Monday, April 30, 2007
Summers on Climate Change
Sunday, April 29, 2007
Bill Bradley on Social Security
To get the budget deficit under control, Bradley proposes gradually raising the minimum eligibility age for Social Security until the year 2099, when it would be 70 (he recommends a “narrowly liberalized” disability benefit for people in their late 60s whose jobs cause health problems that won’t permit them to keep working). This is more than justified, he notes correctly, by the rise in average life expectancy (from 61 years to 78) in the seven decades since Social Security was introduced. Bradley has advocated this reform since his Senate days, but backed away from it during his presidential run when Gore used it to attack him.Another member for Arnold Kling's Reality-Based Retirement Club.
Determinants of Social Spending
“Racial divisions and ethnic divisions reduce incentives for people to be generous to others through social welfare,” said Alberto Alesina, a professor of economics at Harvard. “This is very unfortunate. But as social scientists, we can’t close our eyes to something we don’t like.”
What I've been reading
The paper emphasizes the distinction between the intensive margin and the extensive margin. The intensive margin refers to how many hours an employed person chooses to work. The extensive margin refers to a person's decision whether to work at all. (I personally dislike these terms, because I can never remember which is which.)
Here is the paper's conclusion:
In this paper we develop a general equilibrium life cycle model of labor supply that incorporates both intensive and extensive margins of labor supply....Our analysis produces four main findings. First, macro elasticities and micro elasticities are virtually unrelated: a factor 25 difference in micro elasticities is associated with only a thirty percent change in the associated macro elasticities. Second, macro elasticities are large—in the range of 2.3 − 3.0. Third, in our model with variation in either productivity or disutility of work over the life cycle, tax and transfer programs necessarily imply that higher taxes lead to less work on both the extensive and intensive margin. Fourth, the employment differences generated by differences in tax and transfer programs are necessarily concentrated among young and old workers.This paper deserves to be studied carefully by economists at Treasury and CBO. The bottom line: For simulating the effects of alternative tax regimes, one should use much larger compensated labor supply elasticities than are conventionally adopted. This conclusion, if accepted, would profoundly affect tax policy analysis, such as dynamic scoring.
Saturday, April 28, 2007
Ricardo vs Heckscher-Ohlin
In a post earlier today, I discussed the effects of trade policy using the Ricardian model, the model we teach in first week of ec 10. In a response to my post, Dani Rodrik questioned my conclusion about real wages based on the Stolper-Samuelson theorem, which in turn works within the Heckscher-Ohlin model. So I started wondering, which of these two models is the better workhorse for practical issues in trade policy? (Don't say we need to understand and appreciate all of the models. Of course we do, but that's a cop-out. We need to form judgments as well about the utility of alternative models.)
My first thought was, the Ricardian model is simpler, but it assumes only one factor of production--labor. The Heckscher-Olin model assumes two factors of production--capital and labor--which is surely more realistic.
But more notable in the Heckscher-Olin model may be the assumption that capital cannot move from country to country. That assumption is key to many results. Yet, in today's global economy, capital is highly mobile across national borders. In light of this fact, I wonder whether it may be better to work with a model that includes labor as the only immobile factor of production.
To explain a bit more technically, assume that an industry has production function:
Y = F(K,L).
And assume that the marginal product of capital is determined by the world rental price of capital R:
FK(K,L) = R.
Then with these two equations, we can eliminate K and solve for output as a function of L (and also R, which a nation takes as given). If F is homogeneous of degree one in K and L (that is, constant returns to scale), then the resulting reduced-form production function will be linear in labor, exactly as assumed in the Ricardian model.
As a tentative conclusion, therefore, I am inclined to think that in a world with significant capital mobility, the Ricardian theory of trade is more useful than Heckscher-Olin.
Update: Astute commenter mvpy points out the importance of human capital, which is left out of these conventional trade models. Human capital such as education is undoubtedly central to understanding cross-country differences, but it unclear to me what the best way to incorporate it for the issues at hand.
One might assume that physical capital moves internationally to equalize the marginal product around the world but that human capital cannot move. After all, as an American, I can easily invest in Toyota stock but not in a college degree of a Japanese worker. In this case, one might come to the conclusion that the right distinction for Heckscher-Olin is not capital and labor but instead skilled and unskilled workers.
But there's another way to think about the issue. Suppose every family decides how long to keep their children in school. Each faces a tradeoff between marginal investments in human capital and marginal investments in financial instruments, such as a savings account at a local bank. If financial returns are equalized around world through capital flows, and families make their human capital decisions based on opportunity cost, then rates of return on all forms of capital would move toward equality. Human capital could become, in effect, an internationally mobile factor of production.
Time horizon clearly matters here. Human capital is quasi-fixed. In the short run, we should take it as given. In the the long run, it adjusts in response to incentives. The same might true of physical capital because of adjustment costs, but for human capital, it takes longer to reach the long run.
Taxes around the World
An Anthropological Digression
Does free trade lower prices?
Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart. But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors). When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up!Dani is right about the theory, of course. But I am more sympathetic to the "lower prices" summary of it than he is, for two reasons.
1. Defenders of free trade rarely are in a position of having to defend exports, because people think that exports create jobs. When people complain about trade, it usually about the alleged job-destroying effect of imports. This partial-equilibrium complaint naturally encourages a partial-equilibrium retort: imports lower prices for consumers. The losses to producers in these markets are more than offset by gains to consumers from lower prices. True, the full story can only be told in general equilibrium, where it is relative prices that matter for the allocation of resources. But the distinction between the absolute price level (determined by monetary forces) and relative prices (determined by numerous market supply and demand curves) looms larger in the minds of economists than laymen. The reason is related to my second point.
2. People sometimes instinctively treat the nominal wage as the numeraire. That may be because it is one of the stickier prices around. So maybe when we hear people say that trade lowers prices, we should interpret the statement as meaning that trade lowers the price of a basket of consumer goods for a given price of labor. That is, trade raises real wages. This is one simple way of translating the basic Ricardian model (in which trade expands both trading partners' consumption opportunities) into a language that is a bit more familiar to the general public.
