The Dole and How to Swing It

I’ve given you the libertarian argument: screw you, it’s my money, and redistributing it according to your preferences rather than mine is robbery, plain and simple.  I’ve also given you the empirical economic argument that a larger welfare state makes us all poorer by leading us all to work less, as is the case in Europe.  This perhaps overstated the case –one might argue that an expansion of the welfare state, financed by taxing the rich, could leave the rest of us in between no better or worse off, and amount to a simple transfer from rich to poor.  That proposition seems to me to be the chief domestic policy promise of the Obama campaign.  If this proposition is true, and we are somehow unmoved by the libertarian argument that redistribution is theft, then the middle class can buy its virtue on the cheap by simply supporting the welfare state.  A vote for Obama establishes that you care; at bottom all you care about is having other people support the poor, but of course you get credit beyond this.  To the extent that middle class may have just done precisely this – bought its virtue on the cheap – it is about to find out that it will be a lot more expensive than it anticipated.

Raising taxes has 2 possible effects on labor supply decisions: 1) you work more because you need to work more to achieve the same standard of living (income effect); or 2) you work less because leisure, which cannot be taxed, becomes relatively more attractive (substitution effect).  A few posts ago I discussed the economic research that indicated the second effect dominates when the extra tax revenues finance transfers that provide to us things we would otherwise purchase for ourselves by working more, and therefore the tendency is for all to work less.  This is a dynamic that affects not just those at the bottom – it affects the vast set of people who receive middle class entitlements, such as education and retirement benefits. 

But the extent to which this dynamic is in play for different income groups is a function of how the taxes and benefits are distributed across groups, and of course the doling out of benefits is not uniform across income classes.  A new tax that is levied on only the rich to finance transfers to the poor does not change the tax picture for the poor, but it does change the tradeoff between work and leisure.  An unskilled laborer who can find a job in the market for $10 an hour views staying idle more and more attractive if the effective wage for staying idle increases.  To paraphrase Milton Friedman, the surest way to increase the supply of unemployed people is to pay them more money.  In my experience, I think that many liberals simply reject that such incentives really affect the labor decisions of the poor.  In their view, all people are earnestly seeking employment to earn a living and be self-sufficient.  That is, many liberals I know seem to think that such pride among the poor is there, and that the simple economic calculus does not apply to their labor decisions. 

Consider someone in that low-income set, with little education, busting to scratch out a living at a low wage rate, who sees a neighbor living at a similar standard with no hassles.  I think it would take a rather admirable level of pride for someone in that situation to eschew the easy path; we can all understand the frustration someone in that situation would feel in thinking that all of his efforts get him nowhere.  The only break against giving in to the obvious incentive to not work is pride – the desire to be self-sufficient and not dependent on others.  Rather than celebrating those cases where such pride has kept people off of the dole despite their hard work providing them little or no benefit over the dole – the federal government actively engages in efforts to argue people out of such pride.  There should be a stigma to being dependent – and indeed there is a stigma, otherwise the feds wouldn’t have to run around convincing people otherwise.

A too generous safety net, on pure economic grounds, creates a clear incentive to not seek employment – increasing the benefits derived from not working is equivalent to increasing the effective marginal tax rate for working – few of us face a situation with as steep a marginal tax rate as those at the lowest rung of the economic ladder.  For these people, there is basically no “income” effect from the decision not to work, and of course there is a huge substitution effect.  In supply and demand terms in the market for unskilled labor, the supply curve shifts to the left.  If demand is unaffected (a big if, as I will discuss), the wage rate for unskilled labor goes up, but total employment for unskilled labor goes down.  This may not show up as increased unemployment, because to be considered unemployed you have to be seeking a job.  Nonetheless, many people who are capable of learning on the job, becoming more skilled, and growing in income simply step off the ladder.   When you increase the benefits of the welfare state, you increase the number of people seeking to be beneficiaries via the reduction in labor supply. 

For those who pay – in this example the rich – there is nothing coming back to them in the form of a recycled benefit.  For them, both the income and the substitution effect are equally in play, and therefore there is a chance the income effect will dominate so that the rich do not decrease their work input, and tax revenues go up.  This is clearly the hope of the current administration.  I have made the argument that the substitution effect will dominate in these cases – that the rich will simply work less, and that the increased welfare state will require that the taxes trickle down to the lower income categories.  When I’ve made this argument to liberal friends, they reject that this is a likely response to increased taxation.  In this view, either the rich cannot scale back their labor (i.e. due to employer’s not allowing it), or their sense of vocation in their work makes them unresponsive to such incentives. 

