After some detailed discussion in the e61 offices my boss (Gianni La Cava) snuck off and pulled together a micronote indicating why this policy might not be the right way to go – namely, the average person on the benefit over the age of 55 is much less likely to be in financial stress than a young Australian who is reliant on the benefit. The note isn’t saying that a higher rate isn’t beneficial – it is saying that we should be consistent when applying these arguments to younger Australians! Update: ABC coverage here.

I suggest you go read the note. As I like to pretend to add value I’m going to take a wee bit of a step back to try to contextualise why we are chatting about the payment in this post

Ok, so what’s going on

There is talk of increasing the payment someone over 55 gets from the unemployment benefit, but keeping the payment the same for others. Why?

I need lists to make sense of things. So here goes! When thinking about whether payment rates should differ for individuals on the basis of their age there are three key considerations:

• Does their age tell us something about the hardship an individual may face when faced with job loss.
• Does their age tell us something about the labour supply response of the individual to a higher benefit payment.
• Does their age tell us something about our personal values about how much the individual should be self-reliant vs receive social support.

Hardship

The prior research (mentioned here and here) found some indications that it was older, single, JobSeekers who had to cut spending most sharply on job loss (Appendix H – note that it was for 36-55, not 55+). Older individuals have fewer working years to earn, and single older individuals may also have more limited social and family networks – in that regard, an older individual without savings may be in greater financial hardship which would explain that result.

One way to test this is to find data that actually tells us about financial hardship. That is where Gianni was able to make good use of HILDA – and he found that, although these individuals were financially stressed, it did not compare to the financial stress of younger JobSeeker recipients.

So “hardship on average” is not the argument here, as otherwise we’d be looking at increasing the youth allowance.

If the rationale is instead “hardship due to sickness and disability”, which is likely to increase with age, then the government should consider reversing some of the changes to access to the disability support pension and the scrapping of the sickness benefit, instead of introducing age based discrimination.

Labour supply

Hey, economists are generally ok with discrimination if they think it changes labour supply – so maybe that is the answer.

To be less facetious there are the common anecdotes that young people take the benefit and play Xbox instead of getting a job.  However, international research tends to find that it is older people who are more likely to avoid working if they receive a higher benefit – a summary of the mixed evidence here https://www.aeaweb.org/articles?id=10.1257/aer.20111559.

If older people were more likely to retire or leave the labour force this would suggest that benefits should be lower (at least as a proportion of income) as people age – not higher.

Looking at the Survey of Income and Housing we can see that older benefit recipients are more likely to have left the labour force – with only 23% of those aged over 55 looking for work, compared to 40% of younger recipients (looking from 2007/08 to 2019/20).

Values

The final consideration is the likely driver of this policy.  In the same way we offer people a higher payment when they reach the retirement age, or when they have a disability that prevents work, there is a social belief that the payment rate received by people with some form of lower work capacity should be higher.  As mutual obligations are already reduced when an individual turns 55, a higher payment for this group is consistent.

But why are we treating two people who are the same in every way, except their age, differently? Why does the 55 year old who only has partial capacity to work get a higher payment, and an easier ride, than the 35 year old in the same circumstances.

Age is being used as a tag for need – but why not base the payment on the need itself?

Gianni’s suggestion that policy should instead look to rules around the disability support pension, and opening up access to superannuation funds early for older workers, captures this mix. If someone finds themselves in a situation where they are unable to work lets support them consistently irrespective of age – and if someone just happens to be over 55 and we want them to feel comfortable retiring, give them the option of accessing their own money.

At present, we’ve got a benefit solution that solves none of the identified problems, and makes younger Australians feel discriminated against – that just doesn’t seem right.

I will read both policy reports in the future. I know both the policy teams well, they are smart, have integrity, and provide genuinely useful insights. And my interactions with OliverShaw have always been reasonable, so I’m sure that report is of interest also. As a result, I don’t have much interest in giving a knee-jerk reaction to anything until I’ve had a chance to read the work and to educate myself a bit.

The headline results from all the reports sound pretty plausible – my key concern is that people who aren’t the researchers might start talking about them without understanding what the numbers mean. And man, I don’t want to be one of those people!

How can I say all these different results sound plausible when they are all quite different?

Well, how about we chat about effective tax rates a little bit first to discuss how there are different measures – and why they are different!

I’m pretty into the topic (i.e. my studies, my hobbies) and for those who know me I have a more respectable brother who arguably gets even more excited when he hears about this topic. So it is something I enjoy thinking about and chatting about. Lets have a go.

Note: I have not read any of the reports that are online yet – so please don’t read these as comments about any of the work, as it will be out of context. They are comments about me being a nerd.

What is an effective tax rate?

What is a tax rate? People in the media will talk about how I’ll pay a tax rate of 39% if I’m earning over $180,000 per year – but is that the right number? What about tax I pay when I spend at the shops? What about when I pay local govt rates? What am I even paying 39% of?

Well, this 39% is called a marginal tax rate as it refers to the proportion of an additional dollar of income I would pay directly in income tax.

So it doesn’t count other types of taxes I’d pay. And it doesn’t tell me how much tax I’d pay on the first $180,000 earned during that year.

Now what does it look like when I consider the tax I paid during a year from some measure of the income I earned – that tax paid divided by the income earned is the average tax rate. If I was earning $180,000pa at work my average tax rate would be way lower than 39% – in fact using this neat tool it looks like it looks like it would be 28%.

An effective tax rate takes these two concepts and runs with them – it takes into account other bits and bobs of tax, and importantly it will count “government transfers” in some way – either as income or as a negative tax. Look we’ll come back to this point.

What is income, what is tax?

So what is income? Well that’s a pretty hard topic – income is, in principle, going to refer to what “people can contribute from” on the basis of the means they have. There are legitimate debates about people’s ability to contribute from some things that are called income – and personally I find it easier just to think about these topics in terms of consumption. But we have an income tax system, and so these debates are key!

Lets ignore them!

So we are thinking about contributions to government from some amount of income. There are three types of broad income concepts I want to think about here.

• Market income: The income people generate before they receive anything directly from government, or get taxed.
• Gross income: The income people are sitting around with before they get taxed.
• Disposable income: The income people are left sitting with after they’ve paid tax.

There are other terms, taxable income, adjusted gross income, capital income, labour income, imputed income. But for our purposes, who cares.

The first two (market and gross) are a base that we can build tax measures from. One thing that people get minced up on is that they hear “tax rate” and they think there is one measure to rule them all. But for different questions the relevant rate is completely different!

• Intensive work margin: Hey, I am thinking about work a slightly longer shift this week – what is my tax rate?
• Extensive work margin: I’ve been out of the workforce looking after my young child and I’m thinking about jumping into work – what is my tax rate?
• Redistribution of income: I’m worried about inequality in our society, and I wanted to understand how taxes and government spending is reducing this? Can I do this with a distribution of tax rates?
• Earnings period: I’m taking a big risk going out and building up my hairdressing business – and with COVID coming in and out my profits are going to jump around a lot – how does my tax rate compare to one of the hairdressers I hire over the 30 years I run the business?

Effective rates and the choice to do something … usually work

The first two are “financial disincentives to work” – the first one is a “marginal” tax rate (the effective marginal tax rate, or EMTR), the second is an average or participation tax rate (the EATR, or ETR).

For this we want to start with what people are receiving in the starting circumstance (their gross income) and talk about how much is taken away as a contribution (the difference between gross and disposable income). In the first case the person is working and works a tiny bit more, in the second case they aren’t working and jump to work a number of hours. We care about the two measures as they are refering to two different “choices” related to work – the decision to work a little bit more (intensive margin) vs the decision to move from not working to working (the extensive or participation margin).

The tax here refers to more than just the tangible tax contribution. It also includes any abatement of government support – or in english, the amount your benefits are reduced as you earn more income.

Here the tax rate is the ratio of (tax + benefit removed) divided by gross income. This is because this is the proportion of gross income that is sacrificed when you decide to undertake this other choice – or in english, if your boss pays you a given amount more, how much of that amount goes back to the government.

These types of disincentives can also be considered for a much wider range of behaviours – saving, investment, reporting of income – but work incentives are just a great example of how we’d use such a measure!

