The Causes of Poverty (54): Lack of Trade Liberalization

I mentioned before that trade liberalization – the removal of trade barriers such as tariffs, subsidies and other distortions of international trade – is, on aggregate and in the medium term, a powerful mechanism for poverty reduction. I say “in the medium turn”, because some structural adjustment may be necessary, and “on aggregate” because some may lose while others gain.

The usual fears about trade liberalization – that it reduces government revenues necessary for redistribution, that it leads to labor competition, lower wages and higher unemployment rates, or that it raises prices in developing countries – are, in general and on aggregate, unfounded (an overview of the evidence is here). Of course, trade liberalization may cause local economic shocks, and there can be distributional effects: some people will benefit more than others, and some may even be worse of after liberalization, especially in the short term. But it’s the aggregate medium term effect on a country or an economy that counts.

This is similar to the positive effect of economic growth on poverty reduction:

The vast majority of the world’s poor live in the rural areas of these two countries [China and India]. Both countries achieved significant reductions in poverty during 1980–2000 when they grew rapidly. According to World Bank estimates, real GDP grew at an annual average rate of 10 percent in China and 6 percent in India during these two decades. No country in the world had as rapid growth as China, and fewer than ten countries exceeded the Indian growth rate. The effect on reduction in poverty in both countries was dramatic, entirely in keeping with the “Bhagwati hypothesis” of the early 1960’s that growth is a principal driver of poverty reduction. (source)

Not all of the poor will be automatically better of as a result of economic growth, and growth may widen income inequality or relative poverty while reducing absolute poverty. But on average and on aggregate, economic growth – like trade liberalization – reduces poverty. That’s not just a story of “trickle down” or “all boats rising on a rising tide”; economic growth also means that the government has more resources to fund welfare and redistribution. (Obviously, none of this implies that growth is always beneficial or that there isn’t room to make growth even more “pro-poor” than it already is).

Arguments in favor of trade liberalization

The interesting part of the argument is that the positive effect of trade liberalization on poverty reduction passes through enhanced economic growth: liberalization reduces poverty because it enhances growth.

[P]ractically no country that has been close to autarkic has managed to sustain a high growth performance over a sustained period. Furthermore, … if one classifies countries into globalizers and nonglobalizers by reference to their relative performance in raising the trade share in GNP during 1977–1997, the former group has shown higher growth rates… [T]he outward-orientation of the Far Eastern strategy … led to the Asian miracle. (source)

Free trade is one of the determinants of economic growth. Growth requires increased productivity, and that’s what free trade delivers. Free trade means more productivity because it means

  • more specialization
  • more use of comparative advantage
  • better access to technology and knowledge
  • better and cheaper intermediate goods (raw products etc.) and capital goods (machines etc.)
  • benefits of scale
  • and increased competition.

All these consequences of free trade have a positive effect on productivity and hence on growth. And that’s not just theory; there’s empirical proof. Reductions in trade barriers were almost always followed by significant increases in productivity (source).

And it’s not just productivity; trade liberalization has other effects as well. The removal of tariffs can reduces prices for consumers and hence reduce poverty. It’s often the case that goods consumed by poor people have a higher tariff tax than goods consumed by rich people:

In his research, [Edward Gresser, senior fellow and director of trade policy at the Progressive Policy Institute] found that the tariff rate on a cashmere sweater is 4 percent; the rate for one made of much cheaper acrylic is 32 percent. A silk brassiere has a tariff rate of less than 3 percent, but the rate on a polyester one is slightly less than 17 percent. The tariff rate on a snakeskin handbag is just over 5 percent but climbs to 16 percent for one made of canvas. Similar variations occur when it comes to household goods. Drinking glasses that cost more than $5 each have a tariff of 3 percent, while those that cost less than 30 cents each have a rate of 28.5 percent. A silk pillowcase has a rate of 4.5 percent; this goes up to nearly 15 percent for one made of polyester.

Overall, clothes and shoes contributed nearly $10 billion in tariff revenue in 2009, while higher-cost items including audiovisual equipment, computers and even cars added less than $2 billion. Gresser contends that the $10 billion is disproportionately borne by people who can’t afford to buy luxury goods. What’s more, when customers pay sales tax on these products, that amount is also higher than it would otherwise be thanks to the tariff that drives up the retail price. (source)

Hence, not only does free trade alleviate poverty, trade restrictions and protectionism actually aggravate poverty. Take also the example of restrictions on rice exports in rice-producing countries:

At first glance, this seems understandable, because a country may not wish to send valuable foodstuffs abroad in a time of need. Nonetheless, the longer-run incentives are counterproductive. (source)

When farmers can’t export, there’s little incentive for them to farm rice. Result: the shortages that were meant to be avoided.

Arguments against trade liberalization

However, we shouldn’t lose sight of the undisputed downsides of trade liberalization. The removal of subsidies can hurt certain producers and it can, especially in the short run, depress employment and wages in certain sectors. It can therefore reduce some people’s incomes and push them into poverty. Trade liberalization can destroy entire markets: it can force a country to abandon tomato production for example, because nonsubsidized local producers are no longer able to compete with increased import competition coming from countries with a comparative advantage. The local producers will lose their jobs and income. However, these same people may benefit in other areas: products which they consume may become cheaper. So, when assessing the impact of trade liberalization on poverty, one has to aggregate all the losses and gains in different areas, and that’s ultimately an empirical question that has to be investigated country by country. Overall, the evidence is that, on aggregate, the effect is probably positive.

