Equitable and Efficient Redistribution

Before there can be redistribution, there must be distribution, and if the initial distribution is unfair - and it's hard to argue that, for example, financial executives were paid their marginal products over the last decade instead of being paid inflated, bubble based incomes - then there's no reason to suppose that redistribution necessarily makes us worse off.

If we accept that being paid the value of your marginal product is fair - and not everyone would agree that it is - but if we do take this as our standard, then we need competitive markets to assure that wages are held to this level. Without the discipline of competition to regulate the marketplace, profits, and hence the income of those at the top of the income distribution, will be larger than can be justified by the contribution those individuals make to output. If that is the case, if markets are not ideal and there are significant departures from pure competition, then redistribution can improve the outcome in terms of providing the correct incentives in the marketplace. Redistribution is not necessarily harmful (that is why, for example, modern macromodels with monopolistically competitive agents often assume that the government imposes a set of lump-sum taxes and transfers to correct any distortions arising from the presence of pricing power).

The point is that those who argue against redistribution are implicitly assuming that markets are competitive and that people are paid accordingly. Thus, any interference is a distortion. But if that is not how a typical market functions, and I'm not convinced earnings at the top end of the income distribution are set in anything approaching a perfectly competitive marketplace, then interference can take away distortions rather than create them.

If people want to make the argument that incomes at the top are, in fact, equal to the contributions these individuals make to output at the margin, then they should make this argument explicit. Tell us why you believe this is true. But I suspect that a lot of the people who would be tempted to do so are the same individuals who were, not too long ago, arguing that financial executives were paid according to their contributions at the margin. They may still want to make that argument, but I think it's pretty clear the incomes these individuals earned were excessive, and that redistributing part of it would not have created bad incentives. In fact, it's easy to see how redistributing the excessive gains might have helped to temper the recent mania and improved the economic outcome.

Comments

[quantum_flux]

I was considering a system of redistribution. Redistribution acts as seed money, and the net effect of shaking up or equalizing a healthy market should be the fair emergence of new competiters out of the chaotic transition. In this day and age of computers and information traveling across the world in split seconds, there are many brilliant ideas but not enough entreprenuers who have the means to try new things out. Take me for example, I'm dirt poor without a job but I've chosen to teach myself physics (The 3 volume series of "Richard Feynman's Lectures on Physics" and Penrose's "The Road to Reality") and I'm always researching everything from math to science to engineering to inventions online, it is my passion and obsession. My mere screensavor is chalk full of brilliant solutions and I use them as note-cards, my mind is always being inspired with brilliant ideas on a constant basis, I can't stop coming up with solutions.

Now, just imagine what I could do if I had money (not small wage money like I was making when I worked at home depot and took the product knowledge for every department in the whole store, but real money that I can actually afford to buy my own Chinese machine shop and manufacturing facility with). A redistribution of the wealth is just asking for people like myself to take over the entire world....it would give me seed money so I can put theory into practice!

[quantum_flux]

Other than that, I'm banking on my own work ethic and wise small-time investing.

[Too Much Fed]

Possible scenario:

6 billion people, 4 billion want jobs, only 3 billion jobs

greenspan, bernanke, paulson, other central bankers, and high-end bankers want to exploit this oversupplied labor maket for their own personal and ideological gains (as in to produce MORE AND MORE DEBT to enrich themselves).

What about raising jobs, raising wages, forcing people who do NOT need any more income to retire, and let interest rates rise???

[lonesome moderate]

"it's hard to argue that, for example, financial executives were paid their marginal products over the last decade instead of being paid inflated, bubble based incomes"

Mark, might there be an editing error here? I was a little confused by this.

[Gegner]

Hmmn, I'm with Lonesome in that you appear to be addressing two separate topics, taxes and income.

Unless your attempting to attack in the middle and this is a thread on redistribution of executive compensation?

(A novel concept all by itself.)

FDR's high marginal tax rate did indeed 'redistribute' income very effectively. CEO's during those years chose to compensate their workforce better rather than hand it over to the government.

It could even be argued that reducing the capital gains tax on income derived from securities lead the way towards CEO's/top executives favoring being paid in stock...and all the resultant 'fancy bookkeeping' that followed.