If you consider a high paid employee of a bank, as an example, the increased tax rate may have no effect – he cannot say to his boss that he would like to cut back from 60 hours to 40 hours a week, otherwise he would simply be let go.  But in many cases that same banker will have a spouse, also well-educated and highly skilled, whose decision to work is much more malleable.  Entering the workforce, that person faces the 15 percent payroll taxes (yes, I know, the employer “pays” half of this – but this is the statutory incidence of the tax, not the economic incidence – it comes out of your pocket) right off the bat, in addition to coming in at the top marginal tax rate for federal (currently 35 percent) and applicable state taxes (let’s say 5 percent for arguments sake).  Prior to any tax increase from the current status quo, this person works half of the year to pay taxes.  But it’s worse than that, because that couple faces costs that it could otherwise avoid if one person stayed out of the labor market: child care or a nanny, increased commuting costs, increased wardrobe costs, increased stress, the likelihood of dining out more often, landscaping and other routine house maintenance costs.   The marginal tax rate for a well-to-do two income family can easily be over 75 percent – there is not a huge incentive for the spouse to work under those circumstances.  As a result, trying to inch up the marginal tax rate on this couple may eek a few more dollars out of the bread winner, while giving up all of the tax revenues it might otherwise receive from the spouse. 

So we have two problems right away – we’ve caused some people to drop out of the labor market to go on the dole, with the promise of having to increase only the taxes of the rich.  But the rich don’t play ball, and are likely to cut back their own supply of labor, which leaves tax revenues insufficient for the promised benefits.  There seemed to be only one platform objective of the Obama campaign – increase the taxes on the rich in order to finance the enlargement of the welfare state.  This is based on fantasy.  In order to finance the increased benefits, the taxes have to trickle down.  This trickle down can lead to yet more decisions to become a one income family, further reducing the tax base.

The story so far is all about the effects of the change in policy on labor supply for both rich and poor.  But that is not the whole story – recall the “non-tax” elements of the marginal decision for the spouse – all of the added expenses of going to work.  By dropping out of the labor force, the loss of the take home income is partially offset by avoiding exactly those transactions – the family commutes less, fires the nanny and housecleaning service, cooks at home, cuts the lawn themselves, etc.  All of these decisions reduce the demand for low-skilled workers.   This reduction in demand leads to yet lower employment numbers for the low-skilled workers, and increases the number of people on the dole.  And, of course, this requires yet more tax revenues.

The demand effects of trying to tax the rich are limited to low-skilled workers.  As a quasi-entrepreneur in a service business, scaling up and hiring employees is a decision that is affected by marginal tax rates.  The hope in any such hiring decision is that I can bill sufficient hours of the employee’s time so that I earn some profit.  The risk is that I cannot; and contrary to the Scrooge like image of businessmen firing employees as soon as things look grim, in my experience quite the opposite is true – the entrepreneur will hold on in the hopes that things will improve and delay the firing decision - especially for a well-liked employee.  That means that every employer understands there is a significant risk of loss in hiring an employee; you increase the taxes on the employer in cases where he makes a successful hire, and you’ve reduced the potential payoff to taking such risks.  Ergo, you take fewer risks.  This scenario is worse yet outside of service businesses, where significant capital investments are required as a precursor to hiring more people, and the risks of expanding employment increase significantly.  With less demand among business owners for laborers at all levels of skill, everyone is impacted negatively.

Rich people are like the rich kid whose parents get him the brand new leather basketball. You play by that kid's rules, or the kid takes his ball and goes home, and you don't play at all. If you tell him that half of his points won't count, or will count for the other team, he will surely pick up his ball and go home. You may not like that rich kid, but the game depends on him. If rich people don't invest, because they are rightfully afraid that any gains from the risks they take will be taxed away, we not only are deprived of the ball, we don't even have a court to play on.

There is a point where you can kill the golden goose.  Every communist country killed it long ago; the socialist welfare states of Europe haven’t entirely killed it, but they have it by the neck held under very cold water.  And yet such policies have an unbelievable degree of persistence, attributable to the simplistic Marxist view that the rich are in opposition to the poor.  As the simple logic of what I just conveyed plays itself out, people will double down on their strange belief that the rich are ripping them off.  It is the persistence of crappy economic policies that we need to fear.