Generating Inequality: Mechanisms of Distribution in the U.S. Economy
The first (and last?) thing about Thurow’s book that scared me: “Proceeding on the premise that any long-lasting feature of the economy is apt to be functional”—did this mean a defense of the status quo? What’ll be the definition of ‘functional’?—“the intellectual problem is to construct consistent mechanisms for explaining the observed distributions of earnings and wealth with as little resort to market imperfections as possible.” Page xi. (This would be the second blow to my fondness for the neoclassical, perfect-competition model provided it be made to work like it’s supposed to. The first blow was Prof. Richard D. Wolff suggesting that monopoly is not preventable, and that the railing against it is akin to the taboos about sex.)
Labor has rental prices, capital has sale prices
Since it is illegal to sell human capital, the labor market is a market for renting and not for selling. Measures of earnings (rental prices) are much more accurate than direct measures of human wealth. The latter do not exist. Conversely the capital market is primarily, but not exclusively, a market for buying and selling capital. Buying and selling prices are more prevalent and accurate than rental prices. Often the latter do not exist. [...] human wealth is best estimated by capitalizing measured earnings[,] and income from physical capital is best estimating measured capital.
Page 12. All correct, except should one even try to estimate human capital? It isn’t capital or wealth... but what is it?
Trying to get rich and fighting capitalism is not hypocritical (Thurow uses different words...)
Individuals have different levels of preferences. They have preferences about rules of the economic game and the distribution of prizes that it should generate; but they also have preferences about maximizing their own position in the current economic game, no matter how much they like or dislike the economic game they are forced to play. [Page 40. ...] there is nothing self-contradictory in seeking to become extremely wealthy and powerful in our current economic game yet believing that in a better economic game there would be no “extremely wealthy” economic prizes to be had. A personal limit on accumulation would not produce the more egalitarian society that is desired. There is nothing logically self-contradictory in these two preferences, since they simply do not exist in the same domain. [Page 41.
Higher taxes don’t reduce work effort
High taxes give rise to less work and more leisure (the substitution effect); but they also lower after-tax incomes, leading theoretically to more work and less leisure (the income effect). Much to the surprise of the initial investigators (several were employed by the Harvard Business School), empirical studies indicated that high taxes either did not afect work effort or might even increase work effort among executives and professionals.14 People work as hard or harder to restore their previous incomes or to obtain their income goals.With the current interest in the negative income tax, a series of studies have been commissioned on the work-effort effects of transfer payments in a system of negative income taxes. Most of these studies are not yet completed, but in the experiment in Northern New Jersey that has been completed little significant difference was found between those receiving aid and a control group.15
12. For a more recent confirmation of the same results see Daniel M. Holland, “The Effect of Taxation on Effort,” Proceedings of the Sixty-second National Tax Association Conference, October 1969, pp. 428-524.
15. Harold Watts, Glen G. Cain, “Basic Labor Responses from the Urban Experiment,” Journal of Human Resources 9 (Spring 1974): 156-278.
Pages 49, 241.
Capital overpaid, Labor underpaid according to estimated marginal products
The marginal-productivity theory of distribution is subject to one direct test. Whenever there are estimates of capital and labor stocks, production functions can be estimated econometrically. These production functions can then be differentiated with respect to capital and labor in order to determine the marginal products of capital and labor. The estimated marginal products can then be compared with the observed payments to capital and labor in order to see if they are identical or similar.
When such tests are applied to American data,12 the marginal product of labor exceeds its actual returns and the marginal product of capital is less than its actual returns
12. George Hildebrand and Ta-Chaung Liu, Manufacturing Production Functions in the United States, 1957 (Ithica, N.Y.: Cornell University Press, 1965), p. 187; Lester C. Thurow, “Disequilibrium and the Marginal Productivities of Capital and Labor,” The Review of Economics and Statistics 45 (February 1968): 25.
Pages 70-72, 241-242.
“The Supply of Skills”: most are learned on the job
In neoclassical theory the labor market exists to match labor demands with labor supplies. [... The market tells businesses] to raise wages and redesign jobs in sectors with skill shortages. In surplus sectors they are told to lower wages. Individuals are told to acquire skills in high wage areas and discouraged from acquiring jobs and skills in low wage areas. In the process each skill market is cleared with increases or reductions in wages in the short run and by a combination of wage changes, skill changes, and production process changes in the long run.
The key ingredient in this view of the world is the assumption that workers acquire laboring skills exogenously in formal education and/or training and then bring these skills into the labor market. Possessing skills, they bid for the jobs that use these skills. Unfortunately, the underlying assumption does not seem to be correct for the American economy. Workers do not bring fully developed job skills into the labor market. Most cognitive job skills, general or specific, are acquired either formally or informally through on-the-job training after a worker finds an entry job and the associated promotion ladder.