Update: Dani responds. I disagree with Dani when he says:
Back in his example, he says that "these are export products for Argentina," whereas in point 1 above I was describing a country that is a net importer of the good. For net exporters, prices do rise when a country moves from autarky to free trade. In this case, the gains to producers more than offset the losses to consumers. For readers who want to see a diagrammatic explanation of these two cases, see chapter 9 of my favorite textbook.
there is no theorem that guarantees that the partial-equilibrium losses to import-competing producers “are more than offset by gains to consumers from lower prices.” My wheat-and-beef example in Argentina is exactly an instance where this supposition fails.
The more interesting and difficult issue that Dani raises is how many caveats economists should include in their analysis when they present their ideas as part of the public debate. All economic analysis involves simplifying in order to clarify. This is, in a sense, the very essence of building a model. The art in economics is drawing the line between simplification which clarifies and oversimplification which misleads. Without doubt, that judgment call is always tough. One has to be careful not to make the best the enemy of the good.
Friday, April 27, 2007
Bundorf and Mark Pauly, the health economist at Wharton who was her thesis adviser, found that as much as three-quarters of the uninsured population may be able to afford its own insurance.
Why so much reality TV?
Thursday, April 26, 2007
How Not to Defend Your Dissertation
Goldin on Academic Motives
She tells the story of a colleague at Princeton who said he would write a paper on the taxation of belly button lint if it would get him published.Hmmm....I wonder, is that problem best addressed in a Ramsey or Mirrlees framework?
Wednesday, April 25, 2007
CBO on Cap-and-Trade
The decision about whether to sell the allowances and use the proceeds in ways that would benefit the economy could have a major impact. For example, one study estimated that a 23 percent cut in CO2 emissions could cost the economy nearly twice as much if allowances were given away than if they were sold and the revenues used to cut taxes. Another study found that the economywide cost of reducing emissions by 10 percent would vary by a factor of three, depending on how the allowance value was used. Some researchers even suggest that relatively modest cuts in CO2 emissions could provide net gains to the economy (in addition to the benefits from emitting less carbon dioxide) if the allowances were sold and the revenues used to reduce individual income taxes.Of course, selling emission allowances under a cap-and-trade system makes the system equivalent to a comparably-sized Pigovian tax.
One part of the report that looks suspicious to me is CBO's analysis of what would happen if we used the revenue from selling allowances to cut corporate income taxes. This footnote explaining Figures 1 and 2 strikes me as odd:
This estimate by Dinan and Rogers does not distinguish between the gains in economic efficiency associated with reducing corporate taxes and the gains associated with reducing payroll taxes. It implicitly assumes that capital and labor respond similiarly [sic] to changes in the taxes on them and that increases in marginal tax rates on capital and labor have similar costs to the economy.Standard models of economic growth offer ample reason to doubt this implicit assumption.
If all else fails, try good policy
I would prefer to see the revenue raised by a carbon tax returned to households in the form of lower income or payroll taxes, because I am skeptical that the government is sufficiently good at targeting research dollars to worthy projects. (I have, by the way, made the same argument about subsidies to economic research.) On the other hand, knowledge about new technologies is to some extent a public good, so the Dodd proposal passes the basic test of economic logic.
Senator Christopher J. Dodd had a small group of New Hampshire voters enthralled as he discussed -- of all things -- a carbon tax on businesses to discourage them from polluting.
"Price is the last real barrier" to forcing businesses to install cleaner technologies, Dodd told the dozen or so people at one of his "kitchen table" campaign events at a home in this southern New Hampshire city last week. He detailed his plan to raise $50 billion a year for alternative-energy research by imposing a fee on polluters.
Addendum: Today's San Francisco Chronicle has an article about increasing the tax on gasoline.
Update: Here is a Dodd op-ed on his policy.
Tuesday, April 24, 2007
Is Steve Levitt ruining economics?
Scheiber is right that more young economists today are doing Levitt-style economics and fewer are studying the classic questions of economic policy. That is disconcerting, to a degree. It could be especially problematic twenty years from now, when President Chelsea Clinton looks for an economist to appoint to head the Federal Reserve, and the only thing she can find in the American Economic Association are experts on game shows and sumo wrestling.
But I am not really worried. All research programs run into diminishing returns; eventually, all the cleverness in finding natural experiments and off-beat identification will seem less clever than it did at first. Moreover, the profession has a healthy enough set of incentives that people will keep coming back to the big questions, as long as they think they can make progress on them. Papers on the big questions eventually accumulate more academic citations--the ultimate measure of intellectual influence. It is noteworthy that while Steve's work is highly respected (he won a Clark medal), it is not particularly highly cited for someone of his stature. The citation leaders tend to address the big questions, and that fact should help focus the attention of the next generation of economists.
Meanwhile, Steve's book Freakonomics has made many laymen appreciate that economics is a broader discipline than they had thought, and it has attracted many students to the field. That is a great service. On the first day of ec 10, I asked the students who had read Freakonomics. About a third to a half raised their hands.
In any event, I don't especially trust Scheiber's judgment on important matters. After all, he was the journalist who once accused me of having a big nose.
Addendum: Here is a great talk by Levitt that I posted a while back.
Who has Obama's ear?
Monday, April 23, 2007
Buy This Book
Guess who reads this blog?
Sunday, April 22, 2007
The Economist on Vacation
Easterly on Wolfowitz
Sachs in Ec 10
Inequality in Academia
Other facts in the report that caught my eye: Harvard comes in as the second best paying university for full professors (average salary of $177,400) and third best for assistant professors ($91,300). To all those loyal alums: Thank you.
Saturday, April 21, 2007
Road Pricing in NYC
A plan to reduce traffic by charging motorists who drive into the heart of Manhattan may get another look after Mayor Michael Bloomberg reversed himself yesterday and endorsed the idea....Congestion pricing is popular among economists. What we need is for all cars to be equipped with fast-pass readers to reduce the costs of collection.
"Using economics to influence public behaviour is something this country is built on -- it's called capitalism," Bloomberg said.
