Branko Milanovic
February 16, 2018

The remarkable period of reduced income and wealth inequality in the rich countries, roughly from the end of the Second World War to the early 1980s, relied on four pillars: strong trade unions, mass education, high taxes and large government transfers. Since the increase of inequality twenty or more years ago, the failed attempts to stem its further rise have relied on trying, or at least advocating, the expansion of all or some of the four pillars. But neither of them will do the job in the 21^st century.

Why? Consider trade unions first. The decline of trade union density, present in all rich countries and especially strong in the private sector, is not the product of more inimical government policies only. They might have contributed to the decline but are not the main cause of it. The underlying organization of labor changed. The shift from manufacturing to services and from enforced presence on factory floors or offices to remote work implied a multiplication of relatively small work units, often not located physically in the same place. Organizing a dispersed workforce is much more difficult than organizing workers who work in a single huge plant and share a single interest. In addition, the declining role of the unions is a reflection of the diminished power of labor vis-à-vis capital, due to the massive expansion of wage labor (that is, labor working under a capitalist system) since the end of the Cold War, and China’s re-integration into the world economy. While the latter was a one-off shock, its effects will persist for at least several decades, and may be reinforced by future high population growth rates in Africa, thus keeping the relative abundance of labor undiminished.

Mass education was a tool for reducing inequality in the West in the period when the average number of years of schooling increased from 4 or 6 in the 1950s to 13 or more today. This led to a reduction in the skill premium, the gap between college educated and those with only high or elementary school, so much so that the famous Dutch economist Jan Tinbergen believed in the mid-1970s that by the turn of the century the skill premium will be zero. But mass expansion of education is impossible when a country has reached 13 or 14 years of education on average simply because the maximum level of education is bounded from above. Thus, we cannot expect small increases in the average education levels to provide the equalizing effect on wages that mass education once did.

High taxation of current income and high social transfers were crucial to reduce income inequality. But their further increases are politically difficult. The main reason may be a much more skeptical view of the role of government and of tax-and-transfer policies that is now shared by the middle classes in many countries compared to their predecessors half a century ago. This is not saying that people just want lower taxation or are unaware that without high taxes the systems of social security, free education, modern infrastructure etc. would collapse. But it is saying that the electorate is more skeptical about the gains to be achieved from additional increases in taxes imposed on current income and that such increases are unlikely to find support.

So if the high underlying inequality is a threat to social homogeneity and democracy, what tools should be used to fight it? It is where I think we need to think not only out of the box in purely instrumental fashion, but to set ourselves a new objective: an egalitarian capitalism based on approximately equal endowments of both capital and skills across the population. Such capitalism generates egalitarian outcomes even without a large redistributionist state. To put it in simple terms: If the rich have only twice as many units of capital and twice as many units of skill than the poor, and if the returns per unit of capital and skill are approximately equal, then overall inequality cannot be more than 2 to 1.

How can endowments be equalized? As far as capital is concerned, by a deconcentration of ownership of assets. As far as labor is concerned, mostly through equalization of returns to the approximately same skill levels. In one case, it passes through equalization of the stock of endowments, in the other through equalization of the returns to the stocks (of education).

Let us start with capital. It is a remarkable fact that the concentration of wealth and income from property has remained at the incredibly high level of about 90 Gini points or more since the 1970s in all rich countries. This is to a large extent the key reason why the change in the relative power of capital over labor and the increase in the capital share in net output was directly translated into a higher inter-personal inequality. This obvious fact was overlooked simply because it is so…obvious. We are used to thinking that as the capital share goes up, so must income inequality. Yes, this is true—but it is true because capital is extremely concentrated and thus an increase in a very unequal source of income must push overall inequality up.

But if capital ownership becomes less concentrated then an increase in the share of capital that may be (let’s suppose) inevitable because of international forces, such as China’s move to capitalism, does not need to lead to higher inequality within individual rich countries.

The methods to reduce capital concentration are not new or unknown. They were just never used seriously and consistently. We can divide them into three groups. First, favorable tax policies (including a guaranteed minimum rate of return) to make equity ownership more attractive to small and medium shareholders (and less attractive to big shareholders, that is, a policy exactly the opposite of what exists today in the United States). Second, increased worker ownership through Employee Stock Ownership Plans or other company-level incentives. Third, use of an inheritance or wealth tax as a means to even out access to capital by using tax proceeds to give every young adult a capital grant (as recently proposed by Tony Atkinson).

