International trade policy that works for U.S. workers

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

International trade comes with many benefits for Americans. It lowers the cost and increases the variety of our consumer purchases. It benefits workers who make exports, as well as those who rely on imports as key inputs in their work. It helps fuel innovation, competition, and economic growth. And it helps strengthen international partnerships that are crucial for addressing global policy problems.

Yet trade also poses risks. Because the United States is a country with large amounts of capital and a highly educated workforce, we tend to specialize in products that use those key resources intensively. That’s why we export complex products such as software, airplanes, and Hollywood movies. Yet we import products that reduce demand for our less-educated labor because countries with lower wages are able to make labor-intensive products more competitively.

As a consequence, international trade has harmed many U.S. workers by lowering demand for their labor. Studies find that increased imports, particularly those from China during the early 2000s, displaced more than 1 million U.S. workers.1 There is no evidence that particular trade agreements, such as the North American Free Trade Agreement, or NAFTA, created anywhere near so much displacement, yet many U.S. workers are also skeptical of trade agreements, which they associate with poor labor market outcomes in the U.S. economy over prior decades.2

Indeed, since 1980, the U.S. economy has delivered a poor performance for U.S. workers. While Gross Domestic Product growth has been strong, median household incomes have been relatively stagnant. Income growth in the bottom parts of the income distribution has fallen short of expectations just as income growth at the top has soared.3 Yet, as disappointing as these outcomes are, the evidence indicates that factors beyond trade are driving most of these outcomes.4 Such factors include dramatic technological changes, the increased market power of companies, and important tax and regulatory policy changes.

This essay first examines why blaming our trading partners and our trade agreements for disappointing labor outcomes carries two essential risks—it harms the very workers we are trying to help, as our recent experience with trade wars shows, and it distracts us from far more effective solutions to workers’ woes. I then discuss effective solutions that should be at the heart of U.S. international trade policy, among them expanding the Earned Income Tax Credit, implementing wage insurance, and strengthening and modernizing corporate taxation, alongside recommendations for improvements in international trade agreements. International trade works best when it works for everyone, and policymakers have the tools at their disposal to make that happen.

What not to do: Regressive responses to trade challenges

Unfortunately, U.S. international trade policy has taken a serious turn for the worse over the past 3 years. Aiming to correct perceived injustices in past trade agreements, the Trump administration has engaged in a series of costly and ineffective trade conflicts, levying unusually high tariffs, and issuing frequent disruptive threats.

U.S. workers have borne the cost of these trade wars in three important ways. First, it is important to remember that tariffs are a tax, and, beyond that, they are a regressive consumption tax.5 Low- and middle-income families spend a higher share of their income on tariffs than do the rich, both because they consume all or most of their income (and tariffs don’t burden savings) and because they typically consume a higher share of the taxed import goods. Indeed, concerns over economic inequality were a key reason why reformers advocated for creating an income tax in the early 20th century, since tariffs fell too heavily on the poor.6 Early evidence indicates that the new Trump tariffs have already cost U.S. households hundreds of dollars each year.7

Second, both export workers and workers in industries reliant on imports as part of their production process are harmed by the disruption of global supply chains and export opportunities. Many countries facing new U.S. tariffs have retaliated, risking the livelihoods of workers, from soybean farmers to whiskey distillers. Disruptions to international supply chains have harmed U.S. auto production, negatively impacting auto industry employment.8 And the chaos of constant tariff threats has introduced uncertainty and disruption into business planning, hampering investment while also weakening U.S. alliances and our ability to work with other countries in solving global problems.9

Third, and perhaps most importantly, all of the sound and fury surrounding these trade conflicts has distracted voters and policymakers from far more direct and productive ways to help workers. In fact, instead of using tax policy to make workers more secure, the recent tax legislation, known as the Tax Cuts and Jobs Act (passed in late 2017), increased worker insecurity. While those at the top received large tax cuts, most workers received only tiny tax cuts that disappear over time, leaving only greater government debt and the promise of higher taxes or spending cuts down the road.10

Moreover, the Tax Cuts and Jobs Act weakened health insurance markets by removing the mandate to purchase health insurance. This directly results in higher health insurance premiums in the health insurance market. Indeed, premium increases are likely to dwarf tax cuts for most families.11

What does a progressive response to trade look like? It supports labor.

There are far better ways to modernize economic policy to suit our global economy. The key is to ensure that all of the forces that buffet the U.S. economy (whether trade, technological change, or others) ultimately result in benefits for all U.S. workers.

How do we do that? Federal tax policy is our most effective tool. By taking more in tax payments from those who have “won” due to trade, technological change, and other market changes, and giving more in tax rebates to those who have “lost,” we can make sure that gains in GDP translate into gains for typical workers. This can be done while also funding the important fiscal priorities of the federal government.

Elsewhere, I have elaborated on the outlines of such substantial tax reform.12 Here, I will focus on two essential tools that go directly to worker problems: the Earned Income Tax Credit and wage insurance. The EITC rewards work and increases standards of living by generating negative tax rates for those with low incomes. Presently, this credit is far more generous for a parent with children than for a childless worker. At low incomes, the Earned Income Tax Credit turns every $10 of wages into $14 for a parent with two children; credits can top $5,800 for such families. But credits for childless workers are paltry, peaking at about $530. (In both cases, credits are phased out at higher incomes.)

Since linking the Earned Income Tax Credit to children adds complexity and compliance issues, one ideal reform would be to make the EITC more generous for all workers while simultaneously expanding refundable child tax credits.13 It is important to make such credits refundable since many workers with lower incomes do not end up owing federal income tax, although they all pay payroll taxes and many also pay substantial state and local taxes.

Wage insurance is a second important way to help workers. Wage insurance targets those who have lost higher-paying jobs, helping workers cope with the painful nature of economic transitions. Wage insurance currently exists on a very small scale for some older trade-displaced workers, but it can be expanded to reach workers regardless of their age or the source of job loss.

With wage insurance, the government would make up 50 percent of the difference between the wage received at the old job and the new, lower-paying job. So, if a worker earning $50,000 lost her job and had to instead take a job (or multiple jobs) that paid $30,000, then the government would make up half of the difference. Of course, benefits could be capped and time-limited, and some employment experience would be required in order to qualify. Yet wage insurance would make economic disruption easier to bear. Wage insurance also provides more income to communities that are hit by geographically concentrated disruption due to trade, technological change, domestic competition, or other factors.

Both programs support work and, because they are linked to work, they have a far lower cost than universal support programs, allowing greater generosity. These two policies focus on the key economic problem at hand: It’s not that the U.S. economy doesn’t provide plentiful job opportunities, it’s that existing jobs are too often poorly compensated. If recessions, disability, or child-rearing prevent employment, then those challenges can be handled through programs that target those populations directly.

What does a progressive response to trade look like? It modernizes taxation.

In order to finance wage insurance, an expanded Earned Income Tax Credit, and the many important fiscal priorities of the federal government, we need an efficient, fair, and administrable tax system. Unfortunately, the international mobility of capital creates a conflict between the globalization of economic activity and the revenue needs of the government. It is therefore paramount that we modernize the tax system to ensure that it is suited to a global economy.

One key challenge is addressing the profit shifting of multinational companies. Estimates indicate that the U.S. government was losing more than $100 billion a year due to the profit shifting of multinational corporations before the Tax Cuts and Jobs Act.14 And while that law took some steps to reduce profit shifting, it took other steps that made profit shifting worse by offering U.S. companies a territorial tax system that exempts much of their foreign income from U.S. taxation and by taxing other foreign income at a reduced rate.15

The new tax law also directly encourages the offshoring of U.S. physical assets by U.S. multinational companies because foreign income in low-taxed countries is more lightly taxed when companies have more assets offshore. Early evidence shows that U.S. multinational companies receiving large tax breaks under the law have responded to such incentives by increasing foreign investment.16

Improving the collection of the corporate tax is an important step toward a better tax system. The corporate tax is an essential part of taxing capital since the vast majority of U.S. equity income goes untaxed at an individual level by the U.S. government, as it is held in tax-exempt accounts or by individuals or institutions that are exempt from U.S. tax.17 Capital is becoming a larger share of national income, and taxing capital is an integral part of a fair tax system. This is because capital income is more concentrated than labor income, and capital income is often the result of “rents” that stem from market power or from reaping the gains of global markets and technological change.

Fortunately, there are simple ways to modernize the U.S. corporate tax. One step that could be taken nearly immediately is to strengthen the minimum taxes that are part of the Tax Cuts and Jobs Act, while also raising the corporate tax rate.18 In the medium run, it would be useful to rethink our entire system of international taxation in a way that makes it less vulnerable to profit shifting. A system of formulary apportionment is promising in this regard, and it is already being considered by other countries and as a model for digital taxation.19

The latter proposal works best within a context of international cooperation. Modernizing international trade agreements could provide an excellent forum for such coordination.

What does a progressive response to trade look like? Better trade agreements.

Our multilateral trading system was built over the seven decades since World War II, and it serves an essential function—implementing the rules of the world trading system. The United States should restore our commitment to the World Trade Organization, continuing multilateral efforts to foster the free flow of trade, while at the same time reforming domestic policies to ensure that the resulting prosperity is widely shared.

Preferential trade agreements such as the North American Free Trade Agreement have often been vilified for prioritizing corporate interests over those of workers.20 While there is little evidence that such agreements have harmed workers, there is still substantial room to improve U.S. trade agreements by better balancing corporate and social interests. So-called investor state dispute settlement provisions and intellectual property provisions should either be eliminated or substantially rethought because they unnecessarily prioritize corporate interests over larger social aims.21

In fact, trade agreements can be a useful tool for governments to constrain corporate power. By combining trade liberalization with joint agreements on issues such as tax and regulatory competition, agreements can help counter the negative consequences of capital mobility. When companies threaten to relocate based on tax or regulatory considerations, governments often choose lower tax rates and looser regulations than would otherwise be socially desirable.

Modern trade agreements can pair the “carrot” of open market access with other socially desirable aims, such as combatting corporate tax avoidance or tackling climate change. International trade agreements, for example, could explicitly allow border adjustments to counter inadequate climate policies among trading partners. Global externalities such as climate change require global cooperation. International trade agreements provide a useful forum to build trust and cooperation. In contrast, as we’ve seen lately, trade wars breed distrust, making cooperation less attainable.

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International trade policy that works for U.S. workers

Conclusion

Even ideal international trade agreements will not address the increased economic inequality and wage stagnation of the previous decades since trade agreements had very little to do with these trends. Responding by ramping up trade conflicts and erecting trade barriers only adds insult to injury, harming U.S. workers instead of helping them.

To best help workers, we need to focus on policies that target their needs most directly. An expanded Earned Income Tax Credit can put more of the gains from trade (and other economic forces) in workers’ pockets, and wage insurance can ease the pain of those who have lost jobs due to economic disruption.

We also need to recognize that the global economy generates new policy challenges. Tax rules need to be modernized to combat international tax avoidance, and trade agreements also need to be modernized, both to put workers at the center of the conversation and to better address global policy challenges such as tax competition and climate change.

—Kimberly Clausing is the Thormund A. Miller and Walter Mintz Professor of Economics at Reed College.

Back to Vision 2020 full essay list.

Rebuilding U.S. labor market wage standards

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Over the past 40 years, the United States has experienced a sustained rise in wage and income inequality. This high level of inequality reflects both a disconnect between average wages and productivity and between top and bottom wages, with much of the growth in labor productivity accruing to wages at the top of the distribution.

The results: a growing gap between median compensation and average productivity and between the capital and labor shares of national income. While net productivity grew by 72 percent between 1973 and 2014, median real compensation grew only by 8 percent over that same period. (See Figure 1.)

Figure 1

Much of the gap between mean productivity and median compensation arises from growing inequality in the labor market, which has risen steadily over this period and especially since 1980. This is evident because mean compensation grew by around 43 percent over this period, versus 9 percent for the median. Further underscoring this dynamic, real wage growth for those at the 90th percentile of income was more than 35 percent between 1973 and 2016, compared to 6 percent real wage growth for median income earners and the bottom 10th percentile.

