I dealt with the Bush tax cuts issue in detail in this blog – Income distribution matters for effective fiscal policy<\/a>. The proposal is part of the obsessive debate that is going on in the US about the ways to cut the budget deficit. A correct debate should be focusing on how to expand the deficit while ensuring the benefits go to the poorest citizens and the net spending is job rich.<\/p>\n On August 22, 2010, Paul Krugman said in his column – Now That’s Rich<\/a> that the retention of the tax cuts was an “expensive proposition” and he was affronted by the benefits being provided to the richest Americans. It is more accurate to relate the benefits to the highest income earners which may not be equivalent to the richest but that is an aside.<\/p>\n While not considering specifically whether the tax cuts were sensible in the first place, the notion of the tax cuts being an “expensive proposition” has no meaning per se<\/em> in the context of a fiat monetary system. In terms of Modern Monetary Theory (MMT) such terminology is grossly misleading. The tax cuts just represent “numbers on a bit of paper” and the only issue that is needs to be considered is the volume of purchasing power that is embodied in the tax cuts (or the reversal of them) and how it is distributed.<\/p>\n From a MMT perspective, the purchasing power question really on matters if we think in real terms – that is, what real resources are at stake?<\/p>\n These questions are in relation to (a) the need to balance nominal aggregate demand growth with the capacity of the real economy to absorb it (relevant to the amount of purchasing power being withdrawn by taking back the tax cut); and (b) the aims of social policy to ensure that the benefits of economic activity are shared in some reasonable manner (relevant to the distribution of the tax burden).<\/p>\n The two issues are interrelated because different income groups have different propensities to consume which influences the impact of fiscal policy.<\/p>\n But Mankiw considers there is more at stake than this and suggests that without the higher marginal tax rates he would:<\/p>\n \n… have twice the incentive to keep working.\n<\/p><\/blockquote>\n He says that given there are taxes “Is it any wonder that I turn down most of the money-making opportunities I am offered?”<\/p>\n He explains his conclusion by proposing he is paid $US1000 for some task and then compares what that would compound to after 30 years with no taxes to what the situation would be with and without the tax increases. There are several assumptions he makes which includes that the provision of public infrastructure provides zero real income to him or his family and what would be the impact on his net income position if he had to pay a private provider for all the public services (in the no tax scenario).<\/p>\n I am not suggesting the taxes provide the wherewithal for the government to provide these services – that is simply a false proposition – Taxpayers do not fund anything<\/a> – but it is consistent with Mankiw’s own logic and frame of reference that without taxes there would be no spending. So in his world, the so-called $US10,000 he passes on after 30 years would be seriously eroded if he had to pay for access to all roads, bridges, buildings, protectoin from private police and armies, etc.<\/p>\n But that quibble is an aside.<\/p>\n The bottom line from his calculations is that with the tax hike he ends up with $US1000 after 30 years (that is, the tax effect wipes out the compounding effect) and without the tax hike his initial $US1000 payment grows to $US2000 over the same period. Hence, his “twice the incentive”.<\/p>\n Another inconsistency in Mankiw’s logic (before I get to the major issue) is his assumption of linearity in this thought experiment. Neo-classical economists such as Mankiw always invoke diminishing rates of utility and productivity in their analysis as a convenient, but totally ad hoc<\/em> assertion about humam behaviour which just happens to get the demand and supply curves drawn in such a way that they intersect in price-quantity space and so give them an “analytical result”.<\/p>\n I recall the trivial example provided when I was a student to “demonstrate” this assertion. Accordingly, a consumer buys one cream cake and enjoys it a lot. The second cake is also very well received but by the third cake the enjoying is waning. By the nth cake, the consumer is vomiting and not seeing any extra gain in satisfaction from any more cream cake consumption. Hence, the more you have of something the less satisfaction you are alleged to get at the margin of extra units.<\/p>\n So why is the $US2000th dollar delivering the same “incentive” as the $US1st dollar? We have to be in a linear world it seems – when it suits.<\/p>\n Anyway, the point he is making is that the taxe increases will force him to work less and:<\/p>\n \n… don’t let anyone fool you into thinking that when the government taxes the rich, only the rich bear the burden.\n<\/p><\/blockquote>\n Apparently, there are “particular actors” who will not make the “next movie” or “particular novelists” who will not write the “next book” or a “favorite singer” who will not perform in your local town if the tax hikes go forward. Further, you will be disappointed because just when you need a particular “highly trained surgeon” or “your child” needs “braces from the local orthodontist” you will find them unavailable – gone home because the marginal tax rate has risen.<\/p>\n Mankiw concludes that:<\/p>\n \nAs they face higher tax rates, their services will be in shorter supply.\n<\/p><\/blockquote>\n Where does he get these ideas from? Answer: his own textbook.<\/p>\n In Chapters 2 and 7 of my 2008 book with Joan Muysken – Full Employment abandoned<\/a> – we consider the type of labour market that Mankiw considers relevant to the real world. It allowed us to develop the standard Classical view on unemployment which is still pushed down the throats of students today by the likes of Mankiw and the mainstream macroeconomics profession in general.