inequality

How is the economy doing?

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JDN 2457033 EST 12:22.

Whenever you introduce yourself to someone as an economist, you will typically be asked a single question: “How is the economy doing?” I’ve already experienced this myself, and I don’t have very many dinner parties under my belt.

It’s an odd question, for a couple of reasons: First, I didn’t say I was a macroeconomic forecaster. That’s a very small branch of economics—even a small branch of macroeconomics. Second, it is widely recognized among economists that our forecasters just aren’t very good at what they do. But it is the sort of thing that pops into people’s minds when they hear the word “economist”, so we get asked it a lot.

Why are our forecasts so bad? Some argue that the task is just inherently too difficult due to the chaotic system involved; but they used to say that about weather forecasts, and yet with satellites and computer models our forecasts are now far more accurate than they were 20 years ago. Others have argued that “politics always dominates over economics”, as though politics were somehow a fundamentally separate thing, forever exogenous, a parameter in our models that cannot be predicted. I have a number of economic aphorisms I’m trying to popularize; the one for this occasion is: “Nothing is exogenous.” (Maybe fundamental constants of physics? But actually many physicists think that those constants can be derived from even more fundamental laws.) My most common is “It’s the externalities, stupid.”; next is “It’s not the incentives, it’s the opportunities.”; and the last is “Human beings are 90% rational. But woe betide that other 10%.” In fact, it’s not quite true that all our macroeconomic forecasters are bad; a few, such as Krugman, are actually quite good. The Klein Award is given each year to the best macroeconomic forecasters, and the same names pop up too often for it to be completely random. (Sadly, one of the most common is Citigroup, meaning that our banksters know perfectly well what they’re doing when they destroy our economy—they just don’t care.) So in fact I think our failures of forecasting are not inevitable or permanent.

And of course that’s not what I do at all. I am a cognitive economist; I study how economic systems behave when they are run by actual human beings, rather than by infinite identical psychopaths. I’m particularly interested in what I call the tribal paradigm, the way that people identify with groups and act in the interests of those groups, how much solidarity people feel for each other and why, and what role ideology plays in that identification. I’m hoping to one day formally model solidarity and make directly testable predictions about things like charitable donations, immigration policies and disaster responses.

I do have a more macroeconomic bent than most other cognitive economists; I’m not just interested in how human irrationality affects individuals or corporations, I’m also interested in how it affects society as a whole. But unlike most macroeconomists I care more about inequality than unemployment, and hardly at all about inflation. Unless you start getting 40% inflation per year, inflation really isn’t that harmful—and can you imagine what 40% unemployment would be like? (Also, while 100% inflation is awful, 100% unemployment would be no economy at all.) If we’re going to have a “misery index“, it should weight unemployment at least 10 times as much as inflation—and it should also include terms for poverty and inequality. Frankly maybe we should just use poverty, since I’d be prepared to accept just about any level of inflation, unemployment, or even inequality if it meant eliminating poverty. This is of course is yet another reason why a basic income is so great! An anti-poverty measure can really only be called a failure if it doesn’t actually reduce poverty; the only way that could happen with a basic income is if it somehow completely destabilized the economy, which is extremely unlikely as long as the basic income isn’t something ridiculous like $100,000 per year.

I could probably talk about my master’s thesis; the econometric models are relatively arcane, but the basic idea of correlating the income concentration of the top 1% of 1% and the level of corruption is something most people can grasp easily enough.

Of course, that wouldn’t be much of an answer to “How is the economy doing?”; usually my answer is to repeat what I’ve last read from mainstream macroeconomic forecasts, which is usually rather banal—but maybe that’s the idea? Most small talk is pretty banal I suppose (I never was very good at that sort of thing). It sounds a bit like this: No, we’re not on the verge of horrible inflation—actually inflation is currently too low. (At this point someone will probably bring up the gold standard, and I’ll have to explain that the gold standard is an unequivocally terrible idea on so, so many levels. The gold standard caused the Great Depression.) Unemployment is gradually improving, and actually job growth is looking pretty good right now; but wages are still stagnant, which is probably what’s holding down inflation. We could have prevented the Second Depression entirely, but we didn’t because Republicans are terrible at managing the economy—all of the 10 most recent recessions and almost 80% of the recessions in the last century were under Republican presidents. Instead the Democrats did their best to implement basic principles of Keynesian macroeconomics despite Republican intransigence, and we muddled through. In another year or two we will actually be back at an unemployment rate of 5%, which the Federal Reserve considers “full employment”. That’s already problematic—what about that other 5%?—but there’s another problem as well: Much of our reduction in unemployment has come not from more people being employed but instead by more people dropping out of the labor force. Our labor force participation rate is the lowest it’s been since 1978, and is still trending downward. Most of these people aren’t getting jobs; they’re giving up. At best we may hope that they are people like me, who gave up on finding work in order to invest in their own education, and will return to the labor force more knowledgeable and productive one day—and indeed, college participation rates are also rising rapidly. And no, that doesn’t mean we’re becoming “overeducated”; investment in education, so-called “human capital”, is literally the single most important factor in long-term economic output, by far. Education is why we’re not still in the Stone Age. Physical capital can be replaced, and educated people will do so efficiently. But all the physical capital in the world will do you no good if nobody knows how to use it. When everyone in the world is a millionaire with two PhDs and all our work is done by robots, maybe then you can say we’re “overeducated”—and maybe then you’d still be wrong. Being “too educated” is like being “too rich” or “too happy”.