Effective tax rates and “fairness” – redistribution

The third is a wildly different rate – we aren’t asking about people’s incentives to work, but instead how taxes and transfers transform market income to disposable income. This one is more about “fairness” more generally. It doesn’t tell us what is fair (redistribution is a value-laden issue), but if we coherently want to talk about people paying their “fair share” we want to be building this measure – not the measures of financial disincentives to work.

This third one involves subtracting benefits from tax, and not including benefits in income to start with – so the “tax” is the net payment by the individual to government (tax – benefits) while the “income” base should be the “initial” market income in the absense of taxes and benefits.

The rationale is that this measure of the tax rate is representing the way the tax and transfer system transforms your market income which relates to how much is changes relative to that income.

The difference between disposable and market income is benefit minus taxes, and so the system has generated this by adding benefits to your income, and taking away tax. You “contribute” in a fiscal sense when taxes paid exceed benefits received, and you are “contributing” from the private/market income that is generated from transactions without the imposition of the tax-transfer system.

In terms of “contribution” it may be that many people are not net contributors, but that is by design – “market” incomes are not the demarcation of fairness, and the real question is then whether policy does enough (or too much) to address inequities that do exist in this distribution. In other words, there is no substitute for actually talking about the actual incomes and opportunities that people face and the trade-offs involved.

Furthermore there is a huge wrinkle in these definitions – behaviour. The market income distribution would look very different without taxes and transfers, and in this definition we’ve assumed it wouldn’t change. As a result, it is normally a bit more accurate to say that “the individuals involved in the transactions that lead to market income are contributing” rather than the sole individual who is paying the tax (to capture the idea of tax incidence) – but even then there are shortcomings related to behaviour and counterfactual activities. So we gotta be careful!

How do we get to this fairness measure?

Actually, this is a fun topic – so I’m going to dive into it a little bit.

Now there is a lot of debate about fairness and ETRs in the literature – and the literature often goes in a different direction. By definition the progressivity of the tax system is just a measure of tax paid from an income base, and gross income is a legitimate base to ask how progressive taxes are.

But this isn’t fairness.

If our questions are about whether government policy is “fair” we should be looking at all government policies together, and the way this redistributes income – any half measure of this just doesn’t really tell us anything useful. Yes you’ve stopped a bunch of people having a negative infinitey tax rate when you draw a graph – but you’ve also made your measure treat a dollar paid to someone and a dollar taken from the same person not equivalent!

Ok I need to explain this. Imagine we have a person earning $10. We then tax them $5 and given it back to them. What is their tax rate? If we only looked at taxes on market income it is 50%. If we added benefits in to get gross income it is now $5/$15, or 33%. But their situation – and any view about their contribution – is exactly the same as if there is no tax!!

Fairness is about asking about the change in an individuals situation due to the redistribution tax-transfer system – we then debate if this redistribution meets our “principles of fairness”. Looking at only one part of the system and ignoring the rest to make fairness claims is incoherent.

A “fair” system will redistribute between people based on a set of values – and so if we are using the tax rate to describe this we would want to treat circumstances where the individuals situation is unchanged in an equivalent way. This measure does not and so will give us different numbers for two policies that are exactly the same!

Now, if the goal is to try to look at taxes and benefits in isolation and talk about relative effects, then playing with a variety of income bases is sort of interesting! And if the goal is to comment on distortions in behaviour, and the $5 payment is happening regardless, then this is the damned right measure (hence why I’m using a similar definition here).

I’d even concede that we might have fairness concerns about sharp benefit abatement and poverty traps- which may be easier to understand by looking at the financial disincentive measure.

But if the goal is to comment comprehensively about fariness of the overall tax-transfer system through redistribution, we want to use market income as the denominator and subtract transfers from tax, to ensure we compare policies consistently – by looking at the net amount redistributed to the individual/family as a proportion of the initial (market) income. Anyway, if you are interested read this cool paper (Herault and Azpitarte 2015).

And before anyone swings to the extreme of saying “over 50% of people aren’t net contributors, that is unfair, lets cut taxes” let me give a clear response – yawn. In a world where significant value is generated from the technology and the knowledge we share, it could easily be the case that the “fair” distribution involves even more people being net contributors – and the argument you are making is as incoherent as the situation described above.

To do a fairness comparison we really need to ask “how does the observed contribution compare with how it should be according to our fairness principles”? For this it makes more sense to actually report the distribution of income, and counterfactual distribution if policy was different – what are the outcomes and opportunities for people on the basis of a tangible policy change.

Lifetime contributions

The fourth could be about either incentives or fairness as the person didn’t tell us – but we would want to think about it in a lifetime basis. In New Zealand we don’t tax capital gains (meaning there is income that doesn’t get taxed for the owner in so far as they spend their own time building up the business and goodwill) but we also have a progressive tax scale which taxes “variable” incomes more.

So here, should we be taxing capital gains? If so what part, do we tax inflation? Do we tax the “risk-free return”? If profits are taxed in the future are we double taxing now? Or are we just taxing the bit that is hidden labour income and economic rents?

Hells if I know – the main thing is that if we have a lifetime perspective of the net contribution to government from market income, some of this will wash out, and some important parts will not.

As a result, any discussion on effective tax rates – especially at the top end with a lot of “capital income” – will need to have a discussion of this time dimension. This is where stuff gets super fun – and where we’ll leave todays yarn!

Being born in the old Soviet Union, and having talked to my parents about their experience with it, I thought it might be useful to share my views on the topic. 

What is the Parasite law?

The parasite law was Article 12 of the old Soviet constitution.  It reads as:

In the U.S.S.R. work is a duty and a matter of honour for every able-bodied citizen, in accordance with the principle: “He who does not work, neither shall he eat.”The principle applied in the U.S.S.R. is that of socialism : “From each according to his ability, to each according to his work.”

The parasite law was introduced in the 1936 Constitution with the moral precept that “he who does not work shall not eat,”. However, the “anti-parasite law” that is usually discussed took effect later in 1961. The law then established that all able-bodied adults who do not contribute to the collective work efforts, namely living a parasitic way of life, will be sent to exile in a specific region for a period of two to five years. 

It is not clear how often people were actually sent into exile as parasites as a result of “unearned income” from second-economy activities, but from my parents’ experience I can give the following tip. Even though the law got abolished (amalgamated) in 1976, the perception and the social norms around the law persisted until the end of the Soveit Union. Before writing this post, I called my mom and dad and consulted thoroughly on their work experience under the regime. My dad is 1939 born and mom 1959 born, so they have lived through and worked under different Soviet leaders.

My dad has confirmed that under Khrushev’s and partially Brezhnev’s regimes, it was indeed obligatory for single men and women to work. It was unusual and suspicious to see people walking on streets in the middle of the day (because everyone was supposed to be at work), so the police (militzia) would question them why they are not at work – if they did not have work, they would be taken to a factory and the factory owner would be told to give them a job. My mom confirmed that the idea of obligatory work (especially under Gorbachev – effectively when I was born), would still apply, but mainly to single men.  Furthermore, the expectation wasn’t as strict towards women with kids. 

My parents spoke very positively about past times and they haven’t felt that the restriction was affecting their happiness. 

What is it to do with MMT theory? 

The recent blog by MMT theorist Bill Mitchell points out how this same view underlies the job guarantee he sees as essential to MMT as a functional macroeconomic and political theory.

Let’s note down the first clear problem with such a guarantee.  By treating those who are “less productive” as parasite we can easily go down a road of eugenics and facism – a society, or a nation state, whose sole purpose is maximising output per person may see individuals it deems as without productive value worthless.  And totalitarian regimes (including the Soviet Union) have shown this.  Furthermore, regimes that are excessively free market – without a sufficient safety net – lead to the same issue.

To be fair, Mitchell doesn’t go down this road noting:

Marx clearly considered a progressive society would be one where all those who could work would contribute their efforts to advancing society, while creating surpluses, which would ensure that all those who could not work, would still enjoy a material prosperity in line with the nations’.

Each person should work if they can and contribute to the social product, which would then be distributed according to material need.

People who couldn’t work, would still have their material needs covered.

So instead the moral is from each according to their ability to each according to their need.  Standard Marxism.  Even so there is something that just doesn’t sit right with me.

Often you will hear that a “job guarantee is good for people by ensuring they have work”, where such options are good things. But it is a short step from giving someone the option of work to making it an “obligation” – which is exactly what Bill is pushing. When you are obliged to work for the greater good, when your ability determines that you need to sacrifice your time “for the state”, doesn’t it start to sound like slavery?  Furthermore, what is your incentive to work, how does this ensure that you get allocated to your comparative advantage?

