Tag: Inequality

What Do We Actually Know About “Trickle Down” Economics?

A recent study by David Hope and Julian Limberg has been making the media rounds in recent weeks for its finding that “trickle down” economics doesn’t work. More specifically, the authors look at data from 18 countries and find that tax cuts for the rich have only led to a higher share of income going to the top 1%, but have on average had no significant impact on either GDP or unemployment. In other words, tax cuts help the rich, but do nothing to help everyone else.

The study was cited in just about every major newspaper (a quick google search brings up articles from the New York Times, Washington Post, Bloomberg, and many more). I read a few of these articles and what I found most striking (although unsurprising) was how definitive they make this finding appear. Taking a quote from the Washington Post article as an example, they write: “The Tax Cuts and Jobs Act did not pay for itself, failed to stimulate long-term growth and did not lead to sustained business investments. According to one of the most comprehensive studies to date on tax cuts for the rich, this should come as no surprise. A London School of Economics report by David Hope and Julian Limberg examined five decades of tax cuts in 18 wealthy nations and found they consistently benefited the wealthy but had no meaningful effect on unemployment or economic growth.” From the article, one would think it’s settled science that tax cuts don’t work.

I don’t blame the media for a lack of nuance in reporting and I certainly don’t want to downplay the significance of Hope and Limberg’s new paper. However, given the totally unbalanced nature of the discussion of these findings that I have seen I think it’s important to set the record straight. Hope and Limberg’s study provides one piece of evidence against using tax cuts as an engine for generating economic growth, but it is by no means the definitive account of the effect of taxes on growth in the way the media is portraying it. Other studies (conspicuously absent from media coverage) have found conflicting results and the nature of the question makes it difficult to get enough observations to even test the hypothesis at all.

In this case, the headline finding is actually reported pretty well by the media. From their abstract: “We find that major reforms reducing taxes on the rich lead to higher income inequality as measured by the top 1% share of pre-tax national income. The effect remains stable in the medium term. In contrast, such reforms do not have any significant effect on economic growth and unemployment.” And the paper does appear to be well done overall. The authors should be credited for their contribution in collecting and analyzing a massive amount of data. Tackling a question of this magnitude is not an easy task. Their research design, which tries to match countries that look similar in almost every way except that one cut taxes and the other didn’t, seems to make sense for the question they are trying to answer.

While the media overall doesn’t seem to have misrepresented the paper, there is still reason to take the results with a bit of caution. Looking deeper into their data, the “5 decades of tax cuts in 18 wealthy nations” sounds a bit better than it really is. Maybe the most difficult challenge in tackling questions about tax policy changes is that tax policy doesn’t actually change that much. In their sample of 50 years and 18 countries, Hope and Limberg are able to pull out only 30 observations where taxes actually fell enough to count and that they could match with a country that looked similar enough but did not cut taxes. Even in simple applications, 30 observations sometimes isn’t enough to uncover effects even if they are there. With something as complicated as the relationship between taxes and growth and the number of factors needed to control for across a diverse set of countries, it is not much of a surprise that they can’t pick up a relationship in their small sample.

However, the bigger problem I have with the media (and Twitter) coverage of this study is the total lack of acknowledgement that this question has been asked before. An incredibly brief search pulled up a paper by Karel Mertens and José Luis Montiel Olea, published in the QJE in 2018 begins with the question “To what extent do marginal tax rates matter for individual decisions to work and invest?” and answers “Marginal rate cuts lead to increases in real GDP and declines in unemployment.” Looking specifically at tax cuts for the rich, they find that “Counterfactual tax cuts targeting the top 1% alone are estimated to have short-run positive effects on economic activity and incomes outside of the top 1%, but to increase inequality in pretax incomes.” In other words, a tradeoff. Tax cuts increase inequality, but do seem to positively effect economic variables for the economy as a whole.

My point in bringing up this other paper is not to suggest that it is better than Hope and Limberg’s or that we should ignore any new findings. But I was curious to find such a well published piece of research with opposing results because I don’t remember in 2018 reading a bunch of articles telling everyone that actually “trickle down” economics works. I searched around and was able to find one article in a mainstream source that mentioned the Mertens and Olea study – an op-ed in the Wall Street Journal by Robert Barro, who gives it exactly one sentence of attention (the article was mainly about Barro’s own research which also finds positive effects from tax cuts).

So a new study that has not yet been published or peer reviewed gets paraded around by the media as definitive evidence that “trickle down economics” has no positive effects. A published piece in a top 5 economics journal that finds positive effects of tax cuts gets essentially no media coverage. I’m not always sold on stories of media bias, but in this case it seems pretty clear. Don’t believe the headlines – the question of whether tax cuts for the rich benefit the economy is still very much an open question.

