Wednesday, December 29, 2010

Does Supply Matter During Recessions? Evidence from the Holiday Seasonal

Copyright, The New York Times Company

There will be almost three million fewer jobs next month than in December, and this outcome reveals a lot about how the labor market works.

As I noted last week, employment normally falls sharply after Christmas, for the obvious reason that consumer demand is significantly less in January than in the preceding December. Next month should be no exception.

Three million is a lot of jobs – that happens to be the total number of jobs that the Obama administration contended that it had “created or saved” over the entire life of the stimulus law passed in 2009. Yet next month’s multimillion loss of employment will be largely ignored by news organizations, because it will not be much different than it has been any other January.

But it’s big news that the seasonal employment cycle continues to operate as normal. The cycle is, of course, the outcome of seasonal fluctuations in supply and demand, and Keynesian economists insist that supply and demand have not been operating normally since the recession began and that the economy has been caught in a “liquidity trap.”

Keynesian economists assert that labor supply – the willingness of people to work – doesn’t matter right now, which is why they advocate government stimuli that increase “demand” spending even while they erode work incentives. As Paul Krugman put it: “What’s limiting employment now is lack of demand for the things workers produce. Their incentives to seek work are, for now, irrelevant.”

In other words, a recession like the recent one is purported to be one of those rare times when demand is not constrained by supply.

My view is that lack of demand has not been the primary problem with our labor market, which is why the stimulus law has created no visible employment increase. Because of this disagreement among economists about the roles of supply and demand during recessions, it’s important to examine whether demand was operating normally during the latest recession.

If the Keynesians are right, the disappearance of Christmas demand in January would be even more devastating for total employment during a recession than it would be normally, when supply limits the effects of Christmas demand.

If so, the holiday employment seasonal would be about twice as large during recessions – with January job losses in a recession of five million or six million, compared with the normal three million.

The chart below tests the Keynesian claims by comparing the holiday employment cycle across years. Each series measures the deviation of December employment from the October-January trend (Christmas shopping begins after October and is finished by January).

The green and red bars measure employment from the establishment survey and the household survey, respectively, both conducted by the Bureau of Labor Statistics.

The average holiday seasonal data previous to the recent recession is shown at the left, and the rest of the chart isolates the season for 2007, 2008 and 2009, some, if not all, of which years when our economy was purported to be in a supply-doesn’t-matter liquidity trap. (For further description of these and related calculations, see this paper)

Take, for example, the green bars from the establishment survey. On average from 1980 to 2006, December employment exceeded the October-January trend by 1.5 percent. During the years 2007, 2008 and 2009, the December employment seasonal turned out to be similar – about 1.3 percent, rather than the 3 percent or so that we would expect if the economics of supply and demand were really as different during those years as Keynesian economists say they are.

The red bar of the household survey is noticeably lower in 2009 but well within the range observed over the past several decades.

You might think that Christmas became smaller during the recession, and that change offset the purported extra impact of each dollar of Christmas spending. It is true that almost all kinds of spending are lower during a recession, but I adjusted for that by measuring the seasonal data in percentage terms.

The retail sales data show that, in percentage terms, the holiday spending surge was not much different from 2007 to 2009 than it was in previous years.

People can argue about whether demand effects are marginally bigger during a recession. But the seasonal cycle clearly shows a recession does not free demand – whether it be holiday demand or government demand – from the constraints of supply.

Thursday, December 23, 2010

More Evidence of Hamp Failures

CNBC reports:

"Homeowners applying to the foreclosure-relief program say the program is a bureaucratic mess, with banks losing documents and failing to return phone calls. Banks blame homeowners for failing to submit needed paperwork."

This result is no surprise.

The Holiday Stimulus Package

Copyright, The New York Times Company

With Christmas each year comes lessons about the role of demand in the economy.

Retail sales are typically 15 to 20 percent higher in December than they are in September, October and November, and 30 percent higher than they are in the following January (as averages show for 1939 to 2009).

In dollar terms, that means that retail sales rise and fall by roughly $90 billion in a single month.

A $90 billion change in spending in a single month is larger than even the American Recovery and Reinvestment Act, the fiscal-stimulus legislation that was increasing federal government spending by about $50 billion a quarter (less than $20 billion a month).

Likely a consequence of December retail spending, December employment is high each year. Retail employment in December is typically 3.9 percent higher than in October and 5.2 percent higher than in the following January. Some extra retail employment comes at the expense of non-retail employment, but total employment may be as much as 500,000 greater in December than in other months, because of the retail surge.

Although the holiday spending surge is clearly associated with a high level of employment, it also shows how spending is a rather indirect way of creating jobs. That holiday spending of roughly $90 billion more in December is associated with about 500,000 additional jobs for a month – that amounts to $180,000 per job per month!

Both Christmas and the fiscal-stimulus act increase demand, but the fiscal-stimulus act depresses supply, because many of its major programs – the unemployment-insurance extension, the food-stamp program expansion, the home buyer tax credit and more – are directed at people with low incomes.

In other words, the less you work and earn, the larger your entitlement to various components of the act.

By reducing supply as it increases demand, the fiscal-stimulus act could well reduce total employment, rather than increasing it as Christmas does.

In any case, our experience with Christmas shows how large amounts of spending do not necessarily create large numbers of jobs.

Tuesday, December 21, 2010

Marginal Tax Rates in the Private Sector

I have written about the erosion of incentives to earn income, especially during this recession, by a variety of public and private sector programs (foremost among the private sector programs are debt collection programs that forgive debts for people with low incomes, but enforce them for those with high incomes). Here's another example that involves fewer dollars, but illustrates the point:

Wednesday, December 15, 2010

Keynesian Flavors

Copyright, The New York Times Company

The effects of the payroll tax holiday — part of the new federal tax bill being considered in Washington — depend on the flavor, if any, of Keynesian economics that best describes our economy.

Since 1983, employers and employees have each “contributed” 6.2 percent of payroll to the United States Treasury, earmarked for the Social Security program (those contributions apply only to the first $100,000 or so that each employee earns for the year). President Obama and members of Congress have proposed to reduce the employee contribution rate to 4.2 percent for the duration of 2011 while keeping the employer contribution rate at 6.2 percent.

They argue, and I agree, that the proposed tax cut will increase what employees take home after taxes.

Essentially all economists believe that it usually doesn’t matter whether employers or employees, or some combination, are obligated to pay Social Security tax, because the employer portion of the tax just results in lower wages for employees (and lower wages induce employers to hire more.)

Thus, if the current tax-cut proposal were instead aimed at employers, employees would still see more take home pay because employers could afford to pay higher wages.

From that perspective, it’s fine that politicians are proposing a cut for employees; maybe they score some extra political points for a cut that would be more obvious to employees than an employer cut would be.

However, one version of Keynesian economics stresses that our economic recovery from the recession is hampered by “sticky wages.” That is, employment would rebound more vigorously if only wages would fall, making it more economical for employers to hire. But imperfect competition in our labor market prevents wages from falling as much as would be efficient.