Update: In the comments section, there is some debate about whether road pricing is really a Pigovian tax or just a user fee for consuming a scarce resource. In my view, both are perfectly valid ways of viewing the situation. When people are not charged (or are undercharged) for using a common resource such as a congested road, then incremental use of the resource entails a negative externality on other users. Imposing a user fee for the scarce resource can be described as a Pigovian tax to deal with this externality. Similarly, a conventional Pigovian tax such as a tax on pollution emissions can be described as a user fee for consuming clean air. The distinction between user fee and Pigovian tax in these cases is purely semantic.
In Defense of Parlor Games
Apparently, Professor Frank Pasquale of Seton Hall Law School does not like it:
in a nation where an ever-growing number of people lack basic health insurance, and a world where tens of millions live on a dollar a day and a substantial proportion of the affluent do nothing to relieve their plight, it’s really difficult to see how reductiones ad absurda contribute to the practical decisions we have to make about distributing resources. Parlor games don’t lead to good policy.If this comment had come from someone inside the beltway, I would not have been surprised. Much of the Washington crowd has little tolerance for purely academic pursuits. But I would have thought that an academic like Professor Pasquale would understand that scholarly writing does not always have to focus on the pressing issues of the day. One of the luxuries of the ivory tower is the ability to reflect on fundamental questions of a more abstract variety. For example: "Do conventional models of distributive justice adequately capture of our intuitions about what is fair and what is not?"
Besides, as the erstwhile president of my high school chess club, I do not object to a good parlor game now and then.
The College Premium
Friday, April 20, 2007
Mr. Wolfers and Ms. Stevenson met in a labor economics seminar in graduate school and have been a couple for almost 10 years.Harvard: The world's most elite dating service.
Thursday, April 19, 2007
Barro on Friedman
Update: The talk was based on this paper.
Wednesday, April 18, 2007
Resale Price Maintenance
The QJE is now cool
Tuesday, April 17, 2007
The Optimal Taxation of Height
Should the income tax system include a tax credit for short taxpayers and a tax surcharge for tall ones? This paper shows that the standard utilitarian framework for tax policy analysis answers this question in the affirmative. This result has two possible interpretations. One interpretation is that individual attributes correlated with wages, such as height, should be considered more widely for determining tax liabilities.Please follow the link above to read the paper. Comments welcome.
Alternatively, if policies such as a tax on height are rejected, then the standard utilitarian framework must in some way fail to capture our intuitive notions of distributive justice.
By the way, I am 6' 2".
Plus ça change, plus c'est la même chose
Since 1980, there has been little change in earnings variability for both men and women. There is some evidence that, between 1960 and 1980, earnings variability increased for men but was offset by a decrease for women. Those findings are consistent with most existing studies of the topic that use publicly available survey data, which tend to find higher levels of earnings variability for men in the 1980s and 1990s relative to the 1970s, but little change since around 1980.
A Reading for the Pigou Club
This article shows that fuel taxes serve a very important role for the environment and that we risk a backlash of increased emissions if they are abolished. Fuel taxes have restrained growth in fuel demand and associated carbon emissions. Although fuel demand is large and growing, our analysis shows that it would have been much higher in the absence of domestic fuel taxes. People often assert that fuel demand is inelastic but there is strong research evidence showing the opposite. The price elasticity is in fact quite high but only in the long-run: in the short run it may be quite inelastic which has important implications for policy makers. Had Europe not followed a policy of high fuel taxation but had low US taxes, then fuel demand would have been twice as large. Hypothetical transport demand in the whole OECD area is calculated for various tax scenarios and the results show that fuel taxes are the single most powerful climate policy instrument implemented to date—yet this fact is not usually given due attention in the debate.
Monday, April 16, 2007
Becker on the Romney Health Plan
To avoid the risk that individuals and families would attempt to free ride on taxpayers and others by not contracting for catastrophic medical coverage, one can make such coverage compulsory for everyone, either through group plans, such as from employment, or through individual plans.Becker does not mention Mitt Romney, but the idea of making health insurance an individual's responsibility is the essence of the health plan Romney advocated as governor of Massachusetts.
Clinton vs Friedman
"The unfettered free market has been the most radically destructive force in American life in the last generation."
-- First Lady Hillary Clinton on C-Span in 1996
"What most people really object to when they object to a free market is that it is so hard for them to shape it to their own will. The market gives people what the people want instead of what other people think they ought to want. At the bottom of many criticisms of the market economy is really lack of belief in freedom itself."
-- Milton Friedman, Wall Street Journal, May 18, 1961
Update: A reader finds the C-Span transcript and notices that Human Events did not get the story exactly right:
LAMB: There's a quote here. I want to ask you if you agree with this. This is from Alan Arenhault, author of "The Lost City" -- you put it in your book. "The unfettered free market has been the most radically disruptive force in American life in the last generation."
CLINTON: I believe that. That's why I put it in the book.
The Matthew Effect
eminent scientists will often get more credit than a comparatively unknown researcher even if their work is similar; it also means that credit will usually be given to researchers who are already famous: for example, a prize will almost always be awarded to the most senior researcher involved in a project, even if all the work was done by a graduate student.The term is based on this biblical quotation:
"For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath." (Matthew XXV:29, KJV).A piece by Ernest Christian and William Freznel in today's Wall Street Journal (subscription required) offers a good example. The relevant excerpt:
I wrote the study cited with Matthew Weinzierl, a grad student at Harvard. He deserves full credit as a coauthor but is unjustly ignored.
Consider the two versions of the truth that may be drawn from a recent study by Gregory Mankiw, an economist at Harvard.
Reduced to its essence, Mr. Mankiw concluded that a $1 tax cut on dividends would reduce government revenue collections by about 50 cents, after taking into account taxes on $2 of additional economic growth induced by the tax cut. A $1 tax cut from an across-the-board rate reduction would cost the IRS about 77 cents, after taking into account taxes on the 95 cents of additional economic growth induced by the tax cut.
To the champions of bigger government, the important truth of the Mankiw study was that the amount of tax on induced economic growth was insufficient to make up for all of the revenues lost to the Treasury from the original tax cut. Ergo, the government has less money to spend. Ergo, tax cuts are bad.
