Book III. Economics ‘as Usual’

Economics ‘as usual’

12. Introduction

In ‘economics as usual’ we neglect the World Wars and concentrate on the current problem of stagflation. This book then also provides a novel explanation in this area - novel in the sense that it bundles the articles that have been written since 1989.

In the years after World War II, Western societies created systems of social security - the ‘Welfare State’ - and for a while it seemed as if they could do so without serious economic consequences. From a macro-economic point of view, they hoped to enjoy growth, full employment and low inflation. These indeed happened in the golden years 1950-1970. However, there arose the problem of stagflation around 1970, i.e. the combination of high unemployment, high inflation and stagnating growth. Around 1980, unemployment and inflation reached double digit values. Other economic indicators in the red were budget deficits, high interest rates, and the crowding out of private investments. Adjustment to these problems has been difficult and slow. The economic performance around 2004 is a major improvement from the worst episode, but the progress seems to be stagnating. The ongoing discussion in policy making circles during all these years is how the Welfare State arrangements are related to these economic problems, and what the proper policy reaction should be.

Welfare state economics differs from ‘traditional’ macro-economics in that there are more arrangements that protect individuals from insecurity and that entitle them to benefits. Welfare state economics however does not differ from ‘traditional’ macro-economics in the respect that the basic laws of economics cannot be changed. Generous as arrangements can be, people fundamentally still react to incentives. Welfare state arrangements tend to reduce the base of the economy of those participating in the workforce and they increase the burden on those. The welfare state also tends to generate more unemployment and inflation. While unemployment would ‘traditionally’ cause people to lose their income and thus to be more cautious with their wage demands, in the welfare state they receive an unemployment benefit and may continue tot insist on high wages. These points can readily be verified from comparing the results of the EU and US economies, where the EU is more of a welfare state and where the US has more traditional features.

Not surprisingly, there has been much debate about the sustainability of the welfare state. The US economy clearly is more dynamic and in many respects also more successful and innovative than the European economy. In this debate, a wide range of issues is discussed, from trade to investments, technology, monetary policy, migration, and so on. All these features indeed are very important for a balanced economic judgement. A common conclusion remains that employment plays a key role, as is for example witnessed by the OECD (1994) “Jobs Study”, the OECD Economic Studies 31 (2000), OECD (2003), to name a few. This conclusion actually is not so surprising, since the very definition of the welfare state suggests that it tries to protect people from the uncertainties of the job market rather than anything else.

Many people accept these days that Western economies have a problem with jobs with a low level of productivity and thus a low level of market-earned income. The United States tolerate more poverty while Europe sets its minimum wage much higher so that Europa has more unemployment. This problem with low productivity jobs finds various explanations, notably those of technology, globalisation and labour market inflexibility - or ‘welfare state sclerosis’. Policies based on these explanations have been enacted for some time now. For quite some time, in fact; while little is being achieved. It is proper that we pose the question: why is it that we don’t achieve much ?

The novel analysis presented in these pages finds the problem and answer in taxes.

As noted, benefits have to be financed, and the tax arrangements have a key impact on incentives and costs. We will focus on the influence of taxes that runs via the labour market, both directly by ‘labour taxes’ and indirectly by ‘consumption taxes’ that also affect the cost of labour. The emphasis in our study is on dynamics where interactions have more time to take hold. The idea of this present study is that by proper management of tax dynamics, the economy could become more efficient, in both the EU and US alike, so that ultimately the drawbacks of a welfare state can find a better balance with its advantages.

Obviously, when this analysis is new, then it has not been recognised before, and then it has likely been missing in policy. And policy that was based on a wrong analysis, is likely to have been the cause of the very problem that it wanted to solve.

The emphasis on taxes does not mean that technology, international trade and labour market inflexibilities are irrelevant. It does not mean that we can throw away the current macro-economic models. On the contrary: the emphasis on taxes is only an amendment to the current models. The tax analysis would be meaningless without these current models. I myself participated in the construction of the CPB (1990) Athena model, a sectoral model of the Dutch economy with 7000 variables, and I would be the last one to suggest that only taxes matter !

Though the amendment sounds simple, there still are grounds to cover. Unemployment obviously has a much longer history than the current problem. Also, the Western track record on unemployment can only be understood when the record on inflation is taken into account too. A wrong diagnosis of the cause of unemployment would also have its effects via the anti-inflation policy of the monetary authorities.

Stylized history

Consider the empirical evidence since 1950. This track record coincides with decades:

· The 1950s had low unemployment and low inflation, and high real growth.

· The 1960s had the threat of unemployment, and governments accommodating inflation in order to actually prevent it.

· The 1970s nevertheless had mass unemployment bursting into the open, and governments accommodating high and accelerating inflation to battle it. Growth is volatile.

· The 1980s had governments come down hard on inflation, while they accept high levels of unemployment and stagnating growth as the price for stability.

· The 1990s-till-now: There are different reactions on both sides of the Atlantic. Europe appears reluctant to dress down the welfare state, accepts high minimum wages and more unemployment that is partly hidden in Welfare State programmes. The USA appears willing to accept more poverty. (This difference in regional reactions started already earlier, but is clearest in this period.)

