Subsidies and Fairness

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November 5, 2023

by Stephen Stofka

This week’s letter is about subsidies and fairness. The culture of Western civilization emphasizes individual effort and achievement while downplaying our reliance on others. In the past two weeks, I have questioned an economic assumption that workers are paid the value of their marginal product. This week I will extend that analysis toward other commodities in our lives. Our society is a network of cross-subsidies; we often don’t pay the marginal cost of what we buy or pay our fair share of taxes into the public pot because of tax subsidies we receive. We judge the fairness of a subsidy by the recipient of the subsidy and we tend to favor ourselves as deserving of the subsidies we receive.

This month oil refiners are selling unleaded gasoline near a breakeven cost to wholesalers at $2.20 per gallon, reported the Wall St. Journal. A week ago, the spot price of WTI crude was about $83.00, making the per gallon cost almost $2 per gallon (see oil notes at end). The public uses less gasoline during the winter months so the slack demand reduces pricing power at the wholesale and retail level. A 20 cent profit on a gallon of gasoline does not allow oil refiners to meet their “hurdle rate,” the expected return on investment. The users of diesel and jet fuel, business customer whose demand is less seasonal, make up the difference in profits. The heaviest users of these products are trucking companies, power plants and the airlines. The users of diesel and jet fuel are effectively subsidizing the lower gasoline prices for consumers.

Is it fair that women should spent double the amount of time caring for children that men do, according to the American Time Use Survey. Is it fair that tax revenues from some states are used to subsidize the incomes of people in other states? Vermont, W. Virginia and Alaska rely on federal grants for more than a third of their budget, according to a recent report from the Office of Management and Budget and the Census Bureau. Less than a sixth of Colorado’s budget relies on federal aid.

Many subsidies are indirectly awarded through the tax system. Three of the biggest items are employer contributions to pension plans, employer-paid health insurance premiums and imputed rental income, or owner’s equivalent rent. Employers write off their contribution to an employee’s pension plan but the employee does not report the income. The U.S. Treasury estimated the tax subsidy of the various types of pension plans and IRAs was $228 billion in 2022, a sixth of last year’s deficit of $1,378 billion. Employers write off health insurance premiums they pay for their employees but that expense is not included in personal income. In 2022, the tax loss was estimated at $221 billion. Homeowners make a capital investment in their homes but do not report the annual rental income – termed an imputed rental income – they receive from that investment. In 2022, the Treasury estimated that tax subsidy at $131 billion. We may complain about the deficit but no one lobbies to reduce these subsidies.

Long-term capital gains from investments are taxed at lower rates than ordinary income. That tax exclusion favors the top half of taxpayers and had an estimated cost of $108 billion in foregone tax revenue in 2022. Tax law allows beneficiaries to inherit stocks and other investments at current valuations so that heirs are not responsible for the capital gains accrued during the lifetime of the deceased. That method of valuation is called a step-up and cost the government an estimated $44 billion in 2022. Certain service providers like lawyers and accountants enjoy a 20% deduction on their business income. This pass-through income exclusion had an estimated cost of $56 billion in 2022, about the same amount as the deduction for charitable contributions. In contrast, federal agricultural subsidies were only $15 billion, about ¼% of total federal spending. Like foreign aid, people often overestimate how much the U.S. government subsidizes farmers.

Libertarians devoted to methodological individualism or an 18th century ideal of the yeoman farmer reject the notion of an income tax subsidy. The income belongs to the individual, not the government, and the government cannot rightfully extract a tax without the consent of the individual. A person can avoid or reduce the burden of a sales or excise tax by not buying something or buying a lower cost item. An income tax is levied on someone’s effort. Religious conservatives might reject the legitimacy of an income tax for that very reason. They argue that it was God who commanded that we work after ejecting Adam and Eve from the Garden of Eden. A tax on our effort then is an affront to God’s own commandment.

Some discredit the legitimacy of any tax if they don’t like how the tax money is spent. In 1964, the singer Joan Baez refused to pay 60% of her income tax because the government was using the money for the war in Vietnam. In 1967, writers and editors protested the “Vietnam war tax,” a 10% surcharge on telephone service each month. In response to Bush’s War on Terror, the Code Pink campaign and other tax protesters refused to pay a portion of their taxes. Some were jailed and others had their bank accounts and wages seized by the IRS.

We can’t always stipulate why we think something is fair or unfair but we know it when we see it. Each of us builds a personal framework of justifications for our beliefs and opinions, then finds others with similar frameworks. Our opinions of fairness don’t matter unless we can join with others who have the same criteria we do. Finding others who share our fairness preference validates our sense of justice and raises our personal preference closer to that of a universal law. The more people who share our outrage at an injustice confirms our convictions. However, our assessments of fairness are not universal or eternal. They can change with our circumstances – our age or income, our access to resources. This idea – that justice is a communal agreement about what is fair – disturbs those who prefer to believe that there are universal truths. There may be universal facts like gravity but there is only one universal truth – on average, people give greater consideration to whatever is closer to them.