To those of us who prefer economic growth over government growth, the Mankiw study confirmed a different truth. If Congress is willing to forego 50 cents of revenue, the economy would grow and people would have $2 more income. If given the choice, most people would take the $2.
Now apply the conclusions of the Mankiw study in reverse -- to tax increases. The results illuminate the high costs of providing the government with an additional $1 to spend. A purported $1 tax increase on dividends only nets the Treasury 50 cents -- but costs Americans $2 in lost income, plus 50 cents in tax. When a higher rate is levied on all forms of income, an attempted $1 tax increase yields only 77 cents -- but costs Americans 95 cents in lost income plus 77 cents in tax. If the government were to kick up the tax increases enough to collect a full additional $1, the cost to the public would be between $2.25 and $5, counting both tax paid and income lost. A May 2006 study by Harvard's Martin Feldstein, "The Effect of Taxes on Efficiency and Growth," confirms the disproportionately large economic losses associated with tax increases.
Do income effects matter for tax policy?
The answer is, it depends. To be more specific, it depends on how the government spends the tax revenue it raises. Let's consider three cases:
Case 1. The tax revenue is spent on a feckless war overseas (or on some other program that does not affect private consumption). Then the labor tax to fund the war does indeed have offsetting income and substitution effects. This seems to be the case that people naturally assume. For many purposes, however, it is not the right one.
Case 2. The tax revenue is rebated lump-sum to households in the form of transfer payments (Social Security) or through publicly-financed consumption (health care). In this case, the income effect of higher taxes is offset by the opposite income effect of the rebated revenue. The only effect left is the substitution effect. The magnitude of the subsitution effect is measured by the compensated elasticity of labor supply.
Case 3. The tax revenue is rebated progressively in the form of transfer payments (welfare) or publicly-financed consumption (food stamps) for low-income households. The benefit gets phased-out as a person's income rises. Once again, there is no overall income effect, because the government's tax and transfer scheme does not directly reduce the resources of the private sector. But the substitution effect is now enhanced because the effective tax rate on income includes the phase-out of the low-income benefit. Naturally, one would get the largest effect on hours worked and national income in this case.
FYI, in my paper with Weinzierl on dynamic scoring, we assumed Case 2. As a result, tax cuts were partially self-financing in that model, even though the assumed utility function implied a vertical long-run labor supply curve (for productivity-driven wage growth) because of offsetting income and substitution effects. This seemed a reasonable compromise for theoretical work, but it is an empirical question which of these three cases is most relevant in practice.
Sunday, April 15, 2007
Bob Frank replies
First, my thanks to Greg for his gracious invitation to respond to his comments on my recent New York Times Economic Scene column. In that column, I argued against trickle-down theory’s claim that higher taxes on top earners would reduce economic growth. Here I’ll attempt to explain why Greg’s defense of trickle-down theory falls short.
Greg discounts the significance of the negative relationship I cite between wage growth and the average workweek over the last century. This relationship, he argues, is a consequence of the fact that the income effect of rising wages has offset the substitution effect (which is exactly how I described it). But the observed link is irrelevant, he explains, “because the distortionary effect of taxes depends only on the substitution effect. The evidence cited suggests that income effects are larger than substitution effects, not that substitution effects are small.”
Greg is right about what this particular piece of evidence shows. But he is mistaken in claiming that this evidence is irrelevant to my claim. Indeed, the argument I advanced in my column had nothing to do with whether taxes on the rich are distortionary. That’s an interesting question, and I’ll return to it in a moment. My only point in the column, however, was to question a very different claim—namely, that higher taxes on the rich would reduce work effort. That is precisely a claim about the total effect on work effort of lower after-tax wages. In other words, it’s a claim about the combined impact of the income and substitution effects. So the fact that the workweek declined over the last century in the face of substantial growth in real wages is directly supportive of my argument.
A necessary and sufficient condition for trickle-down theory’s argument to the contrary is that the elasticity of supply of labor with respect to real wages be significantly positive. The most comprehensive recent econometric study of labor supply elasticity in the United States will be published in the next issue of The Journal of Labor Economics. The authors, Fran Blau and Larry Kahn, estimate that the labor supply curve for men has been essentially vertical for many decades. The clear implication is that higher taxes on top earners, most of whom are men, will not significantly reduce work effort.
Greg also mentions research suggesting that higher taxes on the rich may reduce the amount of income they report to the IRS. Perhaps so, but that by itself would not imply any reduction in output. And with even the supply-sider Bruce Bartlett now conceding that tax cuts for top earners don’t boost total tax revenues, it’s important not to exaggerate the problem of unreported income. But irrespective of its magnitude, why isn’t the best solution to this problem a simpler and more strictly enforced tax code rather than tax rates that are too low to sustain minimally adequate public services?
Greg and I both have good health insurance, but millions of others have none. Absent the revenue necessary to fund universal health coverage, their ranks will keep growing as our current system of private, employer-provided insurance continues to unravel. President Bush’s recent proposal to make individually purchased health insurance tax deductible is unlikely to help. (As Stephen Colbert put it, “It’s so simple. Most people who can’t afford health insurance also are too poor to owe taxes. But if you give them a deduction from the taxes they don’t owe, they can use the money they’re not getting back from what they haven’t given to buy the health care they can’t afford.”) Without higher taxes on people like Greg and me, this problem will get worse.
Revenue shortfalls have also led to cuts in other important public services. I cannot imagine, for example, that Greg feels any more comfortable than I do about the Bush administration’s cuts in the Energy Department’s program for helping lock down loosely guarded nuclear materials in the former Soviet Union. But such programs cost money. Unless we can raise additional revenue to pay for this program, or unless we want to borrow even more heavily from abroad (loans that will eventually have to be repaid in full, with interest), it will remain underfunded. It is not satisfactory to assert that we can just reduce government waste. The president, who campaigned as an opponent of government waste, is the one who couldn’t find more wasteful or less politically protected programs to cut.
