The Earned Income Tax Credit is not a subsidy to employers!

In this follow-up to my previous post, which links to a thoughtful piece by Professor Jonathan Meer on the hidden costs of minimum-wage laws, I debunk the myth that the Earned Income Tax Credit is a subsidy to employers. Addressing this issue is important to the debate because most economists who oppose the minimum wage are not motivated by a desire to eliminate support for the working poor. On the contrary, they oppose minimum wage laws because they believe that such laws often hurt the same people they purport to protect, whereas policies like the Earned Income Tax Credit (EITC) are much more effective. Defenders of the minimum wage often respond by claiming that the EITC is a subsidy to employers that drives wages down, thereby making the establishment of a minimum wage even more necessary. Unfortunately, this claim shows a poor understanding of economics. Sadly it is often made by people who have advanced training in economics, and should therefore know better. Bellow I explain why the EITC is not a subsidy to employers as well as why it likely raises, not lowers, wages for low-skilled workers.

First, let's look at how the EITC works. The IRS offers an explanation here, but briefly, the EITC is a payment made to people who are earning an income, but that income is "too low". The IRS describes the EITC as "a benefit for working people with low to moderate income". The credit is more generous for people with children, declines gradually as someone's income rises, and disappears once a person's income has reached a threshold.

Second, let's look at how subsidies work. A subsidy is in essence a negative tax. It is a payment made to one or both trading parties each time a transaction takes place. As an example, let's look at how a subsidy to orange farmers could work. Such subsidies were popular in Greece, where I grew up, in the 1980s so I have an eye-witness account of their impact. Under one scenario, the government could pay a farmer some amount, say 50 cents, each time the farmer sold a pound of oranges. The impact of the subsidy is therefore to reduce the marginal cost of production. For example, suppose that to produce an extra pound of oranges, the farmer had to spend $2. By getting 50 cents back from the government, her cost effectively drops  to $1.50. It doesn't take much economic training to conclude that the decrease in cost motivates farmers to produce and sell more oranges. The problem is, however, that to sell more oranges, farmers have to lower their price to entice consumers to buy the added production. Hence, the subsidy becomes self-defeating to some extent. Farmers receive a payment from the government for each pound of oranges they sell but because they now want to produce and sell more they must charge less. Some of the benefit is lost and captured by the buyers. To prevent the price from falling, the Greek government first engaged in an advertising campaign to convince consumers that they should eat at least three oranges per day, and when that failed it was forced to buy and bury in dump yards large portions of the production so that it wouldn't reach the market. What a waste! Today, to avoid this problem, most subsidies to farmers impose production quotas that limit the amount that farmers can produce. Still a waste, this time of land.

Applying this concept to the labor market would involve the government paying workers some amount for every hour they work. This would motivate employees to work more hours, and in the absence of a minimum wage it would indeed drive wages down as workers would have to accept lower wages to convince employers to hire the added labor. The employers would reap some of the rewards of the subsidy, just like the buyers of oranges did even though the subsidy was directed at the farmers. But the EITC works the opposite way. An employee that worked more hours and earned a higher income would get less money from the government, not more. Therefore, the EITC recipients are discouraged from working since any increase in income is offset to some extent by a loss in government assistance. To convince workers who receive the EITC to work more hours despite that loss, employers would  have to pay not a lower but a higher wage. This is the exact opposite of what defenders of the minimum wage suggest. In economic jargon, if leisure (the time spent not working) is a normal good, then any increase in non-labor income should make people consume more leisure by working less. The decrease in the supply of labor should then raise the equilibrium wage.

In conclusion, the EITC is not a subsidy to labor. The credit is more generous to those who have lower income, and typically these are people who work fewer hours, not more. Because the EITC benefits more those who work less, it reduces the willingness of its recipients to work. To make them overcome their hesitation,  employers would have to pay them higher wages, not lower. Given that the minimum wage is a blunt instrument with several harmful unintended consequences, there is no reason why we should keep it, let alone raise it. We should focus instead on reforming the EITC or, even better, instituting a national dividend. But more on the national dividend in the future. 

The unintended dismal consequences of the minimum wage

David Henderson hosted recently at the Library of Economics and Liberty a guest blog post written by Professor Jonathan Meer of Texas A&M University of the hidden costs of the minimum wage. The article is particularly relevant given an increasing number of voices among congresspeople calling for an unprecedented increase in the Federal minimum wage. But what makes Meer's piece even more interesting is that unlike many of the op-eds we see in newspapers these says, his opinions are backed by making reference to recent scholarly papers and articles written by academic researchers as well as his own work. It is very much worth a read because, as he concludes at the end,

We should never minimize the struggles of low-income families to get ahead. But good intentions are no substitute for good policy. Minimum wage proponents mean well, but the unintended consequences hurt the worst-off the most.