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Photo by Andrew Moca on Unsplash

Keywords: oil, subsidy, sales tax, income tax, tax protest, tax expenditures

Oil notes: A barrel of oil is 42 gallons is different than a drum, which typically has a 55 gallon capacity. The price of a barrel of oil divided by 42 is the spot price of a gallon of oil. WTI crude closed slightly lower at the end of this week at $80.51.

The Choices We Steer By

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October 29, 2023

by Stephen Stofka

Last week’s letter explored income and wealth distribution within a framework that involves choice as well  as chance. The emphasis on choice was first presented in a 1953 paper by the Nobel economist Milton Friedman. This week’s letter develops the implications of Friedman’s speculation.

Friedman suggested that a wage implicitly contained an insurance premium charged by employers for reducing an employee’s income risk. Debt instruments involve an ongoing relationship between debtor and creditor and carry a risk premium that is a component of the interest rate on the debt. The employer-employee relationship is an ongoing financial relationship as well. An employee’s desire for a consistent income leads them to accept a lower income, a tradeoff of some income for some certainty about future income. This implies that a worker’s wage is not just the marginal product of their labor, a bedrock assumption of neoclassical economics. A worker who has a tolerance for more risk will demand higher pay from an employer, reducing the insurance premium embedded in a wage.

During economic crises when there is higher unemployment, employers should be able to charge a higher risk premium, i.e. a lower wage, to workers who would have a greater desire for certainty. But wages are slow to decline during these times. In Chapter 17 of the General Theory, Keynes claimed that wages were “sticky.” Economists attributed it to union wage contracts that do not respond to changing circumstances. Today union membership in the U.S. is less than 10% of the workforce, reducing that as a causal factor in this country. So why don’t workers accept much lower wages to obtain work?

Employers and employees bargain over the price of certainty, each of them aware that certainty at any price is in short supply. In times of stress, employees may be concerned that a smaller employer, the implicit insurer of a worker’s wage, cannot provide the degree of income safety that the lower wage would purchase. Because the employer-employee relationship is a persistent one, employees are concerned that working for a much lower wage might set a precedent that is not easily undone. When economic conditions improve, how likely is an employer to restore wages to their former levels? This was a point of contention in ongoing wage negotiations between the UAW – the auto workers’ union – and car manufacturers. During the financial crisis, the union made wage concessions to help the automobile companies stay in business. When business improved, wage increases were based on the reduced wages. Recent hires were paid less than a delivery driver for Amazon.

In the closing decades of the 19th century, neo-classical economists like Stanley Jevons, Francis Edgeworth, Leon Walras and Alfred Marshall cleaved Economics away from Political Economy in an effort to treat economics as a mechanistic science of exchange. They argued that an employee’s wage was just a factor of production like machines and land. They excluded from their analysis the political and legal constructs that protected private property and the social institutions that were a part of the community that surrounded firms and their employees. The wage was a component of the marginal cost to produce one more unit of whatever the company sold. Economists called it the marginal product of labor, or MPL.

There was a moral implication that employees were being paid their “fair share” of the cost to bring the next unit into production. This model suggested that employees who demanded higher wages wanted to be paid more than their marginal product, or more than they deserved. This provided moral justification and political appeal when employers clashed with employees over wages and working conditions. In 1877, railroad owners convinced West Virginia Governor Henry Mathews to provide state militia to end a workers’ strike (White, 2019, 347).

In the late 19th century there were few legal protections and no social insurance programs for workers. Today an employer acts as an insurance broker for a host of mandated government insurance programs. These include Social Security, unemployment insurance and workers’ compensation. An employer does not provide mandated benefits for free. They are included in an employer’s labor costs and deducted from an employee’s wage. Neither employer nor employee have any choice in these government mandated insurances. The choice an employee does have is how much they must pay their employer for income stability. The employer may charge that fee in many ways. These include a lower wage or the expectation that employees will work varying shifts or staggered hours. The employer may include other working conditions in the employment bargain that require compromise from the employee. This is all part of the insurance premium that an employer charges for providing future income certainty.

An employee’s choice whether to pay that insurance premium is bounded by their expectations, personal circumstances and the broader economy. An employee who asks for a higher wage, refuses to work a varying schedule or declines working overtime risks negative consequences. If the job market looks poor, the employee is more likely to comply with employer demands. An employer calculates the degree of difficulty to replace that employee and the “domino effect” of a higher wage on other employees in the company. Employers may stress confidentiality but employees often spread news of a wage increase, or the lack of one, to their coworkers. This is a series of opportunity cost calculations made by both employers and employees.