[a]

"Thus, any interference is a distortion."

Just to point out that, even if it were a distortion, then there are still good and right reasons to do it.

[hari]

The worst distortion is linking *redistribution* with European style *socialism*. What does that really mean - in economic terms and conditions? There are no *socialist* countries in Europe today.

In a *social market economy*, the benefits far and wide decides how people vote their preferences. In other words, overwhelming support by the European electorate, as represented in European Parliament, gurantees EU governance based on fundamentals of social market economy and its inherent social safety net.

Whether US follows EU or not, current trend in economic disparity between social classes will more or less lead Americans to consider adopting some of the more acceptable features of EU social capitalism, me thinks.

[Redistribution via Inflation]

Consider how inflation has been regressively redistributing resources in our country. The effect is so pronounced in the case of the middle class that it has overwhelmed the progressive redistribution of the income tax. This effect should not be ignored, or assumed to be nil. The middle class standard of living has been falling ever since the high inflation period. Eliminating COLA from wages and private sector pensions eliminated wage price spirals, but it also steadily reduced the middle class standard of living. Private sector retirees were especially adversely affected.

[ken melvin]

They should consider paying people to consume.

[Redistribution via Inflation]

Just letting the general consumer keep their purchasing power would help (eliminating inflation). Steadily reducing the purchasing power of consumers, and then expecting them to keep consuming at the same pace makes no sense. Attempting to make up for the lost consumer purchasing power with ever increasing debt creates a future credit crises.

Let prices fall when technology improves productivity, and consumers will gain purchasing power (they will be able to buy more). Use a progressive income tax to build up a fund to smooth out the cycles via public spending, and to subsidize favorable terms for small business start up loans.

[robertdfeinman]

Two points:

1. Those claiming Obama is promoting "socialism" are desperate GOP flacks watching the ship go down and using any smears that come to hand. Those parroting these claims (and I've jousted with a considerable number of them lately) are useful idiots who don't even know the mean of the term. The essay on Wealth Distribution (written in 2005) on my web site is now the most popular one and has been for the past six weeks.

The useful idiots think that they have a chance of becoming Bill Gates and those don't want to see their vast wealth limited (once they get it). This is the same crowd that opposes the estate tax for similar irrational reasons. Horatio Alger is alive and well in the American Psyche.

2. The reason for excessive compensation for top executives in the financial and other industries is because the power structure in business in totally undemocratic. The most obvious example is the CEO who picks the board of directors, which then awards him a compensation package. The nominal owners, the stockholders, have no say, even when they are able to vote.

You can regard this as a market failure, but I prefer to see it as a governance failure. For-profit and non-profit firms have self perpetuating directors and are thus accountable to no one. The cure is to force such entities to have meaningful management control with input from all parties: stockholders, customers, suppliers, employees and the public.

Some places, like Germany, have explicit laws which require labor representation on the boards of big firms and this has served to keep the most outrageous types of behavior from happening. Once again it is the American myth of the untrammeled "rights" of the individual which allows for these sorts of distortions.

I don't think laws governing the amounts or types of compensation explicitly would work, it would just give lawyers and accountants more money finding loopholes. I do think changing the governance rules (such as requiring elections to the boards of directors be contested with a mechanism for outsiders to be nominated) could work. Let those who now would have influence on governance set the rules as they see fit.

[ken melvin]

RDF - 5 -6 years ago we learned that 'twas the pressure from mutuals that lead to 'Chainsaw Als'. Some are old enough to remember the late seventies and early eighties and the weeding out of industries that couldn't return 13% a la the Apples, AMDs, Intels, Genentechs, ... and, in those days, no one would even consider investing in utilities with their piddlings. There's a connection to the expectation of getting rich off 8% and greater returns to ever increasing rents and disparity, methinks. We can't forever grow our way out. We can't conserve and continue to populate at the going.

[ken melvin]

In re the downsizing, ten years ago and more.

[Larry]

"Before there can be redistribution, there must be distribution, and if the initial distribution is unfair - and it's hard to argue that, for example, financial executives were paid their marginal products over the last decade instead of being paid inflated, bubble based incomes - then there's no reason to suppose that redistribution necessarily makes us worse off."