Don’t Think About Money. Think About Stuff

There has been a lot of fuss in the last few weeks about the ridiculously large wealth of Amazon’s CEO Jeff Bezos. Bloomberg recently reported that Bezos has increased his wealth by $67 billion just this year ($8 million per hour!), which is about 8 times as much as the other 499 billionaires Bloomberg tracks have increased their wealth combined. So you could say he’s doing pretty well for himself.

Of course, this insane achievement has brought out the usual suspects (and even some unusual ones). Bernie Sanders has been on a crusade against Bezos for a while now and has proposed a bill to force Amazon to pay for its workers welfare benefits. It’s literally called the “Stop BEZOS” bill (BEZOS here is an acronym for “Bad Employers by Zeroing Out Subsidies” – how creative). While Sanders’s views are not surprising, Fox pundit Tucker Carlson is also getting in on the Bezos-hating action. Here’s Carlson:

Jeff Bezos, the founder of Amazon, is worth about $150 billion. That’s enough to make him the richest man in the world, by far, and possibly the richest person in human history. It’s certainly enough to pay his employees well. But he doesn’t. A huge number of Amazon workers are so poorly paid, they qualify for federal welfare benefits. According to data from the nonprofit group New Food Economy, nearly one in three Amazon employees in Arizona, for example, was on food stamps last year. Jeff Bezos isn’t paying his workers enough to eat, so you made up the difference with your tax dollars. Next time you see Bezos, make sure he says thank you.

I don’t want to get into the economics of Sanders and Carlson’s statements. Others have taken care of that (hint: Sanders’s tax isn’t going to do what he thinks it will). Instead, I want to touch on this point that the rich owe us something. That they should be thanking us. The reality is exactly the opposite. Next time you see Bezos, make sure you say thank you.

And I think the reason so many people have this concept exactly backwards is because we’ve been trained to think about everything in terms of money. Don’t think about money. Think about stuff.

Looking at Bezos’s monetary wealth on its own misses half of the equation. Sure Bezos has a ton of money. But the way he got that money was by creating an incredible business that revolutionized the retail market. Bezos gets $150 billion in pieces of paper (or more realistically, lines on a computer). We get Amazon. We get stuff (delivered across the country in 2 days or less). Now, of course Bezos does spend some of his wealth, and that’s not so good for our stuff. And his wealth does entitle him to a lot of our future stuff if he wants it. Maybe we’ll be worse off at the time. As for now, we’re making out like bandits.

Unfortunately I think what a lot of people have in mind when they think about the wealth distribution is a big pot of money. If Bezos takes $150 billion out of the pot that’s $150 billion the rest of us can’t use. This metaphor is absolutely the wrong way to think about wealth. Imagine Bezos never existed at all. His $150 billion is never created in the first place. The wealth doesn’t go back to the pot. It’s just gone. Half a million Amazon employees have to find other work. Hundreds of millions of consumers have to go back to shopping at Walmart. Now, there is another option, which is to redistribute Bezos’s wealth after he creates it. That’s a more justifiable policy than preventing him from ever earning it, but it can only be taken so far before it starts reducing the incentive to create – reducing the incentive to make stuff.

The same kind of mistaken thinking shows up in many other policy discussions. Take funding for higher education. Bernie Sanders’s solution is again focused on money. Pay for everyone to get a college education. But what about the stuff? Only so many people can go to Harvard. UCLA only has so many seats in a class. They already reject the vast majority of people who are willing to pay tens of thousands of dollars to attend. Making college free doesn’t do anything to change those facts (and actually it exacerbates the issue). Perhaps increased demand for education services would lead to an expansion of supply on the lower end, but college degrees only work by being somewhat exclusive (especially if the value of education is all signaling). It’s pretty hard to think of a solution that increases the supply of real educational services.

International trade is another good example. If the US imports from China, China gets a bunch of US dollars. The US gets a bunch of Chinese stuff. If we think about the US trade deficit, its essential to remember that it’s just a monetary deficit. But that money deficit gives us a huge stuff surplus. Is either side winning that transaction? China gets more dollars it can use to invest in US assets. US consumers get more cheap products from China. Unless you think you are getting ripped off by Amazon when you trade your dollars for a product, there’s no reason to believe the US consumer is getting a bad deal here either.

