Synopsis: The problems with taxation as a means to redistribute income

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Discussion:

This article discusses the problems with redistribution as a means to reduce inequality, i.e. taxing the rich to give to the poor. In economics, this works theoretically, as giving money to the penniless who will spend it immediately should boost consumption and GDP. However, if done wrong, this can cause more harm than good.

In 1920, the English economist Author Cecil Pigou argued that shifting purchasing power to the poor will do little to dampen the spending habits of the rich, but will boost output as the poor will immediately spend the money on necessity goods.

The argument rests on the assumption that the poor would spend more if they had the means and the rich would smooth over their spending patterns. To investigate this assumptions, Messrs Kaplan and Weidner of Princeton University and Violante of New York University used large microeconomic datasets to see household income and wealth across eight different economies.

They looked for families that lacked a buffer of liquid assets to offset short-term changes in income. These families were the ones who would theoretically spend immediately from a government windfall.

Herein lies the problem: this “hand-to-mouth” term is not so straightforward – many American households may not have liquidated assets, but do have large illiquid ones.

One reason why people are so short on cash is because of the housing debt. In America, those with small mortgages live less hand-to-mouth than those with large ones.

Another reason why is due to age. The research shows that those around 40 years old are most likely to be cash strapped.

The findings show that “cash shortfalls affect behaviour”, in that those with high liquid wealth spend the least from an unexpected windfall, those living “hand-to-mouth” spend more, but it is those with lots of illiquid wealth but low income that spend the most. This links in with another study by Merrs Cloyne and Surico of Bank of Britons and London Business School respectively, which shows that “taxing those with illiquid assets could cause more of a fall in spending than previously expected”.

Yet another research paper shows that the assumption that the more a worker’s wages fall the more they support redistribution rises may not be true. In fact, support for redistribution has not changed, or has fallen, as inequality has risen.

One major culprit could be age – those under 40 follow the predicted pattern but those over 65 do not, perhaps because when the survey was first conducted in the 1970s the now-65-year-olds were more cash-strapped, but they are not any more. (More on why they are not cash strapped is explained under ‘Context’.) They fear that redistribution would cut health benefits.

Overall, these findings show a few things:

1) Stimulus packages should also be aimed at the wealthy, too;

2) Taxes on the wealthiest should be phased to allow them to liquidate their assets, and;

3) Politicians betting on the popularity of redistribution among voters should realize there may be great aversion from the retirees.

Context:

1) It is worth reading my other blog post about why not to tax the rich, although it has nothing to do explicitly with inequality. This can be found here.

2) Why is it that “the chances of being wealthy but cash-strapped peak around the age of 40”? This has to do with the life cycle. The original research paper can be found here. The life cycle is explained in the previous blog post, which can be found here.

3) One question that is not answered is why “the wealthy-but-income-constrained react most, spending 30% of any windfall, suggesting they are even more cash strapped”.

4) It is important to remember for the previous point that there may not be a symmetry between windfall gains and sudden taxes or losses of income, i.e. people may not spend as much when they have windfall gains than they save when they are taxed.

Discussion:

This article from The Economist newspaper (yes, they insist it is a newspaper and not a magazine) discusses recent research that finds the causes of a macroeconomic problem (inequality) in a microeconomic variable (size of the firm). The research focuses on growth disparity in wages, instead of focusing on wealth disparity (as Piketty does) to explain rising income inequality across the world. Growth in wage disparity is increasing despite varying policies on taxation, minimum wages and corporate pay.

A new paper by Holger Mueller, Elena Simintzi and Paige Ouimet, called "Wage Inequality and Firm Growth", links the increasing inequality of wages on the size of the firm, i.e. the bigger the firm, the more unequal the wage pay. It is common knowledge among many economists that economies of scale "allow workers at bigger firms to be more productive than those at smaller ones. That, in turn, allows the bigger firms to pay higher wages".

Theoretically, this should not increase wage inequality, if all workers at the firm receive a proportional pay increase. However, this paper shows that most such firms distribute progressive pay increases. This trend is very similar to "the trend in income inequality in America and Britain... since the 1990s, when pay for low and median earners began to stagnate", the writers of the research paper note.

They suggest two possible reasons for proportional pay increase:

1) The low-skilled workers who demand higher wages can be easily automated away

2) Entry-level workers may accept low wages as the chance of promotion at a larger firm is higher than that at a smaller firm.

They also note that the job requirements in smaller versus larger firms explain why the most senior people reap such high wage increases. A janitor's job requirements are the same in small- and large-scale companies, but a manager's skill set for large companies is not only more demanding, but also rarer.

The article then discusses potential causation between the rise in income inequality and the rise in wage inequality. The research paper shows that the size of the largest 15 firms in OECD countries and their income inequality, stating that this relationship is strong.

Another recently published paper, "Entry Costs Rise with Development" by Albert Bollard, Peter Klenow and Huiyu Li shows that "the trend towards bigger firms is only likely to accelerate". The higher productivity in big firms leads to increased barriers of entry for smaller ones, as shown by the fact that, in America and Europe, startup rates for companies are falling. Since the 2008 crisis, higher barriers in the form of limited access to capital "has caused the number of new businesses to collapse," the article says.