A job guarantee doesn’t ensure you get the job you want – it just ensures you are in a job.  The distinction is significant.  By forcing people to be in work, instead of giving people time to search (which is what most measured unemployment is outside of a recession), will that really put people into jobs where they are happier? Will it even really make the most productive jobs happen?  Finally, who wears the boots if you are obliged to work – does the employer get extra power over you, or does the state more strongly dictate what both of you can do?

Proponents of the Soviet/MMT left, pure free marketers, and the nationalistic right all share the view that someone’s value comes from their ability to produce.  Whether it be a view that all value is derived from labour or instead a more nuanced view that productive value stems from factors of production in general view is that our value comes from what we can produce.  Although theoretically the left and the right (of the above discussion) differ in terms of how that production is allocated, both sides agree that we have an obligation to produce as much as possible.

But this isn’t it.  There is a difference between these people and others who see “social value” embedded in factors of production and technology that should be shared without obligation.

A lot of my economist friends believe in a safety net that is provided without obligation – a minimum standard, a social dividend.  Then given that individuals should be incentivised to move into work, or invest in ideas or capital equipment, on the basis of what they can produce with it. 

The free marketers/strict capitalists overplay the incentive angle without thinking about the differences in power/opportunity – differences that can even destroy incentives to invest in skills and enforce hierarchies to make up for the lack of safety.  The Soviet/MMT/nationalists concentrate on their definitions of obligations and power without thinking about incentives or why production truly has value.  

Our modern society has looked past these naive definitions to give individuals choice, but to offer them a safety net when they fall – it is about maximising wellbeing, not making us machines that build as much stuff as possible.  Quite why people feel a romance for removing choice from others to ensure they are “productive” for the “nation” doesn’t make sense to me, and makes me uncomfortable about MMT – which I had previously thought had something to do with monetary policy.

People born after 1984 have different preferences and a different life experience than people born earlier. Their phones are better, their clothes use less cloth, their cars are more fuel efficient, and they probably left home at a later age. They may eat less meat, be more concerned about global warming, and have a longer life expectancy.

Firms design products for these cohorts that are very different to the products they designed for young people a generation or two ago.

Strangely, however, the government obliges these cohorts to use a similar retirement income policy as their parents. Sure, they occasionally argue over small details such as whether the age of entitlement (on young cohorts) will be raised from 65 to 67, but they never ask: is the current system fit for purpose for a new generation?

What’s wrong with current retirement policy?

There are two good reasons why old people don’t ask this question.

First, the answer is that it is not fit for purpose and will impose large costs on current and future young people.

It was designed with minimal input from current cohorts and is unlikely to meet their needs or desires, particularly as it imposes very large opportunity costs on current and future generations of young people – billions of dollars of costs .

Secondly, it is not easy to change.

The current system directly intertwines people of all ages and if young cohorts were freed from the system there would be large costs on old cohorts. Politicians and bureaucrats of all stripes have been of the opinion that it is better to continue in silence than to unravel that Gordian knot. 

The core problem was examined half a century ago by a trio of Nobel-prize winning economists: Paul Samuelson, Edmond Phelps, and Peter Diamond.

They noted there are two basic ways that you can design a retirement income policy, a pay-as-you-go system and a save-as-you-go system.

In a pay-as-you-go system, young cohorts make transfers directly to old cohorts, and nothing is saved.

This was the traditional arrangement within families from time immemorial: when people got too old to work, they lived with their adult children and their adult children supported them – just as they may have supported their parents when they were younger adults, and just as they supported their children when their children were young. Starting in the 1930s many countries designed public retirement income schemes around this principle. Ironically, these systems were introduced at the same time as they were starting to go out of fashion within the family. 

In a save-as-you-go system cohorts fund their own retirement.

In the private sector, this means people provide for their own retirements by saving, investing and accumulating assets. This is possible in the public sector as well: instead of transferring taxes directly from tax-payers to New Zealand Superannuation recipients, the taxes would be accumulated in a fund and the savings plus compounded earnings, interest, and dividends would be used to pay the pensions of the contributors much later in life. This is the basic idea behind the New Zealand Superannuation Fund.  

Does it matter which system you use?

Peter Diamond showed that the cost of the system depends on whether or not the return to investment exceeds the growth rate of the economy, a condition economists call “dynamic efficiency”.

The implicit return to a pay-as-you-go system is the rate of economic growth (population growth plus productivity growth) [I have explained this elsewhere: see Coleman 2014]. The return to a save-as-you-go system is the average return to investments.

If the economic growth rate is higher than return to investment, a pay-as-you-go-system is the best system. If the return to investment is higher than the economic growth rate, a save-as-you-system is less costly. The difference can be considerable. New Zealand currently raises about $14 billion in taxes to pay pensions. If we had a save-as-you go system, the same pensions could be paid for half that sum. 

The big problem is that once you have a pay-as-you-go system, you can’t exit it without imposing costs.

If young people stopped paying taxes to provide the pensions of old people, these costs would fall on old people – an unacceptable solution. If young people were asked to pay the pensions for old people and save for their own pensions, the costs would fall on themselves.

Rather than confront this difficult arithmetic, politicians have been prepared to avert their gaze and proceed with the current system. Sadly this means turning a blind eye to the large opportunity costs that fall on current and future young generations – something an honest economist can’t abide. 

Well this sucks … what could we do?

Fortunately, there are middle solutions.

One is to significantly increase funding contributions to the New Zealand Superannuation Fund: that is, to increase taxes now so that the future increases in the taxes necessary to pay future government-provided pensions is reduced. Survey evidence suggests that two-thirds of New Zealanders of all ages support this option [Au, Coleman, Sullivan 2019, working paper here].

But in some ways, this avoids one of the central questions. This question is how to design a pension scheme that young people want?

Public policy often proceeds on the principle that there should be a single rule for everyone. This makes sense for some rules – yes, all people should drive on the left (unless all people drive on the right). But it doesn’t make sense for all rules.

There is no inherent reason why people born after 1985 should have the same pension scheme as people born before 1985. There is no inherent reason why people born after 1985 should have the same structure of taxes as people born before 1985. True, it may be difficult to make the transition from one system to another, but difficult and impossible are different things. 

There are good reasons why people born before 1985 might want a different superannuation system, or even an entirely different tax-transfer system than the system currently in place.

Economists have not explored these questions in depth – how might an economy work if it had two tax systems concurrently, one for people born after 1985, and one for people born before 1985? We don’t know. But there are three good reasons to find out.:

• First it is profoundly democratic – young people could have a system designed by themselves, for themselves, meeting their aims and objectives.
• Secondly, it may enable a transition out of the current system, a system that economists recognize probably imposes very large costs on young generations and future generations.
• Thirdly, it may enable them to design a system which is much more environmentally friendly – a topic for future posts. 

Young people arise. You have nothing to lose but their claims.

The authors then used this data to ascertain if there was a consistent relationship between the taxes and regulations that businesses in each country face and the amount of investment taking place in each country. There was: the countries with lower tax rates and less onerous regulations tended to have more investment and more foreign investment. The data were considered so useful that the exercise is now repeated annually. One of the original papers by this group of authors, “The effect of corporate taxes on investment and entrepreneurship” (published in 2010) has been cited more than 750 times. 

New Zealand has low levels of capital for a country of its income level and quite high corporate taxes. 

‘Quite high’ is actually an understatement: in 2004 (that year the data used in the 2010 paper were collected) New Zealand was third highest in the OECD (if social security tax payments made on behalf of workers are excluded), and in 2016 it was the highest. At the same time taxes paid by average workers were the second or third lowest in the OECD, slightly higher than Chile but lower than just about everywhere else. 

The basic reason why New Zealand has relatively high taxes on capital incomes and relatively low taxes on labour incomes is that New Zealand has much smaller social security taxes than almost all other OECD countries, and does not have a compulsory contributory superannuation system. Social Security taxes are only levied on labour income, not capital income, and this forces a wedge between the average tax rates on these two forms of income. On average, OECD countries raise about 9 percent of GDP in these social security taxes. New Zealand raises about 2 percent of GDP, from ACC contributions. 

I have discussed the potential consequences of this in more detail here.  There are at least three theoretical reasons to think that social security taxes – or a compulsory saving scheme – may be a good idea. 