That’s usually enough to placate my interlocutor. I should probably count my blessings, for I imagine that the first confrontation you get at a dinner party if you say you are a biologist involves a Creationist demanding that you “prove evolution”. I like to think that some mathematical biologists—yes, that’s a thing—take their request literally and set out to mathematically prove that if allele distributions in a population change according to a stochastic trend then the alleles with highest expected fitness have, on average, the highest fitness—which is what we really mean by “survival of the fittest”. The more formal, the better; the goal is to glaze some Creationist eyes. Of course that’s a tautology—but so is literally anything that you can actually prove. Cosmologists probably get similar demands to “prove the Big Bang”, which sounds about as annoying. I may have to deal with gold bugs, but I’ll take them over Creationists any day.

What do other scientists get? When I tell people I am a cognitive scientist (as a cognitive economist I am sort of both an economist and a cognitive scientist after all), they usually just respond with something like “Wow, you must be really smart.”; which I suppose is true enough, but always strikes me as an odd response. I think they just didn’t know enough about the field to even generate a reasonable-sounding question, whereas with economists they always have “How is the economy doing?” handy. Political scientists probably get “Who is going to win the election?” for the same reason. People have opinions about economics, but they don’t have opinions about cognitive science—or rather, they don’t think they do. Actually most people have an opinion about cognitive science that is totally and utterly ridiculous, more on a par with Creationists than gold bugs: That is, most people believe in a soul that survives after death. This is rather like believing that after your computer has been smashed to pieces and ground back into the sand from whence it came, all the files you had on it are still out there somewhere, waiting to be retrieved. No, they’re long gone—and likewise your memories and your personality will be long gone once your brain has rotted away. Yes, we have a soul, but it’s made of lots of tiny robots; when the tiny robots stop working the soul is no more. Everything you are is a result of the functioning of your brain. This does not mean that your feelings are not real or do not matter; they are just as real and important as you thought they were. What it means is that when a person’s brain is destroyed, that person is destroyed, permanently and irrevocably. This is terrifying and difficult to accept; but it is also most definitely true. It is as solid a fact as any in modern science. Many people see a conflict between evolution and religion; but the Pope has long since rendered that one inert. No, the real conflict, the basic fact that undermines everything religion is based upon, is not in biology but in cognitive science. It is indeed the Basic Fact of Cognitive Science: We are our brains, no more and no less. (But I suppose it wouldn’t be polite to bring that up at dinner parties.)

The “You must be really smart.” response is probably what happens to physicists and mathematicians. Quantum mechanics confuses basically everyone, so few dare go near it. The truly bold might try to bring up Schrodinger’s Cat, but are unlikely to understand the explanation of why it doesn’t work. General relativity requires thinking in tensors and four-dimensional spaces—perhaps they’ll be asked the question “What’s inside a black hole?”, which of course no physicist can really answer; the best answer may actually be, “What do you mean, inside?” And if a mathematician tries to explain their work in lay terms, it usually comes off as either incomprehensible or ridiculous: Stokes’ Theorem would be either “the integral of a differential form over the boundary of some orientable manifold is equal to the integral of its exterior derivative over the whole manifold” or else something like “The swirliness added up inside an object is equal to the swirliness added up around the edges.”

Economists, however, always seem to get this one: “How is the economy doing?”

Right now, the answer is this: “It’s still pretty bad, but it’s getting a lot better. Hopefully the new Congress won’t screw that up.”

Why immigration is good

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JDN 2456977 PST 12:31.

The big topic in policy news today is immigration. After years of getting nothing done on the issue, Obama has finally decided to bypass Congress and reform our immigration system by executive order. Republicans are threatening to impeach him if he does. His decision to go forward without Congressional approval may have something to do with the fact that Republicans just took control of both houses of Congress. Naturally, Fox News is predicting economic disaster due to the expansion of the welfare state. (When is that not true?) A more legitimate critique comes from the New York Times, who point out how this sudden shift demonstrates a number of serious problems in our political system and how it is financed.

So let’s talk about immigration, and why it is almost always a good thing for a society and its economy. There are a couple of downsides, but they are far outweighed by the upsides.

I’ll start with the obvious: Immigration is good for the immigrants. That’s why they’re doing it. Uprooting yourself from your home and moving thousands of miles isn’t easy under the best circumstances (like I when I moved from Michigan to California for grad school); now imagine doing it when you are in crushing poverty and you have to learn a whole new language and culture once you arrive. People are only willing to do this when the stakes are high. The most extreme example is of course the children refugees from Latin America, who are finally getting some of the asylum they so greatly deserve, but even the “ordinary” immigrants coming from Mexico are leaving a society racked with poverty, endemic with corruption, and bathed in violence—most recently erupting in riots that have set fire to government buildings. These people are desperate; they are crossing our border despite the fences and guns because they feel they have no other choice. As a fundamental question of human rights, it is not clear to me that we even have the right to turn these people away. Forget the effect on our economy; forget the rate of assimilation; what right do we have to say to these people that their suffering should go on because they were born on the wrong side of an arbitrary line?

There are wealthier immigrants—many of them here, in fact, for grad school—whose circumstances are not so desperate; but hardly anyone even considers turning them away, because we want their money and their skills in our society. Americans who fear brain drain have it all backwards; the United States is where the brains drain to. This trend may be reversing more recently as our right-wing economic policy pulls funding away from education and science, but it would likely only reach the point where we export as many intelligent people as we import; we’re not talking about creating a deficit here, only reducing our world-dominating surplus. And anyway I’m not so concerned about those people; yes, the world needs them, but they don’t need much help from the world.