<\/p>\n The Classical\/neo-classical model is represented by the following graph:<\/p>\n For those who like equations, the lines in the graph can be written in algebraic form as follows:<\/p>\n Labour demand: Ld<\/sub> = f(w) f’ < 0<\/p>\n Labour supply: Ls<\/sub> = f(w) f’ > 0<\/p>\n Equilibrium: Ld<\/sub> = Ls<\/sub><\/p>\n where w is the real wage which is the ratio of the nominal wage, W and the price level P.<\/p>\n The real wage is considered to be determined in the labour market, that is, exclusively by labour demand and labour supply. Keynes showed that this assumption is clearly false. It is obvious that the nominal wage is determined in the labour market and the real wage is not known until producers set prices in the product market (that is, in the shops etc).<\/p>\n The labour demand (Ld) function is the derivative of the production function with respect to labour input (the marginal product). The ad hoc<\/em> imposition of the so-called law of diminishing returns ensures this derivative is positive but declining as employment is increased.<\/p>\n In English, they say that as extra units of labour are added to a fixed stock of capital they become increasingly unproductive and hence there is diminishing products (returns). Hence, the labour demand function is downward sloping with respect to real wages. The argument is that firms have to pay the real wage (an amount of actual product) to the marginal workers and so they will only hire extra labour if the amount the worker contributes to production is more than the real wage. The assertion of diminishing returns assures the demand curve will be downward sloping – so the firm will only be prepared to hire extra workers if the real wage is reduced.<\/p>\n This is a short-run relationship based on the fixity of other inputs like capital. In the real world, production processes rarely follow the model presented in the textbook. First, the idea that capital is fixed and production expands purely because extra workers are added seems not a reasonable depiction of reality. A cleaning firm who finds extra contracts do not force extra workers to share a single broom or vacuum cleaner. If there is extra work they add a worker and another broom! <\/p>\n So we have what are called “fixed factor proportions” which is just a fancy phrase meaning that workers and capital are added to production more or less in proportion dictated by the current technology. In that case, each additional worker is more or less as productive as the last. There is very little evidence in the real world to support the ad hoc<\/em> assertion of the “law of diminishing returns”. It always amused me when I was a student how the mainstream attempted to infuse levity into their inane theories by referring to them as “laws” akin to a physical law in physics.<\/p>\n Once you see through this and realise that they are just assertions that these characters dream up (invent) which stand and fall on their empirical applicability you start seeing the nakedness ugliness of the neo-classical theory. I am glad I saw through this after about 1 minute because it meant I was able to devote my student efforts to reading much more interesting stuff.<\/p>\n The labour supply (Ls) function, which is based on the idea that the worker has a choice between work (a bad) and leisure (a good), with work being tolerated only to gain income. The relative price mediating this choice (between work and leisure) is the real wage which measures the price of leisure relative to income. That is an extra hour of leisure “costs” the real wage that the worker could have earned in that hour. So as the price of leisure rises the willingness to enjoy it declines.<\/p>\n The worker is conceived of at all times making very complicated calculations – which are described by the mainstream economists as setting the “marginal rate of substitution between consumption and leisure equals to the real wage”. This means that the worker is alleged to have a coherent hour by hour schedule calibrating how much dissatisfaction he\/she gets from working and how much satisfaction (utility) he\/she gets from not working (enjoying leisure). The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where the worker maximises satisfaction.<\/p>\n I do this every day and I am sure you all do too. It makes it hard to get out of bed each morning. All these calculations!<\/p>\n So why is the labour supply function upward sloping with respect to real wages – that is, the theory asserts that as the real wage rises workers will continue to supply more labour hours.<\/p>\n This is where it gets really funny (at least I was amused by it when I was a student). The neo-classical analysis motivates the following thought experiment as an attempt to explain what happens when a “price changes” – in this case, the real wage.<\/p>\n They isolate two separate “effects” on such a real wage change (say a rise): (a) a substitution effect; and (b) an income effect.<\/p>\n The substitution effect refers to the impact on the worker’s decision to supply hours of labour when the real wage changes. So if the real wage rises, work becomes relatively cheaper (compared to leisure) and the mainstream theory asserts via the so-called law of demand<\/em> that people demand less of a good when its relative price rises. So real wage up, less leisure, more work.<\/p>\n But there is another effect to consider – the so-called income effect. When the real wage rises, the worker now has more income for a given number of hours of work. The mainstream theory of normal goods<\/em> (as opposed to inferior goods – the distinction is just made up largely) tells us that when income rises a consumer will consume more of all<\/strong> normal goods. The opposite is the case for an inferior good.