One sees a certain “trade-off” between unemployment and inflation. Figure 2 reviews the official data for the United States and Figure 3 for the Netherlands for 1950-2001. For both countries, the official values for the 1950s and 2000s are in the same lower left and favourable region, but they have been far outside of it during the years in-between. Since the official statistics in the 2000s have returned to the favourable lower left region, the natural question to ask is whether stagflation has been defeated. Figure 4 reviews the situation in the Netherlands, where the official values have been extended with those on the labour force ‘not working’. One can suspect that Welfare State programmes can hide unemployment.

In macro-economics, the relation between unemployment and inflation is expressed in the Phillipscurve. Next to the standard (wage-) Phillipscurve there is the (price-) Phillipscurve that gives the relationship between unemployment and (consumer) prices (and that relies upon a dependence of prices on wage-costs). A more extensive (participation-) Phillipscurve links the development of wages and prices to unemployment or ‘not-working in general’. Understanding the relationships of the curves is subtle: it is not just the inclusion of the numbers, but rather the effect on the market. Notably, when ‘disability’ means a reduction of the workforce, the remaining workers face less competition and might raise their wage demands (see Figure 4).

Figure 2. The unemployment - inflation space 1950-2001, United States

Figure 3. The unemployment - inflation space 1950-2001, Holland

Figure 4. The Netherlands, ‘official unemployment’ (drawn) and ‘not working’ (dashed)

Above rough division in decades suggests, as said, some ‘trade-off’. There is a discussion among economists whether such a ‘trade-off’ really exists, and in particular for the short run, but, with this division in decades, it cannot be denied that there are some systematic choices involved. Our object of study, stagflation, can be rephrased by observing that the Phillipscurve apparently has shifted to a higher and unfavourable position.

The authors Okun (1981), Hebden (1983), Blanchard & Fischer (1989), Friedman (1991), Phelps (1994) help to put the Phillipscurve in perspective. Extensive empirical work has been done by the Central Planning Bureau (1992a&b).

Okun (1981) emphasises the stability of the US Phillipscurve over the 1954-1969 period, but accepts that wages and prices thereafter are less flexible in the short run, due to ‘implicit contracts’ and ‘invisible handshakes’. Referring to Friedman and Phelps he notes: “In the sense that all economists must recognize that adverse shift of the short-run Phillips curve, they have all become accelerationists now (to reverse Friedman’s celebrated concession to Keynes).” (p239). Rather than getting lost in finding proper functional formats, Okun concentrates on formulating various elements that are important for policy making, indicating that a whole range of instruments must be used. The minimum wage gets short mention, but is not considered in relation to the Phillipscurve.

Hebden (1983) gives a recommendable review of econometric issues and empirical work (till that time) on the Phillipscurve, including (a) the original article by Phillips, (b) papers that remain close to his format, and (c) papers that include trade union influence and price expectations. Hebden notes:

“Models that seek to explain the causes of the inflation that has been experienced in the recent past, and hold out the possibility of helping economists to predict and maybe control inflation in the future, are sought after eagerly by economists and politicians. Many models have been produced and a fair degree of unanimity has been found as to the mechanics of the relatively mild inflation experienced in Britain in the 1950s and 1960s. But when inflation accelerated, in this country as in most of the industralised world, in the mid-1970s, those models were unable to cope; and though almost a decade of ‘hyperinflation’ has passed since then, no model that adequately explains its causes has yet been found.” (p158)

Blanchard & Fischer (1989) note:

“The Keynesian framework, embodied in the “neoclassical synthesis”, which dominated the field until the mid-1970s, is in theoretical crisis, searching for microfoundations; no new theory has emerged to dominate the field, and the time is one of explorations in several directions with the unity of the field apparent mainly in the set of questions being studied.” (p27).

On the Phillipscurve they note:

“The contemporaneous correlation between innovations in wage inflation and GNP is, however, positive and significant: it is this correlation that underlies the Phillips curve, which plays a central role in theories of the business cycle that allow aggregate demand disturbances to affect output.” (p19).

Their discussion is critical and enlightening, but does not involve the role of the minimum wage. On p551 they discuss the high European unemployment, but then refer to the Layard & Nickell 1986 & 1987 model, concluding, a bit non-committingly:

“The Layard-Nickell model provides an example of how to relate the theories developed in this book to the data. It suggests a complex set of causes for high unemployment in which both demand and supply factors play a role and the labor market’s own dynamics explain the persistence of high unemployment with nearly stable inflation.” (p555).

Our analysis will allow a stronger conclusion. From the 1950s till the beginning of the 1990s the common view among economists and policy makers tended to be that the unemployment in the trade-off was “general” unemployment. This is not quite true for all economists, but many made this simplifying assumption. Nowadays we tend to link unemployment to lowly productive labour. For us it may be obvious, but compared to the earlier view of many it is a change of perspective that the once-thought-to-be “general” unemployment now turns up as a rather specific type. To make this change specific: we will hold that the unemployment in the trade-off has always been related to the distribution of productivity across labour.

