Lecture slides for the “Can Government Help?” section of my Social Issues in America course:
Is there a tradeoff between social justice and a healthy economy?
Archive for the 'Economic growth' Category
Are Interest Groups the Source of Our Economic Woes?
February 2, 2009David Leonhardt’s New York Times Magazine piece on how to transform (not just stimulate) the American economy is worth reading. But I don’t share his enthusiasm for Mancur Olson’s explanation of national economic success.
Firms, workers, and citizens tend to organize in interest groups, and those groups sometimes obstruct markets and solicit government favors that benefit themselves at the expense of the larger society. Olson argued, in a 1982 book titled The Rise and Decline of Nations, that in democratic countries such groups grow increasingly powerful over time. Regulations, tax preferences, and government expenditures end up more and more directed toward these special interests rather than the general interest. Economic growth suffers. (The theory is a bit more complicated than that, but I’ll set the complexities aside here.)
Leonhardt says this helps us understand why economic growth in the U.S. has been slower than we’d like it to be. He endorses Olson’s sentiment that what’s needed is to periodically weaken interest groups’ strength and influence.
Olson’s hypothesis seems sensible enough. The trouble is, it’s difficult to find supportive evidence. Leonhardt, like Olson, looks to the experiences of rich nations. He contrasts the United Kingdom with Germany and Japan:
England’s crisis was the Winter of Discontent, in 1978-79, when strikes paralyzed the country and many public services shut down. The resulting furor helped elect Margaret Thatcher as prime minister and allowed her to sweep away some of the old order. Her laissez-faire reforms were flawed in some important ways … and they weren’t the only reason for England’s turnaround. But they made a difference. In the 30 years since her election, England has grown faster than Germany or Japan.
It’s helpful to broaden the comparison to include other countries. Olson suggested we assess his theory based on the timing of the last major societal disruption each country experienced. The longer the period since a disruption, the more powerful interest groups will be and hence the slower the rate of economic growth. The following chart uses this measure (based on a scoring by Erich Weede), with an update to account for the Thatcher disruption in the U.K., Reagan’s in the United States, and a similar one in New Zealand beginning in the late 1980s. Economic growth needs to be adjusted for the catchup effect, whereby nations with lower per capita GDP grow more rapidly simply by virtue of borrowing technology from richer countries. The chart shows catchup-adjusted economic growth in twenty nations since 1973, when the postwar “golden age” of rapid growth for all countries ended. Olson’s hypothesis predicts a positive association. But it isn’t there.
The level of unionization is another indicator Olson used in assessing his theory. Here Olson’s hypothesis predicts a negative association. It too doesn’t pan out.
Olson’s interest group account of economic success and failure may have some merit. But it offers little help, if any, in understanding economic growth patterns over the past few decades.
Taxes at the Top
January 14, 2008For many progressives it is an article of faith that tax rates on the richest Americans should be higher than they currently are.
Why? One reason is that it would be fairer. In the 1950s the top marginal income tax rate was 90%, and it was 70% as recently as 1980. These days the top rate is only 35%.
That’s misleading, however, because prior to the mid-1980s the tax system had a lot more loopholes and deductions than it does now. The meaningful tax rate is the “effective” rate — the share of their income that people actually pay in taxes. The following chart shows the top marginal rate and the average effective rate on the top 1% of taxpayers since World War II. The latter is from calculations by the Congressional Budget Office (here) and is only available beginning in 1979. (As of 2005, a four-person household in the top 1% had a pretax income of $600,000 or more.) The effective rate is lower now than it was in the late 1970s and in the mid-1990s.
Some opponents of higher tax rates for the rich argue that fairness in taxation requires that everyone’s income be taxed at the same rate. Taxation should be proportional rather than progressive. Not many people seem to share this view, however. Most feel that because they can afford to, the richest should pay not only more dollars but also a larger share of their income.
A second rationale for higher taxes on the most well-to-do is that it would increase government revenues, which could be used to help improve opportunity and outcomes for those less fortunate. Health care for all, a more generous Earned Income Tax Credit, and subsidized preschool and child care are among the many good ideas currently on the table.
The taxes paid by those at the top matter a great deal for government finances. As of 2005 the top 1% accounted for 28% of federal government tax revenues. That isn’t because they are taxed at an outlandish rate; an effective tax rate of 30-40% is hardly confiscatory. Instead, it’s because they get a very large share of the country’s income — 18% as of 2005.