You can find the rest of it here.

Surprising Truths About Trade Deficits: A Note

"Surprising Truths About Trade Deficits" is the title of an excellent article written by Greg Mankiw and published in the New York Times. You can find it here. There is a reason why Greg's textbooks are so popular: his ability to simplify complex issues is admirable. I hope he won't mind, however, if I use my own example to elaborate a bit further on why it is a mistake to think of trade surpluses as good and of trade deficits as bad.

Assume that there are two people located in the US: Jane and Bob. Jane sells bread, while Bob sells machinery. Assume also that there are two people located in China: Ai and Huan. Ai produces wheat and Huan produces clothes. Now suppose that in the course of the year, Jane buys $100 worth of wheat from Ai to make her bread. Ai uses $80 of these dollars to buy bread from Jane and lends the other $20 to Huan, who uses it to buy machinery from Bob and expand his business. In this case, there is a balanced trade between the two countries. The Americans bought $100 worth of goods from the Chinese (wheat) and the Chinese bought $100 worth of goods from the Americans ($80 of bread and $20 of machinery). Suppose that next year, Jane buys again $100 worth of wheat from Ai, who uses $80 to buy bread from Jane. This time, however, Ai takes a look at how Huan is managing his business and decides that she is not comfortable with his decisions. Instead of lending Huan the remaining $20, she decides to lend it to Jane because she sees more potential there. Jane borrows the $20 and uses it to buy machinery from Bob. The Americans are now running a trade deficit. They bought $100 worth of goods from the Chinese (wheat), but the Chinese only bought $80 worth of goods from the Americans (bread). Note that Bob still sells $20 worth of machinery but instead of selling it to Huan, he is selling it to Jane. Are the Americans worse off for running a trade deficit? Well, the deficit means that Jane is able to invest in and expand her business. This is a good thing, not a bad thing for the Americans. Are the Chinese better off for running a trade surplus? The surplus means that Huan is unable to borrow from Ai and invest in his business. This is a bad thing, not a good thing for the Chinese.

The above example illustrates that a trade deficit can be a sign of strength; it may mean that foreigners have a strong desire to invest in our economy. To do so, they must sell us products and use part of the revenue not to buy our own products but to lend to us so that our firms can buy the additional equipment they need to expand. Similarly, a trade surplus can be a sign of weakness; it may mean that foreigners have little desire to invest in their own country so they lend whatever they save to us. In essence, running a trade deficit means that we are borrowing from the rest of the world, and as Greg points out, whether this is good or bad depends on what we are borrowing for; whether we are borrowing to expand our productive capacity or instead to increase our consumption and have a good time, like Greece did for much of the 1980s with unfortunate results.

The paradox is that several of President Trump's policies are likely to increase our trade deficit. Cutting taxes without reducing government spending implies that the US government will have to borrow more. If it borrows more from abroad, the result will be a bigger trade deficit, which is the opposite of the President's stated goal. And to the extent that the tax-cut is used by households to increase consumption rather than investment, it may spell trouble in the long run when households will have to pay more taxes to service the bigger government debt without having a higher income to cover the additional tax burden.

The Major pay gap

Every semester in my "Principles" class, I perform a cost-benefit analysis to show that despite the big increase in tuition over the past few decades, the financial benefit of having a college degree relative to a high-school diploma still outweighs the cost, and not by a little. However, I also make a point that the financial benefit depends crucially on what you choose to major in. A recent article by CBS News confirms this and lists the Majors whose holders are expected to earn the highest salary from the beginning to the mid-point of their career. The two conclusions I find most interesting are these:

1. Economics (grouped with Mathematics) is the only social science Major that makes it to the group of top-earning majors. This is not surprising to those of us who teach the subject. As one researcher comments,

When we ask employers about skills that are lacking in new college grads, we thought it would be technical skills. But what we hear from employers is often the new hires right out of college are lacking things that you think everyone in college should graduate with, which are communication skills and critical thinking.

The issues that economists deal with often have costs and benefits (there is no such thing as a free lunch, right?) and are the focus of political debate. Hence, a training in economics certainly encourages and cultivates critical thinking. Elaborating these costs and benefits in a way that other people can understand also hones communication skills. As most economic theories are formulated as mathematical models, a training in economics also cultivates abstract and analytical thinking and sharpens the students' quantitative skills. These are all qualities that employers value.