There can be individual losers from liberalization, and even individual countries can lose: countries that depend on mineral resources, for example, can take the fast lane towards the resource curse when trade is liberalized. But it’s the global balance of poverty alleviation that determines the desirability and success of trade liberalization.

The claim that liberalization negatively affects government revenues because of decreasing income from tariff taxes, and hence diminishes the generosity of the welfare state, is also not well founded. First of all, liberalization also means reduced subsidies, which should improve governments’ fiscal situation. Secondly, trade volumes increase as tariffs are reduced, and hence the net effect of reducing tariffs doesn’t have to be falling revenues. And finally, even if revenues fall, the poor don’t necessarily have to suffer: it’s ultimately a political decision where to spend which types of government revenues. Priorities can change when revenues change.

Another possible disadvantage of free trade is a cultural one. The claim is that free trade means cultural imperialism: small cultures don’t have the resources to export their cultural products and risk being overwhelmed by, in particular, American culture. Hence, there may be a case for cultural protectionism, but this case doesn’t extrapolate to protectionism writ large.

Conclusion

Liberalization isn’t a magic bullet, neither for economic growth nor for poverty alleviation. Sustained growth and substantial long term poverty reduction require more than free trade. Conflict resolution, good governance, education etc. need to accompany liberalization. It’s no secret that we don’t yet fully understand all the determinants of growth and poverty reduction. The advantage of trade liberalization, compared to other possible pro-growth or pro-poor policies, is that it’s relatively easy to implement: it is – or should be – easier to abolish tariffs and other trade restrictions (especially if there’s an element of reciprocity in global negotiations) than to create a solid education system or a non-corrupt judiciary able to enforce market rules and property rights.

The evidence in favor of the pro-poor effects of trade liberalization is compelling, but we shouldn’t underestimate some measurement difficulties: the measurement of poverty, of trade liberalization and of the effect of the latter on the former is by definition imprecise. The concept of trade liberalization may also be too broad or too vague. And the specific outcomes of liberalization policies depend not only on the precise reforms being undertaken, but also on the context in which they are undertaken. The same measures will have different results in different economic environments. The extent of multilaterality also determines the effects.

Read more on the topic here and here. More posts in this series are here.

Income Inequality (25): And Economic (In)Efficiency

As I stated before, economic theory suggests that income inequality is a necessary price to pay for economic efficiency: unequal rewards incite those with talents, skill and perseverance to innovate and to be productive, so they can reap higher benefits. Ultimately, this serves the welfare of the whole of society (a process which is then caricatured in trickle down economics). The mirror image of this is reductions of inequality that take away incentives for doing well, and that therefore result in economic inefficiency and less prosperity for all.

Tyler Cowen has framed it like this:

Redistribution of wealth has some role in maintaining a stable democracy and preventing starvation. But the power of wealth redistribution to produce net value is quite limited. The power of wealth creation to produce net value is extraordinary … We should be putting our resources, including our advocacy and our intellectual resources, into wealth creation as much as we can. (source)

But is that really true? There is some evidence that reducing inequality through redistribution actually promotes wealth creation. What’s the mechanism? Sam Bowles claims to have identified one element of it:

Inequality breeds conflict, and conflict breeds wasted resources … [I]n a very unequal society, the people at the top have to spend a lot of time and energy keeping the lower classes obedient and productive. Inequality leads to an excess of what Bowles calls “guard labor”. (source)

More about that effect here and here. Other parts of the mechanism through which inequality impedes and equality promotes growth may be the following:

Poverty causes credit constraints. This stops the poor investing in businesses or education; the low aspirations caused by poverty can have the same effect. … Inequality can create the threat of redistribution which can blunt incentives to invest. Or it can lead to state interventions – such as the minimum wage – that harm wealth creation. … The backlash against wealth-creating processes such as globalization, offshoring and private equity in the UK and US are founded in the view that they create inequality. If we had better redistribution mechanisms (say, a basic income) such backlashes would be reduced, and the wealth creation process enhanced. (source)

That sounds persuasive and I want to see some evidence. In the meantime, it’s perhaps a bit glib to announce that “the power of wealth redistribution to produce net value is quite limited”.

The Causes of Wealth Inequality (14): Wage Stagnation at the Bottom of the Income Distribution

Income inequality has risen in many countries during the last decades, including the U.S. The causes of this evolution obviously differ from country to country, although some causes may be universal. If we focus on the U.S., one important cause is wage stagnation for middle class and poor families since the 1970s. This stagnation, combined with the fact that the incomes of the wealthy continued along their pre-1970s growth path, caused increasing income inequality. The 1970s are a clear turning point, as you can see here.

The decades before the 1970s were what has been called a time of “shared prosperity”. Maybe trickle down economics really did work back then. Since the 1970s, however, income gains went almost entirely to the very wealthy, without much of the gains trickling down.

If that is why inequality has increased, we still have to answer the question why lower wages have stagnated. Maybe the decline of the minimum wage has something to do with it.

The Causes of Wealth Inequality (13): Deliberate Policy?

Some say that the increase in income inequality in countries such as the U.S. has been the result of deliberate government policy. That’s quite an accusation. It’s not controversial to assume that tax policy under right wing governments tends to be less burdensome on the rich, and that social welfare policy under such governments tends to be more stingy. If you look at it like this, it’s not crazy to argue that right wing policies can aggravate income inequality. But it’s quite another thing to claim that right wing governments use these policies in order to deliberately aggravate income inequality. That accusation is incompatible with right wing ideology, which claims that the preferred policies also and ultimately help the poor (trickle down economics etc.), and that left wing policies supposedly favoring the poor are in fact self-destructive (unemployment benefits create labor disincentives, taxes create production disincentives, etc.). However, it’s possible that this ideology is just a smokescreen for anti-poor policies. But I guess that’s somewhat difficult to prove.

