Another Greedy Capitalist

Her name is Gina Rinehart:

Now, the Australian mining heiress, worth $19 billion and earlier this year thought to be the world’s richest woman, has sparked another controversy in her latest column in Australian Resources and Investment magazine. (Yes, I am a registered reader online.) Rinehart rails against class warfare and says the non-rich should stop attacking the rich and go to work.
“There is no monopoly on becoming a millionaire,” she writes. “If you’re jealous of those with more money, don’t just sit there and complain. Do something to make more money yourself – spend less time drinking, or smoking and socializing and more time working.”

I don’t disagree with these sentiments at all.  Rather, where I have a problem is with things like this:

Union bosses are fuming that the government has approved a scheme to allow mining magnate Gina Rinehart to bring in 1700 overseas guest workers for her Pilbara iron ore project, without making proper attempts to find local workers first.
Immigration Minister Chris Bowen told the National Press Club today that the government had approved the first Enterprise Migration Agreement – which allows “mega” resource projects to negotiate temporary migration needs up-front – and that it would be for Mrs Rinehart’s $9.5 billion Roy Hill project in Western Australia.

And:

The part of Mrs Rinehart’s speech that drew the widespread criticism was: “The evidence is inarguable that Australia is becoming too expensive and too uncompetitive to do export-oriented business.
“Africans want to work, and its workers are willing to work for less than $2 per day. Such statistics make me worry for this country’s future.”

It’s one thing to say that people should work harder; it’s another thing to advocate and enact policies that negate the effects of hard work.  In this instance, Mrs. Rinehart wants to expand the Australian labor pool to include impoverished Africans.  The mere expansion of the labor pool drives down wages generally, but when said labor pool includes extremely marginal labor like this, it drives down wages quite a bit.
What Mrs. Rinehart faces is the corporatist’s conundrum.  She espouses socially productive views (her advice to work harder and take care of one’s self is good advice, especially when you add getting a basic education and not getting pregnant out of wedlock to the mix), but she pursues socially destructive policies.  She doesn’t really believe in hard work or freedom; what she really believes in is having slave labor, or its cheapest alternative.  That’s why she imports African workers, and that’s why she tries to shame her country men into working harder.  Ultimately, her policy is to encourage materialism (“if you want to be a millionaire…”), which should expand the labor pool (more people working more jobs) while simultaneously encouraging the free movement of labor, also expanding the labor pool.  The net effect of both of these policies is to drive down her labor costs.  What’s sickening is how she dresses this personal greed as patriotism.
One lesson that conservatives should take from this is that it is a foolish idea to link conservative principles (hard work, taking proper care of oneself) with political policies that are harmful to one’s fellow countrymen.  If Mrs. Rinehart had told her fellow citizens to work harder and then offered them 1700 decently paying jobs, her message might have been received a little bit better.  But when she told them to work harder and then offered 1700 jobs to Africans to work at slave wages, well, the resulting controversy could hardly have been avoided.
It calls to mind what God says in Malachi 3:5 (“And I will come near you for judgment… Against those who exploit wage earners…”).  Conservatives often want to condemn the poor for being lazy, but often neglect to condemn employers who constantly try to exploit their workers.  The reality of the matter is this:  Employers ought to do what is best for their employees, and pay them fairly (and before anyone accuses me of being a Socialist, no I don’t think ensuring that employees are paid fairly requires government intervention).  Employees ought to be honest and work hard.  And these two messages ought to go hand-in-hand.  And until conservatives start demanding that employers treat employees fairly, conservatives will likely fins that their call for people to “work harder” will go unheeded.

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Heartiste’s Questions

1. How is the present automation and productivity conundrum qualitatively different than ones from the past (for example, the classic case of the auto replacing the horse and carriage)? If you do not believe it is qualitatively different, explain how we escape the “zero marginal productivity” worker trap, especially in an era when human capital is shrinking due to a combination of dysgenic birth rate differentials and mass migration of unskilled poor? Note: “Humans are fungible” is not an acceptable cop-out.

