…While married and unmarried female MBA students perform similarly when their performance is unobserved by classmates (on exams and problem sets), unmarried women have lower participation grades. In a field experiment, single female students reported lower desired salaries and willingness to travel and work long hours on a real-stakes placement questionnaire when they expected their classmates to see their preferences. Other groups’ responses were unaffected by peer observability. A second experiment indicates the effects are driven by observability by single male peers.
The legislative process leading to the enactment of the Tax Cuts and Jobs Act this past December was short and contentious. Proponents of the legislation made their case largely based on claims about economic growth. Opponents disputed these claims and further argued that the legislation would benefit the most fortunate, harm the less fortunate, and require future spending cuts or other policy changes that would exacerbate these inequities. Unsurprisingly, these starkly different predictions about the economic consequences of enacting the legislation now are grist for an ongoing dispute about the interpretation of U.S. economic data and other indicators that could shed light on the law’s effects.
This issue brief offers a guide to assessing the economic effects of the legislation. There are two critical questions that must be answered to assess the effects of the new law on the economic well-being of the public. The first is who bears the burden of the taxes that were cut and thus will benefit from the cuts. The second is how large the increase in the federal budget deficit that results from the tax cuts will be. To answer these questions, economists and policymakers should be looking at three primary outcomes:
Wages rates for workers
The return on business investment
Future federal budget deficits
A central purpose of the Tax Cuts and Jobs Act was cutting corporate taxes. Proponents of the legislation, however, typically argue that the long-run economic incidence (or burden) of corporate taxes primarily or exclusively falls on workers rather than shareholders, and thus workers will be the true beneficiaries of the legislation. How can we tell if the economic incidence of the tax cuts does, in fact, fall on workers? Differences between statutory incidence (who is legally obligated to pay a tax) and economic incidence (who bears the burden of a tax) are mediated by price changes. In the case of the corporate tax, the relevant prices are wage rates and investment returns. (To an economist, wage rates and investment returns are prices just like the price of a car or a sandwich. Wage rates are the price of labor, and investment returns are the price of a dollar today relative to a dollar in the future.) To shift the benefits of a corporate tax cut from shareholders to workers, wage rates must rise, and the return on business investment must fall. Thus, changes in wage rates and the return on business investment should be central to any evaluation of the law.
The legislation also—by all credible estimates—increased the federal budget deficit. This increase in the deficit will require changes in future fiscal policies to offset the cost of the tax cuts. These changes could take the form of explicit tax hikes or spending cuts, or they could take the form of implicit tax hikes or spending cuts when legislation that otherwise would have been enacted is not enacted. And they need not occur in the short run (though they may). Exactly how large any required fiscal changes will need to be depends on exactly how large the impact of the legislation on the federal budget deficit is. This is why the ultimate fiscal consequences of the legislation is also a key outcome that needs to be evaluated.1
In assessing the impact of the legislation on these three outcomes, it is important to keep in mind that wage rates would likely have increased even in the absence of the legislation, given the state of the business cycle and long-term trends. That means it is not enough simply to compare future wage rates to their levels today. Nor is it enough to compare wage rates to what they would have been according to projections released prior to the law, as realized economic outcomes will differ from those projections for numerous reasons other than the enactment of the Tax Cuts and Jobs Act. It will take years for academics to conduct research into the effects of the law, and the interpretation of the research findings will remain subject to dispute even after they begin to come in.
In the short term, policymakers and economists will be engaged in a much more speculative exercise of attempting to parse limited and incomplete data for signs of the law’s effects. But while it will take time to both realize and evaluate the long-term effects of the legislation, one thing is clear about the short run: The Tax Cuts and Jobs Act sharply cut corporate taxes. And every month in which wage rates are not sharply higher than they would have been absent the legislation, and investment returns are not sharply lower, is a month in which the benefits of those corporate tax cuts accrue primarily to shareholders.
Changes in wage rates and investment returns will determine who benefits
The primary metric for judging public policy should be the well-being of the public. The two critical questions for assessing the impact of the Tax Cuts and Jobs Act on well-being are who bears the burden of the taxes that were cut and how large an increase in the federal budget deficit the new law will cause. An answer to the first will determine who benefits from the tax cuts and an answer to the second will determine the size of the fiscal policies required to offset the cost of the Tax Cuts and Jobs Act of 2017.2
Who bears the burden of the taxes that were cut?
The new law cut taxes, on average, for both individuals and corporations in the near term. The individual tax cuts expire after 2025. Most of the corporate tax cuts are permanent. But several revenue-raising corporate provisions are scheduled to take effect in the future. A provision increasing taxes on individuals through slower inflation adjustments and the repeal of the mandate to purchase health insurance imposed by the Affordable Care Act are also permanent.
As is well known, economic incidence often differs from statutory incidence. Payroll taxes, for example, are split evenly between workers and their employers as a statutory matter, but economists typically assume that workers bear the burden of payroll taxes in the form of lower wages.