If we look at the tax rates, it’s true that the rates for the wealthy tend to go down under Republican presidents:

In 1979, the effective tax rate on the top 0.01 percent (i.e., rich people) was 42.9 percent. … By Reagan’s last year in office it was 32.2 percent. (source)

However, things aren’t as simple as that:

From 1989 to 2005, … as income inequality continued to climb, the effective tax rate on the top 0.01 percent largely held steady; in most years it remained in the low 30s, surging to 41 during Clinton’s first term but falling back during his second, where it remained. The change in the effective tax rate on the bottom 20 percent (i.e., poor and lower-middle-class people) was much more dramatic, but not in a direction that would increase income inequality. Under Clinton, it dropped from 8 percent (about where it had stood since 1979) to 6.4 percent. Under George W. Bush, it fell to 4.3 percent. (source)

The tax rate for the rich dropped somewhat around 2005 following the Bush tax cuts, but all the tax effects over the last decades taken together don’t really make a good case that tax policy is the major cause of rising income inequality. So it’s even more difficult to make the case that tax policy was part of a conscious strategy to aggravate inequality. The increase in inequality has been too big compared to the possible impact of taxation. That’s corroborated by the fact that pre-tax inequality in the U.S. rose faster than after-tax inequality.

What’s interesting, however, is that pre-tax inequality in the U.S. tends to rise much faster under Republican rule. So inequality can still be the result of policy, but policy expressed in other ways than taxation. Other policies that may have contributed – deliberately or not – to rising income inequality are anti-labor union policies, decreases in the minimum wage, etc.

More posts in this series are here.

The Ethics of Human Rights (29): Should Taxation Be a Tool For Economic Efficiency or For Social Justice?

Taxation is a recurring theme in political discussions between people of the left and right. People of the left see taxation as a tool for social justice. They tend to prefer rather high taxation rates and a progressive taxation system:

  • High taxation rates bring in revenues that are large enough to enable the government to spend on programs and transfers that are designed to promote social justice: unemployment benefits, poverty reduction policies, education, healthcare etc.
  • Progressive taxation rates are just because they impose relatively (and not just absolutely) higher taxes on people who are more able to pay, and, in addition, reduce income inequality and hence realize another goal of social justice.

People on the right usually favor low tax rates and a non-progressive taxation system (either a proportional system in which everyone pays the same share of their income, or a regressive system in which everyone pays more or less the same amount in taxes). Rather than on social justice, they focus on the economic effects of taxation.

  • They reject high taxation rates because they claim that these high rates discourage people and are a disincentive to hard work, effort and investment. Because high rates limit effort and investment, they also limit productivity, innovation, international competitiveness and job creation.
  • They also reject progressive tax rates because high tax rates for high incomes discourage those people who work relatively hard (they work hard supposedly because they earn a lot) and who are most likely to innovate, to be productive and competitive and to create jobs.
  • However, they don’t necessarily favor regressive taxes because they are equally hostile to high tax rates for low income people, albeit for other reasons. High taxes for low income people discourage them from entering the labor market and hence inflate unemployment. Still, they claim that the worst damage is done by high taxes on the higher incomes, which is the reason they reserve particular scorn for progressive taxation systems. Because high tax rates for the wealthy punish the most productive elements in a society, the whole of society suffers. More productive people will limit their productivity because they don’t want to fall into a higher tax bracket, and the money they pay in taxes can’t be invested in the economy. High tax rates, especially for the rich, have an unacceptable cost in terms of economic efficiency. Keeping taxes low, on the contrary, and allowing wealthy people to use their money in the economy, will ultimately benefit everyone (this is the so-called Trickle-Down theory).

Of course, this distinction between left and right is a caricature. Most people on the left are also concerned about economic efficiency, and most on the right are not insensitive to questions of social justice. The extremes are hardly ever encountered in real life: no one wants to limit taxes to such an extent that economic efficiency is promoted but no money is left for justice, and no one wants to put tax rates at such a high level that there is ultimately no more economy to tax. (The latter concern is expressed in the famous Laffer Curve arguing that beyond a certain level of tax rates government revenues in fact decrease instead of increase. At very high rates there is no longer any incentive for a rational taxpayer to earn any income and hence tax revenues will decline while tax rates increase. However, it isn’t clear what “very” in the previous sentence actually means and where exactly the tipping point is situated).

Personally, I believe that the concerns of both right and left are justified and need to be balanced, and that too much focus on either the element of efficiency or justice is detrimental to the other element. On the one hand, there’s only so much money a government can raise without wrecking the economy, and justice isn’t only about spending money (there can even be perverse effects such as unemployment traps, welfare dependency etc.). On the other hand, there’s only so much an efficient economy can do to realize social justice all by itself and quasi-automatically (remember the invisible hand…). To quote Matthew Yglesias’ sarcastic comment on the skyrocketing incomes of the U.S. top 400 earners in the decades leading up to the 2009 recession:

As is well-known, the Top 400 are considerably more talented than the rest of us. And [the] decline in their tax rates has created exciting new incentives for them to apply their talents. And that, in turn, is why the 2000s were a so much more economically successful decade than the 1990s, not just for the Top 400 but for the rest of us as well. Thanks to their skyrocketing incomes and falling tax rates, we’re currently [during the 2008-2009 recession, FS] all enjoying the fruits of prosperity, rapid growth, and low unemployment. Thanks rich guys! (source)

A similar sentiment is expressed in this clip from the Daily Show (skip to the 4th minute or so).