In the late 19th century, economists devised a mechanistic interpretation of human interaction that is still a component of economic studies today. Bargaining between parties is illustrated by supply-demand diagrams, Edgeworth boxes and other graphical teaching tools. Keynes’ 1936 General Theory is entirely founded on the principle that investors bargain with uncertainty but it wasn’t until the following decade that economists incorporated game theory into their analysis. Friedman’s 1953 paper was an exploration of the choices that underlay the dynamics of economic relationships. Like Keynes, Friedman was fascinated with the interaction between choice and chance in our lives. Chance is like being in a raft on a river. Our choices are like oars that help us navigate the perils of the moving water and the hidden rocks in our way. Throughout his life, Friedman pointed out the hidden aspects of our lives.

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Photo by Bluewater Sweden on Unsplash

Keywords: marginal product of labor, neoclassical economists, wages, insurance, uncertainty

White, R. (2019). The Republic for which it stands: The United States during reconstruction and the gilded age, 1865-1896. Oxford University Press.

Choice and Chance

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October 22, 2023

by Stephen Stofka

This week’s letter is about income and wealth distribution. I’ll take a look at a recent report on those topics through the lens of a  perspective first proposed 70 years ago by a Nobel economist.

This past Wednesday the Federal Reserve released the triennial 2022 Survey of Consumer Finances, or SCF. Gains in household wealth (assets less liabilities) were much more widely distributed than gains in annual income. Real median household net worth increased 37% while its cousin, the mean or average, increased only 23%. Remember that these are percentage gains and percentages depend on the base, or divisor.

A $1 million net worth household with a gain of $200,000 in net worth experiences a 20% increase. A household starting from half that net worth, or $500,000, might have a gain of $150,000 which represents a 30% gain. The second household has experienced a smaller monetary gain but a higher percent gain.

This recent Fed survey found that the median increase was higher than the mean increase, indicating that the increases in wealth were widely distributed. Government support programs during the pandemic helped households reduce their debt levels. Double digit increases in home prices raised the primary asset that is the cornerstone of household wealth. Median net housing values (appraisal value less outstanding mortgage) rose by 45% in the three years between surveys the report found. Gains in income, however, did not exhibit the same equanimity.

I’ll be mentioning top half and bottom half of households a lot in the next sections so I will just refer to them as the Uppers and Lowers. Income gains were not widely distributed. Real median household incomes rose by 1% in each of the three years, but real mean incomes rose by 5% annually. The income gains went to the Uppers and a college degree was a consistent characteristic of the Uppers. Our specialized workplace puts a premium on education. During the period 2019-2022, the retirement account balances of the Uppers rose while those of the Lowers fell. 

Half of Upper households owned their own business but only 1 in 7 of Lower households did so. Let’s visit a paper written by Milton Friedman (1953) called Choice, Chance, and the Personal Distribution of Income. Remember those two words: choice and chance. Friedman remarked “every enterprise in our society is in part an arrangement to change the probability distribution of wealth” (p. 281). Large or small, a business owner takes risks to increase the chance of reaping more income. If an employer cannot sell what their employees produce, the employer’s profit is reduced or disappears entirely. Eventually that business goes out of business.

In his own imaginative way Friedman examined the relationship between employer and employee. An employer makes a profit from the work of an employee in return for the promise of a wage. To the employee, a wage reduces income uncertainty. Friedman reasoned that the calculation of a wage must include an implied premium like that of an insurance policy. Included in an employer’s profit is the price of an insurance policy that the employer sells the employee who desires income certainty.

Friedman pointed out that there is an element of preference in an employee’s decision to work for an employer. He challenged the simplicity of the conventional narrative that the Lowers had, by chance, lacked access to inherited wealth and natural endowments. Friedman constructed a more complex mechanism of income distribution that involved the choices that people made to reduce risk. Yes, those choices might be bounded by the resources available to a person. Their circumstances might induce a preference for certainty but it would be a mistake to disregard the choices that people made as they sought safety in their lives. Imagine a single woman who is the sole provider for two children. For the sake of her children, she needs the certainty of a wage income and is more likely to choose a steady paycheck from an employer rather than start up a business.

On a macro scale, Friedman pointed out that a society makes choices that make it more or less likely that individuals will prefer certainty. If more individuals choose the certainty of wages and there are fewer employers to provide that certainty, employees will be paying higher insurance premiums, i.e. lower wages, to employers in return for that certainty. That is a prediction conforming to the law of supply and demand. Inevitably that will lead to growing income inequality. To make that distribution more equal, a government will have to adopt redistributionist policies that tax employers, essentially stripping away part of the insurance premium and returning it to employees.

Changing mores and welfare policies in the 1960s supported individual independence but inadvertently promoted the growth of a vulnerable demographic. These were single head of households, mostly women, who would be less tolerant of uncertainty. While our society championed the new emphasis on personal freedom, many individuals were becoming less free in their economic circumstances and choosing the certainty of wages rather than risk the unpredictability of business profits. Since the late 1960s, income inequality has grown steadily.

If Friedman’s perspective had some predictive power, economic crisis and redistributive government policies should induce more people to desire certainty. That reach for safety should lead to a decrease in small business startups, enabling employers to pay lower wages to employees seeking income certainty. Does the data support Friedman’s hypothesis? I will look at historical SBA data for businesses with fewer than 20 employees to keep the analysis consistent (see Note). I will call them Smallees, or little small businesses. I will compare the ratio of such businesses to the number of employees in the country.