1. First, social security taxes should create fewer disincentives than other taxes, for in most countries the more money a person pays in taxes the larger the pension they receive. (This does not have to be the case, however: Ireland has a social security tax system, but pension entitlement depends on time in the country not the amount a person has paid in taxes.) 
2. Secondly, a compulsory saving scheme may reduce long run wealth inequality. 
3. And thirdly, social security taxes are a very easy way of letting the tax rates on labour incomes and capital incomes diverge.

The argument that there is no good reason for the tax rates on capital and labour income to be the same was formalised by the Nobel Prize winning economists James Mirrlees and Peter Diamond in the early 1970s (in two articles: on the non-taxation of intermediate goods and on an optimal linear income tax). There has been almost universal acceptance of the basic principle by tax economists ever since (see the discussion in Chapter 6 here or here). 

They argued an optimal tax system should result in a trade-off between redistributive equity objectives and production-enhancing efficiency objectives. Since capital incomes are unevenly distributed, the former motive suggests higher taxes on capital incomes. Since capital is supplied more elastically than labour (meaning the supply of labour does not change much when taxes change, but the supply of capital can change a lot or can be directed to sectors with low tax rates), this provides a reason for low taxes on capital incomes. 

This trade-off suggests labour income taxes could be higher or lower than capital income taxes, depending on both preferences for redistribution and the technical responsiveness of labour and capital to tax rates. 

Most countries have decided that tax rates on capital incomes should be lower than tax rates on labour incomes. These countries include Norway, Sweden, Finland and Denmark, – countries famous for their low income inequality and redistributive policies – which have invented the Nordic tax system (the Nordic model). 

The Nordic model has the same initial basic tax rate for capital and labour incomes, but labour incomes are subject to steeply rising marginal tax rates whereas capital incomes are not. The reason: the Scandinavian countries do not want to jeopardise the high levels of capital investment that help generate high incomes in their countries, fearing that high taxes on capital incomes would generate capital flight. 

Furthermore, wages are likely to decline if capital stocks decline in response to taxes, so that the burden of capital income taxation partially falls on workers as lower wages. (This is a widely accepted result, and there is recent empirical evidence from Germany and the United States supporting this idea.) The appropriate tax on capital incomes is not zero, as some theorists have argued, but there are few who argue it should be higher than the tax on labour incomes either. 

So why has New Zealand adopted a tax system that is significantly different from those in most OECD countries? Do these differences create incentives that lead to a low capital, low productivity economy? I suspect that they do, and it is a conversation – with evidence – that New Zealand needs to have.

At least two possibilities, and the assumptions that they require, come to mind.

The first is that there may be fundamental technical reasons why it is efficient for New Zealand to have low taxes on labour incomes and high taxes on capital incomes. The responsiveness of labour to tax rates could be much higher in New Zealand than in other countries, or the responsiveness of capital to tax could be much lower. This could mean it is not optimal to have higher taxes on labour incomes than capital incomes.

Secondly, it could be that New Zealand has a higher preference for income redistribution than other countries, so New Zealanders are prepared to have inefficiently high taxes on capital incomes because of equity considerations. (There is not much evidence that this is true, as our tax system is not particularly redistributive – New Zealand has a low top marginal tax rate, for example).

Either way, it would be useful to understand why New Zealand’s tax system looks so different from those in the rest of the world. We can hope the new Secretary is just the person to ensure the analysis takes place.

Literature on optimal capital taxation

Optimal taxation would involve individualized lump-sum taxes based on individuals’ earning ability (Kaplow 2006).  However, differences in earning ability are unobservable, so income is used as a signal of underlying ability – the problem is that taxing income will change people’s choices and so is distortionary.

Optimal labour income taxes were discussed by (Mirrlees, 1971) – with a surprising amount of foresight regarding the types of extensions that have come out of the literature over the last 50 years.  The rejection of distortions to productive efficiency, and thereby not taxing intermediate goods, was then argued in Diamond-Mirrlees ( (Diamond & Mirrlees, 1971)a and (Diamond & Mirrlees, 1971)b).

Justification for a tax rate of zero on capital income comes from linking the two in (Atkinson & Stiglitz, 1976) *.  Given this is a comparative-static GE result, a seemingly separate dynamic result from Chamley-Judd ( (Chamley, 1986) * and (Judd, 1985) *) also reinforced the conclusion.  The two broad arguments for a zero rate of tax on capital income are:

1. Atkinson-Stiglitz:  Any type of tax on capital income is a differential tax on commodities (through time) which leads to a misallocation not just due to this acting as a tax on labour, but also an intertemporal misallocation – so assuming that labour and consumption are separable in utility (such that consumption doesn’t tell us anything about an individuals ability) it is most efficient to simply tax labour to raise revenue.

• Chamley-Judd results:  This result has been discussed in two ways – however only the first way is consistent (Jacobs & Rusu, 2018). 
• A tax on capital is an increasing tax on consumption through time (Judd, 1999) * – making this consistent with the (Atkinson & Stiglitz, 1976) result.  This is also stated in terms of the taxation of capital (including human capital) as being taxation of an intermediate good – however (Diamond & Saez, 2011) * disagree with this interpretation.
• The supply of capital becomes infinitely elastic in the long run, so the entire burden of a tax on capital income is borne on labour.  However, this is generally not accepted – the issue here is that the result still holds for a small open economy where the gross interest rate does not change (Jacobs & Rusu, 2018).

Put this way both view boil down to the same key distortion associated with capital income taxation, which we wish to avoid, is that it involves taxing consumption at different periods of time differently.

So to justify a tax on capital income we need to justify why we would want to tax consumption at different periods of time differently – is there a second best argument, a distinction between consumption at points in time, another intertemporal allocation issue, or a corresponding market failure?

This logic suggests a number of channels that could justify why the optimal tax rate on capital income may be different from zero (note that this is probably not exhaustive, and there may be repetition in cases where I accidentally interpreted the same argument in different terms eg some of the following examples are just cases of “non-separable utility”.).

Although all these issues are mentioned by a number of papers, the key assumptions used to practically estimate higher capital taxes are highlighted in red.

Preferences

• Non-separable utility: If labour/leisure and consumption are not separable in utility then it provides information about ability which allows for a tax/subsidy.
• Capital income as varyingly complementary to leisure over time: (Kaplow, 2008) * points out that, with the taxation of labour income causing one distortion it is optimal (in a second best sense) to tax complements to leisure.  (Jacobs & Rusu, 2018) points out that the Chamley-Judd result can be recovered as long as preferences are separable between consumption and leisure through time.  If these preferences differ over time (eg where you would have a form of age-based taxation that is higher when capital income tends to be higher in a lifecycle) you can justify a positive capital tax in the absence of other information (eg using an age based tax).
• Heterogenous saving/consumption tastes by ability:  (Saez, 2002)a * argues a similar point to the one above but instead focused on subgroups – focusing on the idea that those with high ability have a higher taste for savings (eg if high income people were forced to work less to have the same income as lower income individuals, their savings rates would still be higher).  This is further explained in (Golosov, Troshkin, Tsyvinski, & Weinzierl, 2011) *.
  • Sidenote 1: Heterogeniety makes many of the results complex as noted https://www.nber.org/papers/w14170 https://feb.kuleuven.be/drc/Economics/misc/seminars/papers2015/paper_Lehmann.pdf
  • Sidenote 2: It is key to remember that heterogenous preference for leisure complicates a number of results – although this is more about the structure of tax schedules.  However, I raise it as once we start allowing for heterogeneity to drive “unequal treatment” in taxation we have to be consistent! http://qed.econ.queensu.ca/pub/faculty/boadway/Difpref190700.pdf

http://www.sherppa.ugent.be/newsandevents/atkinson/hetpref040315.pdf

https://www.sciencedirect.com/science/article/abs/pii/S0047272715000134

• Complementarity between capital income and work incentives:  If having capital decreases the cost of work, this would lower the optimal capital tax rate (Saez & Stantcheva, 2018) *
• Heterogeneous tastes, or a pecuniary taste, for different assets:  If individuals have pecuniary reasons for holding a given asset, then there is a motivation for taxing that asset.  If there are pecuniary reasons for holding assets/wealth in general that can motivate a capital tax.
• Myopia and short-planning horizons
• Self-insurance (precautionary motive) and bequest motives for capital accumulation: Other motives for saving or investing (eg precautionary motives given expectations of a borrowing constraint, a preference to build up a bequest).