As evidence for his claim that I need to do additional reading, Greg cites a 1988 paper in which Joe Stiglitz argued that the socially optimal marginal tax rate on the most productive person might actually be negative. The reason, Stiglitz explained, is that inducing that person to work more could generate positive spillover effects for less productive workers. In the abstract, this is an interesting claim. (Is it any more than that? Stiglitz, for one, never thought to offer tax policy proposals on the basis of it.) But if we’re going to discuss externalities, then complementarities between skilled and unskilled labor are surely not the most important ones to consider.
For present purposes, by far the most important externalities are those stemming from the link between context and evaluation. As decades of behavioral evidence clearly demonstrates, virtually every evaluation is heavily shaped by local context. As Richard Layard put it, “In a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses.” Because evaluation drives consumer choice, context is an important determinant of consumer demand. The upshot is that almost every consumer choice generates significant context externalities.
Consider, for example, a job applicant’s decision about how much to spend on an interview suit. His goal is to make a favorable impression. But his ability to do so depends far less on the absolute quality of his suit than on how it compares with those worn by other applicants. And when he spends more on a suit, he shifts the context within which other candidates will be evaluated.
Context externalities are pervasive. A good school, for instance, is one that compares favorably with other schools in the same local environment. The amount parents must spend to ensure that their children attend such a school is thus an increasing function of the amounts spent by other parents. The evaluations that guide an employer’s promotion decisions are similarly dependent on context. A worker’s odds of promotion depend less on his absolute performance than on how well he performs relative to his coworkers.
The dependence of evaluation on context lays waste to any presumption that individual decisions about how many hours to work or how much to spend on interview suits will be socially optimal. The general result predicted by theory is that if context shapes evaluation more heavily in some domains than others, too many resources will flow to the most context-sensitive domains and too few to the least context-sensitive domains. In my forthcoming book, Falling Behind, I summarize what available evidence says about the extent to which context differs across domains. For the discussion at hand, the relevant finding is that evaluations of leisure tend to be far less context-sensitive than evaluations of income. The implication is that individual valuations of leisure tend to understate social valuations. Thus people work longer hours in the hope of moving higher on the income ladder, only to discover that when others do likewise, their position remains unchanged.
It would be unfair to single out Greg for ignoring context externalities. After all, most of the standard economic models that serve as the basis for policy analysis make no mention of these externalities. At some point, the economics profession will look back in embarrassment about that fact. But even absent explicit mentions of context externalities, most practical policy analysts already seem to recognize that trickle-down theory’s portrait bears little relation to the behavior of people in the real world.
My point is not that people don’t care about money. On the contrary, when the pay in one occupation goes down relative to others, fewer people enter that occupation. Public school teachers, whose starting salaries were more than 20 percent higher than those of the average college graduate in the 1960s, now earn below-average starting salaries. So we are not surprised that fewer qualified people now enter teaching.
But trickle-down theory is about what happens when after-tax pay falls not just in some occupations but for top earners generally. In a largely meritocratic society like the United States, most top earners are extremely driven people. And as recent studies have shown, most of them will never spend more than a small fraction of their earnings. The trickle-down theorist’s insistence that they will begin slacking off in response to a small increase in their marginal tax rates strains credulity.
While serving as chairman of the Council of Economic Advisers, Greg actively supported the Bush tax cuts targeted at top earners by arguing that the cuts would spur them to work harder. Greg would have been astonished to observe such a response from his colleagues at Harvard. Does he have a behavioral model that leads him to expect different behavior from high achievers in other occupations? Or does he have one that explains why any such differences consistently fail to reveal themselves in the data? In the absence of a plausible behavioral model backed by persuasive empirical evidence to the contrary, I stand by my conclusion that trickle-down theory is supported neither by economic theory nor by empirical evidence.
The tax cuts that were sold by invoking this theory did little to promote the well-being of even the well-to-do Americans who were their ostensible beneficiaries. Money that could have been spent rounding up loose nuclear materials in the former Soviet union was spent instead on larger houses and more expensive cars. In light of what we know about the empirical magnitude of context externalities, the principal effect of such spending was simply to redefine what counts as adequate. As in the familiar stadium metaphor, all stand to get a better view, yet none sees better than if all had remained seated.
Greg titled his response to my column “Frank Needs To Read More Widely.” On that point, he is surely right. I don’t know Greg well enough to presume to know what he needs. But he would almost surely offer better policy advice if equipped with an economic model that better fits current scientific knowledge about human behavior.
Again, my thanks to Greg for inviting me to respond to his critique of my column.
Economics in Song
Saturday, April 14, 2007
On Fama and French
Climate Change as Repeated Prisoners' Dilemma
It's the truly conservative response to an emerging problem. It's simple, involves as little government bureaucracy as possible, and will unleash the private sector to do its magic. Neither Democrats nor Republicans really want to go there, which is a sign of how broken the system is. But Steve Chapman is absolutely right: we need a simple, effective carbon tax. Now.I agree (with tax revenues rebated with lower income taxes). I would add that the carbon tax should start modest and increase gradually in size--for two reasons.
First, the magnitude of the climate change problem is uncertain. If the problem turns out smaller than many now fear, we can change course. Some people argue that we shouldn't do anything until more of the uncertainty is resolved. I don't buy that, but the uncertainty may argue for starting slowly.
Second, we need to get China on board. China is, I understand, fueling its impressive growth with building numerous coal-powered electricity plants, and many experts think that China will be the biggest emitter of greenhouse gases in a few years. If we levy a large carbon tax and China does not, then some carbon-intensive industries will just migrate to China. With such migration, a U.S. carbon tax could end up adversely affecting economic efficiency without much improving the problem of global warming.
Policy toward global climate change is a lot like repeated prisoners' dilemma. We need to convince China to adopt the cooperative equilibrium in which everyone taxes carbon. Starting with a small tax that increases over time, together with the threat that we will revert to the non-cooperative equilibrium without a tax if China does not participate too, may be an effective strategy for inducing cooperation.