My concern is for our tired, our poor, our huddled masses yearning to breathe free. These are the people we are thinking about turning away—and these are the people who most desperately need us to take them in. That alone should be enough reason to open our borders, but apparently it isn’t for most people, so let’s talk about some of the ways that America stands to gain from such a decision.

First of all, immigration increases economic growth. Immigrants don’t just take in money; they also spend it back out, which further increases output and creates jobs. Immigrants are more likely than native citizens to be entrepreneurs, perhaps because taking the chance to start a business isn’t so scary after you’ve already taken the chance to travel thousands of miles to a new country. Our farming system is highly dependent upon cheap immigrant labor (that’s a little disturbing, but if as far as the US economy, we get cheap food by hiring immigrants on farms). On average, immigrants are younger than our current population, so they are more likely to work and less likely to retire, which has helped save the US from the economic malaise that afflicts nations like Japan where the aging population is straining the retirement system. More open immigration wouldn’t just increase the number of immigrants coming here to do these things; it would also make the immigrants who are already here more productive by opening up opportunities for education and entrepreneurship. Immigration could speed the recovery from the Second Depression and maybe even revitalize our dying Rust Belt cities.

Now, what about the downsides? By increasing the supply of labor faster than they increase the demand for labor, immigrants could reduce wages. There is some evidence that immigrants reduce wages, particularly for low-skill workers. This effect is rather small, however; in many studies it’s not even statistically significant (PDF link). A 10% increase in low-skill immigrants leads to about a 3% decrease in low-skill wages (PDF link). The total economy grows, but wages decrease at the bottom, so there is a net redistribution of wealth upward.

Immigration is one of the ways that globalization increases within-nation inequality even as it decreases between-nation inequality; you move the poor people to rich countries, and they become less poor than they were, but still poorer than most of the people in those rich countries, which increases the inequality there. On average the world becomes better off, but it can seem bad for the rich countries, especially the people in rich countries who were already relatively poor. Because they distribute wealth by birthright, national borders actually create something analogous to the privilege of feudal lords, albeit to a much larger segment of the population. (Much larger: Here’s a right-wing site trying to argue that the median American is in the top 1% of income by world standards; neat trick, because Americans comprise 4% of the world population—so our top half makes up 2% of the world’s population by themselves. Yet somehow apparently that 2% of the population is the top 1%? Also, the US isn’t the only rich country; have you heard of, say, Europe?)

There’s also a lot of variation in the literature as to the size—or even direction—of the effect of immigration on low-skill wages. But since the theory makes sense and the preponderance of the evidence is toward a moderate reduction in wages for low-skill native workers, let’s assume that this is indeed the case.

First of all I have to go back to my original point: These immigrants are getting higher wages than they would have in the countries they left. (That part is usually even true of the high-skill immigrants.) So if you’re worried about low wages for low-skill workers, why are you only worried about that for workers who were born on this side of the fence? There’s something deeply nationalistic—if not outright racist—inherent in the complaint that Americans will have lower pay or lose their jobs when Mexicans come here. Don’t Mexicans also deserve jobs and higher pay?

Aside from that, do we really want to preserve higher wages at the cost of economic efficiency? Are high wages an end in themselves? It seems to me that what we’re really concerned about is welfare—we want the people of our society to live better lives. High wages are one way to do that, but not the only way; a basic income could reverse that upward redistribution of wealth, taking the economic benefits of the immigration that normally accrue toward the top and giving them to the bottom. As I already talked about in an earlier post, a basic income is a lot more efficient than trying to mess around with wages. Markets are very powerful; we shouldn’t always accept what they do, but we should also be careful when we interfere with them. If the market is trying to drive certain wages down, that means that there is more desire to do that kind of work then there is work of that kind that needs done. The wage change creates a market incentive for people to switch to more productive kinds of work. We should also be working to create opportunities to make that switch—funding free education, for instance—because an incentive without an opportunity is a bit like pointing a gun at someone’s head and ordering them to give birth to a unicorn.

So on the one hand we have the increase in local inequality and the potential reduction in low-skill wages; those are basically the only downsides. On the other hand, we have increases in short-term and long-term economic growth, lower global inequality, more spending, more jobs, a younger population with less strain on the retirement system, more entrepreneurship, and above all, the enormous lifelong benefits to the immigrants themselves that motivated them to move in the first place. It seems pretty obvious to me: we can enact policies to reduce the downsides, but above all we must open our borders.

The moral—and economic—case for progressive taxation

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JDN 2456935 PDT 09:44.

Broadly speaking, there are three ways a tax system can be arranged: It can be flat, in which every person pays the same tax rate; it can be regressive, in which people with higher incomes pay lower rates; or it can be progressive, in which case people with higher incomes pay higher rates.

There are certain benefits to a flat tax: Above all, it’s extremely easy to calculate. It’s easy to determine how much revenue a given tax rate will raise; multiply the rate times your GDP. It’s also easy to determine how much a given person should owe; multiply the rate times their income. This also makes the tax withholding process much easier; a fixed proportion can be withheld from all income everyone makes without worrying about how much they made before or are expected to make later. If your goal is minimal bureaucracy, a flat tax does have something to be said for it.

