Archive for the 'Economic growth' Category

The mystery of economic growth

August 20, 2013

Well-known economist in 1994: “There are many economic puzzles, but there are only two really great mysteries. One of these mysteries is why economic growth takes place at different rates over time and across countries. Nobody really knows why….”

Same economist in 2013: “The reasons some countries grow more successfully than others remain fairly mysterious….”

I agree. When it comes to rich nations, we have very little clue about what yields faster economic growth over the medium to long run.

From the mid-1940s through the early 1970s, the American economy enjoyed healthy growth. But then the economy sputtered for a decade — a deep downturn in 1973-75, followed by high unemployment and inflation, followed in turn by a double-dip recession in 1980 and 1981-82. Academics and policy makers were befuddled.

The changed context spurred a slew of recommendations for how to rejuvenate the economy. The right blamed government overreach. Taxes, regulations, Keynesian demand management, and welfare state generosity had gone too far, in this view.

The left offered up myriad solutions of its own, including industrial policy, managed trade, a stakeholder-centered financial system, flexible specialization, lean production, corporatist partnerships between business, labor, and government, and collaboration between and within firms. In the mid-to-late 1990s, a Clinton-Reich-Rubin-Sperling approach embraced some of these ideas but emphasized education and skill development, free trade, and a commitment to balance the government budget during economic upswings. Like the “Third Way” orientation championed by Anthony Giddens and Tony Blair in the United Kingdom, adherents aimed to reconcile traditional left concerns for justice and fairness with an emphasis on economic growth.

As it turned out, America’s economic growth from 1979 to 2007 (peak to peak) was pretty healthy. It was slower than during the post-World War II “golden age.” But that isn’t surprising; growth was especially rapid in those years because it had been so slow in the 1930s and because so much of the industrial capacity in western Europe and Japan was destroyed during the war. U.S. GDP per capita grew at a rate of 1.9% per year between 1979 and 2007. That’s right on the long-run trend; the American economy’s average growth rate from 1890 to 2007 was 1.9%. The U.S. also did well in 1979-2007 compared to 19 other rich longstanding democracies. Adjusting for catch-up (nations that begin poorer grow more rapidly because they can borrow technology from the leaders), America’s growth rate was third best.

Unfortunately, we know very little about why. Was it due to the U.S. economy’s traditional strengths, such as its large domestic market and its array of large firms with established brands? To its strong universities and R&D, which keyed a successful transition to a high-tech service economy? To deregulation, tax cuts, and wage stagnation? To the adoption of some of the strategies proposed by the pro-growth progressives? To stimulative monetary policy (after the early 1980s)? To stock market and housing bubbles? To something else? We don’t know.

Nor do social scientists have a compelling explanation for why some rich nations have grown more rapidly than others in recent decades. We know that catch-up matters. Limited product and labor market regulations and participation by business and labor in policy making seem to help, but they account for only a small portion of the country differences in economic growth between 1979 and 2007. Even education seems to have played little role. Growth hinges on technological progress, which should be boosted by education, particularly in the modern knowledge-driven economy. Yet across the rich countries, those with higher average years of schooling, larger shares of university graduates, or faster increase in educational attainment have not grown more rapidly than others since the 1970s. (I’m not yet sure what I make of this.)

An interesting and perplexing piece of the growth puzzle is the tendency of countries to do well for a while and then falter. In the past half century, any number of national models have gone in and out of fashion, first surging and then falling back.

Economic growth is important. Yet for affluent countries, our knowledge about what causes faster or slower growth is very thin. It’s pretty remarkable, not to mention unfortunate.

Will everyone be worse off if the United States turns social democratic?

September 29, 2012

Daron Acemoglu, James Robinson, and Thierry Verdier have a new paper that asks “Can’t We All Be More Like Scandinavians?” Their answer is no. The answer follows from a model they develop in which

  1. Countries choose between two types of capitalism. “Cutthroat” capitalism provides large financial rewards to successful entrepreneurship. This yields high income inequality, but it stimulates lots of entrepreneurial effort and hence is conducive to innovation. “Cuddly” capitalism features less financial payoff to entrepreneurs and more generous cushions against risk. This yields modest income inequality but less innovation.
  2. Because of the difference in innovation, economic growth initially is faster in cutthroat-capitalism nations. But technological advance spills over from cutthroat nations to cuddly ones, so growth rates then equalize. Over the long run, GDP per capita is higher in cutthroat-capitalism nations (due to the initial burst) while economic growth rates are similar across the two types.
  3. Average well-being may be higher in cuddly countries because the more egalitarian distribution of economic output more than compensates for the lower level of output.
  4. Nevertheless, it would be bad for all countries if cutthroat-capitalism nations switched to cuddly capitalism. That would reduce innovation in the (formerly) cutthroat nations, which would reduce economic growth in all nations.