Abilities and endowments

• Different endowments: Inheritance of human and financial capital (related to bequest motives) and differences in initial wealth give a role for redistribution (Saez, 2002)b *
• Differing abilities to obtain returns out of financial assets:  If heterogenous returns on investment income is a signal of underlying skill level, the return to capital should be taxed. (Kristjansson, 2016) *
• Unanticipated change in individuals skills over time (New Dynamic Public Finance):  Justifies a regressive (in income) wealth tax to increase work effort (Kocherlakota, 2005) * (Golosov, Kocherlakota, & Tsyvinski, 2003) *.

Imperfect markets/income identification

• Undiversifiable risk in capital incomes: Capital income tax can work as a form of insurance – implying that the optimal capital tax rises with income risk (Krueger & Ludwig, 2018) *
• Borrowing constraints: With borrowing constraints there are individuals who want to borrow but can’t.  Taxing labour instead of capital worsens this constraint, with a corresponding efficiency cost.  (Hubbard, Judd, & Hall, 1986) *.
• Uninsurable risk in labour income: Uninsurable shocks to labour productivity with borrowing constraints offer a justification for capital taxation (Conesa, Kitao, & Krueger, 2009) *
• Tax avoidance/income shifting/distinguishing entrepreneurial compensation vs the return to capital: (https://ideas.repec.org/a/cup/macdyn/v15y2011i03p326-335_00.html) – can’t find a pdf version.

Other model based complications

• Dynamic inefficiency in OLG models without age dependent taxes: The economy doesn’t reach its full productive capacity as current generations do not take into account the effect of their savings on future generations. (Atkinson & Sandmo, 1980) * (Garriga, 2017) * 
• The response of wage distributions to the capital stock – and thereby distribution of pre-tax income Stiglitz 1985 mentioned in (Piketty & Saez, 2012).
• Capital-skill complementarity:  http://home.cerge-ei.cz/slavik/paper/slidesKSY.pdf – if capital and skills/ability are complementary then this justifies a larger tax on capital.
• According to (Straub & Werning, 2014) * the Chamley-Judd result is also dependent on the elasticity of intertemporal substitution (1/sigma).  Here this elasticity needs to be greater than 1, such that consumption falls as the future real interest rate rises.  Without this then there is a justification for a positive capital tax.  The strength of this critique is questioned in (Chari, Nicolini, & Teles, 2016) *.
• Substitutability of research spending and new capital construction:  https://ideas.repec.org/a/red/issued/05-30.html
• Taxation of “excess return”:  The argument here appears to be that, by taxing excess return, you do not distort behaviour while raising revenue (Bastani & Waldenstrom, 2018).
• Optimal human capital accumulation:  With labour taxes reducing human capital accumulation, a tax on capital to reduce this intertemporal wedge can be efficient (Jacobs & Bovenberg, 2009) *.

Additional normative dimensions

• Taxing wealth or the RFRR in order to incentivise efficient use of assets (Guvenen, Kambourov, Kuruscu, Ocampo-Diaz, & Chen, 2018) *.
• Social welfare weights may be explicitly correlated with capital, where only consumption taxes only act as a levy on wealth rather than reducing wealth inequality (Saez & Stantcheva, 2018) *.

What should the top capital rate be?

Most literature suggests that capital income should be taxed – but that it should generally be at a lower rate than labour. (Banks & Diamond, 2008) * describes it well.

The conclusion that capital income should be taxed does not however lead to the conclusion that the tax base should simply be total income, i.e. the sum of labour income and capital income.  This chapter leans towards relating marginal tax rates on capital and labour incomes to each other in some way (as in the US), as opposed to the Nordic dual tax where there is a universal flat rate of tax on capital income.

However both (Saez & Stantcheva, 2018) * (including (Piketty & Saez, 2012) *) and (Conesa, Kitao, & Krueger, 2009) * suggest that it may be optimal to tax capital more highly than labour – both focused on redistributive grounds.  As a result, it is important to understand where their results come from.  Below we will focus on optimal linear capital taxes, rather than the non-linear results, for practical purposes.

(Piketty & Saez, 2012) * aims to tie together a lot of these threads in order to provide a general model of the optimal capital tax rate.  This should be seen alongside the top marginal labour tax rate paper (Piketty, Saez, & Stantcheva, 2013) * and the (Saez & Stantcheva, 2018) * paper that attempted more tractable optimal capital tax model.

The paper works through two directions.

Firstly, with perfect capital markets they give a case for inheritance tax (of 50-60%) in the following way:

The key feature of our model is that inequality permanently arises from two dimensions: differences in labor income due to differences in ability, and differences in inheritances due to differences in parental tastes for bequests and parental resources. Importantly, top labor earners and top successors are never exactly the same people, implying a non-degenerate trade-off between the taxation of labor income and the taxation of capitalized inheritance. In that context, in contrast to the famous Atkinson-Stiglitz result, the tax system that maximizes social welfare includes positive taxes on bequests even with optimal labor taxation because, with inheritances, labor income is no longer the unique determinant of life-time resources.

Secondly, with capital market and uninsurable shocks they look at the optimal mix between a one-off inheritance tax and lifetime capital taxation (this is section 5).  However, they don’t really seem to go into detail here – just pointing out that a “fuzzy boundary” for labour and capital income, and uninsurable risks, are reasons why we might tax capital income instead of just bequests.

As a result, it is the initial bequest result that drives their recommendation of relatively high rates of capital taxation.  This involves assumptions of differential tastes for wealth and bequests (page 11) and stochastic shocks in earnings ability across generations defined with a real rate of return higher than economic growth (making bequests accumulate across generations).  This framework will tend to push for the taxation of capital.

(Saez & Stantcheva, 2018) * aims to provide a clearer model that highlights the efficiency-equity trade-off that cuts to the core assumptions that give taxation of capital income.

They then point out that two different assumptions could lead to the result of zero capital taxation – no value placed in the welfare function on the distribution of capital income, and infinite (long run) elasticity of capital.

In order to prevent this infinite elasticity wealth needs to be in the utility function (Note: uncertainty about future earnings achieves the same thing).  To get a distribution of wealth outcomes, heterogenous wealth preferences are required.  These two assumptions are key to the idea of an optimal capital tax.  For the level of the tax they state:

Because capital income is much more concentrated than labor income, we find that, if the supply elasticities of labor and capital with respect to tax rates were the same, the top tax rate on capital income would be higher than the top tax rate on labor income

As a result, a higher LR supply elasticity for capital gives a lower optimal rate.  The importance of the bequest motive is then key for determining the optimal capital tax rate.

There is no “benchmark” for comparison.  So although the tax rate gives maximum welfare the aggregate trade-offs involved are unclear.  Pg 136 offers a table that summarises the assumptions changing the optimal capital tax rate.

The (Conesa, Kitao, & Krueger, 2009) * result does not rely on wealth in utility or bequest motives.  Instead they rely on a lifecycle model with borrowing constraints for households, ex-ante heterogeneity in labour productivity (across cohorts), endogenous labour supply, and idiosyncratic income risk through shocks to labour productivity.  As long as these factors all hold, and age-based taxation is not available, capital taxation can fill a similar redistributive role.

The high capital income tax result of this paper is generated by the fact that it is an indirect age-based tax, that helps to redistribute for realised productivity outcomes that were not expected ex-ante – use of a progressive labour tax would reduce labour supply in this case, which is a distortion that can be reduced with the capital tax.

Simulations in this paper show that this is a welfare maximising choice – but it does come with lower GDP, labour supply, capital, and consumption than the benchmark.  This implies to me that the benchmark comparison (which isn’t clearly outlined in the paper, other than a suggestion that it matched stylized facts about the US) must involve significantly less redistribution.

As a result, if current taxation is the result of lower preferences for redistribution than that implied by this model, the level of capital taxation (which is based on such redistribution) would be significantly lower.

Tax equality

The one thing the literature seems to agree on is that the tax rate on labour and capital should not be the same.  However, as has been emailed the “fuzzy boundary” between labour and capital income is being stated as a reason why they should be the same.