Globalization and technological change have likely played a role in these growing income inequality trends, but a sizable body of evidence in economics suggests institutions have been important contributors to these trends as well—including collective bargaining and statutory minimum wages. The stagnation of the federal minimum wage since 1980 contributed to real wage declines at the bottom of the income distribution.22 And the erosion of collective bargaining led to wage declines for middle-income workers.23

This essay first examines the evidence demonstrating that raising the federal minimum wage boosts the incomes of those workers at the bottom of the income distribution without any significant job losses for those workers. I then present the case for establishing so-called wage boards in the United States, akin to those now in place in Australia, where they set minimum pay standards by industry and occupation. Indeed, the legal infrastructure for wage boards in the United States is in place in several states already and could be emulated or expanded upon by policymakers.

If federal policymakers are interested in raising the pretax earnings for American workers in our nation, then these are important arrows in our policy quiver. As I detail below, raising the federal minimum wage (and indexing it to the median wage) is an obvious starting point. Going beyond just raising the minimum wage, policymakers should also consider wage boards, which could also raise wages for the typical U.S. middle-income worker.

Raising the federal minimum wage

Between 1938 and 1968, wages throughout the wage distribution were generally growing together, and the minimum wage also kept up with the wages of most other workers in the U.S. economy. The high-water mark for the minimum wage was in 1968, when it reached $10.50 an hour in 2019 dollars. The minimum wage then began to decouple from both productivity and even the median wage starting around 1980, reaching a historic low of $6.63 an hour in 2006 (in 2019 dollars) and today stands at $7.25 per hour.

Consider also the shrinking size of the federal minimum wage compared to the median wage of full-time workers. This ratio (sometimes called the Kaitz index) reached a high of 55 percent in the United States in 1968. Today, it is around 35 percent, one of the lowest in the developed world. The stagnant federal minimum wage has led 29 states to raise their minimum wages above the federal standard. Yet for a large share of the U.S. workforce, the federal minimum is the only standard in effect—and this standard is at an all-time low in both historical and comparative terms.

A substantial increase in the federal minimum wage is an important lever for raising pretax earnings for those workers at the bottom of the pay distribution.

Are there unintended consequences of raising the minimum wage?

Minimum wages raise the pay of workers at the bottom of the income distribution, but one concern is that a higher minimum wage also may lead employers to cut back on hiring. There is a large and sometimes contentious literature that has looked at this question with varying conclusions.24 In my assessment, the overall weight of recent research strongly supports the view that the minimum wage increases of the magnitude we have seen in the United States in recent years generate only modest employment effects.

In their 2014 book What Does the Minimum Wage Do?, economists Dale Belman at Michigan State University and Paul J. Wolfson at Dartmouth College’s Tuck School of Business review a large body of literature, and conclude that it was unlikely that the minimum wage increases under study led to substantial job losses. A similar conclusion was reached by other economists doing formal meta analysis, a well-defined statistical approach of pooling the results from a large number of separate analyses. And a meta analysis conducted by economists Hristos Doucouliagos at Deakin University and T.D. Stanley at Hendrix College, along with one released in 2015 by Belman and Wolfson, also concludes that the overall impact of minimum wages on employment is small.25

While meta analyses are helpful in summarizing the overall state of the literature, not all studies are created equal. This is why policymakers and economists alike should put more weight on high-quality evidence. In a paper I co-authored that was recently published in the Quarterly Journal of Economics, we provide arguably the most complete picture to date of how minimum wages impact low-wage jobs.26 The basic idea is simple. Imagine the minimum wage rises from $9 to $10 an hour in Nebraska. Clearly, there will be fewer jobs paying less than $9 per hour in Nebraska after the policy is enacted. Some of those jobs that would have paid less than $9 are now simply paying $9 or a bit more; other jobs may be destroyed if the costs exceed benefits to employers.

By comparing how many fewer jobs paying less than $9 there are due to the policy to how many additional jobs are paying $9 or slightly more, we can infer the total change in low-wage jobs caused by the minimum wage policy change. Of course, it’s possible that wages would have risen even absent the policy change in Nebraska; to account for that, we compare the changes in sub-$9 jobs and above-$9 jobs in Nebraska to the same in other states that did not raise the minimum wage. Finally, we pool across 138 prominent minimum wage changes instituted between 1979 and 2016 across various states. The following figure summarizes our key findings. (See Figure 2.)

Figure 2

Figure 2 shows the effect of an average minimum wage increase on the wage distribution at each wage level relative to the minimum wage. As we would expect, minimum wage increases led to a clear reduction in jobs paying less than the new minimum wage, confirming employers are abiding by the law. Yet the reduction in jobs paying less than the minimum was balanced by a sharp increase in the number of jobs paying at the new minimum, along with additional increases in jobs paying up to $5 more than the new minimum.

As Figure 2 also shows, my co-authors and I found virtually no change in employment higher up in the wage distribution. Overall, then, low-wage workers saw a wage gain of 7 percent after a minimum wage increase, but little change in employment over the 5 years following implementation.

Our research also shows why methods used in some of the previous studies are more susceptible to biases resulting from shocks to local labor markets, especially when comparing across long periods of time. These methods also insufficiently focus on workers or jobs that are likely affected by minimum wage policies. In other words, our research doesn’t just provide new evidence—we also show why it’s better evidence. This is one reason why, in my assessment, the 2019 report by the Congressional Budget Office predicted job losses larger than warranted from a federal minimum wage increase by putting equal weight to some of the studies suggesting very large job losses that my co-authors and I showed were flawed.

Encouragingly, we found that minimum wages as high as 59 percent of the median wage generated little indication of job losses. Moreover, in new work updating the published Quarterly Journal of Economics study, I find that minimum wage increases in the seven states with the highest minimum wages have (through 2018) not experienced losses in low-wage jobs.27 Finally, another recent study using sub-state variation focusing on low-wage areas reaches a similar conclusion.28

Overall, the weight of evidence suggests a substantial increase in the federal minimum wage is likely to attain its intended effects of boosting bottom wages and family incomes without substantial unintended consequences in the form of reduced employment growth.29

Beyond the minimum—reaching U.S. middle-income workers using wage boards

A major increase in the federal minimum wage can raise wages for tens of millions of U.S. workers, but its reach will still be limited to the bottom third of the workforce. What about those workers in the middle—what tools do we have to move their wages higher? First, let’s look at why wage boards—defined in detail below—are necessary in the United States today.

In the era following World War II, the key countervailing force to employer-side power in the United States labor market came from unions. Overall union membership reached a height of around 35 percent of the workforce in the mid-1950s. Since then, however, union membership has steadily fallen, and stands at around 12 percent today—and less than 7 percent in the private sector. Unions affected wages both directly and indirectly through pattern bargaining, as in the so-called Treaty of Detroit agreement between the United Auto Workers and the Big Three automakers at the time—General Motors Co., Ford Motor Co., and Chrysler (now Fiat Chrysler Automobiles NV).30

The impact of falling union membership has been particularly acute due to the enterprise-level bargaining structure in the United States (and other countries such as the United Kingdom and Canada), which differs greatly from countries such as France, Germany, and Australia, where collective bargaining coverage (the share of jobs covered by collectively bargained contracts) is much greater than union membership rates.

France, for example, has an 8 percent union membership rate (similar to the United States), yet more than 95 percent of its workforce is covered by extensions of nationally negotiated collective bargaining contracts. While coverage rates also have fallen across the developed world over the past several decades, the outcomes have varied greatly among countries with different legal systems. Consider that:

  • Union membership and coverage have remained high in so-called Ghent system countries such as Denmark, where labor unions are generally responsible for unemployment benefits rather than the government (and named after the city of Ghent in Belgium, where this system was first implemented in the early 20th century).
  • Union coverage has remained high even as membership has fallen in countries with sectoral bargaining and extension of contracts (rather than negotiating a new collective bargaining agreement), such as France.
  • Membership and coverage rates have both fallen sharply in countries with enterprise-level bargaining, as in the United States. Overall, this decline in union density has likely led to substantial reductions in wages of workers in the middle of the income distribution.31

While reforming labor laws to facilitate organizing is important, given the very low coverage rates in the United States today, such changes are unlikely to affect the overall wage distribution in the near term. One way to reach middle-income workers in the United States more immediately would be through instituting a wage board that sets multiple minimum pay standards by sector and occupation—potentially chosen using consultation with stakeholders, such as business and worker representatives.32 This system would allow for raising wages not just for those workers at the very bottom of the overall pay scale, but also for those in the middle. This is effectively done in countries where there are extensions of collective bargaining contracts, but it also can be done by setting multiple minimum pay levels statutorily.

An example of a wage board approach comes from Australia, which has a combination of a national minimum wage, a system of industry- and occupation-specific minimum wages, and enterprise-level collective bargaining, called the Modern Awards system. Around 36 percent of the workforce is covered by collective bargaining contracts, but another 23 percent are covered by the wage board standards. Most of these standards are by industry, although some workers, among them nurses and pilots, are covered by occupation. There are 122 such standards, and within each one, there are a host of wage rates based on skill requirements or experience; there may be anywhere between a handful to several dozen pay grades specified in each agreement.

How to set up wage boards in the United States

In order to institute wage boards at the national level in the United States, federal law would need to be changed. But there are institutions in place already at the state level upon which to build or emulate.

At least five states (Arizona, Colorado, California, New Jersey, and New York) already have legislation on the books that allows for constituting wage boards by industry or occupations. But these boards have been used infrequently. Most prominently, they were used to raise the overall minimum wages in California in the 1990s, and more recently to establish a fast food minimum wage in New York. But there has been little effort to use the wage board mechanism to target wages for those in the middle of the income distribution.

At the same time, the machinery is in place to push for a broader array of wage standards. State experimentation with wage boards to set standards higher up in the wage distribution—as in the Australian case—could play a possibly useful role in mitigating wage stagnation and inequality. Moreover, other states can follow suit and establish similar wage board legislation to those in place in California.

While details can vary, a wage board system would set minimum pay standards by sector and occupation. This allows the mechanism to affect the distribution of wages not just at the very bottom but additionally toward the middle of the distribution. As an illustration, below I simulate the effect of a wage board by imposing region-by-industry-by-occupation standards, separately calculated by region (specifically using nine U.S. Census Bureau divisions), 17 two-digit industries, and six occupational groups—producing a total of 102 wage standards.

The choice of standards is, of course, a key issue. To show how this may affect wage inequality, I consider two standards. In the first, “low” standard, I set the minimum wage to 30 percent of the median wage in each of the 102 categories in that particular Census division. In the second, “high” standard, I set it to 35 percent of the median. While as a share of the median wage, these two standards seem to be not very far apart, they do imply quite different bites for the policy.

As a starting point, the wage standards would be binding for 20 percent and 31 percent of workers under the low and high standards, respectively. In other words, the low and the high standards straddle the Australian case—where around 23 percent of workers’ wages are set by the Modern Award system. Australia, however, also has a substantially higher set of workers with collectively bargained wages (36 percent) than the United States (12 percent). Therefore, the high standard would still imply a smaller set of workers who are covered by either collective bargaining or by a wage board than in Australia. (See Figure 3.)

Figure 3

As shown in Figure 3, overall, both the high and low standards imply substantial wage gains, especially for the bottom and middle of the wage distribution. Under the low standard, the 20th, 40th, and 60th percentile of wages rises by 13 percent, 9 percent, and 4 percent, respectively. Under the high standard, the wage gains extend somewhat further. Wages at the same percentiles would rise by 19 percent, 15 percent, and 12 percent, respectively.