How did the idea of menu costs develop in your mind?My paper on menu costs, which is one of my three or four most cited papers, was conceived in the spring of 1982, while I was a first-year student at Harvard Law School. I was attending a seminar on antitrust policy, and the speaker (I forget who it was) wrote on the blackboard the standard monopoly diagram. He was discussing damage remedies in antitrust cases and the incentives firms face to monopolize markets. In previous years, I had taken graduate-level macroeconomics from Alan Blinder at Princeton and Stan Fischer at MIT, so macro issues were in the back of my mind. As a result, while I sat in the Law School seminar, I started wondering about why prices are sticky and the incentives monopoly firms face to adjust prices when, for some reason, their prices end up away from profit-maximizing levels.
The lesson: Ideas can pop up in unexpected places.
Update: A commenter asks:
Prof.Mankiw, But you did not tell us how you got the catchy name 'menu costs'.I did not make up the name. The earliest reference I can find to the term in J-stor journals is in "Relative Shocks, Relative Price Variability, and Inflation" by Stanley Fischer, published in 1981, the exact year I was a first-year grad student at MIT. I undoubtedly picked up the name in Stan's course.
Friday, April 13, 2007
The Romers on Tax Policy
tax changes have very large effects on output. Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.
CBO on Supply-side Economics
The big question is about magnitudes: How big is this effect? In a new report, CBO reports this estimate:
CBO estimates that the change in tax revenues from the shift in labor supply would offset roughly 4 percent of the static revenue loss.The report is not blunt, but its bottom line is simple: Supply-side effects are trivial.
I don't buy it. To understand why the CBO reached this conclusion, the key seems to be found in Table 2. According to this table, the earnings-weighted compensated labor supply elasticity is 0.14. With such a small elasticity, their model naturally yields small behavioral responses to changes in tax rates.
In my paper with Weinzierl, we reviewed some of the literature and concluded that a reasonable number for this parameter was 0.5. Kimball and Shapiro concluded it is even larger. If one plugs 0.14 into the formulas Weinzierl and I gave, one would find effects as small as those reported by CBO. So the details of the different models do not appear central; this part of the macroeconomic debate seems to boil down to a single parameter. Unfortunately, the academic literature on this topic is far from conclusive. But I am not sure it was prudent for CBO to settle on the low end of the plausible range of estimates.
Herb Stein is supposed to have once said, "There is nothing wrong with supply-side economics that division by ten wouldn't fix." If my reading of the CBO report is correct, then there is nothing wrong with it that multiplication by 3 to 6 wouldn't fix.
Update: An informed reader tells me this particular study is only part of CBO's analysis of tax policy. For example, it does not deal with the offsetting spending changes that must eventually accompany any tax change. As I explain in another post, one cannot fully analyze tax policy without thinking through how the government budget constraint is satisfied. My friend recommends this CBO piece to get a better sense of the full range of models used.
Plosser on Credibility
Thanks to Mark Thoma for the pointer.
Thursday, April 12, 2007
A Teachable Moment
Here is the logic:
“according to standard theory, the distortionary effect of taxes depends only on the substitution effect”
Maybe I need a refresher course in public finance theory, but this doesn’t quite make sense to me. Suppose you have a large income effect and a large substitution effect, and the two are precisely offsetting, so that labor supply is perfectly inelastic. In that case, changes in labor taxation will not affect the quantity of labor supplied or the pre-tax wage. So in what sense can there be said to be a distortion?
Case A. No taxes. Andy earns $10 an hour and works 40 hours a week, for income of $400.
Case B. The government now levies a tax at 20 percent to fund a war. There are offsetting income and substitution effects. Andy still works 40 hours, now earning before-tax income of $400 and after-tax income of $320. The government collects $80 to pay for the war.
Now you might say the tax has no distortion, because hours worked remain the same. But you would be wrong. Consider another situation:
Case C. The government funds the war with a lump-sum tax of $80. Andy faces the same income effect as Case B (which makes him work more), but no substitution effect (which previously offset the income effect). Andy works 45 hours, for after-tax income of $370.
Notice that welfare must be higher in Case C than in Case B. How do I know? Because in Case C Andy could have chosen to work 40 hours, earning $320, the same outcome as Case B, but he chose not to. (By contrast, in Case B, if Andy had chosen to work 45 hours, he would have earned income of only$360.) Thus, Andy is better off under the lump-sum tax than under the income tax that produced the same revenue. The difference in welfare between Case C and Case B is the deadweight loss of the income tax.
In other words, the income effect of taxes alters behavior, but that is the optimal response of behavior to the fact that the individual is poorer when the government takes away resources. The substitution effect measures the deviation from that optimal response. To see the distortion, you don't compare the tax and no-tax cases; you compare the tax and lump-sum cases.
Is that clear, knzn?
Frank needs to read more widely
Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.Apparently, Bob has not read this survey by Stiglitz and come to grips with this theoretical conclusion (from page 35 of the working paper):
Pareto efficient taxation requires that the marginal tax rate on the most able individual should be negative.The reason for this conclusion is that a negative marginal tax rate on the most skilled worker induces him to work more, and if skilled and unskilled labor are complementary inputs, the wage for unskilled labor rises in general equilibrium.
Nor does it seem that Bob has read this empirical work by Gruber and Saez:
A central tax policy parameter that has recently received much attention, but about which there is substantial uncertainty, is the overall elasticity of taxable income. We provide new estimates of this elasticity...We estimate that this overall elasticity is primarily due to a very elastic response of taxable income for taxpayers who have incomes above $100,000 per year, who have an elasticity of 0.57, while for those with incomes below $100,000 per year the elasticity is less than one-third as large....We then derive optimal income tax structures using these elasticities. Our estimates suggest that the optimal system for most redistributional preferences consists of a large demogrant that is rapidly taxed away for low income taxpayers, with lower marginal rates at higher income levels.Bob is perfectly free to believe whatever he likes and to advocate increasing the top marginal tax rate. But to suggest that there is neither theory nor evidence to support the beneficial effects of lower marginal tax rates on high-income taxpayers indicates a lack of appreciation of the academic literature in public finance.
Bob also makes this argument:
If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.This seems just wrong to me, if the goal is to analyze tax policy. When comparing work hours today versus a century ago, you have to consider both income and substitution effects of wages on labor supply, which are offsetting to a large degree. But, according to standard theory, the distortionary effect of taxes depends only on the substitution effect. The evidence cited suggests that income effects are larger than substitution effects, not that substitution effects are small.