Some economists point out the positives of this: bigger firms have much higher investment rates, which increases growth in the economy. In fact, it is the preponderance of small firms that is holding the PIGS economies back from economic recovery.

If governments wish to reduce this inequality, they should reduce barriers to entry to spur competition, by improving small businesses' access to credit. But, they should also be wary of too much crude redistribution, as it dampens economics growth.

Key terms:

1. Economies of scale: This is when a firm reaps the cost benefits due to their large size or output. According to Wikipedia, it is when “cost per unit of output generally [decreases] with increasing scale as fixed costs are spread over more units”.

2. Corporate pay comprises of various forms in which companies pay its workers, including for example, share options.

Context:

1. The first new paper by Mueller, Simintzi and Ouimet is here. The second new paper by Bollard, Klenow and Huiyu is here.

2. What does the phrase “limited access to capital” mean? In a nutshell, it means loans or equity to finance the business venture.

3. In the last paragraph, the author mentions “too much crude redistribution”. This will be explained in the S&P article on the link between inequality and growth in America that I will be publishing soon.

4. The author seems to assume causation between the size of the firm and the level of inequality in a country. The author mentioned research where the first paper by Mueller, Simitzi and Ouiment find that “the relationship between rising levels of income inequality and the size of the firms was strong”. This statement suggests correlation. Later on, the author states that a few solutions to the rising inequality is to lower barriers of entry, thereby increasing competition and allowing smaller firms to participate in the market. This suggests causation. While there may be evidence to show direct causation between inequality and firm size, it has not been mentioned in this article.


5. On the note of disproportionate wages, perhaps more skilled workers get higher pay because they are the ones who can create the benefits of scale, i.e. they are the ones who can make the products to be shared worldwide. This point should not be taken to mean that I am suggesting that more skilled workers deserve the disproportionate wage rises; that is outside the domain of economics. But the question is whether they disproportionately "create"the higher returns to scale; that is a question well within the realm of economics, but the authors of paper have not addressed it directly.

6. The data in this article was taken from Britain. If they had used the same methodology in the US, would they have come up with different results? Arguably, much wealth in the US has been created by small start-up firms and hence is it possible that one might not find similar disproportionate pay rises in larger firms?

Synopsis: Wage gap as a cause of inequality.

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Synopsis: An analysis on the relationship between inequality and growth.

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Discussion:

This article aims to understand the relationship between inequality and growth better. In 1975 an American economist, Arthur Okun, stated that there was a trade-off between equality and efficiency.

Inequality is undoubtedly important, as, otherwise, the lure of large financial rewards, innovation and risky entrepreneurship would cease to exist. Nevertheless, inequality could hinder growth if “those with low incomes suffer poor health and low productivity as a result… [as well as threatening] public confidence in boosting policies like free trade”, according to the article. Government responses to inequality can also create a crisis; according to a 2010 book written by Raghuram Rajan, the Governor of the Reserve Bank of India (RBI), governments often respond to inequality by “easing the flow of credits to poorer households”. More about why this creates a crisis is explained in "Context".

Finding the exact relationship between inequality and growth can be challenging. While some studies suggest that inequality is just mildly bad for growth, others suggest that the nature of the relationship changes as poorer countries become richer. Still others say that, rather than the level of inequality, it is the trend in inequality that matters.

A research paper by IMF economists Messrs Andrew Berg and Jonathan Ostry in 2011 shows that perhaps it is the duration of growth spells that will give us the answer to the link between inequality and growth. They reckon that sustaining a growth spell is much harder than getting an economy growing. They also suggest that, according to the article, “when growth falters, inequality is often a culprit”.

Still others say that inequality is not a culprit but rather governments that tax and spend to try and reduce it. In another paper, Messrs Berg, Ostry and Charlambos Tsangarides analyse the separate effects of inequality and redistribution. They gather data about market income and net income in 173 economies. It is shown that in economies that redistribute heavily, their Gini coefficient is cut substantially. In economies that do not redistribute heavily, their Gini coefficient is cut considerably less. The paper shows that governments of more unequal countries redistribute more, and rich economies redistribute more than poor ones do.

While spreading wealth does not carry growth penalties – growth in income per person is not considerably less in countries with more redistribution – Messrs Berg, Ostry and Tsangarides suggest that redistribution may lead to shorter growth spells.

Inequality has more of a correlation with low growth, i.e. the higher the Gini coefficient, the lower the average annual growth. Therefore, redistribution that reduces inequality may boost growth.

Perhaps, the lesson to be learned is that reckless redistribution may harm growth, but sensible redistribution may help.

Key words:

On the chart labelled “A little off the top”, there are two words in the legend: net income and market income. Net income is income after tax and transfers. To see a precise definition of market income, read the glossary in this S&P article, which I will be analyzing in a blog post soon.

