Risky Business

I have been reading

A note from Menzie Chin on the Forward Premium Puzzle

The afore mentioned If Exchange Rates Are Random Walks, Then Almost
Everything We Say about Monetary Policy is Wrong

Bernanke and Gerler's Inside the Black Box: The Credit Channel of Monetary Policy Transmission

Rereading Mankiw's Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve

and am reminded of Peter Flanigan quip “There is no such thing as scarcity and no such thing as surplus. There is only price.”

Price is the orchestrating mechanism of our entire economy, of our very survival. Inside of it is carried all of the information needed to coordinate the world's work. With that comes all of the world's uncertainty.

When a mother in the western world puts her daughter to bed at night she is not afraid that there will be no milk in the morning, that there will be no place to live, no way to get medicine.

She is worried that the price of milk and housing and medicine, will exceed the price of the labor she wants to trade for it. In the modern world much of our fear can be summed up in a single phrase "That wasn't the price/wage/cost/revenue I was expecting"

Perhaps it is practically impossible to insure against real fluctuations in price without insuring against nominal ones.

Update: I have just started Money in A Theory of Banking and it looks very interesting.

Happy Tax Payers and Elasticity

Garth writes

The whole notion of:
"But, once we make that guess we add it to the price of gasoline and our motorist is once again happy in the knowledge that she has made the world a better place."

...is wrong. They are not "happy." If they were happy to pay the higher price, you would not have had to tax them in the first place!!!

That leaves us with two problems: how can we compensate both the losers in the present (due to higher taxes) and the losers in the future (environment).

We do this by taking the revenue from the tax hike to repay the current losers, and we ASSUME the elasticities are such that carbon consumption falls by enough to provide the adequate benefit to the future.

So you see, the assumption of elasticity IS important if you intend to compensate the current losers (as Mankiw would want to do)

The happiness was a joke. Its a device I somtimes use in class. In economics we assume that people are out to satisfy their own interests but we find that they often end up maximizing social welfare.

I sometimes take the tact that our protagonist wants to maximize social welfare (as many young students imagine themselves) but ends up realizing that all she has to do is act in her own self interest. So long as the government corrects for externalities and the like.

As for the elasticities. You are right that the government does not actually compensate the taxpayers. This does create messy distributional issues.

However, if we were willing to accept Kaldor-Hicks then the elasticity wouldn't matter.

Suppose there were perfect substitutes so that the elasticity was infinte. Then gas would be completed replaced by some alternatives at no cost at all to the consumer. The tax would have the result of completely protecting the environment.

Suppose the elasticity of gas was zero. So that people just had to have it no matter what. Then there would be no change in consumption. Assuming that the damages are not infinte (some might disagree) this is also optimal.

Now, yes we have taken away revenue but we did it a no economic cost. Since, their behavior didn't change there is no deadweight loss. For real nerds, zero elasticity must mean that the compensated elasticity is zero, and that the income elasticity is also zero. If the income elasticity of gas is zero then the gas price elasticity of labor supply must also be zero. This means that high gas prices do not discourage work or investment. In effect we have found the perfect tax.

So at either extreme the gas tax works so long as we ignore distributional issues. By the way those issues are precisely why I think gas tax revenue should go towards increasing the EITC.

Ricardo, H-O, and the Gains from Trade

Dani Rodrik and Greg have an exchange over the gains from trade. Dani points out that real wage can fall via Stolper-Samuelson first derived in a Heckscher-Ohlin framework, but Greg feels that Ricardo is a better model for the real world because in Heckscher-Ohlin capital cannot move.

The problem with Greg's take is that it is, as he sometimes writes, at odds with the facts.

The big problem here, the one that generates all of this hoopla in the first place, is that economies differ greatly in their "capital stock."

Now perhaps, all investors care about is their real rate of return. Though, this itself is not entirely clear. There is some apparent return to having your assets simply denominated in dollars or pounds. Ignoring that, however, persistently different per capita capital stocks means either

(1) Capital is not completely mobile

(2) The production function is not constant returns to scale

(3) There are radically different technologies


In the first case we are back to Heckscher-Ohlin. In the second case we are presented almost immediately with an argument for infant industries. If there are scale effects then it pays to build local business. In the third case it might be technically true that the returns to capital are unaffected but policy makers aren't going to see it that way. Since capital and intellectual property are typically both held intermediately by firms an increase in the return to intellectual property is going to be seen as gains to the investor class.

Moreover, the larger point is that there are multiple factors to production and there are systematic differences in the people who own them. We can replace capital with skilled labor and get the same result.

However, I do find Dani's argument about Argentine beef and wheat strange. In a one shot setting its clear that the material gains to winners outweigh the losses to the losers over all trading partners. Now, if one nation has the ability to tilt relative prices in its favor then restrictions on trade can benefit that nation. Perhaps that's what his has in mind, but I don't know.

My real concern over free trade dogma is that trade is a policy lever. Since, we are in the position of weighing the merits of lots of second-best options it isn't clear to me that ruling out trade restrictions is a priori the best way to go.