Structure of the argument

The crucial insight is that the people who can demand pay rises need not be the people who run the risk of unemployment thereof. High productivity workers run less risk of unemployment and can more easily demand pay rises, while low productivity workers run the larger risk of unemployment. High productivity workers are more versatile and are able to shift the risk of unemployment to the lower income groups. When jobs are scarce, the high productivity workers even crowd out others from the labour market.

The policy rule on taxes is: don’t tax low productivity labour. Why ? To keep it employed so that more productive labour will meet more competition and will not demand inflationary pay rises. In Europe, taxes on low productive labour are still high, causing a high minimum wage that causes unemployment. These taxes could be abolished, and without costs, since these workers are unemployed anyway. Similarly, marginal tax rates are less a problem than often said. The proposed alternative policy provides an improvement on both unemployment and inflation, exactly the kind of policy measure required for in the current situation.

This analysis is not common knowledge. It is missing in the economic journals, it is missing for example in Borjas’s (1996) much used textbook for undergraduates. Borjas (1996:441) states: “The minimum wage, however, affects mainly less-skilled young workers, so it is difficult to attribute much of the unemployment problem to minimum wage legislation.” For policy makers, the OECD (1998) reports: “The cross-country evidence suggests that the minimum wage has no significant impact on overall adult employment.” though OECD (2000) is more guarded, see chapter 44. We will show however that a minimum wage can have huge ‘multipliers’.

The difference that it means

It is useful to clarify the difference between currect macro-economic policy in Western nations and what macro-economic policy can be according to this book.

Current macro-economic policy:

· accepts unemployment as a consequence of low inflation and reduced deficits

· sees the likely cause of unemployment in technology, globalisation and labour market inflexibility

· focusses on aggregates and averages

· discusses the distribution of wages mainly in terms of income (in-) equality.

The new macro-economic policy:

· sees a way to combine low inflation and balanced budgets with full employment

· sees the cause of current unemployment in the system of taxation

· focuses on distributions

· discusses the distribution of wages in its relation to productivity and unemployment.

Table 2 tabulates the differences.

Table 2: Differences between current and possible policy

Current policy

Possible policy

low inflation & low deficit

accepts unemployment

full employment

cause of unemployment

technology, globalisation and labour market inflexibility

system of taxation

method

aggregates & averages

distributions

distribution of wages

income equality

productivity & unemployment

The new analysis means that we get a different perspective on the existing models.

For example, a current argument in Holland on labour market inflexibilities is that the replacement rate is too low. There would be a so-called poverty trap. People in a benefit situation would have little incentives to accept a job offer, since they would earn hardly more. This is regarded as a supply issue, and since one cannot raise wages (which would increase unemployment), the only solution seems to be the reduction of benefits. This was actually the statement of the Dutch Minister of Social Affairs at the presentation of the Dutch National Budget in September 1999. Even the small Socialist Party (SP) accepts this view, vide its January 2000 internet site. The Minister and the oppostion party however are misguided and badly advised. In the proper analysis the problem is crucially different. If there would be sufficient jobs then there already are regulations that people can be fined for not accepting a job offer. This fine creates an incentive of 30% in a warning stage and eventually 100% by full withdrawal of the benefit. So the problem is rather that there are insufficient job offers - with sounds more like a demand problem. By manipulating taxes, it is possible to reduce gross wage costs - and increase demand - while still allowing for a decent net income.

Another point of attention is the word ‘unemployment’. Holland in 1999 features an ‘official unemployment rate’ of about 3.2 %. It seems as if unemployment is no problem for Holland. As an economist I however cannot accept the sausage that the Statistical Office (in this case the Dutch CPB and CBS) here present. (1) Dutch ‘official disability’ is about 10% of the true labour force, (2) people older than 55 years are often excluded from the ‘official labour force’ too, (3) many people work part-time since they cannot find a full-time job, (4) many women will not work outdoors since childcare is too expensive because of the wrong wages, (5) etcetera. Many economists classify these issues under the denominator of ‘participation’, and then agree that Holland has a participation problem. However, in proper economic terms it is unemployment: people who would want jobs but cannot find them. I urge the statisticians to remain servient to economic science, as they claim they are, rather than servient to politics and disinformation.

13. Unemployment via taxes and minimum wage

Let us see in stylized fashion how it went wrong in 1950-2005. Our discussion uses Holland as the example to clarify the general OECD situation. The discussion will also use simplifying assumptions and few footnotes, to keep the text transparant. These defects will be remedied in the subsequent chapters.

Key aspects are:

· heterogeneous labour, and the use of an earnings distribution

· the minimum wage and unemployment

· decomposition of the minimum wage in subsistence and tax burden

· analysis of the Tax Void

· differential indexation

· dynamic marginal tax rates

· consequences for the macro model: spillover and domino effects.