I believe taxes in the U.S. are relatively low and can be raised without too much harm to economic efficiency. The resulting government revenues could then be spent on improving the social safety net and promoting social justice. It’s difficult to imagine for a European that a country such as the U.S. doesn’t offer health insurance to millions of its citizens. Also, unemployment benefits are quite stingy in the U.S., both in terms of eligibility and duration: only one third of the unemployed qualify for benefits and only for 26 weeks (extendable during recessions if the Republicans don’t object, as they infamously did beginning of 2010).

The system of unemployment benefits could easily be improved without perverse effects or harm to economic efficiency. And there are other areas of possible improvement as well.

However, as a European in Europe, I think there’s a strong argument that the social safety net in Europe (at least in some countries) has harmed European competitiveness, labor market participation and innovation.

Still, is there evidence of this? What do the data say about high tax rates harming economic efficiency, in Europe and in general? Is the conservative case against taxes as strong as it seems? I’m afraid not. There’s some evidence that the effect of reasonably rather than extremely high rates on economic efficiency is minimal at best. Here’s more evidence from Lane Kenworthy about the U.S. and other affluent countries (always keeping in mind that correlation doesn’t imply causation and that the absence of a large negative effect of high taxes doesn’t preclude the possibility that lower taxes would have had a large positive effect). One measure of economic efficiency is economic growth. If we plot economic growth rates for the U.S. against tax rates for the wealthy we see that higher tax rates lead to more growth. But of course there can be catch-up effect: higher rates producing their effects only years later. That’s taken into account in these graphs, which also show that an international comparison doesn’t prove that countries with higher tax rates have lower growth.

If we have a look at the data about the effect of high tax rates on unemployment (another conservative concern), we also see that we shouldn’t panic about taxes.

Now, if there is no good reason not to tax at a moderately high level, based on concerns about economic efficiency, the question remains whether there is a good reason to tax based on social justice reasons. Given the caveat that social justice isn’t all about government spending (I argued <a href="http://here that it is primarily about something else) and that such spending can in some cases have perverse effects (see above), I do believe that some spending is necessary in some cases, and that relatively high tax rates are necessary to produce the revenues required for this spending.

Again following Kenworthy, I believe that relatively high tax rates are acceptable and even necessary to create the revenues required for social justice policies, but that progressive tax rates in themselves don’t do the job of reducing income inequality, contrary to what is often claimed as a justification for progressive rates. That doesn’t mean that we shouldn’t reduce income inequality (it’s quite high in the U.S.) – there are good reasons to try. It just means that progressive taxation in itself won’t do the job. The important thing is to have high tax revenues which can then be spent in transfers and services that reduce income inequality and achieve other goals of social justice. Yet, I still think a progressive system is required, not because of its supposed effects but simply because it is just in itself, compared to proportional or regressive systems. A person with more income can afford to pay, not merely more in an absolute sense but more in the sense of a larger share of his or her income.

The Causes of Human Rights Violations (19): Ideology

From Reinhold Niebuhr’s Moral Man and Immoral Society:

Since inequalities of privilege are greater than could possibly be defended rationally, the intelligence of privileged groups is usually applied to the task of inventing specious proofs for the theory that universal values spring from, and that general interests are served by, the special privileges which they hold.

That’s the basis of trickle down economics which is a theory about how inequalities ultimately benefit everyone. It’s also the basis of tax schemes such as a flat tax that limit forced redistribution, because the invisible hand will redistribute wealth or make it trickle down automatically.

And, when trickle down is discredited and when it turns out to be difficult to prove that inequality is a universal value, we hear that inequality isn’t as big a problem as it seems, and that this is the land of opportunity where even people who are on the wrong side of inequality can make it through hard work and discipline. Even Obama seems to believe this, as is clear from his inauguration speech. That’s a classic case of the anecdote turned into a “scientific” law. Data show that social mobility isn’t what the American Dream dreamers think it is. Implicit in this story is that existing inequalities are the sole responsibilities of individuals who haven’t made diligent use of the many opportunities this land has generously provided them. Discrimination, injustice, greed and lack of compassion are obscured as causes of inequality.

In reality, inequalities are indeed greater than could possibly be defended rationally, in the words of Niebuhr. The defense based on trickle down economics has failed, as has the defense based on the claim that inequalities are the sole result of individual choices and a lack of response to opportunities (this defense completely rejects effects of discrimination, which seems to be misguided).

However, it’s not because inequalities are greater than they should be that all inequalities are wrong. Some inequalities are unavoidable or even valuable. We do want Einsteins and Picassos. Society should reward merit. We all benefit from the recognition of exceptional individuals. Nietzsche for example rightly protested against the modern habit of cutting everyone down who dares to stick his head up. Equality of outcome is in many respects distasteful. And apart from the valuable inequalities, there are unavoidable inequalities. Some inequalities that are the result of the “lottery of birth” are impossible to correct: some people are born with more talent than others or with talents that are more appreciated in the economic or cultural market; and there will always be people who are born in privileged families.We wouldn’t want to engage in genetic engineering in order to redistribute talent, and neither would we be willing to redistribute children across families (at least not for the purpose of equality of opportunity).

