Alan Krueger Tries to Justify Income Redistribution

Here's a speech from yesterday by Alan Krueger, on income distribution. It's clear this is an attempt to provide some economics to support the ideas in a previous Obama speech. Maybe we should not give Krueger a hard time about his speech, as he is just out there doing his job. However, I think honesty and good economics are important, so let's see what Kreuger has to say.

It is by now well-known that there has been an increase in the dispersion of income in the United States, beginning perhaps as early as 1970. Krueger discusses this, but he also wants to make the case that there is less mobility across the income distribution than there once was, and less mobility in the United States than in other countries. Kreuger cites as evidence some work by Miles Corak at the University of Ottawa. Corak's "Great Gatsby curve" which shows a positive correlation between income inequality and immobility across levels of income within a country. Of course, this only establishes a correlation that exists in the data. Kreuger is making a policy speech. What we really care about in this instance is the effects of particular policies. To evaluate those, we need a serious structural model on which we can run experiments to evaluate alternative policies and compare their effects on economic welfare.

Krueger tells us about some of the causes of the increase in income inequality in the United States. This is pretty standard, though he has a funny way of assembling the evidence:

In the mid-1990s, I did a poll of a nonrandom group of professional economists attending a conference at the New York Fed. I asked them the extent to which various factors contributed to the rise in inequality.

Hopefully everyone understands why it is a bad idea to take a poll among economists to get a serious answer to any question. If I want to understand why income inequality has increased in the United States, I will read the relevant peer-reviewed published research, sift the arguments, and then draw some conclusions. Fortunately, in this case Krueger actually came up with an answer that is consistent with the received research. If Krueger had asked the same group of people to each write down their estimate of the government spending multiplier, I can assure you that he would get nonsense.

As is well-known, there are three key factors driving the increase in income dispersion. These are technical change, the scarcity of skilled workers, and import competition. Krueger, for political reasons, wants to attribute some blame to the Bush (W) tax cuts, but I think it is well-recognized that the effect of the change in the income tax schedule in this instance is relatively minor. He also talks about union membership and the minimum wage.

Here's where he starts to go off the rails:

Now, I could see why someone could support tax cuts for top income earners if they had materially benefited the U.S. economy, but the macro evidence is clear that the economy did not perform better after last decade’s tax cuts than it did after taxes were increased on top earners in the early 1990s. I already showed you evidence that income growth was stronger for lower and middle income families in the 1990s than it was in the last 40 years overall. This next chart shows that there was more job growth in start-ups in the 1990s than in the 2001-2007 period [Figure 11]. Across all businesses, job growth was much weaker in the 2000s than in the 1990s. So there is little empirical support for the claim that reducing the progressivity of the tax code has spurred income growth, business formation or job growth.

It is well-known as a theoretical proposition that the income tax has negative incentive effects. The key question, though, is how large those effects are. For more on this see this previous post of mine, particularly the part on Diamond/Saez toward the end. I think one can make a case that the incentive effects are large, particularly in the long run. When Krueger points to the fact that the Bush tax cuts were followed by poor economic performance, we know that's not serious evidence, as there were too many other things going on over that period.

In the next part of his speech, Krueger wants to tell us about the harmful effects of inequality. This starts off OK, by appealing to our sense of fairness. Maybe this income inequality is denying people opportunities? We could be seriously misallocating resources if high ability poor people are not being educated while low ability rich people are going to Harvard. But Krueger comes up with some pretty strange ideas as well. The first strange idea he attributes to Raghuram Rajan, which is that high income inequality encourages "families to borrow beyond their means." I haven't read Rajan's book, but Krueger could be mischaracterizing Rajan's ideas. My understanding is that, rightly or wrongly, what Rajan is arguing is that government attempts to redistribute income, working in part through Fannie Mae and Freddie Mac, contributed to the financial crisis. Krueger makes Rajan sound more like Robert Frank, which involves a very different set of ideas.

The second strange idea, attributed to Robert Reich, is that the increase in income dispersion is bad because it reduces "aggregate demand," since high-income people save more than low-income individuals do. To buy this idea, you have to think that we collectively make the wrong consumption/savings decision, and that redistributing income from rich to poor will move us toward a better national allocation of income between consumption and savings. Imagine a world with two people. A has 5 banana trees and B has 20 banana trees. A spends all his working time picking bananas and eating them. B spends half of her working time picking bananas, and the other half of her time planting new banana trees and tending to them. Krueger thinks the world in which A and B live would be better if someone took bananas away from B and gave them to A. I have no idea why he thinks that.

So what policies does Krueger have in mind? The first is health care, which of course is already done, and scheduled to be fully-implemented by 2014. There is a clear redistributive aspect to the Affordable Care Act. Those who stand to benefit from it are the poor, and it will be paid for disproportionately (because of progressive taxation) by the rich. I know this is controversial, but I don't think it should be. The Act won't do anything much to deliver health care more efficiently in the United States, but I don't have a problem with it. I'm from Canada. A second thing he pushes has to do with the American Jobs Act, which again we know about already.

Krueger then gets into some controversial territory - the financial industry and taxation. First, Krueger says "we must adequately regulate excess risk-taking and corrupt practices in financial markets." No one would argue with that statement. Who wants too much risk-taking or corruption in financial markets? However, what does that mean? How do we know excessive risk-taking when we see it? What do we do about it? Financial firms are of course very good at hiding "corrupt practices." How do we root those practices out? How do we tell useful financial innovation from innovation that is there only to obfuscate and allow what is essentially theft? Some people want to put a tax on all financial transactions. But that seems too blunt a tool for correcting the actual problems.

Second, here's a tax proposal:

It also means that we can’t go back to tax policies that didn’t generate faster economic growth or jobs, but rather increased inequality. Instead of going backwards, we should adhere to principles like the Buffett Rule, which states that those making more than $1 million should not pay a lower share of their income in taxes than middle class families. We should also end unnecessary tax cuts for the wealthy, and return the estate tax to what it was in 2009.

We know what he means by "tax policies that didn't generate faster economic growth." He told us that those were the Bush tax cuts. It's not clear whether he wants to let the Bush tax cuts expire, or just have the top marginal rate revert to its pre-Bush era value. The difference matters, particularly for how this is sold politically.

It seems clear that Krueger knows the economics literature, as he should. The interpretation of some of the evidence is stretched, though.