In the case of the Tax Cuts and Jobs Act, the primary question in dispute is who bears the burden of the corporate income tax. Most proponents of the legislation argue that the long-run economic incidence of the corporate tax is primarily or exclusively on workers rather than shareholders, and thus workers will be the true beneficiaries of the legislation. Most opponents argue that workers bear only a small portion of the tax, and most of the burden is borne by shareholders. How can we tell if the economic incidence of the tax cuts does, in fact, fall on workers? Differences between statutory incidence and economic incidence are mediated by price changes; in the case of the corporate tax, the relevant prices are wage rates and investment returns.3
If a corporate tax cut causes returns to fall and wage rates to rise, then the incidence of the tax cut shifts from shareholders to workers.4 Thus, a critical question for evaluating the incidence of corporate tax cuts is the size of any resulting change in wage rates and investment returns.5 Wage increases could take the form of either cash or benefits. Thus, unless explicitly stated otherwise, references to wages in this brief include benefits.6
Note, however, that there is no universally applicable allocation of the burden of corporate taxes among economic actors. The incidence of different provisions is likely quite different. The Tax Policy Center, for example, makes different assumptions about the economic incidence of changes in the corporate rate and changes in the tax treatment of investment in equipment and structures. Additional complexities come into play in the case of the transition between tax systems because the question of who benefits in the long run may differ from the question of who benefits in the short run. Indeed, even most economic theories that suggest a substantial long-run burden of corporate taxes on labor imply substantial short-run gains for shareholders from corporate rate cuts, and thus, in present value, an important portion of the benefits of the corporate tax cuts in the new law will accrue to corporate shareholders. In addition, even in theories under which a deficit-neutral corporate rate cut would deliver large long-run gains for workers, deficit-financed corporate rate cuts often will not.
This issue brief examines estimates of the change in wages resulting from the Tax Cuts and Jobs Act after 10 years implied by the macroeconomic analyses of the Tax Policy Center, the Congressional Budget Office, the Penn Wharton Budget Model, the Tax Foundation, and the White House Council of Economic Advisers. The Tax Policy Center estimated that the law would increase wages by less than 0.1 percent after 10 years. The Congressional Budget Office estimated an increase of about 0.3 percent in the same year. The Penn Wharton Budget Model produced two estimates of the impact on wages, about 0.25 percent and 0.8 percent. The Tax Foundation estimated an increase of about 2 percent, and the White House Council of Economic Advisers estimated increases between 5 percent and 11 percent.7 All of these estimates compare wages in 2027 to what they would have been in that year had the legislation not been enacted.
The analysis focuses on 2027, as estimates for this year are relatively less affected by the then-expired individual tax cuts, which in certain models could reduce the wage gains due to the increase in labor supply. Moreover, as any increase in the wage rate resulting from the corporate tax cuts would likely manifest gradually over time, evaluating effects in year 10 offers a more generous assessment of their effects. Note, however, that the wage estimates cited here also include effects attributable to changes in the taxation of noncorporate businesses. These effects likely account for a relatively small portion of the total change in most cases.
These estimates imply widely varying labor incidence of the corporate tax cuts in the Tax Cuts and Jobs Act, ranging from near zero for the Tax Policy Center to multiples of the conventional revenue estimate for the Council of Economic Advisers.8 As a reference point, wage rates would need to increase by about 1 percent above what they would have been in the absence of the law to shift the benefits of the corporate tax cuts from shareholders to workers—and even more if revenue-raising provisions of the new law scheduled to take effect in the future are delayed or repealed.9 (See Figure 1.)
Figure 1
Corresponding to each of these estimates of increases in the wage rate that would result from the Tax Cuts and Jobs Act is an estimate of a decline in the return on investment that would also result. Estimates of the reduction in returns, however, are less frequently reported in published results, and no estimates are presented here. In the models typically used to evaluate the macroeconomic effects of changes in tax law, the same underlying mechanism—an increase in investment—delivers both an increase in wage rates and a reduction in investment returns in response to a reduction in the corporate tax rate (all else being equal). Thus, if wages are estimated to rise, then the return on investment will be estimated to fall.
In more general models, other mechanisms could be at work. Changes in the corporate tax rate, for example, could affect wages through an effect on the allocation of profits between owners and workers as a result of bargaining. For purposes of evaluating the overall effects of the legislation on well-being, though, it is more important to know by how much wage rates and the return on investment change than precisely why they do.
Estimating the effects of the new corporate tax cuts on wage rates and returns is not a simple exercise. Changes in wage rates and investment returns must be measured relative to the counterfactual in which the new law was not enacted but all other policies remained the same. It is not enough to say, for example, that wage rates have increased relative to their level at the time of enactment, as that would almost certainly have happened even without enacting the tax legislation. Nor is it enough to compare the effects of the tax cuts to projections of what would have happened that were made prior to the enactment of the legislation, as actual outcomes will differ from these projections for numerous reasons beyond the effects of the legislation itself, including both other legislation and other unrelated economic developments.
In addition to the challenge of defining the counterfactual, there are additional conceptual and practical challenges in bringing this question to the data. For wages, the measure of primary interest is the amount of compensation per unit of work, but measuring this quantity requires measures of total compensation—not just cash wages—and measures of how much work is done. In addition, as compensation is not necessarily linear in the quantity of work, simply dividing compensation by measures of labor supply may not yield the appropriate answer if other changes in labor hours are occurring at the same time, as might be expected in a strengthening economy. Measuring compensation for highly paid workers can be even more complex.
A parallel set of challenges applies to measuring the return on investment. The preferred measure would be the current return per unit of capital in the United States. This is difficult to measure in a direct way. There are ambiguities in the measurement of capital and depreciation, for example, which create challenges for estimating returns.