Contrast these distributional impacts of wage boards with those from typical minimum wage increases in the United States. The consequences of raising the federal minimum wage mostly fades out by the 20th percentile of the wage distribution, whereas the wage boards extend wage gains well into the middle of the distribution. In short, wage boards are much better positioned to deliver gains to middle-wage jobs than a single minimum pay standard.

Of course, these calculations are illustrative and make many simplifying assumptions such as ruling out additional spillover effects and changes in composition of jobs, to name a few. But what they show is that a suitably chosen wage standard can substantially raise middle and bottom wages and reduce wage inequality.

While it is difficult to definitively assess the impact of the Australian system of labor standards, there are broad metrics that offer a positive verdict. Household inequality in Australia is more muted compared to the United States: While Australian families at the 90th percentile earn around 4.3 times as much as those at the 10th percentile, in the United States, they earn around 6.3 times as much.33 Importantly, the median wage has kept up with the mean wage in Australia much more than in the United States, where the median has stagnated since the 1980s.

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Rebuilding U.S. labor market wage standards

At the same time, the more muted growth in inequality in Australia is not associated with any obvious differences in labor market performance. While the Australian unemployment rate in August 2019 was 5.3 percent as opposed to 3.7 percent in the United States, over the past 10 years, Australia has averaged 5.5 percent unemployment versus 6.9 percent in the United States. Focusing on younger or lower-skilled workers does not yield very different comparisons. Overall, the Australian evidence is broadly consistent with the perspective that judiciously applied wage setting using a wage board system can help ameliorate wage inequality without causing any serious harm to the labor market.

Finally, at the national level, a wage board system can complement efforts to reform labor law to allow sectoral bargaining in the United States. In particular, having statutory sectoral wage standards can serve as a backstop, which can be superceded by sectoral agreements between unions and employer associations if union membership exceeds a minimal threshold. Overall, policymakers would be well-advised to experiment with a variety of institutional reforms to help reverse wage stagnation and inequality than has afflicted the labor market in the United States.

—Arindrajit Dube is a professor of economics at the University of Massachusetts Amherst and research associate at the National Bureau of Economic Research.

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The economic imperative of enacting paid family leave across the United States

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Many workers across the United States have caregiving responsibilities. The majority of mothers and fathers of infants and small children work in the labor force, and the aging of the baby boomer population implies that many workers have parents and other older relatives who may require care. Paid family leave policies are designed to help employees balance the competing needs of work and family by allowing them to take time off from work with partial wage replacement to care for newborn or newly adopted children or ill family members.

Yet the United States remains one of only a few countries in the world without any national paid family leave policy and the only high-income country without one.34 Only 17 percent of U.S. private-sector workers have access to paid family leave through their employers, and this access is highly unequal—meaning that low-income workers have much less access than their higher-income counterparts.35 Federal law requires 12 weeks of job-protected unpaid leave under the 1993 Family and Medical Leave Act, but stringent eligibility requirements mean that less than two-thirds of the U.S. workforce is eligible. Not surprisingly, the majority of working parents report that their work-family balance is a significant challenge.36

Paid family leave is receiving significant attention in the political discourse. At the end of 2019, Congress and the Executive Branch reached agreement to extend six weeks of parental paid leave for a newly born or adopted child to the federal workforce. During the 2016 election, for the first time in U.S. history, both Democratic and Republican presidential candidates included paid leave proposals in their campaign platforms. Advocates credit paid family leave with encouraging career continuity and advancement for women and improving child and family health and well-being. There is also growing interest in encouraging men to take leave, in an effort to promote gender equality both at home and in the labor market. Yet some business groups and other opponents of paid family leave argue that it could impose substantial costs on employers. Paid time away from work could lower employees’ attachment to their jobs, and even lead to discrimination against women (who are more likely than men to take leave).

In this essay, we first examine paid family leave programs at the state and local level, which are helping to set the stage for a federal paid leave program. We then describe the current research on the impacts of paid family leave on workers, children, and employers, with an eye toward understanding the economic costs and benefits of a potential federal program and the key policy levers to consider. We also briefly discuss how paid family leave may relate to the growth in economic inequality in America and whether a federal policy could help curb this trend.

Paid family leave policies can cover both bonding with a new child and caring for other relatives, but in this essay, we will focus the discussion on the effects of bonding leave. This restriction stems from a lack of research on the impacts of nonbonding leave and the fact that bonding leaves currently make up the vast majority of all claims in states with paid family leave programs.37

Paid family leave at the state and local level

There has been substantial policy action for paid family leave at the state and local level. California became the first state to enact legislation in 2004, followed by New Jersey (in 2009), Rhode Island (in 2014), and New York (in 2018). Washington state and the District of Columbia both recently passed legislation, with benefits available starting in 2020. Massachusetts, Connecticut, and Oregon also recently passed laws to start providing paid family leave benefits in 2021, 2022, and 2023, respectively.38 At least 16 other states have introduced similar legislation.

The current state and local paid family leave laws are all similar in that they provide partial wage replacement during leave and cover a broad segment of the workforce through minimal eligibility requirements. But they differ on several key policy levers: duration, benefit amount, job protection, funding mechanism, and what constitutes a qualifying event.

Wage-replacement rates vary from 50 percent to 100 percent (up to a weekly maximum benefit amount) for 4–12 weeks. The maximum benefit amount currently ranges from $650 to $1,250 per week. While higher-income workers receive higher total benefit amounts, the replacement rate is higher for low-wage workers in California (as of 2018), the District of Columbia, Massachusetts, Washington state, Oregon, and Connecticut. Paid family leave legislation in California, New Jersey, and the District of Columbia do not have any provisions for job protection, which require that employers allow workers to return to their preleave jobs after the leave has ended, though eligible workers can simultaneously take job-protected unpaid leave under current federal or state law. The other states specifically include job security provisions for most employees in their paid family leave laws.

Most states fund paid family leave entirely through employee payroll taxes, while the District of Columbia has a payroll tax on employers. In Oregon and Washington state, the leave will be jointly financed between employees and employers. This payroll tax is currently between 0.1 percent and 1 percent of wages (up to a cap) across states.

All states cover leaves associated with the arrival of a new child (through birth, adoption, or foster care) and serious health conditions of close family members. But the definition of close family members varies somewhat across programs. Additionally, Massachusetts and Washington state will cover needs related to the military deployment of a family member. New Jersey and Oregon include specific provisions to cover victims of domestic violence and their caregivers.

Paid family leave and take-up by employees

Most Americans support a national paid family leave policy.39 But how many workers would such a policy benefit? Evidence from California indicates both mothers and fathers value it. The leave-taking rate of mothers with infants nearly doubled after paid family leave became available, while fathers were 50 percent more likely to take leave.40 This increase in leave-taking indicates that access causes new parents to take more time away from work following the birth of a new child than they would in the absence of the policy. But even those who do not change their leave-taking behavior may benefit by receiving partial wage replacement during periods of leave that would have otherwise been unpaid. Overall, a recent study by one of the co-authors of this essay, along with two other colleagues, estimates that about 47 percent of employed new mothers and 12 percent of employed new fathers in California made a paid family leave claim in 2014.41

Why don’t all new parents access this paid family leave program? There are a number of barriers that may limit take-up, including lack of policy awareness, too-low pay, or the absence of job protection.42 These barriers may be especially high for workers in low-wage jobs, who are less likely to be eligible for job protection through the current federal unpaid leave law and less likely to be able to afford to take even partially paid leave.43

Paid family leave and workers’ labor market trajectories

Paid family leave could impact workers’ subsequent labor market outcomes such as employment and wages in several different ways. Because paid leave increases the time parents spend away from work, it could lead to a loss of job-specific skills and make re-entry into the labor market more difficult. Yet the availability of paid family leave, particularly when job protection is available, may reduce the probability that new parents quit their jobs upon the birth of a child. This could have a positive effect on job continuity and future earnings.

Although employers are not responsible for paying employees during the leave, extended absences are costly in other ways. The productivity of firms, for example, may decrease if it is difficult to reassign tasks or hire a replacement while an employee is on leave for several weeks. Employers who find leaves particularly costly may discriminate against groups most likely to take up the leave—new mothers or women of childbearing age—by being less likely to hire them or offering them lower wages.

Studies on these programs in other countries typically find that provisions of leave up to 1 year in length increase the employment of mothers shortly after childbirth and have positive or zero effects on wages, though longer leave entitlements can have adverse effects on maternal long-term employment and wage trajectories.44 There is no evidence that paternity leave impacts fathers’ subsequent labor market outcomes.45

The evidence on the employment effects of paid family leave in the United States is mixed. While several studies have found the introduction of paid family leave in California had positive impacts on employment and wages of new mothers in the short term, recent work using large-scale administrative data finds zero or small negative impacts on long-term employment and wages.46

Moreover, it is possible that the design of the leave policy in terms of its specific components (such as duration, replacement rate, and the inclusion of job protection) matters. Yet there is limited research on this question because it is hard to isolate the effect of a particular policy lever from the other features that are implemented at the same time. That said, new research by one of the co-authors of this essay, along with two other colleagues, isolated the impact of the wage-replacement rate in California’s paid family leave program for relatively high-income mothers, finding that higher benefit amounts do not affect either the duration of leave or the probability of making a claim, but may improve job continuity by increasing the likelihood that women return to their preleave employers.47

Paid family leave and family health outcomes

A lot of the discussion about the importance of paid family leave focuses on women’s labor market trajectories, yet these policies may also be beneficial for families more broadly. For instance, paid leave could impact maternal and child health and well-being. Access to leave may lower maternal stress during pregnancy, which has been shown to adversely affect child well-being at birth and in later life.48 Paid family leave also may impact breastfeeding duration, enable parents to obtain prompt healthcare for their infants, improve maternal postpartum physical and mental health, and strengthen parent-child bonds.

While studies of the impacts of extensions in already-generous paid family leave policies on children from other countries find no effects, they offer little guidance on what one might expect from the introduction of a shorter-but-similar federal program such as those now being considered in the United States.49 There is one instructive example that comes from research on the long-term impacts of the 1977 implementation of a four-month paid maternity leave policy in Norway. That research shows that it led to a reduction in high school drop-out rates and an increase in adult earnings, concentrated among children from disadvantaged backgrounds.50 Another study further shows that the same policy improved a range of maternal health indicators, with the benefits again concentrated among women from less advantaged backgrounds.51

We can also draw on a small body of research conducted in the U.S. context. One study shows that the introduction of paid maternity leave in five U.S. states lowered rates of low birth-weight and preterm births, with the largest impacts among African American and unmarried mothers. Improvements in these measures of health at birth have been correlated with improvements in long-term health, suggesting that paid leave may have long-lasting benefits for kids. The introduction of paid family leave in California also is associated with increases in the duration of breastfeeding, reductions in hospitalizations for infants due to avoidable infections and illnesses, and improvements in maternal mental health.52

Although paid family leave policies at the state and local level in the United States have not existed long enough to study the long-term impacts of children’s health into adulthood, there is already some evidence of improvements in later childhood health. The introduction of California’s paid family leave program is associated with lower rates of being overweight, attention deficit hyperactivity disorder, and hearing problems in Kindergarten.53 Recent work finds that paid family leave also increases time mothers spend in childcare activities, suggesting that improvements in childhood health may be driven by both physiological and behavioral channels.54

Paid family leave and employers

A central concern among opponents of government-mandated paid family leave is the costs imposed on employers. Even if employers do not have to fund the leave, they could face indirect costs from the need to hire replacement workers, coordinate employee schedules, or reassign work tasks. Alternatively, employers could experience cost savings if workers who would have otherwise quit instead return to their jobs and reduce turnover rates.

The existing evidence on the impacts of paid family leave on employers is sparse. Surveys of selected firms in California and New Jersey find that the vast majority of employers report either positive or neutral effects on employee productivity, morale, and costs.55 These studies do not find much evidence that program administration has been challenging or that employees resent their co-workers who take leave.