Figure 5: Earnings distribution

The earnings distribution

Figure 5 gives an earnings distribution of a standard lognormal shape. The figure approximates the situation in Holland 2002, though without parttimers. With each level of income there is a number of ‘personsyears’ of people who earn that level. The earnings distribution can be used to compute how large unemployment will be below the minimum wage. Figure 6 gives the situation for the Dutch minimum wage of about € 18.3 thousand. Since Dutch unemployment is about 25% of a potential labour force of 8 million people, the graph conforms to the facts.

Figure 6: Unemployment below the minimum wage

Analysing the minimum wage

We wonder how the minimum wage comes about. We see two terms in the minimum wage, as can be seen in equation (13.1a) and its explanation:

M = minimum wage

B = subsistence

T = arbitrary tax function

Bentham = Bentham tax function

y = an arbitrary level of income

r = marginal rate

x = exemption

(13.1a) M = B + T[M]

(13.1b) Bentham[y] = r (y - x) for y > x,

= 0 for y x

(13.1c) Net[y] = y - T[y]

The minimum wage provides subsistence and thus consists of that net minimum and the taxes at that minimum, which is expressed by (13.1a). Since net income must be larger than B, this means for the Bentham function:

y - r (y - x) B & equality at M M = (B - r x) / (1 - r)

Malthus has subsistence B enforced by nature. Under current rules of (European) welfare states, B can be higher, since people who cannot earn subsistence B are entitled to a benefit of that level. Table 3 gives the Dutch example.

Table 3: Tax wedge at subsistence (single person)

Dutch legal minimum wage 2002 (per annum)

Gross minimum wage in the official statute

15,638

Net, after deduction of taxes incl. premiums for the employee (single person)

12,516

Gross minimum wage: gross + premiums for the employer

18,265

All taxes incl. premiums (though exclusive of VAT etc.)

5,749

Tax as a percentage of gross minimum wage

31.5 % % % % % Tax as a percentage of net income

45.9 %

The Dutch situation is depicted in Figure 7, the tax plot. The horizontal axis gives income y, the vertical axis the tax t. The tax line T gives the Dutch tax brackets. Net income is given by the difference between the tax and the 45-degrees line (t = y). Subsistence causes the line y - B parallel to the 45-degrees line. This line cuts off a part of net income. The intersection of the subsistence and tax lines gives y - B = T, and this solves into the minimum wage y = M. You must earn at least M to satisfy the minimum net income requirement B.

Figure 7: Tax plot

Figure 8 clarifies that the minimum wage means that there are no full time wage earners below M, so that tax and net income are only relevant above it.

Figure 8: Tax plot revisited

Figure 9 gives gives the same result but then as a net income plot. The horizontal axis gives income, the vertical axis net income. The tax is given by the difference between net income and the 45-degrees line. Subsistence now is a horizontal line at B. The intersection of the B-line and the net income line gives the minimum wage M. You must earn at least M to satisfy the minimum net income requirement B.

Figure 9: Net income plot

The Tax Void

Let us now combine the earnings distribution and the tax plot.

Note that the tax figures have shaded areas only above the minimum wage. The tax appears effective at and above the minimum wage, but not below it. Though taxes are defined below the minimum wage, there are no taxes collected, since people are unemployed below the minimum wage. The clear area from net minimum till the gross minimum wage M can be called the Tax Void.

The difference between net and gross is called the tax wedge, and it is generally seen as a vertical jump. There is a change of perspective now, in that we see it also as a range, particularly relevant for the minimum wage.

In the Tax Void the tax code has only a paper function (in terms of tax collection). The tax code helps to drive up the minimum wage, but it does not collect any revenue. Abolishing taxes in this area therefor does not cost anything too. Note that abolishing the tax void would mean that exemption would be chosen at subsistence.

Figure 10: Tax Void Unemployment

Part of unemployment below the minimum wage is still above subsistence. If taxes would be abolished in that section, then the affected people could still earn a living wage, and need no income support. This kind of unemployment can be called the Tax Void Unemployment. Figure 10 gives a plot of that section (shaded) for Holland.

For the record: the Dutch minimum wage only holds for fulltimers, and not for parttimers. Holland has a lot of parttime work (for that reason). We have eliminated parttimers from the present analysis.

Cause of the Tax Void

How has the tax void come about ? Since abolishing the tax void does not cost anything, and would generate a lot of employment, why don’t we abolish it ? Why do we continue the present absurd situation of mass unemployment ?

It appears that the situation has come about gradually, by a mechanism that is difficult to observe directly. It involves the co-ordination of tax policy with social policy, specifically the indexation of taxes and subsistence.

First note that OECD countries adjust their taxes for inflation, see OECD (1986). Tax exemption in 2002 will often be close to the inflation-adjusted real value of 1950. On the other hand, research in social psychology shows that subsistence tends to rise with the general level of income, the growth of which consists of inflation and real growth (or real net income). So there is “differential indexation”. In the 1950s exemption was pretty close to subsistence, so that there was no void to speak of. Since then, exemption has lagged behind the standard of living. When tax exemption lags behind net subsistence, then there is a multiplier effect on gross subsistence, with an accelerated increase of the tax void. This process also explains the ‘squeezing of income differentials’ in OECD countries.