In 1988, there were 4.4 million Smallees and 105.4 million employees, a ratio of 4.2 Smallees per 100 employees. In 2006,  there were 5.4 million businesses and 136.4 million employees, resulting in a ratio of 4 businesses per 100 employees. Then came the financial crisis and a slow recovery. In 2019, the year before the pandemic, there were the same 5.4 million Smallees and an employee count of 150.8 million, a ratio of only 3.6 small businesses of this size per 100 employees. Perhaps Friedman had an insight into human behavior after all.

Friedman’s talent was his ability to communicate a change of perspective to his colleagues, his readers and the audiences of his popular lectures. He consistently focused on choices that people make in their personal lives and within the institutions where they work. Friedman concluded that “the foregoing analysis is exceedingly tentative and preliminary” (p. 289) and noted the faults in the simplified model he had presented. The implications of his thought experiment could have undermined a central assumption in neoclassical economics: that workers are paid the marginal product of their labor. More on that next week.

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Photo by Alexander Schimmeck on Unsplash

Keywords: income, choice, chance, small business, income distribution, income inequality

SBA Note: The SBA’s definition of a small business varies with business revenue and number of employees. A micro business is generally one to four employees. Businesses with more than 100 employees is considered a medium business. A small business is in between. The agency used to track businesses with 20 – 49 employees and those with 50 – 49 employees as two distinct groups but now groups them together.

Friedman, M. (1953). Choice, chance, and the personal distribution of income. Journal of Political Economy, 61(4), 277–290. https://doi.org/10.1086/257390

Problems and Solutions

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October 15, 2023

by Stephen Stofka

This week’s letter is about how we process information. I’ll cover everything from investing and FTX to Sesame Street so buckle in. This week’s topic was prompted with my exchange with two people at an online help desk. People who handle a lot of email probably skim the emails they receive without paying too much attention to the details. As a result they become less responsive to customer inquiries and problems. Tuck that word responsive into your pocket. It is a key feature of interpersonal relationships and how web pages are supposed to respond to our mouse clicks and keyboard strokes.

In a complex society, there are many principal-agent relationships. We rely on other people to intermediate a problem we are having. We do not have the knowledge or the capability to reach a solution by ourselves. Often these roles are formalized and licensed. The agent must have some training and testing. Examples include a doctor, electrician, an insurance agent, a real estate or securities broker. However, we often engage with people for which there is no standard of training or testing. People on a help desk – customer service reps – are examples of this type of agent. They may have received training by the company they work for but there is no formal standard. It is up to each company to decide how to spend its resources.

Two weeks ago I had a legal matter with a large bank and wanted to know if I needed a type of notarized affidavit or was there a simpler solution. The person I reached at customer service did not know the answer but repeated the gist of the problem back to me, indicating that they understood the nature of my problem. After thirty seconds of waiting she came back with an answer that was appropriate to the problem I stated, confirming that the person had listened and understood my problem. Within minutes the problem was resolved and I could see confirmation of the solution. This past week I had a technical problem with a computer program. The online customer service rep could neither help me resolve the problem nor respond appropriately to the problem I presented. A second service rep was also unresponsive. This company touts itself as a leader in responsive technology and design. A search within a customer forum suggested a solution which worked.

I have been a customer service rep and trained reps in the days before the widespread use of computers. We wrote out general classes of problems that customers had and the questions that needed to be asked to determine a path toward resolution. A rep might fail to recognize that a specific problem belonged to a general set of similar problems. They did not know enough about the company’s business to comprehend a suitable classification so that they could reference the correct question and present a way forward to the customer. Companies now have powerful search engines that can empower customer service reps. Are they deploying those tools and training reps properly? I fear not. We can do better.

Being able to classify events and data is a skill that we begin learning early. Those who watched Sesame Street may remember “One of these things is not like the other” drills. Presented with a picture of a dog, a horse, a cow and a bird, which one is not like the others? We learn to compare and contrast, to extract qualities from individual objects that are similar and different. Is the bird different because it has two feet, because it has a beak or because it is small compared to the others? Was the horse different because it had hooves and the others didn’t? Why is that not the best choice? We learn to reason.

As adults we learn to classify cancerous tumors from x-rays, to identify money-making schemes that are too good to be true, to assess the risk of recessions or asset bubbles. Despite extensive training and experience, these are all difficult to classify. A second radiographer reviews a mammogram to reduce diagnostic errors. Every day people fall for a swindle because they cannot see the similarity with other swindles. This week’s trial of FTX founder Sam Bankman-Fried is an example of our vulnerability in this area. Economists and financial advisors are often surprised by recessions and asset bubbles. The financial crisis in 2008 caught many economists off guard. Irving Fisher, a leading economist during the early part of the 20th century, expressed his confidence in the stock market and was fully invested when the stock market crashed in 1929. He lost all his savings and spent the rest of his life in poverty, beholden to some charitable benefactors for a place to live and a respite from debtor’s prison.