Context:

1. In the third paragraph, the author states how “governments often respond to inequality by easing the flow of credit to poorer households. When the borrowing binge ends everyone suffers.” In fact, this is one of the main reasons for the 2008 financial crisis that stemmed from the US. On this note, it is worth mentioning that allowing sub-prime lending (easing the flow of credit to poorer households) is actually a means of redistribution by the government.

2. To read the IMF paper by Messrs Berg, Ostry and Tsangarides, click here.

3. Arthur Okun, quoted in this article, is well known for Okun’s Law, which details the relationship between a country’s unemployment and production. The relationship he observed is inversely proportional: increases in unemployment lead to decreases in production. To read more about this on Investopedia, click here.

Synopsis: A criticism on the way in which Piketty measures inequality.

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Discussion:

“Capital in the 21st Century”, Thomas Piketty’s international bestseller, discusses the driving forces of inequality. The main idea of the book is that r > g is the driving force of inequality. More about Piketty’s book and r > g can be found here. Daron Acemoglu of the Massachusetts Institute of Technology and James Robinson of Harvard University have published a paper stating many criticisms of the book. Below are the main criticisms:

1. They disagree with the claim that r > g is the driving force of inequality. They state that political institutions and technology drive inequality.

2. They argue that Piketty cannot prove the correlation between r > g and inequality.

3. While Piketty claims that there is a positive and strong correlation between r – g and inequality, research points to the contrary: rather, there was a weak correlation, and if anything, is negative.

Piketty criticises these claims, saying that Acemoglu and Robinson’s research was too narrow and did not cover enough time. Piketty also says that he did acknowledge the effect of institutions on inequality and that his research and that of Acemoglu and Robinson are “broadly consistent and complementary”.

Acemoglu says that the focus on the top 1% is too narrow, stating an example in South Africa that contradicts Piketty’s work: the top 20% had the most wealth and power during apartheid, but between the top 1% and the top 20%, the difference is negligible.

Acemoglu suggests looking at the bottom of the distribution instead of the top 1%.

Context:

1. Acemoglu and Robinson are well known for writing a book, “Why Nations Fail”, which discusses how it is that some countries amass power, wealth and prosperity, while others do not. More about the book can be read on their official website.

2. Acemoglu’s statement that we should focus on the bottom of the distribution has not been elaborated in this article. One question to consider is why we should look at the bottom, instead of the middle, or perhaps the whole. The usual measure of inequality, the Gini coefficient, anyway looks at the whole of the distribution, instead of the top or the bottom. Another question is whether the bottom of the distribution is the bottom 1%, or the bottom 5%, or the bottom 20%.

Synopsis: A summary of “Capital in the Twenty-First Century” by Thomas Piketty

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Discussion: This article summarises “Capital in the Twenty-First Century”, by Thomas Piketty, a book that discusses past inequality trends and predicts future ones.

Mr. Piketty, along with a handful of other economists, has gathered data from the beginning of the Industrial Revolution about the change in the concentration of income and wealth. During the 18th and 19th centuries in Western Europe, wealth inequality was rampant. National income was less than private wealth, the latter of which was concentrated in the hands of the elite few. Even when industrialisation increased the wages of the working class, this problem persisted. When WW1, WW2 and the Great Depression hit, the inequality of income and wealth reduced, due to high taxes, inflation and bankruptcies. After these shocks faded, the same problems are creeping back, so much so that the importance of wealth is reaching levels pre-WW2.

From here, Piketty outlines general patterns between wealth and growth. He explains that wealth grows faster than economic output in general, which represents in the expression r > g (where r is the rate of return to wealth and g is the economic growth rate). Ceteris paribus, “faster economic growth will diminish the importance of wealth in a society”, and the same vice versa. “Demographic change that slows growth will make capital more dominant”. However, it is only rapid growth or government intervention that will disperse the concentration of wealth, and prevent it from entering the patrimonial situation Karl Marx was worried about.

Mr. Piketty ends by saying that governments should step in now and impose taxes on wealth, lest it leads to soaring inequality or political instability.

Critics have question Piketty’s assertion that the future will resemble the past, arguing that returns to wealth decreases as the amount of wealth increases. They also add that today’s generations come upon wealth by working for it, rather than through inheritance. Furthermore, they question the feasibility of Mr. Piketty’s recommendations to governments, stating that they are ideologically, rather than economically, driven. Regardless, Piketty’s book as received major critical acclaim for its data gathering and analysis.

Key terms:

1) Welfare state: According to Brittanica, this is where the government plays an active role in taking care of the citizens of a state.

2) Return on wealth: This is the income from investing in wealth.

Context:

It is worth discussing Piketty’s idea of inequality. He discusses how r > g in general. He states that if the economy grows faster, then the importance of wealth will reduce, and if the economy grows slower, the importance of wealth will increase. This concept is illustrated in the diagrams below:

If the rate of return to wealth increases faster than the growth rate, then inequality increases. In other words, Piketty claims that inequality = r-g. Whether this is true or not will be discussed in another blog post.

In the introductory blog post I had posted about this inequality series, one of the questions I said that would be discussed is the link between growth and inequality. According to Piketty, faster growth reduces inequality.