If you ignore the effects on expectations and incentives that might be true. For better or worse, the US economy has benefited greatly from the efforts of people who worked at "insane" levels assuming that the returns would be worth it. If they come to believe that their gains will be simply be "redistributed", will they continue to do so? Siemens is a great company, but would we trade Intel for it? Microsoft for SAP?

"If we accept that being paid the value of your marginal product is fair - and not everyone would agree that it is - but if we do take this as our standard, then we need competitive markets to assure that wages are held to this level."

If you live by that rule you have to die by it and accept extraordinary incomes for extraordinary contributions.

"Without the discipline of competition to regulate the marketplace, profits, and hence the income of those at the top of the income distribution, will be larger than can be justified by the contribution those individuals make to output."

Which markets did not feature such competition? In finance, performance was measured minutely and incomes flowed therefrom. The error wasn't lack of competition, it was that players could win by profiting from good calls and not losing from bad calls.

"if markets are not ideal"

Markets are certainly not ideal. The question is whether their outcomes can be improved by redistributors. Redistributors must show how their adjustments improve the situation, not as measured by the Gini coefficient, but by improving the match of marginal product and incomes.

"If people want to make the argument that incomes at the top are, in fact, equal to the contributions these individuals make to output at the margin, then they should make this argument explicit."

It is clear that they are not equal. Markets have an error rate >0. I remain skeptical that redistributions are committed to reducing the error rate, rather simply desiring an outcome that matches their predispositions. Let redistributionists demonstrate otherwise.

"I think it's pretty clear the incomes these individuals earned were excessive"

I think that their comp plans had flaws, which like every other part of our economic system, were underlain by the notion that risk distributions had no tails to wag. We can already see that markets are plugging that leak.

[anne]

Mark Thoma, nicely done:

http://www.portfolio.com/views/blogs/odd-numbers/2008/09/26/financial-sector-employees-are-overpaid

September 26, 2008

Financial Sector Employees Are Overpaid
By Zubin Jelveh

In a recent paper, * New York University's Thomas Philippon estimated the size of the financial sector. The model he used was surprisingly accurate from 1920's through the 1990's. But as this chart from his paper shows, something happened in the late 1990's that threw off the model:

[Income share financials]

Here are Philippon's possible explanations for the discrepancy:

"Up to the 1990s, the model seems able to predict most of the changes in the size of the financial sector. The model falls short in the more recent decade. Since the model forces all the demand for financial services to come from domestic firms, the discrepancy could reflect the globalization of the finance industry. There could also be an increase in financial services provided to U.S. households. Alternatively, it could be that the financial sector is too large and should be reduced."

In another new paper ** (this one is more preliminary than the first), Philippon and University of Virginia's Ariell Reshef try to explain why bankers, traders, and other financial sector employees get paid so much.

It first turns out that these workers didn't always used to be so richly rewarded:

"From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and it wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward, another shift occurred. The financial sector became a high-skill high-wage industry again. Even more strikingly, relative wages and relative education relative to the private sector went back almost exactly to their levels of the 1930s."

What accounted for much of this change? Deregulation of course.

"We find a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial industry in the wake of the depression era regulations, and started flowing back precisely when these regulations were removed."

During the recent surge in wages for financial sector workers, Philippon and Ariell find that technology played a relatively small part in explaining higher pay:

"Computers and information technology also played a role, but, contrary to common wisdom, they cannot account for the overall picture for the simply because the financial industry of the late 1920s looked remarkably like the one of the late 1990s."

The researchers also looked into the role of risk: finance sector employees are more likely to lose their jobs than average. How much does that account for the rise in pay? About six percent of it.

The duo next create a model of finance sector wages and come to a very interesting conclusion:

"We find that in 1920-1940 and in 1990-2005 employees in finance are overpaid."

Why is this the case? Some economists have argued that the flow of highly-skilled workers into fields like law and finance may not be desirable because even though the private returns are higher in these jobs (i.e. they pay more), social returns in some other less-well-paying jobs are higher.

