Archive

Tag Archives: wealth

In the continuing saga of responses to Noah Smith’s article about the poor and their savings, squarelyrooted chimes in:

Hmmm, I wonder what would happen if everyone started saving as much income as they reasonably could? Where would the high yield investments be with so much capital sloshing around? How would the markets react when aggregate demand plummets even further? – Ethan Gach

 

Snark aside, the key here is that, while it would benefit any individual poor person to save more (assuming, of course, that’s possible given their income and cost-of-living, which is not an assumption I’m eager to make), if every poor person somehow stumbled onto Smith’s article and tried to save more it might generate economic disequlibria that wouldn’t benefit anyone. This is semi-related to the point I’ve made before that aggregate saving is a very different animal than individual saving.

This is just not true. I wish it were true, because it means the poor actually represent a more than insignificant part of our economy. It’s not true for the same reason Noah wrote his article: the poor have no cash savings.

Let’s take a model economy where the top 20% are “rich” and everyone else is “poor”. Let’s be generous and assume the rich control only 80% of the wealth when, in our economy, that figure is far higher. Let’s also stipulate the total value of this economy is a million dollars, and the poor’s aggregate savings grow at 2% per annum against the rich whose grow at 10%. I’ll be conservative and model this with a constant returns on capital across the rich and poor. This obviously isn’t the case, but it doesn’t need to be.

So what we have is 20% of the population controlling $800,000 and the remaining 80% controlling $200,000. At the initial savings rate for the poor, this is what the economy will look like in 10 years:

Year

Poor

Rich

Ratio

1

200000.00

800000.00

0.25

2

214000

920000

0.2326087

3

228980

1058000

0.2164272

4

245009

1216700

0.2013714

5

262159

1399205

0.1873630

6

280510

1609086

0.1743290

7

300146

1850449

0.1622018

8

321156.3

2128016

0.1509182

9

343637.2

2447218

0.1404195

10

367691.8

2814301

0.1306512

11

393430.3

3236446

0.1215624

12

420970.4

3721913

0.1131059

13

450438.3

4280200

0.1052377

14

481969.0

4922230

0.09791680

15

515707

5660565

0.09110519

Now, let’s consider that the poor triple their savings rate to 6%:

 

Year

Poor

Rich

Ratio

1

200000.00

800000.00

0.25

2

222000

920000

0.2413043

3

246420

1058000

0.2329112

4

273526

1216700

0.2248099

5

303614

1399205

0.2169904

6

337012

1609086

0.2094429

7

374083

1850449

0.2021580

8

415232

2128016

0.1951264

9

460908

2447218

0.1883394

10

511607

2814301

0.1817884

11

567884

3236446

0.1754654

12

630351

3721913

0.1693622

13

699690

4280200

0.1634714

14

776656

4922230

0.15778540

15

862088

5660565

0.15229721

I’m not posting a table to vindicate the obvious, but the portion of aggregate savings allocated to the poor will continue to fall until their savings rate is equal to that of the rich, or 10%. This means that it’s highly unlikely that even a significant increase in the savings rate of the bottom 50% (which, in terms of wealth not income, are poor as far as our society is concerned) will cause any “disequilibrium effects”.

Indeed, the ability of the poor to affect our capital markets are even more dispersed in our economy. Because of high levels of risk aversion and poor investment practices, it’s unlikely that they will earn the same rate of return on their savings as the rich. The wealth distribution I assumed is also a lot more equal than what America actually is.

So, contrary to hazy economic thinking, nothing will happen to interest rates and investment markets if we encourage the poor to save. It would be irresponsible to think so because of what Mr. Ethan Gach says. Time to look at the numbers.

Noah Smith has an article in The Atlantic about wealth inequality in the United States. A viral video caught the attention of the economics-blogosphere, and Noah is the latest to comment.  The import of Noah’s argument is the importance of thrift:

Today, wealth equality is closely tied to income equality. But in the long run, it’s all about thrift, frugality, and saving — in other words, teaching a consumer nation a lesson in cheapness.

Progressives have a hard time ascribing wealth inequality to savings rate and (predictably, though not incorrectly) blame structural issues like falling wage share of income. As one very popular commentator notes:

This is absurd. The real wealth gap is based in capital gains, not direct income. Teaching Americans to be frugal is not going to address any of the systemic differences that make it easier by orders of magnitude for the already rich to keep making money.

The fact is, poor American’s can save, they just have really bad habits. For example, as Derek Thompson notes, the poor spend a whopping 9% of their income on lottery tickets. So let’s be honest here, the whole diatribe against Noah that the poor can’t save is crap.