Acemoglu, Robinson, and Verdier say the model might help us understand patterns of economic growth and well-being in the United States and the Nordic countries — Denmark, Finland, Norway, and Sweden. The United States chose cutthroat capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for a short time, but since then all five countries have grown at the roughly same pace. America’s high inequality encourages innovation. The Nordics can be cuddly and still grow rapidly because of technological spillover. If the U.S. were to decide to go cuddly, innovation would slow. Both sets of nations would grow less rapidly.

Incentives, innovation, and economic growth in the U.S. and Sweden

I won’t provide the “detailed empirical study of these issues” that Acemoglu and colleagues say they hope their paper will inspire, but I can offer a little data. To keep things simple, I’ll compare the United States with just one of the Nordic countries: Sweden.

An indicator of financial incentives for entrepreneurs is the top 1%’s share of household income. An indicator of the extent of cushions against risk is government expenditures’ share of GDP. What we see in the data is a lot of similarity between the U.S. and Sweden until the second half of the twentieth century. Government spending begins to diverge in the 1960s, income inequality in the 1970s.

Though Sweden’s top 1% get a smaller share of the total income than their American counterparts, are incentives for entrepreneurs really much weaker in Sweden? Swedish CEOs and financial players don’t pull in American-style paychecks and bonuses in the tens of millions, but there is little to prevent an entrepreneur from accumulating large sums. In the 1990s Sweden undertook a significant tax reform, reducing marginal rates and eliminating loopholes and deductions. Corporate income and capital gains tax rates were lowered to 30%, and the personal income tax rate to 50%. Later the wealth tax was done away with. In the early 2000s a writer for Forbes magazine mused that Sweden had transformed itself from a “bloated welfare state” into a “people’s republic of entrepreneurs.”

But set this aside for the moment. Suppose the incentives for entrepreneurs did begin to differ in the two countries around 1960 or 1970. The model predicts innovation will subsequently diverge. Acemoglu, Robinson, and Verdier refer to one measure of patent applications per capita that has the U.S. leading Sweden beginning in the late 1990s. That timing perhaps is consistent with the model’s prediction if we allow a substantial lag. But they cite another measure that is available starting in 1980 and has the U.S. well ahead of Sweden already by then. This suggests America’s innovation advantage might have preceded rather than followed the two countries’ type-of-capitalism choice.

The final outcome is GDP per capita. Here the model stumbles. The gap between the two countries isn’t recent; it dates back to more than a century ago. Apart from a few hiccups, each country has stayed on its long-run growth path throughout the past 100 years, with Sweden slowly catching up to the United States.

So the U.S. and Sweden have chosen different styles of capitalism, at least as measured by income inequality and public spending. That choice looks to have occurred around 1960 at the earliest. The U.S. may be the more innovative of the two nations, and that advantage may have come after the type-of-capitalism choice. But the model doesn’t seem to help in explaining the gap between the two countries in per capita GDP.

Will American innovation slow if we go “cuddly”?

The really interesting question posed by Acemoglu, Robinson, and Verdier is whether innovation would slow in the United States if we strengthened our safety net and/or reduced the relative financial payoff to entrepreneurial success. I’m skeptical, for three reasons.

The first flows from America’s past experience. According to Acemoglu et al’s logic, incentives for innovation in the U.S. were weakest in the 1960s and 1970s. In 1960 the top 1%’s share of pretax income had been falling steadily for several decades and had nearly reached its low point. Government spending, meanwhile, had been rising steadily and was close to its peak level. Yet there was plenty of innovation in the 1960s and 1970s, including notable advances in computers, medical technology, and other fields.

Second, the Nordic countries, with their low income inequality and generous safety nets, currently are among the world’s most innovative countries. The World Economic Forum’s Global Competitiveness Index has consistently ranked them close to the United States in innovation. The most recent report, for 2012-13, rates Sweden as the world’s most innovative nation, followed by Finland. The U.S. ranks sixth. The 2012 WIPO-Insead Global Innovation Index ranks Sweden second and the United States tenth. Whether or not this lasts, it suggests reason to doubt that modest inequality and generous cushions are significant obstacles to innovation.