What to do with labor? There, in a rich and well-educated society, the issue is not just to make education more accessible to those who did not have a chance to study (although that too is obviously important) but to equalize the returns to education between equally educated people. A significant source of wage inequality is not any longer the difference in years of schooling, but the difference in wages (for the same number of years of education) based either on the perceived or actual difference in school qualities. The way to reduce this inequality is to equalize the quality of schools. This, in the US, and increasingly in Europe as well, implies an improvement in the quality of public schools. This can be achieved only by large investments in improved public education and by withdrawals of numerous advantages (including tax-free status) enjoyed by private universities that command huge financial endowments. Without the leveling of the playing field between private and public schools, a mere increase in the number of years of schooling or the ability of a rare child of lower middle class status to attend elite colleges (that increasingly serve only the rich), will not reduce inequality in labor incomes.

The original post can be found at GlobalInequality.

Paul Krugman
February 08, 2018

Late last year Republicans enacted a huge tax cut, mainly for corporations. They then seized on some seemingly supportive data points – investment announcements by some major corporations, bonuses paid to some employees, an uptick in some measures of wage growth – as evidence that the cut was already benefiting workers. But while there is a case for cutting corporate taxes, the logic of that case says that any benefits to workers should unfold gradually over time, not show up in a few weeks.

And there is also a case against corporate tax cuts, even aside from the fact that revenue must be raised somewhere, and getting less from profit taxes means either raising other taxes or cutting spending.

The purpose of this note is to lay out a stylized framework for thinking about these issues. There exist carefully specified general-equilibrium models for tax incidence, but my sense is that there’s not enough intuition in these models for them to play as large a role in the discussion as they should. So, I’m going to present a slightly different approach, one that I described in a somewhat disconnected series of blog posts over the course of the tax debate. Here I try to collect it into a unified, comprehensible narrative.

1. The simple analytics of trickle-down

Imagine that we had a one-sector economy with no monopoly power, open to inflows of foreign capital. In reality, the economy is characterized by considerable monopoly rents, most of the capital stock isn’t in the corporate sector, and most of GDP is nontradable. These complications all weaken the extent to which corporate tax cuts trickle down to wages. But let’s give some hostages here, and consider the most favorable case.

Such a stylized economy would look like Figure 1. The downward-sloping line is the marginal product of capital, which is equal (in this model) to the pre-tax rate of return r. The after-tax return is r(1-t), where t is the tax rate. Given an initial capital stock K, GDP is the integral of the area under the r curve up to K. Of this, rK goes to pre-tax profits, of which the government takes a share t and the rest goes to after-tax profits. What’s left, the triangle at the top, is wages.

Figure 1

Now, the key justification being offered for corporate tax cuts is that the U.S. is the international mobility of capital: reducing U.S. taxes will, supposedly, draw in investment from abroad, either from U.S. corporations bringing money home or foreign corporations buying into the U.S. economy. We can capture this effect by adding a supply curve for capital, as in Figure 2.

For a small open economy, this supply curve would be horizontal in the long run. It is, however, surely upward-sloping for the United States.

Now suppose the corporate tax rate is cut to a lower level t’. This raises the after-tax rate of return for any given capital stock. Over time the capital stock rises to K’. This in turn leads to higher wages.

Figure 2

The crucial words, however, are “over time.” For a variety of reasons, it would take a number of years for the capital stock to rise to its long-run level.

What are these reasons? One is that adjusting the capital stock would take time even if purely domestic factors were involved: a large increase in capital formation would drive up the wages of construction workers, the rent on construction equipment, the prices of commodities used in construction, etc. This is why we don’t expect Tobin’s q to be one all the time.

Beyond this, we’re talking about capital inflows here, which would have to have as their counterpart an expanded trade deficit, effected via a temporarily strong dollar. And this temporary strength of the dollar would in itself be a deterrent to capital inflows, since investors would expect it to go back down again.

The bottom line is that the short-run supply curve of capital should be more or less vertical; full trickle-down should happen only in the long run, where this run is measured in a number of years. Whatever cherry-picked good news comes in the first few weeks after a corporate tax cut is, almost by definition, irrelevant to the case for that cut.

2. Long-run welfare effects

Since the capital stock is effectively fixed in the short run, the short-run incidence and welfare effects of a corporate tax cut are simple: no change in real income, all the gains go to owners of capital. In the long run, however, the capital stock does rise. So, what are the effects?