Other aspects of the lottery of birth, however, are more difficult to defend. Why should the good luck of being born in a wealthy family with educated parents guarantee you a better education, better healthcare and better economic prospects? But of course it isn’t just the contingency of your place of birth that determines your opportunities and you future place in society. Some people are pulled down by discrimination or bad luck. We justifiably don’t accept that people’s prospects in life are fully determined by their family, luck or discrimination.

Again, equality of opportunity is different from equality of outcome: most of us don’t think it’s a good idea to strive towards equality of outcome in most spheres of life. We’re quite happy to accept that some people earn less money, have less vacation time, have lower social status and recognition levels and have more uncomfortable, dangerous, or physically draining work etc. What we don’t accept is that those outcomes are predetermined by the family they happen to be born in, by discrimination they suffer or by other instances of bad luck.

Measuring Poverty (6): The Poverty Line in the U.S.

The poverty rate or poverty line in the U.S. is based on a system pioneered by Mollie Orshansky in 1963. In the 1960s, the average US family spend one third of its income on food. The poverty line was calculated by valuing an “emergency food” budget for a family, and then multiplying that number by 3. (Some more data here).

This results in a specific dollar amount that varies by family size but is the same across the U.S. (the amounts are adjusted for inflation annually). To determine who is poor, actual family income is then compared to these amounts. Obviously, if you’re under, you’re poor.

Amazingly, this system hasn’t changed a lot since the 1960s, yet it suffers from a series of measurement problems, resulting in either an over- or underestimation of the number of families living in poverty. The problems are situated both in the calculation of the poverty rates and in the calculation of the income that is subsequently compared to the rates:

  • Obviously, the system should take regional differences in the cost of living, especially in housing, into account. It doesn’t.
  • As already apparent from the image above, a family today spends relatively less on food and more on housing, health care and child care etc. yet the poverty line is still dollars for emergency food times 3. So the question is: should the system take today’s spending patterns into account? We would have to know which it is: 1) Either the increased spending on non-food items has occurred because people can now afford to spend more on such items. 2) Or the increased spending on non-food items has occurred because these items got disproportionately more expensive (housing for instance) or because there wasn’t really any need to buy those items in the old days. Only if 2) is the case should that have an influence on the poverty line. And I think that to some extent it is the case. Child care for instance has become a necessity. In the 1960s, many mothers didn’t go out and work. Now they do, and therefore they have to pay for child care. Those payments should be deducted from income when measuring disposable income and comparing it to the poverty line. The same is true for cars or phones. Today you can’t really have a job without them so they’re no longer luxuries. A society would show very little ambition if it continued to designate the poor as those who have to wash by hand, read with candlelight, and shit in a hole in the floor. In fact, what I’m advocating here is some kind of relative concept of poverty. I’ll come back to that later. All I can tell you now is that this isn’t without complications either.
  • The current poverty measurement doesn’t take into account disproportionate price rises (it merely adjusts for general inflation) and changing needs. An obvious improvement of the U.S. measurement system would be to adjust for exceptional price evolutions (such as for housing) and also to revisit the definitions of basic needs and luxuries. Hence, a better poverty measurement should subtract from income some work-related expenses, child care expenses, and perhaps also some health expenses to the extent that these have become disproportionately more expensive. But that’s not easy:

There is considerable disagreement on the best way to incorporate medical care in a measure of poverty, even though medical costs have great implications for poverty rates. But costs differ greatly depending upon personal health, preferences, and age, and family costs may be very different from year to year, making it hard to determine what exactly should be counted. Subtracting out-of-pocket costs from income is one imperfect approach, but if someone’s expenses are low because they are denied care, then they would usually be considered worse off, not better off. (source)

  • Another problem: the current poverty rate doesn’t take all welfare benefits into account. Income from cash welfare programs counts, but the value of non-cash benefits such as food stamps, school lunches and public housing doesn’t (because such benefits weren’t very common in the 1960s). Those benefits successfully raise the standard of living for poverty stricken individuals. There’s a bit of circular reasoning going on here, because the poverty rate is used, i.a., to decide who gets benefits, so benefits should not be included. But if you want to know how many people are actually poor, you should consider benefits as well because benefits lift many out of poverty.
  • The poverty measure doesn’t include some forms of interests on savings or property such as housing.
  • The poverty measure doesn’t take taxes into account, largely because they didn’t affect the poor very much in the 1960s. Income is counted before subtracting payroll, income, and other taxes, overstating income for some families. On the other hand, the federal Earned Income Tax Credit isn’t counted either, underestimating income for other families.
  • And there’s also a problem counting the effects of cohabitation and co-residency, overestimating poverty because overestimating expenses.

Because the poverty measurement disregards non-cash benefits and certain tax credits, it fails to serve its purpose. Poverty measurement is done in order to measure progress and to look at the effects of anti-poverty policies. Two of those policies – non-cash benefits and certain tax credits – aren’t counted, even though they reduce poverty. So we have a poverty statistic that can’t measure the impact of anti-poverty policy… That’s like measuring road safety without looking at the number of accidents avoided by government investment in safety. Since the 1970s, the U.S. government implemented a number of policies that increased spending for the poor, but the effects of this spending were invisible in the poverty statistics.