Third, if Acemoglu and colleagues are correct about the value of financial incentives in spurring innovation, we should see this reflected not only in the United States but also in other nations with relatively high income inequality and low-to-moderate government spending, such as Australia, Canada, Ireland, New Zealand, and the United Kingdom. But we don’t.

There’s one additional possibility worth considering. If financial incentives truly are critical for spurring innovation, it could be the opportunity for large gains that matters, rather than the absence of cushions. Suppose we were to increase government revenues in the United States via higher taxes on everyone — steeper income taxes on the top 1% or 5% plus a new national consumption tax. And imagine we used those revenues to expand public insurance and services — fully universal health insurance, universal early education, a beefed-up Earned Income Tax Credit, a new wage insurance program, more individualized assistance with training and job placement. These changes wouldn’t alter income inequality much, but they would enhance economic security and opportunity. Would innovation decline? I doubt it.

We may get a test of this moderate-to-high inequality with generous cushions scenario at some point. I suspect this is where America is heading, albeit slowly. Interestingly, the Nordic countries, where the top 1%’s income share has been trending upward (see figure 10 here), might end up there first.

Progress for the poor

October 1, 2011

That’s the title of my new book. In it I try to answer the following questions:

How much does economic growth benefit the poor? When and why does growth fail to trickle down?

How can social policy help? Is more social spending better for the poor?

Can a country have a sizeable low-wage sector yet few poor households?

Are universal programs better than targeted ones?

What role can public services play in antipoverty efforts?

What is the best tax mix?

Does improvement in the living standards of the least well-off require a sacrifice of other desirable outcomes?

Is heavy taxation bad for the economy?

May 22, 2011

Taxes reduce the payoff to entrepreneurship, investment, and work effort. If taxation is too heavy, these disincentives will weaken a nation’s economy. But at what point does the harmful impact kick in? And how large is it?

A puzzle

Half a century ago, in 1960, taxes totaled about a quarter of GDP in Denmark, Sweden, and the United States. The tax take then began to rise in Denmark and Sweden, reaching half of GDP by the mid-1980s, where it has remained. In America it has barely budged, hovering between 25% and 30% of GDP throughout the past five decades.

Has heavy taxation hurt the Danish and Swedish economies? If so, how much?

Begin with GDP per capita. America’s is higher than Denmark’s or Sweden’s. But that’s a legacy of the distant past. Growth of per capita GDP in the three countries has been virtually identical, both in the five decades since 1960 when the divergence in tax levels began and in the three decades since the 1970s (shown in the chart) when the tax difference has been most pronounced.

(Here and throughout I use 2007, the peak year of the pre-crash business cycle, as the end point. Adding the crash and its aftermath would improve the standing of Denmark and Sweden relative to the U.S.)

Each year since 2001 the World Economic Forum has scored most of the world’s countries on a “competitiveness” index. The index aims to assess the quality of twelve components of a nation’s economy: institutions, infrastructure, macroeconomic stability, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market sophistication, technological readiness, market size, business sophistication, and innovation. In 2007 Denmark and Sweden were judged to be nearly identical to the United States in competitiveness. That was true throughout the decade. It also was true for the “innovation” components of the index in particular.

Employment, measured as average hours of paid work per working-age person, is a little lower in Denmark and Sweden (more here ). A larger share of working-age Danes and Swedes are employed — around 76%, compared to 72% in the U.S. But employed Danes and Swedes tend to work fewer hours than employed Americans — about 1,600 per year versus 1,800. This is due in large part to the fact that Danes and Swedes have more than five weeks of legally-mandated paid vacations and holidays, whereas Americans have none. This gap, in turn, is a function of historical differences in the strength of unions.

Employment hours increased between 1979 and 2007 in all three countries. The rate of growth was fastest in Denmark, followed by the U.S. and then Sweden.

Household income (after taxes and transfers) is higher in the United States at the ninetieth percentile (p90) of the distribution and at the median (p50). This owes to differences in per capita GDP, in income inequality, and in the degree to which citizens receive their income in the form of (tax-financed) public services. Here too the U.S. has not gained ground in recent decades. Household incomes in the middle of the distribution have grown more rapidly in Denmark and Sweden than in the U.S. (shown in the chart), and at the ninetieth percentile they’ve increased at about the same pace.