Pages 77 to 78.
(The evidence follows in Thurow’s book; it’s overwhelming. Not just most, but the vast majority of skills used in jobs are learned on the job. Some are learned in formal training programs provided by the employer. College? Anyone who’s been to college, or high school, even if they haven’t worked, can guess they didn’t learn much in the way of work-useful skills there. (What am I doing with my life again?)
Therefore,
Employers sort potential workers based on expected training costs
As far as the employer is concered, the problem is to find those background characteristics that are good predictors of potential training costs differences. Given this desire, it is not surprising that educational attainment and performance become critical background characteristics. Education is a form of training. The ability to absorb one type of training probably indicates something about the ability to absorb another type of training. Education becomes an indirect measure of an individual’s absorptive capacity and is relevant to the employer even when no cognitive job skill is learned in the educational process. Through education one learns how to be trained or exhibits that one is trainable.
Education also is one way for workers to show that they have “Industrial discipline.” Having gone through the educational process, the worker has demonstrated an ability to show up on time, take orders, do unpleasant tasks, and observe certain norms of group behavior. These characteristics are also fundamental to the work process. Often they are more important than specific job skills. Many manpower training programs report that industrial discipline is more difficult to teach than specific job skills. Schools may or may not teach these economically desilable characteristics, but traditionally they have provided the employer with an opportunity to find out whether the individual does or does not have them.
Page 88.
Job-competition makes people need to over-invest in formal education defensively
Assume that you have decided that you are not going to acquire a college education but then notice that your neighbors are acquiring a college education. Under the wage-competition model, this observation will confirm your original decision not to acquire a college education. A substantial increase in the supply of college-educated workers will cause their wages to fall, whereas the wages of the remaining noncollege-educated workers will rise because of the reduction in the supply [. . .]
In the job-competition model, your observation about your neighbors’ actions would lead to different conclusions. Remember that an individual’s background characteristics are used to place him in a labor queue. Based upon his relative position in this queue, he will be selected for different job or training opportunities. The best, highest income jobs go to the best workers. Consequently, the job distribution open to each set of background characteristics depends upon the supply of people who possess superior background characteristics can lead to a deterioration in the expected earnings of less preferred groups. Every additional college worker, for example, may mean a deterioration in the position of the remaining high-school workers.
In the job-competition model, education may therefore become a defensive necessity.
Page 96. (See also pages 184 to 185.) According to Thurow, to know if rational private investment for education is too high from society’s perspective, we need to know its effect on training costs. A justification for subsidizing education, meanwhile, is that people my privately underinvest from the socially optimal point of view because of the risk they face as individuals that they will still do badly in the job-competition lottery. (Pages 186 to 187.)
People judge their own wellbeing and fairness based on the relative positions of others, and workers can impose their feelings on the wage structure
Utility functions are “heavily, if not completely, determined by relative incomes and interdependent preferences rather than absolute incomes and independent preferences.”
To say that utility functions are highly interdependent, however, is not to say that men are going to be able to implement their interdependent preferences in the labor market. What allows individuals to exercise their interdependent preferences in the labor market? My utility may depend upon the income of my neighbor, but this would not influence my own wages or productivity in the standard wage-competition model. Like it or not, each individual would be paid his marginal product.
The lack of interest in interdependent preferences flows from two factually incorrect assumptions implicit in the wage-competition model. First, individuals are wrongly assumed to have fixed marginal products—skills—that they sell in the labor market. In fact, depending upon their motivations, individuals have a variety of marginal products. An unhappy worker can lower his productivity, often in such a manner that it is difficult and expensive to determine whether or not he has in fact done so. Although a worker’s happiness or utility is irrelevant if he has a fixed marginal product, it is highly relevant if he has a variable marginal product. Employers need to set a wage structure that elicits voluntary cooperation and motivates their workforc. The net result is an avenue whereby interdendent preferences can influence the wage structure.
Second, individuals are wrongly assumed to be interchangeable parts in the production process. In fact, most production processes require a degree of teamwork that can only be acquired through on-the-job experience and a high degree of internal harmony. A production team that has a revolving membership and is unhappy with its wage structure has a lower productivity than a team that is satisfied with its wage structure and has a stable membership. There is a high degree of truth in the old aphorism, “There is no institution that cannot be brought to its knees by working to rule.” Efficient economic production is not possible if everyone does just what is required or what is compelled. The net result is an avenue whereby group preferences about a “just” wage structure can have a major impact on production. Because it can have an impact on productivity, it must be taken into account by the employer.