The present automation and productivity conundrum is not qualitatively different from the past. The zero marginal productivity trap is escaped by the fact the fact that human demand always exceeds supply, broadly speaking. As such, there will always be demand for more…something, anything, and everything.

Of course, the broader assumption—that automation and productivity will continue apace without interruption—is wrong. In Neurodiversity, the author noted that dysgenics and/or small populations lead to technological stagnation and regression. Furthermore, the history of progress is not exactly linear. Thus, we may be in for a stretch of devolution for a while, as “society” becomes too stupid to maintain its current level of wealth. It’s happened before (that’s why it was called “The Dark Ages”). Let’s not be so arrogant to suppose it won’t happen again.

On a more optimistic note, it may be the case that technology becomes more idiot friendly, which enables the less intelligent to capitalize on intelligence without actually possessing any. Simplified UIs should do the trick, they it will be a while before they are common. I’ve written on this before.

2. If, say, most of the profits go to the top 10% in society, while the bottom 90% are unemployed or marginally employed, how is it exactly that those top 10% will be able to extract profits from a customer base that doesn’t have the income stream to afford more than the basic necessities?

It helps to keep in mind that money is dynamic. It is a medium of exchange, after all. Income is usually spent, which is how the wealthy extract profits from it. The poor earn money then turn around and spend it. Rinse and repeat. The key is to differentiate between wealth and income. Income is what you earn; wealth is what you keep. The wealthy will keep, in a sense, the labor of the poor (beyond that which is necessary for survival, of course). Since poor people don’t want to starve to death, they will continue to work as long as they can provide for their needs. And the rich will exploit them in the meantime. Assuming, of course, that the poor don’t get pissed off and kill the wealthy and the elite, as has been done in the past.

Working Hard in the Garden

Thanks for the article from Laura Ryan

I worked in the garden all day yesterday. I was trying to clean out all of the winter nastiness because I heard that we were having an early spring. I raked and hauled off leaves, pulled vines, tended the soil, and picked up an trash that had made its way to the garden. I worked really hard. I worked so hard that my back was killing me at night. I ended up taking two ibuprofen and turning on direct tv new haven and relaxing the rest of the evening. I spent most of the next day doing the same too. You can imagine my disappointment when a big snow storm rolled through on Sunday. I was so upset! I thought that the snow was over. I had spent all day working hard getting the garden cleaned up and ready. Now, I am going to have to do it all over again, but this time I am going to make sure and take some ibuprofen before I get out there!

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ECONomics

This is what happens when you drop out of econ 101 halfway through:

When you make a few hundred dollars an hour, it costs you more to mow your own lawn than it does just to pay someone to do it for you. Of course, this simple math is something that most of the 99% never get.

This tool has apparently never heard of opportunity costs. It only costs you more to mow your lawn if the alternative would cost more than doing it yourself. Basically, this will only happen if you take (non-paid) time off from work to mow your lawn. If you don’t work on weekends, you can mow your lawn then and your opportunity costs will be zero, in terms of foregone work/pay. Mowing your lawn is only a money-losing proposition if the only way to mow your lawn is foregoing earning a paycheck. This is not something most nine-to-fivers face.

This reminds me of another example that was cited in one of my college classes (econ 195, to be precise). My professor had apparently calculated the net wealth of Bill Gates and determined that he earned approximately $4.8 million per hour (approximately $1,333 per second) and, as such, it would be a waste of his time to pick up a one hundred dollar bill that he happened to pass by on the street. This analysis, like a lot of modern economic analysis, is too clever by half.

Actually, it’s not clever at all. Net wealth and income are not the same, and therefore Bill Gates does not earn $1,333 per second. He has (had) $42 billion dollars, period, and that simply exists; it is not earned. Not only that, if he’s walking down the street, he’s clearly not working (unless he’s getting paid to walk down the street). As such, his opportunity costs are zero, in terms of money earned because he is not currently engaged in money-earning activity. Thus, it is clearly within his best pecuniary interests to pick up a one hundred dollar bill, since doing so will increase his net wealth by one hundred dollars.