Ultimately, when estimates for the national accounts are released, they will incorporate assumptions about many of these issues and offer a complete and internally consistent set of estimates. These will be of interest to many economists and policymakers looking at the effects of the legislation. At the same time, the national accounts will lack the richness of detail that will be required for many academic studies that seek to parse out the finer details of the causal impact of the legislation. Moreover, the national accounts are sorely lacking in distributional information about how the experience of people across the income distribution compares to aggregate economic growth, and would not on their own allow for estimates of changes in the wage rate at different points in the wage distribution.10
In evaluating the effects of the legislation on wage rates and investment returns, a few additional points are of note. First, the quantity of interest is the wage rate, not aggregate labor earnings. In other words, the incidence of corporate tax changes is not primarily about changes in the number of hours worked. Thus, increases in earnings driven by increases in total employment or increases in the number of hours worked do not get at the key issue. Similarly, changes in the composition of the workforce can confound estimates, as can issues relating to intermittent payments such as bonuses.
Second, many analyses of incidence focus on average wages, but distributional questions matter. Do wages increase robustly across the entire income distribution, or only at the top, or largely at the bottom? In assessing who benefits from the Tax Cuts and Jobs Act, it is not enough to know only the change in average wages for the entire population, it is necessary also to know changes in wages across the income distribution. Indeed, in most models in which wages increase as a result of corporate tax cuts, the aggregate gains are still largely concentrated among more highly paid workers.
Third, much of the information that will be available to estimate the return on investment, especially in the short run, will be strongly influenced by expectations of future profitability, actual profits in the past, and the value of retained earnings going forward—not current profitability. One case in point: If the market valuation of a company increases because a piece of legislation is enacted, then it reflects an increase in expected profits in all future years, not just an assessment of profits in the coming year. Similarly, if a company buys back outstanding shares of its own stock, it is distributing cash that is reflective not only of current returns but also of past returns. Moreover, the decision to do so reflects, in part, assessments about the value of that cash inside the firm in the future such as the value of additional capital investments. Increases in dividends and buybacks are thus noisy indicators of returns on investment.
What is the fiscal impact of the Tax Cuts and Jobs Act?
Effects on wage rates and the return on investment will determine who benefits from the corporate tax cuts. Effects on future federal budget deficits will determine how large the cost of the legislation will be in terms of the offsetting policies required to pay for the tax cuts.
No credible estimate suggests that the Tax Cuts and Jobs Act would pay for itself. But there was still a range of estimates of exactly how large an increase in the deficit would result from the legislation prior to its passage in December and more recently from the Congressional Budget Office.11 The ultimate fiscal impact of the legislation is a question of critical importance, as higher budget deficits will confront policymakers with more limited choices in the future. Future fiscal adjustments will be required to the extent that deficits and debt exceed what they otherwise would have been, especially if revenue-raising corporate provisions of the new law scheduled to take effect in the future are delayed or repealed or the individual tax cuts are made permanent.12
High-frequency information on government deficits is available from the U.S. Treasury Department, and in various summary forms from other organizations, including the Congressional Budget Office. Interpreting that data, however, is still as difficult as interpreting wage rates and investment returns, as the level of realized deficits must be compared to the level that would have been realized absent the enactment of the legislation. Moreover, corporate tax receipts are not paid steadily throughout the year but rather are concentrated in four months, creating additional challenges for interpretation.
The discussion of wage rates and the return on investment above did not directly consider changes in economic growth, and likewise the discussion of rising federal budget deficits and debt does not directly consider changes in economic growth. This exclusion is reasonable because, as a good approximation, changes in growth induced by supply-side tax changes do not themselves deliver gains directly to the public. Economic growth results from additional hours of work and additional capital investments, but both the additional hours of work and the additional capital investment come at a cost. The benefits and costs of those changes in hours worked and capital investment are roughly equal in terms of their impact on the public.13 Instead, supply side-driven economic growth matters insofar as it affects the cost of the legislation. Higher growth will generate additional tax revenue that reduces the cost of the legislation relative to what it would have been, assuming economic activity was unchanged by the legislation.
There are, of course, economic relationships between changes in economic activity and changes in wage rates and the return on investment, but there is no formulaic rule that applies across all economic models. The same growth impact can be consistent with very different changes in wage rates and returns, and different amounts of growth can be consistent with the same changes. For this reason, while economic growth was a central focus of the proponents’ case for the legislation, it is not in and of itself a critical issue for assessing the effects of the legislation on the broader public. Growth alone is not sufficient to deliver the promised benefits of the legislation for workers. And the corporate tax could be highly incident on labor even if corporate tax cuts have a negligible impact on growth. In addition, relying on economic growth as an outcome necessarily ignores distributional considerations entirely, both in terms of differences between high- and low-income families and between workers and shareholders. A focus on wage rates and deficits instead provides the relevant information for assessing the impact of the law on economic well-being and naturally allows for a consideration of distributional implications.
What other effects might the Tax Cuts and Jobs Act have?
The Tax Cuts and Jobs Act made far-reaching changes to the tax system, and many of these changes will have economic consequences. For instance, changes in the financial incentives to report income in the United States rather than in foreign countries for tax purposes may change where firms report their earnings, how much they pay in taxes, and may even create challenges for the accurate measurement of U.S. output in the national accounts.
These effects will be informative about how the economy works and will be a rich source of study for economists for years to come. They also will be highly relevant for more narrowly defined questions. Assessing the role of measurement and reality in national accounts, for example, is an important question in its own right. Similarly, changes in the mix of debt and equity used by corporations to finance their activities may have interesting economic consequences of their own.
Yet for purposes of evaluating the overall effects of the legislation on the well-being of U.S. families, these questions are not of primary importance. Instead, for that purpose, the key ingredients for an evaluation of the legislation are changes in wage rates and investment returns, as well as the net fiscal impact.
