David R. Henderson  

Ross Douthat's Strange Supply Curve

Olympanomics... Big Finance and Big Government...

In his New York Times column this morning, Ross Douthat considers various ways of reducing income inequality. While not endorsing higher taxes on high-income people, Douthat's takes it as given that such taxes would reduce inequality. Ignore the fact that he confuses income and wealth, referring to high-income people as the rich and low-income people as the poor. He makes an even bigger mistake: assuming an implausible supply curve for labor.

Note that the income inequality he talks about is before-tax. He says nothing about after-tax inequality. Then Douthat writes:

For one thing, the lazy liberal's cure for income inequality -- soaking the wealthy with higher tax rates and cutting taxes for everybody else -- simply isn't going to happen.

In part, this is because the Democrats have become as much the party of the rich as the Republicans, and parties rarely overtax their own contributors. (That's why the plan to pay for health-care reform with a "surtax" on high earners found so many skeptics within the Democratic caucus.)

But it's also because soaking the rich only makes a difference on the margins. The federal income tax is already quite progressive, and our corporate tax rate is one of the highest in the West.

He's right that it would make a difference only on the margins. But he gets the direction of the difference wrong. If high-skilled (and therefore high-income) workers have even a slightly upward-sloping supply curve, then a higher marginal tax rate on their income will cause their rate of pay to rise. Assuming that the elasticity of demand for their labor is less than one, that higher rate of pay times slightly reduced hours will cause their pre-tax pay to rise. Therefore, inequality rises. Of course, their after-tax pay is likely to fall, but that's not what Douthat's discussing and it's not what critics of income inequality point to. Virtually all of them point to pre-tax inequality.

What if these high-skilled workers have a vertical supply curve? Then there would be no effect on pre-tax income for them. But higher marginal tax rates on them would still not reduce measured pre-tax income inequality.

The only even-somewhat-plausible way Douthat could save his point is to assume that the demand for high-skilled labor has an (absolute value of) elasticity greater than one. Is that what he had in mind?

BTW, in trying to graph out the effect of a tax when there's a backward-bending supply of labor, I realized that I have never seen this on standard supply and demand graphs. Does anyone have a cite showing how to do it?

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COMMENTS (5 to date)
jywz writes:

Well, Hausman in his famous paper on taxes and labor supply assumed labor demand was infinitely elastic if I remember correctly. All Ross has to claim is that its greater than 1.

Adam writes:

I don't get the obsession with income inequality within nations such as France, Germany, UK, and US. Virtually anyone within these nations is rich by world standards. How did they get so rich? They got rich by growth and not redistributive policies.

It's also interesting that government redistribution fails so badly. Consider who is enriched when government spending increases. The people who are enriched are those employed and contracted by government--they are union workers, skilled trades, the highly educated, and professional groups. The latter are the people who provide office services, infrastructure, policy and legal analysis, and medical care.

The poor get poorer when government redistributes wealth. In contrast, markets and trade, over time, make everyone wealthier.

ryan yin writes:

Is it possible to draw a backwards-bending labor supply curve in a supply & demand graph? I thought that backwards-bending curve implies strong income effects and that the S&D model is more appropriate when we're thinking that income effects aren't significant

Joe Calhoun writes:

One area that gets little attention in the inequality debate is the role of inflation. As a Miami resident and long time observer of Latin America, it seems quite obvious, to me at least, that inflation and public corruption play a very large role in developing and maintaining inequality. I don't think the inequality in the US is that big a problem now but if we continue to develop along the lines of the typical banana republic, it will. The poor in a society with little income mobility become discouraged and fatalistic about their prospects.

As Douthat points out, the debate about inequality in the US has ramped up since the 70s. I don't think it is coincidental that this corresponds with the end of Bretton Woods and the subsequent inflation.

And by inflation I mean the classic definition of inflation not the concentration on CPI that has prevailed more recently. Asset inflation over the last two decades affected inequality every bit as much as the CPI inflation of the 70s.

The concentration on tax rates is just political populism. It won't solve the problem but it makes a good stump speech. Politicians have no incentive to address the real root causes.

Adam writes:

Joe: Interesting points. One might say that 'inequality roots in iniquity'.

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