Suppose I need to raise living standards in the rural South. Its not clear to me that increasing marginal tax rates to provide a subsidy is a better policy than restricting textile imports. Both have negative side effects but if I am going to raise living standards of the rural poor it is going to have negative effects for the economy as a whole. If there was a magical win-win it would have been used already.

Now, as Dani pointed out perhaps this is really a debate about how economists talk about policy. I understand Greg's view that economists should always offer the best policy regardless of political reality. We should all understand, however, that real policy involves interpersonal comparisons of utility. If it didn't most policy work would be impossible.

What Ricardo shows is that the nation as a whole will be wealthier, this does not mean at all that any particular social welfare function will be maximized.

Moreover, as a paper I a working on will show it is possible to have a policy which passes Kaldor-Hicks yet which no person in the economy would want to see implemented. Like Greg's paper on height I think this may cast doubt on the whole notion of net benefit.

The Take Out Paradox

Byran has an interesting conversation on why there are so few high-end take out places. In the end he concludes

Dine-in patrons provide an important advertising benefit for restaurant owners that dine-in patrons do not. If you see a restaurant empty during peak times, you infer that it's no good; if you see a restaurant full during off-peak times, you infer that it's excellent.

As a result, restaurants are willing to give a price break to dine-in customers to encourage them to sit down and serve as human billboards. Or in other words, dine-in customers actually double as covert employees, whose job it is to advertise the restaurant. Their implicit pay roughly matches the extra cost of the dine-in experience, bringing it into parity with the cost of take-out.

I like the general theme but I think the advertising concept is weak.

What I do think is happening is that there is an interactions based effect. People prefer to go to a restaurant where there are lots of people in part because it is more exciting but for any number of reasons.

Thus the more people you can get into the restaurant the more will want to come. Since their are high fixed costs it pays to subsidize the cheapskates who will then draw in the more environmentally sensitive diners.

Indeed, what a restaurant would really like to do is give a price cut to the first X customers. Then charge the rest more.

My guess is that cheaper places do this by varying price on time of day. More expensive places do this by making you wait in line.

The question is why does the restaurant benefit from you waiting in line. That will have to wait till I get back from Boone.

How Much Do You Need to Know to Tax Gas

A few people have complained in the comments on Greg's site that we shouldn't increase the gas tax because we don't know the elasticity of gas or how much consumption we should give up in exchange for saving the envrionment. There are two points about this.

First, we do have estimates of the price elasticity of gas.

Secondly, however, the beauty of Pigouvian taxes, unlike cap-and-trade by the way, is that we don't have to know that much. We don't need to know elasticities. We don't need to know the "right" amount of pollution. We don't even need to know whether or not people should be driving less.

We do have to an estimate of the envrionmental damages that gasoline brings. Admittedly that might be hard to pin down exactly. The nice thing about taxes, however, is that if we are off by a bit the economic harm isn't that great.

See the price of gasoline is basically the cost of making it plus some reasonable profit for the refinery. There is the messy issue of OPEC but that has become increasingly less important in recent years.

So when people decide to fill up their tank they are implicitly asking themselves, "Is the benefit to me of taking this drive greater than the cost to the driller of drilling the well, plus the tanking company for transporting the crude oil, plus the refinery for turning it into gasoline plus the retailer for operating this store plus the tax the state charges for building the roads."

If it is then the motorist fills up her tank content in the knowledge that she has maximized social welfare. She imposed a cost on all of those people, but the benefit to her was greater and she proved it by paying the going price for gasoline.

But wait! We forgot someone. We forgot the child who will be born just one day to late ever see a glacier because our motorist added just a little bit more carbon to the atmosphere and speed up the rate of global warming by a teeny-tiny amount.

The little child did not get paid and so our motorist can no longer be confident that she is maximizing social welfare. We can she do!? Should she shun gasoline forever? Feel guilty until the day she dies?

Well, she could just pay him. The one problem is that since our kid isn't born yet we don't know exactly what his asking price will be. We have to take a guess. But, once we make that guess we add it to the price of gasoline and our motorist is once again happy in the knowledge that she has made the world a better place.

In this entire story we didn't say how much gasoline our motorist was buying, where she was going or even what kind of vehicle she's driving. Thats because we don't really need to know. All we need to know is that she was willing to compensate that little boy for the cost she was imposing upon him.

My Pedigree

A reader asks

Karl, where did you do your PhD? Just wondering. I've been noticing your posts on Mankiw's blog for a while and was curious.

I have been wondering what to say or not say about this for a while. I was, at first, worried about revealing my pedigree and whether or not it would impact my online reputation. The fact that a lack of sleep and food have pushed me to make some pretty crazy posts and comments over the last week or so should lay those fears to rest, however.

I went to NC State University. In the past I have been advised, by NC State faculty, to never let anyone know this. There is, at least a sense, that anything outside of the Top 20 means that some people will never take you seriosuly. In the internet age that might be changing. What do commenters think?