2. The highest-paying Majors are all in STEM fields, which explains a big part of the gender pay-gap since these fields are dominated by men. Of course, the issue remains whether women choose voluntarily to pursue careers in lower-paying fields like the arts or education or whether they are steered in this direction by societal gender norms. However, this is a different and more difficult question to answer.

Discrimination and Disparities, by Thomas Sowell

While there are several books on discrimination as well as inequality, this one by Thomas Sowell matters much for two reasons. The first reason is that Sowell has a remarkable academic background that includes a B.A in Economics from Harvard, an M.A. in Economics from Columbia, and a PhD in Economics from University of Chicago. As well, aside from his monographs and articles, he has a respectable peer-reviewed publication record in such high-ranking journals as The Journal of Political Economy and The American Economic Review.  The second and perhaps most important reason, given the topic of the book, is Sowell's personal background. He is a black man who spent his early childhood in the segregated south and with limited financial means. Here is part of his biography from goodreads

Sowell was born in North Carolina, where, he recounted in his autobiography, A Personal Odyssey, his encounters with Caucasians were so limited he didn't believe that "yellow" was a hair color. He moved to Harlem, New York City with his mother's sister (whom he believed was his mother); his father had died before he was born. Sowell went to Stuyvesant High School, but dropped out at 17 because of financial difficulties and a deteriorating home environment. He worked at various jobs to support himself, including in a machine shop and as a delivery man for Western Union. He applied to enter the Civil Service and was eventually accepted, moving to Washington DC. He was drafted in 1951, during the Korean War, and assigned to the US Marine Corps. Due to prior experience in photography, he worked in a photography unit. After his discharge, Sowell passed the GED examination and enrolled at Howard University. He transfered to Harvard University, where he graduated magna cum laude with a Bachelor of Arts degree in Economics. He received a Master of Arts in Economics from Columbia University, and a Doctor of Philosophy in Economics from the University of Chicago.

While Sowell has a free-market perspective, and in my opinion sometimes exaggerates to make his case, Discrimination and Disparities is very well thought-out, and makes some excellent points backed by both economic theory and the data. It is a must-read for anyone who is interested in the topic and is open to having their thoughts provoked. Below are some points on a few of the issues Sowell deals with in the book.*

ON PROFILING:
Information is not costless. People seek to economize on information cost. In doing so, they tend to substitute less expensive forms of information for more expensive forms. Physical attributes are “cheap” to observe.

ON MINIMUM WAGE:
A wage rate set above where it would be set by supply and demand in a competitive labor market will cause chronic surplus of job applicants. There will be a surplus of qualified black job applicants as well as qualified white job applicants. Under such circumstances, the cost of discrimination to the discriminating employer will fall. The discriminating employer may decide not to hire black job applicants. Minimum wage laws cause the overall youth rate of unemployment to rise and will particularly hurt the young minority job seekers: “what is particularly striking is that there was no significant difference between the unemployment rates of black and white teenagers in 1948”. Between 1940 and 1960, before the great expansion of the welfare state, black poverty rate declined significantly.

ON INEQUALITY:
At some point between ages of 25 and 60, over three-quarters of the population will find themselves in the top 20 percent of income distribution. The turnover rate in the highest income bracket is particularly high. Fewer than half the people in the “top one percent” in income in 1996 were still there in 2005. The highest incomes are usually very transient incomes, reinforcing the conclusion that these are transient capital gains rather than enduring salaries. And most of “the poor” are not permanent residents in low-income brackets. It is important to note that “the poor” are not a given set of human beings, but an ever-changing mix of people. Entry -level jobs are, therefore, not necessarily “dead-end jobs”.
Despite equal numbers of households in each 20 percent, there are far more people in the top 20 percent of households. The number of people participating in the labor force and earning income is four times as great in the top quintile as in the bottom quintile.

ON “THE POOR PAYING MORE”:
While prices are higher in inner-city neighborhoods, rates of profits are generally lower.  The community is actually paying additional costs generated by some residents in that community. The local residents who created none of those costs are victims of those who did.

*The points were summarized and kindly provided by my colleague, Massoud Fazeli.

Finding your match in the US labor market: trends part II

This post is not about dating at work, though dating is a good way of thinking about a phenomenon that used to puzzle economists: why are some jobs vacant at the same time that some workers are unemployed? The explanation uncovered by research is that, just like in dating, before committing to a relationship each party wants to verify that the counter-party is  a good match, that they possess the qualities that are important to them. For example, rather than hire the first person that responds to its ad, a firm will typically wait until it has a large-enough pool of applicants. Then, it will screen this pool by reviewing resumes, conducting interviews, and so on. Similarly, a job-seeker will typically not take the first job available. Instead, they will apply for several jobs and wait until they have found out more about the salary, location, requirements and potential for advancement of each job before deciding which offer, if any, to take. Because this process is lengthy, in the meantime vacant jobs remain unfilled and job-seekers remain unemployed.