If the sticky-wage flavor of Keynesian economics were correct, then cutting taxes for employees has less impact on employment than cutting taxes for employers would, because the employer tax cut is the only way employers will see lower hiring costs. (It may be true that the employee cut would “put money in the hands” of different people than an employer cut would, and perhaps it is also true that money in the hands of employees would do more to increase national spending. But that effect on employment, if any, is less direct than lowering employer hiring costs).

I admire our labor market more than sticky-wage Keynesian economists do, but parts of the sticky-wage model are relevant for some sectors. In particular, minimum wage laws prevent wages from fully reflecting economic conditions, and those laws are most relevant for the low-skilled workers who are experiencing the highest unemployment rates.

In such cases, it matters whether a payroll tax cut goes to employers or employees (Prof. Stephen Trejo of the University of Texas wrote a dissertation on this at the University of Chicago).

If the sticky-wage Keynesians are right, then the employee payroll tax cut will have hardly any effect on employment among low-wage workers and will actually increase the measured unemployment rate for such groups, as they try harder to seek employment that, in 2011, would pay more after taxes.

Another flavor of Keynesian economics emphasizes sticky prices for consumer goods, rather than sticky wages. In this view, prices need to fall more to stimulate demand, and only that extra demand can create hiring. Unfortunately, they contend, imperfect competition in our consumer goods markets prevents prices from falling as much as would be efficient.

Sticky-price Keynesians agree that an employer tax cut would have the same effect as an employee tax cut. But both cuts have a minimal employment effect, if any, because it’s not employer costs that hold back hiring — it’s the lack of demand for consumer goods that would be there if only prices would fall.

Indeed, some sticky-price Keynesians have argued that payroll tax cuts would actually reduce national employment, because more people would compete for jobs that aren’t there.

In summary, the proposed payroll tax cut does not increase national employment in the sticky-price Keynesian model, regardless of whether the cut is aimed at employers or employees. The sticky-wage Keynesian model says that, because the cut is aimed at employees, it will not increase hiring in those sectors where wages are sticky — such as the market for low-skilled workers.

In my view, all flavors of Keynesian economics ignore the many mechanisms that permit markets to adjust to changes in costs and benefits. Although a minimum wage cut would be an effective and revenue-free way of raising employment, the proposed payroll tax cut increases the benefits and reduces the costs of employment and will result in more employment among people earning less than $100,000 a year — even among those earning the minimum wage.

Friday, December 10, 2010

The Marginal Products of Residential and Nonresidential Capital through 2010 Q2

We will soon be updating our paper.

The level of the non-residential series changed a bit when we changed our treatment of indirect business taxes. Here's the (slightly) revised introduction:

Economic theory suggests that marginal product of capital series might help predict economic growth forward one or two years, even under abnormal conditions such as wartime or depression. In some situations, the marginal product of capital is an essential ingredient in cost-benefit analyses (Harberger 1968; Byatt, et al., 2006; Mityakov and Ruehl, 2009). Evidence on the marginal product of capital can also help test various explanations for business cycles, help identify causes and consequences of the recent housing “bubble,” and help quantify the economic burdens of business taxes. The purpose of this paper is to produce annual and quarterly estimates of the marginal product of capital (net of depreciation), one each for the residential and nonresidential sectors of the U.S. economy.

By definition, the marginal product of capital net of depreciation is the change in net domestic product (NDP) during the accounting period (e.g., one quarter) that would result from an increase in the beginning-of-period capital stock of $1 worth of capital, holding constant the total supply of all other factors. The additional $1 of capital is assumed to have the same composition as the rest of the capital stock. For example, if the economy’s capital consisted of 400 identical structures and 100 identical vehicles, each of which cost $2 to acquire, then the marginal product of capital would be the extra NDP attained by starting the quarter with 400.4 identical structures and 100.1 identical vehicles (that is, $0.80 worth of structures and $0.20 worth of vehicles).

Suppose that origins of the current recession could be traced back to limits on the supply of aggregate investment due to a “credit crunch.” (Real investment did fall through the first year and a half of this recession.) The credit crunch theory says that the marginal product of capital would rise over this period as a consequence of the increased cost of capital faced by those with new capital projects. Alternatively, a financial crisis or something else could reduce labor usage more directly, and, given the complementarity of labor and non-residential capital in production, a fall in non-residential investment would merely result from low marginal products of capital, thereby putting the non-residential capital stock on a path that is consistent with a lesser amount of labor usage (Mulligan, 2010).

The marginal product of capital is also interesting as an aggregate leading indicator of business conditions, which is the motivation for its use in a number of studies (e.g., Feldstein and Summers (1977), Auerbach (1983)). This relationship alone may make it a predictor of subsequent economic growth.

Additionally, Fisherian consumption-saving theory suggests that the marginal product of capital, or variations of it, should predict consumption growth. In a Robinson Crusoe economy, the consumer would save for the future by reducing current consumption and using the proceeds to build capital assets. She would then use the marginal product and capital gains from those assets to add to consumption in the future. Because the saving decision is made in the present while the principal and interest are spent in an uncertain future, the incentive to save depends on, among other things, the expected marginal product and expected capital gains. The current marginal product itself helps predict the incentive to save only to the extent that it is closely related to the expected sum of future marginal product and capital gains. For this reason, we present measures of the marginal product that might be more indicative of those expected gains, and (consistent with national accounting practices: see Fraumeni, 1997) measures of depreciation that reflect expected depreciation and obsolescence, rather than actual depreciation and obsolescence.

It is helpful to examine the marginal product of residential capital separately from the marginal product of non-residential capital for at least two reasons. For one, the aggregate demand for labor is expected to have a closer relationship with the stock of non-residential capital than the stock of houses, because workers use non-residential capital in doing their jobs. Additionally, some important capital market distortions – such as business taxes and the “housing bubble” – are expected to have opposite effects on the stocks of residential and non-residential capital, and thereby opposite effects on their marginal products.

Section II presents our methods for calculating annual marginal products, and discusses the findings for 1930-2009. The marginal product of capital is very different in the residential and non-residential sectors, both in terms of levels and fluctuations. Section III examines the importance of taxes in explaining the gap between marginal products in the two sectors. The methods and results for quarterly postwar marginal products through 2009-IV are presented in Section IV. In order to isolate some of the possible determinants of measured marginal products, Section V compares them with average products. Section VI concludes, and Appendices record the time series values discussed in the body of the paper.

Wednesday, December 8, 2010

Who Gets Paid by Big Government?

Copyright, The New York Times Company

One of the myths of big government is that most of its spending goes to the poor.

Last week I examined tax payments by income distribution decile in France and the United States. France’s bottom decile (the 10 percent of French households with the lowest incomes) paid more than half of its income in various taxes, compared with less than 20 percent paid by America’s bottom decile. France’s top decile is taxed at a rate that looks more like the rate in the United States – less than 40 percent.

Taxes help finance, among other things, government transfer payments and other social-welfare expenditures like medical spending. These payments are more generous in France than in the United States, and some of them are received disproportionately by low-income people.

But there are two reasons we cannot immediately conclude that low-income people get their money’s worth from big government that, as in France, takes more than half of their income in various taxes.

First, much social-welfare expenditure goes to the elderly, in the form of public pension benefits and medical spending. Some of the elderly are poor in every sense of the word. Others receiving medical and public pension benefits are only technically poor (by the definition of the tax incidence studies I cited two weeks ago), because they no longer generate income on a job, but enjoy above-average living standards (which they afford by owning their own homes and receiving pension payments from their former employers).