The following chart shows federal government tax revenues as a share of GDP by the effective tax rate on the top 1%. The data points represent each year for which data are available. Although the correlation is far from perfect, tax rates on the richest are positively associated with the portion of GDP collected in taxes. This is as we would expect. It suggests that steeper tax rates at the top are likely to bring in more revenue.
But not so fast. It is commonly objected that higher tax rates on the affluent will reduce incentives for saving, investment, entrepreneurialism, and hard work. Economic growth will slow. Thus, taxes will be collecting a larger share of a less-rapidly-growing economy. In the end, higher tax rates will yield no increase (and perhaps a reduction) in government revenues.
Is this true? A lot of research has been done on this question, but there is little agreement about the answer. (For a helpful overview, see Joel Slemrod and Jon Bakija, Taxing Ourselves.)
The next chart shows the growth rate of per capita GDP by the effective tax rate on the top 1%. The effective tax rate on the richest appears to have had no noteworthy impact on economic growth. Averaging growth over several years does not change the picture.
What about the effect of tax changes? As the first chart above indicates, the effective tax rate on the top 1% fell sharply between 1979 and 1982. In the five-year period beginning in 1982 the growth rate of per capita GDP averaged 2.6%. By contrast, the effective rate on top incomes jumped appreciably between 1990 and 1995. Yet over the five-year period starting in 1995 the average rate of economic growth was virtually identical: 2.7%.
There have been several smaller changes in the high-end effective tax rate since the late 1970s. In the late 1980s the rate increased slightly, and in the late 1990s it declined slightly. In both of these instances, however, assessment is complicated by the fact that recessions occurred fairly shortly afterwards. More recently, between 2000 and 2005 the top rate was reduced from 33% to 31%. Per capita economic growth in the mid-2000s has been relatively weak for a non-recession period, at just a little more than 2% per year, but it is too early to fairly judge the impact.
To sum up: The effective tax rate on the incomes of the top 1% of Americans is substantially lower now (31%) than it was in the late 1970s (37%) and in the mid-1990s (36%). When the rate is higher, the federal government tends to collect a larger share of the national economy in taxes. And the experience of the past several decades suggests that higher rates have had no adverse impact on growth of the economy.
This evidence is by no means conclusive. But it lends credence to progressive hopes that a somewhat higher rate of taxation on the richest Americans would not only be fairer but also enhance the government’s ability to provide valuable services and benefits.
Does More Equality Mean Less Economic Growth?
December 3, 2007“Tax cuts for the wealthiest benefit everyone.” “Though seemingly compassionate, generous government assistance for the poor is unwise.” These and a variety of related policy arguments rest on the notion that equality and economic growth are at odds. Are they?
That the economy would suffer if there were very little inequality is certainly true. To get inequality to a very low level, the government would have to impose high tax rates and redistribute much of the revenue to those who get paid little. Or it could mandate that everyone be paid approximately the same amount. Either option would drastically reduce many people’s motivation to work hard, learn new skills, save and invest, and start new businesses. The result would be a far less dynamic economy.
But most of those who believe inequality in the United States is too high would like less inequality, not no inequality. Hence, the real question is: Would the economy suffer if incomes were less unequal?
Evidence
To answer this question it helps to examine some evidence. We could, for example, look at the experiences of the United States and other similarly-affluent countries in recent decades. A number of studies have found that among poor and middle-income countries, less inequality tends to boost economic growth. But these countries are so different from richer nations in their economic and political institutions that it doesn’t make sense to try to generalize from one to the other.
The following chart includes the seventeen affluent nations for which comparable data are available for inequality and growth over a reasonably lengthy period of time. Income inequality in 1980 (or the closest available year) is on the horizontal axis. It is measured using the Gini index; larger values indicate more inequality. The average rate of economic growth from 1980 to 2005 is on the vertical axis. There is no association between inequality and growth.
What about Ireland? It began the 1980s as a high-inequality country, and it enjoyed by far the fastest economic growth among these nations over the ensuing two and a half decades. Like that of any individual nation, however, Ireland’s story is a complex one, and explanations of the Irish growth miracle seldom attribute any importance to its high level of income inequality.
Of course, the United States is unique in various ways. Perhaps what applies to rich countries in general doesn’t hold for the U.S. in particular. Another source of evidence is the experience of the American states. The next chart shows a similar lack of association across the states.
We also can examine the U.S. historical experience. There are good data on income inequality and economic growth going back to the late 1940s; before then data are less reliable, especially for inequality. Inequality decreased a little in the 1950s and 1960s, but has risen a good bit since then. The following chart shows the U.S. economic growth rate by income inequality for each year from 1947 to 2005. Economic growth is averaged over ten-year periods beginning in the year inequality is measured. (For the year 1990, for instance, inequality is measured during that year and economic growth is averaged over 1990 to 1999.) As with the cross-country and cross-state evidence, there is no indication here of a tradeoff between equality and growth.
