Archive for December 2014


Noah Smith on taxes and labor supply

Here’s Noah Smith on the disincentive effects of taxes:

There are reasons to think that taxes, unless they reach very high levels, don’t have a big effect on how much people work.

First, most jobs, even part-time jobs, require a minimum number of hours per week. Few people are likely to quit working entirely because of taxes.

The required number of hours worked is itself endogenous.  In Europe, required yearly hours are less than in the US, due to higher taxes.  Some claim the differences are cultural, but back in the 1960s when French tax rates were comparable to US tax rates, the French worked just as long hours as Americans.  Culture is endogenous.  In contrast, many of the so-called “tiger economies” in East Asia have lower tax rates than the US, and their citizens work longer hours.

Second, when you tax people, they are poorer, and they need to work more to maintain their standard of living.

This is a common misconception that I see all the time.  There is no first order effect of taxes on national income, as the tax money gets recycled into the economy.  Now it’s true that the government might waste the tax money, leaving a country poorer, but in that case it would be more accurate to say that government waste causes people to work harder.  In modern economies most extra spending at the margin goes back in transfer programs.  Since national income doesn’t fall from the direct impact of taxes, there is only a substitution effect on labor supply, not an income effect.  Of course income falls as people work less, but that is a second order effect.  All tax and transfer studies should use income-compensated labor supply curves.

When you look out at the world, you see lots of circumstantial evidence that taxes don’t have a crushing effect on the labor supply. For example, in a recent blog post at the NYT’s Upshot, Neil Irwin reports that countries with higher taxes and more generous welfare systems also tend to have a higher share of the population in the labor force:

Of course taxes are not the only factor that impacts labor supply, programs like free child care matter as well.  (And here I’ll diverge from Smith’s post, and get some things off my chest.) But it’s interesting to note that when progressives like Paul Krugman are confronted with the fact that the per capita GDPs of countries like France are only 70% of US levels, they insist that productivity is just as high, it’s just that the French work far fewer hours.  Indeed that’s generally true of Western Europe; the biggest reason they have lower incomes is that they work fewer hours.  Then they insist that this extra leisure should be counted in utility calculations, proving the European model actually does pretty well.  But when the topic switches to taxes and labor supply, progressives tend to make exactly the opposite argument; they claim the Europeans work just as long hours as we do.

A similar bait and switch occurs with the term ‘leisure.’  When criticizing the US model they focus on how unemployment is not just “leisure,” as those awful RBC models might imply.  It causes people to become depressed, as unemployed breadwinners lose self-esteem.  Fair enough.  But when the discussion turns to Europe the low labor supply is suddenly seen as evidence that the less materialistic Europeans wisely avoid the American rat race, even though a substantial part of the difference is due to much higher structural rates of unemployment in Europe.

Back to Noah Smith:

Also, if you look at the U. S.’s past, you see that although taxes have come down over time, people are not working more than they used to.

You don’t want to use time series data, as there is a long-term downward trend in hours worked due to increasing affluence.  If you look cross sectionally, hours worked in America relative to Europe have risen since the 1960s.  And it’s not clear that taxes have actually come down. Compared to the 1950s and 1960s the rich face a lower MTR, but very few rich people ever faced those 90% brackets. Lower income people face a much higher implicit MTR than in the 1950s and 1960s.

So why do economists such as Mankiw spend so much time warning about the dangers of moderate tax increases on the well-off? It might be because they are morally opposed.

I have no moral objection to very high tax rates, unless they reduce aggregate utility.

PS.  Of course there is one European country that has per capita GDP levels (PPP) that are comparable to the US, despite lacking oil—Switzerland.  Oh wait, that’s the European country with low taxes.

HT:  Saturos

What went wrong in Brazil?

Back in 2012, Paul Krugman did a post praising the “New Economic Policy” in Latin America, which focused on reducing inequality.  A few weeks later he singled out Argentina and Brazil for special praise:

Just to be clear, I think Brazil is going pretty well, and has had good leadership. But why exactly is Brazil an impressive “BRIC” while Argentina is always disparaged? Actually, we know why “” but it doesn’t speak well for the state of economics reporting.