Indeed, the fact that someone has been able to live until her or his elder years may itself be evidence of some amount of affluence: good health is something enjoyed disproportionately by higher-income people.

Public pension benefits have been so generous in France that the elderly have obtained a disproportionate share of the nation’s labor income through the pension system, while France’s young people did a disproportionate amount of the labor.

The amount of public pensions paid has exceeded one-fifth of the nation’s labor income (and this does not even begin to count any private-sector incomes received by elderly people), even when France’s elderly were less than one-fifth of the population.

As a result, the average elderly person in France has a better living standard than the rest of its population does. Even in the United States, the elderly poverty rate is below the poverty rate for other adults and below the poverty rate for children (see page 16 of this Census Bureau publication).

This is not to say to say that the elderly do not deserve their public pension payments, for which they worked many years. But it is incorrect to characterize many payments they receive as payments to poor people (for this reason, a few economists have attempted the difficult exercise of relating taxes and public spending to people’s lifetime incomes).

Second, taxes and transfers cannot be simply subtracted to determine the net position of the poor and other groups vis-à-vis the public treasury, because the government benefits often come with strings attached — that is, because the government spends poor taxpayer money in different ways than the poor would spend it themselves, government spending is less valuable to them than the equivalent number of dollars they may have paid in taxes.

The phenomenon of “topping off” illustrates how higher-income people derive more value from various types of government spending than low-income people do. High-income people seem to value pensions, which is why they “top off” Social Security: they accumulate pensions above and beyond what the government forces them to accumulate though the Social Security system. You might say that pensions are easy to accumulate when your income is high — and that’s the point.

Low-income people, on the other hand, often accumulate no pension beyond what Social Security forces them to accumulate.

That’s why the taxes being paid are that much more burdensome on the poor — snatching money from people trying to pay their bills. Big government is taking money from people when they need it most; what consolation is the promise that government will help out later in life?

Big government leaves both poor and rich taxpayers with less to spend on themselves, and more to be spent at the discretion of big government.

Wednesday, December 1, 2010

Who Pays for Big Government?

Copyright, The New York Times Company

President Obama’s bipartisan National Commission on Fiscal Responsibility and Reform meets today and is expected to release its final recommendations soon on balancing the federal budget.

Progressives hope that the federal government will raise revenue mainly, if not exclusively, by levying taxes on wealthy Americans. But a comparison of France and the United States suggests that raising tax revenue will ultimately involve increasing tax rates on the poor much more than they would be increased on the wealthy.

Because the federal individual income tax is “progressive” — the tax is collected at higher rates from higher-earning groups — it is easy to assume that big government involves high tax rates on wealthy taxpayers without commensurately high tax rates on poorer taxpayers.

However, the individual income tax brings in only a minority of government revenue. According to the Organization for Economic Cooperation and Development, most taxpayers in Western European countries — countries known for their relatively generous welfare states — pay a smaller fraction of their income in individual income tax than Americans do (to view the O.E.C.D. data, click here, then on the “tax” pull-down menu, click on the second item, “Of individuals”).

Because the individual income tax is one of the few truly progressive taxes, and other taxes are regressive, the overall tax systems in Western Europe may not be as progressive as you might think.

For a specific example, consider France, where taxes are 43 percent of gross domestic product, compared with 26 percent in the United States (as I noted in last week’s post, I look at 2005 and exclude "miscellaneous" taxes and fees collected by state and local government, but include all other taxes such as payroll taxes, state sales taxes, property taxes, and state income taxes). The chart below shows my estimates of the income shares paid in taxes across French income deciles (blue) and across income deciles in the United States (red).

For example, France’s bottom decile (the 10 percent of French households with the lowest incomes) paid more than half of their income in various taxes, compared with less than 20 percent paid by America’s bottom decile.

France’s top decile is taxed at a rate that looks more like the rate in the United States — less than 40 percent.

The chart suggests that if the United States were to move to a French-style tax system, low-income Americans would see their tax rates more than double. High-income Americans would see their rates go up, too, but proportionally less.

To derive these results, I used calculations from the Congressional Budget Office for individual income and payroll taxes and rescaled them for France to reflect the differential importance of those taxes to collect revenue in the two countries. For state and local taxes in the United States, I used the calculations of the late Joseph Pechman (discussed in last week’s post). For the French value-added tax, I assumed that the income incidence was the same as Professor Pechman calculated for the state and local sales taxes.

I assumed that capital taxes in both countries are ultimately shifted to workers and consumers, and therefore have the same incidence as sales taxes (as I discussed last week).

It’s difficult to know the exact results for either the American or French tax systems, but it is clear that the two countries have very different tax mixes, with the French mix heavily skewed away from the kinds of taxes that might be progressive.

France’s individual income taxes, which are progressive like ours, bring in less than 4 percent of its G.D.P. to public treasuries, compared with 10 percent for individual income taxes in the United States.

The regressive payroll tax is France’s biggest tax, bringing in more than 17 percent of G.D.P. (plus another 4 percent from its flat-rate “contribution sociale généralisée”), compared with the 6 percent of G.D.P. the United States gets from its payroll tax. Customs, excise and sales taxes amount to 11 percent of G.D.P. in France, but only 4 percent in the United States.

With three of France’s regressive and flat-rate taxes amounting to a combined third of French G.D.P, not to mention the other taxes, it seems that low-income French have to be paying close to half of their income in various taxes, much more than low-income Americans do.

For these reasons, I am not the first to conclude that the taxes used by big governments are less progressive, and perhaps even regressive.

In a study published in 2005 that focused on the top-income decile (and unfortunately was limited only to the federal direct taxes), Professors Thomas Piketty and Emmanuel Saez noted that “countries in which government spending is a fairly high share of G.D.P. have always relied on a mix of taxes” with less progressivity.

Another study by Professors Monica Prasad and Yingying Deng, who used a different methodology, found the United States tax system to be the most progressive out of a sample of 13 countries.

Big government is no free lunch, even for the poor.

Tuesday, November 30, 2010

More on the Progressivity of the French System

Tomorrow I will be posting a calculation of French tax burdens by decile. The purpose of today's post is to consider three issues in additional detail.

(1) How regressive is the French system?
I found the French system to be pretty flat -- deciles 2-8 all paying in the low 50s percent of their incomes -- with the exception of deciles 9 and 10. For example, the average tax rate for the 10th decile was about fifteen percentage points less than the rates for deciles 2-8.

As a matter of arithmetic, most of the dip at deciles 9 and 10 comes from the fact that France gets so much revenue from the payroll tax, and my assumption that the decile-pattern of payroll tax collections is the same in France as the CBO estimated for the U.S., with, for example, the 10th decile paying at half the rate that deciles 1-8 do. (For these purposes, I consider France's "Contribution Sociale Generalise" as a separate tax with the same rate for all deciles).

As a qualitative matter, I suspect that my French result is correct because much of the payroll tax in France was capped at less than 3000 Euros per month, and thus below the average (Piketty and Saez reported a French average household income of 38,665 euros per year). Moreover, the payroll tax does not tax capital income, and the high deciles are the more capital income intensive.