<\/p>\n Leisure is considered to be a normal good as are other consumption goods the worker might buy with the income he\/she earns. So as the real wage rises, the income effect suggests that the worker will demand more of all normal goods (because they have higher incomes for a given number of working hours) including leisure. That is the worker will work less!<\/p>\n Now think about a tax rate in this model. The labour supply function can be conceived of as expressing the relationship between the number of hours a worker chooses to supply and the net real wage (that is, the amount post tax). <\/p>\n So without a tax system, the model above describes the “perfectly competitive model” that students get beguiled by in their initial studies and they are told that this is the most efficient outcome. This is Mankiw’s dream world where his initial $US1000 payments compounds to $US10000 after 30 years.<\/p>\n The imposition of a tax rate now reduces the relative price of leisure (compared to work) because it amounts to a real wage cut for the worker. So in this model, the so-called income and substitution effects work in opposite directions. The substitution effect reduces the opportunity cost of leisure and thus leads to an increase choice for leisure. So the substitution effect says that the imposition of a tax causes a reduction in labour supply.<\/p>\n But the tax hike also reduces income at each level of hours worked. So for the same quantity of work, the person is able to command less goods. To enjoy the same quantity of goods as before they have to work more when there are higher taxes. In other words, the income effect predicts the worker will work more.<\/p>\n This is all very scientific but that is as far as it goes. It is dripping in rigour when it is taught mathematically and students are beguiled by it. How dare we challenge the authority of the mathematics?<\/p>\n However at this stage there are no possible “scientific” or rigorous conclusions to be drawn from the analytical framework. Which of these effects dominates? The model cannot tell us. There is a lot of ad hoc<\/em> manipulation with various scenarios proposed but nothing can be advanced further from the model as it is set up.<\/p>\n So what do the mainstream economists such as Mankiw do? Answer: make up stuff. The so-called elegance and rigour of their framework gives away to them just asserting that the substitution effect dominates. It becomes as simple as that. So the supply function is upward sloping in terms of real wage (and pivots down but remains upward sloping if there is a marginal tax rate imposed).<\/p>\n If that wasn’t the case, then there is a danger the labour supply curve might not intersect the equally asserted shape of the labour demand curve and then the theoretical framework would not even predict an equilibrium relationship between real wages and employment, which is, after all, its purpose.<\/p>\n So never think that mainstream theory is anything more than stuff made up even if it is disguised as rigorously reasoned argument.<\/p>\n There have been lots of attempts at finding out which effect dominates when tax rates change. These include Econometric modelling, experimental studies and interview studies. All are rife with problems which I will not elaborate on here.<\/p>\n The results from the interview studies that have any credibility suggest that the aggregate effect of taxation on labour supply is small if there is any perceptible effect. Generally, these studies find that people try to work more overtime (if available) to make up the lost income – that is, the income effect of the tax dominates the substitution effect.<\/p>\n Notable studies of the affect of higher marginal tax rates (exactly the case Mankiw is considering) are inconclusive. One famous study (James and Nobes, 1998, The Economics of Taxation: Principles, Policy and Practice, Prentice Hall) summarised the literature on interview studies in this way (page 63):<\/p>\n \n… there appears to be no substantial disincentive effects from taxation. Instead, it appears that there are both small incentive and small disincentive effects which tend, of course, to offset each other, so that the net effect on the taxation of labour is likely to be small.\n<\/p><\/blockquote>\n The results from the other methodologies are equally inconclusive.<\/p>\n Further, there is a notion in economics called rent. An economic rent is a payment to a “factor of production” which is in excess of that required for the current supply of that resource. So popular guitar players (who are scarce but in demand) will likely earn very high incomes – yet still be prepared to perform at the current levels with significant reductions in those incomes (as their popularity wanes, for example). I just thought of a concert that my host took me to when I was in Boston in June. It was a Ringo Starr concert and I am sure he still wants to perform even though his returns are (in real terms) much lower these days than when the Beatles were at their top. He was probably earning huge rents. So a tax impost on such a worker will have no impact on their labour supply.<\/p>\n There are many more problems with the orthodox labour supply analysis which I could discuss. For example, the model suggests a worker will only engage in paid empoyment if the real wage they are paid exactly offsets the pleasure they would have received from enjoying an hour of leisure. If you think of this workers are always on their “supply curves” and can never be “forced” by the market to work more or less hours than they desire.<\/p>\n In Mankiw’s model, the worker always enjoys working hours and real wages that maximise their utility – pleasure. They cannot be coerced into working more hours than they desire and never have to endure less hours than they desire.<\/p>\n So how do we explain the rising underemployment? That is why are there a growing number of part-time workers who want more hours but are rationed by a lack of overall hours in the labour market? This could not occur in the mainstream model that Mankiw is suggesting allows us to understand the real world.