One may argue that while this may be true in the short run, given enough time eventually all vacancies will be filled so any unemployment that persists past that point must be due to a lack of jobs. This would be true if workers that found a job kept it for the rest of their working life. The reality is, however, that as in love so in employment, relationships do not always survive the test of time. Currently, in a typical month about 5.5 million unemployed workers will be matched with a vacant job. However, during the same month approximately an equal number of workers will become separated from their job. Eventually, these or other newly vacant jobs and these or other newly jobless workers will start looking again for a match. Because this match-and-break-up process takes place every month, vacant jobs and unemployed workers will always coexist, though it is important to remember that the vacancies and job-seekers of today are not necessarily the same as those of previous months.

Observing how the job-search process works helps us understand why unemployment goes up during recessions and down during expansions. The data suggest that this phenomenon is due to fluctuations in the number of job openings. During good times, firms post more vacancies so it takes less time for a job-seeker to find the "right" job. Hence, unemployment declines. During a recession, firms reduce their hiring so it takes longer for a job-seeker to find a job. This inverse relationship between the vacancy rate, the percentage of jobs that are vacant, and the unemployment rate, the percentage of workers that are looking for employment, can be plotted to produce the so-called Beveridge curve. Below, I graph the curve corresponding to the time-period from December 2000 (when the Bureau of Labor Statistics started conducting the Jobs Openings and Labor Turnover Survey) until June 2003, which is when the unemployment rate peaked following the 2001 recession. The vacancy rate is on the vertical axis and the unemployment rate on the horizontal. As can be seen, the curve is downward sloping capturing the inverse relationship between the vacancy rate and the unemployment rate. The left end-point, corresponding to December of 2000, is affiliated with a high vacancy rate and a low unemployment rate of 3.9%. The right end-point, corresponding to June 2003, is affiliated with a low vacancy rate and a high unemployment rate of 6.3%.

What happens if we extend the time-period to show the recovery? The Beveridge curve below plots the data from December 2000 to November 2007. The left end-point still corresponds to December of 2000. We see that from 2003 until the end of 2007, vacancies rise and unemployment declines. Graphically, the economy starts moving up and to the left along the same curve.

In 2008, the economy was hit by a recession so severe that it has been named, The Great Recession. How does the Beveridge Curve look if we extend the time-period to capture its effect? Below, the left end-point still corresponds to December of 2000 but the right end-point corresponds to October 2009, which is when the unemployment rate peaked. Starting in December of 2007, the economy starts sliding down along the same curve, as the vacancy rate begins to fall and the unemployment rate rises. Compared to the 2001 recession, the rate of vacancies experiences a bigger drop resulting in a bigger increase in the unemployment rate. The economy passes the right end-point of the 2001 recession and stops at 10%.

Based on the behavior of the economy up to this point, what should we expect to see happening if we extend the time-period to capture the recovery from the Great Recession? A good guess would be that the economy should move up and to the left along the same curve, as it did when it recovered from the 2001 recession. However, if we plot the data all the way until May of 2018, we get this instead. Like before, as firms open more vacancies it becomes easier for job-seekers to find a job so the unemployment rate declines. Unlike before, instead of moving along the same curve, the economy starts moving along a new Beveridge curve that lies to the northeast of the old.

What does the shift of the curve signify? It means that since the end of 2009, there have been more unemployed workers for each vacancy, or alternatively there have been more vacant jobs for each unemployed worker. This implies, in turn, that it takes more time for a given number of unemployed workers to fill a given number of vacancies. In other words, there seems to be greater mismatch between those looking for a job and the jobs available. Although the unemployment rate, currently at 4%, is low by historical standards, it is still higher than what we would have expected based on our previous experience given that there are so many vacant jobs. One possible explanation for the mismatch is that the vacant jobs are located in different geographic areas than the bulk of unemployed workers, and that these workers are reluctant to move. Another explanation is that the existing vacant jobs require skills that are different from the skills that most jobless workers possess. Examining the validity of each explanation is beyond the scope of this post. The shift does suggest, however, that to understand current labor market outcomes we should stop viewing the labor market as homogeneous and instead focus on how the characteristics of the job-seekers vary relative to those of the available jobs. 

