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Fixing Income Inequality

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Solutions From the World's Last Fundamentalist Progressive Libertarian

It's clear that somehow we've developed an economy in America that is prone to concentration of income and wealth among corporations and the rich.   Objective measures show that the rich are getting richer, the middle class is losing ground, and poor people are doing worse.   This is the biggest issue facing the US economy today.   Furthermore, this concentration results from public policies that have become so much a part of American institutions that they are taken for granted by citizens resigned to a status quo they have always known.

Poor people are a problem, and they are not going away just because we ignore them.   Most progressive economic talking points focus upon poverty in one way or another.   These include a statutory minimum wage and safety-net programs like welfare, food stamps, unemployment compensation, Medicare, Medicaid, and even key features of the ACA.   A little further afield, but still closely related, are efforts to provide equal opportunity for women and minorities, and to promote education for all citizens, especially the poor and disadvantaged.

Some of these programs have been successful, and all have done some good for some people.   The statutory minimum wage is among the more successful.   Even today, an increased minimum wage would benefit the majority of low-wage workers, would provide a boost for the Social Security trust fund, and would even contribute to a more balanced federal budget.   So in the absence of more fundamental solutions, I favor an increase in, and future indexing of, the statutory minimum wage.   Any program that benefits women, minorities, and the working poor can't be all bad, and would move us ever so slightly toward a less skewed concentration of income in America.

All good and well, but the fundamentals of the US economy are deeply flawed, and have never been effectively addressed by progressives.   Some people believe that a capitalistic, free-market economy necessarily brings with it an intrinsic tendency to concentrate wealth and therefore must be fine-tuned with regulation and encumbered with liberal or progressive programs to equalize for the natural tendency of a market economy.   And today we have a system that reflects this notion.   In such a system, it is indeed necessary to institutionalize safety-net programs, statutory minimum-wage requirements, and extensive systems of regulation to address the power of corporations.   These I consider to be flawed progressive solutions, and we can do better.

Labor Market Supply and Demand - Theoretical
(image by Larry Butler)
     First, let's examine what a free-labor market would look like from a microeconomics perspective.   Take a look at the first graph.   It illustrates the patterns of supply and demand at different intersections of price and quantity.   At a single point, supply and demand intersect with each other in equilibrium.   This illustrates the assumption that a free-labor market exists in America, and it is a fallacy.   But it makes a good starting point for understanding the economic problems in the labor market today.   A lot of conditions keep free-labor markets from being a reality, but I'll present two solutions that are clearly in the realm of public policy, and show one enormous benefit that would result from the restoration of a more balanced and free market.

Solution #1:   Stop subsidizing capital

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The concentration of income and wealth we see around us was not an accident; it was the planned consequence of public policies promoted by wealth and business from the beginning.   You may have your own list, but here are examples from mine.   Federal land grants to settlers, ranchers, and railroads over the past 200 years have favored commercial interests over mostly Native American poor people.   Income-tax policy grants subsidies on income derived from capital investment at the expense of income derived from labor.   Federal, state, and local governments have lent their forces to the direct support of management at the expense of labor at times of conflict.   A private, for-profit, contract-prison industry has grown up among us at the expense of taxpayers and citizens.   The US military protects the interests of American multinational corporations all over the globe, at a public cost of several hundred billions of dollars.   Monetary policy subsidizes banks and other lenders by infusing them with cheap money at the expense of fixed-income investors and retirees.   Foreign humanitarian and military aid subsidizes domestic agribusiness and arms manufacturers, at the expense of taxpayers.   Income-tax policy favors the banking, construction, and real estate industries by subsidizing the cost of home ownership at the expense of other taxpayers.   Corporations are accorded the power to finance and influence elections and the formation of public policy in an increasing range of ways, at the expense of individuals' exercise of power at the ballot box.

Concentrating wealth concentrates power, and that power is exercised by employers to maximize profits.   Reducing labor costs is a key goal of profit maximization, and can be achieved in several ways.   Paying as little as possible is a valid strategy, of course, especially in a free-labor market.   Minimum-wage employers pay a minimum wage because they can, not because they cannot afford to do otherwise.   In the absence of free and balanced labor markets, it becomes necessary to apply the progressive remedy of reasonable minimum wages to offset the power of the employer, and to protect those who fall into unemployment when they are laid off.   Centuries of subsidies for capital and business have empowered management with enormous resources at the expense of labor.