Again, as a starting point we can think of a downward-sloping demand for capital, reflecting its marginal product. We can also think of an upward-sloping supply of capital, with the upward slope reflecting both the size of the US — we’re probably around half of the world’s capital market not subject to capital controls — and the imperfect nature of capital mobility, even now.

For current purposes it’s helpful to focus not on the corporate tax rate per se but rather on the wedge corporate taxes place between the rate of return to capital before taxes — which is assumed equal to its marginal product — and the after-tax return received by investors. This does not mean changing the model, it’s just a way of presenting the picture that bypasses some messy algebra that can (and has) led some economists to make errors. So, we think of the corporate profits tax as being kind of like an excise tax on capital, as shown in Figure 3.

Figure 3

Notice that I’ve indicated here the reality that a significant fraction of the current capital stock is owned by foreigners. This is a big deal: gross U.S. liabilities to the rest of the world are around 1.7 times GDP, and around 35 percent of corporate equity is foreign-owned. As we’ll see in a minute, it matters for the welfare analysis.

What happens if we cut corporate taxes? We reduce the size of the corporate tax wedge, which brings in more capital from abroad and raises GDP. But it doesn’t raise GNP – the income of domestic residents – by the same amount, for two reasons. First, the additional capital doesn’t come free: we have to pay foreigners for the use of the additional capital (or get less income from investments abroad if it’s U.S. capital coming home.) Second, we pay a higher rate of return on the foreign capital already here. So net international investment income falls, offsetting at least part of the rise in GDP. In fact, the fall in investment income could be larger than the rise in output, so that national income actually falls.

Figure 4 tells the slightly intricate story, for a small change in the tax rate (so we can ignore triangles):

Figure 4

The lower tax rate shrinks the wedge, leading to a higher capital stock, lower pre-tax rate of return, and higher wages. The green rectangle at the top is the part of the tax cut that’s passed through to increased wages. As long as the supply curve for capital is upward-sloping, it also leads to higher after-tax returns to capital, with the gains partly accruing to domestic investors, partly to foreign investors. These gains are offset by a loss of revenue.

The possibility of overall gains to the U.S. economy comes from the fact that we started with a wedge: the rate of return on investment, equal to the pre-tax return on capital, was larger than the cost of capital from abroad, equal to the after-tax return. So, bringing in more capital produces a net gain equal to the change in the capital stock times that wedge – the yellow rectangle at the right.

Notice, however, that this is a lot smaller than the rise in GDP, which is the whole pre-tax return times the rise in the capital stock. Since the initial tax rate was 35%, the gain to the U.S. should be only 0.35 times whatever gain we get in GDP.

And that’s without taking into account the extra payments to foreign capital already here – the red rectangle at the lower right. Back of the envelope calculations suggest that once we take that into account, any net gains are very small, and maybe negative.

One way to think about all this is that because the U.S. is a big player in world capital markets, and already effectively employs a lot of foreign capital, we effectively have considerable monopsony power in world capital markets. When we cut corporate taxes, we end up attracting more foreign capital but paying the capital we already employ more. This analysis shows that it is not at all clear that the cut in corporate tax rates works in our favor, which makes the case for the tax bill just enacted look remarkably weak.

Andreas Kakolyris
January 30, 2018

On November 15, 2017, the City University of New York Graduate Center and the Stone Center on Socio-Economic Inequality co-hosted a presentation by Richard Reeves, Senior Fellow at the Brookings Institution, on the topic Dream Hoarders: Is the Upper Middle Class Leaving Everyone Else Behind The presentation focused on the widening gap between those in the top quintile of the income distribution and the remaining 80 percent and was based on Reeves’ latest book Dream Hoarders: How the American Upper Middle Class is Leaving Everyone Else in the Dust, Why That is a Problem and What to Do About It. The presentation was followed by a panel discussion with panelists Janet Gornick, Paul Krugman, and Leslie McCall of the Stone Center and Miles Corak of the University of Ottawa (who will be joining the faculty of the Graduate Center Economics Program in January).