There is some nuance here that I’ve been deliberately avoiding. We don’t live in a pure exchange economy, which means money does matter. In economics, we sometimes make the mistake of going in the other direction by only worrying about stuff and never thinking about money. And sometimes it’s worth thinking about money, especially when it doesn’t work so well (as I’ve discussed in other posts). But even then, discussions of money should only be allowed if they’re in the context of figuring out how to get more stuff.

It’s really easy to get people more money. We can quite literally print it whenever we want. It’s a lot harder to get people more stuff. But stuff’s the stuff that really matters.

Equality, Value, and Merit

A common argument against absolute equality is that individuals should be paid based on merit. Should somebody who works 80 hours a week earn the same amount as somebody who sits on their couch and watches TV all week? Even the most ardent supporter of redistribution would have a hard time answering yes. One of the alleged benefits of a free market economy is that it does a pretty good job allocating resources to those who work for them. Reading Hayek, however, I find it interesting that his defense of unequal outcomes explicitly denounces the idea of meritocracy. Value, not merit, is what should determine a person’s reward.

Some clarifications are in order. “Value” and “merit” are not well defined concepts. Let’s take an example to see the distinction between these two concepts. Imagine 2 students are studying for a math exam. One student studies 8 hours per day all week for the exam, but math has never been his strength and he ends up with a hard earned B+ on the exam. For the other student math has always come easy. He takes a quick look at his notes for a couple hours the night before and breezes through with an easy A. We might say that the first student deserves a higher grade than the second. If we graded based on merit we would want to give the higher grade to the student who worked the hardest. Of course, this grading system makes no sense when we consider that a grade is meant to represent a student’s knowledge of the material. Even though he didn’t work as hard, the second student knows math better and therefore deserves a higher grade.

The same arguments can be applied to an economic context. If two entrepreneurs each develop a product, a meritocratic society might suggest paying each based on how much work they each put into its creation. However, this criteria doesn’t consider the fact that consumers might place different values on the two products. If we want to maximize the benefits to society, we don’t actually care whether a product was created by a team of people and 2 years of strenuous research and development or by a guy coming up with ideas in the shower. All we care about is the value of the two products to the consumer. In Hayek’s words, “it is neither desirable nor practicable that material rewards should be made generally to correspond to what men recognize as merit…we do not wish people to earn a maximum of merit but to achieve a maximum of usefulness at a minimum of pain and sacrifice and therefore a minimum of merit” (The Constitution of Liberty, 157, 160).

It might seem unfair that talented people tend to earn more than the less talented. The handsome actor already gets good looks and fame. How is it fair that he also gets a big paycheck? And it’s not fair. But that doesn’t mean it’s not desirable. Because without that paycheck, without that incentive, maybe he wouldn’t have become an actor at all, and the opportunity to create a product that millions would have enjoyed is gone. It’s not fair that Tom Brady gets paid so much to play a game, but the only reason he does is because so many love watching him play. The alternative might not be that he gets paid less and still plays, but that he doesn’t play at all because his incentives to work hard and become a great player are diminished.

Another problem with a meritocratic society is that merit is hard to measure. Going back to the math example, I said that one student studied more than the other. But maybe his studying was not as efficient. Maybe he was actually on Facebook half the time, or didn’t focus on the right problems. And there are other factors. Maybe the second student paid better attention in class or had worked harder in previous classes and therefore didn’t need to work as hard now. Even if we wanted to reward the students’ merit, doing so would be a challenge. Similarly, looking at two products tells us little about how much work and how much effort went into the creation. What we can see is how much people like each product (by looking at how much they pay for it).

One of the greatest benefits of a market economy is that it pushes people towards the tasks that other people actually want them to do. In Hayek’s words, “If in their pursuit of uncertain goals people are to use their own knowledge and capacities, they must be guided, not by what other people think they ought to do, but by the value others attach to the result at which they aim” (The Constitution of Liberty, 159). By rewarding value over merit we ensure that people can only earn money by offering something that others desire. Everybody acts in their own self-interest, but the market usually ensures that that interest also aligns with the interests of others. Potential earnings act as a signal that shows what society values and attempts to regulate the market will almost certainly mess with these signals.

With this perspective, it is difficult to find a reason to care about others’ wealth. Steve Jobs, Bill Gates, and Mark Zuckerberg only got rich by offering a service that other people valued. Their contribution to society is likely far greater than any monetary compensation they received. Encouraging others to continue in their footsteps, to innovate and invent, is more important to the welfare of society as a whole than any attempts to redistribute their existing wealth. In fact, attempts to accomplish the latter discourage the former. I disagree with Ayn Rand on many points, but I think the overall theme in Atlas Shrugged is about right. When society feels like it can take anything it wants from the producers, they might decide that it’s simply not worth it any more, leaving no wealth left to redistribute at all.

