Thought du Jour

NYU economist Michael Spence explains that competitive markets, however useful and necessary for economic efficiency and growth, do not ensure stable and sustainable growth, nor an equitable distribution of income.

In the 66 years since World War II ended, virtually all centrally planned economies have disappeared, largely as a result of inefficiency and low growth. Nowadays, markets, price signals, decentralization, incentives, and return-driven investment characterize resource allocation almost everywhere.

This is not because markets are morally superior, though they do require freedom of choice to function effectively. Markets are tools that, relative to the alternatives, happen to have great strengths with respect to incentives, efficiency, and innovation. ….

But markets have … fundamental weaknesses. Or, rather, most societies have important economic and social objectives that markets and competition are not designed to achieve. In today’s rapidly globalizing world, the most important of these objectives – expressed in various ways through the political and policymaking process in a wide range of countries – are stability, distributional equity, and sustainability. ….

A relatively narrow focus on efficiency and growth, at least in many advanced countries, may have worked in the early decades after WWII, when distributional patterns were benign and instability rare. Today that is not enough. Stability, equity, and sustainability challenges have become crucially important, and the role of the state in relation to markets may need re-thinking as a result.

Michael Spence, “Mind over Market“, Project Syndicate, 13 January 2012.

Click on the link above to read the full column.

Michael Spence (born 1943) won the 2001 Nobel Prize in Economics, jointly with George Akerlof and Joseph Stiglitz, for “analyses of markets with asymmetric information”. His latest book is The Next Convergence: The Future of Economic Growth in a Multispeed World (Farrar, Straus and Giroux, 2011).

The top 1% of US earners now command a far higher share of the country’s income than they did 40 years ago. This column looks at 18 OECD countries and disputes the claim that low taxes on the rich raise productivity and economic growth. It says the optimal top tax rate could be over 80% and no one but the mega rich would lose out. ….

Figure 1 shows that there is indeed a strong correlation between the reductions in top tax rates and the increases in top 1% pre-tax income shares from 1975–79 to 2004–08 across 18 OECD countries for which top income share information is available. ….

Figure 1. Changes in top 1% pre-tax income shares and top marginal tax rates since the 1970s

To tell … [whether top pay fairly reflects productivity or whether top pay, rather unfairly, reflects mostly socially wasteful activities] we need to analyse to what extent top tax rate cuts lead to higher economic growth. Figure 2 shows that there is no correlation between cuts in top tax rates and average annual real GDP-per-capita growth since the 1970s. For example, countries that made large cuts in top tax rates such as the United Kingdom or the United States have not grown significantly faster than countries that did not, such as Germany or Denmark. Hence, a substantial fraction of the response of pre-tax top incomes to top tax rates documented in Figure 1 may be due to increased rent-seeking at the top rather than increased productive effort.

Figure 2. GDP-per-capita growth rates and top marginal tax rates since the 1970s

Naturally, cross-country comparisons are bound to be fragile …. But by and large, the bottom line is that rich countries have all grown at roughly the same rate over the past 30 years – in spite of huge variations in tax policies.

Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva, “Taxing the 1%: Why the top tax rate could be over 80%“, Vox, 8 December 2011.

The authors are economists. Piketty teaches at the Paris School of Economics and Saez at the University of California-Berkeley. Ms Stantcheva is a PhD candidate at MIT. The changes graphed in the two figures above refer to changes from 1975-9 to 2004-8 for 18 OECD countries. The top tax rates include both central and local individual income tax rates.

In a related post, Timothy Taylor compares two articles on this issue from the Journal of Economic Perspectives – one published this year, and one published two years ago. His goal “is not to take sides”, but rather to show how a shared framework can be applied to the same problem by different economists with strikingly different results.

There’s often a belief that economics is like an arithmetic problem–even if it’s a complicated arithmetic problem–and it should have a right answer. But the study of economics isn’t a cookbook with a set of ready-made answers. Instead, economics is a way of thinking that can be used by all political persuasions.

Timothy Taylor, “Should the Top Income Tax Rate be 48% or 73%?“, Conversable Economist, 9 December 2011.

Harvard economist Ken Rogoff predicts that technical change, which has hit unskilled workers hard, will soon lower the relative earnings of highly skilled workers, reducing levels of inequality around the world.

Until now, the relentless march of technology and globalization has played out hugely in favor of high-skilled labor, helping to fuel record-high levels of income and wealth inequality around the world. ….

There is no doubt that income inequality is the single biggest threat to social stability around the world, whether it is in the United States, the European periphery, or China. Yet it is easy to forget that market forces, if allowed to play out, might eventually exert a stabilizing role. Simply put, the greater the premium for highly skilled workers, the greater the incentive to find ways to economize on employing their talents. ….

As skilled labor becomes increasingly expensive relative to unskilled labor, firms and businesses have a greater incentive to find ways to “cheat” by using substitutes for high-price inputs. The shift might take many decades, but it also might come much faster as artificial intelligence fuels the next wave of innovation. ….

Many commentators seem to believe that the growing gap between rich and poor is an inevitable byproduct of increasing globalization and technology. In their view, governments will need to intervene radically in markets to restore social balance.

I disagree. Yes, we need genuinely progressive tax systems, respect for workers’ rights, and generous aid policies on the part of rich countries. But the past is not necessarily prologue: given the remarkable flexibility of market forces, it would be foolish, if not dangerous, to infer rising inequality in relative incomes in the coming decades by extrapolating from recent trends.

Kenneth Rogoff, “Technology and Inequality“, Project Syndicate, 6 July 2011.

Professor Rogoff’s predictions may or may not come true. As Danish Physicist Niels Bohrb famously said, explaining the Heisenberg Uncertainty Principle, “it is exceedingly difficult to make predictions, particularly about the future”.

Nonetheless, technical change has profound effects on labour markets, even if it is difficult to predict these effects. Reliance on the magic of markets is not acceptable, even if the outcome is good for everyone in the long run. Governments should provide generous benefits to displaced workers, perhaps in the form of of wage subsidies (earned income tax credits). I hope that is what Rogoff means when he calls for “genuinely progressive tax systems, respect for workers’ rights, and generous aid policies”. The way it is written, ‘aid’ seems to refer only to transfers from rich to poor countries, excluding the possibility of transfers within a country. In my opinion, both types of transfers are needed.

Kenneth Rogoff (born 1953) was formerly chief economist at the IMF and is co-author with Carmen Reinhart of This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009).

Via Mark Thoma, University of Arizona sociologist Lane Kenworthy asks: If high taxes are so bad, why haven’t they harmed the economies of Denmark and Sweden?

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?

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.

[...]

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? [See the full essay for details.]

…. 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.

Lane Kenworthy, “Is heavy taxation bad for the economy?“, Consider the Evidence, 22 May 2011.