Measuring the economic effects of policy changes
Prior to the enactment of a piece of legislation, analysts use the findings of prior theoretical and empirical research to predict the effects it will have if enacted. These evaluations may take the form of constructing a mathematical model of the economy and using that model to predict how the economy will respond to a change in policy. The assessments may also take the form of applying prior empirical findings on how policies affect the economy to the proposed change in policy, generally with modifications to reflect differences between the policy change studied in the past and the proposed policy change.
After legislation is enacted, researchers then will study the effects that the legislation had on the economy. These methods used in these studies will often be quite different from the methods used in the pre-enactment simulations and focus on more narrowly defined empirical questions about specific provisions of the law. Researchers may study how the changes in cost-recovery provisions affected investment, or how the changes in state and local tax deduction affected the behavior of state governments, or other similar questions.
While economists use many different methods to examine the effects of policy changes, a common idea across such studies is to try to identify people, firms, governments, or other actors who were relatively more affected by a policy change and those who were relatively less affected but who are otherwise similar, and then compare their subsequent behavior to learn something about the policy. As with prior pieces of major tax legislation such as the Economic Growth and Tax Relief Reconciliation Act of 2001, the Tax Reform Act of 1986, and the Economic Recovery Tax Act of 1981, economists will be publishing numerous studies of the Tax Cuts and Jobs Act in the coming years. These findings will inform the modeling of analysts in their attempts to evaluate and provide advice regarding future pieces of tax legislation.
The challenge of defining the counterfactual
A major challenge in these studies, as noted above, will be defining the appropriate counterfactual, or what would have happened absent enactment of the tax law. A steadily improving labor market, for example, would be expected to deliver wage gains regardless of changes in tax policy. Nominal wage gains excluding benefits (increases in the wage rate excluding benefits before accounting for inflation) are strongly correlated with labor market tightness, as measured by the employment-to-population ratio for people ages 25 to 54.14 With continued improvements in the labor market, we would expect faster wage gains.15 (See Figure 2.)
Figure 2
In its June 2017 economic forecast, the last forecast released prior to enactment of the Tax Cuts and Jobs Act, the Congressional Budget Office projected increases in the wage rate (excluding benefits) of 3.2 percent in 2018 and 3.4 percent in 2019, consistent with a tighter labor market.16 If the U.S. labor market would have continued to strengthen absent the enactment of the Tax Cuts and Jobs Act, as seems likely, then these estimates may even understate the wage increases that would have occurred. In the late 1990s, when the employment-to-population ratio reached its highest levels ever recorded, wage growth also reached high levels.17
What can we say about the economic effects of the Tax Cuts and Jobs Act today?
The Tax Cuts and Jobs Act made major changes to the U.S. tax system, including a substantial corporate tax cut. Yet the results of academic studies of the legislation will only be available with a substantial lag. Effects can only be studied after they occur. Thus, it will take time before even the short-run effects can be studied. In addition, the research process itself takes substantial time. Even the earliest studies will likely not appear until years after the legislation has been enacted. Prior to the completion of these studies, policymakers and economists will be left to sift through much more limited information and engage in more speculative analysis using more readily available economic data. With that caveat in mind, this issue brief closes with an assessment of what we can say about the incidence of the corporate tax cut at this time.
First, who is benefitting from the corporate tax cut today? At present, primarily shareholders. There has been substantial discussion of potential bonuses and wage gains from the law, but it is important to scale these appropriately. An increase in wage rates of about 1 percent relative to wage rates that would have prevailed absent the law would be required to shift the benefits of the corporate rate cut from shareholders to workers. An increase on that scale would amount to about $100 billion in 2018. Tallies of wage gains, bonuses, and other forms of increased compensation tend to fall under $10 billion.18 Even taking these tallies at face value, they still suggest that at present, the gains are accruing predominantly to shareholders.
The absence of an increase in wages in the short run is not surprising. Most economists expected the corporate tax cuts to deliver windfall gains to shareholders. Yet even if it is not surprising that these tax cuts have delivered such gains to shareholders, that windfall remains the short-run story. Will the distribution of benefits from the corporate tax cuts change in the longer run? The long run has yet to occur, of course, so a direct examination is not yet possible. The best estimates of the long-run impact of the legislation today are informed primarily by the research that was available prior to enactment of the Tax Cuts and Jobs Act and that informed evaluations of its likely effects then. That research suggests that probably only a small portion of these corporate tax cuts will be shifted to workers in the long run, and most of the gains that are shifted to workers will accrue to more highly paid workers.19
Are there other inferences that can be made based on the experience to date? There is some suggestive evidence that share buybacks and dividends have increased relative to the counterfactual that would have occurred absent the law.20 This finding is certainly consistent with the observation that a substantial portion of the benefits of the corporate tax cuts in present value will accrue to shareholders. Yet it may also raise concerns about the longer-run consequences of the law. The channel by which investment returns decline is that firms increase investment in response to the change in the tax law, and these higher investment levels reduce returns. If firms that receive large tax cuts are distributing cash to shareholders, then it indicates those firms do not see a need to retain the cash to engage in productive investments. Some firms may well increase their investment levels by more than average, but if large profitable firms are not sharply increasing their investment levels as a result of the law, then that raises concerns about not only the cost effectiveness of corporate rate cuts as a means of spurring more investment, but also how large any aggregate increase in corporate investment in the economy might be.