 

Interesting Paper on Inequality and Fairness

As a followup to my recent post on inequality, I wanted to highlight some recent research by Christina Starmans, Mark Sheskin, and Paul Bloom on fairness and inequality. Based on a survey of lab experiments and evidence from the real world, the paper argues that people don’t actually care about unequal outcomes as long as they are perceived as fair.

They highlight several studies that show that in laboratory settings people (even children) are likely to distribute resources equally. However, in many of these settings, equality and fairness are indistinguishable. Since none of the participants did anything to deserve a larger portion, participants could simply be attempting to create a fair distribution rather than an equal one. And experiments that explicitly distinguish between fairness and equality do find that people care more about the former. For example, people were not unhappy with allocations that were determined randomly even if the outcome ended up being unequal as long as everybody began with an equal opportunity. Children who were asked to allocate erasers as a reward for cleaning their rooms were more likely to give the erasers to those who did a good job.

In reality people also seem to prefer an unequal distribution of income as long as it is perceived to be fair. In surveys, while people’s perception of the true income distribution is often highly skewed, their ideal distribution is not one of perfect equality. Of course, looking at these surveys does not necessarily tell us much about what the “best” income distribution would be, but rather the one people (think they) prefer. As I argued in my last post, I think too much weight has been placed on income or wealth inequality when really all that matters are differences in people’s happiness or utility. The evidence presented here does not go that far, but it does suggest that people realize that different behavior should lead to different rewards in some cases.

One reason that I think the debate has focused mostly on income or wealth inequality rather than on fairness or another measure of inequity is due to issues with measurement. Everybody has different ideas about what is fair so it’s easier to frame the question in terms of something that can be easily reported numerically. We may want to reconsider our acceptance of those statistics as a meaningful representation of a social problem. The whole paper is well worth reading and it opens up some interesting questions about human behavior. I will have at least one more post related to inequality coming in the next week or so.

What Kind of Inequality Matters?

Thomas Piketty’s book, Capital in the Twenty-First Century, a thorough analysis of the causes and effects of inequality, recently became an international best-seller. It’s not often that thousand page economic treatises attract popular attention, so clearly there’s something important to discuss here. Looking at some of the data on inequality, it’s not hard to see why many people are concerned. Here’s a chart showing the share of income held by the top 10% in the United States since 1910:

Notice where the two peaks occur – 1929 and 2009. I seem to recall something important happening in each of those years. Whether inequality was a symptom or a cause of the broader problems that led to the Great Depression and the Great Recession is an interesting question and definitely deserves scrutiny. For the purposes of this post, however, I want to address a simpler topic. Should we care about inequality on its own? And, more specifically, what kind of inequality should we care about?

For the first question, let’s do a simple thought experiment. You can choose to live in one of two societies. In Society A, everybody makes $50,000 per year no matter what their profession is. LeBron James and a janitor get paid the same amount. In Society B, average income is the same $50,000 per year, but it is now dispersed, so that some people earn less than average and some earn far more. Now assume that you are guaranteed to begin at average income (to avoid questions of risk aversion). Which society would you rather live in?

The answer to the hypothetical depends in part on whether you care about absolute or relative income. Does it matter if you are rich, or does it only matter if you are richer than others? In Society A everybody is on the same level, which might seem to be an appealing feature.

Except as soon as we start to think a bit harder, we realize that people in Society A aren’t equal at all. At least to some extent, differences in income do come from differences in effort. Some people work harder than others. Should people get paid the same regardless of effort?

Of course, this reasoning attacks a bit of a straw man. Hardly anybody would argue for full equality of income. But that doesn’t mean that there aren’t some situations where reducing income inequality could be helpful. I don’t believe in free will, which means that I think that where you are today is determined by circumstances you had no control over. But even with free will, it’s impossible to deny that some people are luckier than others. Some people are born into families with higher incomes or better connections. Some people are just smarter, or more talented. Two people can put in the same amount of effort and come out with wildly different outcomes. Isn’t there some justification for correcting these kinds of inequalities?

Now we need to bring in the second question: what kind of inequality matters? To this point, I have focused entirely on income inequality, but money is only as good as what you can buy with it. Somebody who earns $1,000,000 per year but saves $950,000 is no better off than someone who earns $50,000 per year (until they start spending those savings of course). We also need to consider a dynamic component to inequality. The chart above shows only a snapshot of inequality at one point in time, but there is large variation in earnings over a person’s lifetime. So a better measure of the kind of inequality that actually matters would be total lifetime consumption inequality (due to measurement difficulties, the question of whether consumption and income inequality move together is still under debate – see a nice survey here).