And it’s true that these countries had shown some impressive growth.  But that was more than 2 and 1/2 years ago.  How do things look today?  Obviously things are going downhill rapidly in Argentina, but what about Brazil?  Here’s The Economist:

IN 2005 a debate raged between the two most powerful figures in President Luiz Inácio Lula da Silva’s government. Antonio Palocci, the finance minister, proposed taking advantage of faster economic growth to eliminate Brazil’s persistent fiscal deficit””and thus lower its exorbitant interest rates””by capping the increase in federal spending. But Dilma Rousseff, Lula’s chief of staff, thought Mr Palocci’s plan “rudimentary” and blocked it. Ms Rousseff became Lula’s successor as Brazil’s president in 2011, implementing a “new economic model” that placed full employment and wage increases ahead of macroeconomic rigour.

Fiscal laxity has come back to haunt Ms Rousseff, who won a second term last month by the narrowest of margins. As we went to press she was due to announce that Joaquim Levy, one of Mr Palocci’s deputies in 2005, will become her new finance minister. Nelson Barbosa, the most capable economist in the ruling Workers’ Party (PT), will get the planning ministry. Mr Levy is a Chicago-trained economist who has been running a big asset manager; his presumptive appointment has been welcomed by investors. It seems that Ms Rousseff has at last tacitly accepted the error of her economic ways.

Big spending policies to promote jobs, and wage increases to reduce inequality—no wonder Krugman was impressed. Unfortunately Brazil is now paying the price, with only about 1%/year RGDP growth over the past three years.  Fortunately, after Keynesian economics makes a mess of things there’s always a few “Chicago Boys” available to clean up the mess.  I have another post at Econlog, discussing how Krugman’s preferred tax policy failed in France, and how a somewhat more moderate economic minister was brought in to clean up the mess.  Not a good two years for Keynesian/Piketty economics, maybe 2015 will be better.

Speaking of the supply-side, I endorse Miles Kimball’s post where he argues that Doug Elmendorf should be reappointed at the CBO. The GOP would be making a mistake if they force him out.

I won’t do much blogging over the holidays.  Merry Christmas to my Christian readers, and Happy New Year to everyone!

(Look for some big announcements in January.)

Update:  Here is an RSS feed for my Econlog posts:


Nobody is going to out-“crotchety old man” me!

Here’s Paul Krugman’s latest:

David Beckworth has a good post pointing out that the Fed has been signaling all along that the big expansion in the monetary base is a temporary measure, to be withdrawn when the economy improves. And he argues that this vitiates the effectiveness of quantitative easing, citing many others with the same view. My only small peeve is that you might not realize from his list that I made this point sixteen years ago, which I think lets me claim dibs. Yes, I’m turning into one of those crotchety old economists who says in response to anything, “It’s trivial, it’s wrong, and I said it decades ago.”

Krugman may be 2 years older than me, but I’m more grouchy and reactionary. And thus I can’t help pointing to an article I did 21 years ago (5 years before Krugman’s admittedly far superior paper.)

[Note (1=r)n and (1+r)x are meant to be (1+r) raised to the power of n or x. I don’t know how to do superscripts.]

For example, suppose that at time=zero there is a nonpermanent currency injection that is expected to be retired at time=x. Then, if the real return from holding currency has an upper bound of r, the ratio of the current to the end-period price level (Px-n/Px) cannot exceed (1 + r)n. Furthermore, if real output is stable, it would not be expected that Px would be any different from Po. Both price levels would be determined by the supply and demand for money, as in the quantity theory. The existence of a maximum anticipated rate of deflation (r) has the effect of placing a limit on the size of the initial increase in the price level. No matter how large the original currency injection, the price level at the time of the currency injection cannot increase by more than a factor of (1+r)x. Furthermore, these restrictions on the time path of prices can be established solely on the basis of the future time path of the quantity of money, without any reference to fiscal policy. It is this quantity-theory model that is applicable to the colonial episodes of massive and nonpermanent currency injections. . . .The impact of U.S. monetary policy during the period from 1938 to 1945 provides a good illustration of the preceding hypothesis. Between 1938 and 1945 the currency stock increased by 368 percent while prices (the GNP deflator) increased by only 37 percent. There was no depreciation in the dollar (in terms of gold.) Although real output grew substantially, the ratio of currency to nominal GNP increased from .062 to .132. Why was the public willing to hold such large real balances?

Although the U.S. did not experience deflation following World War II (as it had following previous wars), surveys indicate that deflation was anticipated. During the entire period from 1938 to 1946, the three-month Treasury Bill yield never rose above 1/2 percent. The fact that massive currency injections (associated with expectations of future deflation) were able to drive the nominal interest rate down close to zero, is at least consistent with the modern quantity-theory model I have described.