This principle is evident in the favorable treatment of investment capital.   Capital is obtained through the sale of equity, through borrowing, or from accumulated profits.   Equity capital is subsidized by tax limits on capital gains and qualified dividends; borrowing is subsidized by monetary policy and tax policy; and retained earnings are subsidized by an array of profit-friendly laws and regulation.   Once capital is ready to deploy within the business enterprise, additional subsidies are available.   These include everything from investment tax credits to accelerated depreciation allowance to enterprise-zone incentives.   In America we have come to adopt business investment as a national value, but I believe this is misguided; business corporations have proven to be perfectly capable taking care of themselves and making their investments pay off.

Voluntary business investment is directed toward one or more of the following goals:   (1) to produce something innovative that didn't exist before; (2) to expand productive capacity; and/or (3) to increase labor efficiency.   Only the first is likely to generate incremental employment.   Expanding capacity often cannibalizes competitors' operations and is usually more labor efficient than the operations it replaces.   Investments in labor efficiency by their nature reduce labor demand per unit of output.   Please understand that none of these things is bad; only the financial subsidies and incentives found in our public policies are bad.   And they are very bad, because capital investment is a substitute for labor employment, which is a true commodity at the low end, and is not generally subsidized.   This is one of the things that keeps the labor market in America from being a free market.


Labor Market With Capital Subsidies
(image by Larry Butler)
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Now take a look at the second graph.   This one illustrates the pattern of supply and demand when it has been altered by capital subsidies.   Capital investment tends to reduce aggregate labor demand because of the efficiencies introduced by such projects as process automation and capacity scaling.   Reduced labor demand affects the equilibrium point by reducing both the price of labor and the quantity in demand.   In effect, reduced wages and unemployment are directly caused by capital-investment subsidies.   And the simple, obvious, and inescapable solution is to stop subsidizing capital investment!

Solution #2:   Stop taxing labor

A look at the federal budget for a typical year shows that 40%-45% is funded by personal-income taxes, another 40%-45% is funded by payroll taxes, and the balance is funded by corporate-income taxes, ad valorem levies, and borrowing.   This mix of revenue harms the economy and damages the labor market beyond all recognition.

The miasma of penalties and incentives in the income-tax system is criminal.   Many are designed to affect the decisions we make, ranging from marriage and family through buying or renting our home, to political action and charitable donations.   To the extent that these provisions influence our decisions, they diminish our personal freedom.   And each feature of this cruel system generates its own winners and losers, eroding the efficiencies of free markets, adding friction with each complicating provision.   Worse, federal income taxes are lower on income from capital than on income from labor, due to favorable treatment of capital gains, qualified dividends, and even interest on certain classes of investments.

As bad as the income-tax system is, payroll taxes are even worse.   In a free market, the supply and demand of a commodity finds its equilibrium at a particular price and quantity, as shown in the first graph.   But there's no free market here.   Adding a tax to a commodity raises the price to a point along the demand curve that corresponds to a reduced quantity consumed.   Labor, especially the undifferentiated low-wage services, is indeed a commodity, and currently costs employers a federally-mandated premium of 13.85% for all lower-wage employees.


Labor Market With Tax On Labor
(image by Larry Butler)

Now take a look at the third graph.   This one illustrates the impact of payroll taxes on labor-market dynamics.   Adding a payroll tax raises the price and shifts utilization horizontally toward the origin of the graph.   This directly causes an increase in unemployment and underemployment as marginal employers fail and others seek substitutes for labor employment.   These substitutes include capital investment directed toward increasing labor efficiency, and outsourcing the production of goods and services to markets that are more favorable.   Some employers may seek to offset increased costs with direct reductions in pay or benefits wherever possible.

Of course, this was implemented about eighty years ago, and the labor market long ago found its revised equilibrium.   We should expect to find widespread structural unemployment and underemployment as a result of this policy, and our observations today are consistent with this expectation.   Years ago, when withholding rates were much lower, frictional unemployment was thought to be around 3%, and was caused by the mobility and seasonality of the workforce.   Today, structural unemployment estimates are much higher, and recognize that there are about three unemployed people for each job opening in the economy.   The causes are complex, but the taxation of labor is an obvious and major contributing factor.