Wednesday, April 11, 2007
More on Milton
The Case against Cap-and-Trade
This just occurred to me, so maybe I'm missing something but there seems to be another big advantage for taxes: they probably are much more likely to be both tax-burden and progressivity neutral.
Here's why: Both carbon taxes and cap-and-trade would affect consumers by raising energy costs. (Approximately equally, although to the extent that cap-and-trade imposes more administrative costs, you might need to add more to the price of energy to achieve equivalent carbon emissions.) Taxes raise the after-tax prices directly; cap-and-trade raises the price indirectly by forcing producers to purchase credits, which raises the cost of producing, and thus purchasing, energy. Raising energy costs harms the poor most, because they spend more of their budget on energy.
The regressive effects of a carbon tax are obvious because they are direct, so it should be relatively easy to convince Congress to make the tax revenue and progressivity neutral by instituting income tax cuts (and hikes in the earned income tax credit) weighted toward the poor. (And there's a great bargain to be struck here between conservatives and liberals. Liberals can say, "We'll keep it revenue neutral as long as you keep it progressivity neutral.")
But this will be much more difficult to do for cap-and-trade programs. The main reason that Congress might choose such a program over a carbon tax is the fiction that, unlike a tax, it does not impose costs on consumers. This fiction ignores the indirect cost imposed on consumers when the program increases the price of producing energy. Given that animating fiction, it seems like Congress would be less likely to make progressive changes in the tax code to offset the regressive effects of cap-and-trade. (Congress couldn't argue that they were just offsetting the costs of cap-and-trade because their choice of cap-and-trade was based on denying that those costs exist.)
A Good Trade Complaint
The United States filed two new complaints against China at the World Trade Organization on Tuesday over copyright policy and restrictions on the sale of American movies, music and books, trade officials said....One case contends that Beijing's lax enforcement of copyright and trademark protections violates WTO rules.Unlike the trade complaints filed last week, these make economic sense.
When China fails to protect intellectual property, its consumers free ride off the efforts of American producers. This free riding reduces the income of those producers, reduces the incentive for such creative activity, and eventually makes American consumers worse off because they enjoy less product variety. Reduced product variety could also impede competition and raise the prices that American consumers pay.
Note that price controls on pharmaceuticals, which are common in many other countries, have a similar adverse effect on the United States. But the U.S. government does not have the policy tools through the WTO to complain about these violations of intellectual property rights.
On Academic Success
I wish to follow an academic career and I would like to teach at famous universities (like Harvard, MIT, Stanford and so forth). Do you think that this is possible?Yes, absolutely. Academia is very much a meritocracy. Success at getting goods academic jobs is determined by research productivity, measured by such things as publications in top academic journals (such as the AER, JPE, and QJE) and citations by others in academic journals (recorded in the Social Science Citation Index and Google Scholar). One can argue with that too much emphasis is put on research relative to teaching and public service, and one can argue that some research in academic journals is excessively arcane and pedantic. I believe that myself. But there is little doubt that a person who achieves research success as conventionally judged will be rewarded with job offers at top universities.
The main value of being trained at a top university is that it gives you access to faculty who have achieved such research success. They can bring you up to date on the latest research, give you advice about your work, and get you involved in their own research projects. But so much information is now available over the Internet that it should be easier today than in the past for someone at a lower-ranked school to reach and contribute to the research frontier if he or she is equipped with intelligence and a work ethic.
Tuesday, April 10, 2007
Mark Your Calendar
Harvard deans dis econ
Monday, April 09, 2007
Warning: Spoiler Alert
Here's my question for the comments section: What do you think will really happen to government spending and tax revenue as a share of GDP over the next half century?
According to the latest long-run outlook of the Congressional Budget Office, government spending may take up fully 50 percent of GDP by 2050.
Yet revenue will increase tremendously over the same time period. Revenue relative to GDP, currently a smidgen more than 18 percent, will climb to 23.7 percent by 2050 and extrapolate out to a whopping 27.5 percent by 2075. A spending binge is coming, and a good chunk of the revenue needed to pay for it is coming as well.
The bad news for fans of small government is this: Even if spending were reined in enough to keep it equal to revenue, the size of the government will increase by about 50 percent in the coming decades.
Why the big climb in revenue? There are three reasons. First, current law calls for the expiration of the Bush tax cuts in 2010. Second, the Alternative Minimum Tax, which isn't adjusted for inflation, sucks in more and more revenue over time. Finally, as the economy grows in real terms, more individuals get thrust into the top tax bracket.
A New Reading for the Pigou Club
A Goofy Debate
Sunday, April 08, 2007
Lunch with Jeff
Saturday, April 07, 2007
From the West Coast
The Gray Lady
Friday, April 06, 2007
Making the Case for Tax Cuts
Thanks to Andrew Roth for the pointer.
We are all supply-siders now
Thursday, April 05, 2007
Harvard students love the social sciences
Just 42 percent of Princeton undergrads and 37 percent of Yalies concentrate in the social sciences, well below below Harvard’s 54 percent. Both Stanford and Berkeley boast far fewer (25 and 30 respectively).
China's New Currency
Varian on Fashion
I have the same fashion sense that most economists have — that is, none whatsoever.Me too.
Wednesday, April 04, 2007
Does Wall Street prefer cap-and-trade?
Interesting observation about Wall Street. Under a cap-and-trade system, someone has to set up the market to arrange the trades, and those market makers could potentially be a political interest group. Of course, this does not make cap-and-trade a better policy--in fact, to the extent that resources are used up on the market makers, that is a downside of cap-and-trade. But perhaps it may help explain some of the politics.
Fellow power company CEOs "would probably cringe to hear me say it," Williamson said, but he believes a federal tax on carbon dioxide emissions would be more fair than a cap-and-trade system. The latter allows companies to buy and sell the right to emit CO2.
A tax is "the easiest method, the fastest and the most equitable," Williamson said, because cap and trade systems tend to be more costly for companies to manage and create regional imbalances that would likely lead to federal lawsuits. "I've made the joke before that Wall Street would likely lose its interest in the environment if there wasn't money to be made from a trading opportunity."