If we’re going to talk about wealth inequality, it’s pretty informative to understand its emergence, why it’s fundamentally different from income inequality, and why an “equal” society won’t help. Consider, an island which is functionally equal – you might say socialist. I’m not suggesting this is a plausibly sustainable situation, but it’s an interesting starting point. Let’s also assume that somehow socialism hasn’t eroded work ethic and desire to innovate. In reality, this isn’t a reasonable assumption, but I’m not making an argument about economic ideology.

So, on day one, the Keynesian economist, farmer, laborer, and lawyer each earn $100 a year. The economist is a spendthrift, with a good taste for Portuguese wine and Victorian clothes, and has only $10 left each year. The laborer, saves diligently, and has $50 leftover. Very soon, an island that once had income equality becomes very unequal, both in income and wealth. The wealth inequality comes first, but soon the laborer has more money to invest in his daughter’s education, and to loan to the moderately-thrifty lawyer and farmer to earn a good return.

So wealth inequality comes first. This is especially true if you consider, in our society, income derived from education to be a capital gain (though, legally, it is treated as labor). In the island, wealth and income inequality were both functions of preference.

However, in our society, as wealth inequality isn’t just a function of preferences, but income itself (in the island this isn’t the case because future income inequality is derived from wealth inequality which itself is derived from preferences). But, in a given snapshot, wealth inequality grows as, in some ways, the integral, roughly speaking, of income inequality.

This is because, if preferences are randomly distributed, the savings become a function of income. As income inequality rises (as it has in the past 40 years), the ability to save gets rather more concentrated amongst the rich. This, and not preferences, becomes the key force of wealth inequality. This is further compounded by the fact that, in a very literal sense, wealth begets wealth through capital income.

So my point of all this is I think Noah’s wrong that somehow altering preferences will fix the situation. Noah argues that, for a “return to equality”, the poor need to be nudged and educated:

In addition to “nudging” middle-class and poor Americans to save more, we can help them get a better return on their assets — the second thing that has a huge effect on wealth in the long run. This means helping middle-class people invest in stocks without paying high fees. The first part of this is teaching middle-class people to avoid making frequent changes in their stock portfolios. Studies show that individual investors consistently lose money when they try to buy and sell and buy and sell, mostly because they tend to ignore trading costs. So financial education should teach people to let their stock portfolios just sit there for decades, and ignore the ups and downs.

The second way to get better returns is to avoid actively managed funds. Actively managed mutual funds charge high fees to purchase portfolios of stocks that, statistically, are no better than simply buying a low-cost “index” fund that tracks the overall level of the market. Pension plans like TIAA-CREF tend to charge even higher fees, meaning even worse returns. Financial education can teach middle-class people what a low-cost index fund is, and how to invest in one.

The first point is rather interesting, and Richard Thaler has the best evidence that it might work (Save More Tomorrow – fantastic study, I think everyone should read it). I don’t have much to say about personal finance education, I think it’s important, but I just don’t think it will have a lasting effect on habits in a consumer culture. Education will be artificial and instituted in the context of grades, which will be the only reason people pursue the subject.

But, as I argued, changing preferences will have only an ephemeral effect. What we need are:

  • Robust risk sharing programs (particularly universal healthcare, strong social insurance, and unemployment insurance). This will a) decrease the need for wealth, mitigating the effect of wealth inequality and b) allow the poor to invest most of their income in stocks, so that they can take part in America’s wonderful capital market. Noah mentions China a country that’s poor but manages to save a lot. One of the many reasons for this, I believe, is an underdeveloped insurance market, creating a greater need for wealth.
  • Ban lotteries. This is simple. Sure, states make a lot of money from them, but this is absolutely the most regressive tax in the country. Not only are educated people informed enough to know that the state has an edge, but it’s a very small part of their income.
  • “Nudge” Americans to save through opt-out programs sponsored by an employer.
  • Institute a progressive consumption tax with negative income
  • Fix income inequality.

The integral-relation with income inequality explains why it will always grow as income inequality is constant, but wealth distribution doesn’t need to be as skewed as it is. Preferences will go some way, but the real change needs to come from income distribution (by investing in human capital) and access to capital markets (by pooling risk).

The falling role of labor in our economy will make wealth very important. Acting now is a pretty good idea. But, moving on, let’s remember a few things: demand creates supply, and wealth inequality creates income inequality. Let’s not mistake cause and symptom.

Edit: There are quite a few negatives that I didn’t address, as Evan Soltas points out. I think (1) and (2) are sufficiently mitigated by an exemption and amortization of tax burden over time, but the coordination of this policy definitely requires some more thinking on my part.

