The trade-off between equality and efficiency mentioned in Sargent’s 2007 Berkelee commencement address generated a surprising amount of commentary online (surprising to me anyway). Much of the online posts were directed at dispelling the existence of this trade-off. Matt Yglesias described it as “one of the big myths of our time.” Noah Smith argued that there might be important opportunities to improve equality and efficiency. Several other commenters pointed out that nations with relatively high per capita GDP have relatively more equal income distributions and so on.
Instead of arguing these points one by one (and yes, they’re basically all either wrong or practically wrong), I thought that perhaps it would be more constructive to present a realistic policy option that might actually make an impact on income inequality in the U.S. I want to make clear at the outset that I am not necessarily endorsing this policy. I’m just presenting it as a device to make the trade-offs and policy options clear.
Before I begin, let me mention a few facts so we can appreciate the issue a bit.
The U.S. labor force is roughly 156 million people and the U.S. population is 314 million people.
U.S. Gross Domestic Product (GDP) is currently roughly $17.15 trillion though it should probably be higher. As most of you know, GDP is total annual income. If we divide by the population we get income per person or GDP per capita. U.S. per capita GDP is approximately $54,600. (If you didn’t know about the extent of income inequality in the U.S., for a family of four people you might expect a yearly pre-tax income of almost $220,000). Typical household income is nowhere close to this however. Median household income is only $52,000. (The median household is the household that would be exactly in the middle if I lined up all households from lowest income to highest income.) The reason for this discrepancy is that there are a small number of extremely wealthy households who get enormous incomes. To be fair, there are many households with only one person (singles) and this is comforting to an extent. Don’t fool yourself though. There are many, many households with 4, 5 or more people who take home a combined income that is well below $50,000 per year.
The minimum wage law under consideration (increasing the minimum wage from $7.25 to $10.10) would provide a transfer of $6,240 for every full time worker earning the current Federal minimum. Unfortunately, if you earn $10.10 or more, you won’t get anything from the minimum wage. If workers were evenly distributed between $7.25 and $10.10 then the average transfer would be $3,120. That still sounds like a lot, however there are only about 4 million workers (about 2 percent of the labor force) currently at or below the Federal minimum wage. Also, many of these people are teenagers working part-time and living in middle class households. Compare a teenager who works a minimum wage job flipping burgers with a worker who supports a family but earns $11.00 an hour as a waiter. The minimum wage will transfer money to the teenager even if she lives in a family that is fairly well off. The policy does nothing for the other worker. How many examples like this are there? Lots. About 30 percent of all workers earning the minimum wage are teenagers.
Suppose we wanted a policy that helped out a greater number of lower income Americans. Specifically, let’s target the bottom 1/3 of all income earners. Given the size of the U.S. labor force, this is approximately 50 million people. 50 million workers is a convenient figure. To transfer $1,000 to each of one million workers would require $1 billion. So, to afford an average transfer of $1,000 to the bottom 50 million workers, we would need $50 billion. The proposed minimum wage policy transfers about $3,000 to each worker at the lowest end of the income scale. If we wanted a policy that did essentially the same, we would need to come up with $150 billion dollars per year. We could have the policy phase-out gradually as most transfer programs do. The very lowest earners could get a transfer of $6,000 and the workers at the top end of the phase-out would get nothing.
How would we achieve this transfer? I would suggest a wage subsidy with an explicit negative tax withholding feature. If you get a job for $7 an hour, the government would subsidize the worker with by contributing roughly an extra $3 per hour and the wage subsidy would slowly phase-out. Eligibility for the wage subsidy would be dependent on household income to avoid paying teenagers and focus instead on low-income primary and secondary earners (a teenager earning $7 per hour but living in a household that earns $150,000 would not get the subsidy).
Unlike the minimum wage law, this law would phase-out at around $20.00 per hour rather than $10.10 – this policy helps a large number of working Americans (50 million workers rather than 4 million). Unlike the minimum wage, this policy encourages employment of low-income workers.
Now the bad news… Where do we get the $150 billion required to fund the program? Well one way of getting it would be a substantial tax increase on upper income Americans. This is not entirely implausible. The Piketty and Saez study shows that earners in the top 0.1 percent of the income distribution get roughly 10 percent of all income – roughly $1.7 trillion. If we could get an additional 10 percent of their income in tax revenue we would have enough for this program just by raising taxes on the top 1/1000 of the working population. Unfortunately, this is easier said than done and there are serious costs which would need to be carefully considered were we to take this path. Among these costs are, first (1), introducing a new top marginal tax 10 percent greater than the current maximum tax rate would not be enough. Much of this income is not taxed at the top marginal tax rate so the marginal rate would have to go up by more than 10 percent. [Note: currently, the top marginal tax rate is 39.6 percent. A 10 percentage point increase would make the top rate close to 50 percent (ouch).] Second (2), much of this income is capital income. Taxing capital income is not a very good idea since it compromises business expansion in the long run. Third (3), these households will take steps to shield their income from the additional taxes. Fourth (4), such a tax increase will reduce work for upper income Americans. Some working spouses will leave the labor force and stay at home. Some workers will retire early. Some businesses will shift operations overseas, etc. Fifth (5), there will be significant administrative and enforcement costs associated with the policy. These last costs could easily add another 10-20 percent to the overall cost of the program.
These costs (1-5) represent the tradeoff between efficiency and equity that Noah Smith, Paul Krugman and Matthew Yglesias want to de-emphasize (Yglesias seems to think they don’t exist). There are other options to getting this revenue. For instance, we could raise taxes on the top 1 percent rather than just the top .1 percent. We could cut spending in other areas, etc. In any case, this policy would require either cutbacks or heavy taxes or both to implement.
In many respects, this policy option is a lot like the Earned Income Tax Credit (EITC). The EITC requires a budget outlay of roughly $50 billion per year. The above proposal would differ in a couple of ways. First, the EITC is targeted to low income workers with children while the proposal outlined above would transfer to all low income workers regardless of family size. Second, the EITC is a smaller program. It is fairly generous to very low income workers with children but the phase-out occurs much faster.
Ignoring the problem of income inequality is not an option (that said, the minimum wage policy is one way of taking a passive stance to inequality to put off dealing with the problem directly). If we really want to make a noticeable dent in U.S. inequality, we will need to get aggressive and we will need to be prepared for policies with serious price tags. There are real costs to achieving a more equitable distribution of income. Exactly how costly, is up to us.