Conclusion
Public policies should be evaluated based on their impact on the well-being of the public. In the case of changes in tax law, that means the two questions of primary interest are about tax incidence (who bears the burden of a change in taxes) and fiscal impact (what the change in tax law means for the government budget). The Tax Cuts and Jobs Act included large corporate tax cuts that proponents claim will primarily or entirely benefit workers. The mechanism by which this shift would occur—if it does—is an increase in wage rates and a decline in the return on investment. Thus, in evaluating the Tax Cuts and Jobs Act, the first issue is whether this shift occurs. Do wage rates rise and investment returns fall sufficiently to negate the value of the corporate tax cuts to shareholders?
Every month in which these changes do not occur is a month in which the corporate tax cuts provided by the Tax Cuts and Jobs Act redound primarily to the benefit of business owners, not workers. These changes certainly have not occurred yet. Will they occur in the future? That remains to be determined.
Prior research, however, suggests only a partial shift to workers in the medium run and potentially negative effects in the long run for workers from higher U.S. budget deficits and federal debt if revenue-raising corporate provisions of the new law scheduled to take effect in the future are delayed or repealed or the individual tax cuts are made permanent. Moreover, even to the extent workers do benefit from the tax cuts, it is important to consider whether the benefits accrue equitably across the entire working population or primarily to more highly compensated workers.
In addition to the question of who benefits from the corporate tax cuts directly, the second issue is how large the fiscal costs of the legislation will be. Higher federal budget deficits and debt will require offsetting fiscal policies in the future, which means any assessment of gains from deficit-financed tax cuts must also reflect the costs they impose on the public in the future.
Should-Read: One of the several disastrous consequences of Robert Lucas was the severe downweighting of the “disequilibrium foundations of equilibrium” agenda of Frank Fisher and company. But George Evans and company have revived it: George W. Evans and Bruce McGough: Equilibrium Selection, Observability and Backward-stable Solutions: “We examine robustness of stability under learning to observability of exogenous shocks…
The minimal state variable solution is robustly stable under learning provided the expectational feedback is not both positive and large, while the nonfundamental solution is never robustly stable…. We examine the concerns raised in Cochrane (2009, 2011, 2017) about the New Keynesian model. These concerns arise in large part by his adoption of RE as a modeling primitive. We view RE as more naturally arising as an emergent outcome of an adaptive learning process, and we find that by modeling agents as adaptive learners Cochrane’s concerns vanish….
Under adaptive learning agents are assumed to form expectations using forecasting models, which they update over time in response to observed data. There is a well-developed theory that allows the researcher to assess whether agents, using least-squares updating of the coefficients of their forecasting model, will come to behave in a manner that is asymptotically consistent with RE, i.e. whether the rational expectations equilibrium (REE) is stable under learning: see Marcet and Sargent (1989) and Evans and Honkapohja (2001)….
The “minimal state variable” (MSV) solution, also referred to as the backward- stable solution… is always stationary… a “non-fundamental” (NF) solution, which may or may not be stationary. We then turn to stability under learning. In a model with observable shocks, McCallum (2009a) showed that determinacy implies that only the MSV solution is stable under learning. However, Cochrane (2009, 2011) argued that McCallum’s stability results hinged on observability of these shocks…. The MSV solution is robustly stable under learning, provided only that the positive feedback from expectations is not too large. In contrast the NF solution is never robustly stable under learning…
Should-Read: Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, AND Alan M.Taylor: The Rate of Return on Everything, 1870–2015: “This paper answers fundamental questions that have preoccupied modern economic thought since the 18th century…
…What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including—for the first time—total returns to the largest, but oft ignored, component of household wealth, housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from 1870 to 2015, and our new evidence reveals many new insights and puzzles….
On risky returns… residential real estate and equities have shown very similar and high real total gains, on average about 7% per year. Housing outperformed equity before WW2. Since WW2, equities have outperformed housing on average, but only at the cost of much higher volatility and higher synchronicity with the business cycle. The observation that housing returns are similar to equity returns, yet considerably less volatile, is puzzling…. Before WW2, the real returns on housing and equities (and safe assets) followed remarkably similar trajectories. After WW2 this was no longer the case, and across countries equities then experienced more frequent and correlated booms and busts…. One could add yet another layer to this discussion, this time by considering international diversification. It is not just that housing returns seem to be higher on a rough, risk-adjusted basis. It is that, while equity returns have become increasingly correlated across countries over time (specially since WW2), housing returns have remained uncorrelated….
On safe returns… the real safe asset return has been very volatile over the long-run, more so than one might expect, and oftentimes even more volatile than real risky returns…. Viewed from a long-run perspective, it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Consequently, we think the puzzle may well be why was the safe rate so high in the mid-1980s rather than why has it declined ever since…..
On the risk premium… the risk premium has been volatile…. Our data uncover substantial swings in the risk premium at lower frequencies that sometimes endured for decades, and which far exceed the amplitudes of business-cycle swings. In most peacetime eras this premium has been stable at about 4%–5%. But risk premiums stayed curiously and persistently high from the 1950s to the 1970s, persisting long after the conclusion of WW2. However, there is no visible long-run trend, and mean reversion appears strong. Curiously, the bursts of the risk premium in the wartime and interwar years were mostly a phenomenon of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 6%–8% across all eras….