<\/p>\n Further, there is a major problem with the conception of the work-leisure choice. Is the extra satisfaction gained from an extra hour of leisure always positive? Further, is the extra hour of work always bad? Both assumptions are required to motivate the orthodox model. <\/p>\n The reality is different. First, there are different capacities to enjoy leisure depending on ones income. An unemployed worker with minimal income support is unlikely to value the extra hour of leisure more than a high income worker who can afford to buy high value-added leisure products (restaurants, concerts, ski vacations etc). Poverty and unemployment provides plenty of non-work hours but each one is miserable.<\/p>\n Second, work is not seen as intrinsically bad by most workers and unemployment is not seen as a state where a person is enjoying leisure!<\/p>\n Most of us gain satisfaction from working quite apart from the income it generates. We meet our partners, enjoy social esteem and in many cases actually enjoy the process of work. The opposite typically applies to the alienated and lonely existence that the unemployed are forced to endure.<\/p>\n So while the mainstream model characterises unemployment as a state chosen by the worker to maximise their utility given the current choices facing them all the studies by sociologists, psychologists and thinking economists suggest otherwise.<\/p>\n If we consider this discussion more broadly, then the diagram above can be used to consider macroeconomic situations. The important Classical result is that the interaction between the labour demand and supply functions determines the real level of the economy at any point in time. Aggregate supply (using the aggregation fudge of the so-called representative firm) is thus a technological mapping from the equilibrium employment determined by the equilibrium relationship into the production function. Say’s Law (in whatever version) is then invoked to assume away any problems in matching aggregate demand with this supply of goods and services.<\/p>\n The equilibrium employment level, E* in the graph (assuming it now applies to the overall economy rather than an individual), is constructed as being full employment because it suggests that every firm who wants to employ at the equilibrium real wage, w* can find workers who are willing to work and every worker who is willing to work at that real wage can find an employer willing to employ them.<\/p>\n The Classical economist thus considered the preferences of the workers always would have a bearing on the labour market outcome and through price adjustment (real wage flexibility) any changes in supply preferences would – via mediation through the demand side – result in a changing full employment level.<\/p>\n In other words, adoption of the competitive paradigm demands that departures from full employment are ephemeral at best. Any sustained unemployment (say BC in the graph) must be due to a real wage constraint (a real wage, w1, above the marginal productivity at implied equilibrium full employment) which would be competed away more or less immediately.<\/p>\n A fundamental aspect of this labour market conception, which you will find in Mankiw’s own text, is that fluctuations in unemployment reflect supply-side changes arising from imperfect information or reflecting changing preferences between leisure and work.<\/p>\n In this mainstream macroeconomics dream world, he considers the classical labour market model to be applicable to the real world. So to repeat – the real wage is assumed to be determined in the labour market at the intersection of the labour demand (Ld) function and the labour supply (Ls) function. The equilibrium employment level is constructed as full employment because it suggests that every firm who wants to employ at that real wage can find workers who are willing to work and every worker who is willing to work at that real wage can find an employer willing to employ them. Frictional unemployment is easily derived from the Classical labour market representation, as is voluntary unemployment.<\/p>\n Holding technology constant (and hence the Ld curve fixed), all changes in employment (and hence unemployment) are driven by labour supply shifts. There have been many articles written by key mainstream economists (such as Milton Friedman) that argue that business cycles are driven by labour supply shifts.<\/p>\n The essence of all these supply shift stories is that quits are constructed as being countercyclical despite all evidence to the contrary. This induces Lester Thurow in his marvellous book from 1983 – Dangerous Currents<\/em> to ask:<\/p>\n \nwhy do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.\n<\/p><\/blockquote>\n So one of the most simple ways to reject the mainstream macroeconomics conception of the labour market, which constructs unemployment as being a supply side phenomenon and hence quits as being countercyclical is to look at the quit rate. If you examine any data on quit rate behaviour from any country you will sese that the quit rate behaves in a cyclical fashion as we would expect – that is, it rises when times are good and falls when times are bad. Many studies have demonstrated this phenomenon for several countries where decent data is available.<\/p>\n Further, rates of layoff and discharges, which reflects the demand-side of the labour market are always firmly counter-cyclical as we would expect. Firms layoff workers when there is deficient aggregate demand and hire again when sales pick-up. Again this is contrary to the orthodox logic.<\/p>\n The clear significance of this behaviour is that the orthodox explanation of unemployment that Mankiw considers to be reasonable is not supported by empirical reality.<\/p>\n![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/08\/Mitchell_Muysken_Figure_2_1_classical_labour_market.jpg\" "\\"Mitchell_Muysken_Figure_2_1_classical_labour_market\\"")
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