Piketty and Saez (2007) looked at France's 10th decile's payroll tax rate. Their study was not designed to consider the lower deciles, and therefore not designed to calculate an all-decile average, but they reported a 10th decile rate that was 87 percent of the average (here I have subtracted off the "Contribution Sociale Generalise," which they considered as part of the payroll tax), as compared to 63 percent the CBO found for the U.S. payroll tax. You might think that 87 and 63 are different because the countries are different, but interestingly Piketty and Saez found the U.S. 10th decile payroll rate to be 100 percent of the average rate, which means (a) they disagreed with CBO about the U.S. and (b) by this metric they find the U.S. payroll tax to be less regressive than France's.

(2) Do Low Income French Really Pay that Much More?
In case you are dubious that below-average-income French pay more tax than below-average-income Americans, consider a Frence household that earns 24,000 Euro per year (inclusive of payroll taxes paid by employers on this household's members' behalf -- the same income concept used by Piketty and Saez), entirely labor income at a rate of 14 Euro per hour, and spends 20% of that on food (4,800) and spends everything else (after taxes) on consumption items. (this calculation is entirely separate of the data I used to calculate tax rates by income decile).

That French household has an annual income after employer contributions of 17,805 Euros, because French employers pay almost 35 percent payroll tax (8.3 percent to the old age program, 1.6 percent to the survivor's program, 13.23 percent to the health insurance program, 2.26 percent to the work injury program, 4 percent to the UI program, and 5.4 percent to the family allowances program; my source is here) on employees earning below the cap. Then the employee has another 9.9 percent taken out of his check for his "contributions," for a total of 7,957 Euros in payroll tax -- a third(!) of what this employee would earn if he were exempt from payroll tax.

To be conservative, I will assume this already includes the roughly 5 percent flat rate "Contribution Sociale Generalise," and this household owes ZERO individual income tax.

That leaves the household with 16,043 Euros, on which it will pay another 250 Euro on food VAT (the rate is 5.5 percent) and 1,842 on other VAT (the rate is 19.6%). So from payroll and VAT alone that is a tax bill of 10,050 Euro, or 42 percent of its income.

Compare to an American who would pay 16 percent in payroll taxes and probably less than 4 percent on retail sales taxes for a combined payroll and sales tax liability of less than 20 percent of its income.

This is yet another way to see that tax burdens on below-average-income French must be double, and probably more, the tax burdens on below-average-income Americans.

(3) Treatment of the estate tax
Last week I explained how the estate tax might be interpreted as a tax on capital income, and therefore ultimately born by labor. That's a reasonable approximation, especially in a closed economy analysis in which most of the capital employed in a country was owned by residents of that country. At the other extreme, one could think of wealthy French and wealthy Americans as owning essentially the same capital portfolios, so that the estate tax in one country would actually hurt workers all over the world, and not particularly workers in the country levying the tax.

In the open economy case, one might assign estate tax incidence according to the decile of the payer, at least for the purpose of cross-country comparisons. This adjustment would have no perceptible affect on my results for the country tax rate gaps at deciles 1-9, but it would widen the France-U.S. gap at decile 10 by 1.5-2 percentage points. As one can see in the chart I posted today, it would still remain the case that the France-U.S. gap at the 10th decile is a small fraction of what it is at deciles 1-8.

Home Prices during and after the "Homebuyer Tax Credit"

The Case-Shiller Composite 20 index averaged 144 during the months that the "Home Buyer Tax Credit" was in effect. This credit was claimed by many (including Professor Shiller himself) to be essential to housing market performance.

As of September 2010 -- the most recent data available, and certainly after the credit was expired -- the index stood at 147.

So now the evidence is supporting what economic theory said all along: if the Home Buyer Tax Credit were to cause housing prices to be higher, that effect would be at most minuscule.

Friday, November 26, 2010

VAT: Another Reason for a Housing Boom?

The U.S. does not have a national sales tax, or a value-added tax (VAT). Many other countries do have VAT, and a number of economists and accountants (not me!) have recommended that the U.S. get a VAT.

Suppose that we knew that, say, a 10% VAT was coming to the U.S. in the year 2015. In principle, a consumption tax is levied on all forms of consumption, including housing consumption. However, in practice a VAT only taxes new housing -- that is, a sales tax is collected when a new home is sold, and no sales tax is collected on home resales or home rents (actual or imputed).

Thus, homes built before 2015 would be 10% more valuable that home built after 2015, because only the latter would pay tax. So anticipation of VAT would cause a temporary boom in housing construction and new housing prices.

Was something like this important during the housing boom of the 2000s?

Wednesday, November 24, 2010

Who Pays the Other Taxes?

Copyright, The New York Times Company

The federal individual income tax may be progressive – it collects at much higher rates from higher income groups – but the collection patterns of other taxes are quite different.

The federal government’s single biggest tax, the individual income tax is a complicated function of each family’s income from wages, investments and other sources. It is the subject of much analysis of its fairness.

For example, the Congressional Budget Office found that, in 2005, the highest 10 percent of households in terms of income paid 16 percent of their income in federal income tax. The next 10 percent of households in terms of income paid 12 percent of their income.

At the same time, the bottom 40 percent of households in terms of income owed, on average, no tax, in the sense that those households received more in refundable income tax credits than they paid in tax.

That is the concept of progressive taxes — high-income households not only pay more tax but pay a greater fraction of their income in tax. It would seem, then, that taxes are something paid by people with above average incomes, without cutting noticeably into the purchasing power of people with lesser income.

Although the personal income tax is the federal government’s single biggest tax, most federal revenue, and most state and local government revenue, comes from a combination of other taxes.

Of these, the three largest are payroll taxes, sales taxes and property taxes, bringing a combined 12 percent of gross domestic product to public treasuries, as compared with 8 percent of G.D.P. collected by the federal income tax. (In order to abstract from the effects of the recession, and for reasons of data available, this post and next week’s focus on taxes as collected in the mid-2000s. How things may have changed since then can be seen here and here).

Sales taxes collected from retailers are an important revenue source at the state and local level, and are not significantly progressive even when they tax “necessity” and “luxury” items at special rates.

Payroll taxes are regressive, because the tax rate on the first $100,000 or so of earnings (this level has varied by year) is five times the tax rate on earnings above $100,000.

When interpreted as a tax on housing, the property tax is also somewhat regressive, because high-income people spend a lesser fraction of their income on housing, especially on the rental housing that is often subject to higher property tax rates than owner-occupied housing.

Corporate, estate and other taxes on capital may appear to hit wealthy taxpayers disproportionately, but I explained last week how that appearance is deceiving and inconsistent with the economics of capital taxation, which says that workers bear much of the burden of capital taxes in the former of lower employment and wages.

For this reason, I assume that capital taxes have essentially the same income incidence as sales taxes, although quantitatively results for the total tax burden would be pretty similar if I assumed (contrary to economic reasoning) that capital taxes are borne by who writes the checks to the government, because capital taxes don’t bring in much revenue.

The chart below shows the progressivity of taxes in 2005 by comparing income shares paid in taxes across income deciles. The bottom area shows the combined income shares of all federal, state and local taxes with the exception of the federal individual income tax. The shares paid in federal individual income tax are stacked on top of the bottom area, so that the sum of the two shows the shares of income paid in all taxes.