Economists have ignored the problem of getting individuals to produce, but industrial psychologists have made this their key problem. They ask how wages and other incentive systems can be used to promot maximum productivity. Economists see the work decision as a go-no go decision according to which the individual either does or does not sell his time and a fixed productivity for the offered bribe. Industrial psychologists see the work decision as a more continuous decision. A person decides to work, but he also decides how much effort and cooperation to provide. Economists might respond that workers can always be fired if they are not producing at the agreed upon level, but this ignores the costs of hiring and firing the costs of determining whose productivity is below the norm, and the costs of disrupting the production team. Although there is a limited role for inspection and punishment, productivity in the final analysis always depends upon voluntary cooperation, and this requires a wage structure that is in harmony with the interdependent preferences of the work force.
Pages 106 to 107.
The fact that a person can’t get a job they are qualified for by agreeing to work for less is actually something I’ve noticed and, frankly, been annoyed by. It’s economically inefficient, but more so for the person. I wonder if Thurow’s explanation for it, essentially that the current workers would not train someone bidding down their wages, is correct. I can’t think of another explanation, but it sounds pretty unlikely, especially when phrased the way I just phrased it. Thurow talks about training elsewhere, which I didn’t quote, but I misconstrue what he’s saying. If people don’t feel they’re being paid fairly, their productivity will drop, and thus employers must maintain a structure people feel is fair. But would hiring new people for less, without firing anyone, actually be viewed as not fair?! And the fact is that employers do routinely, at least at the Sears associate level and I imagine elsewhere, the absolute worst wage differential: paying new people more, because that’s what they have to pay to get new people at the time. And people seem to put in passable effort even when they have every reason to be discontent, on relative grounds.
Wealth accumulation is characterized by instant wealth
The prevalence of instant wealth is also visible if one looks at the names of the richest Americans [. . .] the current generation of Rockefellers, Mellons, Fords, Duponts, Whitneys, and Posts may have inherited their wealth, but their fortunes were made very quickly at some point in the past. Their families did not become rich over a long period of time but made their fortunes in a matter of a few years.
[...] three basic questions. First, why is the distribution of wealth so much more unequal than the distribution of earnings or the presumed normal distribution of abilities? Second, why are large inheritances passed from generation to generation? Third, how can you explain the quick, almost instantaneous, generation of very large fortunes?
[. . .]
[...] neoclassical economics treats wealth as stored future consumption. Each individual starts off his life with some initial inheritance of wealth provided by his parents and some earnings potential from his raw labor. Inheritances plus raw earnings place a limit on his potential consumption in the current period of time. The individual can, however, devote some of his potential current consumption to savings and investment so as to enhance his future consumption potential. This trade-off between present and future consumption is at the heart of the standard economic rules for wealth accumulation.
(... and at the heart of sickening inspirational posters and lying conservative rhetoric across the nation.) Page 131.
People hold wealth until death for the economic power it gives
Despite the neoclassical ‘rational economic’ goal of maximizing lifetime consumption and the tax disadvantages when passing it on, all those with wealth routinely hold it until their death.
The desire for economic power does not fit into neoclassical models for a number of reasons, the most basic being the assumption of perfect competition. In a perfectly competitive economy, economic power does not exist and therefore economic power cannot be a goal. [...] If you refuse to invest in some project in an attempt to exercise economic power, some other investor will simply replace you. If the project earns a morket rate of return, it will always be done with or without your capital. Similarly, you also cannot increase economic investments above the level dictated by the market. If you seek to do so, some other investors will withdraw from the area, leaving the total volume of economic activity just what it was.
In the real world there are, however, oportunities to exercise economic power within the family, the economy, and the political process. The holder of wealth has some leverage to redesign his family, private charities, the economy, and the political structure in his own image What does not exist in perfect competition may lie at the heart of wealth accumulation in our less than perfectly competitive world. The net result of a desire for economic power is an accumulation of wealth and a transmittal of wealth that is irrational from th point of view of simple consumption economics.
Long-term differences in rates of return to real capital are papered over with more equal rates of return to financial investments, creating instant wealth
Data on real capital markets indicate little, if any, tendency for real capital markets to approach equilibrium. Substantial differences exist in real rates of return, and these differences are often perpetuated over long periods of time. [...]
In 1973, 71 percent of all U.S. savings took the form of retained earnings and depreciation allowances. If you subtract those funds that go into residential housing, then over 99 percent of all industrial and commercial investment funds were internally generated. If you think of a real capital market as a place where the savings of the household sector are allocated to the business sector, then the United States does not have a real capital market. The household sector’s savings are basically used to finance the direct investments of the household sector (housing), and the business sector is self-financing.
But the real capital market is even more atrophied than the lack of net household saving would suggest. There is also very little transfer of saving from one firm to another within the business sector. Firms almost always reinvest their own internal funds and seldom make long-term loans or investments in other firms.