In A Word - No

One of Greg’s students inquires about Noam Scheiber’s retort that “all the cleverness has crowded out some of the truly deep questions we rely on economists to answer” There are many reasons to defend Steven Levitt but I’ll focus on just one – his work is vitally important.

I spend most of my days thinking about taxes, and government spending and public policy, issues well with in the schema of traditional big economics. My hope is that one day I’ll have a clever new idea, or perhaps as importantly, a clever way of explaining an old one that will help us and our children live happier, healthier, more productive lives.

Steven Levitt spends his days thinking about the roots of crime, corruption, and the racial divide. If he can help us understand those issues he will do more for economic prosperity than I ever could.

Creating the right incentives for corporations to locate here in the US is important, but getting young urban kids out street gangs and into college is much more important. Tax policy works at the fringes of the free market economy, corruption goes right to the heart of why some economies succeed and others fail.

In 2004 the median black man earned only 75% of the median white male. That gap is virtually eliminated when accounting for 8th grade test scores. A cure for the test score gap could mean a GDP boost of nearly 3% based on earnings alone.

These questions are big questions.

Perhaps, the deeper question is whether we have to take ourselves seriously to do serious work. Do we have to talk about boring issues in a boring way? Or, can we address the things that that everyday people care about? Does being a uncommonly productive scholar mean being divorced from common things?

The 80-20 Rule

The Wall Street Journal opines on Nassim Taleb's latest book. Taleb is concerned with the impact of highly unlikely events and asks the question, "What happens when normal is not average?"

We are used to taking normal an average to be about the same thing. The familiar bell curve which dominates how even the most sophisticated among us think about risk, demands that average and normal are the same thing.

Unfortunately, this is not how the world really works. Most Americans have a net worth that is significantly below average. When we look at the entire world the average person is doing OK, but most people still live in poverty.

I am continually struck by the power of power law distributions as in occupational talent. To many people a PhD is a PhD and certainly all professors are experts. Yet, the disparity of understanding within academia dwarfs the gap between academia and the outside world.

That is, if you look at the gap between how well the average economist understands the economic problem and the understanding that the very best have, its much wider that the gap between the average person and the economics profession in general. Its truly amazing to behold.

More Macro Musing

First off, just so everyone is clear - I am in no way a macroeconomist. My only course in monetary economics was in the core and I had that as an undergrad. These are simply my only mildly educated thoughts, with the hopes that my commenters can point me to good resources.

Now, two markets which introduce much of the messiness into non-neutrality are the labor market and the housing market. Unfortunately these two markets account for the lion's share of economic activity.

However a few facts are striking to me

(1) Both of these markets entail a good deal of matching. You don't just go out and buy a house, you buy a particular house in a particular location. You don't just take a job, you take a particular job.

(2) There seems to be a great deal of surplus associated with both jobs and housing. For example, you lose a job or you lose the house. Being laid off or being foreclosed on are particularly stressful events in people's lives.

(3) Regardless of whether or not these housing and employment contracts have to be nominally rigid they are nominally rigid. That is, people choose to have jobs that pay a certain amount no matter how good business is and people choose to have mortgages that don't move with interest rates.

The second fact is extremely striking because one can choose a mortgage that moves with the market and can save money by doing so. Yet, few people choose this.


My initial feeling is that the matching produces surplus which leads people to try to secure it by writing contracts with nominal rigidity.

So perhaps there is this sort of problem, some of the variance in the labor and housing markets comes from money and some from real shocks. I want to insure against the real shocks, but how can I write a contract that insures against real shocks without insuring against nominal ones?

We could index for inflation, but that assumes that the shock makes its way through to the price level. House else can you insure against a money shock?

Ruination and Despair

Inspired by the two articles below I have been thinking about the link between Monetary Policy and risk. In particular there is this pop concept that one can be ruined.

That is, there are realizations of stochastic events whose effects cannot be smoothed out by access to credit. In plain English, if a lot of bad things happen to you at once the result can be much worse than if those same bad things happened to you over a longer period of time. Is this true? And if so, what are the causes? Why can't you borrow to get out of the situation?

Does being put in a bad situation make you more vulnerable to other bad things? When it rains does it pour?

This is important because it could mean that short term fluctuations in terms of credit could have long term repercussions. If suddenly everyone finds it more difficult to borrow to cover an emergency does this make the whole system more vulnerable?

What I Am Reading

Doing some background on this whole monetary policy thing. Reading Inside the Black Box: The Credit Channel of Monetary Policy Transmission By Bernanke and Gertler

I also checked out If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy is Wrong that a reader suggested though a reply will have to wait until the begining of the week.

Causes of Inflation

KNZN reports on debates he's had over the causes of inflation. Apparently he is being chided for suggesting that inflation could be produced by tax cuts. Inflation as we all know is everywhere and always a monetary phenomenon.

Well OK, but does that mean that inflation can only be caused by increases in the money supply? Well, of course not. Money is in the equation somewhere but its not the only factor.

Suppose, for example, that I managed to organize the greatest trade union known to man. In fact, all workers in the United States are members of my union and they all obey my commands.

Now, I decide that I am going to decrease labor supplied to the US economy to fight the evil capitalists. The workweek will be reduced 1% per month from now until I decide otherwise.