Holland is the example again. In 1951, exemption for a single person household was € 354 and for a couple without childern € 463. At that time there was no official minimum wage, but it can be taken at that value. The price level in 2002 (1951=1) is 6.25 and the wage index 2002 is 25.59. This allows us to construct Table 4.

Table 4: Development of tax exemption in Holland

Euro’s

1951

1997

2002

Inflation index (%)

100

545

625

Wage index (%)

100

2082

2559

Exemption, single person

354

3223

8025

Idem, price adjusted

354

1930

2211

Idem, wage adjusted

354

7369

9060

Exemption, couple without children

463

6445

*13116

Idem, price adjusted

463

2524

2892

Idem, wage adjusted

463

9638

11850

* Dutch readers can find the computation in Colignatus & Hulst (2003)

Till 1997, official exemption € 3223 lagged strongly behind the wage adjusted 1951 value € 7369. In recent years the gap has been reduced, but the 2002 official exemption of € 8025 still lags more than € 1000 behind the wage adjusted 1951 value. Most important, it lags € 4500 behind the (single person) net minimum wage of € 12500.

Taxes

If we index tax parameters on inflation only, then this affects exemption x in the Bentham tax function, and thus x should be included in the function call.

P = price index

x[0] = exemption at the base year

xi = real exemption index

(13.2a) x = x xi P (and here xi = 1)

(13.1b’) Bentham[y, x]

(13.2b) Bentham[y, x P] = r (y - x P)

We also write the tax function as T[y, x] and net income as Net[y, x].

Subsistence

The indexation of subsistence differs from other incomes. When wages follow, on average, an index wi, the real subsistence index rsi commonly follows the net average wage, i.e. the wage after taxes.

W = the average wage (nominal)

W[0] = the average wage in the base year

wi = wage index = W / W

rwi = real wage index = wi / P

B = subsistence in the base year

h = B / W[0]

rsi = real subsistence index

rnai = real net average wage index

(13.3a) W = W[0] wi = W[0] rwi P

(13.3b) Subsistence = B = B rsi P

(13.3c) _rsi = rnai =

Net[W] / P / Net[W[0_]]

(13.3d)

Deduction of the real net average income index

We choose the base year so that x = B. Let W[0] be the average wage in the base year, and let h = B / W[0] be the base year ratio with subsistence. Then the index of real (net) subsistence rsi is set to the index of the real net average wage rnai, and is (proving (13.3d)):

with B = W[0] h:

(13.3d)

For example, if base subsistence is half the base year average wage, B[0] = ½ W then h =0.5. When r = 0.5 then rsi = 0.33 + 0.67 rwi.

With h and B given, the causal chain is {rwi, r} rsi B M u.

When all incomes grow as fast

Before we continue it is useful, however, to first clarify a formal property for the Bentham tax function.

Property (13.3e): For the Bentham tax function: There is equal growth of gross and net income, if and only if exemption is indexed on either.

Note: The distinction between (13.3d) and (13.3e) is that the former indexes x on P only, and the latter indexes x and B on wi = P rwi.

Corrollary: Under (13.3e): If the income distribution remains the same (all incomes grow with the same rate) then also the average income, y = W grows at the same rate, and then also the net income distribution remains the same, and then the ratio of net average to subsistence remains the same too. Note: Western nations thus could wisely index subsistence and exemption on gross average income.

Note: These relations seem obvious enough, but actually proving it turned out to be a bit tedious.

Proof: Denote y[+1] = (1+gr) y = g y for growth rate gr, and Net[y[+1]] = n Net[y] (both g and n one period indices).

Net income with the Bentham tax is Net[y[+1]] = g y - r (g y - X) with X the new exemption. This should be equal to n Net[y] = n (y - r (y - x)). Thus n is defined by:

g y - r (g y - X) = n (y - r (y - x))

() Take z = g = n. Then z y - r z y + r X = z (y - r y + r x) and this gives X = z x.

( g) Take X = g x. Then g y - r(g y - g x)) = n (y - r (y - x)), so that n = g.

( n) Take X = n x. Then

g y - r(g y - n x)) = n (y - r (y - x))

g y - r g y + r n x = n y - n r y + n r x

g y - r g y = n y - n r y

g (1 - r) y = n (1 - r) y

g = n

Q.E.D.

Development of the Tax Void

These formulas call for a graphical illustration. We only need data on rwi, r and h for a stylized display. We will take r = h = 50%. Then we need data on rwi, and we can use our example of Holland.

Graphical presentation of the Dutch data

Appendix Table 20 gives the required data on the Dutch economy. Dutch 1951 exemption can be taken as 1951 subsistence. Before we use the data for the formula, let us first see what they mean. Figure 11 and Figure 12 on inflation P and real income growth rwi = wi / P show that the data fit above classification of subperiods for inflation and real income growth behaviour.