To explain why internal funds are frozen into the firms generating them, it is only necessary to think about the basic characteristics of U.S. capitalism. It is managerial capitalism. large firms are controlled by individual managers who usually do not own any substantial fraction of the firm that they manage. Although a stockholder might like to see his funds invested [(“his funds”— the stockholder’s funds are only really invested when new stock is offered)] in the highest rate of return industries, the existing manager clearly has other incentives. He wants to use internally generated savings for investments under his management, since this is the pattern of investments that brings him increasing returns in the form of income, power, and prestige. As a result, those who direct real investments are simply not the profit-maximizing investors imagined in simple neoclassical economics. They are interested in maximizing profits, but only profits from operations they themselves manage.
Pages 146 to 147.
This dispersion in rates of return in the real capital market provides the role for financial markets. It serves not to generate and direct real capital to high rates of return investment opportuities but to capitalize away the differences in real rates of return. Consider a new real investment opportunity costing $10 million and earning a 30 percent rate of return, or $3 million. With a market rate of return of 10 percent, this investment would be valued at $30 million ($3,000,000 ÷ 0.10). With a [market] rate of return of 5 percent, it would be valued at $60 million ($3,000,000 ÷ 0.05). If the investment is in something that can be expanded [...] so that additional real capital can be invested and also earn 30 percent rates of return, the market may capitalize current investments at very high multiples because of the prospect of future real investments at above-average rates of return. [...]
Based on current and future earnings, shareholders shift their financial portfolios from low real rate of return firms to high real rate of return firms. In the process their actions lower the market value of the first firm and raise the market value of the second firm. When enough shareholders have shifted their investments, the financial rates of return will be equal regardless of the differences in underlying real rates of return on capital investments.
Large instantaneous fortunes are created when the financial markets capitalize new above-average rate of return investments to yield average rates of return financial investments. It is this process of capitalizing disequilibrium returns that generates rapid fortunes. Patient savings and reinvestment has little or nothing to do with tem. To become very rich one must generate or select a stituation in which an above-average rate of return is about to be capitalized.
If real capital markets reach equilibrium quickly, large fortunes could not be made in this way. I nthat case once a new investment opportunity was discovered, real investment funds would quickly flow into the area and bring the real rate of return down to the market rate of return. Thus, above-average profits could not be expected to last very long and there would be no possibility of obtaining a monopoly on future above-average investment opportunities. Other people would move int othe area and future investments would only earn the market rate of return.
Pages 148 to 149.
Random Walk
Although, the random walk has been extensively tested and is widely accepted among professors of finance in business schools, it has not percolated into either the public arena or into basic courses in economics.
The random-walk literature attempts to prove several hypotheses. First, the expected rate of return on any financial investment is equal to the expected rate of return on any other financial investment in the same risk class. Financial markets are like the economist’s vision of perfect capital markets in that they equalize rates of return but only expected ex ante rates of return are equalized. Actual ex post returns will differ since returns are generated in a probabalistic process.
Second, once the appropriate adjustment is made for the risk class of an investment, the expected rate of return on any investment will be equal to the average rate of return on all investments (the market average). Once again, the financial market is lake a perfect market in that every investment earns the same rate of return but only on an expectational basis.
Third, the expected rate of return on a financial investment, given no information about that investment (except its risk class), is equal to the expected rate of return on an investment, given all of the legally available public information. Since all information is quickly capitalized into the price of an asset, information has a zero value. It is from this principle that the name “random walk” springs. If information is already capitalized into the price of an asset, knowing it does nothing to make you a good investor. Throwing darts at the financial pages of the New York Times is just as good an investment strategy as trying to accumulate all of the relevant information about a stock. Dart throwing is in fact a better investment strategy since it costs nothing whereas attempts to collect information are expensive.
Fourth, within each risk class there is a random lottery in which individuals place bets on individual investments with equal expected values (an equal chance of winning) but in which investments yield very different returns ex post. As in any lottery, there is an expected average rate of return for any invested dollar, but also, as in any lottery, someone will win and someone will lose. Even more specifically the lottery within each risk class is a nonnormal random lottery. There is a long upper tail. This tail says that there is a very small probability of making a very large return on an investment. As we have seen, an investment may be capitalized at a very high multiple. At the same time losses are limited, since it is not possible to lose more than you invest [...].
Pages 149 to 151.
“Random walk” inevitably results in inequality
The random walk is a process that will generate a highly skewed distribution of wealth regardless of the normal distribution of personal abilities and regardless of whether the economy does or does not start from an initial state of equality. Once great wealth has been created, the holder diversifies his portfolio and after that is subject to diversification and to earning the market rate of return. Because most holders of wealth eventually diversify their portfolios, great fortunes remain even after the underlying disequilibrium in the real capital markets disappears. It should be emphasized that there is no equalizing principle in the random walk. Those who have had good luck are not then more apt to be subject to bad luck than the random individual. There is no tail of large negative losses to balance the tail of large positive gains. You cannot lose more than you have, but you can make many more times what you have.