On returns minus growth… “r ≫ g”… The only exceptions to that rule happen in very special periods: the years in or right around wartime. In peacetime, r has always been much greater than g. In the pre-WW2 period, this gap was on average 5% per annum (excluding WW1). As of today, this gap is still quite large, in the range of 3%–4%, and it narrowed to 2% during the 1970s oil crises before widening in the years leading up to the Global Financial Crisis. However, one puzzle that emerges from our analysis is that while “r minus g” fluctuates over time, it does not seem to do so systematically with the growth rate of the economy. This feature of the data poses a conundrum for the battling views of factor income, distribution, and substitution…
The crisis and its aftermath showed that the North Atlantic economies could not maintain full employment by following the Keynesian road. The idea that when the private sector sits down the public sector should stand up—that consistent durable prosperity can be achieved by having government step in as a spender of last resort—proved unsustainable. It also showed that full employment could not be maintained by following the monetarist road: the idea that successful regulation could keep finance on a sound footing, or at least a steady enough footing for central banks to manage, also proved unsustainable.
Ultimately prosperity is unlikely to be maintained without competent democratic government, and that has proven shaky since the slump. The big question is: what institutional—and perhaps political—changes are necessary to avoid another wild swing? In all likelihood we’ve only a decade to build better institutions of economic management. And we have not yet begun…
What other people say:
Larry Summers: Get to grips with vicious cycles: The central lesson of 21st century economic experience is that modern economies are not self-equilibrating systems. Indeed, modern economies are often dominated by positive feedback effects that destabilise. Margin calls, bank runs, portfolio insurance, option hedging all cause more selling of assets as their values go down. When selling causes lower prices, which cause more selling, the market mechanism is in trouble. We now understand how it can give way to long-term economic problems such as secular stagnation, where excessive saving drags down demand and economic growth slows.
The challenge is to prevent vicious cycles from developing and to contain them when they start. This will mean more, smarter government policy, not a retreat into market fundamentalism….
Martin Wolf: Pathology, prophylactics and palliatives: Macroeconomics needs to grapple with three linked questions. First, what causes financial crises? Second, what policies would best reduce the risks of such crises? Third, what should the policy response be to crises once they have happened?
On the first, how should we understand the interaction between the financial and monetary systems and the real economy? Sometimes the economy seems to depend on a combination of asset-price bubbles with the unsustainably rapid growth of debt. Why should this be so? On the second, are there more sustainable ways to generate demand? Might redistribution of income towards spenders be the answer? What role can government spending play?
On the third, are there alternatives to a combination of heavy government borrowing with supportive monetary policy? This combination has brought recovery. But the indebtedness built up before the crisis has, in part, just shifted onto the public sector. Moreover, even the private sector’s deleveraging has been modest. Economies remain fragile. Macroeconomics is, alas, not healthy….
Barry Eichengreen: Get to work on jobs: The global crisis and populist backlash laid bare the fact that American “blue-collar workers” had been left behind by technology and globalisation. President Trump promises to rescue them by “making coal great again” and taxing steel imports. We need a better way.
The conventional wisdom used to be that if manufacturing jobs can’t be recaptured from robots and China, then the solution is better service-sectors jobs—jobs that were presumed to be safe from automation and import competition because they require situational adaptability, interpersonal skills and oral communication. But now advances in artificial intelligence raise questions about the future of even those jobs.
Still, jobs requiring workers to combine practical services, communication and empathy—care workers, for example—should remain safe for the foreseeable future. So the pressing question becomes how to better prepare workers for these particular tasks. This requires rethinking education, training and the nature of work itself—a process that has only just begun.
Jim O’Neill: Learn to learn from China: The presumption used to be that China would have to learn from the west if it wanted to keep developing, especially when it comes to the political system. But 20 per cent of the Chinese now pull in a western-style income of $40,000-plus per year—that’s 260m people living on western-style incomes, far more than in any actual western country except the US. So the question becomes: what can we learn from China?
In addition to detailed areas like maths tuition (where the UK is already running pilots based on the best Chinese schools) two big areas stand out. First, when it comes to big changes, we should ensure everyone is informed and prepared; the circumstances of the EU referendum is the kind of thing that makes Beijing doubt the wisdom of western-style democracy.
And then there is macro-economic policy. For at least 20 years, Beijing has shown it can head off problems, and deal with crises. Western experts have repeatedly predicted a UK-style housing bubble-and-burst for China, but its authorities have pricked bubbles before they grew too big. Bankers and hedge funds bemoan how hard it is to predict what Chinese policymakers will do next. But the Chinese authorities see their role as being to fix real problems, not to provide clarity to market participants….
Tim Congdon: Figuring out (again) where the banks fit in: Some big questions in economics come and go, but one is there all the time: how are national income and output determined, and what does the answer mean for unemployment and inflation? Economists flopped this exam question when it was put to them in the Great Recession of 2008. In the coming decade, they will be trying to do better.
Keynes is supposed to have supplied a good reply. Unfortunately, in the last 20 years, central banks have instead preferred “New Keynesianism,” a three-equation model which has been widely described as the workhorse of modern macroeconomic analysis.
But in 2008, it was useless. Not one of the equations referred to the banking system, or the quantities of bank credit and money, even though it is obvious that banks were important in the Great Recession. One of the equations (the so-called “Taylor rule”) prescribed heavily negative interest rates to deal with the slump. This would have been fine, except that interest rates cannot go much beneath zero. New Keynesianism ought long ago to have been sent to the knacker’s yard.
The main intellectual challenge for economics now, just as it was when Keynes was writing, is to identify how the banking system—with its alleged masters of the universe, and its undoubted manias, delinquencies and pathologies—interacts with the rest of the liberal capitalist democracies of today.