A regressive tax, on the other hand, is just as complicated as a progressive tax but has none of the benefits. It’s unfair because you’re actually taking more from people who can afford the least. (Note that this is true even if the rich actually pay a higher total; the key point, which I will explain in detail shortly, is that a dollar is worth more to you if you don’t have very many.) There is basically no reason you would ever want to have a regressive tax system—and yet, all US states have regressive tax systems. This is mainly because they rely upon sales taxes, which are regressive because rich people spend a smaller portion of what they have. If you make $10,000 per year, you probably spend $9,500 (you may even spend $15,000 and rack up the difference in debt!). If you make $50,000, you probably spend $40,000. But if you make $10 million, you probably only spend $4 million. Since sales taxes only tax on what you spend, the rich effectively pay a lower rate. This could be corrected to some extent by raising the sales tax on luxury goods—say a 20% rate on wine and a 50% rate on yachts—but this is awkward and very few states even try. Not even my beloved California; they fear drawing the ire of wineries and Silicon Valley.

The best option is to make the tax system progressive. Thomas Piketty has been called a “Communist” for favoring strongly progressive taxation, but in fact most Americans—including Republicans—agree that our tax system should be progressive. (Most Americans also favor cutting the Department of Defense rather than Medicare. This then raises the question: Why isn’t Congress doing that? Why aren’t people voting in representatives to Congress who will do that?) Most people judge whether taxes are fair based on what they themselves pay—which is why, in surveys, the marginal rate on the top 1% is basically unrelated to whether people think taxes are too high, even though that one bracket is the critical decision in deciding any tax system—you can raise about 20% of your revenue by hurting about 1% of your people. In a typical sample of 1,000 respondents, only about 10 are in the top 1%. If you want to run for Congress, the implication is clear: Cut taxes on all but the top 1%, raise them enormously on the top 0.1%, 0.01%, and 0.001%, and leave the 1% the same. People will feel that you’ve made the taxes more fair, and you’ve also raised more revenue. In other words, make the tax system more progressive.

The good news on this front is that the US federal tax system is progressive—barely. Actually the US tax system is especially progressive over the whole distribution—by some measures the most progressive in the world—but the problem is that it’s not nearly progressive enough at the very top, where the real money is. The usual measure based on our Gini coefficient ignores the fact that Warren Buffett pays a lower rate than his secretary. The Gini is based on population, and billionaires are a tiny portion of the population—but they are not a tiny portion of the money. Net wealth of the 400 richest people (the top 0.0001%) adds up to about $2 trillion (13% of our $15 trillion GDP, or about 4% of our $54 trillion net wealth). It also matters of course how you spend your tax revenue; even though Sweden’s tax system is no more progressive than ours and their pre-tax inequality is about the same, their spending is much more targeted at reducing inequality.

Progressive taxation is inherently more fair, because the value of a dollar decreases the more you have. We call this diminishing marginal utility of wealth. There is a debate within the cognitive economics literature about just how quickly the marginal utility of wealth decreases. On the low end, Easterlin argues that it drops off extremely fast, becoming almost negligible as low as $75,000 per year. This paper is on the high end, arguing that marginal utility decreases “only” as the logarithm of how much you have. That’s what I’ll use in this post, because it’s the most conservative reasonable estimate. I actually think the truth is somewhere in between, with marginal utility decreasing about exponentially.

Logarithms are also really easy to work with, once you get used to them. So let’s say that the amount of happiness (utility) U you get from an amount of income I is like this: U = ln(I)

Now let’s suppose the IRS comes along and taxes your money at a rate r. We must have r < 1, or otherwise they’re trying to take money you don’t have. We don’t need to have r > 0; r < 0 would just mean that you receive more in transfers than you lose in taxes. For the poor we should have r < 0.

Now your happiness is U = ln((1-r)I).

By the magic of logarithms, this is U = ln(I) + ln(1-r).

If r is between 0 and 1, ln(1-r) is negative and you’re losing happiness. (If r < 0, you’re gaining happiness.) The amount of happiness you lose, ln(1-r), is independent of your income. So if your goal is to take a fixed amount of happiness, you should tax at a fixed rate of income—a flat tax.

But that really isn’t fair, is it? If I’m getting 100 utilons of happiness from my money and you’re only getting 2 utilons from your money, then taking that 1 utilon, while it hurts the same—that’s the whole point of utility—leaves you an awful lot worse off than I. It actually makes the ratio between us worse, going from 50 to 1, all the way up to 99 to 1.

Notice how if we had a regressive tax, it would be obviously unfair—we’d actually take more utility from poor people than rich people. I have 100 utilons, you have 2 utilons; the taxes take 1.5 of yours but only 0.5 of mine. That seems frankly outrageous; but it’s what all US states have.

Most of the money you have is ultimately dependent on your society. Let’s say you own a business and made your wealth selling products; it seems like you deserve to have that wealth, doesn’t it? (Don’t get me started on people who inherited their wealth!) Well, in order to do that, you need to have strong institutions of civil government; you need security against invasion; you need protection of property rights and control of crime; you need a customer base who can afford your products (that’s our problem in the Second Depression); you need workers who are healthy and skilled; you need a financial system that provides reliable credit (also a problem). I’m having trouble finding any good research on exactly what proportion of individual wealth is dependent upon the surrounding society, but let’s just say Bill Gates wouldn’t be spending billions fighting malaria in villages in Ghana if he had been born in a village in Ghana. It doesn’t matter how brilliant or determined or hard-working you are, if you live in a society that can’t support economic activity.

In other words, society is giving you a lot of happiness you wouldn’t otherwise have. Because of this, it makes sense that in order to pay for all that stuff society is doing for you (and maintain a stable monetary system), they would tax you according to how much happiness they’re giving you. Hence we shouldn’t tax your money at a constant rate; we should tax your utility at a constant rate and then convert back to money. This defines a new sort of “tax rate” which I’ll call p. Like our tax rate r, p needs to be less than 1, but it doesn’t need to be greater than 0.