Now the Fed believing that inflation can only be caused by increasing the money supply decided to keep the monetary base constant. What is going to happen?

Well, as my minions slowly retreat from the labor market output will decrease. Given that MV = PY and M and V are constant, decreases in supply must be eventually matched by increases in price.

In a similar way I believe that KNZN is arguing that tax cuts can actually increase V by causing the supply of bonds to grow. Without a corresponding increase in the growth rate of Y or response by the monetary authority to decrease the growth of M, P must also grow. If an increase in the growth rate of prices is not inflation, what is?

Splain Me

Update This post is getting a few hits from non-regulars so I'll give a little background. My question was around this idea:

It seems to me that in the absence of price increases an increase in the money supply should theoretically increase the demand for durables but not non-durables. This is because without an increase in prices more money represents an increase in transitory income.

However, if there is no increase in the demand for non-durables there is no reason to raise their prices.

Therefore, the common neutrality argument has a chicken and the egg problem. Why does nominal demand for non-durables increase in the absence of price changes? Why does the price of non-durables change in the absence of an increase in nominal demand?

Unless the problem is answered then it would seem that money should increase the real demand for durables. This is at odds with the common neutrality result from theory.

In response to my question on the money supply commenter writes

If you're committed to market clearing as a modeling strategy then you need something like the Lucas islands model or some sort of stickiness to get short-term non-neutrality.

In Hume's account of long-run neutrality and short-run non-neutrality, the new money worked its way through the economy, pushing prices up as it went round and round. His story was credible because people didn't observe the increase in the monetary mass.

OK so this is the common assertion. However, and I recognize that I must be missing something, I don't see why observing the increase in the money supply matters.

For example, suppose I am the proprietor of a McDonald's. Tomorrow the money supply doubles. This is great. However, the nominal demand for my product is not going to double. In fact, the real demand will likely fall.

I won't experience a decrease in demand, but what I will experience, over time, is lots of my employees quiting to take jobs in construction because of the housing boom that just occurred.

How is it in my interest to raise prices? It won't be until I actually have to start paying my workers more. I have to wait for the increase in money to work its way to my cost structure before I begin to raise prices.

It seems to me this should be true for everyone whose product demand doesn't depend on the interest rate.

Products whose demand does depend on the interest rate will experience the opposite phenomenon. They will see a nominal and real increase in the demand for their product.

In other words an increase in money should shift demand towards durables and away from non-durables. But it should do it in a two-step fashion. First, real durable demand goes up, then wages and input prices go up, creating an effective real decline in demand for non-durables.

This doesn't depend on myopia, islands or any other non-market clearing devices. \

So I ask again, where do I have it wrong.

Immigration and Capital

Samwick writes,

In the current environment, I would expect to see capital going south across the border with Mexico, drawn by the high returns available due to the large amount of low-wage labor. But that's not what we are seeing. We are seeing the labor cross the border--at considerable personal cost--to take the low-wage jobs and then send remittances back to Mexico.

In many ways this is much more natural. I think a lot of economists are still look at world through the lens of Solow Convergence. They believe that low wage countries countries will naturally grow faster than high wage countries because capital earns a higher return. Yet, this leaves open entirely the question of why some countries are low wage to begin with.

Shouldn't we expect that low wage countries are low wage for a reason? That for some reason technology is not employed, capital is accumulated or education is retarded. A priori, I don't think there is any reason to presume that investment will earn a higher return in low wage countries than in high wage countries.

Evaluation Scales

Arnold asks

I am going to make the following conjecture:



In an evaluation scale (e.g, rate this professor on a scale of 1 to 5), the mean evaluation is biased toward the middle.


Is this conjecture false? Is it true, but widely known? If it is true but not published, then someone should formally prove it and submit it to a journal.

Your errors are being drawn from a trucated distributions. In this case your distribution is trucated fom both ends and so variance is artificially low. Thus your covariance will be artificially low. If I rember correctly this is covered in Greene

Second Wives

Jane Galt asks

I'm not sure whether [the idea that second wives are less intellegent than first wives] is true on average, or whether it's just folk wisdom that appeals to our envious streak (sure, she may be younger and prettier, but boy is she stupid!) Nor can I imagine there's much data on it, but maybe I'm wrong. What do y'all think?

I don't know of much data but my hunch is that they are on average less intellegent. Whether people admit it or not estimates of you are your future spouses combined income feature prominetly in the marriage decision.

When marrying for the first time men are generally less wealthy. Having a wife who has earning capacity can be important simply for making the household finances add up. The second time around the man is better situated and likely doesn't put as much of a premium on spousal income.

Since intellegence is major factor in earnings as well as attractiveness its double counted when choosing a first wife. When a wealthier man chooses a second wife the earnings criteria is diminished and so intellegence counts only as far as it contributes to attractiveness.

For men who really find intellegent women attractive the difference between the first and second wife will be small. However, for men who don't care as much about attractiveness per se the difference will be large. The large differnce for the second category of men should tend to drive the average down.