Then, there’s the recent survey of small and medium-sized businesses in the food services and manufacturing sectors in Rhode Island, Connecticut, and Massachusetts just before and shortly after Rhode Island’s paid family leave program went into effect.56 Comparing Rhode Island employers pre- and post-law to Massachusetts and Connecticut employers over the same time period, the study found no evidence of significant impacts of the law on outcomes such as turnover rates or employee productivity. Still, the sample sizes were small, limiting the conclusions that could be drawn from this analysis.

One of the co-authors of this essay and another colleague used administrative data on nearly all California employers that ever existed between January 2000 and December 2014 to study how employers’ labor costs and productivity respond to changes in employee leave-taking rates.57 They find no evidence that employee turnover or wage costs change when leave-taking rates rise. In fact, the average firm has a lower per-worker wage bill and a lower turnover rate today than it did before California’s paid family leave program was introduced.

But there still may be significant differences in the costs of paid family leave faced by different firms. Again using administrative from California, another recent analysis finds that take-up of paid leave is substantially higher in firms that pay similarly skilled workers relatively higher wages.58 These firms also have higher employee retention following periods of leave. That research posits that better-paying firms may have cultures that are more conducive to leave-taking, suggesting that changing firm behavior and norms may be important for encouraging the use of leave more broadly.

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The economic imperative of enacting paid family leave across the United States

Conclusion

As other states and the nation as a whole consider paid family leave legislation, it is critically important to understand the costs and benefits of existing programs and identify key policy features. The current research yields five key take-aways.

First, both mothers and fathers respond to the introduction of paid family leave programs through higher leave-taking rates and longer leave duration, but barriers to take-up remain, especially among low-wage workers in small firms. Job protection and high wage-replacement rates for workers at the bottom of the wage distribution may be important for encouraging more widespread take-up.

Second, relatively short leave entitlements can improve job continuity for women and increase their employment rates several years after childbirth. Paid leaves longer than 1 year, however, could have adverse consequences for mothers’ long-term career opportunities.

Third, the current paid leave programs at the state and local level in the United States have positive impacts on child health and development, as well as maternal well-being. Thus, while there is no research identifying the “optimal” duration of leave precisely, it appears that programs of up to six months in length are likely to generate benefits for families without significant costs to women’s careers.

Fourth, the current evidence shows minimal negative impacts of existing state programs on employers, suggesting that paid family leave programs afford benefits to workers and their families at little to no cost to the employers. These benefits may be especially important for the least advantaged families, in which workers are the least likely to have access to any employer-provided paid leave.

Finally, a growing body of evidence underscores that rising economic inequality and persistent intergenerational transmission of low socioeconomic status in the United States are perpetuated through disparities in early childhood circumstances.59 The current research suggests that a federal paid family leave policy could level the playing field for children from all backgrounds and help curb the growth in inequality and boost long-term U.S. economic growth and stability.

—Maya Rossin-Slater is an assistant professor of health policy in the Department of Medicine at Stanford University School of Medicine. Jenna Stearns is an assistant professor of economics at the University of California, Davis.

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Addressing the need for affordable, high-quality early childhood care and education for all in the United States

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

In 2017–2018, most children in the United States under 6 years of age—68 percent of those in single-mother households and 57 percent in married-couple households—lived in homes in which all parents were employed.60 Most of these families require nonparental early care and education, such as childcare centers, preschools, family childcare homes, or informal arrangements with relatives or neighbors, to care for their children while at work. In a typical week in 2011, the most recent year for which complete data are available from the U.S. Census Bureau, 12.5 million of the 20.4 million children under the age of 5 living in the United States (61 percent) attended some type of regular childcare arrangement.61

Unfortunately, on average, the early care and education settings attended by many young children, particularly low-income children or children of color, provide quality at levels too low to adequately promote children’s learning and development.62 This exacerbates socioeconomic and racial and ethnic inequalities. At the same time, in most regions of the country, families with young children are spending more on childcare than they are on housing, food, or healthcare.63

In this essay, I argue that greater policy attention to early childcare and education is warranted for three reasons:

  • High-quality early care and education promotes children’s development and learning, and narrows socioeconomic and racial/ethnic inequalities.
  • Reliable, affordable childcare promotes parental employment and family self-sufficiency.
  • Early care and education is a necessary component of the economic infrastructure.

I then provide the research underlying these three statements, and follow with a discussion of several policy solutions to address the current problems of affordability, quality, and supply of early care and education in the United States. The overwhelming evidence shows that more public investment is needed to help ease the cost burden for families and ensure that a trained, stable workforce has adequate compensation. A universal early care and education plan, particularly one with a sliding income scale to provide progressive benefits, may not pay for itself in the short term, but will very likely do so in the long term by boosting broad-based U.S. economic growth and stability while narrowing economic inequality.

High-quality early care and education promotes children’s development and learning and narrows inequality

Early childhood, especially the first 3 years of life, constitutes a sensitive period of the life course, one during which caregiver warmth, responsiveness, and developmentally appropriate stimulation are vital for development.64 Experiences during early childhood—whether positive, such as language exposure, or negative, such as high and chronic levels of stress or deprivation—have lasting effects.65 Research demonstrates that socioeconomic disparities in cognitive skills and physical development are apparent in infancy.66

Over the past five decades, a wealth of research has examined how early care and education affects children’s development. Most studies find that the majority of the intensive, high-quality, at-scale model programs promote children’s academic school readiness in the short term. These include the Abecedarian project (studying a set of children born between 1972 and 1977 into their adult years), the Perry Preschool project (studying of a select group of children born between 1962 and 1967), the Infant Health and Development Program (a 1980s program that studied low birth-weight children in their first 3 years), and longstanding federal at-scale early care and education programs such as Head Start, state pre-Kindergarten programs, and high-quality center-based programs.67 Effects are generally strongest for disadvantaged children, suggesting that early care and education may help to narrow socioeconomic, racial, and ethnic disparities in achievement.68

Among the early care and education programs in existence long enough to have data on long-term effects, research finds substantial and lasting benefits for educational and economic outcomes, including higher rates of high school completion, college attendance, and earnings, and reduced criminal activity and public assistance reliance into adulthood.69 There also is emerging evidence for intergenerational benefits.70 Yet the research is somewhat mixed for the mid-term effects of early care and education programs. Research finds benefits of participation for reduced grade retention, or repeating a grade in school.71 The short-term benefits on test scores, however, appear to “fade out” or converge with children who did not attend early care and education programs as they age.72 But some research suggests that may be due to the quality of the schools attended after early childhood.73

A largely separate body of research examines the health effects of early care and education. Studies find that the initial entrance of young children into group care is associated with a short-term increase in the incidence of communicable diseases.74 But there are substantial and lasting benefits of early care and education participation for health, including increased on-time immunization rates, early screening rates, improved cardiovascular and metabolic health, and reduced smoking.75

Reliable, affordable childcare promotes parental employment and family self-sufficiency

Early care and education provides a context for child development, as well as temporary relief to parents for childcare, allowing them to work. Indeed, increased access to affordable childcare increases parents’ labor force participation, particularly among single mothers. A recent review of the labor effects of childcare estimates that a 10 percent decrease in childcare costs would lead to a 0.25 percent to 1.25 percent increase in parental labor force participation.76 Research finds that public preschool programs, which typically offer part-day, school-year programming, have some but potentially limited effects on parental employment.77 But full-day, full-year early care and education—particularly for infants and toddlers for whom care is expensive and hard to find, and who are less likely to attend center-based care (See Figure 1)—would likely have larger effects on parental labor force participation.78

Figure 1

Early care and education is a necessary economic infrastructure component

Childcare can be considered an infrastructure component akin to transportation. Without reliable, affordable sources, workers cannot regularly get to work or stay there. In the short term, early care and education settings support the productivity of two types of workers: employed parents and childcare workers. Research by University of Chicago economist and Nobel Laureate James Heckman and others suggests that many early childhood programs pay for themselves before children begin kindergarten via increased maternal employment, which generates both household income and tax revenue.79 Further, research from the early 2000s suggests that investments in childcare have strong local economic development effects, or multiplier effects, because much of those dollars are spent on childcare worker wages that they, in turn, spend locally.80

In the long term, early care and education supports the preparedness and skills development of the future workforce of the country. Benefit-cost analyses of several intensive model programs and public early care and education programs indicate that the benefits—such as improved educational, economic, and health outcomes, and reduced criminal activity and receipt of public assistance—outweigh the initial program costs, demonstrating positive returns for participants, as well as the public.81

Barriers in accessing the promise of early care and education

Unfortunately, families with young children today face barriers in accessing and paying for the opportunities offered by early care and education. High-quality early care and education is expensive and hard to find, particularly for infants and toddlers.82 Families with young children spend about 10 percent of their incomes on childcare expenses, but families in poverty—families below 100 percent of the Federal Poverty Level of about $12,000 per year for a family of three—spend 30 percent.83 These expenses represent families’ actual expenses at a mix of regulated centers and homes and informal lower-cost arrangements with relatives, not necessarily what they may choose to spend if more options were available.

In 2017, infant childcare at centers or licensed homes cost an average of $9,000 to $12,000 per year across the country, more than public college tuition in most states.84 These high childcare costs accrue during a period when parents are at the lowest earning years of their careers and when the financing mechanisms of grants and low-interest loans are unavailable.85 The public programs that exist to help families access early care and education—namely the Early Head Start/Head Start program and childcare subsidies provided under the federal and state Child Care and Development Block Grant program—serve a small fraction of those eligible. In 2016–2017, 35 percent of 3- to 5-year-old children in poverty attended Head Start, and 10 percent of children under age 3 in poverty attended Early Head Start.86 In 2015, of the 13.5 million children eligible for childcare subsidies under federal rules, only 15 percent received them.87

Public investments in preschool contribute to dramatic increases in participation in early learning programs in the year or two prior to children’s entry into kindergarten. Whereas in 1970, about 1.09 million (27 percent) 3- to 5-year old children in the United States attended preschool, by 2016, 4.701 million (60 percent) were enrolled.88 Yet these overall rates mask disparities in attendance. While income-based gaps in enrollment in preschool narrowed in recent decades, children in low-income families continue to be less likely to attend center-based care than their higher-income peers.89 As shown in Figure 1, among children under age 5 with employed mothers, only 28 percent of those in homes under the poverty line attend center-based care, versus 39 percent of those above the poverty line. This is problematic, as center-based settings tend to provide higher-quality, more stable care, on average, than unregulated arrangements.90

Further, centers that low-income children attend provide lower quality care, on average, than those attended by their higher-income peers.91 Research shows that higher-income families are enrolling children in formal early care and education programs at increasingly younger ages.92 In 2005, for example, 22 percent of 1-year-olds from families with incomes above 200 percent of the federal poverty line (at that time, about $32,000 per year for a family of three) attended center-based settings, compared to just 11 percent of 1-year-olds from families with incomes below 200 percent of the federal poverty line.93 Our system’s reliance on private family investment in early childhood is a driver of inequality, putting children on unequal playing fields well before they walk through the doors of their kindergarten classrooms.94

Despite their high expense, early care and education programs should actually cost more, not less. The quality of early care and education depends on the warmth and responsiveness of teachers and caregivers and on the strength and consistency of caregiver-child relationships, which means economies of scale do not apply to childcare in the same way as with other economic sectors. For good reason, state and local regulations set child-adult ratios and group sizes and teacher training requirements. In turn, most childcare costs are directed to labor expenses.95

Yet, despite parents paying as much (or more) than they can afford, childcare workers are paid little. In 2018, the median hourly wage for childcare workers was $11.17 ($23,240 per year).96 This is considerably less than the $16.56 median hourly wage for bus drivers ($34,450 per year).97 What’s more, there are wide racial and ethnic gaps in teacher pay and benefits such as health insurance coverage or paid sick leave.98 Many workers earn so little that they rely on public assistance. Between 2014 and 2016, more than half (53 percent) of childcare workers lived in families that participated in one or more of four public programs.99 This compares to 21 percent in the general population.100

Low pay and few benefits present barriers in attracting and retaining a skilled early care and education workforce. Teacher educational qualifications and stability are associated with the quality of early childhood settings and, in turn, a wide range of children’s outcomes.101 In 2012, 25 percent of childcare centers had turnover rates of 20 percent or higher.102 A 2018 study found that 10 percent of children in Head Start (whose teachers average lower pay than those at public preschool programs) had a teacher who left Head Start entirely during the program year, with harmful consequences for children’s outcomes.103 Adequate caregiver and teacher compensation and training is necessary for supporting quality and stability in, and augmenting the supply of, early care and education.