The interest group that benefits most from cap-and-trade compared to the tax are the energy companies. It the permits are handed out, rather than auctioned, the companies in effect get the revenue that the government could otherwise use to cut distortionary taxes, such as income taxes. That is why it is surprising to see Williamson being so forthright here. You would think that his shareholders would prefer a less honest CEO.
I wonder if you might consider having an item that asks your readers what books they think would be excellent for economics students to read. Perhaps each reader with a good recommendation could offer a paragraph or so about the book and why they think it's an excellent read for students.Please post your suggestions in the comments section.
By the way, I am pretty sure that Ron is not referring to textbooks: Everyone knows which one of those to pick.
Tuesday, April 03, 2007
Wisdom from Warren
He wisely counsels that anything that happens to your finances is secondary to the important things in life – picking a suitable and compatible mate, developing a relationship with your children, and doing something that you enjoy.I hope all those Harvard students aspiring for jobs in investment banking or management consulting keep this advice in mind.
From Milton Friedman
Thanks to Alex Tabarrok for the pointer.
The economic isolationists win one
You might expect me, as a former economic advisor to President Bush, to defend these policy moves by the administration. If so, you'd be wrong.
U.S. Puts Tariffs on Chinese Paper
More Actions Anticipated Over Subsidy System
SHANGHAI, April 2 -- Chinese industry and trade groups accused the Bush administration on Monday of a misguided and hypocritical approach to trade for its decision last week to slap steep tariffs on certain Chinese-made paper.
The United States contends the glossy paper is subsidized by the Chinese state. But China's Ministry of Commerce called the economic sanctions "unacceptable." Hua Min, head of the World Economy Research Institute at Fudan University in Shanghai, called the American stance "absurd," noting that the United States just a few years ago was found to be giving illegal tax rebates to companies such as Boeing and Microsoft.
In Washington, officials at the Commerce Department said they had no choice but to act on a petition filed by an aggrieved U.S. paper company whose sales have been undercut by cheap Chinese imports.
"The Chinese economy is replete with subsidies," Undersecretary of Commerce for International Trade Franklin L. Lavin said in an interview Monday. "It gives Chinese exporters an unfair advantage in the U.S. market, and we're determined to do what we can to unwind that advantage."
The decision to impose tariffs on one product -- high-gloss paper, used to print magazines and some books -- has sown anticipation that this is merely the first in a string of such cases, with the administration likely to follow with similar action against a range of Chinese industries, possibly including steel, textiles and plastics.
Industrial subsidies are bad policy, but they are bad policy for the country paying for the subsidy. The country buying the subsidized goods benefits from cheaper imports. Think of these subsidies as the opposite of OPEC--another country conspires to sell goods below competitive prices. For the same reason that high prices from a cartel hurt us, low prices from a subsidy help us. It is common sense that when you buy something, you would rather pay less than more for it. That is as true for a nation as it is for a household.
The bottom line: The Chinese taxpayers should be complaining about these subsidies, not the American government.
Monday, April 02, 2007
What I've been reading
Tax Incidence in Illinois
That lesson is apparently lost on some elected leaders in Illinois. Here is the latest news from that state:
On Thursday, March 22, 2007, Illinois Governor Rod Blagojevich released a draft of bill language designed to implement the 3% health care payroll tax first announced on March 7, 2007....The proposed legislation indicates that the tax is intended to fall on the employer rather than its employees, providing that the payroll tax "shall not be withheld from wages paid to employees or otherwise be collected from employees or reduce the compensation paid to employees."Life is a constant reminder that we teachers of basic economics need to try harder.
Sunday, April 01, 2007
Carbon Tax Problem
Here is the good homework problem for introductory microeconomics:
Tax on Carbon Emissions Gains Support
By Juliet Eilperin and Steven Mufson
As lawmakers on Capitol Hill push for a cap-and-trade system to rein in the nation's greenhouse gas emissions, an unlikely alternative has emerged from an ideologically diverse group of economists and industry leaders: a carbon tax.
Most legislators view advocating any tax increase as tantamount to political suicide. But a coalition of academics and polluters now argues that a simple tax on each ton of emissions would offer a more efficient and less bureaucratic way of curbing carbon dioxide buildup, which scientists have linked to climate change.
"We want to do the least damage to the growth of GDP," said Michael Canes, a private consultant and former chief economist for the American Petroleum Institute, who led a Capitol Hill briefing on the subject in late February sponsored by the conservative George C. Marshall Institute. Between a cap system and a carbon tax, "a carbon tax will be the much more cost-effective way to go," he said...
Few lawmakers, Democrat or Republican, have the stomach for a carbon tax, however. Some are still smarting from a vote in the early 1990s when President Bill Clinton persuaded the House to adopt a BTU tax -- a tax on the heat content of fuels -- only to abandon the effort in the Senate.
Democrats such as House Natural Resources Committee Chairman Nick J. Rahall II (W.Va.) say they have no desire to revisit the issue. "I'm not an advocate of a carbon tax," Rahall said. "That's going to be passed on; the consumer would end up paying for that."...
Only one House Democrat, Rep. Pete Stark (Calif.), has drafted a carbon tax proposal. Stark, who first proposed such a tax 16 years ago as a way to ease the nation's energy crunch, plans to introduce a bill in April that would levy a tax of $25 per ton of carbon released for five years.
"It's more efficient, more equitable, and it's less subject to gaming, I might add," Stark said, estimating that it would raise the cost of gasoline by 10 cents a gallon.
Compare the effects of a $25 carbon tax with a cap-and-trade system in which the cap is set so that the price of a carbon permit ends up at $25. Is the impact on carbon emissions different under the two systems? Is the impact on consumers different? Who wins and who loses with cap-and-trade compared to the tax?
Post your answers in the comments section.
Update: Patrick gives the best answer:
The two systems produce the same effect on carbon emissions [and also on consumers]. The difference is purely distributive. In the tax situation, the government keeps all the revenue. In the cap-and-trade system, the revenue from the sale of permits goes to current polluters (it ends up essentially being a transfer to them).