Figure 11: Continued inflation, stagnating real wage

Holland, 1951 = 1

Figure 12: Inflation plotted against the real wage

Holland, 1951 = 1

Using the data for our analysis

We now use the data for our analysis. There are four combinations of gross/net and real/nominal. This results into Figure 13. ‘Subsistence’ is always measured as a net term, and ‘minimum wage’ as a gross term. For Holland, we find that real subsistence has risen about 4-fold since 1951, and the nominal minimum wage more than 30-fold. The computed nominal minimum wage relates well to the factual 2002 minimum wage. Not only inflation accounts for the rise, but also an increased tax burden (that encounters inflation again).

Figure 13: Different indices at the minimum

Holland, 1951 = 1

It was the slow rise of subsistence B and the lagging of exemption x in the 1950-1975 period that caused a multiplied rise of M, creating the Tax Void. Also, since the earnings distribution is nonlinear (lognormal), there was an even sharper nonlinear increase in unemployment.

Figure 13 shows that the real values stagnate since about 1980, and that the development since then is determined by inflation. Since inflation does not occur in the rsi index, the real situation is stable. For example, the gross-to-net ratio at the minimum since 1980 is quite constant.

Note too that this in a sense presents a difficulty. The problem with the minimum wage was caused before 1980, and policy makers wanting a solution in 2002 will rather look at the last decennium rather than to the 1950-1975 period.

Marginal tax rate & VAT

While the above considers exemption x, the analysis can be extended with an analysis on the marginal tax rate r.

Many economists hold that a high marginal tax rate is a disincentive for labour effort. They frequently propose a change from the income tax to the Value Added Tax (VAT). If we assume the same total tax revenue then the VAT might allow for a lower marginal tax rate, for the reason that the VAT has no exemption. At least, that is commonly conjectured.

Above analysis already exposes one flaw to the argument ‘in favor of the VAT’. Having no exemption means a higher minimum wage ! So, those tax theorists who propose a shift from income tax to VAT tend to neglect an important part of labour market economics. Note that a higher VAT on luxuy cars does not affect the subsistence worker who cannot afford these, and hence there is some truth in the statement that a VAT sometimes can be preferred. However, once we have solved unemployment by proper labour market policies, the discussion about income tax or VAT could be done in terms of fiscal properties only, and it might quickly appear that a low VAT of say 5% suffices.

Secondly, it is said that a VAT taxes profits too and thus seems to allow a general reduction of the price of labour. But it raises costs disproportionally for the lowly productive (who generally work with less capital).

Figure 14 shows the development of the relative revenue shares of Dutch income tax and VAT for a selection of years (i.e. 1975, 1980, 1985, 1990, 1997 and 2003). The Dutch minimum wage problem has worsened also by this development.

Figure 14: Revenue shares of income tax and VAT

Marginal tax rate & dynamics

I agree with the basic idea about the disincentive effects of marginal tax rates. Namely, economic theory assumes maximising agents, and the condition for a maximum can normally be expressed in terms of marginals. However, the marginal must be computed correctly. Above marginal rate r is only a static rate, that applies to a specific regime, for example a specific period. However, tax rates are adjusted from year to year. A dynamic situation requires a dynamic analysis.

Let y = y - y[-1]. Then the proper (dynamic) marginal tax rate is DMR = T / y. For the Bentham function:

Generally the dynamic marginal is lower than the static marginal. In fact, when tax parameters are indexed in a certain way, then the tax can have the same growth rate as income, and then the dynamic marginal rate equals the average tax rate. This holds for individuals and for the macro data if all individuals are on a balanced growth path. Let the balanced growth rate be bgr:

(13.4)

The following is a small example of how a dynamic marginal rate can equal a normal average. Let exemption be $10000, and let the statutory marginal rate thereafter be 50%. Someone earning $50000 pays the tax of $20000, on average 40%. Let all incomes grow 5%, and exemption be indexed on national income. Then exemption becomes $10500, income $52500, tax $21000, again 40%. Thus on the (dynamic) “marginal dollar” this person doesn’t pay 50% but 40%.

For the Bentham tax function we can derive a simple expression for individual growth. We are most interested in expected developments. Let personal income grow by rate , so that y[+1] = (1 + ) y, and let exemption be expected to be adjusted by rate _, so that x[+1] = (1 + ) x._ Then we find:

Let us regard the dynamic marginal rate for a Dutchman in 2002 who considers an increase in work effort for 2003 (and beyond), and let us assume a regime of sound economics. In the ideal case, exemption in the base year is put at subsistence, in this case € 12.5 thousand. Ideally, subsistence rises with income, and not just real net average incomes. This ideal implies that exemption is adjusted not just for inflation, but for the nominal growth of income. Let us assume this ideal, and let us assume that national nominal growth is 4%, for example consisting of 2% inflation and 2% real growth. Let us then regard the situation of a single economic agent. He knows that next year exemption will be adjusted with 4%. He has to judge whether it is worthwhile to him to invest or to increase labour effort, so that his income will rise. If his personal income rises with 4%, then his dynamic marginal will be equal to his present average tax rate. If his personal income rises by 8%, then his dynamic marginal will differ; it will depend upon his actual income level, but anyway will be less than the statutory marginal rate of 50%. Figure 15 gives the plot of the dynamic marginal for those two rates, for various levels of income. The 4% line here also gives the average tax level.