Another Teachable Moment

Economists from KNZN, to Byran Kaplan to apparently Greg Mankiw have stopped by Modeled in the past. I am hoping to catch one of them or anyone else in the blogosphere who can explain the following quandary to me.

How can we feel comfortable assuming that increases in the money supply feed directly into increases in nominal demand?

Here is the quandary as it occurs to me. Increases in nominal demand lead to increases in prices. But don't we need increases in prices to see increases nominal demand?

Suppose that we live in an economy with no technological growth and no population change so that every period is the same as the one before. There is a constant money supply until time some time t0.

At t0 the money supply doubles. At this particular moment nothing has happened to prices. So everyone has just received a real increase in their transitory income. They should then attempt to smooth it out by saving it.

This drives down the interest rate. This should encourage accumulation of more capital and an increase in consumption and as such an increase in aggregate demand. Yet, I see no reason to suppose that the increase in demand would be proportionate.

Capital and consumer durables should be favored. Furthermore, there are those who posses scare inputs in the production of these goods. They should see real increases in relative demand. This should lead to an increase in their demand for labor.

It seems that price increases for the rest of the economy should come primarily from labor moving into the durables market away from non-durables. This run up in price would decrease the value of the extra money leading to a slow unraveling of this process.


However, I cannot see how it is in any one's interest to raise prices before they face a decrease in labor supply, nor how it is in the interest of the consumer to spend more on non-durables before the price goes up. It would seem that the whole thing has to work its way through the durables market.

Furthermore, as long as there is some time cost associated with changing jobs this process will take time.

As far as I can tell this seems largely consistent with what happens in the world. What is wrong with my story?

Update: Just to be clear. This is a geniune question not a see who can get the answer question.

Why Instrument Taxation Just Seems Wrong

Greg's new working paper demonstrates that social welfare can be enhanced by placing an extra tax on people who are tall. To public finance nerds the underlying logic is obvious if odd, to everyone else its probably repugnant.

Greg's Question is Why?

Is it because Public Finance Nerds think about the world the wrong way or is it because there is something special about taxing height.

I'd say its a little of both.

First, though here is the logic behind taxing height. If the government wants to make everyone as well off as possible then it wants to take a little from people who experience good luck and give it to people who experience bad luck. This is because we feel more bad when we are unlucky then we feel good when we are lucky.

The problem is that it is hard to tell when something good happened because the person was lucky or because they worked hard. Is the wealthy doctor who just passed you in his Jaguar rich because he was born into the right family with the right smarts, or is he rich because he worked his butt off to get into medical school.

The truth is that its most often a little of both.

So usually the government is between a rock and a hard place.

Height, however, is a different story. Few people actively choose their height yet it turns out that height makes a fair bit of difference in terms of ones earning potential. Clearly then the extra earnings you get from being tall is the result of luck. (This isn't so clear but lets gloss over that for now)

So why not take a little from the lucky tall people of the world and give to the unlucky short. Why not? Well, its seems just wrong for starters.

Part of the reason that it seems wrong is that some tall people will also be unlucky. Some short people on the other hand will be very lucky. Height may help, but its one of only many factors. It seems particularly cruel for the government to add insult to injury by placing an extra tax on an already unlucky tall person just to turn around and give it to some lucky short person.

Indeed, most people find injustice created by the government to be far worse than an equal injustice solved by the government. In a sense people are risk averse when it comes to policy action. I think this features prominently in most peoples notion of what is "fair". How and why this result occurs is the topic of the paper I am working on now.

Incidentally, the results also show why most people are skeptical of free trade although on net it benefits us.

Note: Kling also gets in on the action.

Cases 4 and 5: Where the Money Goes

Greg delves a little deeper into the question of taxation and brings up one of my constant refrains. When analysing tax policy it is critical to think about what actually happens to the revenues.

Traditionally, economists simply assume that the revenue is given right back to the population in general. This is to avoid the multitude of murky issues that arise when the government starts to actually spend money.

Greg's three cases, however, miss what I think are the two most important real world outcomes.

For those who came straight here he mentions

1) The government spends the money on a useless war. I always say "Throws it down a rat hole", but the example of war is more realistic and timely. Its important to remember that most federal employees are still soldiers.

2) Rebates it back to the people in the traditional way economists assume. This is in fact what Greg does in his paper on dynamic scoring. The assumption that underlies this case is that the people are no poorer than they were before and hence there is no reason to expect income effects to be important - more on this later.

3) The government spends on some program for the poor, which is on net basically like spending it on everyone but then increasing taxes on the rich again to take the money right back. This makes the substitution effect of a tax worse.

There are at least two more cases, however, that I think or relevant.

4) The government uses the money to reduce the budget deficit. The argument today is not over whether or not the government spending grows the economy. Most people even on the left would probably concede that government spending on the poor and elderly doesn't grow the economy.

The often debated question, however, is whether deficit financed tax cuts can grow the economy. So here we have to assume that the revenue goes to national savings. At this point the effects become complex. However, I think it is easiest to think about this as case (1) plus some sort of subsidy on investment. Then think about the tax interaction effects between the investment subsidy and labor supply.