This lack of reliable, affordable childcare has reverberating effects for parents, employers, and the U.S. economy. Interrupting a career due to a lack of adequate childcare—something more often done by mothers—has both short- and long-term economic ramifications for families in terms of lost wages, retirement savings, and other benefits, with an estimated average reduction of 19 percent in lifetime earnings.104 Even when maintaining labor force participation, working parents and their employers feel the economic consequences of childcare inadequacy. A 2018 survey found that workers with children under the age of 3 lose an average of 2 hours per week of work time due to childcare problems, such as leaving early or arriving late. One-quarter of respondents reported they reduced regular work hours, turned down further education or training, or turned down a job offer due to childcare problems.105 One recent study estimated that the childcare crisis results in $57 billion in lost earnings, productivity, and revenue each year.106

Policy solutions

Most early care and education policies are designed for one or both of two purposes: to provide care while parents work or to promote children’s readiness to enter kindergarten by supporting cognitive, social-emotional, and behavioral development. This is a false dichotomy. As detailed above, high-quality, affordable, reliable programs accomplish both purposes. Yet there are simply too few high-quality, affordable, reliable programs in the United States today, and most are out of reach for low- and middle-income families.

In order to address families’ and employers’ early care and education needs, policies must address the affordability, quality, and supply problems in our current system. More public investment is needed to help ease the cost burden for families and ensure that a trained, stable workforce has adequate compensation, which will promote affordability and quality. Low-income families disproportionately shoulder the economic and other burdens caused by the lack of childcare, although middle-income families are also economically squeezed during the years in which their children are young.

A universal plan, particularly one with a sliding income scale to provide progressive benefits, may not pay for itself in the short term, but will likely do so in the long term.107 A universal plan that offers benefits such as mixed-income classrooms may have beneficial peer effects.108 And these kinds of plans have fewer administrative barriers and stigma, and a broader base of political support.109 Further, an analysis of the Infant Health and Development Program estimates that socioeconomic achievement gaps would be substantially narrowed from universal programs.110 Policies should be flexible enough to meet families’ diverse needs, address the overall supply of early care and education, and cope with the gaps that are particularly troublesome for families today, such as care during nonstandard hours and for children with special needs.111

Two examples of universal policy solutions that would improve affordability, quality, and supply are the Child Care for Working Families Act and the Universal Child Care and Early Learning Act. Both of these proposed bills would increase public investment in early care and education to limit families’ out-of-pocket payments to 7 percent of family income (the threshold recommended by the U.S. Department of Health and Human Services), increase childcare worker compensation and training, and expand public preschool and the supply of childcare for infants and toddlers. The Child Care for Working Families Act does so by expanding childcare subsidies, nearly doubling the number of children eligible.112 The Universal Child Care and Early Learning Act relies more on public provision, expanding a network of early care and education options through federal-state or federal-local partnerships.113

Both bills, if passed by Congress and signed into law, would lead to substantial increases in the availability of high-quality, affordable early care and education programs. An analysis of the Child Care for Working Families Act estimated that, at full implementation, the availability of new childcare subsidies and reduced childcare costs would lead to 1.6 million more parents joining the labor force, the bill would create 700,000 new jobs in the childcare sector, and pay among teachers and caregivers would increase by 26 percent.114

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Addressing the need for affordable, high-quality early childhood care and education for all in the United States

Conclusion

The recent increases in state and local paid family leave programs in a handful of states and cities are laudable and help parents manage their own health and their newborns’ needs, while maintaining their jobs and a basic income.115 Likewise, federal and state public preschool programs and Head Start serve increasing numbers of children, with 44 percent of 4-year-olds and 16 percent of 3-year-olds enrolled in public programs across the country.116 But in the years following the (relatively brief) period of paid leave and preceding the availability of preschool, families require affordable, high-quality, stable early care and education arrangements that match their working hours.

To ignore early care and education policy means to ignore a major expense and pressing concern for families and employers across the nation. Moreover, the research shows that early care and education can promote children’s cognitive and other outcomes, narrowing disparities and leading to greater economic growth.117 Our nation’s current lack of investment in early care and education—unique among our peer countries—constitutes a lost economic opportunity to enhance our global competitiveness, as well as a lost opportunity for narrowing pervasive social and economic inequalities among families today.

—Taryn Morrissey is an associate professor at the School of Public Affairs at American University.

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Fair work schedules for the U.S. economy and society: What’s reasonable, feasible, and effective

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Scheduling practices in low-wage jobs are the focus of increasing public concern in the United States, as awareness has grown of their potential harmful effects on workers and families. Changing work schedules requires changing the behaviors of frontline managers because they are the ones who schedule employees. Policymakers in the next Congress and administration can enact new federal laws to shift incentives on the frontlines of firms to help establish work-hour standards that benefit both employers and employees.

In this essay, I first detail the problematic scheduling practices prevalent in today’s U.S. economy and their serious ramifications for firm productivity and worker well-being. I draw on recent evidence indicating that improving work schedules can be good for families, employees, and employers alike. I then suggest two promising directions for public policy: legislating new work-hour standards in low-wage jobs and helping businesses meet them.

Problematic scheduling practices: Serious ramifications, widespread prevalence, and unproductive results

Research tells us that several dimensions of work schedules in today’s jobs—instability, unpredictability, inadequacy, and lack of input—undermine worker health and family economic security. Specifically:

  • Schedule instability and unpredictability make it difficult to fulfill a host of family responsibilities, from arranging childcare and attending parent-teacher conferences to securing benefits through public safety-net programs.118
  • Shortfalls in weekly work hours fuel financial insecurity and distrust in societal institutions, including Congress.119
  • Problematic scheduling practices are more strongly associated with psychological distress, sleep quality, and unhappiness than are low wages.120

These problematic scheduling practices are widespread in today’s labor market, especially among low-paid workers. More than three-quarters of hourly-paid workers in the bottom third of the wage distribution report fluctuations in weekly work hours that average more than a full day of pay.121 Fully 40 percent of hourly workers say that they “know when they will need to work” one week or less in advance, and 1 in 6 know their schedule a day or less in advance.122 What’s more, between 2007 and 2015, involuntary part-time employment increased almost five times faster than voluntary part-time work and about 18 times faster than all work.123 And about half of hourly workers report that they have little or no input into the number or timing of the hours they work.124

Work scheduling problems are multidimensional problems. The most disadvantaged workers experience fluctuating, unpredictable, and scarce hours, determined by their employers. A larger proportion of black than white workers have highly fluctuating work hours at the behest of their employer, not by choice.125 And a larger proportion of low-paid than higher-paid workers, and black than white workers, experience the “triple whammy” of work-hour volatility, short advance notice, plus lack of schedule control.126

Importantly, evidence indicates that scheduling practices that are problematic for employees can also be problematic for employers. The latest research on the operations of retail firms reveals an inverted U-shaped curve between store-level labor flexibility and profit, demonstrating that too much labor flexibility undermines business goals.127 A recent randomized experiment at the U.S. retailer Gap, Inc. finds that improving schedule stability and predictability for hourly sales associates increased labor productivity and store sales, suggesting that improving scheduling practices can yield positive business benefits.128

Policy answers to problematic scheduling practices

Depending solely on employers to improve work schedules voluntarily is risky if policymakers are to improve the quality of jobs and quality of life for all U.S. workers and their families.129 The business models revered by Wall Street emphasize the importance of minimizing the cost of labor in order to maximize returns to shareholders.130 These pressures trickle down to frontline managers who are held accountable for operating within increasingly tight labor budgets.131

Frontline managers adopt practices that allow them to keep their workers’ schedules flexible so they can readily adjust staffing levels to perceived business needs. Key among managers’ labor-flexibility tools are the scheduling practices that create the problems for workers: posting schedules with little advance notice, making last-minute changes, and maintaining a large pool of workers just in case they need more.132 The incentive structures of firms make it difficult for frontline managers to change their scheduling behaviors.

Public policy can shift incentives on the frontlines of firms. Since 2014, one state (Oregon) and six municipalities (San Francisco, Seattle, New York City, Philadelphia, Chicago, and Emeryville, California) have passed comprehensive scheduling laws, and more than a dozen additional cities have legislative initiatives underway. The new regulations are intended to establish universal standards for scheduling hourly employees in targeted industries, primarily in retail, food service, and hospitality, and in large corporations.133

Although the administrative rules vary across municipalities, these laws are coalescing around common provisions that align with the problematic dimensions of work schedules. By addressing multiple dimensions of work schedules, the laws are consistent with social science research indicating a multidimensional approach is needed to accomplish meaningful change. The major provisions included in current legislation and the scheduling dimension each one is intended to improve are compiled in Table 1.

Table 1

Scheduling legislation is designed to preserve flexibility for both employers and employees

One concern of employers is that regulating scheduling practices will impede profitability by limiting their ability to adjust labor to changing demand. But the provisions of the laws place more emphasis on improving schedule predictability rather than schedule stability. This focus on predictability preserves labor flexibility for employers. Notably, even though workers’ schedules are to be posted two weeks in advance of each workweek, these laws do not prohibit employers from making changes to the schedules once they are posted. Instead, the laws require employers to provide a premium—“predictability pay”—to workers when a manager requests a change, commonly an extra hour of pay.

Predictability pay for schedule changes is a risk-sharing approach. It acknowledges that schedule changes create costs for workers such as by disrupting childcare arrangements, school and training schedules, and transportation arrangements. Just as an overtime premium compensates hourly employees for working beyond what is conventionally viewed as a reasonable workweek, predictability pay helps to compensate employees for the adjustments they have to make when accommodating employer requests for flexibility. Predictability pay also provides an incentive to managers to limit schedule changes to those literally worth it to the business.

Of equal concern is that by increasing the cost to employers of schedule changes, scheduling legislation will reduce flexibility for employees. But the predictability premium only pertains to employer-driven schedule changes. The laws do not require that employers pay a premium when employees swap shifts with one another or actively initiate a change, including requesting additional hours or even leaving work early.

And, although it may seem logical that employers may become hesitant to grant an employee’s request for time off out of fear that they will have to provide predictability pay to another employee who works those hours, the administrative rules governing the implementation of current laws outline procedures employers can follow to respond to such employee-driven schedule changes without having to pay a predictability premium. Moreover, the “right to request” and “access to hours” provisions, along with the “right to refuse” to work hours not on the original work schedule, expand employee control over work hours.

In sum, the concern that scheduling legislation will necessarily curtail employer or employee flexibility appears overstated, as does the assumption that low-paid jobs provide substantial flexibility to begin with—more than 50 percent of low-paid hourly workers say they have little or no input into the number or timing of their work hours.134 Nonetheless, such concerns are important and are being addressed in ongoing research on the implementation and effects of current scheduling legislation, described below.

Problematic scheduling practices are often driven by factors under employers’ control

The common view is that schedule instability and unpredictability are driven by factors outside the control of employers, notably variations in consumer demand. But research indicates that much of the variation in employees’ schedules is driven by internal corporate processes, such as the accountability practices discussed above and adjustments to scheduled sales promotions and deliveries rather than by changing consumer demand.135

A telling case in point is data from one store that participated in the Gap scheduling experiment referenced above. Specifically, the data show that although there are certainly peaks and valleys in traffic and overall store labor hours, individual employees’ hours vary much more dramatically. (See Figure 1.)