Here is a chart showing the predicted and actual wages in the financial sector:

[Overpaid]

It implies that workers in finance are overpaid by 40 percent.

* http://pages.stern.nyu.edu/%7Etphilipp/papers/finsize.pdf

** http://isites.harvard.edu/fs/docs/icb.topic440347.files/pr_rev4_a1.pdf

[Larry]

@hari - "Whether US follows EU or not"

I expect Obamaworld to resemble Europe far more than Bushland does today. I'm not happy about it.

@Redi - "The middle class standard of living has been falling ever since the high inflation period."

Don't forget that a significant part of that change has been a shift of resources to health care and supporting retirees. We'd have a lot more of the stuff that we consider "living standard" if those shifts had not taken place. Instead of "infrastructure", we're spending on "oldfrastructure" and "healthfrastructure".

@robertdfeinman - "useful idiots"

Those people are the reason that small business formation and small business employment in the US remain so high. I suppose we could live without that...

"the power structure in business in totally undemocratic"

Isn't the solution to make boards more accountable rather than to shift to the German model?

"loopholes"

Isn't that, i.e., regulatory/political capture, a fundamental flaw with government generally? It seems to be very difficult to come up with productive regulations beyond basic health and safety. Our economy, and the world economy has become so dynamic and fluid that it doesn't seem like regulators have a chance. See, e.g., Sarbanes/Oxley, which was the most dramatic expansion of regulations in decades, and completely failed to fix the problems from which we now suffer.

[robertdfeinman]

Larry, the only problem with the various European models seems to be that the rich don't get rich enough. You can't expect the plutocrats in the US to come right out and say that so they have devised a number of misdirections to cover their true motives.

Among these are the Horatio Alger myth, the idea that Americans are exceptional people and deserve to consume more than an equitable share of the world's resources, that individualism and small businesses can only thrive without regulation, that a progressive tax system stifles innovation and that the wealthy deserve all the money they have accumulated (even though the majority of them got it through inheritance).

The fact that various European countries provide better social services, have less poverty, live longer, etc. is swept under the rug because it undercuts all the myths the wealthy like to promote. Under what rational system can someone defend the Walton family being worth $100 billion?

Conservatives find that when reality provides inconvenient truths the best thing is to either ignore them or deny them. The useful idiots I keep referring to are the ones that swallow the propaganda even though it hurts their own interests.

Which would you rather have your earnings increase by 10-20% because of better wage distribution within firms, or the possibility that your heirs might have to pay 45% on your estate if you happen to end up being worth more than $5 million when you die? What is the probability that the average person will have an estate of this size?

See this site if you want the answer to that question:
http://www.demos.org/inequality/numbers.cfm

[Larry]

@Robert - "the only problem with the various European models seems to be that the rich don't get rich enough."

Is that what explains the ongoing brain drain westward? One of the keys to Europe's success has been its free-ride on US defense and research policies. If we become Europe, those subsidies end. We're buying a future based on a falsely pretty picture. But all our arguments are about to be tested in practice. We'll learn a lot in the next few years.

"the Horatio Alger myth"

It's a fiction, but a useful one with immensely positive impact and one that you mischaracterize.

"the idea that Americans are exceptional people"

We are and we welcome exceptional people from all over the world and they know it and keep on coming.

"deserve to consume more than an equitable share of the world's resources"

I don't buy that, but let's face it, Europe is doing much the same.

"individualism and small businesses can only thrive without regulation"

Definitely not part of the myth. Sensible regulation is welcome (starting with property rights.)

"a progressive tax system stifles innovation"

There are many ways to run a progressive tax system without stifling innovation. We just don't happen to use one. Even VAT would be less stifling than what we will soon have.

"the majority of them got it through inheritance"

Not so. Take a look at the Forbes 400. In America, fortunes often do not last. BTW, I think that's a good thing. Silver spoons are bad for mouths. There are better and worse ways to encourage that kind of turnover.

"various European countries provide better social services, have less poverty, live longer"

If all this is true, why have they been shifting towards US-style openness and opportunity. Lowering corporate tax rates, liberalizing employment law, etc. Europe's demographics are going to hit their economies very hard very soon. The solution for their very high youth unemployment rates seems to be...fewer youths. But then who pays for all the goodies? Even with our troubles, I think we're better positioned.