For example, the top decile (the 10 percent of households with the highest incomes) paid 15.5 percent of their income in the other taxes, 16 percent of their income in federal income tax and 31.5 percent of their income in all taxes combined.

The bottom decile paid 25.8 percent of their income in other taxes and -6.5 percent in federal individual income tax (that is, the tax paid them in the form of a refundable credit), for a combined total of 19.3 percent.

To derive these results, I used calculations from the Congressional Budget Office for the federal taxes, with the exception of the capital income taxes cited above. For the state and local taxes, I used the calculations of the late Joseph Pechman, published in 1985. Because of a lack of data, I excluded a significant amount of “miscellaneous receipts” by state and local governments (e.g., revenues from the state lottery), although I suspect they are regressive, too.

In the years since Professor Pechman made his calculations, the average state and local taxes have not experienced the kinds of changes that federal taxes did with the 1986 tax reform and with President George W. Bush’s tax cut, so I simply rescaled his calculations to reflect the minor changes in the share of G.D.P. obtained by state and local taxes.

Beginning with the blue series in the chart, we see that other taxes are regressive. The poorest decile pays the largest fraction of income in those taxes – more than 25 percent – while the highest income decile pays the smallest fraction of its income – less than 16 percent. (By definition, the high-income deciles have more income, so they pay more absolute dollars in tax even while their fractions are lower).

Especially noticeable is the dip from the 8th to the 10th decile, which occurs because much of the payroll tax is capped and does not apply to capital income, which is relatively more numerous in the higher deciles. (Note that the 9th and 10th decile are not the “quarter millionaires” that have received so much attention in recent tax debates; they would be only a minor fraction of the 10th decile. For a paper that looks at federal taxes for the top couple of percentiles, click here).

Total tax payments are the combination of other federal individual income taxes and the other taxes, and are mildly progressive. The fraction of income paid in all taxes (shown as the black line in the chart) tends to rise with income; it is about 20 percent for the lowest four deciles, about 25 percent for the middle two deciles and about 30 percent for the highest four deciles.

As noted above, the bottom deciles pay negative individual income tax, so for them the combined tax rate is actually less than the “other” tax rate.

Although low-income Americans pay little, if any, individual income tax, much of their income does go toward payroll, sales, property and other taxes. When all taxes are considered, most income groups pay taxes that amount to roughly 20 percent of their income.

Added: To calculate sales tax incidence for 2005, I scaled Pechman's 1985 estimates to reflect changes in the amount of revenue obtained by those taxes. However, the technology for sales tax avoidance has changed a lot over those years -- in particular, many people avoid sales tax by making purchases on the internet. To the extent that the internet intensity of a household's purchase patterns rises with its income, sales taxes in 2005 are even more regressive than I have assumed.

Friday, November 19, 2010

Stop, Thief!

Copyright, The New York Times Company

Even if you do not receive a bill from the tax collector, your living standards are still affected by taxes.

To understand who wins and loses from capital taxation, consider your personal experiences with theft.

Many people, including me, lock the doors of our homes and automobiles. We do not make a habit of keeping valuables in the car or large amounts of cash in the house. We lock our computer with a password (or, at least, know we should) and are careful about giving out our personal identification numbers. Many apartment buildings have a doorman to monitor who enters. And law-enforcement departments keep an eye out for theft, along with their other duties.

With all these precautions and defensive measures, perhaps your home, car and computer have never been burgled, nor your identity stolen. But that does mean that you are unharmed by theft.

First, theft has a kind of “excess burden,” because of the actions people take to avoid it. Theft’s total cost is not only the value of any items stolen from us, but also the costs and efforts of protecting ourselves from additional thefts. Simply put, the value of what thieves obtain is less that the costs to theft victims.

Second, theft victims are not the only ones whose living standards are reduced by theft, because third parties are affected as the theft victims react. For example, a store owner who has been robbed or burgled may shut his store or raise prices to pay for security and compensate himself for the risks of his business. Because of the store owner’s reaction to theft, his customers bear much of the cost of what is stolen from the store, even though they were never owners of the items stolen.

Taxation is not necessarily the moral equivalent of stealing, but the same principles apply because of the chilling effect that each causes.

Both taxpayers and theft victims have in common that they take actions to reduce what they pay. Prof. Richard H. Thaler, a colleague of mine at the University of Chicago, pointed out earlier this month that under President Obama’s proposal for the estate tax, 99.7 percent of people would not owe estate tax when they died, suggesting that the estate tax is something that affects only rich heirs and heiresses like Paris Hilton.

His conclusion ignores two basic results from the economics of taxation: Some of the people do not owe estate tax because they spent resources avoiding the tax, and these avoidance behaviors affect third parties — as these taxpayers take steps to reduce their wealth, they may invest less or generate less economic activity.

Because the estate tax is a tax on wealth, estate holders may accumulate less wealth than they would in the absence of the tax. In this regard, the estate tax has a lot in common with other capital taxes, like the corporate income tax and the personal income tax on “unearned” income.

In principle, capital accumulation, or a lack of it, has effects that are not limited to the owners of capital. If some among them accumulate less wealth because capital taxation reduces their incentive to do so, they will have less to invest in existing enterprises or new companies. And that will not only benefit competitors, but also adversely affect would-be workers, vendors or other beneficiaries.

The effect of capital accumulation on the rate of return enjoyed by capital owners is more than a textbook possibility — it is readily seen in the economic data.

The chart below, adapted from one of my papers on capital accumulation, displays the annual national income accruing to the owners of capital, subtracting capital income taxes paid, and expressed as percentage of dollars invested. For example, a value of 5 percent means that $100,000 invested gave the owners of that capital $5,000 of income in a year, after taxes, in the form of interest, dividends, property rent or retained earnings in a business.

What is striking about the data is how little they changed over the years. Capital income rates were almost always between 4.5 and 6.0 percent. Although the population more than doubled, our economy grew by a factor of five or six, and tax laws changed many times, the owners of capital at the end of the 20th century were earning at rates much like the owners 50 years earlier.

On average, the owners of capital saw little change in the rate they earned income as the economy dramatically changed its size, largely because of changes in the amount of capital and the competition among owners.

The same logic does not seem to apply to labor — the amount that workers earn per hour, week or year depends very much on the size of the economy — because the supply of people for work adjusts less than the supply of capital does. For this reason, we expected taxes on capital largely to affect the amount of capital, have little effect on the rate at which capital owners earn income and ultimately to have a significant effect on employment and wages.

You may think that the wealth accumulation of decisions of the mere 0.3 percent of taxpayers who pay estate taxes would have a minor effect on the rest of us, and you would be correct. But the estate tax also brings in little revenue — about $20 billion last year — so the minor effect on the rest of us is actually quite large in comparison to the revenue collected through the tax.

Taxpayer losses from taxes are not limited to the amount received by the public treasury, and the losers from taxes are not limited to those writing the checks.

Saturday, November 13, 2010

Productivity in the Oil Industry

MJ Perry has a remarkable figure showing how labor productivity changed during the recession. It's a nice example because output is measured in physical units -- barrels.