Figure 1

Each thin line represents a store employee and shows how much an individual employee’s hours diverged from his/her average hours over a six-month period. The thick blue line graphs how much the store’s overall labor hours varied from its mean over the months. And the orange line shows how much customer traffic varied. As is evident, although there are certainly peaks and valleys in traffic and overall store labor hours, individual employees’ hours vary much more dramatically. This and other evidence indicates that there is more stability and predictability already in business that can be passed on to workers by improving basic business and scheduling practices.136

Is scheduling legislation effective?

Given that scheduling legislation is new, so too is research on its effects. To date, state-of-the-art studies conducted in Seattle and Emeryville, California suggest these laws are making a difference in the lives of workers in jobs in retail and food service. By comparing survey responses of retail and food-service employees working in the same firms but in municipalities with and without scheduling legislation, sociologists Kristen Harknett and Véronique Irwin at the University of California, San Francisco and Daniel Schneider at UC Berkeley are able to isolate changes in workers’ scheduling experiences due to Seattle’s Secure Scheduling Ordinance, which became law in 2017. They find that just eight months after the new scheduling law went into effect, the share of covered employees reporting at least 14 days advance notice increased by 20 percent (more than 9 percentage points). The new law also more than doubled the reported receipt of “predictability pay” for schedule changes (a 7 percentage point increase relative to baseline).137 In the second year of the evaluation of Seattle’s scheduling ordinance, Schneider and Harknett will examine the possible effects on employee health and well-being.

In Emeryville, economist Elizabeth Ananat at Columbia University and child development expert Anna Gassman-Pines at Duke University have fielded time-diary studies with mothers of young children that enable them to track the effects of scheduling legislation on parents’ daily well-being. They find that the Emeryville Fair Workweek Ordinance decreased daily instances of schedule unpredictability overall and also reduced last-minute schedule changes. They also find an overall effect on the well-being of working parents, with the law improving subjective reports of sleep quality.138

Research conducted by myself and my colleague Anna Haley at Rutgers University on the implementation of scheduling laws by frontline managers in Seattle, New York City, and Philadelphia indicates that compliance will take time. The laws are complex, and firms and managers are still figuring out strategies of implementation.139 The full effects of the laws may not be realized for some time.

A consistent challenge for managers is complying with requirements for documentation of the scheduling process, especially documenting schedule changes. Even though most covered employers are part of large chains, not all use sophisticated software, and the manager/owners of franchises are often left to develop their own systems. The federal government could help businesses by subsidizing research and development of technology to ease compliance and documentation, facilitating enforcement too.

Is federal legislation a useful next step?

The federal-level Fair Labor Standards Act of 1938 was informed by decades of prior state-level legislation demonstrating that businesses could, in fact, thrive without child labor and testing employer incentives to reduce the punishingly long work hours characteristic of the industrial revolution—what is now our overtime premium. Eight decades later, similar policy innovation at the state and local level to improve the quality of U.S. jobs in the 21st century lays a foundation for federal legislation, providing evidence of the feasibility of changing employer scheduling practices and the consequences for workers, families, and firms of doing so.140

In addition to establishing universal work-hour standards, federal legislation might also lessen implementation challenges. Both corporate representatives and software vendors express a reluctance to change their scheduling and “workforce optimization” technologies, given that administrative rules vary from one city to another.141 Perhaps most importantly, without federal legislation, there is no clear incentive for corporations to change the labor-cost accountability structures that drive these practices.

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Fair work schedules for the U.S. economy and society: What’s reasonable, feasible, and effective

Conclusion

Workers in low-paid hourly jobs often face a constellation of problematic scheduling conditions, among them fluctuating hours, short notice of their work schedules, too few scheduled hours, and little input into when and how much they work. Research is clear that the consequences of these conditions can be grim. Unstable, unpredictable hours over which workers have little control make it difficult to care for loved ones, do well in school, and achieve economic security.

But change is feasible. The best available evidence indicates that it is possible for employers to improve the predictability and stability of employees’ schedules while also meeting business imperatives. Currently, firms’ accountability metrics focus managers’ attention on the instability and unpredictability in business demands, leading managers to discount the substantial stability and predictability that also exists. Scheduling legislation shifts incentive structures and the focus of managers. With the right tools and assistance, managers can learn to identify and deliver greater stability and predictability to workers. The federal government has an opportunity to provide leadership in transforming problematic scheduling practices into fair scheduling standards that will support the vitality of U.S. families and firms.

—Susan Lambert is a professor at the University of Chicago’s School of Social Service Administration.

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Earnings instability and mobility over our working lives: Improving short- and long-term economic well-being for U.S. workers

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Rising inequality in earnings is a fact of the U.S. economic landscape. The rise in earnings inequality has occurred because earnings have become more unstable in the short term, and because the more stable, or permanent, part of earnings has become more unequal in the long term. As permanent earnings have become more unequal, workers find it harder to move up the earnings distribution over their careers.142

Instability in year-to-year earnings, or earnings volatility, can result from economywide trends such as increases in unemployment or decreases in work hours during recessions, or from more microeconomic trends such as changes in the prevalence of precarious work arrangements, job turnover, or bonuses and other types of performance pay.143 Some volatility, such as receiving a large bonus or switching to a higher-paying job, is welcome. Yet an unexpected negative earnings shock can be difficult to manage, especially for low-income workers facing an involuntary or unanticipated decline in earnings.144

Permanent earnings inequality reflects longer-term trends in the U.S. labor market such as changes in the returns to education and other skills, international trade and technological change, changes in unionization, and the value of the minimum wage.145 Growing permanent earnings inequality not only increases persistent disparities in living standards among workers but also is associated with declines in long-run earnings mobility. The result is that an increasing number of workers will have persistently low earnings while other workers will spend large parts of their working lives at the very top of the earnings distribution.146

In this essay, we briefly review what recent research suggests about trends in short-run earnings volatility, permanent earnings inequality, and mobility, as well as the causes of these trends. We then offer a number of policy recommendations that we think will help alleviate some of the negative effects of these recent changes. In particular, we discuss the merits of incentives and reforms to boost household incomes and savings alongside education reforms to help today’s workers find good jobs and our future workers be better prepared early in life to contribute productively over the long term.

What do we know about earnings volatility, permanent earnings inequality, and mobility?

Most evidence shows that year-to-year volatility in men’s wage and salary earnings increased considerably from the 1970s through the early 1980s as inequality increased rapidly.147 Since the 1980s, short-term earnings volatility for men is highly cyclical, increasing during recessions and declining during expansions, though whether the trend is broadly increasing, flat, or decreasing differs between datasets and studies.148

Earnings volatility is the highest for men with less education and with lower earnings—that is, for workers who likely have the hardest time maintaining their well-being during periods of low earnings.149 For women, earnings are more stable than in the past, with falling earnings volatility since the 1970s, though earnings volatility for women is higher than for men.150 Volatility in family income—which includes both wage and salary earnings and other sources of income such as transfers from government programs, including the Earned Income Tax Credit and Supplemental Nutrition Assistance Program—is rising over time, and government transfers are less able to buffer earnings fluctuations than in the past.151

Even ignoring the year-to-year fluctuation in earnings and focusing instead on the more constant part of earnings over a lifetime, permanent earnings inequality is growing rapidly. Much of this increase is driven by an increase in inequality in earnings early in workers’ careers.152 This increase in permanent earnings inequality means that individuals are more “stuck in place” in the earnings distribution throughout their careers, with smaller chances of upward mobility than in the past.153

What are the risks that U.S. workers face?

Workers face two distinct types of risk. Despite the relatively flat trend in short-term earnings instability since the 1990s for all workers, short-term earnings risk remains large and is growing for less-educated and lower-earning workers. Unanticipated declines in earnings are particularly problematic for low-income families and less-educated adults who have little in savings. Only 29 percent of low-income households have savings for unexpected emergencies, and 42 percent of adults with a high school degree or less could not pay their monthly bills if faced with an unexpected $400 expense.154 These workers have limited ability to weather earnings shocks because of the weakening of the public safety net, because low earnings make saving difficult, and because they lack access to formal low-cost credit markets.

At the same time, the vast majority of workers face a new risk: If early-career earnings are low, the likelihood that earnings remain low has increased. Workers with more education are more likely to have high earnings, but even for these workers, the likelihood of rising up through the earnings distribution over a career is declining.

These dual risks necessitate investment in policies that reduce short-run earnings volatility and enhance workers’ ability to cope with temporarily low earnings, particularly for workers with fewer resources, alongside policies to promote careers that provide for long-run upward mobility.

Policy remedies for short-term earnings volatility

Earnings can be volatile because of both positive changes such as end-of-year bonuses, or negative ones such as unexpected cuts in work hours. We focus on policies that address the source and consequences of negative earnings changes, particularly for families who are less likely to be able to adequately weather periods of lower earnings.

Policies to reduce volatility

Outside of employment transitions, we know relatively little about the sources of earnings volatility, which makes articulating policies that reduce volatility difficult. Reducing employment transitions reduces earnings volatility. We focus on policies to reduce earnings volatility from two specific sources—poor health and family caregiving responsibilities—that would be particularly helpful to lower-income families.

The first policy is to increase access to paid leave for workers’ own healthcare needs and for family caregiving. Employees’ access to such leave is more common among high earners than low earners, though eight states, the District of Columbia, and the federal government for its own employees have enacted paid leave policies. Access to paid leave may reduce the instability of earnings for workers who themselves become ill or whose family members (including infants) require care.155

Similarly, access to flexible, low-cost childcare may also promote stable earnings. Such childcare arrangements would provide insurance against unanticipated childcare needs that can disrupt work and would be compatible with the irregular work schedules that are common for low-income workers.156

Policies to help families cope with downward earnings shocks

Because unexpected negative earnings changes are inevitable, families must be able to maintain basic living standards during periods of low earnings.

The Supplemental Nutrition Assistance Program is one of the most effective transfer programs to help all families cope with temporary spells of unemployment or low earnings because benefits through this program can be obtained quickly.157 Eliminating work requirements for this program entirely or establishing a national unemployment trigger in which work requirements would be automatically suspended when unemployment is high would help workers during recessions when short-term earnings volatility spikes.158 Because low-income and less-educated individuals face persistently volatile earnings, policymakers also should increase the value of benefits—for example, by accounting for the time required for food preparation and the geographic variation in food prices—helping those workers who face volatile earnings in both recessionary and expansionary periods.159

Government policies can also help households save to self-insure against short-term earnings losses. A suite of small policy changes would facilitate higher levels of savings for low-income households. First, improving access to banking services for low-income families would encourage saving. Only 17 percent of households without a bank account report saving for unexpected emergencies, compared to more than 55 percent of households who have at least one checking or savings account.160 These expansions must encourage savings vehicles such as no-overdraft accounts to prevent households with low levels of savings from incurring substantial costs from banking.161

Second, we should provide incentives for individuals to save regularly from each paycheck or from lump sum amounts from government transfer programs such as the Earned Income Tax Credit or the child tax credit. Encouraging employers to offer nonretirement savings plans to workers though payroll deductions and for households to receive tax refunds through direct deposit to a bank account would both help encourage saving.162 Ten states and one city have enacted legislation allowing for state-facilitated retirement savings programs, some of which feature autoenrollment, and nonretirement savings plans could follow a similar model.163 Direct deposit of tax refunds from the Earned Income Tax Credit are particularly relevant for low-income families and are large, worth an average of $2,488 in 2018.164

Policy remedies to address long-term inequality and stagnant mobility over our working lives

Policy proposals to decrease long-term inequality and increase long-term economic mobility should help young adults start their careers in strong economic positions. Many of these policies would be cost effective because the costs of the programs are offset by increased tax revenues and decreased transfer payments over the working lives of adults.

