovereign government is the entity with the power to make that happen.

Why tax?

If deficit spending is so good for the economy, then “why not just eliminate taxes altogether?” the authors ask.

One reason is that the power to tax is the main thing standing behind the currency. If people didn’t need to pay their taxes in dollars, the demand for dollars might fall, weakening its exchange value on currency markets and its purchasing power.

Another reason is that the public and private sectors are somewhat in competition, especially when the economy runs at higher capacity. If taxes go too low, private consumption goes too high, commanding too many resources, especially labor. If all the most qualified workers are comfortably employed in the private sector, government agencies have trouble finding talented people. Taxes divert spending from private to public uses, enabling society to create public goods and services. “Taxes create real resource space in which the government can spend to fulfill its socio-economic mandate. Taxes reduce the non-government sector’s purchasing power and hence its ability to command real resources.”

A related reason is that by reducing private-sector spending, taxes also help control inflation. Disposable income is now about 88% of Gross National Income. If taxes would move closer to zero, disposable income would move closer to 100%. The increase in aggregate demand could put a big strain on supply, pushing prices up.

The conclusion is that deficit spending is economically useful, but so are taxes.

Income redistribution

An additional effect that government has on income is to redistribute it. One way it does that is through mildly progressive taxation, taxing high incomes at higher rates than low incomes. The other way it does it is by spending more on low-income households through such transfer programs as Medicare, unemployment insurance, veterans benefits, food stamps and family assistance.

For the aggregate effects, I will refer to the study by Thomas Piketty, Emmanuel Saez and Gabriel Zucman for the Washington Center for Equitable Growth. The researchers divided the U.S. population into three broad income groups, and then compared their shares of national income before and after taxes and transfers. Here’s what they found for 2014:

  • Top tenth: 47.0% of income before taxes and transfers, 39.0% after
  • Next two-fifths: 40.5% of income before taxes and transfers, 41.6% after
  • Bottom half: 12.5% of income before taxes and transfers, 19.4% after

Overall, 8% of the national income was reallocated downward from the top tenth of the population, with 1% going to the next two-fifths and 7% going to the bottom half. That reallocation had a big impact on those who received it, boosting the average income of the lower half of the population by 54%. Since the top tenth already had so much, what they gave up only amounted to 17% of their income.

Redistribution from the haves to the have-nots tends to boost consumption and aggregate demand. Lower-income households have a higher propensity to consume; they consume most of any additional dollars they receive. “This arises because lower-income families find it harder to purchase enough goods and services to maintain basic survival given their income levels.” Wealthier families have a higher propensity to save. They “not only consume more in absolute terms, but also have more free income after they have purchased all the basic essentials.”

Continued

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