As individuals we are not good at processing the amount of information we encounter. In a complex society, the information can be disorienting so we rely on others to help us digest it. Our society and culture provides props that we use as shortcuts, or heuristics, to navigate the load of information. A foundational assumption of economics is that we want to maximize our sense of satisfaction. To do that, we must choose among the resources available to us. We may not know how to achieve the satisfaction we desire but we care about achieving it. Schemers and promoters take advantage of us because we care about our satisfaction. 

Because we rely on others to help us navigate toward greater satisfaction, we are vulnerable to get-rich schemes. We want to be more financially secure so we invest in FTX tokens or pay a monthly fee to get hot stock tips that will turn our meager savings into a comfortable cushion of cash. In our search to satisfy our wants, we don’t think to ask if this solution is easily accessible, why isn’t everyone financially secure? We are told that we are getting in early on an idea and when the idea becomes popular, we will reap the rewards of recognizing a golden opportunity. We may be reminded of Amazon or Microsoft and the astronomical gains of those who invested early and held on.

We must put up with customer service reps that don’t respond appropriately to our questions or problem. We must be on guard against those who promise solutions before we have even presented our problem. Our greatest challenge is that we are both agent and principal in many of our financial affairs. We may not become better informed agents and protect our savings and assets until have we have been hooked like a fish by some promoter.

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Photo by Jon Tyson on Unsplash

Keywords: utility, satisfaction, classification, diagnosis, swindle, security

A Twist of History

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October 8, 2023

by Stephen Stofka

This week’s letter examines the deployment of the COVID-19 vaccine in 2021 and the passage of the 3rd stimulus plan on March 11, 2021, six weeks after President Biden took office. This past week Katalin Kariko and Drew Weissman were awarded the Nobel Prize in Medicine or Physiology for their work in developing the mRNA vaccine. Republicans have blamed Biden and that stimulus as being a major contributor to inflation, claiming that the government handed out too much purchasing power as the economy was recovering. We tell history in hindsight so that it has what statisticians call a survivorship bias. At each point in the narrative there were several possibilities that did not happen.

Biden came into office just weeks after protesters, spurred on by Trump’s rhetoric of “We fight like hell,” stormed the Capitol. Many businesses, deemed non-essential, remained closed. Despite two large stimulus payments and several relief plans, GDP growth in the fourth quarter was flat at just 0.56% annualized. Like any President coming into office, Biden wanted to make his mark. With narrow majorities in the House and Senate, his party could steer legislation to the finish line. A third rescue plan was politically feasible and advantageous. Was it economically prudent? In hindsight, we make judgments. Decisions are made in the fog of foresight.

In February 2021, just a few weeks after Biden took office, vaccines first became available to vulnerable populations – seniors and the immunocompromised. There are three phases – Phase 1, 2, 3 – that a drug goes through before approval. Normally, Phase 3 alone takes one – four years. In February 2021 the approved vaccines had been through all three phases in less than a year. The mRNA vaccine was an entirely new development process and had never been approved for human use. In short, there was a lot that could have gone wrong. In addition to those concerns was the possibility that the disease might mutate enough to render some vaccine varieties impotent.

More than a decade earlier Biden had been Vice-President when the administration did not push for enough stimulus. Critics on both sides of the aisle worried that further support programs after the financial crisis would spur inflation. Instead, inflation remained stubbornly low and the economy idled in low gear. Biden was not about to make the same mistake again.

What if the vaccines had not been successful or successful enough to hinder the further spread of Covid? The economy would have remain partially shuttered and people in both parties would have been grateful for the third stimulus, demanding even more stimulus payments and other relief measures. Thankfully, that didn’t happen. We often shape our memories of historical events to confirm our choices and to support our opinions. We cut out those events that contradict the coherence of our narrative. We create a history that has shared elements with others of our political persuasion but each history is unique to us alone. We bring that unique set of memories into the voting booth each election and help create our country’s history.

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Photo by Thomas Kelley on Unsplash

Keywords: stimulus, inflation, Covid-19, vaccine, election

Two Growth Paths

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October 1, 2023

by Stephen Stofka

This week’s letter is about the federal public debt and GDP. This weekend the federal government may experience a partial shut down unless there is some last minute bargain. The Constitution gave Congress, not the President, the power of the purse yet it been unable to pass a budget on time for 29 years, according to Pew Research. Conservatives complain that entitlement programs like Social Security and Medicare have put most federal spending on automatic pilot, taking away much of the power that the Constitution gave to Congress. Democrats complain that too much money is devoted to military spending at the cost of programs that support families.

The conflict over social benefit programs is not new. Congress struggled with pension spending for decades following the civil war. Veterans benefits were expanded to survivors in 1879 and 1890 and by 1893, pension payments were over 40% of federal spending. The passage of the 16th Amendment in 2013 authorized the taxing of incomes to provide a funding source for these pensions.