Labor market trends and their political implications

Politicians often paint an overly rosy picture of economic data when they are in the administration, and put a negative spin when they are in the opposition. Statistics regarding the labor market are no exception. Below I attempt an objective analysis, and debunk claims that the decline in the official unemployment rate is not reflective of reality. However, I also show that any improvements should not necessarily be credited to the current administration. When reading, please remember that you can magnify a graph by clicking on it.

The most frequently-cited labor-market statistic is the unemployment rate, which is compiled by the Bureau of Labor Statistics (BLS). It is computed by dividing the number of unemployed workers with the sum of employed and unemployed workers. This sum is the labor force. To be considered unemployed, a jobless worker must have looked for employment four weeks prior to when they were surveyed. In May 2018, the U.S. unemployment rate, shown below on a monthly basis, stood at 3.8%, the lowest it has been since the late 1990s, and before that since the 1960s. Clearly, this is something to be happy about.

Some critics claim, however, that the low unemployment rate is an artifact. They argue that the drop is due to previously unemployed workers becoming discouraged and quitting their search. When this happens they stop being considered unemployed and are removed from the labor force. The critics argue that this explains the decline in the labor force participation rate, the percentage of the adult population that is either employed or looking for a job. The labor force participation rate on an annual basis is shown below, and we do observe a decline since 2000. Other critics argue that the official unemployment rate masks that some workers who are considered employed are working part-time because they are unable to find full-time employment. Finally, a third group suggests that while the unemployment rate may have gone down, the decline has not materialized in higher earnings for workers. Let's look at these claims in detail.

Is the decrease in the labor force participation rate due to unemployed workers becoming discouraged? The answer is no! It is mainly due to the fact that the baby-boomers continue to age and retire. When they retire, since they are neither employed nor looking for work, they are removed from the labor force. To show that this demographic trend is responsible for most of the decline in the labor force participation, I graph below the labor force participation rate of adults between the ages of 25 and 52. People in this age-range are typically not eligible for retirement. Hence, fluctuations in this rate are more likely to be driven by changes in employment opportunities than demographics. Here, too, we see a decline from 2000 until 2013. However, it is much smaller. More importantly, since 2014 the rate has been increasing, just as the unemployment rate has been falling. Therefore, it seems that the recent drop in the unemployment rate does reflect an improvement in labor market conditions, which has motivated prime-age workers to re-enter the labor force.

Alternatively, we can look at broader measures of unemployment, compiled by the BLS since 1994. These are shown below, on a monthly basis. The red line adds to the number of unemployed the number of discouraged workers. These are workers who had looked for employment in the 12-month period before they were surveyed but not in the past four weeks, and who gave up looking because they felt that their search was futile. Adding discouraged workers makes little difference, however, since it raises the joblessness rate by less than half of a percentage point relative to the official rate. The green line adds to the unemployed all marginally attached workers. These are workers who had looked for employment in the 12-month period before they were surveyed but stopped looking, regardless of the reason why they quit. Hence, this group includes discouraged workers but also workers who stopped looking because they decided to, say, go to college. Adding all marginally attached workers still makes little difference, as it raises the joblessness rate by less than one percentage point relative to the official rate. Finally, the purple line adds to the unemployed all marginally attached workers and those working part-time because they cannot find full time employment. Including underemployed workers to the pool does make a difference, since it raises the rate of joblessness by about four percentage points. Of course, one can argue that this rate overestimates unemployment, since those working part-time are at least partially employed. In any case, what matters for our purpose is that the four measures move together, so in terms of historical trends it does not matter much which one we look at. In fact, choosing the broadest measure suggests that the improvement in the labor market since 2010 has been greater, as this rate fell by more than nine percentage points while the official rate fell by about six. Visually, both the purple and the blue lines have been falling but the purple line has fallen faster, thus closing the gap with the blue line.

Finally, what about the claim that despite the drop in the unemployment rate there have been no gains in labor earnings? The graph below shows the real (adjusted for inflation) median weekly earnings of wage and salary workers. The median earnings is the earnings right in the middle between the lowest and the highest. We can see that contrary to that claim, median earnings have, in fact, been increasing since 2013, and are now higher than they were before the Great Recession. 

The conclusion that can be drawn once all these numbers are put together is that the current labor market is tight, and that during the past half decade there has been an improvement in labor market conditions both in terms of employment opportunities and in terms of earnings. At the same time,  the improvement began before the current administration took office. Hence, it is way too early to assess its footprint, as to do so we would need to examine whether the improvement accelerated or decelerated since President Trump took office, and we don't have enough data for that. Finally, while these numbers should make us happy, there are some signs of trouble. Specifically, there is some indication that since 2010 there exists a greater mismatch between the workers seeking employment and the jobs that are available to those workers. But more on that on the next post.