In the real world this means that perhaps mortgage rates are lower. The question is does this make you want to make more, since now you have a shot at a really nice house or less because you current house is cheaper?

However, I think it is difficult to weave a tale where a) overall investment is not increased b) the incentive to work today is not increased.

5) The government spends the money on services or transfer payments that are for the most part unrelated to income. Here I am think of Medicare or Social Security or K12 for the states. On net there is zero income effect but this does not mean that the net income effect is zero.

Huh?

For ubernerds this means that the income effect is not homomorphic with respect to summation. For regular nerds it means that the "income effect function" is non-linear. For everyone else it means this:

The top 20% of the income distribution earns a lot more than the bottom twenty percent. So suppose you took away an equal percentage of income from everyone. Then you gave everyone back exactly the same amount of money.

For the rich this would mean that on net they are loosing money. For the poor it means on net they are gaining money. This means that the income effect will encourage the rich to work more to make up for there lost earnings and the poor to work less.

Because, however, the poor earn less than the rich, each hour of work the poor give up is worth less than each hour the rich work more. Thus even though on net the population got back what it paid in taxes the result is that there is less low income work but more high income work and a richer economy.

The take home of all of this nerdiness being that income effects will tend to be important when looking at changes in tax rates.

By Monday

I'll be settled in and back blogging by Monday. Thanks to the regulars who have been clicking despite the fact that I have no new material up.

As just a side point on the Imus Affair that took over the business news this afternoon. I, being of the South Park Generation, didn't find it that offensive. I do, however, understand how it offends the Boomer generation that directly experienced far more racism and misogyny than I can imagine.

Here is the actual comment

How To Tax Corporations - And Grow The Economy Doing It

Optimal Corporate taxation is something that I have been thinking about for a while and it comes up on in the comments on Greg's Kennedy Tax Cut post.

A few of my readers will be scratching their heads now, wondering when I missed the lecture that the optimal tax rate on corporations was zero. If we tax income or consumption then why in the world would we want to slap a separate tax on a particular form of income that will eventually be used for consumption. Isn't the essence of the corporate tax distortion and inefficiency.

Maybe. Almost Certainly as it is now designed. However, I am not convinced that an optimally designed corporate tax would be distorting - at least not in a "bad" way.

The basic problem as I see it is not that the corporate tax represents double taxation. Its that it represents one sided taxation. Allow me to explain.

Corporations pay taxes when they earn a profit and they don't when they take a loss. This is all wrong. When corporations take a loss they should still have tax liability, its just that the liability should be negative.

Paying taxes on profits but not on losses discourages risk taking and innovation. If you stick your neck out and you win, you only get a fraction of your winnings, if you loose, however, you loose the whole enchilada. That doesn't seem like such a great deal.

What if on the other hand, when you lost, you didn't loose everything? What if the government covered the same fraction of your losses that it takes from your winnings? What would that do to risk taking?

Well, its pretty straight forward to show that if the world works the way we think it usually works, then this type of tax could actually encourage you to take more risks.

Why?

Well, because for most people the pain of loosing is greater than the joy winning the same amount. This is why people will pay money to take out insurance. On average people would be better off just putting the money they pay towards insurance premiums in a rainy day savings account. However, sometimes your account would be more than enough to cover your losses and sometimes it would come up short.

People don't want to take that risk so they fork over a little bit more to an insurance company that promises to come through for you with exactly the right amount each and every time.

A similar logic would apply to investors. Without any corporate tax, you win what you win and you loose what you loose. With my kind of corporate tax you win part of what you win and you loose part of what you loose. Its almost like insurance for investing.

That type of insurance makes investing safer and perhaps more attractive. Now because on average corporations win more than they loose the tax will tend to raise revenue. That also means that the tax will be reducing returns more than it will be shoring up losses and so the average return to investors will also go down.

The question is how the trade-off between risk and reward under the tax will effect investment. As far as I can tell right now this is an empirical question. By that I mean that I don't think there is anyway I can figure that out by just thinking about it. Someone has to actually go out and gather data on risks and rewards to find out.

If someone is interested in doing that with me, by the way, let me know.

Depending on what I (we) find the optimal tax rate on corporations could be zero, positive or even negative. Its negative if it turns out that we can increase economic growth by actually rewarding corporations when they make a profit and taxing them when their down. Though, I don't think the idea of sending billions to high profit tech companies while pouring salt into the wounds of the dying auto industry is going to win very many sponsors in Congress.

There are some additional fuzzy details like:

1) Even if we can increase investment by taxing corporations does that mean its optimal? Maybe we will end up with too much investment. I don't think that's correct but it needs to be worked out.

2) How exactly do you plan to pay some of a corporation's losses? Isn't this a prescription for fraud?! I have some ideas about this one. The short story is that I would pay them in a special way that makes it more difficult to cheat.

More on all of this later.

Oh and by the way this has nothing to do with the paper idea I had a few days ago. Which by the way I need to get back working on . . .