In 2014, the public debt exceeded GDP, or the country’s annual output. I have charted the annual growth rates of the public debt and GDP below. The growth rate of debt has remained above the growth rate of GDP under both Democratic and Republican presidents. I’ll present the trends and highlights but here is a link to the chart at FRED’s website if you want to explore more.  

During the 1980s, the debt began to consistently grow more than the economy. Republicans excused the deficits under Reagan as a necessary expense to end the threat of the Soviet Union. The 1984 Republican Party platform proposed a multi-front strategy to contain and combat Soviet influence and aggression. Republicans excused the profligate spending of the Bush Administration who pursued two wars in Afghanistan and Iraq in response to the 9-11 attack on the Twin Towers in Manhattan. In September 2008, the Bush administration took extraordinary measures to rescue the banking system. The 2008 bank bailouts first ignited dissent within the Republican party and the Republican Study Committee emerged as a fierce opponent to a pattern of federal spending that was suddenly out of control. Under President Obama, the growth rate of debt increased to handle the fallout from the financial crisis. Democrats blamed the crisis and the increase in debt on the lax financial oversight of the Bush administration.

Economics students are introduced to a lot of unfamiliar concepts. One of these is elasticity, a ratio of growth rates that divides (compares) the percent change in one variable by the percent change in another variable. The economist Alfred Marshall (1842-1924) – the one who popularized the familiar supply-demand diagram – coined the term to compare two growth rates. Responsiveness would have been a better term, I think. Here’s the idea. If the price of bananas goes up 1%, does the quantity of bananas decrease 1%? If so, then the elasticity is minus 1 (Often, the absolute value is used), a unit elasticity. There is an equal response of bananas to changes in price. If there is no change in the quantity of bananas bought, then the demand for bananas is perfectly inelastic, or unresponsive. If a small rise in the price of bananas causes a large drop in the demand for bananas, then demand is very elastic, or responsive. See the notes below for more.  

The critical benchmark for policy makers and business strategists is 1 (using the absolute value), or unit elasticity. A policymaker will ask: if a city increases their police force by 1%, does crime decrease by 1%? If the relationship is relatively inelastic, then the number of crimes will not decrease by as much. That will make it more difficult for a policy maker to appeal for greater police funding. Let’s keep that threshold of 1 in mind as we look at the public debt and GDP.

I will make a reasonable presumption that when GDP goes up, more taxes are collected and there are fewer claims for unemployment benefits and other social support benefit programs. In a blackboard theoretical world, debt would decline when GDP grew. The best we can expect is that debt increases by a smaller percent than the percent increase in GDP. Unfortunately, that’s not the case and the history of debt and GDP provides several paradoxes.

Let’s start with the 1970s, a decade noted for:

  • the Vietnam War,
  • Nixon’s impeachment and resignation,
  • The end of gold convertibility,
  • high gas prices and energy bills
  • high inflation
  • two recessions, one of them severe

For economists, the decade is a benchmark used for comparative analysis. “Are current conditions as bad as the 1970s?” Despite all the political and economic upheaval, the elasticity we are charting was above 1 for only two years, 1975 and 1976. In other words, the growth in debt was less than the growth in GDP for most of the 1970s.

Economists regard the 1980s as a turnaround but the decade marked a new regime of using debt to buy GDP growth. During the period 1980 through 1995, there was only one year when economic growth was higher than the growth of debt.  The Omnibus Budget Reconciliation Act of 1993 raised taxes, reducing the growth of debt as GDP increased during the years 1995 through 2001. When the Bush Administration signed a tax cut package in 2001, the growth rate of debt again overtook economic growth. Two wars and a financial crisis kept the elasticity above 1. 2015 and 2017 were the only two years when the growth rate of debt was less than the growth rate of GDP.  In 2020, the year of the pandemic, the elasticity spiked to almost 15. Low percent of economic growth, high percentage growth in debt. In the past two years, the elasticity has been below 1 only because debt grew so high and so fast during the pandemic.

Can we continue to borrow to buy ourselves economic growth? There is an old adage: anything that can’t go on forever won’t. The question is how long before a change of sentiment turns our present policy into folly?

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Photo by Markus Spiske on Unsplash

Keywords: elasticity, growth rate, debt, GDP

Elasticity Note: If the quantity of bananas sold falls 0% for a 1% rise in the price of bananas, then 0% / 1% = 0, a perfect inelasticity, or unresponsive. If the quantity of bananas sold falls 99% for a 1% rise in price, then -99% / 1% = -99.  Often the absolute value is used. Here is an explainer on the price elasticity of demand.

Labor Productivity

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September 24, 2023

by Stephen Stofka

This week’s letter is about labor productivity. The autoworker’s union (UAW) expanded its strike to 38 parts and distribution plants in the hopes that a wider impact will incentivize further concessions from auto executives. Labor constitutes only 10-15% of the price of a car yet labor disputes may give the impression that rising car prices are entirely or mostly the fault of labor union demand.