At any rate, both of these analyses are evidence of what I like to call eCONomics. Essentially, all you need to practice eCONomics is a poor grasp of opportunity costs and the ability to conflate terms and reason badly. Basically, be like Paul Krugman (zing!) and you can be a successful eCONomist.

The Squirrel and the Grasshopper

The text below was forwarded to me a few years ago and I rediscovered it today. I’ve edited it to take out Australian specific references. The Squirrel and the Grasshopper story really resonated with me when I first heard it as a kid. I thought the squirrel was prudent. I’m sure other kids felt sad for the Grasshopper. I propose everyone can be divided into two groups – those who side with the squirrel and those who side with the grasshopper.
ORIGINAL VERSION

The squirrel works hard in the withering heat all summer long, building and improving his house and laying up supplies for the winter.
The grasshopper thinks he’s a fool, and laughs and dances and plays the summer away.
Come winter, the squirrel is warm and well fed. The shivering grasshopper has no food or shelter, so he dies out in the cold.
MODERN VERSION
The squirrel works hard in the withering heat all summer long, building his house and laying up supplies for the winter.
The grasshopper thinks he’s a fool, and laughs and dances and plays the summer away.
Come winter, the squirrel is warm and well fed.
A social worker finds the shivering grasshopper, calls a press conference and demands to know why the squirrel should be allowed to be warm and well fed while others less fortunate, like the grasshopper, are cold and starving.
The media shows up to provide live coverage of the shivering grasshopper; with cuts to a video of the squirrel in his comfortable warm home with a table laden with food and informs people that they should be ashamed that in a country of such wealth, this poor grasshopper is allowed to suffer so while others have plenty.
Do gooders demonstrate in front of the squirrel’s house. A Lefty Politician rants in an interview that the squirrel got rich off the backs of grasshoppers, and calls for an immediate tax hike on the squirrel to make him pay his ‘fair share’.
In response to pressure from the media, the Government drafts the Economic Equity and Grasshopper Anti Discrimination Act, retroactive to the beginning of the summer, and creates The Grasshopper Housing Department. The squirrel’s taxes are reassessed. He is taken to court and fined for failing to hire grasshoppers as builders, for the work he was doing on his home, and an additional fine for contempt when he told the court the grasshopper did not want to work.
The grasshopper is provided with a Grasshopper Housing Department house, financial aid to furnish it and an account with a local taxi firm to ensure he can be socially mobile. The squirrel’s food is seized and re-distributed to the more needy members of society – in this case the grasshopper.
Without enough money to buy more food, to pay the fine and his newly imposed retroactive taxes, the squirrel has to downsize his home.
A 60 Minutes special shows the grasshopper finishing up the last of the squirrel’s food, though spring is still months away, while the Grasshopper Housing Department house he is in, crumbles around him because he hasn’t bothered to maintain it. He is shown to be taking drugs.
Inadequate government funding is blamed for the grasshopper’s drug ‘Illness’.
The grasshopper gets arrested for stabbing an old dog during a burglary to get money for his drugs habit. He is imprisoned but released immediately because he has been in custody for a few weeks. He is placed in the care of the probation service to monitor and supervise him.
Within a few weeks he has killed a guinea pig in a botched robbery.
A commission of enquiry, that will eventually cost $10 million and state the obvious, is set up.
Additional money is put into funding a drug rehabilitation scheme for grasshoppers.
The grasshopper dies of a drug overdose.
The usual sections of the press blame it on the obvious failure of government to address the root causes of despair arising from social inequity and his traumatic experience of prison.
The squirrel’s taxes are increased to pay for law and order, and they are told that they will have to work beyond 65 because of a shortfall in government funds.

Logical Conclusions

Sometimes economists can be complete idiots:

What is the biggest single drag on the beleaguered global economy? Opponents of globalisation might point to the current crisis, which shrank the world economy by about 5%. Proponents of globalisation might point to the remaining barriers to international flows of goods and capital, which also serve to shrink the world economy by approximately 5%. That sounds like a lot.

But the truly big fish are swimming elsewhere. The world impoverishes itself much more through blocking international migration than any other single class of international policy. A modest relaxation of barriers to human mobility between countries would bring more global economic prosperity than the total elimination of all remaining policy barriers to goods trade – every tariff, every quota – plus the elimination of every last restriction on the free movement of capital. [Emphasis added.]