This had a perverse effect: certain politicians now found it easy to claim that spending on the poor was ineffective and a waste of money. It’s no coincidence that trickle down economics became so popular in the 1980s. The poverty measurement, rather than helping the government become more effective in its struggle against poverty, has led to policies that reduced benefits. Of course, I’m not saying that poverty reduction is just a matter of government benefits, or that benefits can’t have adverse effects. Read more here.

Fortunately, the US Census Bureau has taking these criticism to heart and has been working on an alternative measure that counts food stamps and other government support as income, while also accounting for child-care costs, geographic difference etc. First results show that the number of poor is higher according to the new measurement system (it adds about 3 million people). For some reason, I think the old system has still some life in it.

Some details of the new measurement:

when you account for the Earned Income Tax Credit the poverty rate goes down by two points. Accounting for SNAP (food stamps) lowers the poverty rate about 1.5 points. … when you account for the rise in Medical Out of Pocket costs, the poverty rate goes up by more than three points. (source)

More posts about problems with poverty measurement are here.

Economic Human Rights (32): The Economic Cost of Taxing the Rich

Taxation is linked to human rights in several ways:

I personally belief that a progressive tax is best in light of the last two concerns. In a progressive taxation system, higher earners pay a larger percentage of their income on taxes. Compared to a regressive taxation system (people with higher incomes pay less in percentage of their income, as in the case of a consumption tax or VAT) or a flat tax (the tax percentage is the same for all income groups), a progressive tax reduces income inequality: it makes incomes more equal in a direct way because it reduces the income of higher-earning families by a larger percentage than the income of lower earning ones; but also in an indirect way because this system – under certain conditions – yields more tax revenues which can then be spent on poverty reduction and the safety net. Also, it seems to be a good example of a just and fair system. The strongest shoulders should carry the most heavy burden. Someone earning a low income can end up in poverty after paying a small percentage in taxes; a wealthy person will perhaps not even notice paying a relatively large sum in taxes.

The counter-narrative states that high tax rates discourage people; they are a disincentive to hard work and effort. High tax rates for high incomes discourage people who work relatively hard (they work hard supposedly because they earn a lot). Because high tax rates punish the most productive elements in a society, the whole of society suffers. More productive people will limit their productivity because they don’t want to fall into a higher tax bracket, and the money they pay in taxes can’t be invested in the economy. Taxing the rich therefore has an unacceptable economic cost. Conversely, low tax rates for the rich produce benefits for all (this is trickle down economics, read also about the Laffer curve).

But this narrative doesn’t quite stand the test of data. As is clear from this link, high tax rates don’t slow down economic growth, and low tax rates don’t speed it up. This paper also supports the claim that moderate, as opposed to dramatic, increases in marginal rates don’t have any impact on the willingness of the wealthy to participate in the economy. They won’t go Galt. Atlas won’t shrug, except to signal indifference.

The top income tax rate was 91% (beginning at taxable income of $400,000) … [in] the period from 1951 through 1963. Those were the golden years of the U.S. economy, in which the average annual rate of productivity growth was 3.1% (compared with about 1.5% after 1981). Of course, the growth might have been even faster had the marginal tax rates been lower, but the coincidence of high rates and high productivity raises challenging questions for those who believe that high marginal tax rates carry an unacceptable cost. (source)

To be fair, marginal tax rates are a crude measures of tax burden. There’s a difference between marginal tax rates and effective tax rates.

  • A marginal tax rate is the tax rate that applies to the last dollar of the tax base (taxable income or spending, usually income). It’s not the rate at which all your dollars are taxed. It’s the maximum rate you’re paying on any of your dollars of taxable income.
  • An effective tax rate refers to the actual rate, i.e., the rate existing in fact, for the entire income, after tax deductions and credits and taking into account lower rates for lower income brackets (see here). It’s your total tax obligation (including your income tax and any other additional taxes and/or credits), divided by your total taxable income.

But even if we look at the effective tax rates of the rich, we see that this has steadily decreased over the decades, with little or no positive effect on overall economic performance.

And when there’s no positive effect of decreasing tax rates, there’s probably also no negative effect of increasing tax rates. To the extent that the wealthy (and productive, although those groups obviously don’t overlap completely) respond to changes in the tax system, their responses focus not on increased/decreased labor, productivity or investment, but on tax avoidance (see here).

Economic Human Rights (31b): Certain Objections

Economic rights are a subset of human rights. Put very briefly and simplistically, they are what could be called anti-poverty rights: for example, there’s a right to a certain standard of living, to social security, to work, to fair wages, to healthcare, housing etc.

It’s an understatement to say that there’s no universal consensus on these rights. Some say that these aren’t “real” human rights (like Bill Easterly for example). Others say that these rights are useless or even harmful. Here are a few of the most common objections raised against economic rights.

The big state criticism

Economic rights are believed to require invasion of privacy and hence violations of an important freedom right (freedom rights such as free speech, privacy, habeas corpus etc. are usually distinguished from economic rights, political rights etc.). In order to verify whether people have a right to social security benefits or healthcare benefits, the state has to check people’s income (legal and illegal), their family composition, their health, their medical consumption, their lifestyle etc.

The assumption behind this criticism is that the state is the only or the main party responsible for the realization of economic rights. This is not the case. People in need can call on other people to help. And these other people have a moral responsibility to help. The duties of mutual assistance, charity and philanthropy point to a horizontal aspect of economic rights. People in need do not only have a vertical right to assistance, or a right directed at the state. Their economic rights can be addressed at their fellow citizens, and these have a duty to respect and protect these rights. It’s only when horizontal duties fail that the state should intervene. If we think of economic rights in this way, the dangers of an overbearing state don’t look that ominous anymore.

