Monday, August 21, 2006

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.

13 comments:

Bibamus said...

Andrew: Am I that predictable?

Actually, I don't think this one is silly. Though I don't think you are being completely fair to Krugman here, I can't say I found this column entirely convincing either, and for largely the same reason as you: it seemed to come up short on explaining the mechanisms that would allow the government to generate such large swings in the income distribution.

I'm not sure you are being entirely fair in two respects, though:

First, while his failure to spell out what those mechanisms are is a shortcoming of the column, I don't think pointing that out is as devastating as you seem to think. Sure, Krugman's failure to do this makes his conjecture weak and incomplete. But it doesn't make it wrong by itself. (Though this latest post, considering some of the explanations that have popped-up since, shows that you appreciate this distinction.)

Second, while the examples Krugman does bring up do seem to be insufficient to explain the recent explosion of inequality at the very top of the income distribution, the version of the human capital story that Paulson tells doesn't explain it much better. I suspect that what Krugman has in mind here is something like the argument he has advanced in previous columns, which is that workers at the 99.99th percentile of the income distribution are not pulling away from workers at the 99.9th percentile because of the increase in the returns to a college degree. There is clearly something else going on there. (I'm a "superstars" kind of guy myself, and Krugman's case certainly would seem to fit).

The one part of this story you haven't really commented on is what explanation you would offer to explain why the stylized facts do seem to fit Krugman's argument so well. I know that whenever I look at a time series plot of an income inequality measure over the last century, the non-economist part of my brain can't help but label the post-war compression "FDR" and the late-century up-tick "Reagan". Do you think that the causation runs the other way (income distribution drives politics)? Or that the relationship is simply spurious?

spencerengland said...

From 1980 to 2003 the rise in the market PE accounted for over half the increse in the S&P 500 capitalization.

I would think that the Fed should get primary responsibility for that,
so why should corporate management be rewarded for something that played virtually no role in creating.

Moreover, the long term trend growth rate of S&P earnings per share since WW II has been 7% and
there is little or no evidence that there was a significant change in this trend after 1980.

If EPS growth was the same before 1980 and after 1980 and much of the market gain was due to lower inflation and interest rates I see
little justification for comparing management pay to the change in
market capitalization.

It look more like stock owners have an agent problem.

eightnine2718281828mu5 said...

How about this mechanism:

CEO gets 25% increase in pay; no response from the Fed.

Average wages rise by 3%; Fed hikes interest rates, kills economy, demand for labor falls, CEO lays off 15% of workforce, CEO gets another 25% raise for making the 'tough calls'.

Wash, rinse, repeat.

Longitudinal studies reveal that unemployed 50 year old worker with mortgage and 2 kids in college basks in the knowledge that he's insulated from ever have to make such 'hard calls'.

eightnine2718281828mu5 said...

Question:

How can the equality gap ever be closed?

Can anyone show a reasonable mechanism that would allow average wages to rise while CEO pay falls WITHOUT causing the fed to kill the economy?

Andrew Samwick said...

Spencer:

It seems like this would be the explanation for CEO pay that would resonate with you.

Bibamus:

I guess you are not so predictable after all. I do seem to get animated when Krugman takes a swipe at a government official with a weak and incomplete conjecture. I do not presume to suggest that this is a majority of such swipes, but I think it applies here.

Perhaps we might make progress on this issue if we speculated as to what a left-of-Clinton Democratic President would do if elected (along with a suitably complacent Congress) to reverse this trend toward extremely high income at the top of the distribution. How high would the top marginal tax rate go? How high would estate tax rates go? How much avoidance behavior would there be?

And if all of those questions are answered with "very high" or "a lot?", do we think society would be better off?

eightnine2718281828mu5 said...

---
do we think society would be better off?
---

Define 'better off'?

If gdp goes up 50%, but the bottom 60% lose money, is society better off?

Roland Patrick said...

Yglesias said:

' 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...'

They pay more now, with the top rate half that.

eightnine2718281828mu5 said...

---
They pay more now, with the top rate half that.
---

I understand that Al Capone also paid (or owed, as the case may be) a lot in taxes.

Roland Patrick said...

Btw, commenter JG at Mankiw's blog, reminds us what Krugman had to say about HIS high income when he had to defend himself for taking $50,000 from Enron:

"In 1998-1999 my normal fee for a one-hour business speech in Boston or New York was $20,000...

"I was a hot property, very much in demand as a speaker to business audiences: I was routinely offered as much as $50,000 to speak to investment banks and consulting firms. They thought I might tell them something useful....

"If it still seems implausible that my advice might be worth that much, think about how I have been warning about Argentina for the past year and a half; a company that had listened to me and reduced its exposure would be rather grateful, don't you think?....

"The point is that the money Enron offered wasn't out of line with what companies with no interest in influence-buying were offering me. You may think I was overpaid, but the market - not Enron - set those pay rates."

Bibamus said...

Andrew:

Well, the first thing we could do with taxes is, as the advice goes to those who find themselves in a hole, stop digging. A return to Clinton-era tax rates would hardly be the on-ramp to the road to serfdom that Republicans go on about. And we could go from there.

But I think that what people like Krugman are really talking about are government policies that influence the pre-tax distribution of income. The example that pops into my head first is government policies toward labor. The Federal government, at least, has become indisputably more hostile to labor in the last three decades than it was in the immediate post-war period. People like Krugman would, I think, advocate policies like whipping the NLRB into shape so that it does a better job of protecting the right to organize. Whether or not such policies would make much of a difference to the distribution of income (debatable), they strike me as both worthwhile and unobjectionable.

Moreover, I've always supposed that what Krugman and people who hold these views really have in mind is that society has changed (and government along with it) in ways that facilitate the explosion of inequality at the top of the income distribution. For example, these people complain a lot about CEO pay. My suspicion is that what these people have in mind is that in the immediate post-war period there were social checks on the multiple of CEO pay to worker pay. The story goes something like: back in the old days CEOs who were paid too much relative to their workers would be perceived as greedy and exploitative; the threat of social opprobrium kept them in check. Now we worship them as heroes. I know I'd rather live in the first world, but whether it ever really existed, or whether we could bring it back if it did, I don't know.

Anonymous said...

James Galbraith claims in his book "Created Unequal":

the jobless rate explains 80% of the fluctuations in inequality from 1920 to 1992.

The truth is that if you look at more "equal" societies such as in Old Europe (as measured by income distributions), they are actually not much more "equal" than the U.S. before tax redistribution, some are even less "equal" before redistribution due to high unemployment rates.

So before we go raising the minimum wage, lets keep in mind that it might enhance unemployment, and thus income inequality.

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