What is the evidence for the random-walk hypothesis? First, an examination of large financial firms (such as mutual funds) indicates that none of them is able to outperform the market averages. Professional financial managers able to make large investments in obtaining market information are not able to outperform the market average or a random drawing of stocks. Second, no one has been able to design a set of decision rules (when to buy and sell) that yields a greater than average rate of return. Third, tests indicate that stock prices quickly adjust to changes in information (announcements of stock splits, dividend increases, etc.). Fourth, there is no serial correlation among stock prices over time. The price at any moment in time or its history cannot be used to predict future prices. When put together, all of these findings form an impressive body of evidence as to the existence of the random walk.
The net result is a process that generates a highly skewed distribution of wealth from a normal distribution of abilities. Fortunes are created instantaneously or in very short periods of time. Personal savings behavior has little or nothing to do with the process. Once created, large fortunes maintain themselves through being able to diversify and through inheritance.
Pages 151 to 152.
He might have mentioned that poor people can’t win this lottery at all, while the more money you have in stocks the more your chances of winning this stock lottery with a part of your fortune. Hasn’t someone already said “the rich get richer”?
“Random walk” also applies to entrepreneurs
Although entrepreneurial activities cannot be investigated in the same manner as financial investments (the unsuccessful entrepreneur is not visible in the same manner as the unsuccessful stock), they may also be subject to the same random-walk principle. Within a group of individuals with equal entrepreneurial talents, there may be a nonnormal random lottery. There is an expected rate of return for the group as a whole but a wide dispersion in individual results around this average. Entrepreneurial talent is a necessary condition to entering the lottery, but it is not a sefficient condition for making instantaneous wealth.
If you read the Fortune biographies that accompany its lists of the most wealthy, the winners will be described as brighter than bright, smarter than smart, quicker than quick. But look beyond the description to see if they were simply lucky or posess some unique abilities. Remember that the unsuccessful entrepreneur of equal abality will not be featured in Fortune. To what extent were they like many other people but in the right place at the right time? The real test of unique abilities is to ask how many have repeated their performance. How many have made a great fortune on one activity or investment and then managed to go on to earn another great fortune on another activity or investment? If the Fortune list is examined, it is impossible to identify anyone whose personal fortune was subject to two or more upward leaps. The typical pattern is for a man to make a great fortune and then to settle down and earn the market rate of return on his existing portfolio.
In any case the nonnormal random walk found in recent research on financial markets seems to lie at the center of the process generating wealth. Within risk and entrepreneurial-ability classes, a random lottery is conducted. As with all lotteries, someone wins even though the probability of winning is very small. Chances of winning the lottery twice are almost nonexistent, but once a great fortune is made it earns the market rate of return.
Pages 152 to 153.
(At least one possible exception to Thurow’s description of relatively instantaneous wealth-generation in his list of the wealthiest people in the U.S. in Appendix B is Bob Hope. Although, looking at it from another level, there were certainly comic talents of equal or greater ability.)
Changing distribution of earnings requires social consensus
I think Thurow is wrong. I’ll grant this sentence: “To significantly alter the distribution of earnings, it is necessary to significantly alter the distribution of on-the-job training.” But the rest...
Public policy makers, in their efforts to equalize the distribution of earnings, probably have most to learn from the World War II experience. At the time, there was overwhelming social and political consensus that the economic burdens of the war should be more equally shared. This type of consensus is a necessary ingredient since it allows changes in the distribution of earnings to occur without running counter to the existing structure of interdependent preferences. If wage contours are to be changed, most of the people in the existing contours must support the changes. If they do not, they are in a position to veto the resulting changes by refusing to cooperate in the team-work necessary for production. Strikes, working to rule, refusals to train, etc., are all devices for insurinng that changes in wages cannot be imposed on the wage structure by outside fiat.
Maybe it is so that only at the bottom of the wage scale (although this is a very large portion of workers) that employers actively seek to pay each individual the least possible, but I think Thurow is still vastly overstating the power of workers over the wage structure. This is so if only because entire job categories change and wage differentials can change over time by one set moving and the other set not moving. How does he explain the variance within categories (occupations etc.), (page 192) by interdependent preferences, anyway? I propose that wage structures, like middle management, are (in part) part of employers’ ways to prevent organization and the exercise of control by their employees. Stratification is necessary to keep people separate and disunited. The change in income distribution came from organized labor in the 1930s and 1940s, not the depression and the war itself. It was the power of organized labor that helped keep the new, more equal income distribution. And it is the weakness of organized labor that has helped allow the increase in inequality since 1973.