I’ve addressed the stupidity of the “free trade” advocates before, so I won’t do it again here.  However, I will address the problems with the concept of free labor.

First, the economic models used to demonstrate the wisdom of free labor often ignore the simple fact that the conditions facilitating trade in the first place are predicated on culture, and that allowing people from one culture to interact with the trade-oriented culture will diminish the support for the very conditions that allow for trade in the first place.  In other words, all cultures are different.  Some are pro-trade, others are not, and some are only pro-trade when the benefits are staggeringly obvious.  Expecting radically different cultures to interact with one another without also expecting a change in the cultural institutions that harbored that interaction in the first place is astonishingly stupid, and, indeed, ignorant of basic human nature.

This mindset, that the free market will be enough to ensure that all people from all cultures will behave rationally and interact peacefully with one another, is predicated on the wholly fallacious assumptions that people are inherently rational, that all cultures are equivalent, and that cultural biases and prejudices are easily overcome.  Of course, the real world differs significantly from this model.  People are not rational creatures; they are rationalizing creatures.  And, shockingly, people still hate people from other countries simply because they’re from other countries!

Economic growth is rarely (perfectly) linear and never guaranteed.  Furthermore, the conditions for growth are vast and complex, and so it is the height of arrogance to think that models that inaccurately measure a few irrelevant variables are going to make for a compelling argument.  Yet, this is precisely what economists are doing when they argue for free labor.

Second, free labor (and, come to think of it, free trade) advocates tend to ignore the very simple fact that wealth is not based on being able to buy things at lower prices.  Lower prices are the effect, not the cause.  Quite simply, economists ignore fundamental microeconomic principles, leading to this wacky macroeconomic theory.

Wealth, fundamentally, comes from producing something of value, whether for yourself or someone else.  As long as you value that which you’ve created in the quantity in which you’ve supplied it, you have created wealth.  If you create something that someone else values in the quantity in which they value it, you have created wealth.

The standard macroeconomic theory posits that people are effectively wealthier when they can consume more products at identical or lower prices.  Of course, this thinking extends to labor, with the argument being that cheaper labor enables one to produce more with less (in essence, the decreased cost of inputs means that cheaper labor translates to greater economic activity).

This argument is technically true, but irrelevant.  Lower prices as a result of cheap labor does not make consumers wealthier because consumption is, by definition, destructive since one is using up a resource.  What makes consumers wealthier is their own personal production, not lower prices.  Lower prices, in a sense, give the illusion of wealth because they make it easier for poor people to have the things that rich people once exclusively enjoyed.  Note that this is not to condemn lower prices in and of themselves, but rather to clarify that lower prices are no substitute for production.

And so, the argument made by free trade and free labor apologists is largely irrelevant.  Lower prices do not make people inherently wealthier.  Instead, they reveal how other people have become wealthier by improving their means and methods of production.  Confusing cause and effect is a fundamental error, and one that is often overlooked in this debate.

In sum, the argument for free movement of labor completely ignores human nature, as well as basic economic principles.  As such, it does not merit any further discussion, nor should it be taken seriously.

Maybe It’s Time to Give Up on Africa

Britain’s international aid budget costs the equivalent of 22 days of national borrowing from international markets. By 2015, British Aid will have increased by 34.2% to £11.5 billion per annum. Including personal donations and state spending, Britain gives 0.8% of GDP in international aid. With state aid increasing, more people should ask: Why are average per capita incomes in Africa lower than 40 years ago after $1 trillion of aid being given over that period?

If there is one thing I simply do not understand in this scenario, it would have to be why Britain feels compelled to help Africa at all.  The British government’s only concern should be with taking care of its citizens and acting directly in their best interest.  (Of course, as a libertarian, I’m inclined to argue that this can be accomplished simply by ensuring that property rights are observed, and that the taxation necessary to ensure this result is as small and painless as possible.)