Figure 15: The dynamic marginal rate

Individual income grows at 4% or 8%, while national income grows at 4% and the statutory marginal rate is 50%

Empirical analysis often shows marginal rates to be less relevant - and average tax rates to be more important - than ‘common theory’ claims. This analysis on the dynamic marginal provides a useful part of the explanation.

Spillover and domino effects

Above analysis concerns minimum wage unemployment. The next question is how this relates to other kinds of unemployment.

It is useful to observe that the analysis in these pages is new. Concepts like the tax void, differential indexation and dynamic marginal tax rates, and the insights on their interaction, are really new, and have been concocted by me in a search for new scientific results. That means that governments have not incorporated these concepts in their policy making (even though the occasional civil servant may have been aware of some phenomena). Policy making up to now has been based upon a different analysis, and, alas, by being different from the right analysis, the governmental analysis is a wrong one. This is not without consequence. By analogy, when a patient gets a medicine based on a wrong diagnosis then the illness may get worse rather than diminish. In the present case, the tax void unemployment has important spillover or domino effects on unemployment above the minimum wage, and the channel of transmission is the misguided policy reaction up to now.

For example, in the 1970s governments tried to stimulate the economy by incurring big deficits, but they ended up with inflation. In the 1980s and 1990s governments opt for low inflation, and they end up with high real rates of interests and mass unemployment in Europe and poverty in the United States.

For example, Dutch economic policy is based on a general restraint on wages. This policy has fueled Dutch exports and reduced Dutch imports. The general restraint in fact subsidises exports, and Holland runs an external surplus for quite some years now. The internal imbalance is reflected in an external imbalance. The proper policy reaction however would be a wage cost policy targetted at the minimum.

Diagnosis and Therapy

Please note that the present review only gives a diagnosis, and that it is a different affair to find the proper therapy. The first is necessary step before the second can be considered.

In the course of some years I have experienced that discussing therapy is useless when people do not even understand the diagnosis. Policy makers tend to be focussed on therapy - but judge this from a wrong diagnosis. For example, in The Hague in 1992 (at a social-democratic political rally when I was no longer a member of his party) mr. Wim Kok, the Dutch Prime Minister of 2000, occasional chairman of the European Union and the social-democratic ‘respected elder’ to mr.-s Clinton, Blair, Schröder and Jospin, and a person who did some basic econometrics in his younger years, laughed loudly when I suggested to raise Dutch tax exemption from the then € 3 thousand to € 10 thousand. He must have thought of staggering costs, and it didn’t help when I said that it need not cost anything.

A major remark about therapy is that to undo the damage of the last four decades, it is not necessary to take four new decades. Return to optimality can be much faster.

The alternative and new policy would be to abolish taxes in the tax void and to allow people to earn their own - decent and untaxed - living. This alternative policy reminds of an old rule. The Dutch economist Cohen Stuart proposed in 1889 (cited in Hofstra (1975)) to put tax exemption at the level of subsistence. To drive the point home he drafted the following analogy:

“A bridge must carry its own weight before it can carry a load.”

In 2005 there is the additional argument that abolishing void taxes will not cost anything, while nations will save benefit payments due to more employment.

Note that the ideas of Cohen Stuart’s ‘bridge’ and the tax void are not very complex in themselves. In 1991 I explained them to a 12 year old kid and he commented: “A child can understand that.” Still, the EU and its score of modern governments sin against these concepts.

If unemployment is inefficient, then by definition there is a Pareto optimising solution, that will not cost anything. Most economists don’t believe in cheap solutions. Much of the debate hence focusses on ‘efficient unemployment’, where the sad state is caused for example by globalisation, technology or ‘welfare state scelerosis’ (with poverty traps). But, clearly, the tax void exists, it is a cheap way out, and the other arguments will turn out to be ghosts, which they already can be shown to be.

Note though that some period of transition may be required. Policy makers will be hesitant, advisedly, about an overhaul of the tax system. Note, then, that the tax system defines our notion of a subsidy. A wrongly levied tax, in this case the tax void, can be compensated for by a wage cost subsidy. Abolishing the tax void is more sensible in the long run, but since this can only be done gradually, then some general subsidy directed at lowly productive jobs would speed up short term adjustment. The rule would be that those subsidies are reduced when tax exemption rises towards subsistence.

Stagflation resolved

More employment.... Does that not fuel inflation ? The pieces of the puzzle fall into their places when the tax void is related to the unemployment & inflation problem. The steady rise of the tax void explains the track record of unemployment and inflation. The 1950s have been characterized by relatively low taxes on low income earners, and this allowed for full employment and low inflation. From the 1960s onwards the lagging tax exemption started causing problems with unemployment. The tax policy since at least 1965 enhanced the imbalance of the internal bargaining positions of labour instead of counter-balancing it. Hence inflation was persistent, and high levels of unemployment were required to achieve price stability.