Before the recession, each employee produced about 800 barrels. After the recession, each produced about 1100 barrels.

Added: A problem with this example is that it is difficult to separate employees who help produce oil from those who invest in future oil production, which may be reacting to time pattern of oil prices rather than the forces that caused the recession (HT: James Donald).

Wednesday, November 10, 2010

Let the Estate Tax Die

Copyright, The New York Times Company

The Obama administration’s proposal for the estate tax has all of the ingredients of a damaging tax – large exemptions and loopholes, confiscatory marginal tax rates and little revenue potential. The best reason for having such a tax, if there is one, is to tap into any punish-the-rich sentiment that may be in the electorate.

The Obama administration has proposed an estate tax for 2011 and later years that is much like the one that was in place before to 2010. Writing in favor of the proposal, Prof. Richard Thaler of the University of Chicago acknowledged that the marginal estate tax rate “sounds high, almost confiscatory.” He then notes the $7 million exemption available last year, says that with it in place only 3 estates in 1,000 would have to pay an estate tax and adds that those with big-enough estates could afford a good lawyer to help them further increase the effective size of their exemption.

But the huge potential for avoidance behavior is exactly why the proposal is so damaging from an economic point of view.

Taxes affect behavior, because taxpayers take steps to pay less tax. As a result, every tax dollar brought into the public treasuries harms the private sector more than a dollar, and the amount of extra harm depends on the marginal tax rate. (That’s not to say that taxation ought to be zero — the private sector could benefit much more than one dollar from a dollar of government spending.)

Telephone-service taxes offer an example of a basic principle that applies to taxes on estates and just about everything else: the higher the rate of taxation, the more households and businesses that take steps to reduce their tax liability.

Consider a business with, say, 1,000 telephone calls a day and no telephone tax. If the government began to assess a penny tax on each call the business pays for — outgoing, incoming 800 and collect calls — and the business did nothing in response, the business would owe $10 a day in telephone tax.

But the business would probably consider alternative means of communicating with customers and suppliers and might soon no longer have 1,000 calls a day. It might, for example, switch some or all of its calling to an Internet-based system. Or it might give customers additional incentives to place orders or make inquiries on its Web site, rather than call using its toll-free number.

These actions might reduce taxed calling to, say, 800 a day, from 1,000, and thereby reduce the telephone tax bill by $2 a day (see the middle column of the table below). But those actions would be costly to other parts of the business; some customers might be lost because they were not called, or revenue might be reduced through the incentives given to get customers to use the Web. Those additional costs would be roughly $1 a day.

Ultimately this telephone tax brings $8 a day to the public treasury, but it costs the company $9: $8 sent to the treasury and $1 in tax-avoidance behavior. The taxpayer is harmed more than the amount received by the public treasury, because the taxpayer took costly actions to make sure that the tax liability was not even higher.

Economists agree that taxes have an excess burden beyond the revenue surrendered to the treasury by taxpayers, even if they do not agree about the exact amounts. Examples of excess burdens include health insurance plans that are excessively expensive in part because of their special personal income tax treatment, and corporate debt burdens that are excessive in part because of the special treatment of interest payments by the corporate tax.

All together, the excess burden of taxes in the United States is more than a trillion dollars a year. Of course, government spending may have great benefits, and that spending would be worthwhile if it exceeded all of the costs to the taxpayer (namely, the taxes they pay and the excess burden they bear).

With the telephone tax, the amount by which calling is reduced by a tax, and thereby the excess burden of that tax, depends on the rate of taxation on those last 200 calls: a penny a call in my example.

This business propensity to avoid the tax by seeking other communication means would be the same if the tax law provided a tax exemption for the first, say, 400 calls a day, because reducing calls from 1,000 to 800 would still result in a tax saving of $2 per day. The only difference is that public treasury would get less revenue with the tax exemption in place: $4 per day rather than $8. And the tax exemption means that each $8 brought the treasury costs the taxpayer $10 rather than $9 (with the exemption it takes two days to get $8 in revenue, rather than one day).

So tax exemptions and other loopholes reduce revenue collected without necessarily affecting the marginal tax rate. In this way, tax exemptions and loopholes raise the excess burden per dollar of revenue and thereby the ultimate cost to taxpayers of bringing any given amount of revenue into the Treasury.

Economists’ opinions on tax exemptions and loopholes generally derive from the arithmetic of excess burdens. Exemptions and loopholes raise the marginal tax rates – the creators of excess burden – required to maintain treasury revenue. So if you want the government to get its revenue with a minimum of economic harm, smaller exemptions, loopholes and marginal tax rates are the way to go.

The federal estate tax — sometimes called the “death tax” by its critics — is remarkably extreme in terms of the size of its exemptions and marginal tax rates. The estate tax brings in only about $20 billion a year (with no revenue this year) despite marginal tax rates that have varied from 45 to 55 percent, because of its large exemptions and many loopholes. And some of its excess burdens are evident: an entire estate-planning industry would be largely unnecessary if marginal estate-tax rates weren’t so high. Planning is part of the reason that many estates do not pay tax, and planning is part of the excess burden.

Alternatives to President Obama’s plan include elimination of the estate tax, sharply reducing its rates or integrating it with the capital-gains part of the personal income tax. If necessary, the small revenue loss could be recovered with a tiny increase in the rates of a broader-based tax, like the taxes on payroll or personal income.

Professor Thaler explained how that eliminating the estate tax would “make sure heiresses like Paris Hilton have the proper attire for trips to St.-Tropez.” I agree that the estate tax’s best attributes do not derive from economic efficiency, but rather its contribution to the sport of envying some of the love-to-hate members of America’s rich.

Wednesday, November 3, 2010

Why HAMP Failed

Copyright, The New York Times Company

The Obama administration’s Home Affordable Modification Program for reducing mortgages of homeowners who owe more than their houses are worth has fallen far short of its objectives. Officials seem surprised by that outcome and blame the result on administrative problems. But, all along, the program’s bad economics doomed it to failure.

Home buyers take usually out mortgages that cover only part of the value of the houses they are buying. In other words, the house is worth more than the mortgage owed. This means that in the event a borrower defaults, the lender can, in most cases, be repaid in full by foreclosing on the house and selling it to someone else.

However, housing prices have fallen dramatically since 2006. By 2009, about one in four home mortgages was “under water” — the market value of the house had fallen below the amount owed on the mortgage, or, put differently, the home equity was negative.

Under President George W. Bush, the Federal Deposit Insurance Corporation, the Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (known as Freddie Mac) all announced debt forgiveness or “loan modification” formulas. The Treasury Department under President Obama continued this policy with the Home Affordable Modification Program, part of its Home Affordable initiative, which replaced the Fannie and Freddie programs. The modification program alone was aimed at three million to four million mortgages.

These modification programs encourage lenders to reduce mortgage payments, so that each borrower’s housing payments (including principal, interest, taxes and insurance) are no more than 31 percent of the borrower’s gross income. The payments are to be reduced for five years or to whenever the mortgage is paid off (whichever comes first).

The amount of the payment reduction depends on the borrower’s income — the less he or she earns, the more the payment is reduced. For example, a borrower whose annual family income is $100,000 can get housing payments reduced to $31,000 a year; a borrower whose annual income is $50,000 can have the payments cut to $15,500 a year.