This was a good article with respect to Phil’s point that lower taxation of capital income encourages identifying labour income as capital income – and that this is a big part tax avoidance towards the top of the income distribution in the US.

https://siepr.stanford.edu/research/publications/tax-avoidance-top

The income data they are talking about for this is here:

https://www.nber.org/papers/w25442

One point that is missing from the article is that, if lower taxation of capital income is justified on the basis of capital being more response to taxation then we if this “labour income” is also more responsive than other types of labour income the same argument would hold.  Given that a lot of it involves returns to innovation this could potentially dovetail into the literature on top tax rates and innovation (https://www.nber.org/reporter/2018number3/stantcheva.html) – which in turn could justify this unequal treatment in a way the article doesn’t note as a possibility.  

Bibliography

Atkinson, A., & Sandmo, A. (1980). Welfare Implications of the Taxation of Savings. The Economic Journal, 529-549.

Atkinson, A., & Stiglitz, J. (1976). The Design of Tax Structure: Direct Versus Indirect Taxation. Journal of Public Economics(6), 55-75.

Banks, J., & Diamond, P. (2008). The Base for Direct Taxation. Report of a Commission on Reforming the Tax System fr the 21st Century. Oxford: IFS.

Bastani, S., & Waldenstrom, D. (2018). How Should Capital Be Taxed? Theory and Evidence from Sweden. IZA Discussion Paper Series(11475).

Chamley, C. (1986). Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives. Econometrica, 54(3), 607-622.

Chari, V., Nicolini, J., & Teles, P. (2016). More on the Optimal Taxation of Capital. European Univeristy Institute.

Conesa, J., Kitao, S., & Krueger, D. (2009). Taxing Capital? Not a Bad Idea After All! American Economic Review, 99(1), 25-48.

Diamond, P., & Mirrlees, J. (1971). Optimal Taxation and Public Production II: Tax Rules. The American Economic Review, 61(3), 261-278.

Diamond, P., & Mirrlees, J. (1971). Optimal Taxation and Public Production: I — Productive Efficiency. American Economic Review, 61(1), 8-27.

Diamond, P., & Saez, E. (2011). The Case for a Progressive Tax: From Basic Research to Policy Recommendations. Journal of Economic Perspectives, 25(4), 165-190.

Garriga, C. (2017). Optimal Fiscal Policy in Overlapping Generations Models. Federal Reserve Bank of St Louis Working Paper Series.

Golosov, M., Kocherlakota, N., & Tsyvinski, A. (2003). Optimal Indirect and Capital Taxation. Review of Economic Studies(70), 569-587.

Golosov, M., Troshkin, M., Tsyvinski, A., & Weinzierl, M. (2011). Preference Heterogeneity and Optimal Capital Income Taxation. Harvard Business School Working Paper, 11(104).

Guvenen, F., Kambourov, G., Kuruscu, B., Ocampo-Diaz, S., & Chen, D. (2018). Use it or Lose it: Efficiency Gains from Wealth Taxation. Federal Reserve Bank of Atlanta Working Paper.

Hubbard, R. G., Judd, K., & Hall, R. (1986). Liquidity Constraints, Fiscal Policy, and Consumption. Brookings Papers on Economic Activity, 1986(1), 1-59.

Jacobs, B., & Bovenberg, L. (2009). Human capital and optimal positive taxation of capital income. International Tax Public Finance.

Jacobs, B., & Rusu, A. (2018). Why is the Long-Run Tax on Capital Income Zero? Explaining the Chamley-Judd Result. Amsterdam.

Judd, K. (1985). Redistributive Taxation in a Simple Perfect Foresight Model. Journal of Public Economics(28), 59-83.

Judd, K. (1999). Optimal Taxation and Spending in General Competitive Growth Models. Journal of Public Economics(71), 1-26.

Kaplow, L. (2008). Taxing Leisure Complements. NBER Working Paper Series(14397).

Kocherlakota, N. (2005). Zero Expected Wealth Taxes: A Mirrlees Approach to Dynamic Optimal Taxation. Econometrica, 73(5), 1587-1621.

Kristjansson, A. (2016). Optimal taxation with endogenous return to capital. University of Oslo Working Paper.

Krueger, D., & Ludwig, A. (2018). Optimal Taxes on Capital in the OLD Model with Uninsurable Idiosyncratic Income Risk. NBER Working Paper Series(24335).

Mirrlees, J. (1971). An Exploration in the Theory of Optimum Income Taxation. The Review of Economic Studies, 38(2), 175-208.

Piketty, T., & Saez, E. (2012). A Theory of Optimal Capital Taxation. NBER Working Paper Series(17989).

Piketty, T., Saez, E., & Stantcheva, S. (2013). Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities. NBER Working Paper Series(17616).

Saez, E. (2002). Optimal Progressive Capital Income Taxes in the Infinite Horizon Model. NBER Working Paper Series(9046).

Saez, E. (2002). The Desirability of Commodity Taxation under Non-linear Income Taxation and Heterogenous Tastes. Journal of Public Economics(83), 217-230.

Saez, E., & Stantcheva, S. (2018). A simpler theory of optimal capital taxation. Journal of Public Economics(162), 120-142.

Straub, L., & Werning, I. (2014). Positive Long Run Capital Taxation: Chamley-Judd Revisited. NBER Working Paper Series(20441).

Now I think I have a clear idea on it all again, so I’m just noting this down so I can look it up in the future!

Use value:  Read this as utility Matt.  It is the value of the person using it.

Exchange value:  Price.

You’ll notice something is missing here when I talked production functions though … the actual supply of goods and services.

Right ok, how does this all fit into a supply and demand graph?  Well, the use values are points on the demand curve for each product purchased, the exchange value is the market price.  This gives us consumer surplus (the difference between the exchange value and the use value).  Cool.

Then we have producer surplus, as the way the exchange value is above the price necessary to get producers to sell the product.  At each point on the supply curve/marginal cost curve a producer is willing to sell that product individually (covers their costs – including wages – and opportunity cost, which includes a required rate of return) but they receive the market price.  The difference between firm structures (monopoly, perfect competition) is determines where this market price is set – not how the MC curve looks (although X-inefficiency would disagree here).

So producer surplus goes to producers.  Is that funamentally unjust, I mean we haven’t actually made a model of how wages are determined here so I don’t think we can describe it.  The “marginal cost” function that leads to producer surplus has an embedded wage rate which may – in of itself – involve labour receiving surplus value from the production process.  Let us not forget that we need to consider this labour market.

Hence why Marxist factor shares depend on a view about subsistence wages – and sometimes a peripheral view that this surplus is immediately capitalised and can be viewed as a “rent” that is used to accumulate more capital.  But to discuss this we need a general idea about how “steep” supply curves are.  What happens if supply curves are very flat, something you may expect in a situation with constant returns to scale … well producer surplus will not occur in the long run and the “scale” of the firm is determined by demand.

Matt, overall I still think talking in terms of market imperfects and imbalances of bargaining power is a bit more useful than trying to find a “fundamental law” or “contradiction in capitalism”.  Although I know that terminology is popular now (Piketty review, and added notes) lets stay away from it.

Is the Sims the critique of modern capitalism we've all been missing https://t.co/T01dR6Hv5m

— Unlearning Economics (@UnlearningEcon) September 17, 2018

I hear this sort of thing a lot – and want to hear your views.  I will give a view in the future.

Also we used to just play Sim City 2000 in economics class at high school and I thought it would be cool if the individuals in the city followed rules – something they talked about for the latest Sim City but didn’t really do.  So remember any model we build to explain this is sort of like that, just maybe less entertaining with a dearth of colourful sounds.

My concern four years ago was that the non-rationalist identity politics of the left would open this type of negative nationalistic politics on the right – or would at least be used as a foil for it.  The refusal to actually state our assumptions and values is a failure irrespective of the intentions we hold.  In that way, when exploring Youtube I’ve been pleasantly surprised by the leftist video blogs – and their willingness to fully articulate their views.  Key examples of this are Shaun, Contrapoints, and Philosophy Tube.

However, these channels are distinctly “anti-capitalist” in terms of wanting sizable change in the status quo.  I am a mainstream economist that believes in incremental change.  A full discussion of this would be interesting – but give me time.  But to do so we need to get something clear about the labour theory of value that I am hearing them describe – it doesn’t make sense as a justification for anything let alone as a “theory of value”.

Note: The actual labour theory of value has been defined many ways – and the most profitable Marxian interpretation I’ve seen is trying to understand LTV as part of a subsistance wage argument on factor income shares.  That isn’t the focus here.