At the tenth percentile (p10), incomes are higher in Denmark and Sweden. And they’ve increased more. (See here and here.)

Denmark and Sweden have done better than the United States at keeping government debt in check.

Have high taxes required a sacrifice of liberty? Not according to the Freedom House measure of civil liberties or the Heritage Foundation-Wall St. Journal measure of economic freedom.

Finally, consider two social indicators of well-being: life expectancy and life satisfaction. On both counts, Danes and Swedes fare, on average, just as well as or better than their American counterparts.

If heavy taxation has harmful economic effects, why have Denmark and Sweden performed similarly to the United States during a period of several decades in which their taxes were much higher than America’s?

Three explanations that sidestep the puzzle

One common explanation is that small size facilitates administrative efficiency. The Danish and Swedish governments can function effectively because their scale is manageable. They are “big” governments, but in small countries. This might be true, but to say that heavy taxation isn’t a problem if government works well is to say that heavy taxation isn’t in and of itself a problem.

A second explanation looks to the mix of taxes countries use. The Nordic countries rely disproportionately on consumption taxes; in 2007 consumption taxes totaled 16% of GDP in Denmark and 13% in Sweden, compared to just 5% in the U.S. These are said to create less in the way of investment and work disincentives than do taxes on individual and corporate income.

Yet there is a sizeable difference in income taxation too. In the U.S. income taxes were 14% of GDP in 2007, versus 19% in Sweden and a whopping 29% in Denmark. More important, to suggest that heavy taxation isn’t harmful given an effective tax mix is to suggest that a high level of taxation per se is not necessarily harmful.

A third explanation points to tax compliance. Each April most Swedes receive a pre-prepared tax form. The relevant information about income, deductions, and the amount still owed or to be refunded has already been filled in by the Swedish Tax Agency. If the information is correct, the taxpayer simply confirms that by mail, telephone, or text message. Pre-prepared tax returns not only are more convenient for taxpayers; they also reduce cheating. Greater compliance, in turn, is likely to make heavy taxation more workable. If cheating is extensive, tax rates need to be higher in order to raise a given quantity of revenue, which increases the likelihood of disincentive effects on entrepreneurship, investment, and work effort. In a tax system with minimal cheating, more revenue can be raised at moderate tax rates.

This can’t be done in the United States, so the argument goes, because the American tax code (unlike its Swedish counterpart) has too many available deductions and rebates. But the U.S. could simplify its tax code to enable pre-preparation. Moreover, even with this advantage, income tax rates in Denmark and Sweden are a good bit higher than in the U.S. And a large portion of Danish and Swedish tax revenues come via payroll and/or consumption taxes, which are less vulnerable to evasion, in those countries and in the U.S. as well.

Two explanations that attempt to address the puzzle

Here are two accounts of Danish and Swedish economic performance that don’t sidestep the question of tax levels’ impact.

The first is hypothetical; I don’t know of anyone who’s offered this argument explicitly. It says that the adverse effect of taxation kicks in once a country passes 15% or 20% or 25% of GDP, and it doesn’t worsen the farther beyond that you go. Denmark, Sweden, and the United States each exceeded 25% already by 1960, so in this story we would expect the three countries to have experienced similar (poor) economic performance in subsequent years.

This hypothesis doesn’t strike me as especially compelling. None of the world’s rich nontiny democracies have had tax levels below 25% of GDP since the 1970s, and only a few have been below that level since 1960. Yet a number of these countries have had relatively good economic outcomes during this period.

A second explanation says the Danish and Swedish economies have performed similarly to America’s despite heavier taxes because they have some advantage(s) that I haven’t adjusted for. This certainly would be true if I had chosen Norway as one of the comparison countries. Norway’s economy has been boosted by extensive oil resources. Has Denmark or Sweden had any such advantage?

One possibility is catch-up. Laggard countries can get an economic growth boost by borrowing technology from the leaders. But this has become less relevant for Denmark and Sweden in recent decades, as they’ve invested heavily in education and R&D and become technological leaders in their own right (more here).

Ethnic and cultural homogeneity is sometimes mentioned as a key economic asset of the Nordic countries. This might help, though in rich nations diversity may have some benefits as well.