These policies start from early childhood. Expanding access to high-quality preschool has been shown to increase educational attainment and to improve income and health in adulthood, particularly for children from low-income families.165 Moreover, these programs have high rates of return: $1 invested in the Perry Preschool program—one of the most successful high-quality preschool interventions for black children with risk factors of failing in school—returned $7 to $12 back to society.166

Promoting college graduation is also important for reducing long-term earnings inequality and increasing long-term earnings mobility. The gap in college completion between individuals from high- and low-income families is growing.167 Because college-educated workers have higher levels of long-term mobility than less-educated workers, and because these workers begin their career at higher points in the earnings distribution and are more likely to stay there throughout their working lives, promoting college completion among children from low-income families is critical.168

There are several policy options to consider. The expansion of Pell Grants, which target low-income college students, is one such policy. Its costs are recouped within 10 years.169 Increasing state funding for community colleges to provide more clear pathways to both associates degrees and four-year colleges would also improve graduation outcomes for low-income students.170

Because much of lifetime earnings inequality is driven by inequality in early-career earnings, and permanent inequality is growing even among college graduates, young adults must start their careers on a solid trajectory.171 Assisting four-year and community colleges to develop programs to teach students how to conduct a job search to find a high-quality first job or to establish explicit pathways to apprenticeships for high-demand careers is another step toward maximizing early-career earnings and improving long-term earnings mobility.172

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Earnings instability and mobility over our working lives: Improving short- and long-term economic well-being for U.S. workers

Conclusion

Workers in the United States face the risks of high short-term earnings volatility for less-educated and lower-income workers, declining rates of mobility, and increasing permanent earnings inequality for most workers. To cope with these risks, workers require a combination of more accessible and robust public safety net programs and incentives to increase private savings to buffer short-term declines in earnings and spells of unemployment, alongside investments in education and pathways to high-quality employment to reduce long-term earnings inequality. Importantly, increases in education and high-quality employment—both of which reduce long-term inequality and increase long-term mobility—also reduce the number of workers with particularly high levels of short-term earnings volatility, thus providing a double benefit to U.S. workers.

—Emily E. Wiemers is an associate professor of public administration and international affairs at the Maxwell School of Citizenship and Public Affairs at Syracuse University. Michael D. Carr is an associate professor in the Department of Economics at University of Massachusetts Boston.

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Policies to strengthen our nation’s Supplemental Nutrition Assistance Program

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Our nation’s Supplemental Nutrition Assistance Program, previously known as food stamps, is a central element of the U.S. social safety net. SNAP is the nation’s primary food support program, providing electronic vouchers that can be used to purchase most foods at participating retail outlets and helping low-income families afford the food that they need.

SNAP reaches a broad range of low-income individuals, including the elderly, disabled, families with children, workers, and the unemployed. During a typical month in 2018, the program helped 40 million people—about 1 out of every 8 Americans—afford the food they need. SNAP is means tested, and eligibility for the program requires that net household income (equal to total income less allowable deductions) be no higher than 100 percent of the poverty line, or about $1,780 per month for a family of three. This benefit is designed to supplement out-of-pocket spending on food, and benefits average about $4 per person per day. The result of this targeting is one of the most important anti-poverty programs in the United States.

A recent National Academy of Sciences report on child poverty finds that the elimination of the program would raise the child poverty rate from 13 percent to 18.2 percent. Only two federal refundable tax credits—the Earned Income Tax Credit and the refundable portion of the Child Tax Credit—are more successful at alleviating child poverty. Further, the report found that this supplemental nutrition assistance is the most effective program at reducing deep child poverty (income below 50 percent of the poverty line). Eliminating it would raise deep child poverty from 2.9 percent to an estimated 5.7 percent.

SNAP caseloads can quickly respond to increased need—for example, during economic downturns or natural disasters—and benefits are quickly spent, generally in the recipient’s community, which also stimulates the local economy. This program increases households’ spending on food, reduces recipients’ likelihood of experiencing food insecurity, and improves economic and health outcomes.173

A key priority of the next US. Congress and administration in 2021 should be to preserve this important program and to enact policies that enhance its impacts on the macroeconomy and on children. This essay examines currently proposed changes to key policy components of the Supplemental Nutrition Assistance Program—its broad-based eligibility category, its “public charge” criteria for legal immigrants, and conditions under which work requirements are waived—and then offers ways to strengthen the program’s ability to protect young children by increasing SNAP benefits to their families, as well as enhance its recession-fighting power.

Preserve work supports built into the Supplemental Nutrition Assistance Program

An increasing share of SNAP participants are low-wage working families, reflecting our nation’s recent shift toward a work-based safety net for those who are not elderly. Today, about 80 percent of the federal safety net spending on families with children goes to working families, compared to about a third in 1990.174 Per-child spending directed to nonworking families decreased in real terms by 20 percent over this period.175

But two recent policy changes by the Trump administration make it harder for many working families to receive SNAP benefits. First, the administration proposes to eliminate the program’s broad-based category eligibility, which allows families with total incomes above 130 percent of poverty to participate if they have certain characteristics, such as high expenses for housing or childcare, or if the earned-income deduction in the SNAP formula gives them eligibility (they must still meet the net income test whereby net income is below 100 percent of the poverty line). The overwhelming majority of benefits paid under this broad-based eligibility go to households with total incomes between 131 percent and 150 percent of the poverty line. This category also allows the program itself to be more efficient by waiving the requirement to collect detailed information on a household’s assets. Most SNAP participants have no or very low levels of assets, and documenting this for every case is costly to families that must provide documentation, as well as states that must collect it.

Families that include employed, elderly, or disabled family members are disproportionately represented among families receiving supplemental nutrition assistance through the broad-based category eligibility. The Trump administration’s proposed elimination of broad-based eligibility introduces a sharp cliff in benefits that may act to discourage these SNAP participants from working, which would hurt working families. States’ option to adopt broad-based category eligibility should be reinstated.

Second, the Trump administration has proposed changes to the public charge rule, a long-standing administrative rule that determines whether to confer citizenship to an immigrant, with one factor for consideration being whether the applicant is likely to become a “public charge” of the state. Recently, the Trump administration announced a change to the interpretation of this public charge rule, which will make it difficult for members of families of documented immigrants who receive SNAP benefits to obtain citizenship. This rule provides strong incentives for documented immigrants who are eligible for supplemental nutrition assistance to not participate in the program and other safety net benefit programs. Immigrant households make up a small share (only 6 percent) of the total SNAP caseload, yet the program provides an important source of supplemental food benefits to these families, many of which also include U.S. citizen children. Households that tap nutrition assistance often have immigrant members who are more likely to be employed than U.S. citizens who avail themselves of the program.

Removing documented immigrant families from the Supplemental Nutrition Assistance Program will cause harm to these families and to their local economies, as we note below. This proposed “public charge” categorization is grossly out of line with the modern realities of SNAP and related social safety net programs. Today, a large share of social benefits spending goes to support working families who need an extra boost to afford the food and medical care that they need, due to market realities such as stagnant wages and instability in employment and hours. The radical reforms proposed by the Trump administration that define anyone who is likely to use even modest amounts of SNAP benefits temporarily as a “public charge” should be rejected.

Supplemental nutrition assistance helps stimulate the economy

SNAP is an effective “automatic stabilizer” that responds quickly at times, in places, and for individuals experiencing the effects of periodic economic downturns.176 At the depths of the Great Recession of 2007–2009, 15 percent of Americans received benefits from the program. At the time, Congress authorized a temporary increase in maximum benefits, which was a very effective fiscal stimulus—every dollar in new SNAP benefits during this period was estimated to spur $1.74 in economic activity.177 We have elsewhere argued in more detail that temporary reforms to SNAP during the Great Recession were highly effective at increasing family well-being and fiscal stimulus.178

Learning from this experience, the next Congress and administration should implement two automatic-stabilizer reforms that would automatically kick in when an economic downturn occurs. Both would be triggered when the national unemployment rate rises at least 0.5 percentage points above its low in the prior 12 months, according to the so-called Sahm rule, developed by Claudia Sahm, former chief of the Consumer and Community Development Research Section at the Federal Reserve in Washington, D.C.179 (Sahm is now Director of Macroeconomic Policy at Equitable Growth.) First, maximum SNAP benefits should be automatically increased by 15 percent. Second, existing SNAP work requirements would automatically be waived by the U.S. Department of Agriculture when the Sahm rule indicates that a recession has begun. Automatic waivers at the beginning of a recession will quickly help alleviate hardship and stimulate the economy without costly delays. Note that this stands in contrast to the Trump Administration’s recent final rule on work requirement waivers to SNAP, which makes it more difficult for areas to qualify for waivers even when unemployment is increasing.180

Strengthen the protection of young children and intergenerational benefits

An increasing base of evidence demonstrates that children’s access to adequate resources in early life improves later-life health and economic outcomes.181 In particular, research by the two authors of this essay and another colleague used a variation in the original introduction of SNAP across counties to estimate the impact of having access to the program from conception through age 5.182 We found that access to food stamps before age 5 leads to large and statistically significant reductions in the subsequent adult incidence of “metabolic syndrome” (obesity, high blood pressure, heart disease, diabetes).

In addition, our research found that access to food stamps in early childhood for women (but not for men) leads to an increase in economic self-sufficiency. Our measure included current earnings and family income, and indicator variables for whether the individual graduated from high school, is currently employed, is currently not living in poverty, and is not participating in the Temporary Assistance for Needy Families program or SNAP. The effects were largest among those children who had access at the youngest ages and among those who spent their childhoods in the most disadvantaged counties.

More recent research extends our work and finds that early life access to SNAP benefits leads to improvements in long-term earnings and education, reductions in mortality, as well as a reduction in incarceration among black men.183 And other research finds that access to the program between conception and age 5 improves the child’s parent-reported health in later childhood, measured at ages 6 to 16 (with suggestive evidence of reductions in school days missed, doctors’ visits, and hospitalizations at ages 6 to 16).184

Despite the evidence on the importance of resources during early childhood, young children in the United States face high rates of poverty: 13 percent of children overall, 18 percent of black children, and 22 percent of Hispanic children live in families with income below the poverty line.185 Some straightforward changes to SNAP would yield a double dividend by reducing poverty for families with young children and improving the children’s life trajectories.

To address the unmet needs of families with young children, we propose introducing a “young child multiplier” that would increase maximum SNAP benefits by 20 percent for households with children between ages 0 and 5. For any family with a qualifying child in the household, the maximum benefit will be multiplied by 1.2, then the family’s benefits would be calculated according to the standard benefit formula for deductions and net income calculations.

Although SNAP is a universal program with no additional targeting besides income and asset criteria, it nonetheless serves a large number of young children and would be an effective lever for increasing resources in families with young children. As of 2017, more than one in five households receiving these benefits has a young child (aged 0 to 5), and 12.9 percent of all individuals receiving these benefits are young children. Of the $60.6 billion spent by the federal government to provide SNAP benefits in 2018, about $24 billion (40 percent of the total) went to families with young children.

A strength of the Supplemental Nutrition Assistance Program, compared to other programs such as the Earned income Tax Credit, is that SNAP benefits are paid monthly and can be incorporated into a household’s regular expenses on an ongoing basis. We estimate the annual cost of the young child multiplier to be $6.5 billion. This would serve as a supplement to the current Women, Infants and Children, or WIC, social benefit program that already targets low-income families with young children. Paying additional benefits through the Supplemental Nutrition Assistance Program would be more efficient and effective than expanding WIC for several reasons. First, SNAP benefits are more flexible than WIC benefits and are expected to have a stronger protective effect on other aspects of a family’s financial well-being. Furthermore, the WIC program is hampered by low participation rates among families with children—the participation rate drops from 35 percent of 1-year-olds to only 15 percent of 4-year-olds, while SNAP participation rates are relatively high, estimated at 85 percent in 2016186 and steady across these ages.187

Continue the progress of increasing take-up rates for SNAP benefits

Like any safety net program, for SNAP to be effective, it must reach those who need it. Participation rates have been steadily increasing in recent years, up from a low of 53 percent in 2001. Despite this progress, high take-up rates are not universal. There is substantial variation in take-up rates across states—from 72 percent in California and 73 percent in Texas, to near 100 percent in Illinois, Oregon, and Michigan.188 Participation rates are lower for the elderly and for those with lower expected benefit levels, such as eligible households with income above the poverty threshold.