The rule that economic rights should – in part – be realized by citizens has another advantage as well: economic rights tend to foster community spirit and feelings of solidarity and belonging.

But this insistence on solidarity shouldn’t obscure the rule that people have a responsibility to help themselves and support themselves. This kind of independence is a part of freedom and an important good. Solidarity comes into play only when self-help is unsuccessful or impossible, and the state comes into play only when solidarity is unsuccessful or absent.

Different kinds of duties

Another objection: some say that economic rights, if they are rights at all, are radically different from “normal” human rights – also called freedom rights – and can therefore be given a lower priority (and maybe aren’t even real rights at all). Freedom rights imply duties of abstention or forbearance, whereas economic rights require duties of active help, involvement and intervention. In the case of violations of freedom rights, the remedy is easy: stop doing what you’re doing. In the case of violations of economic “rights”, the remedy is often very difficult if not impossible. If there is no work, no one can give it to me. If a country is poor, no one can raise the standard of living.

When freedom rights are violated, the victim can go to a court and a judge can force the violator to stop his or her actions. When economic rights are violated, it’s useless to go to a court. Not only isn’t there an obvious violator who can be stopped, there is often no one who can stop the violation from happening. Hence it looks like these rights are unenforceable and often have no remedy. Rather than rights, it seems that they are aspirations or policy goals, often long term policy goals.

However, there’s again an erroneous assumption underlying all of this. The distinction between the two types of duties – forbearance and active assistance – isn’t clean-cut. Freedom rights require active intervention by the state in order to enforce forbearance. They require an efficient judiciary and police force. For some states, this may be as unattainable as prosperity. In fact, it’s precisely because of a lack of prosperity that many states are unable to guarantee protection for freedom rights. Of course, the fact that economic rights are a prerequisite for freedom rights isn’t a sufficient reason to call them rights. But neither is it a reason not to call them rights.

Conversely, economic rights often require more forbearance than active intervention. Economic rights in China during the Great Leap Forward would have been better served by state forbearance. All types of human rights require forbearance and intervention. Perhaps economic rights generally need more intervention, but that is a difference in degree and not in essence, and it isn’t a sufficient reason to reject the label of “rights” for the aspirations inherent in economic rights.

Ought implies can

There’s another criticism of economic rights, related to the previous one. Economic rights are said to violate a general rule for rights: ought implies can; there can be no obligation to do something if there is no capability to do it. You cannot have a duty to help someone who’s drowning if you can’t swim yourself. Hence the person drowning doesn’t have a right to be assisted by you. The same is said to be true of economic rights which therefore aren’t real rights. If a poor country doesn’t have the resources to help its poor citizens, then these citizens don’t have a right to be helped.

However, we don’t follow the same logic in the case of freedom rights. Freedom rights also require resources, as we have seen. When a state doesn’t have the resources necessary to protect its citizens’ freedom rights, we usually don’t say that the citizens of such a state have lost their freedom rights. People have rights irrespective of the probability that they can be protected. Or better: the less people’s rights are protected, the more important it is that they have rights. And anyway, violations of economic rights don’t occur because there are insufficient resources but because of an unequal distribution of resource, nationally or internationally. So the “can” part of “ought implies can” isn’t as fanciful as the critics of economic rights believe.

Economic rights are superfluous and useless

This is supposed to be the case because free markets should automatically produce a certain standard of living for everyone that is high enough to realize the goals inherent in economic rights. Free trade, deregulated markets and low taxes cause profits to rise, which in turn means more investments, which in turn means more and better jobs and higher incomes. All boats rise on a rising tide.

Now, it’s my belief that history – and especially recent history – has shown that this isn’t enough. Free markets are beneficial, but they don’t automatically provide high standards of living for everyone.

Economic rights are harmful and counterproductive

This is a stronger version of the “useless” argument. Economic rights are believed to require a big state (see above), high taxes and intrusive regulation. All of this hinders the economy and the creation of wealth. As a result of economic rights, there is less wealth to redistribute, and economic rights therefore undo what they want to achieve.

They are also harmful in another way: they violate freedom rights, especially the right to privacy and the right to property (because of redistribution). We’ve already seen that we can mitigate this risk when we include horizontal duties. But even if this risk is real, why should property and privacy automatically rank higher than the absence of poverty? If we assume that economic rights are real rights, then it’s not surprising to see that they can contradict other rights. Contradictions between human rights are very common. The right to privacy is often in conflict with free speech for example. Sometimes one right has to be limited for the sake of another. So why should this be a problem when dealing with economic rights?

Of course, one shouldn’t dramatize. Economic rights and freedom rights are generally not incompatible. On the contrary, they are interdependent. Freedom for the poor often doesn’t mean a whole lot. But, on the other hand, the squeaky hinge gets the oil: poverty has to have a voice if it is to be eliminated.

Income Inequality (18): No Such Thing – Good Thing – Necessary Evil – Gone Thing?

Attitudes towards income inequality in the U.S. differ widely.

  • There are those who deny that there is any, or better that there is enough to be worried about (see here for an example, or here).
  • Others say that it’s a good thing, and that there should be more of it. People are very different in their talents and work ethic, and rewarding the highly productive and creative ones for their efforts – which is only “fair” – automatically results in income inequality, because the unproductive and uncreative will not be rewarded, or less generously.
  • And then there are those who believe income inequality is a necessary evil. They don’t particularly like huge differences in rewards for activities which are, after all, often hardly comparable in any quantitive sense (is it so much more worthwhile to invest your efforts and creativity in the development of the iPhone than in the education of your children?). But they do believe that financial rewards stimulate productivity, and that higher rewards stimulate more. And increased productivity ultimately benefits us all, even those who are worse off and on the wrong side of the income inequality. (This is a version of “trickle down” economics).
  • Still others think that income inequality isn’t a problem any longer, given the effect of the recession on high earners.