I simply do not see how giving aid to Africa is in the best interest of British citizens.  Need cheap labor?  Asia is a good place for that, and doesn’t generally require near the amount of aid that Africa does.  Besides which, Asian labor is more reliable in terms of quality, and many Asian governments have made a point of developing their infrastructure.  So why care about Africa?

This question becomes extremely poignant once on also considers that African countries have not simply stagnated in spite of aid, but have actually regressed.  This being the case, it seems obvious that aid, if not hurtful, is at least irrelevant to African countries.  And if they can’t manage the money transferred to them from the pockets of productive first-world citizens, then how and why would anyone think that they are worth investing in?

Quite simply, it is time to cut the purse-strings to Africa.  They squander the generous gifts given to them time and again, and it appears that this trend isn’t going to change anytime soon.  If insanity is doing the same thing over and over again while expecting different results, then the sane thing to do at this point might be to cut the aid and force Africa to stand on its own feet.  And who knows?  It just might be crazy enough to work.

Man vs. Machines

charlie_chaplin02This post will be useful in the fall, when I hold a Principles of Microeconomics class. In that class we take a look at the market for labor, including productivity. We know that if we add a production input, like labor, but hold other inputs (like capital equipment) steady, that marginal improvements to output will eventually decline – i.e. we see declining marginal productivity. Adding more of other inputs, like equipment, can enable labor to achieve higher productivity levels.

In microeconomics we also look at the ways that labor and capital (equipment) can substitute for one another. As costs for one input rises, there is an incentive to purchase more of the other input. Decades ago the automotive manufacturers added more and more robotic assembly processes to their production, in part to deal with increasing labor costs. Catherine Rampell wrote an article and a blog post in The New York Times this week, on this topic.

In “Employers Spend on Equipment, Not Workers“, she points out,

Indeed, equipment and software prices have dipped 2.4 percent since the recovery began, thanks largely to foreign manufacturing. Labor costs, on the other hand, have risen 6.7 percent, according to the Labor Department. The rising compensation costs are driven in large part by costlier health care benefits, so those lucky workers who do have jobs do not exactly feel richer.

Labor theory suggests that as workers become more productive, the demand curve for labor shifts to the right, and should raise the equilibrium price (wages). This hasn’t been happening – in part because of high unemployment levels and an excess supply of labor. Rampell also argues that total compensation is rising – but that most of that increase is in benefit costs rather than wages.

In an Economix blog post she explores the health care benefit assertion further.

It may seem strange that the cost of labor is rising so fast. With such a weak economy, it doesn’t seem as if a lot of workers are getting raises. (Are you?)

And technically, employees are not getting much of a raise — at least not in cash. The higher cost of labor is primarily being driven by rising benefits costs and, in particular, rising health insurance costs.

[...]

[T]he benefits cost line is quite steep. Even more daunting to employers, it could get even steeper in the years ahead; health care costs are rising sharply, and their costs a year or two from now are very hard to predict.

Several take away points from this pair of articles. First – as capital equipment (particularly software-driven) improves and gets cheaper, we should expect it to substitute for labor. Second – health care costs drive so much of our economy, including the pace of unemployment changes.

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Human Capital, Labor Market and Economic Growth

The OECD recently published the international comparison of the gap in employment rates between university graduates and workers with secondary education or less (link). There is no single exception to the fact that the employment rate is the highest in the group of individuals with college and university degree. Nonetheless, the comparison of the variation in employment rate in the cross section of OECD countries is very interesting.

Among the OECD countries (link), Iceland enjoys the highest employment rate (94.7 percent) of those with college or university degree followed by Switzerland (93.9 percent), Norway (92 percent) and Denmark (91.4 percent). The lowest employment rate for university graduates in 2008 was in Turkey (81.4 percent), Italy (86.5 percent), Israel (86.6 percent) and Greece (87.2 percent). In contrast, the employment rate for those below the secondary education is the lowest in Slovakia (39 percent), Hungary (47.5 percent), Poland (55 percent) and Czech Republic (57.4 percent).