Of the U = ln(I) utility you get from your money, you will get to keep U = (1-p) ln(I). Say it’s 10%; then if I have 100 utilons, they take 10 utilons and leave me with 90. If you have 2 utilons, they take 0.2 and leave you with 1.8. The ratio between us remains the same: 50 to 1.

What does this mean for the actual tax rate? It has to be progressive. Very progressive, as a matter of fact. And in particular, progressive all the way up—there is no maximum tax bracket.

The amount of money you had before is just I.

The amount of money you have now can be found as the amount of money I’ that gives you the right amount of utility. U = ln(I’) = (1-p) ln(I). Take the exponential of both sides: I’ = I^(1-p).

The units on this are a bit weird, “dollars to the 0.8 power”? Oddly, this rarely seems to bother economists when they use Cobb-Douglas functions which are like K^(1/3) L^(2/3). It bothers me though; to really make this tax system in practice you’d need to fix the units of measurement, probably using some subsistence level. Say that’s set at $10,000; instead of saying you make $2 million, we’d say you make 200 subsistence levels.

The tax rate you pay is then r = 1 – I’/I, which is r = 1 – I^-p. As I increases, I^-p decreases, so r gets closer and closer to 1. It never actually hits 1 (that would be a 100% tax rate, which hardly anyone thinks is fair), but for very large income is does get quite close.

Here, let’s use some actual numbers. Suppose as I said we make the subsistence level $10,000. Let’s also set p = 0.1, meaning we tax 10% of your utility. Then, if you make the US median individual income, that’s about $30,000 which would be I = 3. US per-capita GDP of $55,000 would be I = 5.5, and so on. I’ll ignore incomes below the subsistence level for now—basically what you want to do there is establish a basic income so that nobody is below the subsistence level.

I made a table of tax rates and after-tax incomes that would result:

Pre-tax income Tax rate After-tax income
$10,000 0.0% $10,000
$20,000 6.7% $18,661
$30,000 10.4% $26,879
$40,000 12.9% $34,822
$50,000 14.9% $42,567
$60,000 16.4% $50,158
$70,000 17.7% $57,622
$80,000 18.8% $64,980
$90,000 19.7% $72,247
$100,000 20.6% $79,433
$1,000,000 36.9% $630,957
$10,000,000 49.9% $5,011,872
$100,000,000 60.2% $39,810,717
$1,000,000,000 68.4% $316,227,766

What if that’s not enough revenue? We could raise to p = 0.2:

Pre-tax income Tax rate After-tax income
$10,000 0.0% $10,000
$20,000 12.9% $17,411
$30,000 19.7% $24,082
$40,000 24.2% $30,314
$50,000 27.5% $36,239
$60,000 30.1% $41,930
$70,000 32.2% $47,433
$80,000 34.0% $52,780
$90,000 35.6% $57,995
$100,000 36.9% $63,096
$1,000,000 60.2% $398,107
$10,000,000 74.9% $2,511,886
$100,000,000 84.2% $15,848,932
$1,000,000,000 90.0% $100,000,000

The richest 400 people in the US have a combined net wealth of about $2.2 trillion. If we assume that billionaires make about a 10% return on their net wealth, this 90% rate would raise over $200 billion just from those 400 billionaires alone, enough to pay all interest on the national debt. Let me say that again: This tax system would raise enough money from a group of people who could fit in a large lecture hall to provide for servicing the national debt. And it could do so indefinitely, because we are only taxing the interest, not the principal.

And what if that’s still not enough? We could raise it even further, to p = 0.3. Now the tax rates look a bit high for most people, but not absurdly so—and notice how the person at the poverty line is still paying nothing, as it should be. The millionaire is unhappy with 75%, but the billionaire is really unhappy with his 97% rate. But the government now has plenty of money.

Pre-tax income Tax rate After-tax income
$10,000 0.0% $10,000
$20,000 18.8% $16,245
$30,000 28.1% $21,577
$40,000 34.0% $26,390
$50,000 38.3% $30,852
$60,000 41.6% $35,051
$70,000 44.2% $39,045
$80,000 46.4% $42,871
$90,000 48.3% $46,555
$100,000 49.9% $50,119
$1,000,000 74.9% $251,189
$10,000,000 87.4% $1,258,925
$100,000,000 93.7% $6,309,573
$1,000,000,000 96.8% $31,622,777

Is it fair to tax the super-rich at such extreme rates? Well, why wouldn’t it be? They are living fabulously well, and most of their opportunity to do so is dependent upon living in our society. It’s actually not at all unreasonable to think that over 97% of the wealth a billionaire has is dependent upon society in this way—indeed, I think it’s unreasonable to imagine that it’s any less than 99.9%. If you say that the portion a billionaire receives from society is less than 99.9%, you are claiming that it is possible to become a millionaire while living on a desert island. (Remember, 0.1% of $1 billion is $1 million.) Forget the money system; do you really think that anything remotely like a millionaire standard of living is possible from catching your own fish and cutting down your own trees?Another fun fact is that this tax system will not change the ordering of income at all. If you were the 37,824th richest person yesterday, you will be the 37,824th richest person today; you’ll just have a lot less money while you do so. And if you were the 300,120,916th richest person, you’ll still be the 300,120,916th person, and probably still have the same amount of money you did before (or even more, if the basic income is doled out on tax day).

And these figures, remember, are based on a conservative estimate of how quickly the marginal utility of wealth decreases. I’m actually pretty well convinced that it’s much faster than that, in which case even these tax rates may not be progressive enough.