"Conservatives find that when reality provides inconvenient truths the best thing is to either ignore them or deny them."

I fear that confirmation bias is part of the human condition, and not limited to conservatives.

"Which would you rather have your earnings increase by 10-20% because of better wage distribution within firms, or the possibility that your heirs might have to pay 45% on your estate if you happen to end up being worth more than $5 million when you die?"

I'm afraid your math is very flawed. The fraction of people who make the big bucks is very very small. Of course, I'd rather make more money. But if I thought I was taking it out of somebody else's pocket under penalty of law, I would feel like a thief. But that's just me.

[Jack]

We should forget about "marginal productivity" as it's probably a myth anyway and just try through political engineering to create and enviroment in which high wages are a constant, more or less fixed cost. Businesses that flourish in such an environment will be highly productive, efficient, and technologically advanced. This is the exactly what we want, but in order to get it we have to abandon much of current economic theory which lends such a sympathetic ear to businesses who constantly whine about having to innovate in order to stay competitive and would rather cut wages and benefits to preserve profit margins. This strategy is leading to the worst of all possible worlds and is currently destroying the middle class, but in order to counter this trend we would need strong unions, social pressure against business greed, and an aggressive full employment policy. And, of course, the economist's view is that all of this should never be done becuase inflation is always and everywhere a monetary phenomenon necessitating a tight money policy, and also government bad(!!!), giving Heideggerian intellectual cover to policies which are causing this country to become, as said elsewhere, a third world nation with nukes. Good job, idiots.

[ken melvin]

How different arguing with a platitude and arguing with a fence post?

[Paul]

Mark,

Ok, so redistribution could actually correct market distortions. I'll buy that. Now what is your actual plan for doing this redistribution? Does your mechanism require that people have knowledge that, had it been known, would have prevented the market distortions in the first place? Does it suffer from a tendency for actors involved in its implementation to strategically misrepresent themselves or act in a way that fails to serve the public interest, etc? You should not assume that some extra-market mechanism will have godlike powers.

Now, perhaps you aren't assuming this, and you are just arguing that *in principle* redistribution could be more efficient. But I think it is intellectually dishonest to mention this without saying anything about the difficulties of implementing any system capable of correcting for these inefficiencies. Undoubtedly, some people are going to use arguments like yours to justify some half-baked market intervention that, when implemented in the real world by real people, actually makes things considerably worse.

[Acton.]

Speaking of inflated incomes, why only the top execs? Isn't it possible that the other quintiles' incomes are also inflated? If redistribution should be "correcting", then in turn every other quintile should give up their corresponding gain.

Of course, you'll also have to find a government that can omniciently redistribute to efficient market levels...

[Patricia Shannon]

Larry,
Those Forbes figures on backgrounds of the rich leave out relevant facts, like having financial backing from relatives. I don't have time to look it up right now, because I have to get home and get to bed, because I'm going to be a poll watcher tomorrow, and have to be there at 6:30am. Viva democracy!

I have a reference on my own blog to a study that corrected some of those Forbes factoids..

[Patricia Shannon]

I got the reference to the study on the fallacies of the Forbes 400 fairy tale from this blog, so maybe someone can find it here.

[Fred Thompson]

If one looks at the combined tax and transfer programs of the two presidential candidates, one finds that both propose massive net transfers from government to just about everyone. The main difference is that Obama wants to claw back from high earners about half of his giveaways. That is probably a good thing, but one should bear in mind that the overwhelming majority of wage earners in the top percentile of the population are not Fortune 500 CEOs, hedge fund managers, or sports stars. Most are 'small' business proprietors, doctors, lawyers, etc.

[Patricia Shannon]

Larry, at what age or under what conditions do you plan to commit suicide to spare other taxpayers from having to help you?