(Data used in these charts are from the Luxembourg Income Study, OECD, Census Bureau, and Bureau of Economic Analysis.)
Objections
Is something missing from the picture conveyed by these data? How would a proponent of the notion that more equality means less growth respond?
First, she or he might point out that even Arthur Okun, a respected liberal economist and one-time chair of Lyndon Johnson’s Council of Economic Advisers, admitted that there is a tradeoff between equality and growth. Indeed he did. In his influential 1975 book, Equality and Efficiency: The Big Tradeoff, Okun wrote “Equality in the distribution of incomes … would be my ethical preference. Abstracting from the costs and consequences, I would prefer more equality of income to less and would like complete equality best of all.” But he reluctantly concluded that given the existence of a tradeoff between equality and growth, society ought to forgo greater equality in favor of a healthy economy.
However, Okun’s conclusion was based largely on theorizing rather than evidence. What does theory tell us about the effect of inequality on growth? Until recently the standard view was that there is a tradeoff. Less inequality will produce less investment, because the rich do most of the saving and investing. It also will produce less work effort, because those at the top of the income distribution lose more of their earnings to taxes and those at the bottom can live off government benefits instead of getting a job.
These days, however, it is widely recognized that theory is ambivalent about the impact of inequality on growth. Yes, higher taxes might reduce savings. But if the money is redistributed to the poor, consumption may increase, since the poor tend to spend a larger of their income. Consumption tends to be just as important for economic growth as savings. (High-spending America grew much more rapidly than high-saving Japan in the 1990s.) Yes, generous government benefits may reduce work effort by those at the bottom of the distribution. But generous benefits can have strings attached. In Denmark and Sweden, working-age adults can receive government benefits such as social assistance and unemployment insurance for only a limited period of time, after which they are expected (and helped) to find employment. Furthermore, a relatively egalitarian income distribution is likely to enhance perceptions of justice, potentially boosting work effort while reducing crime and other socially wasteful behavior. Bottom line: to understand inequality’s impact on growth, we have to rely on empirical evidence.
It also is worth noting that Okun wrote at a time, the early 1970s, when the level of income inequality in the United States had reached a historical low and the economy was mired in a recession. Had he been able to consider developments in the U.S. and other affluent countries in the ensuing decades, his assessment might well have been different.
A second line of response is that these charts must be hiding something. It is, of course, possible to mislead with statistical data (as with any other type of evidence). But what, exactly, might these charts be hiding? One possibility is that income inequality and/or economic growth is measured improperly or inaccurately. Another is that choosing a different starting or ending year might change the picture. A third is that taking into account (“controlling for”) other determinants of economic growth could lead to a different conclusion. In a recent book, Egalitarian Capitalism (Russell Sage Foundation, 2004), I considered these objections in some detail. None of them turns out to alter the picture conveyed in the charts here.
A third type of response is that while the level of inequality might not affect economic growth, government action to reduce the existing level, such as raising tax rates on the rich, will. Here the historical experience of the United States is again instructive. Although they aren’t perfect, the best available data suggest that income inequality fell sharply between 1930 and 1950. This was due mainly to higher tax rates, New Deal benefits such as social security and unemployment compensation, legalization of union bargaining rights, and wartime wage controls. In the forties, fifties, and sixties the economy boomed. After holding steady during the 1950s and 1960s, inequality has jumped sharply since the mid-1970s. There has been no upward shift in the rate of economic growth during this period.
Why Americans Are Confused
In 1987, 1996, and 2000 the General Social Survey asked American adults whether they agreed or disagreed with the statement “Large differences in income are necessary for America’s prosperity.” On the one hand, in each of these years only about 30% said they agreed or strongly agreed. On the other hand, fewer than half tended to disagree or strongly disagree. A relatively large share said “neither,” probably because they weren’t sure what to think.
This ambivalence, or confusion, offers a significant opportunity for those appealing to the notion of an equality-growth tradeoff. Claim that a tax cut for the well-to-do will boost economic growth and a sizable share of Americans won’t feel confident in objecting. The idea seems plausible, and social scientists and policy makers have not been effective at communicating the relevant empirical evidence.
In this instance the evidence speaks rather clearly. Is it likely that less income inequality here in the U.S. would result in less economic growth? No.