And stay off of my lawn!

Update:  David Glasner found an even older example.  (I’m sure there are dozens out there.) But I’d quibble slightly with this:

For one thing, reasoning in terms of price levels immediately puts you in the framework of the Fisher equation, while thinking in terms of current and future money supplies puts you in the framework of the quantity theory, which I always prefer to avoid.

I can’t help pointing out that the Quantity Theory, the Fisher effect, and PPP are three very similar theories, which share almost exactly the same strengths and weaknesses.  And let me add that all three have enormous strengths and massive weaknesses.  (Yes, the Fisher effect isn’t actually a theory, but you can imagine an associated theory that says nominal interest rates change one for one with inflation.  Or if you prefer you can compare the Fisher equation with the very similar MV=PY equation.)

These three theories say the real interest rate, the real demand for money, and the real exchange rate are stable.  All three theories are far more useful at double-digit inflation rates than single-digit inflation rates.

My macro toolkit

I’ve begun reading a very interesting book by the brilliant Steven Landsburg, entitled The Big Questions.  I find that we share a taste for contrarian opinions.  Of course Steven is much more skilled at defending his views.  Here’s something that caught my eye:

I sometimes hear economists defend the unrealism of their models thusly: “Economics is an infant science. Today our models are unrealistic; a decade from now, they’ll be a little so, in a decade from then little less. Eventually we’ll have realistic models that make accurate predictions.”

That, I think, is pure poppycock. Our predictions are not, and never will be, based on models; they’re based on informal reasoning. We study models because they own our reasoning skills. We can figure out what happens in these models and thereby develop a good intuitive feeling for what sorts of reasoning are likely to be productive.

In this we are no different from, say, physicists.

. . .

When economists can’t do is tell you what interest rates will be eighteen months from now. Neither can the physicists. You could, I suppose, point to that as a failure of modern physics. After all, interest rates are determined by physical processes in the brains of bond traders; isn’t that the stuff of physics? The answer, of course, is that physical (or economic) models are not designed to make precise predictions of complicated phenomena outside the laboratory.  They are designed to hone the intuition.

Great stuff.  I used to complain that physicists were horrible at predicting earthquakes, or the weather next month.  Steven has the courage of his convictions, and finds even deeper flaws.  🙂

So I decided to sit down and try to make a list of my money/macro toolkit.  Here’s what I came up with off the top of my head:

1.  The hot potato effect (AKA Quantity Theory of Money.)

2.  The interest elasticity of money demand

3.  Value of money = 1/P (or 1/NGDP, or 1/forex prices)

4.  Money neutrality

5.   The liquidity effect

6.  The income effect

7.  The price level effect

8.  The Fisher effect

9.  Money superneutrality

10.  The Natural Rate Hypothesis (Exp. augmented Phillips Curve.)

11.  Sticky wages and prices.

12.  Nominal debt contracts

13.  Non-indexed capital income taxes

14.  Money illusion

15.   Purchasing power parity

16.   Interest parity theorem

17.   current account deficit =  capital account surplus

18.   Consumption smoothing

19.   Okun’s law

20.   Wage tax =  consumption tax =  universal 401(k)

21.   Exchange-rate overshooting

22.   Balassa-Samuelson effect

23.   Optimum quantity of money

24.   Efficient markets hypothesis

25.   Arbitrage

26.   Asset purchases =  asset sales

27.   Ricardian equivalence

28.   Crowding out

29.   Monetary offset of fiscal policy

30.   Policy impotence under fixed rates

31.    Temporary versus permanent monetary injections

32.   Downward-sloping labor demand schedule

33.   Expectations hypothesis of the term structure

34.   Liquidity premium hypothesis of the term structure

35.   Laffer curve effect

36.   Solow growth model

37.   CAPM

38.   Tax equivalence: consumer and producer taxes

39.  Tax equivalence: import and export taxes

40.   Export subsidies neutralize import taxes

41.   Zero bound on nominal interest rates

42.  Wicksellian equilibrium interest rate

43.  Identification problem

44.  Lucas critique

45.  Rational expectations

46.  AS/AD model

47.  Policy credibility

(I’m sure there are dozens I’ve forgotten)

Some of these tools are based on more basic tools.  Thus Dornbusch’s overshooting model relies on the QTM, PPP, liquidity effect, price level effect, ratex, and IPT.