Many economists worry that taxes reduce the incentive to work. If you are taxed at 30%, that’s like having a wage that’s 30% lower. It’s not hard to imagine why someone might not work as much if they were being paid 30% less.

But there are actually two effects here. One is the substitution effect: a higher wage gives you more reason to work. The other is the income effect: having more money means that you can meet your needs without working as much.

For low incomes, the substitution effect dominates; if your pay rises from $12,000 a year to $15,000, you’re probably going to work more, because you get paid more to work and you’re still hardly wealthy enough to rest on your laurels.

For moderate incomes, the effects actually balance quite well; people who make $40,000 work about the same number of hours as people who make $50,000.

For high incomes, the income effect dominates; if your pay rises from $300,000 to $400,000, you’re probably going to work less, because you can pay all your bills while putting in less work.

So if you want to maximize work incentives, what should you do? You want to raise the wages of poor people and lower the wages of rich people. In other words, you want very low—or negative—taxes on the lower brackets, and very high taxes on the upper brackets. If you’re genuinely worried about taxes distorting incentives to work, you should be absolutely in favor of progressive taxation.

In conclusion: Because money is worth less to you the more of it you have, in order to take a fixed proportion of the happiness, we should be taking an increasing proportion of the money. In order to be fair in terms of real utility, taxes should be progressive. And this would actually increase work incentives.

The Rent is Too Damn High

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Housing prices are on the rise again, but they’re still well below what they were at the peak of the 2008 bubble. It may be that we have not learned from our mistakes and another bubble is coming, but I don’t think it has hit us just yet. Meanwhile, rent prices have barely budged, and the portion of our population who pay more than 35% of their income on rent has risen to 44%.

Economists typically assess the “fair market value” of a house based upon its rental rate for so-called “housing services”—the actual benefits of living in a house. But to use the rental rate is to do what Larry Summers called “ketchup economics”; 40-ounce bottles of ketchup sell for exactly twice what 20-ounce bottles do, therefore the ketchup market is fair and efficient. (In fact even this is not true, since ketchup is sold under bulk pricing. This reminds me of a rather amusing situation I recently encountered at the grocery store: The price of individual 12-packs of Coke was $3, but you could buy sets of five for $10 each. This meant that buying five was cheaper in total—not just per unit—than buying four. The only way to draw that budget constraint is with a periodic discontinuity; it makes a sawtooth across your graph. We never talk about that sort of budget constraint in neoclassical economics, yet there it was in front of me.)

When we value houses by their rental rate, we’re doing ketchup economics. We’re ignoring the fact that the rent is too damn high—people should not have to pay as much as they do in order to get housing in this country, particularly housing in or near major cities. When 44% of Americans are forced to spend over a third of their income just fulfilling the basic need of shelter, something is wrong. Only 60% of the price of a house is the actual cost to build it; another 20% is just the land. If that sounds reasonable to you, you’ve just become inured to our absurd land prices. The US has over 3 hectares per person of land; that’s 7.7 acres. A family of 3 should be able to claim—on average—9 hectares, or 23 acres. The price of a typical 0.5-acre lot for a family home should be negligible; it’s only 2% of your portion of America’s land.

And as for the argument that land near major cities should be more expensive? No, it shouldn’t; it’s land. What should be more expensive near major cities are buildings, and only then because they’re bigger buildings—even per unit it probably is about equal or even an economy of scale. There’s a classic argument that you’re paying to have infrastructure and be near places of work: The former is ignoring the fact that we pay taxes and utilities for that infrastructure; and the latter is implicitly assuming that it’s normal for our land ownership to be so monopolistic. In a competitive market, the price is driven by the cost, not by the value; the extra value you get from living near a city is supposed to go into your consumer surplus (the personal equivalent of profit—but in utility, not in dollars), not into the owner’s profit. And actually that marginal benefit is supposed to be driven to zero by the effect of overcrowding—though Krugman’s Nobel-winning work was about why that doesn’t necessarily happen and therefore we get Shanghai.

There’s also a more technical argument to be had here about the elasticity of land supply and demand; since both are so inelastic, we actually end up in the very disturbing scenario in which even a small shift in either one can throw prices all over the place, even if we are at market-clearing equilibrium. Markets just don’t work very well for inelastic goods; and if right now you’re thinking “Doesn’t that mean markets won’t work well for things like water, food, and medicine?” you’re exactly right and have learned well, Grasshopper.

So, the rent is too damn high. This naturally raises three questions:

  1. Why is the rent so high?
  2. What happens to our economy as a result?
  3. What can we do about it?

Let’s start with 1. Naturally, conservatives are going to blame regulation; here’s Business Insider doing exactly that in San Francisco and New York City respectively. Actually, they have a point here. Zoning laws are supposed to keep industrial pollution away from our homes, not keep people from building bigger buildings to fit more residents. All these arguments about the “feel” of the city or “visual appeal” should be immediately compared to the fact that they are making people homeless. So 200 people should live on the street so you can have the skyline look the way you always remember it? I won’t say what I’d really like to; I’m trying to keep this blog rated PG.

Similarly, rent-control is a terrible way to solve the homelessness problem; you’re created a segregated market with a price ceiling, and that’s going to create a shortage and raise prices in the other part of the market. The result is good for anyone who can get the rent-control and bad for everyone else. (The Cato study Business Insider cites does make one rather aggravating error; the distribution in a non-rent-controlled market isn’t normal, it’s lognormal. You can see that at a glance by the presence of those extremely high rents on the right side of the graph.)