Crisis, Rinse, Repeat: Key economic data from the periods following the 1929 stock-market crash and the 2007-2008 financial crisis suggest that the current recovery has been unnecessarily anemic. If policymakers refuse to heed the lessons of the New Deal era, then the next crisis is destined to be as prolonged as the last.
When the economic historians of the late 21st-century compare the Great Recession that started in 2007 with the Great Depression that started in 1929, they will write two things:
They will write that the initial policy response to the crises by the Federal Reserve and the Treasury was first rate in 2007 and after but fifth rate in 1929 after—what could have been a post-2007 repeat of the Great Depression in terms of the crash in production and employment was instead moderated to a painful episode.
But they will also write that while the post-business cycle trough policy response of President Franklin Roosevelt, the Congress is elected by American voters in the Federal Reserve was if not first at least second rate and laid the foundations for rapid recovery and satisfactory equitable growth; the post-business cycle trough policy response of President Barack Obama’s, the Congresses elected by American voters, and the Federal Reserve was at best third rate and did not lay foundations for rapid recovery or satisfactory equitable growth.
United States national income and national income per capita peaked in 2007 just before the Great Recess Ion. Two years later, into thousand nine, national income per capita was 5% below its peak. Four years later, in 2013, output per capita retained its peak. And this year, 2018, if we are lucky, national income per capita will stand 8% above its previous peak of 11 years ago.
There is no comparison with the Great Depression. Four years after the business cycle peak of 1929 national income per capita was down 28% from its peak. In the great depression, output per capita did not retain its peak level for a full decade.
Thus there is no comparison with the Great Depression—save that 11 years after the pre-Great Depression Business cycle peak output for worker was 11% higher and growing rapidly, well this year output per worker is only 8% higher than the pre-Great Recession peak and growing slowly. Plotting relative performance since the peak on the same axes, this year the lines will cross. And given how much better a relative starting position policymakers had in late 2009 than Franklin Delano Roosevelt and his team had in early 1933, that is appalling.
Democrats blame Republicans for turning off the fiscal stimulus spigot in 2010 and then refusing to turn it back on. Republicans say… nothing comprehensible or coherent. They say things like:
It must be the fault of Barack Obama, via Dodd-Frank or ObamaCare.
Maybe it’s the fault of all those people who want to work but are useless—the “zero marginal product workers”.
Anyone who does not have a job must not really want one.
There is much more truth in the Democratic assignment of blame. But not everything can be blamed on fiscal austerity. And a considerable amount of inappropriate fiscal austerity in the early stages of the recovery is properly laid at the door of Barack Obama and his team.
Most worrisome, however, is that policy during the anemic recovery is not perceived as a failure by either those at the tiller at the time or by their successors. With a few honorable exceptions, Federal Reserve policymakers tend to say that they did the best they could given the fiscal headwinds imposed on them. With a few honorable exceptions, Obama administration policymakers tend to say that they stopped a second Great Depression, and that during the recovery they did their best given how they were hobbled by the Republican congressional majorities. And Republican economists tend to either be silent or say that the policies—both fiscal and monetary—pursued by the Obama administration and by the Bernanke Fed were dangerously inflationary, and that we have been lucky to escape the fate of Greece—or Zimbabwe.
Christina and David Romer tell us that in the post-WWII period economies that run into a serious financial crisis have levels of production ten years later fully 10% lower if they had neither monetary nor fiscal policy space to deal with the crisis. We will run into a serious financial crisis: that has been the rule for modern capitalist economies since at least 1825. And there is nothing in view that suggests that, when we do, we will have both the will to use monetary and fiscal policy and the space available.
Should-Read: That prime-age employment-to-population has been increasing without vacancies increasing tells us, I think, that the economy is not “overheating”, but rather getting closer to some medium-run concept of full employment as the hysteresis effects of the Great Recession are slowly being repaired: Nick Bunker: “What does this tell us?: “.@de1ong asked so here it is: the Beveridge Curve with the prime employment rate instead of U3…
…What does this tell us? Notice that most of the movement recently has been sideways as prime EPOP has increased & vacancies haven’t increased much. Like the U3 curve did as it started shifting back. In other words: this could be just another sign of remaining slack. Graphs collected here https://t.co/Hu6JPSorXJ. See you all on May 8th! (back to JOLTS Tuesdays!)…
Should-Read: Justin Fox is right in noting that Paul Ryan was always running a con game—that his aim was a more unequal country with lower taxes on the rich, not a country in which the federal government balanced its budget. But I would quarrel slightly with how he sets up this article. “Entitlement crisis” is a political framing that appeals not just to “very wealthy people and/or those with excellent health insurance”: it also appeals to lazy centrist journalists with no understanding of demography or policy, and no desire to learn. We never had—and do not have—a Social Security crisis. We had—but apparently no longer have (but it may return)—a health care cost explosion crisis. We still have a we-pay-too-much-for-the-health-care-we-as-a-country-get crisis. “Entitlement crisis” leads us away from getting value for our social insurance spending, and toward an unequal and unhappy society: Justin Fox: Paul Ryan’s Roadmap Was an Epic Fiscal Failure: “Paul Ryan did not cause the financial crisis. He has nonetheless failed pretty spectacularly… his actions have made the situation much worse than it had to be…
…I pin this on two main flaws in his approach: One has to do with the term “entitlement crisis,” the other with tax policy. The big problem with “entitlement crisis” is that it’s a political framing designed to appeal only to very wealthy people and/or those with excellent health insurance and retirement plans…. Improving Social Security, Medicare and Medicaid so that they can keep delivering benefits is a political project that, while fraught with pitfalls, has a chance of eventual success. Hacking at them to avert an “entitlement crisis” decades in the future appears to be a non-starter. The reason I keep putting “entitlement crisis” in quotes is, first, that “social insurance” better describes the programs than “entitlements” does and, second, that projected increases in social spending alone are unlikely to bring on a crisis. It is increasing government spending without also increasing government revenue that could, eventually, cause trouble….