For more than 100 years, auto plants of the Big Three automakers have been union shops. Foreign manufacturers like Toyota and Honda have built non-union plants in southern states where union organizers have less influence with policymakers. There are almost a million auto workers now in Mexico where wages have been lower. In 2022, GM Mexico paid its workers between $9.15 and $33.74 an hour, but relatively few auto workers in Mexico make more than $16 per hour.

Two weeks ago, the BLS released their productivity figures for the second quarter. Productivity rose faster than labor costs by a good margin – notching a 3.5% annualized gain versus a 2.2% increase in unit labor costs. The manufacturing sector that car manufacturers belong to had a lower productivity gain of 2.9%. In that productivity release the BLS provided a chart grouping productivity gains by decade. The 75-year average is a 2.1% annual growth rate.

An often repeated theme of union workers and workers in general is that wage gains have not kept up with productivity gains. The BLS charted both series since 1973 and the divergence keeps growing by decade. American workers are competing with lower wage workers in Mexico, China and southeast Asia.

The annual gain in Productivity is erratic, rising sharply at the onset of recessions when workers are let go and the total hours worked declines. Recessions reduce the percentage of hours worked far more than the percentage reduction in output. I charted the annual gain in Labor Productivity (FRED Series OPHNFB) to show the effect of these shocks. The pandemic caused a particularly sharp rise and fall, as shown in the red rectangle below.

A five-year chart smooths out the divergences, letting us see the patterns more clearly. The red line in the graph below is the 1.5% current growth rate.

Trends in productivity growth are a medium term process, longer than any Presidential term. Despite that, candidates promise big productivity gains if they are elected. Republican candidates promise that lower taxes will boost productivity because that claim appeals to Republican voters. When productivity growth declined following the Bush tax cuts in 2001, conservatives blamed the stifling effects of regulatory compliance and called for more tax cuts. Democratic politicians promise more subsidies to an industry that is not nimble enough to respond to changing economic circumstances.

There are many factors that contribute to productivity growth. Some economists claimed that lower interest rates after the financial crisis would raise productivity. It fell. Those believers assert that declining productivity growth would have been worse without lower interest rates. This claim also cannot be disproved. Hypothetical situations are the favorite shield of a believer.

Corporate profits are up sharply since the start of the pandemic. For the past year, GM has enjoyed strong profit growth but they have had far too many down quarters since the financial crisis. Ford has fared better but its profit margin of 2.4% is only slightly more than the high-volume, low margin grocery giant Kroger. Stellantis has struggled to make a profit since 2018. For decades, federal and state governments have subsidized these auto giants with tax breaks and loans because the industry as a whole employs 1.7 million workers and contributes more than 10% to GDP. It is an industry where politics and economics are tightly intertwined. The politics clouds the economic analysis and the economics contorts the political calculations.

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Photo by carlos aranda on Unsplash

Keywords: auto industry, GM, Ford, Stellantis, union, UAW, labor, workers, wages

The Power in Our Pockets

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September 17, 2023

by Stephen Stofka

This week’s letter is about wages and income and the real purchasing power in our pockets. The auto workers’ union (UAW) went on strike limited to three auto plants while they continued negotiations with the auto companies. Nurses at Kaiser Permanente have voted to go out on strike by September 30th if they cannot resolve outstanding differences with Kaiser’s management. Executive compensation at the auto companies is now more than 300 times the average worker’s pay, the UAW points out, claiming that workers have as much right to share in the profits as executives and shareholders.

Legislation passed after the financial crisis required that publicly held companies report their CEO-to-Worker pay ratios. A recent analysis of companies in the SP500 estimated a pay ratio of 272-1 in 2022. The auto industry is part of the consumer cyclical industry, whose median executive compensation in 2021 was $13.7 million, as reported by Equilar. In 1965, the pay ratio was approximately 20-1. In the 1980s, the Reagan administration adopted a relaxed regulatory stance to corporate mergers and companies have grown much larger in the past decades. The pay ratio, however, has grown out of all proportion to the growth in corporate size.

A combination of factors contribute to high relative CEO pay. Thomas Greckhamer (2015) identified six paths – configurations of various factors – that are present in countries with high CEO pay and those without high CEO pay. He found that the relative pay of CEOs is high in countries where equity markets are well developed and highly liquid. Ownership is widely dispersed so that the CEO enjoys more power relative to stock owners and can negotiate higher compensation packages. CEOs do not have high relative pay in high welfare states where there are strong worker rights. A cultural acceptance of inequality and hierarchical authority, termed “power distance” by Geert Hofstede in 1980, contribute to high relative CEO pay. Here is a quick explainer. As a comparative example, the power distance factor in the American culture is low, half that of Mexico.  