Here is the theory being used recently on Philosophy Tube [Note: In his Marx video he says there is debate about it … but I was of the impression that Marxists didn’t rely on the specific assumption articulated here, and economists have would not find this particularly useful for description or as having normative significance – after all Joan Robinson did call the whole LTV tautological and a silly verbal game, and she is one of the most historically left leaning people in the economics discipline].

So without labour it does not matter how much capital we have nothing is produced.  Therefore all “profit” is generated by labour and is labour value that is extracted by capitalists.

Now that first premise is true isn’t it?  Without labour, capital produces nothing!  This is indeed an assumption I teach early in stage 1 economics, and the production process in most firms shows this to be very true.  Take the example of a lawnmowing business – if we have a lawnmower but no-one to operate it we can’t mow lawns.  Furthermore, buying another lawnmower won’t “increase” output, as we still have no-one to actually do it!  This is textbook true.

But lets flip the script.  Suppose you have hired a bunch of people to work for several hours for your lawnmower business, but:

1. You provide them no lawnmower [physical capital – or the tools used by labour which increase their output]
2. You provide no fuel for a potential lawnmower [other inputs]
3. You provide no information about where lawns need to be mowed [coordination services]
4. You have no connection to the demand for lawnmowing services [entreprenuership]
5. The labourers have no knowledge or skills that make them able to mow a lawn [human capital]

Well in that case no matter how many people you hire you get no output!  Wait a second … does this mean that all the value of production is embedded in one of these other inputs!!!  No, no, no.

Could it instead be that all factors of production codetermine output.  Furthermore, these factors require a minimum return in order to be supplied, where these rates of return/ prices are termed “profit” and “wages”?  Doesn’t this make it a collaborative process rather than extractive?  [Protip:  It can be both collaborative and extractive – but we need to model why rather than just positing it is ]

The production process

Production is a process of coordination between factors of production – that is why in macroeconomics we have a firm (the thing that combines factors of production to create output) and households (the group that buys output, but also supplies all the different factors of production to the firm – yes including capital, capital owners are “households”).  In macro we refer to these varying incentives (the incentive to supply factors of production to purchase consumption over time, and the incentive to supply output in order to “get profit”).

Yes it is true, labour does not receive the entire surplus from production.  But they don’t supply the only factor of production either – so I am uncertain why they should.  Production is a joint process which creates surplus value – and this surplus value is then shared according to the bargaining power of participants.  Inequity is then a process of insufficient bargaining power – not a natural consequence of private capital.

Much economics treats other factors as fixed and labour as variable.  Typical descriptions of the labour theory of value also look at a “fixed production process” such that additions to labour explain the entire addition to output.  Furthermore, there is an opportunity cost associated with every single input – labour is sacrificing alternative uses of their time, capital owners could liquidate assets to fund consumption or alternative investments.  Each has an opportunity cost, and is undertaking a process that creates surplus value – we need to ask about the relative bargaining power (which then determines the price here, the real wage) in order to ask how this is split.

Or to put it another way, there is a stock of labour and a flow of labour provision (hours of work) which is remunerated with wages, there is a stock of physical and coordination capital and a flow of related business services (the use of capital hours, “effective” entrepreneurial labour by capital owners) which is remunerated through profits.  Those utilising capital may need to borrow in some way (selling shares, borrowing from a bank) to put this in place which then changes the allocation of these profits sure – but is still predicated on the provision of this flow of services.

So given that economists often treat the level of capital as if it is fixed and provided in the moment (a similar assumption to the one we make for land – and one that is not necessarily appropriate in many instances), if we want a theory of price determination looking at the “labour embodied in a production process” appeared to be a way to get there.  This Ricardian view wasn’t saying that labour was solely responsible for production – this is a semantic point that gets lost!

In the end this left some problems though – why is a painting that ages with no additional labour input more expensive than when it was initially painted?  The solution to this appeared to be adding “use value” which in turn begs the question why is water free while diamonds are so expensive?  In the end marginalism, with price set in relation to the marginal cost of production and the marginal use value/utility of consumption solved both of these!  With labour is often treated as the variable factor, the marginal cost is often stated as the marginal cost of labour – and thereby wages being set relative to the marginal product of labour became a description for labour markets as well.

We can go too far with this as well.  We may say that any urge to change this “natural” wage by increasing labour’s bargaining power will reduce employment and output/surplus value in the industry.  Of course this ignores two things (assuming it is descriptively accurate of firm-employee behaviour in the long-run):

1. There can be bargaining power the other way – monopsony matters.
2. Just because this describes prices doesn’t tell us that labour is receiving their contribution to the process [we might think of this in terms of the average product of labour IF we could define a portion of production that is attributable to labour]

That last bit makes the issue of distribution bloody difficult – and the idea that we can rely on marginal products for considering a fair income distribution is NOT mainstream economics.

At this point the relation between this and income shares must become sort of clear – so let me just point out the posts we’ve done on classical, Marxian, Neo-classical, Marshallian, Post-Keynesian, Neo-Ricardian, and General Equilibrium factor shares here.  Given the complication of discussing such shares I note:

It is for this reason I strictly favour analysis of household level data for discussing points on distribution, rather than analysis of factor shares.  If I was to build up larger “groups” than households to discuss, I can tie them together on shared characteristics in this framework – compared to the arbitrary and loaded combinations of “parts of individuals” that occur with factor work.

A big point here is also prices in goods markets.  If returns to labour AND capital are equal to their opportunity cost then we know that prices will be set in a way that “maximises surplus” from the production process.  This is nice.  Now if that process leads to very low labour income WHEN those things are occurring, the implied labour value must be low in that process – that is fine.  This doesn’t need to imply that incomes must be low – instead it describes a specific income generating process, and would suggest to many people that we should find a way of supporting individuals with a low opportunity to earn income.

Now, if we were in a situation where labour and capital were only earning their opportunity cost I doubt the return to most labour would be that low – but there would be industries, and individuals with issues that limit their income earning capabilities, where that may be the case.  I think, perhaps, the focus can then be on:

1. Competition in goods markets
2. Competition in factor markets (specifically labour markets)
3. The opportunities and income adequacy of the worst off.

There are a lot of clear functional injustices in these places – why do we need to use a nonsensical “theory of value” to complain about the return to labour?

Conclusion

Left Youtube seems to view the idea that “all surplus is generated by labour” as true – and by association “all surplus should go to labour”.  They term this the “labour theory of value” and use it in a normative sense.  However, it makes no sense to use the labour theory this way, especially once we start thinking about other factors of production and how they are chosen.

The reason this narrative is used is because they seem to disagree with the idea of private capital, and they want to see fundamental injustices as due to the private nature of capital.  However, applying a standard supply-demand framework allows us to see that there is potential for piles of injustices out there that have nothing to do with the ownership structure of capital – instead there are clear power imbalances, power imbalances that can be identified and “solved” if they exist.

There is no need to dismantle current ownership and governmental structures – but there is need to think about fairness and distribution more clearly using the economics tools we already have

Equity.  Is the word economists unjustifiably confuse with fairness in order to pay lip service to distributional concerns

Ok I’m being a bit of a dork – in all fairness equity is a good start in asking these questions, but we have to see these measures as only a start!

At the most basic level, when we think about output/income and its distribution in society we consider the average of the income distribution (the mean) and its dispersion (the variance).  If incomes are rising over time as they have been for 200 years, then the variance also rises so we normalise such measures.  This is where inequality measures like the Gini coefficient come from.

The idea of (income) equity goes a step further than just describing the general distribution of income – it considers what happens when we impose an external policy that changes that distribution.  It measures a couple of principles that we may – or may not – value when applying a policy that changes the distribution of income:

1. Vertical equity:  Captures the proportionality of the system applied – if we introduce taxes are people with higher initial incomes paying proportionally more, if we introduce transfer payments are people with lower initial incomes receiving proportionally more?
2. Horizontal equity:  When we have two individuals we see as “equals” does this policy system treat them the same way?

With taxes and transfers these measures involve comparing the way people are treated by the tax-transfer system based on a view on what constitutes “equals”.  Specifically, these two concept can only fit together without conflict when looking at income if equals are defined as people with the same income.

Now in this post I will concentrate only on Vertical Equity – we can do Horizontal Equity another time!  And in line with my desire to be a bit more useful I want to focus on how we might measure these concepts, and what we are assuming when we do.

Wait, what is vertical equity?