Ryan got his way on tax cuts while making no progress whatsoever on that “entitlement crisis.” A 0.8 percent-of-GDP drop in tax revenue isn’t the end of the world. It is, however, a move in the wrong direction if you’re worried about growing fiscal imbalances…. Raising the tax burden, though, was never part of Paul Ryan’s plan. He wasn’t even willing just to hold it constant. Which would seem to mean that he was never all that serious about fixing America’s fiscal ills…
This is a weekly post we publish on Fridays with links to articles that touch on economic inequality and growth. The first section is a round-up of what Equitable Growth published this week and the second is the work we’re highlighting from elsewhere.
With Equal Pay Day having occurred earlier this week, we’ve decided to feature only the work of women in our “Links from around the web.” We won’t be the first to share these articles, but we hope by taking a look back at the whole week, we can put them in context.
Equitable Growth round-up
Equitable Growth released a new report, “Gender wage inequality: What we know and how we can fix it,” by Sarah Jane Glynn, on April 10—Equal Pay Day—the date symbolizing how far into the year women in the United States must work to earn what men earned the previous year. The report details the multiple drivers of pay inequality, and what steps need to be taken at the state and local level to address it.
Sarah Jane Glynn also authored an op-ed published in the Lansing State Journal with Heather Boushey. The authors discuss why pay inequality is not just a “women’s issue,” but rather one that affects entire families and the economy as a whole.
Kate Bahn unpacks the arguments used to support legislation that would impose work requirements on government programs that support low-income workers and their families, such as the Supplemental Nutrition Assistance Program and Temporary Assistance for Needy Families. Bahn details the research showing that work requirements are counterproductive and harmful.
A new Equitable Growth working paper looks at Texas charter schools from 2001-2011. The authors find that while charter schools were on average of lower quality than public schools at the beginning of the time period, charters eventually surpassed public schools in effectiveness by the latter half of the decade. One of the co-authors of the paper, University of Illinois at Chicago’s Marcus Casey, also wrote an analysis highlighting these results, which differ from previous studies that look at educational reforms at a single point in time.
More job vacancies in the United States are still producing fewer hires even after accounting for the strength of the U.S. labor market. In a new issue brief, Nick Bunker explains why “employer complaints about being unable to find workers to fill jobs should be taken with a grain of salt” because employers themselves may be the problem.
Links from around the web
Journalism continues to be a male-dominated field, and women are particularly underrepresented among those who write about the economy and certain economic issues. This is a small sample of female writers who do, helping broaden our perspective on how the economy works—and doesn’t work—for broad swaths of the American populace.
Joelle Gamble examines the latest study by Raj Chetty and his coauthors on race and mobility in the United States. Gamble talks about the limitations of the research in understanding why racial inequality in the United States has persisted for generations. [the nation]
In the 1980s, the United States was outranked only by Sweden in terms of the proportion of prime age women in the labor force. Today, that’s far from the case. Heather Long details a new International Monetary Fund report warning that our country’s failure to help working women could have significant consequences for the national economy in future years. [wonkblog]
Many people assume that undocumented immigrants do not pay taxes. Alexia Fernández Campbell debunks this myth and talks about a new study finding that, in fact, undocumented immigrants paid $23.6 billion in income taxes in 2015. [vox]
Laura Kusisto highlights how people moving into expensive U.S. cities such as New York, Miami, San Francisco, and Los Angles are much wealthier than the people moving out. She says new research finds that, “expensive American metros are losing lower- and middle-income families who help power sectors of the economy such as restaurants and hotels and public services […] to completely different metropolitan areas.” [wsj]
After having a child, the gender pay gap between a husband and wife doubles. But the age at which a woman has her baby may determine what happens next. Claire Cain Miller writes that women who have their first child between 25 and 35 never close the salary gaps with their husband, while those who have their first child before or after this period do. [the upshot]
Every month the U.S. Bureau of Labor Statistics releases data on hiring, firing, and other labor market flows from the Job Openings and Labor Turnover Survey, better known as JOLTS. Today, the BLS released the latest data for February 2018. This report doesn’t get as much attention as the monthly Employment Situation Report, but it contains useful information about the state of the U.S. labor market. Below are a few key graphs using data from the report.
The quits rate continues to hold steady at 2.2 percent. The rate has been 2.2 percent on average for the past 3 months as well as the past year.
The ratio of unemployed workers to vacant jobs is no longer at an all-time low as it ticked up slightly, but the three-month average is still at 1.1. Consider that number to the ratio’s peak of 6.5 unemployed workers per job vacancy.
Job vacancies have produced fewer and fewer hires for employers during the current economic recovery, but the pace of the decline seems to have slowed recently and may even have stalled. The three-month average is 0.93, while the 12 month-average is currently 0.92.
Despite concerns about a structural increase in unemployment during the recovery from the Great Recession, the Beveridge Curve shows a current relationship between unemployment and job openings that’s very similar to the one before the recession.