Companies today derive their revenue and profits globally. For that reason it is not accurate to divide corporate profits by the number of employees in the U.S. I am going to do it anyway just to show the profound change that has taken place since the 1970s, a benchmark decade often cited as the beginning of growing inequality in the pay ratio. In the chart below I have adjusted after-tax corporate profits (FRED Series CP) for inflation, then divided that by the number of employees reported by the BLS (FRED Series PAYEMS). The trend is more important than the actual figures. Even though the 2010s were relatively flat the level of profits per employee was about double the level of the 1990s. Let’s compare that to worker incomes.

Since 1992, median household income adjusted for inflation has risen 23%, a level that is far below the rise in profits per worker. The chart below shows the gain on a log scale. Real incomes have gained less than 1% per year.

A few weeks ago I proposed adjusting prices by a broad index of house prices instead of the CPI. Two-thirds of American households own their home and home values reflect the discounted flow of housing services that we get from a home during our lifetimes. Housing costs are already almost half of the CPI and trends in home prices capture the feel of inflation on household budgets more accurately than the many CPI measures economists currently use.

During the 1980s and 1990s, housing prices increased 4% annually. The chart below describes the median household income adjusted by the all-transactions home price index (FRED Series USSTHPI). Notice that household incomes during those two decades stayed on an even keel.

Had the Fed structured their monetary policy to keep home price growth at the same level as the 1980s and 1990s, real incomes would be near the level of the green line, 10% higher today. Instead, workers feel as though they are on the path of the red line, regardless of what official measures of real household income indicate. The red line reflects a sense of discomfort and tension in many American households that plays out in our politics. The trend began with housing and finance policies enacted by both parties in Congress across five Presidential administrations.  

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Photo by Charles Chen on Unsplash

Keywords: home prices, labor unions, wages, income, household income

Greckhamer, T. (2015). CEO compensation in relation to worker compensation across countries: The configurational impact of country-level institutions. Strategic Management Journal, 37(4), 793–815. https://doi.org/10.1002/smj.2370

Historic Employment Boom

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September 10, 2023

by Stephen Stofka

This week’s letter is about the mix of full-time and part-time workers and what it tells us about the economy. Although unemployment remains below 4%, it rose slightly, according to the most recent unemployment report. This was a good sign, however, because much of that increase was due to formerly discouraged people returning to the labor force and looking for a job. This economy is producing historic employment numbers. Let’s dig in.

I’ll be looking at ratios of workers to the working age population so I’ll discuss that briefly before heading into the data. The Bureau of Labor Statistics now defines the working age population as someone 16 years and older. According to that definition, a 90 year old person is working age. The U.S. is part of the OECD group of developed countries, which uses a more traditional definition of the working age population as 15 to 64.  I am going to use the OECD definition to make historic comparisons more accurate. Two-thirds of this working age population is employed full or part time.

The percent of working age people who are employed full time – the red line in the chart below – is about 64%, a historic high that has eclipsed the economic boom of the late 1990s.

Only 2% of working age people are working part time.

The ratio of full-time workers to part-time workers reveals the strength of the economy. When it is high, employers have the confidence to commit resources to full-time workers, including better benefit packages. Workers have more bargaining power. The chart below shows the peaks in that ratio since the 1960s. A rise in investment accompanied each period. Defense spending led the surge in the 1960s. Investment in technology was a major driver of emploment growth in the 1990s. Spending on infrastructure has been a key driver of growth since the pandemic.

In the post-pandemic recovery, employers have sharply increased wages to fill positions, as shown below by the Atlanta Fed’s wage growth tracker. The decrease in wage growth during the past year is more typical of recessions but without a recession. In the chart below, note that today’s wage growth is one percent higher than the peak during the strong labor market of the late 1990s.   

The greater the number of full-time workers, the more the federal government receives in FICA taxes, reducing the yearly deficit in the Social Security Trust Funds. Since the early 1980s, income tax rates have been indexed to inflation but social security taxes have not. Only the earnings subject to social security, the earnings cap, is indexed. According to the latest Trustees report, the drain on the trust fund last year was $22 billion, less than 1% of the $2.8 trillion fund, but a drain, nevertheless. The first of the historically large Boomer generation were eligible for retirement almost a decade ago. The last of that generation will be eligible for retirement in eight years. The era of annual surpluses in the trust funds is over. During the past decade, outlays increased at a 4.5% annual pace while tax collections increased at a 5.3% rate. This was a welcome change of pace from the previous decade 2003 through 2012 when social security tax collections grew at only 3.6% annually, while outlays grew at a 5.4% rate.

The financial crisis had a deep negative impact on the trust funds and the current estimate is that the trust funds will be depleted in 2034. After that date, retirees will not receive full benefits without some legislation to provide additional funding. In 1990, the trustees estimated a depletion date of 2043, almost nine years later than today’s estimate. These long-range forecasts necessitate many assumptions about economic growth and benefits and such forecasts cannot anticipate outlier events like the financial crisis. There is a lot of catching up to do. We need all the boom we can get.

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Photo by bruce mars on Unsplash

Keywords: social security, taxes, employment, wages

Note: In the past twenty years, the number of working Americans who are older than 65 has jumped from four million to 11 million, or 6.5% of the labor force.