Most people respond by saying, “Okay, but what do we do for people who can’t afford the regular rent? Do we just make them homeless!?” I wouldn’t be surprised if the Cato Institute or Business Insider were okay with that—but I’m definitely not. So what would I do? Give them money. The solution to poverty has been staring us in the face for centuries, but we refuse to accept it. Poor people don’t have enough money, so give them money. Skeptical? Here are some direct experimental studies showing that unconditional cash transfers are one of the most effective anti-poverty measures. The only kind of anti-poverty program I’ve seen that has a better track record is medical aid. People are sick? Give them medicine. People are poor? Give them money. Yes, it’s that simple. People just don’t want to believe it; they might have to pay a bit more in taxes.

So yes, regulations are actually part of the problem. But they are clearly not the whole problem, and in my opinion not even the most important part. The most important part is monopolization. There’s a map that Occupy Wall Street likes to send around saying “What if our land were as unequal as our money?” But here’s the thing: IT IS. Indeed, the correlation between land ownership and wealth is astonishingly high; to a first approximation, your wealth is a constant factor times the land you own.

Remember how I said that the average American holds 7.7 acres or 3 hectares? (Especially in economics, averages can be quite deceiving. Bill Gates and I are on average billionaires. In fact, I guarantee that Bill Gates and you are on average billionaires; it doesn’t even matter how much wealth you have, it’ll still be true.)

Well, here are some decidedly above-average landowners:

  1. John Malone, 2.2 million acres or 9,000 km^2
  2. Ted Turner, 2 million acres or 8,100 km^2
  3. The Emmerson Family, 1.9 million acres or 7,700 km^2
  4. Brad Kelley, 1.5 million acres or 6,100 km^2
  1. The Pingree Family, 800,000 acres or 3,200 km^2
  1. The Ford Family, 600,000 acres or 2,400 km^2
  1. The Briscoe Family, 560,000 acres or 2,270 km^2
  2. W.T. Wagonner Estate, 535,000 acres or 2,170 km^2

I think you get the idea. Here are two more of particular note:

  1. Jeff Bezos, 290,000 acres or 1,170 km^2
  1. Koch Family, 239,000 acres or 970 km^2

Yes, that is the Jeff Bezos of Amazon.com and the Koch Family who are trying to purchase control of our political system.

Interpolating the ones I couldn’t easily find data on, I estimate that these 102 landowners (there were ties in the top 100) hold a total of 30 million acres, of the 940 million acres in the United States. This means that 3% of the land is owned by—wait for it—0.000,03% of the population. To put it another way, if we confiscated the land of 102 people and split it all up into 0.5-acre family home lots, we could house 60 million households—roughly half the number of households in the nation. To be fair, some of it isn’t suitable for housing; but a good portion of it is. Figure even 1% is usable; that’s still enough for 600,000 households—which is to say every homeless person in America.

One thing you may also have noticed is how often the word “family” comes up. Using Openoffice Calc (it’s like Excel, but free!) I went through the whole top 100 list and counted the number of times “family” comes up; it’s 49 out of 100. Include “heirs” and “estate” and the number goes up to 66. That doesn’t mean they share with their immediate family; it says “family” when it’s been handed down for at least one generation. This means that almost two-thirds of these super-wealthy landowners inherited their holdings. This isn’t the American Dream of self-made millionaires; this is a landed gentry. We claim to be a capitalist society; but if you look at who owns our land and how it’s passed down, it doesn’t look like capitalism. It looks like feudalism.

Indeed, the very concept of rent is basically feudalist. Instead of owning the land we live on, we have to constantly pay someone else—usually someone quite rich—for the right to live there. Stop paying, and they can call the government to have us forced out. We are serfs by another name. In a truly efficient capitalist market with the kind of frictionless credit system neoclassicists imagine, you wouldn’t pay rent, you’d always pay a mortgage. The only time you’d be paying for housing without building equity would be when you stay at a hotel. If you’re going to live there more than a month, you should be building equity. And if you do want to move before your mortgage ends? No problem; sell it to the next tenant, paying off your mortgage and giving you that equity back—instead of all that rent, which is now in someone else’s pocket.

Because of this extreme inequality in land distribution, the top landholders can charge the rest of us monopolistic prices—thus making even more profits and buying even more land—and we have little choice but to pay what they demand. Because shelter is such a fundamental need, we are willing to pay just about whatever we have in order to secure it; so that’s what they charge us.

On to question 2. What happens to our economy as a result of this high rent?

In a word: 2009. Because our real estate market is so completely out of whack with any notion of efficient and fair pricing, it has become a free-for-all of speculation by so-called “investors”. (I hate that term; real investment is roads paved, factories built, children taught. What “investors” do is actually arbitrage. We are the investors, not them.)

A big part of this was also the deregulation of derivatives, particularly the baffling and insane “Commodity Futures Modernization Act of 2000” that basically banned regulation of derivatives—it was a law against making laws. Because of this bankers—or should I say banksters—were able to create ludicrously huge amounts of derivatives, as well as structure and repackage them in ways that would deceive their buyers into underestimating the risks. As a result there are now over a quadrillion dollars—yes, with a Q, sounds like a made-up number, $2e15—in nominal value of outstanding derivatives.