Side Note: Angry Bear gets in on the general tax/growth theme.

What I am Up To

Blogging might be slow for a bit. I am moving into new house and working on a new paper idea that was actually inspired by some of the interaction from this blog. The paper will be short but I hope interesting and important.

I will post a link and a non-technical summary as soon as I am done.

New house below.

On Infant Industries

Why shouldn't developing economies protect their fledgling industries so that they might develop a comparative advantage over time?

This is the infant industries argument. Africa will never develop a steel industry if foreign steel producers can use their superior technology, infrastructure and capital to undercut African producers.

There are some extremely sophisticated reasons why this might be true. Perhaps I’ll have time to sketch them at the end. The basic intuition, however, is misleading.

Why?

Well because everyone has a comparative advantage. You don’t have to develop a comparative advantage. It comes straight out of the relationship between two countries, communities or people.

So what’s the developing world’s comparative advantage? By and large it’s the cost of living. If you travel to third world you will notice this immediately. Food costs less. Clothing costs less. Shelter costs less. This means that factory workers in the third world can survive on what would be below subsistance wages in the US.

There are some things that US consumers simply couldn’t have if it weren’t for this cost of living difference. An example that comes to mind is those new florescent bulbs, the kind that are made to replace regular incandescent bulbs. Those bulbs are twisted into a little ice cream cone like shape.

It turns out that we haven’t yet figured out how to get a machine to twist glass that way. For all of the great technology, education and capital stock of the United States we can build a machine that can twist glass in just the way it needs to be twisted to make those florescent bulbs.

We could pay a person to do it but it takes a long time to make a perfect twist. Wages and the cost of living are so high that it would make the bulbs outrageously expensive. No one would buy them.

The cost of living in rural China, however, is much lower. There a man can work all day twisting bulbs for cents on the hour and still have enough to feed his family. The man has an advantage over every single worker in the US. That advantage is that he lives in a place where the cost of living is fraction of what it is here.

His comparative advantage gives him and job and gives us those ice cream cone shaped florescent light bulbs. It also gives the man the resources to let his sons and daughters go off to school, rather than spend their adolescence working the farm.

When we look at the countries that have escaped poverty over the last 25 years they have done it by trading more, not less. Typically, at first they produce “cheap” goods with low wage labor. They reinvest the profits, however, into capital and education that helps then produce more sophisticated goods.

The sad thing is that today many poor countries have their natural comparative advantage in agriculture. Yet, trade barriers from Europe and United States prevent them from selling their crops here.

Others suffer from more fundamental problems such as corruption, lack of property right or rampant disease and war. While these problems put those countries at an absolute disadvantage it is hard to image how limits on their ability to trade on their comparative advantage could make matters better.

I hesitate to mention the more sophisticated arguments for fear that I will cause more confusion that clarity. I, however, ask this two part question:

1) Is the marginal product of an input higher in situations where there is a little of it or when there is a lot of it?

2) Do computer programers move to Silicon Valley or away from Silicon Valley?

How can we reconcile the answers to these two questions?

I Answer Chris on Trade Wars

Reader Chris asks,

I am for free trade. I wish everyone was. However, I do wonder if unilateral 'disarmament' of trade barriers is akin to unilateral military disarmament?

In both cases, government's are spending money in a non-productive fashion (at least, not directly) to protect local production.

In both cases, it would be better if everyone disarmed, but it would also be better if each country was slightly better armed than everyone else.

thoughts? please tell me I'm wrong.

I debated about whether or not produce a set of graphs to deal with this question. In the end I decided, mostly in the interest of time, to try to do it verbally. Lets see how I do.

So, the basic Econ 101 answer to the question is that unilateral reduction in our trade barriers would help us.

Why?

When we erect a trade barrier the cost to our consumers is greater than the profit to our companies.

To see this suppose that we were to but a tariff on Chinese toys. Lets assume that currently the average Chinese toy is selling for $10. However, it costs an American company $15 to make the same toy. This means that the Chinese toy makers are completely driving the American toy makers out of business.

So, we decide to put up a tariff on Chinese toys equal to $7. Now a Chinese toy costs $17. With this new tariff the American companies can now safely charge $16 per toy and stay in business. They wind up covering their costs and pocketing $1 per toy in profit.

However, the American consumer winds up paying $16 per toy rather than $10 per toy. That means that each consumer is out $6 but the manufacturer only gets $1 in profit! It cost us $6 just to make $1! There is no way that's in our national interest.

Immediately people will say "But what about the jobs we gained. Its not just about corporate profits."

I'll put aside for a second a discussion of how the labor market actually works and just remind you of this - Each American consumer now has $6 less than before. That means that he or she has to buy $6 less of products. So even though there are more jobs in the American toy industry there are fewer jobs in other industries.

(Not to mention that in reality the $10 that we sent to China gets loaned back to us so that we can buy houses at a low interest rate. Thus, the tariff also hurts the housing industry)

That's the Econ 101 story.


Now as per usual GenEq (General Equilibrium) throws a big monkey wrench into that whole narrative. There are several reasons that I will just sketch.