Corporatist policy making, which features institutionalized participation by business and labor representatives, is associated with faster economic growth in affluent countries in recent decades. This may have helped Denmark and Sweden. Yet both countries have made their share of policy mistakes.

Of course, the United States has some important advantages of its own, including a huge domestic market, excellent universities, a culture that prizes innovation and entrepreneurship, a well-developed venture capital system, bankruptcy laws that facilitate risk-taking, a tradition of regional mobility, and an attractiveness to talented immigrants. The question is: If taxation at Danish and Swedish levels has a significant negative economic effect, do Denmark and Sweden have advantages relative to the U.S. that are large enough to have fully offset that effect in recent decades? It’s a difficult question to answer with any certainty, but I think probably not.

A challenge

At what point does the harmful impact of taxes on the economy kick in? And how large is it? The Danish and Swedish experiences over the past generation pose a challenge for those who believe the answers to these two questions are “somewhere below 50% of GDP” and “large.” It’s a challenge that in my view has yet to be met.

Price index clarification

February 3, 2011

Paul Krugman rightly notes a potential problem in comparing the post-1973 trend in GDP with the trend in median income: the price indexes used to adjust for inflation differ. But that’s not an issue in this “decoupling” chart. It uses the same price index for both.

The great decoupling

January 31, 2011

Tyler Cowen’s e-book The Great Stagnation offers a novel explanation of the slowdown in U.S. median income growth since the 1970s. Here’s his causal model:

Innovation —> economic growth —> median income growth

In this model there are three potential sources of the reduction in median income growth:

1. Innovation has slowed.

2. The degree to which innovation boosts economic growth has declined.

3. The degree to which economic growth boosts median income growth has declined.

Cowen argues for hypothesis #1. He cites an estimate by Jonathan Huebner, a Pentagon physicist, that the rate of global innovation per capita peaked in the late 1800s, remained high to the mid-1950s, and then steadily declined. And he suggests that whereas “The period from 1880 to 1940 brought numerous major technological advances into our lives…. Today … apart from the seemingly magical internet, life in broad material terms isn’t so different from what it was in 1953.” The high rate of innovation through the mid-1950s enabled rapid economic growth for a few additional decades. But beginning in the 1970s economic growth slowed, and along with it median income growth.

The book is well worth reading. (At four dollars it’s also a good deal — less than a large latte, a Sunday New York Times, or a newsstand copy of The Atlantic.) But I’m skeptical on two counts.

First, I’m not convinced that innovation has in fact slowed significantly. Cowen discusses the internet but not computers more generally. Computers are the engine of the postindustrial economy; they are the modern counterpart to steel, railroads, and the assembly line. Advances in computer hardware and software, their widespread dissemination, and their application to myriad tasks — automation and coordination of supply chains in manufacturing, record keeping and scheduling in services, and much much more — surely represent a massive improvement.

Second, the data point to hypothesis #3. A key difference between the WW2-1973 period and the decades since then is that median income growth has become decoupled from economic growth. (Mark Thoma makes this point too.) The rate of economic growth has been lower in the recent era, but it’s nevertheless been decent. Yet median income growth has been very slow. This contrasts sharply with the prior period.

Here’s one way to see this (others here):

Between 1947 and 1973, GDP per family increased at a rate of 2.6% per year and median family income grew at 2.7% per year. From 1973 to 2007, GDP per family increased at 1.7% per year, but median family income grew at just 0.7% per year.

And note the absolute numbers: GDP per family rose by $52,000 during 1947-73 and then by $82,000 during 1973-2007. Median family income increased by $26,000 during 1947-73 but then by just $13,000 in 1973-2007.

Median family income was $64,000 in 2007. Had it kept pace with GDP per family since the mid-1970s, it instead would have been around $90,000.

I’m all for helping to accelerate the rate of innovation. But the big change in recent decades lies in the degree to which economic growth lifts middle-class incomes. If we want to understand slow income growth, that should be our focus.

Why do some rich economies grow faster than others?

January 4, 2011

Between 1973 and 2007 the twenty rich nations in the following chart averaged a 2% per year growth rate of per capita GDP. But some of them grew faster than others.

Why?

One reason is “catch-up”: partly because they could borrow technology from the leaders, countries that began with a lower per capita GDP tended to grow more rapidly. The growth rates shown here adjust for this.