The persistence of high unemployment rate for those below the secondary education degree is a broad outline of the findings from the course of labor economics. The human capital, defined as the stock of years of education per capita, is highly positively correlated with career earnings. The evolution of human capital across the countries has been a subject of debate on economic growth. The empirical study by Robert Barro and Jong-Wha Lee (link) has shown that, for instance, upper secondary school attendence by males has a significant long-term impact on the economic growth. The level of education, sustained by the years of schooling, is not a sole determinant of economic growth in the international perspective. Although, the economic growth is strongly positively correlated with the average years of schooling, the relationship is less powerful considering different parameters of the educational attainment. In the Barro-Lee dataset (link), there is a significant variation between the share of female population that enrolled in a tertiary education and the share of female that completed the tertiary degree. The difference is significant not only in the cross section but also in the country-based time series.

By far the highest tertiary degree completion rate for females has been present in Australia, Canada, Ireland, New Zealand and the United States. Among other countries, the completion rate of Iceland and the Netherlands has been significantly higher compared to the countries of the Continental and Mediterranean Europe. The rate of return to an additional year of schooling significantly differed across countries and across the level of education. For instance, Barro and Lee estimated that the rate of return is the highest at the tertiary level (17.9 percent per annum) compared to the secondary level (10 percent) while the rate of return from an additional year of schooling at the primary level is statistically insignificant from zero. The picture shows the regional variation in the average rate of return from an additional year of schooling.

Rate of return from an additional year of schooling across the world
Source: R. Barro & J.W Lee: Educational Attainment in the World, 1950-2010 (link)

The creation of human capital is essential to higher economic growth. Ultimately, the investment in human capital is the essential means of higher standard of living in poor countries. An interesting theoretical question is what could account for a divergence across the countries? Considering the relevant economic theory as well as scholarly contributions to the theory and empirics of economic growth, there are several factors that explain the significance of divergence in the rate of return from an additional year of education.

First, the impact of behavioral patterns on education and labor market decisions explains a pretty large part of the difference between the effect of education and labor market structure on the rate of return from schooling. Although the field of behavioral economics (link) is still a largely evolving discipline within the economics, the existing empirical studies of the effects of institutional variables on education outcome try to capture these effects by different proxies such as the estimates of political freedom, the rule of law and civil liberties. The changes in the return to education may be related to these factors since the relative worth of education in regions such as Sub-Saharan Africa and Latin America may incur high opportunity cost given the payoff from predatory behavior or working in the informal sector of the economy.

Second, general and firm-specific human capital investment, the increase in college premium and the enormous increase in female labor force participation help explain high rate of return from an additional year of schooling in advanced countries and East Asia. In particular, East Asian tigers were able to sustain high economic growth rates partly because of well-trained and educated labor force able to use the modern technologies. The resulting outcome of the Asian economic miracles has been a steady growth in output per worker and a gradual convergence of wage rates in South Korea and Japan to the level of U.S. According to Kevin Murphy and Finis Welch (link), the premium of getting a college education in the U.S in 1980s was 67 percent. The growth in college and university attendence rates is largely explained by the robust increase in tertiary education premium.

And third, greater labor force participation of women has also led to higher rates of college and university attendence. In spite the persistent male-female pay gap, women have experienced a tremendous increase in lifetime earnings as a consequence of higher rates of college and university attendence. The persistence of the male-female pay gap can be explained by the rewards to education rather than by inherent gender bias. The U.S. Census published the relevant data (link) on the distribution of female earnings. In 2003, the female earnings of high school graduates in the 25-34 age thresold represented 78 percent of average male earnings. The earnings of the same female age thresold with bachelor’s degree represented 89 percent of male earnings and 71 percent for those female with master’s degree. What accounts for the gender earnings gap across the levels of age and education is the asymmetric self-selection that led to dispersed gender distribution of relative earnings. Men usually self-select into the areas of work requiring a significant amount of risk-taking and rather uncertain payoffs while the female labor market pattern is inclined towards less risk-taking and greater certainty regarding the stability of lifetime earnings.