I watched a shocking video earlier today. We all know the story behind wealth inequality in the United States, but it’s good to be reminded just how divided our nation is. I’ve long argued that an income tax system should be replaced with a wealth tax for several reasons:

  • Donald Trump supports it (kind of)
  • It’s easier to design a simple tax code
  • Wealth inequality is kind of like the integral of income inequality. Because those with higher incomes save more, even if the GINI remains largely constant over a period of time, a lot of wealth will accrue in the hands of a few

But there’s another big, structural, reason why a wealth tax makes more sense for the 21st century:

Image

I graphed what economist’s call the “wage share of GDP” out of curiosity. Take a farm that sells wheat. Before the industrial revolution, there might be many farmhands who would each earn a wage to work the farm, producing n kilograms of grain. Assuming this farm has no capital, the wage share of total income is 100% (distributed in some manner among the farmers). Now consider the landlord buys a tractor, allowing him to save 60% of his outlays by laying off the worst farmers. Because it’s a nice tractor, he can still produce n kilos of grain.

Economists would say the wage share of income has fallen to 40%, and the capital share of income has increased to 60%. You don’t need to be Nancy Drew to figure out that this is broadly what’s happened to the American economy with the advent of ever-more-powerful technology.

This is a good thing, but needs to be handled with care. A worker is by definition the owner of his labor (and hence the income derived thereof), but the capitalist is the owner of the machine (and hence the income derived from technological advances).

Where does this tie in with wealth inequality? By saving money in mutual funds, companies you think will succeed, and even a bank you are accumulating capital. And yet, in 2010, the top 1% owned 35% of all mutual funds and 61.4% of all business equity. 

Wages will continue to fall as a percent of GDP. If they didn’t, it would imply that natural evolution can somehow beat human ingenuity. It took millions of years for nature to create sentient life, and yet glimpses in the long years of human history for us to create computers.

In light of this trend, income taxes will become increasingly irrelevant. But what are the numbers behind a wealth tax? Is it sustainable? Would it erode wealth? Could it really replace income taxation?

These are questions that I can’t answer, but I can provide a glimpse of why I firmly believe it will work. Using FRED, I graphed the total financial assets held by households and nonprofits as well as the % year-on-year change:

Image

Several things are pretty clear. Wealth has almost always increased year-on-year, with the exception of the dot-com bust and the subprime mortgage crisis (a quick aside here to direct interested readers to The Banker’s New Clothes, which explains why the latter created a long recession and the former was a blip. Hint: equity is safer than debt).

The data looks pretty noisy so I generated a histogram of year-on-year changes:

Image

It’s not really a normal distribution, but one can see pretty clearly that wealth usually grows by more than 3% a year. In fact, it’s a very smooth exponential curve, with an average growth rate of around 7.3%. The ten year average on wealth-growth has remained largely unchanged so taking this estimate, I generated this projection of wealth through 2023:

Image

Please note that value is measured in billions of US dollars. To determine the wealth tax rate needed to replace the income tax, I borrowed the CBO projections through 2022:

Image

Total income tax revenues is projected at 21.3 trillion US dollars. At an average wealth tax rate of 2.5%, the corresponding figure would be 20.6 trillion US dollars. Pretty similar. (And it’s growing faster, as well).

There should be two modifications to a wealth tax:

  • Although IRS should aim for an average tax rate of 2.5%, it should be progressively implemented. One way to do this would be to exempt the first 50% of all wealth generated for society as a whole, and provide those exemptions on the first k dollars of overall net worth, and tax everything above at 5%. This is not purely for egalitarian reasons, but to incentivize saving. If all wealth is taxed, there is an implicit subsidy of consumption, discouraging long-term savings. For example, if k was 250,000 US dollars, the only people who would face a disincentive to save are those with already high savings rates, with a low marginal propensity to consume.
  • Wealth, as estate, taxes are a tricky business. Especially when much of one’s net worth is in form of home equity and similarly non-liquid assets, it might be difficult to pay an immediate 2.5%. Government can introduce the option to amortize the cost over 5 to 10 years, removing the immediate burden on a family.

I hope this post has demonstrated that a wealth tax is fiscally feasible, and socially egalitarian in the face of an ever-mechanized economy. Incidentally, the United States is one of the few nations that can really succeed with this kind of a taxation system because of its international jurisdiction on assets. France tried, and failed – but to be fair, France also had a highly-progressive income tax scheme which doubly-burdned the affluent. I’m proposing a complete replacement of a highly complex system.

A wealth tax would also be well-supplemented with a progressive consumption tax on carbon, sugar, and cigarettes – balancing out any non-market incentives to save or consume, while at the same time ridding the country of associated external costs.

I truly believe this reform can achieve a bipartisan consensus. Much of the country would be grateful to be rid of an awful income tax system. Indeed our tax code is so complex, that accounting costs represent 4% of overall revenue (enough, for example, to achieve the Simpson-Bowles goal without increasing tax rates). Of course, since I hear very little noise in the news world of any such reform, I doubt it will come to pass – but I would love to hear some debate.