1) We have to raise taxes to pay for government spending. When we put a tax on something the ultimate cost is split between consumers and producers. If we put a tax on goods from China then Chinese producers will bear part of the burden from the tax. That means that a tariff makes it cheaper for the government to raise money.

2) Tariffs cause redistribution. We may want redistribution. If we do not redistribute via tariffs we have to use some other method. That method will probably involve raising taxes to pay for some sort of subsidy. A tax-subsidy redistribution scheme causes dead weight loss twice, a tariff only once.

3) Tariffs can change the terms of trade. That is, suppose the United States is a big exporter of something. The US government can use a tariff to raise the price of that thing not just in the US but abroad as well. Then we will be exporting a more expensive product which better for us.

So for those reasons and few other more complex ones it is not always the case that trade barriers will make us worse off.

However, as far as I can tell it will almost always be in our interest to take advantage of countries that want to foolishly subsidize their exports. This is the case Greg was talking about this morning. In this case we just get cheap stuff and they pay for it. The only problem I see is if the foriegn subsidy caused serious redistribution issues that were very costly to fix.

What Will Immigration Do to Wages

So, I was reading over this piece by Card on the wage effects of immigration and was wondering what a Cobb-Douglas function had to say about it.

For those outside the know, the US factor shares are typically estimated to be around 30% for capital and 70% for labor. Using those numbers I plotted the effect of an increase in the labor force on the equilibrium wages. The results are interesting and I am surprised I haven't heard someone refer to this before.

According to the model, even if the US gets no new capital the reduction in wages is small for any reasonable amount of immigration. Suppose we have 12 million illegals in a labor force of about 200 Million. That's about a 6% increase which translates into about a 1.75% drop in wages.

A more interesting and perhaps provocative simulation would be to look at the predicted effects of an increase in female labor participation. Maybe I'll get to that tomorrow.

Greg's Not Quite Right

Greg misses transition costs and disequilibrium effects in his analysis on tax incidence. He says it doesn't matter who is required to pay the tax, the final incidence is determined by supply and demand.

That's not quite right for a couple of reasons. First and foremost Illionis's requirement that the cost not be passed on to employees means that the payment shock falls on employers. There is a cost to changing the number of workers that a firm has or renegotiating wages.

If the firm cannot immediately pass the cost on to the workers then it must absorb the costs until the market re-equilibrates.

Furthermore, the labor market is prevented from reaching equilibrium in some cases. The most obvious is the minimum wage. This legislation effectively then raises the minimum wage and causes real effects.

In addition, my guess is that public employees are also affected. There is no particular reason to think that public employees are paid equal to their marginal product or that there is a smooth downward sloping labor demand curve. In this case there can be real effects for public employees.

The devil is details and the details are always messy.

Tyler Takes a Walk On The Supply Side

Long story short TC says that if you assume that the rich have an unfair advantage because they can use their wealth to make more wealth then it makes sense to redistribute from the poor to the rich.

Why?

Well, if you give a rich guy $1000 then he is going to use his superior connections, education, prior wealth, and other unfair advantages to grow that $1000 into $10,0000 or eventually $100,000.

If you give it to the poor guy then basically the poor guy just has an extra thousand.

Even if you believe the trickle effect is very small, say 2%, then the poor guy is still better off when the rich get a $1000 than when he gets the grand. After all, eventually the rich will have $100,000 and if even 2% trickles down then that $2000 for the poor guy.


Whats the problem with this story?

Well, TCs logic rests on the fact that the returns to more money are constant for each group, however, the redistributionist believes that they are not constant at all.

In fact, the redistributionist is implicitly assuming that the returns to money are S-shaped and that this S creates a poverty trap. What the poor need is a Big Push to set them on the road to wealth.

On the accompanying graph one has to get beyond $100K or so in wealth before you can really enjoy the returns the rich do. The goal is to get everyone beyond the $100K point.

Now, I'm not arguing that the S-Shaped poverty trap theory is true but it is the logic behind redistribution.

Note: The point here isn't that $100K specifically is a special value. Its that there is some level which changes the game. If the poor are given some level of redistribution then new options are opened to them. That level could $100K it could be $30K.

Why Not Ad Hominem?

Byran asks why serious scholar eschew ad hominem augments.

First, I think that most ad hominem attacks are not in fact a logical fallacy. By ad hominem I mean attacking an opponent's character, qualifications, motives or experience rather than addressing the substance of her argument.

The logic doesn't go:

A is a bad person therefore A's argument is false.

It goes this way

1) Intelligent and well motivated people are usually correct

2) If A were intelligent and well motivated then this alone would be reason to believe her.

3) However, A is either unintelligent or ill motivated and thus there is no particular reason to believe her.

The underlying assumption is that I, the debater, cannot independently verify some of A's facts. Therefore, A's competence and trustworthiness become important inputs to the debate.

However, a serious scholar will never admit that he or she cannot independently verify the facts. Thus, he avoids ad hominem arguments. To engage in them would draw into question his expertise.

Bryan would know this if he weren't such a jerk ;)