The data by the U.S. Bureau of Labor Statistics (link) published in 2003, showed that female-to-male earnings ratio in high-paying jobs is the lowest in the field of chief executives where female earnings represented 80 percent of average male earnings in the same field of occupation. On average, the female-to-male earnings ratio declined in low-paying occupations such as cashiers (93 percent), cooks (91 percent), food preparation (93 percent) and hand packaging (101 percent). Contrary to the popular perception, female earnings in the field of computer systems management and legal industry represented 91 percent of average male earnings while the highest ratio in high-paying occupations was recorded in pharmaceutical industry (92 percent).

Indeed, there is a persistent and historically lowest male-female earnings gap. But, as the labor economic theory of human capital predicts, the gender pay difference reflects different cognitive abilities and preferences of occupational selection considering the degree of risk-taking and payoff uncertainty. Even the international test scores (link) confirmed that advantage of female cognitive abilities comprehends in verbal reasoning and reading skills (link) while the cognitive abilities of male are more inclined towards the use of computer technology (link) and mathematics (link).

Even in a cross-country perspective, the gender wage differential persists. The gap, defined as the female-male ratio, ranges from 0.9 in France to 0.7 in Canada. The gender wage differential is a cross section of major economies is shown in the table below.

The Gender Earnings Gap Across Countries

Source: F.D Blau & L.M Kahn, Gender Differences in Pay, 2000

The set of different institutional characteristics of labor market in different countries could easily complement the productivity growth rates as to explain the evolution of wage differential across countries. Even though wage rates are primarily determined by the productivity growth, the existence of collective bargaining schemes and rigid labor market mechanism determining wage rate and total compensation can add significantly to the enforcement of particular labor market policies affecting gender bias in wage determination. In the United States and other advanced countries, the main cause of the wider gender earnings gap is a significant gap between college education premium and high school premium. In addition, reductions in personal income tax rates furthermore increase the rewards to college education relative to the education levels of high school or less – which, by the empirical evidence, seems to be the main determinant of earnings gap in the labor market of advanced countries.

The Tax Wedge and Productivity in OECD Countries

The OECD Factblog highlighted a comparison of tax burden across the OECD countries. The main findings of the comparison is that overall tax burden, measured as a percentage of labor costs, is the highest in Western European countries. Belgium, Hungary, Germany and France are the countries with the highest overall tax burden while Ireland, Iceland, Australia and Korea have sustained a low tax wedge. The data acquired by the OECD pose an intriguing question: is slow economic growth in European countries attributed to high tax burden of labor supply and, if so, has the gap between the U.S. and Europe grown further?

Let’s decompose the data and underline the main findings. Tax wedge, measured as a percentage of taxes and transfers paid in the share of total labor costs, is a sufficient measure of the overall level of taxation. In the analysis of the effect of taxation on labor supply, the economic theory distinguishes between substitution and income effect. The former means that tax rate on labor supply would reduce the number of working hours and shift the individuals to allocate more time into leisure. The income effect, on the other hand, states that the effect of tax on labor supply would be neutral and would, hence, not have an effect on the relative allocation of resources between working hours and leisure. In general, there are two largely opposing views in economic policy regarding the relationship between taxation and labor supply. Conservative and liberal economists tend to emphasize the role of incentives. Higher tax rate would raise the labor cost and the corresponding decline in wages would be offset by the re-allocation of resources into leisure sector of the economy. Left-wing economists mostly disagree with the abovementioned proposition. Instead, they emphasize the role of elasticity of labor supply. According to New Keynesian view, short-run tax elasticity of labor supply is low in absolute terms, meaning that the amount of working hours does not respond significantly to relative changes in tax rates. The Keynesian economists thus emphasize the significance of income effect while the conservative and liberal economists tend to emphasize the substitution effect. The distinctions and policy effects of these two theoretical propositions remains a controversial issue of economic policy debate.