What else matters? The list of hypothesized causes is lengthy. It includes investment, consumption, education, natural resources, macroeconomic policy, levels of taxation, welfare state size and structure, industrial policy, government regulations, the distribution of income, interest group organization, corporatist concertation, the partisan complexion of government, interest group-government coherence, cooperation-promoting institutions, and institutional coherence, among others.

In a chapter in the Oxford Handbook of Comparative Institutional Analysis, I take a stab at assessing the merits of some of these hypotheses. Many turn out to be of little use in understanding the cross-country variation in catchup-adjusted growth. Two that do seem to help are business and labor participation in policy making (“corporatism”) and limited product and labor market regulations, yet these go only a small part of the way toward accounting for the country differences.

An interesting element of the story is the tendency of countries that do well for a while to then lapse. During the course of these four decades an array of national models have gone in and out of fashion, first performing effectively and then falling on hard times: Germany (“modell Deutschland”) and Japan (“Japan Inc.”) in the 1970s and 1980s; the United States in the 1980s and 1990s; the Netherlands (“Dutch miracle”) in the 1990s; Denmark (“flexicurity”) and Ireland (“Celtic tiger”) in the 1990s and 2000s. Some later rebound, such as Sweden in the 2000s.

My conclusion: we know far less than we’d like to about this very important issue.

When is economic growth good for the poor?

November 17, 2010

In a good society, the living standards of the least well-off rise over time.

One way to achieve that is rising redistribution: government steadily increases the share of the economy (the GDP) that it transfers to poor households. But there is a limit to this strategy. If the pie doesn’t increase in size, a country can redistribute until everyone has an equal slice but then no further improvement in incomes will be possible. For the absolute incomes of the poor to rise, we need economic growth.

We also need that growth to trickle down to the poor. Does it?

The following charts show what happened in the United States and Sweden from the late 1970s to the mid 2000s. On the vertical axes is the income of households at the tenth percentile of the distribution — near, though not quite at, the bottom. On the horizontal axes is GDP per capita. The data points are years for which there are cross-nationally comparable household income data.

Both countries enjoyed significant economic growth. But in the U.S. the incomes of low-end households didn’t improve much, apart from a brief period in the late 1990s. In Sweden growth was much more helpful to the poor.

In Austria, Belgium, Denmark, Finland, France, Ireland, the Netherlands, Norway, Spain, and the United Kingdom, the pattern during these years resembles Sweden’s. In Australia, Canada, Germany, Italy, and Switzerland it looks more like the American one. (More graphs here.)

What accounts for this difference in the degree to which economic growth has boosted the incomes of the poor? We usually think of trickle down as a process of rising earnings, via more work hours and higher wages. But in almost all of these countries (Ireland and the Netherlands are exceptions) the earnings of low-end households increased little, if at all, over time. Instead, as the next chart shows, it is increases in net government transfers — transfers received minus taxes paid — that tended to drive increases in incomes.

None of these countries significantly increased the share of GDP going to government transfers. What happened is that some nations did more than others to pass the fruits of economic growth on to the poor.

Trickle down via transfers occurs in various ways. In some countries pensions, unemployment compensation, and related benefits are indexed to average wages, so they tend to rise automatically as the economy grows. Increases in other transfers, such as social assistance, require periodic policy updates. The same is true of tax reductions for low-income households.

Should we bemoan the fact that employment and earnings aren’t the key trickle-down mechanism? No. At higher points in the income distribution they do play more of a role. But for the bottom ten percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time some will be out of work due to structural or cyclical unemployment. And in all rich countries a large and growing number of households are headed by retirees.

Income isn’t a perfect measure of the material well-being of low-end households. We need to supplement it with information on actual living conditions, and researchers and governments now routinely collect such data. Unfortunately, they aren’t available far enough back in time to give us a reliable comparative picture of changes. For that, income remains our best guide. What the income data tell us is that the United States has done less well by its poor than many other affluent nations, because we have failed to keep government supports for the least well-off rising in sync with our GDP.

Can government help?

March 31, 2010

Lecture slides for the “Can Government Help?” section of my Social Issues in America course:

What is just?

What do Americans want?

Is there a tradeoff between social justice and a healthy economy?

What can government do?

How to pay for it

Are Interest Groups the Source of Our Economic Woes?

February 2, 2009

David 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, 2008

For 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.

Follow

Get every new post delivered to your Inbox.

Join 136 other followers