Reeves opened the event with a summary of the key points in his book. He argued that the United States has a class system that, unlike the United Kingdom, is not widely recognized. Class consciousness can help the members of a society become more aware of class divisions and create more political room for tackling inequality. A second point is related to the more traditional division between the top one percent of the income distribution and the bottom ninety-nine percent. The author claims that the focus of the inequality debate on this gap is unhelpful and allows people belonging even to the 99^th percentile of the income distribution to believe that inequality is the fault of rich people, more specifically, of an ambiguously defined set of people; the people who are richer than them. In his work, Reeves defines the upper middle class as those in the top quintile of the income distribution. He emphasizes the important role of education in replicating class inequality and the sense of entitlement and the hoarding of opportunities by those in this upper quintile, including exclusionary housing zoning, legacy admissions, and internship opportunities. He stresses the need for change in the U.S. political culture that allows a system of entitlement at the top of the society. Reeves uses the example of the squelching of the attempt made by President Barack Obama to limit the tax benefits of a savings plan (520 plans) that helps families pay for the cost of college as an illustration of the political power of the American upper middle class. This group of people, which is in the top quintile of household income, is well organized and numerous enough to be a serious voting bloc and able to control many critical institutions. In his concluding remarks, Reeves spotlights the dimensions of well-being that play a role in class reproduction, among them wealth, health, parenting, life expectancy, neighborhood, and education.

Following the presentation, panel moderator Janet Gornick raised a number of questions related to the zero-sum framework where in order for someone to win, someone else has to lose. Whereas Gornick agrees with the problematic focus on the top 1%, she expresses her concern regarding the right place to draw the fault line and whether the top quintile is the basis of the “elite” group. She also suggests more attention should be given to the intra- and inter-generationally absolute income mobility, and how to tackle class inequality and move the framework from a zero-sum game. The expansion of the middle class, defined as those whose income falls in a band around the median, would make a contribution to this end. In addition, she raises the issue of whether there are policies that could support the increase in the share of households whose members enjoy the other “positives” associated with the top fifth, such as access to quality health care and education. She also emphasizes the large difference in the United States compared to other countries between the 20^th and 80^th percentiles of the income distribution.

Miles Corak presented data on the issue of the relationship of dream hoarding and inter-generationally income mobility. He presents geographically disaggregated income mobility data that show that in communities where the probability of being born in the top quintile of the income distribution and staying there are high, it is more likely for poor people to become rich. On the other hand, in communities where the inter-generational cycle of poverty is high, we observe that is really hard for poor people to become rich. The challenge is really how to break out of the bottom of the distribution. He also brought up the issue of changes in peoples’ behavior resulting from the observation of groups of people who are much better than them as well as groups of people who are much lower than them. As the last point, Corak wonders whether the political agenda proposed in the book is utopic, for example, is there a political program that could support the people of upper middle class to not only fight for the best for their children, but also to have their energy and drive help others.

Paul Krugman addresses the issue raised by Gornick about the right setting of the fault line that would define an “elite” group in the society. He doubts the existence of such a line due to the growing inequality between any two points of the income distribution and raises the question of whether the group of people from 80^th to 99^th percentile could be considered as a unique social class. He presents data that show a strong pulling apart of the income distribution at the 99^th percentile, and above, and also expresses some doubts about the political dominance with an example showing that the current tax legislation increases the relative amount of taxes paid by dream hoarders.

Leslie McCall sheds more light on the political dimension and characteristics of the upper middle class. She agrees with the expansion of the political focus to a broader group than the top 1%, and proposes to shift attention from the white working class to the middle/upper class, that according to her is the real impediment to greater equality. McCall also proposes the political agenda to be focused on opportunity-enhancing policies rather than general tax and transfer policies. She concludes that the reduction of market inequality would reduce economic anxiety that feeds dream hoarding.

Reeves made several points in response to a number of the issues raised by the panelists. First, he continues the discussion about the answer as to the appropriate measurement of the inequality gap. He refers to a graph used by Krugman which shows that, although the average annual growth of income for the 80^th percentile is roughly equal to the average, the pulling apart of the distribution starts there. Reeves notes that Corak’s comments showing the important features of geographic inequality is very interesting and takes an interesting perspective, as presented in the book, on the zero-sum framework.

In a follow-up comment, Krugman reiterates a point made by other panelists that extreme inequality as observed for income, access to health or access to good education create a war feeling in our society. Thus, the hoarding of the dream can be thought of as a reaction to the extreme inequality of the society in that the alternative for not hoarding the dream can be costly.

Reeves closed the event by taking questions from the audience.