The country distribution data is extensively underlined in the data (link). For example, one-earner married couple at 100 percent of earnings distribution is taxed at 20 percent of the overall labor cost in the United States, 22 percent in Australia, 18 percent in Switzerland and 13 percent in New Zealand. On the other tax wedge statistics for Western Europe is a completely different picture. In Sweden, one-earner married couple at 100 percent of earnings distribution will earn only 57 percent of net earnings, indicating a 43 percent effective tax rate on labor supply. In Belgium, the effective tax rate on labor supply is 42.6 percent. Is the difference in effective tax rates statistically significant feature of productivity variation across OECD countries. The OECD recently composed a breakdown in key productivity statistics in developed countries (link). To estimate the relationship between productivity and tax burden, I collected data on multifactor productivity dynamics from Groningen Growth and Development Center (link) and data on tax wedge across OECD countries (link). I estimated the noted relationship for 16 developed OECD countries. Multifactor productivity is a dependent variable while tax wedge is an explanatory variable.The estimates are displayed on the graph below.

Multifactor productivity in OECD relative to the U.S. and total tax burden (% of labor cost)

Source: GGDC, OECD Factblog

The horizontal line on the graphs marks the U.S. level of multifactor productivity. As the graph shows, the underlying relationship between multifactor productivity (MFP)and tax wedge is fitted with quadratic equation. Total tax wedge explains about 34.5 percent of the variation in multifactor productivity index across OECD countries. The trend exerts a decreasing MFP as the tax wedge rises and, after reaching a local minimum, a slight increase alongside the proporional rise in tax wedge. The relevant question is at which rate of tax wedge the MFP reaches the minimum. Setting the first-order derivate to zero (dy/dx=0) yields 0.0016x-0.0488=0. Rearranging the equation yields x=30.5. The first-order derivative implies that MFP reaches the minimum at 30.5 percent tax wedge. The estimate sample-based tax elasticity of productivity ((dy/dx)(x/y)) is 1.78. The elasticity indicates that 1 percentage point increase in tax wedge would reduce the multifactor productivity in a sample country by 1.78 percent, ceteris paribus. In other words, the estimated slope coefficient suggests that a 1 percentage point increase in tax wedge would widen the MFP gap between the average country and the US by additional 0.05 index points.

In economic terms, MFP would decrease as long as the countries in the sample would exert less than 30.5 percent tax wedge. In the horizon after the local minimum (30.5 percent), MFP would initially increase but at a smaller rate than before the function would reaches the minimum point. At 20 percent tax wedge (close to Japanese level), the expected decrease in MFP would be 0.0168 index point. At 40 percent tax wedge, the expected increase in MFP would be 0.0152 index point. Economically, the relationship between MFP and tax wedge should not be interpreted as a mixed effect of tax wedge on MFP. In countries, where tax wedge exceeds 30.5 percent (Austria, Denmark, Sweden, Belgium etc.) , the multifactor productivity is close to the U.S. level. The only country with higher MFP level than the United States is Luxembourg. In these countries, the average number of annual hours worked per worker is lower than in the U.S. Hence, hourly productivity output is higher. The following graph illustrates the relationship between annual hours worked (per worker) and MFP level.

Average annual hours worked per worker and multifactor productivity relative to the US

Source: OECD Statistics (2010)

As the graph illustrates, there is a negative relationship between average annual hours worked and MFP. The estimated regression coefficient suggests that an increase in annual hours worked by 100 hours would reduce MFP level (compared to the U.S) by 0.06 index points. As expected, the implied elasticity of productivity is negative. Taking the average values ov both variables, an increase in average annual hours worked (per worker) by 1 percent would reduce the MFP relative to the U.S level by 1.16 percent, ceteris paribus.

The conclusion is that there is a significant and negative impact of tax wedge on multifactor productivity. Taking the differences in annual hours worked into account, tax wedge alone explains almost 35 percent of the differential in multifactor productivity across the OECD. The findings suggest that there is a relatively strong substitution effect in labor supply. The finding is underlined by the fact that higher tax wedge would correspondingly reduce annual hours worked. However, the interpretation should be taken with a grain of warning. As previous empirical studies have shown, there is a widespread disparity in the distribution of working hours in formal and household sector of the economy. A sizeable proportion of working hours in household sector of the economy is not officially measured. Consequently, a blick of distortion of the real relationship between labor supply and tax wedge, in its broadest sense, is a major impediment to the measurement of labor supply dynamics. These estimates will, in a large part, determine the future research of the effect of taxation on labor productivity.