Increasing the rate of growth of productivity
“Productivity [...] seem[s] to be an unmitigated good.”
Recommendations [...] tend to be based on the virtues that economists claim for their model of perfect competition. “Remove market imperfections” is the general answer to any and all questions. Usually the only analysis revolves around isolating the areas where the economy does not seem to fit the model of perfect competition. Once these areas are found, recommendations are made as to how the area could be made more competitive. In such cases the model of perfect competition is employed in its normative sense. Actual institutional arrangements are to be hammered into conformity with the model.
Yet from the perspective of the job-competition model, many of the market imperfections that are to be removed are in fact central to the conditions necessary for an economy to be dynamically efficient. Thus, in order to promote training and the acceptance of technical change, the labor market is so structured as to reward those giving training and accepting change by minimizing their chance of potential loss. Wages are infelxible and seniority provisions abound. No one denies that wage competition is an essential ingredient to static efficiency. Without flexible wages, labor cannot be allocated in accordance with the princibles of static efficiency. But in a job-competition model, there is a question about the virtues of flexible wages in the context of dynamic efficiency.
The basic argument revolves around a trade-off between static and dynamic efficiency. Many of the changes that would cause improvements in static efficency would cause deteriorations in dynamic efficiency. The problem is to balance the gains and losses that come from both sources of efficiency. In general, the gains from increasing knowledge and skills will be much larger than the gains from increasing the utilization of existing skills and knowledge. The latter is a once and for all gain, whereas increases in skills and knowledge can go on forever. Thus, the trade-off should be heavily weighted in favor of dynamic over static efficiency. [...]
In practice, attempts to impose the theoretical conditions necessary for static efficiency may also cause deterioration in static efficiency. If individual production functions (motivation) and team production functions are sensitive to the structure of wages, attempst to impose wage competition on a highly structured set ofg interdependent prefgerences might result in substantial short-run reductions as well as a slowdown in long-run growth. [...]
When it comes to improving productivity, the job-competition model calls for a lot more empirical analysis and caution than is required under wage competition. The higher rates of productivity growth in Continental Europe and Japan provide at least some evidence that perhaps we should be reducing wage competition and not increasing it. Japan is the extreme example, but all odf these countries have substantially less wage competition than is to be found in the United States. Most of them also have higher rates of productivity growth.
Pages 194 to 195.
Note that before employers were so quaking at the power of employees’ interdependent preferences that the income distribution for the entire economy was held hostage by them; yet now the violence that is done to interdependent preferences is harming our productivity growth relative to Europe’s and Japan’s. I’m inclined to believe the latter situation over the former, even though I think what was happening in productivity growth rates over the last twenty-five years weakens this thesis. What I really want to know: is there a third way? If workers really do have the power, will wage-competition be possible without reducing teaching of skills and knowledge?
Altering the distribution of wealth requires wealth taxes
Since the time of the Declaration of Independence, inhertance taxes have been advocated as a means of preventing fortunes from being passed on from generation to generation. Financially, everyone was to start the economic race roughly equal. Individual winners could keep their winnings, but they could not pass them on to the next generation. Although the random-walk model does not change the usefulness of inheritance taxes (approximately half of all great wealth is inherited), it does undercut the idea of limiting wealth taxes to inheritance taxes. From the point of view of marginal productivity, a person is only wealthy if he contributed a lot of productivity to the economy. The contributor, therefore, should be allowed to keep the fruits of his contributions. Under the random-walk model, however, the wealthy are not wealth because their productive contribution is higher than others, but because they are luckier than others.
Page 197.
US has no broad wealth taxes and inheritance taxes effectively do not exist
In theory, inheritance and gift taxes could reduce the concentration of wealth substantially. In practice, loopholes have become so large that inheritance taxes have virtually ceased to exist: collections abount to an annual wealth tax of less than 0.2 percent. For all practical purposes, gift and inheritance taxes do not exist in the United States. They do not stop wealth from being transferred from generation to generation.
Page 197.
Inheritance taxes have been undercut, presumably against popular will
The technical problems of preventing large inheritances from passing from one generation to another are not large or unknown.5 Rather, the basic problem is one of political power. Are inheritance taxes zero because a democratica society decides that they are zero? Or are zero inheritance taxes merely the best example of the political power that wealth can buy?
Proponents of the first argument can maintain that the popular will is best revealed in low effective tax rates rather than in high nominal tax rates. The public may verbally subscribe to an equal start, but they do not really believe their own rhetoric. Although this is not a completely preposterous argument, it is hard to understand why the public should want to go through the fiction of high nominal rates and then nullifying them with generous loopholes unless someone is to be fooled. The most obvious purpose of high nominal rates and low effective rates is to use the high nominal rates as a smoke screen to hi[d]e the transfer of wealth from generation to generation. The public is led to believe that stiff inheritance taxes exist when in fact they do not exist.