Because this is of course about 20 times as much as there is actual money in the entire world, sustaining this nominal value requires enormous amounts of what’s called leverage—which is to say, debt. When you “leverage” a stock purchase, for example, what you’re doing is buying the stock on a loan (a generally rather low-interest loan called “margin”), then when you sell the stock you pay back the loan. The “leverage” is the ratio between the size of the loan and the amount of actual capital you have to spend. This can theoretically give you quite large returns; for instance if you have $2000 in your stock account and you leverage 10 to 1, you can buy $20,000 worth of stock. If that stock then rises to $21,000—that’s only 5%, so it’s pretty likely this will happen—then you sell it and pay back the loan. For this example I’ll assume you pay 1% interest on your margin. In that case you would start with $2000 and end up with $2800; that’s a 40% return. A typical return from buying stock in cash is more like 7%, so even with interest you’re making almost 6 times as much. It sounds like such a deal!

But there is a catch: If that stock goes down and you have to sell it before it goes back up, you need to come up with the money to pay back your loan. Say it went down 5% instead of up; you now have $19,000 from selling it, but you owe $20,200 in debt with interest. Your $2000 is already gone, so you now have to come up with an additional $1,200 just to pay back your margin. Your return on $2000 is now negative—and huge: -160%. If you had bought the stock in cash, your return would only have been -5% and you’d still have $1900.

My example is for a 10 to 1 leverage, which is considered conservative. More typical leverages are 15 or 20; and some have gotten as high as 50 or even 70. This can lead to huge returns—or huge losses.

But okay, suppose we rein in the derivatives market and leverage gets back down to more reasonable levels. What damage is done by high real estate prices per se?

Well, basically it means that too much of our economy’s effort is going toward real estate. There is what we call deadweight loss, the loss of value that results from an inefficiency in the market. Money that people should be spending on other things—like cars, or clothes, or TVs—is instead being spent on real estate. Those products aren’t getting sold. People who would have had jobs making those products aren’t getting hired. Even when it’s not triggering global financial crises, a market distortion as large as our real estate system is a drain on the economy.

The distorted real estate market in particular also has another effect: It keeps the middle class from building wealth. We have to spend so much on our homes that we don’t have any left for stocks or bonds; as a result we earn a very low return on investment—inflation-adjusted it’s only about 0.2%. So meanwhile the rich are getting 4% on bonds, or 7% on stocks, or even 50% or 100% on highly-leveraged derivatives. In fact, it’s worse than that, because we’re also paying those rich people 20% on our credit cards. (Or even worse, 400% on payday loans. Four hundred percent. You typically pay a similar rate on overdraft fees—that $17.5 billion has to come from somewhere—but fortunately it’s usually not for long.)

Most people aren’t numerate enough to really appreciate how compound interest works—and banks are counting on that. 7%, 20%, what’s the difference really? 3 times as much? And if you had 50%, that would be about 7 times as much? Not exactly, no. Say you start with $1000 in each of these accounts. After 20 years, how much do you have in the 7% account? $3,869.68. Not too shabby, but what about that 20% account? $38,337.60—almost ten times as much. And if you managed to maintain a 50% return, how much would you have? $3,325,256.73—over $3.3 million, almost one thousand times as much.

The problem, I think, is people tend to think linearly; it’s hard to think exponentially. But there’s a really nice heuristic you can use, which is actually quite accurate: Divide the percentage into 69, and that is the time it will take to double. So 3% would take 69/3 = 23 years to double. 7% would take 69/7 = 10 years to double. 35% would take 69/35 = 2 years to double. And 400% would take 69/400 = 0.17 years (about 1/6, so 2 months) to double. These doublings are cumulative: If you double twice you’ve gone up 4 times; if you double 10 times you’ve gone up 1000 times. (For those who are a bit more numerate, this heuristic comes from the fact that 69 ~ 100*ln(2).)

Since returns are so much higher on other forms of wealth (not gold, by the way; don’t be fooled) than on homes, and those returns get compounded over time, this differential translates into ever-increasing inequality of wealth. This is what Piketty is talking about when he says r > g; r is the return on capital, and g is the growth rate of the economy. Stocks are at r, but homes are near g (actually less). By forcing you to spend your wealth on a house, they are also preventing you from increasing that wealth.

Finally, time for question 3. What should we do to fix this? Again, it’s simple: Take the land from the rich. (See how I love simple solutions?) Institute a 99% property tax on all land holdings over, say, 1000 acres. No real family farmer of the pastoral sort (as opposed to heir of an international agribusiness) would be affected.

I’m sure a lot of people will think this sounds unfair: “How dare you just… just… take people’s stuff! You… socialist!” But I ask you: On what basis was it theirs to begin with? Remember, we’re talking about land. We’re not talking about a product like a car, something they actually made (or rather administrated the manufacturing of). We’re not even talking about ideas or services, which raise their own quite complicated issues. These are chunks of the Earth; they were there a billion years before you and they will probably still be there a billion years hence.

That land was probably bought with money that they obtained through monopolistic pricing. Even worse, whom was it bought from? Ultimately it had to be bought from the people who stole it—literally stole, at the point of a gun—from the indigenous population. On what basis was it theirs to sell? And even the indigenous population may not have obtained it fairly; they weren’t the noble savages many imagine them to be, but had complex societies with equally complex political alliances and histories of intertribal warfare. A good portion of the land that any given tribe claims as their own was likely stolen from some other tribe long ago.

It’s honestly pretty bizarre that we buy and sell land; I think it would be valuable to think about how else we might distribute land that didn’t involve the absurdity of owning chunks of the planet. I can’t think of a good alternative system right now, so okay, maybe as a pragmatic matter the economy just works most efficiently if people can buy and sell land. But since it is a pragmatic justification—and not some kind of “fundamental natural right” ala Robert Nozick—then we are free as a society—particularly a democratic society—to make ad hoc adjustments in that pragmatic system as is necessary to make people’s lives better. So let’s take all the land, because the rent is too damn high.