But we’re still not quite there. Why do we consume anything? Presumably because it makes us happy, or, in the words of an economist, because it gives us utility. Simply giving people more stuff might not actually help them at all unless it’s stuff they actually want. So shouldn’t we actually care about total lifetime utility? And as soon as we jump into the world of utility, the problem gets much more difficult.

Consider an extremely wealthy person. Incredibly talented and smart, he excelled in school, founded a business, and became one of the most successful CEOs in the world. He has a beautiful house, ten expensive cars, flat screen TVs, season tickets to the Patriots. He can buy anything you could ever want. Except he works all the time, hates his job, and has no time for his family or friends. Despite his money, despite his consumption, he is miserable.

Another individual earns far less. She isn’t poor, but she earns right around median income. She doesn’t have a luxurious life, but she can afford the basics. More importantly, she’s happy. She has a loving family, great friends, a job she likes. Would she be happier with more income? Probably. But she doesn’t need luxuries to live a good life.

How do we make this society more equal? Simply looking at income would suggest a transfer from the wealthy man to the average income woman. This transfer would of course reduce income inequality, but it would increase utility inequality. The woman is already pretty happy and the man is not. Taking money from him and giving it to her would only increase the happiness gap. Is this outcome desirable? I don’t think so.

Then maybe we should try to minimize utility inequality. But how? Taking money from the woman would probably reduce the woman’s utility and eventually it would be as low as the man’s, but giving it to the man would probably do little to increase the man’s utility unless he takes comfort in the fact that others are as miserable as he is. The woman’s happiness comes from pieces of her life that can’t be transferred to others. Despite being born with all the skills necessary to succeed, the man would likely view the woman as the more fortunate one.

In general, trying to equalize utility gives some strange implications. Let give a few more examples.

Two people work in the exact same job and get paid the same wage. Seems perfectly fair. But what if one of them enjoys working and the other hates it? In dollars per hour, they are equal. In utility per hour, one receives more than the other. Reducing utility inequality would require that people who enjoy their jobs be paid less for the same work.

Some people prefer living in cities while others would prefer to live in smaller towns. Houses in cities are usually much more expensive, which means to achieve the same utility, a city lover will have to pay far more. In this case, income equality greatly benefits people who hate cities. Utility equality would suggest transfers from people who love rural areas to those who love cities.

Consumption equality could also generate large utility inequality. If one person places a lot of meaning on material goods while another values other aspects of their life, they would need different levels of consumption in order to achieve the same utility. Should we give more to the materialist than the ascetic simply because giving to the latter wouldn’t help them anyway?

And even these examples ignore the largest problem with trying to achieve equality in utility – it’s difficult to measure and impossible to compare across individuals. I have trouble defining my own preferences and determining what makes me the happiest, I certainly don’t trust others to do that for me.

So utility equality is probably not an option even if it were desirable. But income equality almost certainly worsens the problem of utility inequality. The people who make a lot of money are much more likely to also be people who place a high value on money. Those who earn less are more likely to enjoy a simpler life. In fact, there is little evidence that the rich are any happier than the rest of us. Taking their money makes them even worse off while helping those who are already pretty happy despite their relatively low income. The happy get happier while the miserable get more miserable.

Notice that I have deliberately avoided using examples with truly poor people. I can certainly see an argument for redistributing income to the poorest. Nobody should have to live at subsistence levels if they are willing to work. But being concerned about poverty and being concerned about inequality are not the same. It is possible for a society to have zero poor people and still be incredibly unequal and also possible to be almost perfectly equal with everybody poor (as it was for most of the history of human existence).

Have we gotten any closer to answering the original question? What kind of inequality should we care about? If you’ve made it this far, it should be clear that there isn’t an easy answer. We often use the term “less fortunate” as a euphemism for poor people and that almost exclusively refers to poverty in a monetary context. We view income as if it came from a lottery and then aim to use redistribution to correct for discrepancies. Why is that? Aren’t people that can be happy despite low income really the most fortunate? Isn’t money just one of many factors that matter for a person’s happiness? And aren’t many of these other factors difficult to measure and even more difficult to redistribute?

If we answer yes to the above questions, reducing the kind of inequality we care about becomes a much harder task. Can we really correct the deeper inequalities that arise due to people’s preferences and talents – some of which will lead to higher incomes and some not? Or should we accept that inequality is an essential part of society, accept that treating everyone equally necessarily produces inequality in outcomes, that differences in wealth don’t necessarily lead to differences in happiness, and that correcting differences in happiness is almost impossible?