Show Me the ... Mechanism

Brad DeLong does the public service of recapping the blogosphere's discussion of Krugman's "Wages, Wealth, and Politics" column. I blogged about it in the last two posts.

Krugman argues that the dominant political ideology is the main cause of changes in inequality. I want him to show a mechanism by which that occurs. Brad notes that Krugman has a book coming out on the subject--I guess we'll have to wait for it to see whether his criticism of the Treasury Secretary's remarks can be validated.

Others in Brad's recap have speculated about such mechanisms. There are a few different groups of them. Here's my quick take on them.

1) Weaker bargaining positions for labor, exacerbated by government policy

In this group are factors like less vigorous enforcement of laws protecting unions and opposition to increases in the minimum wage. A commenter named "Dark Helmet" at Matthew Yglesias's blog offered the following hypothesis:

The notion of putting more economic risk on the middle class -- in Orwellian, the "Ownership Society" -- reduces the bargaining power of middle-income employees. The more risk people bear, the more they cling to the remaining hedges against uncertainty. Which usually means the job that they have. This shows up most starkly in the "job lock" problem with health care. Want to quit your job and start a business? Better not have any preexisting conditions.

Interesting idea. I think it's plausible that these factors are inhibiting workers to press for higher wage growth. But wages are not everything. Greg Mankiw has noted, not all of the observed weakness in wage growth is the result of total compensation not growing. Compensation includes wages and fringe benefits, and the fraction of compensation taken up by wages is falling. So while these factors may be at work, we've got to insist on a better comparison before assessing their importance.

2) Tax policy leading to higher pre-tax incomes disproportionately at the high end, Part I

In this group are explanations based on the higher incentive to realize income when marginal tax rates are lower. For example, if capital gains tax rates are high, then investors hold their gains rather than realize them. When capital gains tax rates are lower, the same investors realize the gains, paying the smaller tax rate, and then reinvest. Reported income goes up, and it does so disproportionately at the high end. I don't think this is a valid explanation of some fundamental economic shift. It is a criticism of using reported income, rather than accrued income, to compare income distributions at different points in time.

3) Tax policy leading to higher pre-tax incomes disproportionately at the high end, Part II

This one comes from Matthew Yglesias. Part of it belongs in (2) above, so I've emphasized the elements that wouldn't just be a measurement issue:

One thing to say is that tax policy impacts pre-tax distribution. When the top income tax rate was very high -- 70 percent or above -- this not only meant that rich people paid a lot in taxes, it also meant that there were a broad range of circumstances where it didn't necessarily make much sense to offer well-compensated people even more compensation. When you have a very progressive rate structure, an employer can get a lot more bang for his buck by directing his employment budget at middle-income people than at rich people. As
you flatten the tax structure, this becomes less-and-less the case.

Similarly, very high tax rates encourage high income people to engage in more leisure and less work whereas right now we have the somewhat odd situation where highly compensated people tend to work more than do the moderately compensated.

I think that's fascinating. I hadn't fully appreciated that a progressive tax system might be used to give lower-income workers a leg up in competing for the marginal unit of production. It remains an empirical question as to how important this might be over the last 25 years. I would have thought the effect to be small, compared to things like increasing global competition in product markets.

4) Lax enforcement of laws that should prevent the rich from stealing from others

This group is basically organized around the notion that CEOs and other top corporate officers have seen their pay grow tremendously over this period, and some of that, the theory goes, must be due to illicit activities. Hard to argue that none of it is ill-gotten, though I am not in the camp that suggests it is very high. As food for thought, here is the abstract of a new paper by Xavier Gabaix and Augustin Landier, "Why Has CEO Pay Increased So Much?"

This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO’s pay changes one for one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period. We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.

Another interesting hypothesis. The part I've emphasized suggests that the rise in CEO pay is the passive result of growth in market capitalization.