5. For a discussion of the technical problems of wealth taxation see Lester C. Thurow, The Impact of Taxes on the American Economy (New York: Praeger, 1971), chap. 7.
Pages 197-198, 248.
A cumulative lifetime tax on inheritances is the best method to limit inheritances
If inheritances were to be prevented or reduced, the most effective technique would be to substitute a cumulative lifetime accessions tax for the current inheritance tax. The inheritance tax is not a good instrument for preventing the transfer of assets across generations, since it is levied on the giver rather than the recipient so that a person who will inherit wealth from more than one source can become wealthy regardless of the tax on each individual giver. In a cumulative lifetime accessions tax, the tax is levied on the recipient. What is more, the rate structure is based on total lifetime accumulations of inheritances and gifts. One of the principal techniques for avoiding inheritance taxes is to split inheritances into several inheritances through trusts, etc. Under an accessions tax the person pays the same tax on a series of small inheritances as he would on one large inheritance.
Page 198.
To reduce instant wealth from capitalization of unequal return on real capital, tax policies must allow flow of real capital funds by forcing corporations to distribute all earnings
To control the non-inherited half of unearned wealth, “it becomes necessary to alter the conditions of the random walk. In the random walk instantaneous fortunes are created in the process of capitalizing disequilibrium in the real capital markets into equilibrium in the financial markets. Although the capitalization cannot be prevented as long as capitalism exists, it is possible to eliminate or reduce the disequilibriums in the real capital markets.”
To eliminate or reduce disequilibrium in the real capital markets, it is necessary to improve the flow of real capital funds across the real capital markets. Essentially, this means that more of the country’s total savings must be forced into the real capital markets so that they can be alocated to the highest bidder. And that means reversing the current corporate tax policies that encourage internal savings. Instead of allowing generous depreciation allowances and taxing corporate earnings at a lower rate than the maximum rate paid by individuals, taxes should be so adjusted as to force corporations to pay out all of their depreciation allowances and earnings. If the funds were paid to stockholders, they could flow back into the real capital markets and be allocated to those areas with the highest rates of return. The simplest procedure would be to abolish the current corporate income tax, but to require that all firms distribute all of their earnings and depreciation allowances to their stockholders. The earnings would then be taxed at normal personal income tax rates, and firms would be forced to sell equities or bonds if they had good investment projects. If the real capital markets were restructured in such a fashion, disequilibrum in the real capital markets might be smaller and less lengthy. With less disequilibrium there would be fewer and smaller capitalized fortunes.
Second, instantaneous fortunes would be reduced if unrealized capital gains and realized capital gains were taxed as normal income. At present, the unrealized capital gains are untaxed and realized capital gains are taxed at less than the normal rate for income. If both were taxed at normal income rates, instantaneous wealth would still be large but not as large as it is today.
Pages 201 to 202.
Statistical discrimination is efficient for employers but individually unfair and societally inefficient
From the job-competition point of view, statistical discrimination becomes a key ingredient in any system of discrimination. Statistical discrimination occurs when employers judge the potential training costs of prospective employees based upon the objective characteristics of the groups to which they belong. Statistical discrimination is practiced because it is efficient and employers can cut their training costs by practicing it. But [...] it is inequitable in the job-competition model because it leads to treating both individuals and groups unfairly relative to their productive characteristics.
The same problem exists in formal educational programs and the acquisition of other skills and background characteristics. Imagine a medical-school admissions committee. Suppose it checks its alumni records and finds that 95 percent of all the men they have admitted have finished medical school and that 95 percent of these graduates went on to be lifetime practitioners. But the committee finds that only 90 percent of all the women they have admitted finished medical school and that only 90 percent of these graduates went on to be lifetime practitioners. Based on expected values, the admissions committee would then know that there was a 90 percent probability (0.95 × 0.95) that every man admitted would practice medicine and a[n] 81 percent probability (0.9 × 0.9) that every woman who was admitted would practice medicine. If the admissions committee were simply being efficient, it would notice that it could generate more doctors per unit of resources by admitting men rather than women. Efficiency considerations would lead them to admit all men and no women.
But this decision would be inequitable to both the 81 percent of the women who would go on to become lifetime doctors and to the group relative to its average characteristics. Although there is only a 9 percent difference in male-female probabilities of practicing medicine, this is translated into a 100 percent difference in their chances of becoming doctors.
For each employer or admissions committee, statistical discrimination is efficient (it maximizes their output per unit of resources), but from the point of view of the economy as a whole it is inefficient. Statistical discrimination stops the economy from making use of the talents and working desires that are available to it.
Pages 203 to 204.