[Patricia Shannon]

http://www.lcurve.org/

If we divided the income of the US into thirds, we find that the top ten percent of the population gets a third, the next thirty percent gets another third, and the bottom sixty percent get the last third. If we divide the wealth of the US into thirds, we find that the top one percent own a third, the next nine percent own another third, and the bottom ninety percent claim the rest. (Actually, these percentages, true a decade ago, are now out of date. The top one percent are now estimated to own between forty and fifty percent of the nation's wealth, more than the combined wealth of the bottom 95%.)

http://www.lcurve.org/images/LCurveFlier2003.pdf

Picture your annual income as a stack of $100 bills.
Do you make $25,000? Your stack of $100 bills is 1 inch high.
Do you make $100,000? Your stack of $100 bills is 4 inches high.
Do you make $1 million? Your stack of $100 bills is 3.3 feet high.
Do you make $1 billion? Your stack of $100 bills is over ½ mile high!

[Larry]

@Patricia - Always so extreme. Pension plans, public and private, can be structured fairly to eliminate the need for senior suicides.

Some among the poor are truly incapable of caring for themselves, and I support helping them. But as we saw with Clinton/Gingrich welfare reform, many people who have convinced themselves and others that they are helpless are not. I don't think we've become too harsh since then.

The most important thing to do is to reform the psychotic culture which has convinced itself that academic education is for geeks only (among many other fallacies). If only geeks are willing to be educated, only educated geeks will make a good living.

We know from the Flynn effect that IQs are rising across the board in the US, and probably everywhere. Yet US education levels stopped rising 30 years ago. Don't tell me that isn't a big part of our problem.

[Patricia Shannon]

Larry, you were the one who blamed all our financial problems on the poor and sick.

[Patricia Shannon]

That should have been
Larry, you were the one who blamed all our financial problems on the old and sick.

[Patricia Shannon]

I found the reference to the Forbes 400
http://economistsview.typepad.com/economistsview/2007/10/reich-the-logic.html

http://www.faireconomy.org/press_room/1997/born_on_third_base_sources_of_wealth_of_1997_forbes_400

Forbes Magazine likes to herald its reports on the wealthiest Americans as demonstrating the realization of the American dream: that one can go from rags to riches. For Forbes, the Horatio Alger story is the true story of America.

But careful identification of how Forbes' centi-millionaires and billionaires attained their wealth tells a different account of the plebeian origins of the richest Americans. Half of those on the Forbes 400 list started their economic careers by inheriting businesses or substantial wealth. Of these, most inherited sufficient wealth to put them immediately into Forbes' heaven. Only three out of ten on the Forbes list can be regarded as self-starters whose parents did not have great wealth or own a business with more than a few employees.

[baileyman]

Isn't the question how much slope should the income schedule have? I mean, does a highly motivate individual need 400 times median wage to stay motivated, or is 2 times enough?

[X Man]

Let's talk multipliers--if the poorest 20 percent of the population have an extra couple thousand a year, they will certainly spend it. This generates a considerable amount of demand... causing the economy to expand...

If the richest 2 percent have a couple extra million a year, they will likely save/invest it, which is great, unless you have a situation like today, where there's no demand, in which it's not so great.

In other words, here come the demand-siders.

[Larry]

@Patricia - I don't "blame all our financial problems on the poor and the sick". I blame them on the braindead "solutions" to these very real human problems.

"Only three out of ten on the Forbes list can be regarded as self-starters whose parents did not have great wealth or own a business with more than a few employees."

Only 3 out of 10? That hardly indicates stagnation. And how many of the rest built successfully on what they started with rather than clipping coupons?

[Fred Thompson]

Patricia: you wrote: "If we divide the wealth of the US into thirds, we find that the top one percent own a third, the next nine percent own another third, and the bottom ninety percent claim the rest. Actually, these percentages, true a decade ago, are now out of date. The top one percent are now estimated to own between forty and fifty percent of the nation's wealth, more than the combined wealth of the bottom 95%."

That is not what the Luxembourg Wealth Study reports so far. What is your source? The site referenced is all assertion, no data.

Sierminska, Eva, Brandolini, Andrea and Smeeding, Timothy M.,Comparing Distribution Across Rich Countries: First Results from the Luxembourg Wealth Study (August 2006).
Available at SSRN: http://ssrn.com/abstract=927402