The Cost of Labor
The standard model of Economic Development is Romer’s (1989, JPE 1990) adaptation* of Solow’s (1956, 1957) Model. Basically,
became
Y = AKα(HL)(1-α)
where the H stands for “human capital,” which multiplies the ability of labor. (Think high-skills labor—construction work, plumbing, teaching—where the worker continually “learns by doing” [op cit., Arrow, 1962]. The additional “human capital” multiples the effect of the labor.
One central question is how much of α is attributable to capital and how much is attributable to labor. Standard Macroeconomics and Economic Development courses teach varying values for α, ranging from around 25% to about 1/3 (33.3%): that is, the mixture is between 3 and 4 parts of Labor to every one part of Capital.
How does the compensation go? Well, not quite that way:
The banded area is the estimate of actual allocations of capital and labor. The bars show the compensation to labor (and, therefore, the area above that to 100% are the portion of GDP that is being allocated to capital).
Economic theory tells us that if something is receiving excessive rents—as capital is clearly doing in the United States—there is suboptimal growth occurring across the economy. The standard method of adjusting for that is to reduce the excessive rents through either the introduction of competition (preferred if possible) or through taxation and redistribution. Following are the tax rates on Capital v. Labor:
Labor Tax Bracket |
Capital Gains, Short Term |
Capital Gains, Long Term |
10% |
10% |
0% |
15% |
15% |
0% |
25% |
25% |
15% |
28% |
28% |
15% |
33% |
33% |
15% |
35% |
35% |
15% |
Note also that labor is not necessarily allowed to exclude its “depreciation” above the value of the “standard deduction” ($8,500 for an individual, $11,600 for a married couple). This is clearly a skewed incentive, with preferable tax treatment given to the overvalued resource (capital) at the expense of the undervalued one (labor).
Happy Labor Day!
*NBER subscribers can access paper w3173. Others can just type “Human Capital and Growth: Theory and Evidence” and probably find an ungated copy somewhere. The uncurious are referred to Wikipedia.
“The standard method of adjusting for that is to reduce the excessive rents through either the introduction of competition (preferred if possible) or through taxation and redistribution”
so Mike Kimel is right. there may be more to this “standard” method than we usually hear about.
The one argument I’m extremely sympathetic to on the tax on cap gains being lower (and the only one) is the idea that many company founders eschew pay for a long time and this is a way to make sure they are compensated. (i.e., the income comes all at once after X number of years of sweating to make the company take off.) The problem is that the low tax on cap gains is not being reserved just for that purpose, but for anyone who buys shares of whatever stock and sits on for a couple of years.
Mike
you may be right as i have no insight in this, but it seems to me that taxing all income as income and letting the entrepreneurs adjust their expectations accordingly would be simpler, less susceptible to gaming, and the economics would work itself out. it would be the “free market” way to do things.
when i had a little business, i had all i could do… 90 hour weeks?…. to do what needs to be done. didn’t have time for tax games, or the money to pay someone who did.
i’ll go even further than that… for those who complain about paying “both” the employer and employee share of the payroll tax because they are self employed. there is a reason they are self employed, not only do they get the employees share of wages, they get the employers share of wages… and if that is not about twice as much as they could get by working for someone else, they either don’t have a “successful” business, or they are in it for the fun of it. no reason not to pay taxes like everyone else.
i think the argument i have heard for a special capital gains tax is that otherwise you are being taxed on “inflation.”
that is likely true enough. but if you knew going into your “investment” that that would be the case, you would adjust what you were willing to pay for the investment, or at least your expectations of what you would get out. having “some” money after ten years is better than having “less” money after ten years, even if inflation has reduced the value of it. again, i would expect the prices of investments would adjust themselves to meet the new expectations.
what troubles me is the attitude by the rich that somehow the government owes them a profit. because of course they would never create those “jobs” if they couldn’t make a profit.
fact is, it seems to me, that if the tax rate is the difference between a profit and not worth the investment… then it’s not worth the investment from society’s point of view.
fact is, it’s all whining and special pleading by the investment class, who have largely designed the tax system in this country for their own benefit. and we see the results.
Mergers and acquisitions create money (no longer worried it is over 63T) but the money does not create anything productive.
In addition to raising taxes on “speculation” there needs to be incentive to raise money for technology.
Big government versus wall st, who is better for the social contract?
I ain’t no economist and these days no more than a jackleg historian but if there is one lesson you can take away from labor history it is this:
Capital will drive labor costs to as close to bare subsistence as will allow the market to clear without outright peasant/worker revolt. And in most times and places have had first call on state police power to enforce that.
The New Deal in America and various forms of Western European Social Democracy in post-war Europe made more or less successful attempts to reverse that on a combination of the universal franchise and pragmatic ‘greatest good for greatest number’ philosophies, augmented a little bit by a little known philosopher’s treatise often referred to as ‘The Sermon on the Mount’.
But history shows that capital never gave up trying to redress what it considers to be a total perversion of natural order. You don’t have to go all out Marxist to appreciate that capital has always operated on the simple capitalist principle of “what the market can bear”. Which only at the margins has a operative relation to supply and demand and only in the fever swamps of Freshwater Economics (and boy is THAT a mixed metaphor) does it have any relation to marginal productivity.
Marx wasn’t entirely wrong about the dynamics of the feudal economy, for example you see it working quite well in Shogun era Japan, it just overestimated the actual efficiency of such extraction of labor productivity under medieval European conditions. “What the market can bear” having a different calibration in 12th century England than 16th century Japan or to put a sharper point on it in almost any European colonial setting in the 19th century.
That is when it comes time to allocate the gains of productivity between labor inputs and capital inputs the Invisible Hand often carries as Visible and Reactive a Sword as political conditions allow. And even with the best intentions in the world Solow and Romer are not going to capture that z-axis deriving from pure coercive power.
Gosh the wealthy and powerful take what they can when they can? Who knew!?
Good, pithy post, but those aren’t “the tax rates on labor and capital”. They are the fed individual income tax rates on said factors. To get to the “tax rates on labor and capital” you’d have to incorporate the other taxes (state, local, corporate income,unincorporated business, business license fees, payroll tax, property tax – which is a form of capital, and costs to business owners of complying with the tax code and regulations, and assign each of them, to the extent not obvious, via a theory of tax incidence. I am not saying it negates your fundamental point, But the language and table are not well matched and the impacts are more complex. You’d also want to think about asymmetries of risk of loss as between the two – if one loses one’s job, one can get another, but if one loses one’s capital, one does not as easily get another stake. So adequate incentives are needed to overcome that risk and generate the business activity needed for employment as opposed to hoarding capital.