Some economists are really good at zeroing in the the proper tool to employ in a given situation. Paul Krugman is perhaps the best in the macro blogosphere. Among academics, Bennett McCallum is excellent.  Keep in mind that this is just one skill among many.  Thus about 90% of the time I would agree with John Cochrane on policy issues more than with Paul Krugman, and yet on methodological issues I’m far closer to Krugman.  I tend to think the profession overrates the importance of things like micro foundations and general equilibrium, although for certain problems a GE model is appropriate.

Regarding Landsburg’s opening remarks about progress in economics, I can’t help thinking of Milton Friedman’s claim (made in the 1970s) that in the past 200 years macroeconomics had merely gone one derivative beyond Hume.  Today I can proudly say we are ahead of Hume in three areas, monetary superneutrality (the extra derivative), rational expectations, and the EMH.  The latter two also represent advances over Friedman.  Unfortunately, on the liquidity trap the profession still lags behind John Locke.  (Yes, Landsburg’s point was slightly different.)

Over at Econlog I repeat the Landsburg quotation, and apply it to a specific example.

PS.  David Beckworth has recently been showing off his artistic skills.  I’m honored to be portrayed here and here.

Update:  In this op ed, John Cochrane shows off one of his best skills, brutally skewering Keynesianism.

Why doesn’t ISIS threaten Hollywood?

I’m incredulous.  And when you are incredulous you are probably missing something important. You always need to ask yourself WWTCT (what would Tyler Cowen think?)  So I should probably have taken a deep breath before writing this post.  You guys tell me what I’m missing.

1.  Tell me why this country isn’t showing abject cowardice by canceling one film project after another (some of high quality), because we were told to do so by a crackpot on the other side of the world.  And yet the news media reports all this like it’s perfectly normal.

2.  Tell me why Americans being interviewed say; “well how do you expect the North Korean people to feel?”  Um, how would the Jewish people in Germany have felt if Hitler was insulted by Hollywood? (Yes, I know, never use Nazi analogies.)  OK, then how did the American people feel when the North Korean media compared our first African American president to an ugly monkey? The guiding principal of the North Korean regime is that North Koreans are superior and other races are inferior.  And we are worried about hurting their feelings?

3.  Back in 2013 the city of Boston showed similar cowardice, shutting down the entire city (and many suburbs) because a single 17 year old with a gun was on the loose.  I wonder what would happen if they shut Detroit down every time a dangerous 17 year old with a gun was walking the streets.  How often would Detroit be open?  And after that incredible show of cowardice the people of Boston were so proud of their actions that they made “Boston Strong” into a sort of slogan.

4.  And then there’s the TSA.

Perhaps this is a generation thing.  Maybe it’s rational to become increasingly risk averse as we get richer.  After all, my generation has trouble with the notion that kids are no longer free to roam around by themselves.  Maybe I’m just out of touch with the world of today. Or is it our legal system?  Are movie theaters afraid of lawsuits?

But here’s what I don’t get.  If America really is this weak and cowardly, then why can’t ISIS easily defeat us?  They could phone in threats against movie theaters just as easily as the North Koreans can.  And there must be 100 times as many Hollywood films that offend ISIS sensibilities as there are that offend Kim.  Recall that women get stoned to death in ISIS-controlled areas for things like wearing a miniskirt.  Then consider Hollywood films, which often show Arab terrorists as villains. So why doesn’t ISIS copy North Korea?  Why does ISIS let us insult them? I don’t get it.

I suppose when I can no longer tell the difference between articles in The Onion and articles in the mainstream media it’s time for me to retire, or go back to focusing on monetary policy.

PS.  Et tu, Facebook.

PPS.  There is some debate about whether the Sony hacks and subsequent threats came from North Korea.  I have no expertise in that area, and obviously that issue has no bearing on anything in this post.  I do believe it was unethical for the press to print private emails that were stolen.  But heh, it’s the American media–what do you expect?  They prefer to print stories about gossip rather than controversial reports on illegal US government spying on US citizens.

PPPS.  And what’s up with the GOP?  Between defending torture and insisting that the 50 year old Cuban trade embargo will start paying off any day now, you have to wonder whether they have a secret plan to win in 2016 by locking up the reactionary vote.

End of rant.

Happy Holidays!