If the mortgage modification rules were actually followed, one implication would be that a family that earns $50,000 more in the year before the modification stands to pay an additional $15,500 a year for five years on housing payments — a total of $77,500. Adding $50,000 to your income adds $77,500 to your expenses: the mortgage lender gets more than 100 percent of your extra income! Economists call this a marginal “tax rate” that exceeds 100 percent, because the person earning that income is obligated to give all of it to a third party (the lender, in this case), and then some.

Economists may argue about how high tax rates should be, but we all agree that marginal income tax rates of 100 percent (or more) are terribly destructive. And the terrible incentives in the federal mortgage modification guidelines were known even before the Obama administration put together its program.

Because of its destructive economics, the modification program was proposing changes that were only marginally beneficial to borrowers and massively costly for banks. Assuming that banks understood this, I predicted that banks would pursue their own interest by randomly and arbitrarily refusing to modify most of their mortgages according to the program formula.

A year and half into the program, this is no longer just a theoretical possibility. The Associated Press reported that many borrowers say the modification program is a bureaucratic nightmare. The A.P. report said, “They say banks often lose their documents and then claim borrowers did not send back the necessary paperwork.” Instead of modifying three million mortgages and preventing their foreclosures, less than one-half million mortgages have been modified under the program, while about three million borrowers received foreclosure notices (see the latest report by the Office of the Special Inspector General of the Troubled Asset Relief Program).

Rather than overtly contradicting the Treasury by denying eligible borrowers, banks are encouraging borrowers to deny themselves by requiring those borrowers to endure deluge of paperwork.

Both the Bush and Obama administrations have run roughshod over incentives, and the housing market and the wider economy continue to suffer because of it. We can hope that economic policy might be different after yesterday’s electoral shake-up, but more likely we’ll be drinking old wine from new bottles.

Monday, November 1, 2010


Professor Krugman writes this today (excluding the phrases in brackets) about why running a business does not automatically qualify you as a macroeconomist:

The thing is, no amount of experience meeting a payroll helps you understand issues that are critically affected by the way things add up at a macro level. Businesses are open systems; the world economy is a closed system, with feedback effects that are crucial but play no role in ordinary business experience. In particular, an individual businessman, no matter how brilliant, never has to worry about the fact that total income equals total spending [equals total production], so that if some people spend less, either someone else must spend more, or aggregate income must fall. [If somebody produces less, then somebody must spend less.]

This is why we have a field called macroeconomics.

I agree! That's why modern macroeconomics pays attention to supply, and not just demand, even while the average businessman may think that "more customers" are all he needs to be successful. And that's why it's wrong to expect policies that reduce production to increase spending.

Thursday, October 28, 2010

Latest Mortgage Modification Readings

Wage Cut Story

from here.

"We're a little unique," said Capt. Joseph Frohnhoefer of Southold-based Sea Tow International. His company not only serves boaters in distress, but also assists in situations like the recent Gulf of Mexico oil spill. Sea Tow has also diversified into building pontoon boats to work on at oil spill sites, he said. His workers are also involved in reseeding oyster beds in southern states, he added.

When the stock market crashed and companies began laying off workers in 2008-09, Capt. Frohnhoefer asked his staff to take a 5 percent pay cut to save jobs. They agreed and, within a few months, Sea Tow was able to restore the pay cut, he said.

Wednesday, October 27, 2010

Assessing the Power of One at the Polls

Copyright, The New York Times Company

Signs outside an early voting station in Lauderhill, Fla.Joe Raedle/Getty Images Signs outside an early voting station in Lauderhill, Fla.

Candidates for office can be heard these days telling constituents, “I need your vote.” But, actually, they do not: the outcomes of civic elections almost never come down to a single vote.

A pivotal vote is one cast in an election that was tied or decided by only one vote. The vote is pivotal because the election outcome might be different if that vote were cast differently. If a person votes next week with the purpose of helping her or his perceived right candidates win, that person is either delusional or extraordinarily concerned with rare events, because essentially all votes cast in civic elections are not pivotal: practically all civic elections conclude with a winner’s vote margin that is two or greater.

We have been electing presidents for more than 200 years, and none of those elections came down to one vote. Even the 2000 election between Al Gore and George W. Bush had a margin greater than two votes in Florida (and much wider margins in every other state), so any single voter in Florida that year could have voted differently, and George W. Bush would still have been elected.

An election of a United States senator, or a governor, has never in the history of the United States been decided by one vote. University of Chicago PhD Charles Hunter and I studied almost 100 years of elections of members of Congress – almost 20,000 of them in which an aggregate two billion votes were cast – and only one election was determined by a single vote of the 40,000 cast (that was in the New York’s 36th Congressional District in 1910). And that election had a recount that determined the election was decided by a margin of six votes, rather than one.

Thus, when it comes to elections to federal office, history suggests that the chances that your vote next week will change the winner of the election is less than one in 100,000; more people die in an election year in car crashes than cast a pivotal vote in a federal election.

Dr. Hunter and I also studied 21 years of elections to state legislatures in the 50 states. Our data included more than 50,000 elections with an aggregate of about a billion votes cast. Those elections were markedly smaller than the federal elections and therefore more likely to come down to one vote.

Still, only nine of these came down to one vote (before recounts), and included a grand total of less than 40,000 pivotal votes. So the probability of a pivotal vote in these elections was less than one in 25,000. (The odds are somewhat higher – one in 15,000 for the state elections and one in 89,000 for Congressional elections – if the election actually has more than one candidate; a number of elections do not, such as this year’s election in Florida’s 21st Congressional District).

Many times we cannot know for sure whether next week’s will be the election when your district’s Congressional balloting ends in a tie. Tomorrow could be the day when the lottery draws your lucky number, but few of us make the effort and accept the expense to be sure that no lottery is ever drawn without our owning a ticket. In each case, the outcome of interest is much too rare to justify action by itself.

If the election were not tied, your vote might help your, say, candidate win by 18,001 votes rather than just 18,000. Representatives who win with bigger margins can act differently in office than they otherwise might. But your representative will not change his habits or commitments based on 18,001 rather than 18,000 votes. However you look at it, the expected effect of your vote is minuscule.

Many eligible voters will not exercise their right to vote next week, and some think their vote does not matter. Civic pride, or just having fun, may be good reasons for you to vote, but history suggests that next week’s winners will not actually need your vote.

Monday, October 25, 2010

Jobs Created or Saved

A translation of White House econ jargon from Jonah Goldberg:

The White House insists that it's ... responsible for every single new job that has been created or "saved" since then. Forget the "saved" part since that has always been so much Bidenesque frippery. (Though for the record, I drink scotch because it keeps away vampires and ensures the moon doesn't catch fire. You can thank me later).

Wednesday, October 13, 2010

Large States Show the Way, Continued

Copyright, The New York Times Company

California and other states with large populations are legal innovators of sorts, as I explained last week. In order to make all of those laws, big states need to have a different kind of legislator.

The sheer mass of state law in California and other states with large population — California has six to seven times the amount of law of small states — shows that large states are legal innovators in many other ways, using their large populations as incubators.