Vertical Equity (VE) is the idea that those with greater access to resources SHOULD pay PROPORTIONALLY more – not just more, but more as a percentage of their income.  You may personally agree or disagree, that is fine, that is just what it is.

Given that idea, there is a certain level of proportionality that is desired – so there is some optimal level of VE, which could be higher or lower than it is.  Again, this is a value statement so I just leave that as is.

The key take away is that VE is a measure of the proportionality of the tax-transfer system, and we don’t necessarily want more or less VE – we need to come up with a set of values that articulates how much VE we believe is appropriate.

Now we need to figure out how to measure this concept assuming that we can boil everything down to income!

Stop.  You can calculate a Gini coefficient for pre-tax and transfer income and post-tax and transfer income and just look at the difference.  Why complicate matters.

Look I feel you random comment – but things are never that simple.

Let us put Horizontal Equity (HE) to the side for now, as it is an epic can of worms.  Instead, let’s think about Vertical Equity (VE) and fairness.

At face value we are taking proportionally more from those with more and giving proportionally more to those with less, it sounds perfectly fair.  But lets do a thought experiment regarding this idea to see how – even before asking about family structure and differences in need (what income for a couple is equivalent to an income for a single person for meeting needs?) – this concept alone can twist into unfairness.  Imagine a parade of dwarves – not real ones, this income one here:

https://www.theguardian.com/society/datablog/2012/jun/22/household-incomes-compare

All along this parade we have people organised by their incomes – from lowest income to highest income.

A Gini coefficient gives us a summary measure of this parade, by looking at the absolute distance each of these people are from all the other individuals in the parade.

So say we walked up to this parade and took the person at the back (the poorest person) and swapped their income with the person at the front (the richest person).

What happens to the Gini coefficient after this change?  Nothing – everyone is still the same absolute distance from other people.

But what about VE?  The wealthiest person has paid proportionally more than the poorest person (sacrificing nearly all their income and giving it to the poorest person) and so there is a disproportional transfer which meets our definition of vertical equity!

So even though the Gini coefficient is unchanged, this policy change refers to a progressive transfer and so produces vertical equity.

But there is an issue.  If we have no reason for valuing one person above another (anonymity) then we can see that this transfer has just swapped the position of two individuals – specifically there has been no reduction in income inequality, instead the policy has just changed who is in what position.

If we were to reorder the parade of dwarves into the same ordering by after policy income, the person at the top who lost all their income would move to the bottom while the person at the bottom who gained all the riches of the top person would move to the top.  As a result, their relative position in the income parade changed!  This is termed reranking.

As a result, we can have a progressive transfer that takes from those with higher incomes and gives to those on lower incomes – but if that transfer changes the relative incomes of individuals (thereby leading to reranking) it leads to a smaller reduction in overall income inequality than this progressive transfer alone would suggest.

Reranking is often termed Horizontal Inequity (although as we get into in the future, it is only one type of HI) as given the assumption of anonymity a transfer that is so large it swaps the relative position of a higher income individual and lower income individual appears inequitable.  Given VE simply states that those on higher incomes should pay proportionally more it does not rule out circumstances where they pay so much more that they end up worse off than people who were below them on the income parade.  Reranking captures that difference.

I thought you were going to measure these things?

As stated, reranking involves allowing the income parade to be reordered after a tax-transfer policy is introduced.  So reranking compares the income parade before this reordering, with the new post tax-transfer incomes to the income parade after this reordering.

When measuring VE and reranking we take advantage of the fact that these orderings correspond to different income parades, and calculate summary statistics that represent these parades.

The initial income parade can be thought of in terms the share of cumulative income as we move from the poorest to the richest person – the Lorenz curve.  The Gini coefficient is then a summary measure of this Lorenz curve.

When a progressive transfer is introduced we can keep everyone in the same order, but the density of income will rise towards the bottom of this curve.  The summary measure of this is the concentration coefficient from this curve (Note:  The Gini is just a concentration coefficient too but ordered from lowest to highest income in whatever income we are discussing).

Once reordering occurs based on the new incomes we get a new Lorenz curve for post tax and transfer income.  The Gini coefficient for this can be thought of as our summary measure of that distribution.

Vertical equity is then shown with regards to the difference between the Lorenz curve for market income and the concentration curve for disposable income – these are simply cumulative income of each measure for the same ordering of the population (by market income).  The difference between these curves tells us if people who had higher market income were paying proportionally more!

Reranking is then the difference between the concentration curve for disposable income and the Lorenz curve for disposable income – or in other words the same disposable income numbers, but ordered in different ways.  If no individuals changed position these would be the same thing!

You’ll notice something.  VE takes us from the original Gini to another number, then Reranking takes us from that number to the new Gini.  As a result, the change in the Gini coefficient after we introduce policy (commonly called the redistributive effect) can be nicely split into a change due to VE (transfer from richest to poorest) and reranking.

How can we think about this?  Say we have some target redistribution and we want to to achieve for some reason.  A system that has less reranking can do that with a less progressive tax-transfer system than a system that has more reranking.

A super clear description of this can be found here.  And I’ve discussed it here.  For clarity I’ve also been giving visual examples in a presentation of my results -> Nolan VE-HI presentation.

Cool, so the transformation of market income to disposable income – given the same ordering – is VE.  I have an idea that ….

Wait.  Urg things get a bit ugly here.

This is an estimate of VE, but eagle eyed readers may noticed something is missing.  Why doesn’t the imposition of policy change MARKET income as well.

What are our “counterfactuals” here.  One scenario with policy and one without.  A world without tax and transfer policies will have a different market distribution of income as well … which implies that VE is wrong.

Now people who write this literature (eg people like me) make the claim that we are looking at policy changes and considering the CHANGE in VE (not the level).  As a result, we assume that the distribution of market income does not change due to this.  This implies that we have to be a little bit careful with the measure.  I like the way it is described here.

The fixed-income approach proposed by Kasten et al. (1994) provides a straightforward framework to isolate these effects. Widely used in the literature on income redistribution and tax policy, this method provides a baseline for the identification of policy effects by keeping the distribution of market incomes fixed and by applying the tax and benefit schemes of different periods to this distribution of reference.

It is important to recognise, however, that this approach only isolates what we could call the immediate policy effects as it does not account in any way for behavioural responses to these policy reforms.

Well, what is the bias then?

Great question.

So for this we need to figure out how the introduction of the tax-transfer system would change market income.  Or if we focus solely on changes, how the change in the system would change market income.  Here we need to answer questions such as:

• Who faces the incidence of tax due to these changes
• How do patterns of employment and capital expenditures change following these changes
• How will the characteristics of households change following these changes

This is more than a question of “will wages rise”.  It is a question of “how will the distribution of wages be influenced by the change in the tax-transfer system”.  And these will depend on the type of policy that was used to introduce a change in progressivity – not just the fact that the tax-transfer system has become more progressive!

For some hypothetical examples where we are keeping the average tax rate fixed but changing progressivity we can say:

1. If redistributing income does not change any behaviour and the full payment of tax-transfers occurs by households then nothing happens … this is the “fixed income”.
2. If redistributing income does not change any behaviour, the tax-transfer system is levied on individuals, the tax-transfer system is linear in income, and the actual tax payment is equally split between households and firms then a more PROGRESSIVE tax system will INCREASE pre-tax income inequality … and thereby exaggerate the amount of VE as the “true” inequality in pre-tax incomes without a progressive tax system would be lower.
3. If by redistributing income we reduced investment in the capital used by low income earners then the amount of VE caused by the tax system would be overstated.
4. However, if by redistributing income we increased the incentive for low income earners to enter the labour market the amount of VE caused by the tax system change would be understated.

Man, those examples hurt my head – and it is not very evident which way the bias goes in a very complex system (both the economy and tax system) such as the ones we observe in reality.  I have guesses I would hazard, but I’m not going to.

I haven’t seen this type of work undertaken for VE (Kasten et al (1994) discuss it with reference to EMTRs) – but that doesn’t mean it isn’t important

Ok, what about HE – I think that is very important to me

Nice question.  I have no doubt Horizontal Equity (HE) is important to you, real important.  Constantly we hear about discrimination by sex, race, and even age.  On top of this we may view treating those with the same initial income as violating horizontal equity.

But this post is already long, so I’ll leave this discussion for another time – I tell you what though, it will be a doozy … or at least long again!