[...] to achieve both equity and social efficiency, individuals must pay a price in terms of less private efficiency. Employers and other screening agencies must give up the use of some perfectly good statistical indicators of future performance and replace them with more expensive tests that relate to expected individual performances and not to expected group performances.
Eliminating statistical discrimination is also important because such discrimination is the major technique for enforcing and spreading monopolistic social-distance discrimination against minorities. Under statistical discrimination, prejudiced individuals can create and enforce discrimination if they can lower the characteristics of even a few members of the group being discriminated against. If they can affect even a few members of the group, the group’s average characteristics will fall and statistical discriminators will act as if all members of the group had the lower characteristics. Not only will this practice be unfair to individual minority-group members who have the desired characteristics, but it will lead to larger income gaps between the discriminator’s group and the discriminatee’s group than their average characteristics would warrant.
Eliminating statistical discrimination is difficult, for it requires that employers and other screening agencies refrain from using objective and efficient information. It can only be done by some type of affirmative action that requires institutions to hire or admit women and members of minorities, and thus forces them to search among these groups for individuals who have the characteristics they desire. Unless they are under affirmative action pressures, all of their incentives will lie in the direction of practicing statistical discrimination.
Affirmative action to eliminate statistical discrimination can also help adult white males with certain background characteristics.
Pages 204 to 206.
The zero-one hiring rules of the job-competition model lead to greater discontinuities in individual economic positions than data on training costs would warrant. A continuous distribution of individuals is broken into discontinuous groups. Individuals whose characteristics are only slightly different find that they participate in radically different lotteries. The discontinuities may also exist over the working lifetime of one individual. When a worker loses his job in the job-competition model, he may not be able to re-employ the skills that he has learned on his old job and loses the benefits of whatever sen[i]ority he has accumulated. He is not working along a continuum where the willingness to accept a small reduction in wages will guarantee re-employment at his old skills.
Page 206.
From the point of view of simple marginal-productivity theories, there is a direct linkage between any individual’s inputs (hours of work, skills, savings, etc.) into the productive process and his outputs (earnings and increases in physical wealth). An individual gets what he or she produces. To get more output one must simply contribute more inputs. [...]
[...]
In both the job-competition model and the random-walk models, conditional random lotteries are at the heart of the distributional process. In the random-walk model the lotteries are conditional upon the degree of risk desired, and in the job-competition model the lotteries are conditional on the background characteristics that the individual has acquired. But in both cases [...people’s ] positions in the distributions of earnings and wealth are to a great extent determined by the characteristics of economic lotteries rather than by their own individual characteristics. The economic system is deterministic in the sense that it will generate some known and predictable distribution of outcomes, but the position of any one individual is not deterministic. In this sense, job-competition and the random walk are similar to quantum mechanics. The overall distribution of atoms is known, but the place of any one individual atom is stochastic. Ex post individuals who make identical contributions are going to be rewarded very differently.
[...] Changes in individual background characteristics and the elimination of statistical discrimination have an important role to play in altering the distribution of positions (minorities, etc.) upon the overall distributions of earnings and wealth, but tax-transfer policies must bear a major weight in any effort to change the overall distributions themselves. The conditional lotteries simply are not different enough to make major changes in the overall distribution of earnings and wealth by moving individuals from one conditional lottery to another.
[...]
Stochastic processes also have implications for how we assess the economic justice or injustice of the existing distributions of earnings and wealth. They force us to confront the problem of whether the distributions of earnings and wealth are equitable or inequitable not just once, but at every point in time. With stochastic processes it is not possible to argue that the distributional mechanism automatically creates economic justice by rewarding each individual in relation to his productive inputs. It doesn’t. Each individual is not paid in accordance with what he produces, and equals do not have equal ex post incomes.
It is possible to argue that lottery processes are fair or just, just as it is possible to argue that marginal productivity is fair or just, but being willing to call a lottery fair is only a partial solution to the justice problem. Even if a lottery is just, there still is the subsidiary problem of determining the distribution of prizes that the lottery ought to produce. Should it be a widely dispersed distribution of economic prizes or a narrowly concentrated distribution of economic prizes? The same lottery process can create both.
Pages 207 to 209.
, Generating Inequality: Mechanisms of Distribution in the U.S. Economy (New York: Basic Books, Inc., 1975).
How I came across the book: borrowed it from Prof. Julie Graham’s office library.
Note on the notetaking: Passages in blockquote format or in quotation marks has been typed out verbatim. Deviations, including notes, omissions (...) and corrections of apparent errors, are in brackets []. Some footnotes are included but most are simply ignored. And all periods are followed by two spaces, even though they aren’t in the text. All quotation is fair use and for educational and not for commercial purposes.
Read 2003 January.
Review written 2003 January 19 to 21.