Employers benefit from increased levels of unemployment in obvious ways.   First, access to a ready supply of labor ensures that corporations can select from a large pool of candidates for any job opening.   And an increased labor supply will tend to reduce the unit cost of labor to lower levels, thus recovering much of the price penalty that resulted from the original labor tax.   It's a win-win for corporations, at the expense of the labor sector, and ultimately the middle class.   All because government programs are funded from a universal tax on labor.

There are alternatives.   If we agree that government revenues must come largely from taxes, we need only to determine which taxes are least harmful to the economy.

Look again at the very first graph that shows supply and demand.   This familiar model only applies to commodities -- something of value that is interchangeable with others of the same type.   Production inputs like cotton, steel, and water are commodity goods, and so is undifferentiated labor.   Changing the price of a commodity will affect the quantity used.   Taxing a commodity will reduce its consumption in the market, and subsidizing a commodity with increase its consumption in the market.   Either strategy, when incorporated into public policy, is unwise in a free-market economy and is likely to produce unintended consequences.   A much less disruptive strategy would be to generate tax revenue from that which does not operate as a commodity in a free market.

Before European economies took shape many centuries ago, landowners enjoyed everything they wanted at the expense of their own captive labor force.   With greater agricultural productivity came surpluses beyond current consumption needs, and with these surpluses came trade.   Kings and princes got a piece of the action with levies upon this trade.   The age of mercantilism pumped up this concept as the monarch took a portion of the proceeds from an increasingly lucrative trade, as well as requiring tribute from lesser landed nobles.   In each case, taxes were generated by trade surpluses or land wealth rather than current consumption.   But here in the New World, colonists revolted when taxes were levied on items of consumption, such as tea.

Economic market theory and the historical record both guide us to the same strategy in raising revenues for government:   tax income and wealth rather than marketed commodities.   Neither income nor wealth is a commodity, and when taxed do not cause changes in the shape of any markets.   Income is by definition that which is left over when all costs and expenses are deducted from revenues.   Wealth is by definition that which is left over when all liabilities are deducted from all assets.   Taxing income makes income no less desirable.   Taxing wealth makes wealth no less desirable.   Taxing either income or wealth disrupts no market and compromises no free-market economy.

But taxing labor causes unemployment, yet we have been doing this for decades.   And the simple, obvious, and inescapable solution is to stop taxing labor!

Now enjoy a more manageable US economy

Imagine for a moment that we could implement the two above-proposed solutions at the ballot box, and perhaps could even begin to erode the excess power presently vested in business and wealth institutions.   Simultaneously taxing labor and subsidizing capital over the long term has had a compounding effect, each reinforcing the negative economic impacts of the other.   If US public policy were to stop making both mistakes simultaneously, the positive effects would compound as well.   Before long, market dynamics would equalize the value of labor employment relative to capital investment.   Wages would tend to increase and unemployment would decline.   Much of the excess liquidity lodged in corporations and financial institutions would be freed up in the form of dividends and loans to flow through the economy.

Such an economy would be much more responsive to Keynsian fiscal management, which balances the federal budget at a defined level of full employment, banks a surplus when the economy overheats, and runs a deficit when the economy lags.   Full employment could be defined in terms of minimum frictional levels rather than a permanently underutilized workforce.   A marginal fiscal spending increase triggered at, say 4% unemployment, would flow through an economy more likely to respond to stimulus with marginal employment rather than bubbles, outsourcing, and automation.   Conversely, a reduction in fiscal spending triggered by a return to, say 3% unemployment, would more effectively prevent cost-push inflation and pay down the national debt.

Today's monetary policy is likewise rendered largely ineffective by vast pools of liquidity among banks, corporations, and wealthy individuals.   Increases in money supply that are intended to stimulate real increases in economic activity instead only trigger commodity and stock-price bubbles.   With greater free-market participation by labor and the middle class, money flowing through the economy would not be trapped in these liquidity pools, and unemployment would take care of itself.   Monetary policy could focus on the health of the currency instead of the fragmented mission-impossible of managing unemployment as well.   Let the bankers be bankers!

If government allowed free markets to function within a framework of regulation designed to guarantee free choice rather than grant favors, good things would happen.   Enormous savings in the cost of safety-net programs would be realized as labor markets became energized.   Eliminating subsidies and penalties would reduce friction in markets for labor, materials, and even capital.

Such an environment would make our discussion about minimum wages far less relevant than it is today.


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Years ago I made a decision to commit to a life of business management. Kids do the dumbest things! After thirty five years as a small business consultant, CFO, and university educator specializing in quantitative business and economic (more...)

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