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Thursday, July 26, 2007
The Broken Labor Market
Economist Mark Thoma, over at Economist's View, locks in on an essential point in the inequality debate that often gets overlooked.
One thing that bothers me about the whole inequality debate is the presumption that the winners deserve their incomes because it reflects their contribution to the firm, i.e. it is the wage that would be earned in well-functioning competitive markets, with the reward is equal to the person's marginal contribution to the firm. Thus, the analysis often begins with the idea that any tax takes away someone's hard-earned income and redistributes it elsewhere.
But for the incomes where inequality is rising most - those at the very top of the income distribution - this is a questionable claim. The idea that the salary of a CEO or hedge fund manager is set by competitive markets, or even approximately so, seems unlikely, or at least open to serious question. It should not just be assumed in these debates.
If the incomes of the winners are higher than they would be in a competitive market, then many of the arguments against taxing their "hard-earned money" melt away. For example, if a person would earn $1,000,000 in a competitive market, but because of market imperfections earns $1,200,000 instead, is it unfair to tax away the extra $200,000?
At a 33% tax rate in a competitive market, after-tax income would be $667,000, i.e. the competitive income of $1,000,000 minus 33%. At the non-competitive income of $1,200,000, it would take a tax rate of around 44% to leave the person equally well off (i.e. $1,200,000 - 44% of $1,200,000 = approx. $667,000).
For this reason, I would argue that tax rates such as the 44% rate in this example are not as high as they might seem. Part of the tax simply levels the playing field, i.e. taxes away the income in excess of the competitive level, and the tax rate is then 33%, not 44%, on the part of income that would be earned in a competitive market.
The issue isn't only whether CEOs need this money, or if someone else needs it more, though those are perfectly legitimate questions. It's whether their salaries are earned; that is, are they set by competitive markets? Is the compensation proportional to their contribution to their firm or the economy?
If the answer is no, those of us who aren't CEOs, hedge fund managers, or corporate lawyers are being taken for a ride. Whoever earned that money isn't getting it.
This argument, to my mind, aims for the heart of capitalism, which is the supposition that the market is virtuous, that it rewards work, talent, and enterprise. I don't think the high priests of capitalism ever claim that it offers equality of opportunity- that's the government's job. But they do, often tacitly, believe that it provides just desserts. However, this just isn't happening in the labor market at large, where productivity and earnings have diverged to such a great extent. It's here that government is obligated to intervene, rather than just influence inputs and outputs, because market mechanisms are performing unjustly. A similar argument could be made about labor market inefficiencies.
The key question is, where is all this happening? Which labor markets are inefficient? There's plenty of anecdotal evidence and macro-data on inefficient labor markets. But it'd be nice if we knew where and to whom this was happening before moving forward on policy discussions.
Posted by Matt Lewis
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