Note: these 4 views aren’t necessarily incompatible. One and the same person can, as I see it, hold at least 3 of them at the same time. (E.g. you can believe that there isn’t much inequality, that what is left will soon be gone, and that you hope it will be back one day).

I think only the third view has some relation to the truth. Regarding the first view:

The basic conclusion of this data, that the nation [the U.S.] suffers from extreme and growing income inequality, is essentially irrefutable. Bruce Judson (source)

Regarding the second view: I object to it not because I don’t want to reward people or because I think justice has nothing to do with merit. On the contrary. I object to it because it assumes that different people and different activities can be placed on a single scale of merit and reward. It’s impossible to compare activities and say that one deserves a $10.000 per year reward (i.e. income) and another activity, compared to this first, is 10 times more deserving and hence deserves a $100.000 per year reward. Merit isn’t just a financial or quantitative thing, and hence it cannot – at least not exclusively – justify income inequality. Moreover, the income inequality that we see in the real world has little or nothing to do with merit. Most people aren’t paid according to any definition of merit. In the best case, they are paid because of their talents, which isn’t anything anyone deserves. In all other cases – and in the large majority of cases – people’s pay or income is determined by factors such as luck, family, networks, playing on the stock exchange etc., and none of these things are even marginally related to merit. In a society that rewards people for their creativity and productivity, you expect to see high levels of social mobility, and that’s precisely what you don’t see in the U.S.

Regarding the third view, I do believe that it is essentially correct, but it obfuscates many of the problems caused by income inequality. Hence, even if economic efficiency doesn’t justify efforts to limit income inequality, other things do.

The fourth view would seem to make sense intuitively. A lot of the income of the very wealthy comes from the stock markets, and the recession has pushed these markets down.

Professor Saez concludes that “the most likely outcome is that income concentration will fall in 2008 and 2009.” But, he follows this conclusion by stating that in the absence of significant policy actions such declines will be temporary: “Based on the US historical record, falls in income concentration due to recessions are temporary unless drastic policy changes, such as financial regulation or significantly more progressive taxation, are implemented and prevent income concentration from bouncing back. Such policy changes took place after the Great Depression during the New Deal and permanently reduced income concentration till the 1970s. In contrast, recent downturns, such as the 2001 recession, lead to only very temporary drops in income concentration.” Bruce Judson (source)

Moreover, the poor are also suffering as a result of the recession, not in the same absolute measures as the rich, but that is because they have less to lose in the first place. However, what they do lose as a result of the recession is for them relatively more important.

Recent data show that income inequality hasn’t actually decreased in 2008. Maybe in 2009… The recession only got started late in 2008.

The Failure of “Trickle Down Economics”

Trickle Down Economics, also called Reaganomics (due to its association with the policies of Reagan and Thatcher) or supply-side economics, is the theory according to which policies destined to alleviate poverty and redistribute wealth are unnecessary and even counterproductive. The rich should be allowed to become even more wealthy, by imposing very low tax rates on high incomes (or a flat tax for example) rather than using the tax system to redistribute wealth. The result will be that their wealth will “trickle down” towards those who are less well off.

When government policies favor the wealthy — for example, via tax cuts for upper-income classes — the increase in wealth flows down to those with lower incomes. That’s because the rich are more likely to spend the additional income, creating more economic activity, which in turn generates jobs and eventually, better paychecks for the less well-off. Michael S. Derby (source)

All boats rise on a rising tide. Redistribution is counterproductive because it will take away the incentives to do well, and hence also take away the possibility of wealth creation and subsequent automatic wealth distribution through “trickling down”. All this is reminiscent of laissez-faire and the invisible hand theory.

Reagan’s trickle down policies in the U.S. can still be felt today:

According to the Tax Policy Center, the top marginal tax rate in the U.S. stood at 70% when Reagan was elected in 1980, falling steadily to 28% by 1989, before it began to rise modestly. The top marginal rate now stands at 35% against a peak of 94% in 1945. (source)

These tax cuts were implemented with the support of the Democrats in the House, which explains why they have been upheld all these years. The result of this was, unsurprisingly, a higher concentration of wealth in fewer hands:

In the period since the economic crisis of the early 1970s, US GDP has grown strongly, and the incomes and wealth of the richest Americans has grown spectacularly. By contrast, the gains to households in the middle of the income distribution have been much more modest. Between 1973 … and 2007, median household income rose from $44 000 to just over $50 000, an annual rate of increase of 0.4 per cent. … For those at the bottom of the income distribution, there have been no gains at all. … incomes accruing to the poorest 10 per cent of Americans have actually fallen over the last 30 years. John Quigging (source)

This is already part of the refutation of the doctrine. Obviously not all boats have risen on the same tide. But if you don’t believe this, there’s a paper here and a blogpost here arguing against the doctrine in a more intelligent way. Maybe “spreading the wealth around” a bit and imposing some tougher taxes on the rich isn’t such a bad idea after all. I mean, the “tricklers” have had decades to prove their point, and failed; maybe now it’s time for the “spreaders” to have a go.