As I noted last week:

Population is a major determinant of whether a state has various laws, and of the amount of detail state lawmakers provide in their statutes. States with a lot of people have a greater variety of situations that arise that might be addressed by lawmakers. We found that the large states tend to be the early adopters of new laws, with the smaller states following later.

Laws do not come out of thin air but require effort by legislators to come to a consensus and put their statutes on paper. Working as a legislator in a small state like New Hampshire is a very different job than working as a California legislator.

To examine this further, I went back to studies of state politics by Robert E. McCormick and Robert D. Tollison of Clemson and William F. Shugart of the University of Mississippi that began in the 1970s. They examined the size of the state legislatures, the work hours of legislators and legislator salaries.

I have reformatted some of their data to focus on the effects of population and displayed some of the results in the chart below, comparing the population of each state with the total payroll of the state’s legislature in the 1970s (as these studies were published years ago, they do not reflect more recent data). Total payroll is the product of the number of legislators and the annual salary of each legislator.

California’s legislature had about five times the payroll of the smallest states’ legislatures (and 90 times the payroll of New Hampshire!). Just as a state’s population is tied to the volume of its laws, so, too, is there a clear positive relationship between number of people in the state and the amount the state spends on its legislature.

It is not simply a case of more people, more legislators, because the number of seats in state houses and state senates were in most cases determined more than 100 years earlier when California and Texas did not have much population, while Massachusetts and other eastern states were among the nation’s leaders in population.

Instead, the states seem to differ in the amount of work they require from each legislator. In small states, being a legislator is a part-time part-year job, whereas many large states have their legislators working full-time full-year. And legislators are paid for their efforts: in the 1970s, the average annual pay of California legislators was more than 300 times the salary in New Hampshire ($32,000 compared with $100).

Because the number of legislators is not closely linked to population, each legislator in a high-population state has a much larger constituency than his counterpart in a small state. The process of getting elected and making legislation once elected varies widely with the population of the state, and those different processes demand different talents from the politicians.

When voting takes place in every state next month, the types of candidates on the ballot and the ultimately victorious will vary widely between the small states and the large states. Given the differences in workloads, compensation and expectations, this is no surprise.

Wednesday, October 6, 2010

Will California Show the Way on Marijuana?

Copyright, The New York Times Company

Next month Californians will vote on Proposition 19, which would change state law to allow adults to possess and grow small amounts of marijuana. Possession and sale of marijuana remain federal crimes, but the proposition is a current example of how California is a legal innovator of sorts.

Much economic and social activity is regulated at the discretion of the states. Federal laws apply uniformly across the states but, when state law comes into play, some activities can be legal in one state and illegal in another. (Connecticut requires gamblers at casinos and race tracks to be at least 21, while New York sets the bar at 18, for example.) Proponents of Proposition 19 hope that marijuana use by adults will soon be one such activity.

Economists have long studied why jurisdictions vary in their regulation of activities, and one of those studies was published by me and Prof. Andrei Shleifer of Harvard. With states legislating so many behaviors, we borrowed a device from Ronald Reagan’s 1981 State of the Union Address: we measured the number of kilobytes (a printed page is about a kilobyte) in each state’s law books.

The chart below, from our paper, compares each state’s law kilobytes (measured in 2002) with its population. The first thing to notice is how much law the states have: more than 20,000 kilobytes (about 20,000 printed pages). California is the most highly regulated state by this measure, with well over 100,000 kilobytes.

Legal Statutes and Populations Among the States Legal Statutes and Populations Among the States

California’s penchant for unusual legislation is well known, so its leadership in terms of the quantity of law is no surprise. But we noticed that Texas — a state with quite a different society and economy than California — is fairly similar to California in terms of kilobytes of law. We also noticed a similar pattern at the bottom end: Alaska and Delaware have a similar number of pages in their law books, despite being very different.

We concluded that population is a major determinant of whether a state has various laws, and of the amount of detail state lawmakers provide in their statutes. States with a lot of people have a greater variety of situations that arise that might be addressed by lawmakers. We found that the large states tend to be the early adopters of new laws, with the smaller states following later.

Like it or not, the tens of millions of people in California serve as a laboratory for new legislation, and their state sets a legal example that the rest of the states might follow. So, even if you do not live in California, pay attention to Proposition 19: maybe someday marijuana may come to a store near you.

Saturday, October 2, 2010


Today Professor Krugman applauded my creativity, but forgot to mention my detailed forecasts, and their accuracy over the past year-and-a-half.

Click below for some of those predictions:

The academic papers are released later than the blog entries, but they give extensive details of how the models work, and how the statistical analysis compares them to "Keynesian" models:

Does Labor Supply Matter During a Recession? Evidence from the Seasonal Cycle

The Housing Cycle and Prospects for Technical Progress

Simple Analytics and Empirics of the Government Spending Multiplier and Other “Keynesian” Paradoxes

Aggregate Implications of Labor Market Distortions: The Recession of 2008-9 and Beyond

And don't forget my debate with Dr. Eggertsson.

Contrary to Professor Krugman's claims, I have not made any predictions regarding interest rates. I have made predictions related to inflation:

Government spending does NOT create inflation

Inflation depends on investor sentiment, and I don't make predictions about that!

When inflation comes, it will be welcome.

Wednesday, September 29, 2010

Look to Europe to Understand Why This U.S. Recovery Is Jobless

Copyright, The New York Times Company

Thanks in part to the legacies of presidents like Ronald Reagan and the Bushes, our country may have been long overdue for an expansion of the social safety net. But Europe shows us that, on the whole, social programs reduce employment, not raise it.

Progressives point out that the Western European economy has a lot going for it: a productive work force, new technologies, universal health care and access to education. Perhaps they’re right that getting our government more involved in the economy and smoothing out capitalism’s “rough edges” would give Americans some of those things, too.

Those same progressives tell us that expanding unemployment insurance and other government programs is an easy way to raise employment in the United States. But they seem to have forgotten that European policies have probably caused Europe’s employment to be less than ours, not more.

The chart below shows the percentage of people who are employed in the United States and in the six Western European countries for which the Bureau of Labor Statistics has compiled comparable employment measures.

Employment has been consistently lower in Western Europe, with an average employment rate gap of 10 percentage points over the years 1980-2007. Our recent sharp drop still leaves two-thirds of the European-American employment gap that was there a few years ago.

Economists have debated the reasons for Western Europe’s relatively low employment, although they generally agree that public policies are at least part of the story.

Profs. Edward Prescott, Jonathan Gruber and David Wise have argued that taxes of one kind or another give Europeans less reason to work. Profs. Alberto Alesina and my fellow blogger Edward L. Glaeser blame more of the difference on heavy regulation of the European labor market. Demographics, especially immigration, are also part of the story, although government policies are responsible for part of the demographic differences, too.

I do not expect our government policies to become 100 percent European any time soon, and even if they did, some employment gap might remain. If the employment rate gap is ultimately only 2 percentage points less than it was before the recession (8 percentage points rather than 10), that will leave our employment pretty similar to what it is now.

Our future is likely to have a permanently larger role for government, and that means employment rates may never be as high as they once were. We might enjoy some of the European lifestyle, or recover the jobs lost during this recession, but not both.