As said, governments suffer from a co-ordination problem. How governments reacted in the past depended upon the view of the day. Since the proper solution was not known, the problem did not go away. The differential indexation of tax exemption and the social minimum did not draw attention to itself. Each year adds only a slight effect which is hard to see. But over the years the void has accumulated, and with huge consequences. And the problem will remain with us in the future unless policy changes.

The co-ordination problem persists, currently. Governments currently regard minimum wage unemployment as just one type of unemployment, and not even the most important type. Current policy is based upon other explanations for unemployment, notably those of technology, globalisation and flexibility. The policy reaction based on these views is to reduce taxes for higher incomes, so that they are encouraged to work, invest and spend more, and so that labour market flexibility might be increased. However, the ineffectiveness of current policy can be explained by the fact that these views are not entirely logical. The arguments of technology, globalisation and flexibility run up against contradictions:

· Technology is a source of wealth, and it boosts the productivity of the lowly productive jobs, making the problem of poverty and unemployment less serious than it would otherwise have been.

· “Globalisation” is a scare word for “trade”. Trade however is another source of wealth, and it too has been with us for ages. Rising wealth in distant countries means rising wages over there, and trade itself thus puts limits to foreign competition. Japan over the last 60 years is a prime example of this phenomenon, but every rich nation has had the same experience.

· The “flexibility” or “welfare state sclerosis” argument can only explain that the US has poverty and Europe unemployment, but it does not explain that there is a problem with low productivity jobs in the first place. The poverty trap as said does not exist.

Thus to be sure: the real policy target is low inflation, and policy makers only discuss technology, globalisation and sclerosis/flexibility in a second line of the argument. This second line is essentially a cop-out, since it does not concern the real issue - and a discussion can be very tiring if people behave like that.

At the same time, the wrong policies work counterproductively. The reduction of taxes for the higher incomes obviously is financed by a reduction of provisions for the lower incomes, aggravating the minimum wage and poverty problems.

In my analysis, the present situation bears another surprise. We diagnose current unemployment as inefficient. Be sure that you see what inefficiency means: it means that there is a solution that is beneficial to some and that does not hurt others. Having a bright idea always means a “win-win” situation or a free lunch. In the present case there is the move to full employment under price stability. The present unemployed will find jobs. The higher productivity group will have a theoretically larger risk of unemployment, but in practice this risk will be modest as in the 1950s. The real gain for the higher income earners will come from the services that will be provided by the jobs of the presently unemployed. So you do not need to reduce taxes for the higher paid, since they already will have a real gain at current income.

This was it, in a nutshell. Now I beg your understanding. My analysis is more complex than can be stated in these few lines. Both tax policy and social policy are quite complex themselves, and this certainly holds for their interaction with inflation and unemployment. For example, you may ask why I haven’t discussed income redistribution effects. Actually, this is because the alternative policy could be neutral to the income distribution. The reason for this is that the analysis focusses only on the link between wage costs and productivity. But you might want to hear more about this. Also, you might ask whether above explanation covers all possible cases of unemployment and inflation. Of course it doesn’t. The analysis does help to clarify that other types of unemployment need other types of policy, such as education and so on. But you might want to hear more on that too. These are just examples of issues, and there are many more issues that need to be dealt with. Which space forbids. However, given that my model amends existing economic models, much of the required explaining is ‘existing economics’.

This novel explanation is in the tradition of Keynes and Tinbergen while it fits in with mainstream economics. When economists check and confirm these findings, our economies are likely to enjoy more growth with full employment and low inflation.

14. The 1974 Duisenberg disaster

While the above uses a stylized example of Holland, there is a short and enlightening story about actual Dutch politics, far remote from econometric regressions. Quotes are here in my translation, Dutch readers can also read Colignatus (1994b:28).

In Dutch politics, parties have to form coalitions to be able to govern, and the Biesheuvel 1971 cabinet came about by a coalition agreement that contained the following plan:

“Increase of tax exemption (in the direction of equality exemption for married couples with one child towards the minimum wage (….))”

The explanation of this idea to parliament was (MvT 1971/72):

“(…) it doesn’t require more adstruction that current exemption is too low. Its size doesn’t satisfy the fundamental notion of a threshold, the exemption of taxation of part of income, that is reasonably required for financing the necessary means of existence as seen in contemporary social views.”

This plan didn’t succeed, the government broke down prematurely. There came about a new leftist government under leadership of Den Uyl, and his Minister of Finance was Wim Duisenberg, the president of the European Central Bank in 2000. This cabinet however rejected above concept. The 1974 argument was:

“De government (…) explained that the social minimum had been raised in the preceding years in such extent that it could be considered to provide means to pay taxes.”

The latter statement is rather shocking. Subsistence is by definition a net concept, and the politicians don’t stick to that definition. The statement also means that someone who falls in the tax void is forced into a benefit situation.

What is alarming too, is that Duisenberg was not alarmed, didn’t veto this nonsense.

After this ‘Duisenberg disaster’, the issue disappeared from people’s mind, it got transformed into an annual debate on indexation and the topic of discussion became the level of benefits for the needy. In 2005 Holland still suffers the consequences.