Recent work shows that providing information on eligibility or information plus application assistance can meaningfully increase these rates for the elderly.189 Other work shows that regular recertification periods contribute to incomplete take-up.190 Overall, we need more experimentation and attention to maintaining and increasing SNAP participation.

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Policies to strengthen our nation’s Supplemental Nutrition Assistance Program

Conclusion

The Supplemental Nutrition Assistance Program has been effective and efficient, providing food benefits to a wide range of needy individuals and families that, in turn, purchase the foods they desire from local food retailers. The next Congress and administration should repair the damage done to the program by recent rulemaking in the Trump era, reversing the rule changes for eligibility and public charge determinations for legal immigrants, and preserving the ability to appropriately waive work requirements during economic downturns. And policymakers should strengthen the program’s ability to protect young children by increasing SNAP benefits to their families, as well as enhance its recession-fighting power. Each proposal would be a well-targeted incremental reform that would strengthen the program to better serve U.S. families.

—Hilary Hoynes is the Haas Distinguished Chair in Economic Disparities at the Richard and Rhoda Goldman School of Public Policy at the University of California, Berkeley. Diane Whitmore Schanzenbach is the Margaret Walker Alexander Professor of Education and Social Policy at Northwestern University, where she also directs the Institute for Policy Research.

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A modest tax reform proposal to roll back federal tax policy to 1997

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

The fiscal position of the United States was much healthier in the late 1990s than it is today. The federal government now collects 3 percent less of Gross Domestic Product than it did two decades ago, yet the nation faces a number of pressing needs for new spending, including on infrastructure, research and development, education, and healthcare. This essay draws on new research to present a modest proposal to address this problem: roll back federal tax policy to 1997.

We propose a set of reforms to the individual income tax and estate tax, with particular attention to the tax treatment of “pass-through” income—profits from certain types of businesses that, for tax purposes, pass through to individual owners who then pay income tax on those profits. These reforms would raise revenues by $5 trillion over the next decade and reduce after-tax income inequality.

In terms of tax revenues, it’s important to recognize that pass-through firms generate more taxable income than traditional C corporations, so the tax treatment of these business entities and their owners is key. Higher tax rates on individual income and these reforms for pass-through taxation represent important steps for taxing substantial amounts of income.

Top incomes and U.S. tax policy

The rise in income inequality over the past several decades presents a natural place for federal policymakers to start to raise revenue. The rise of top incomes since the mid-1990s coincided with a series of changes to tax policy that reduced top tax burdens and contributed to rising federal budget deficits. These revenue reductions include the 2001 income tax cuts, the 2003 dividend tax cut, the 2001 estate tax cuts, and the reduction in capital gains taxes in 1997 and again in the early 2000s.

More recently, changes include the permanent extension of part of the 2001 income tax cuts and the personal and business income cuts in the 2017 tax law. While there were modest increases in income taxes in 2013, the net effect over the past 25 years of federal income tax policy has been to reduce the overall revenue collected from top earners. (See Figure 1.)

Figure 1

Our research seeks to characterize the nature of top income inequality and understand the drivers of its recent rise. Within the base of taxable income, nearly half of the rise since 1980 in the top 1 percent of income share comes from pass-through businesses, which includes the ordinary income earned by partners in partnerships and the profits of S corporation owners.191 While this income is taxed as business profits, its underlying nature more closely reflects the labor income of the business owners.192

We highlight three implications of these findings. First, policymakers need to look at income beyond wage income to understand top incomes and how to tax them. More than sixty cents of every dollar of income for top earners comes from nonwage sources. (See Figure 2.)

Figure 2

Second, the data reveal a striking world of business owners who prevail at the top of the income distribution. Most top earners are pass-through business owners—a group that encompasses consultants, lawyers, doctors, and owners of large nonpublicly traded businesses such as autodealers and beverage distributors. More than 69 percent of the top 1 percent of income earners and more than 84 percent of the top 0.1 percent of income earners accrued some pass-through business income in 2014, the most recent year for which complete data are available.193

In 2014, in absolute terms, that amounts to more than 1.1 million pass-through owners with annual incomes of more than $390,000, and 140,000 pass-through owners with annual incomes of more than $1.6 million. In both number and aggregate income, these groups far surpass that of top public company executives, who have been the focus of much inequality commentary. (See Figure 3.)

Figure 3

Third, policymakers need to take seriously the nebulous boundary between labor and capital income, especially among business owners who can flexibly characterize their income to minimize taxes. Politicians in both parties, for example, have successfully lowered their taxes through the so-called Gingrich-Edwards loophole, named after former Speaker of the House Newt Gingrich (R-GA) and former Sen. John Edwards (D-NC), which involves characterizing compensation for consulting and speaking fees as business profits rather than wages.

Our tax reform proposal

The growth of pass-through businesses in recent decades and the concentration of ownership make the taxation of pass-throughs a central element of reform. While we believe that reforming the broader corporate tax system is important, detailing reforms to the corporate tax system is beyond the scope of this proposal. In terms of tax revenues, however, it’s important to recognize that pass-through firms generate more taxable income than traditional C corporations.194

The tax treatment of these pass-through business entities and their owners is a critical part of reform. Higher tax rates on individual income and these reforms for pass-through taxation represent important steps for taxing substantial amounts of income. Rolling back tax policy to 1997 entails reforms in four main areas: marginal income tax rates, business income taxes, taxes on dividends and capital gains, and estate taxes. Let’s consider each one in turn.

Marginal income tax rates

We propose returning the personal tax rate and bracket structure, adjusted for inflation, to where it was in January 1997. For married couples, taxes would amount to 36 cents instead of 24 cents of their 300,001st dollar. For those making $500,000, marginal rates would increase to 39.6 percent from 35 percent.

These changes will raise average tax rates on top incomes considerably. Rolling back the 2001 and 2017 income tax cuts would also entail modest increases throughout the income distribution. Under our proposal, a tax credit similar to the Making Work Pay tax credit from the 2009 Recovery Act would offset tax increases for low- and middle-class earners in a targeted way. Figure 4 shows how this change (without the Making Work Pay credit) would affect marginal tax rates relative to the 2016 and 2019 tax rate schedules.

Figure 4

Business income taxes

We propose removing the active business income exclusion from the net investment income tax and repealing the recently enacted deduction for people who receive income from pass-through businesses. These provisions offer lower tax rates on income from some pass-through firms. These changes will increase taxes on private business owners who prevail at the top of the income distribution and ensure parity in the tax rates between people who receive income in different forms.

We also propose taxing nonpublicly listed C corporations at the top personal income tax rate rather than the otherwise applicable corporate rate of 21 percent. This change would prevent entrepreneurs from using retained earnings and deferral as a strategy for avoiding higher income tax rates.

Dividends and capital gains

We propose returning the dividend and capital gains tax rates to their 1997 levels. This change would increase the top federal tax rate to 39.6 percent from 20 percent for the recipients of most taxable dividends. For capital gains, this change would bring maximum long-term capital gains tax rates back to 28 percent from 20 percent today.

We also propose extending the time horizon for preferential capital gains rates to 10 years to treat more carried-interest compensation as wage income while preserving incentives for long-term investment. Dividends, and especially capital gains realizations, are quite concentrated at the top of the income distribution. In recent years, more than 50 percent of taxable dividends and 80 percent of capital gains realizations have gone to the top 1 percent of income earners.195 These changes will increase taxes at the top of the income distribution.

Estate taxes

We propose unwinding the 2001 and 2017 reductions in estate and gift taxation by returning to a 55 percent top rate and setting a $1 million effective exemption. We also propose eliminating the so-called step up in basis at death, a policy that exempts from income tax any capital gains on assets held by a taxpayer at death.

Our proposal also treats charitable contributions and gifts as realization events, meaning that taxes would be due on any unrealized capital gains at that time. Reinvigorating the estate tax should also be paired with careful steps to curtail abusive private business valuations.196 These changes will help reduce wealth concentration, raise revenue, and increase the fairness of the tax system.

Revenue and distribution analysis

Our proposal would raise $5.1 trillion over the next 10 years, according to the Penn Wharton Budget Model. The largest contributors to this increase are $1.8 trillion from the increase in tax rates on ordinary income net of the Making Work Pay credit, $1.7 trillion from taxing privately held C corporations as pass-throughs, and $0.6 trillion from increasing taxes on capital gains and dividends. Without the Making Work Pay Credit, the other changes raise $6.9 trillion, with the increase in tax rates on ordinary income accounting for $3.6 trillion instead of $1.8 trillion. (See Table 1.)

Table 1

Most of the revenues from our proposal come from the top of the income distribution. Specifically, the top 10 percent, 5 percent, 1 percent, and 0.1 percent account for 83 percent, 70 percent, 46 percent, and 23 percent of the increase, respectively. The average after-tax income of the top 0.1 percent, whose average pretax income is $2.1 million, would fall by 14 percent, or $220,000. The average after-tax income of the fourth quintile, whose average pretax income is $98,000, would fall by 2.5 percent, or $2,000. In contrast, the bottom three quintiles do not face tax increases due to the Making Work Pay credit. The estimates highlight the extent to which the changes since 1997 have been concentrated at the top. (See Table 2.)

Table 2

Addressing potential criticisms

In 1997, tax revenue was 3 percent higher as a share of GDP. Top federal rates were approximately 40 percent, tax rates on labor and capital income for entrepreneurs were more closely aligned, and the tax base was broader. The subsequent evolution in pass-through income has raised the stakes in how we tax nonwage income, especially for closely held firms. Our proposal would directly address this development in aligning the taxation of private C corporations with pass-through businesses.

One might criticize this proposal for jeopardizing economic growth. Recent research, however, about the growth effects of taxing top incomes suggests this criticism is overstated. In response to the dividend tax cut of 2003—one of the exact policies we propose to roll back—economist Danny Yagan at the University of California, Berkeley finds a large increase in payout and no change in investment in a large sample of private firms, whose ownership likely skews toward top incomes.197

One of the co-authors of this essay finds that tax changes of the magnitude seen in the post-World War II period for top earners have small impacts on employment growth.198 These findings suggest returning to modestly higher top income tax rates and to a dividend tax closer to the personal rate will have small effects on investment and growth. Indeed, estimates of this plan prepared by the Penn Wharton Budget Model suggest it would have no discernable impact on growth in the first two decades but ultimately would increase growth by 2050.

While some critics may cite large taxable income elasticities as evidence for large distortions, Matthew Smith at the U.S. Department of the Treasury, UC Berkeley’s Yagan, and the two co-authors of this essay document a large shifting response to the difference between top entrepreneurial income treated as wages versus that treated as profits.199 Prior to the 2017 tax reform, the tax-preferred form was pass-through profits because this form benefited from lower social insurance and passive investment income tax.

Because much of this income is better thought of as reflecting human capital, the literature documenting small labor-supply responses to income taxes applies to most pass-through income as well. Proposals that align tax rates on different income sources receive additional support in the literature that finds large reporting responses to tax changes.

A second criticism is that this proposal is modest. Indeed it is! We view it as a point of departure for tax reform and are sympathetic to additional steps that focus on top incomes and enforcement. We view our approach as complementary to more ambitious revenue-raising proposals, such as a national value-added tax, a carbon tax, and a wealth tax.

—Owen Zidar is an associate professor of economics and public affairs at Princeton University. Eric Zwick is an associate professor of finance at the University of Chicago’s Booth School of Business.

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Good U.S. monetary policy can’t fix bad U.S. fiscal policy

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

In August 2018, Federal Reserve Chair Jerome Powell gave a speech in which he explained the macroeconomic “stars” that guide monetary policy.200 The three stars are the values for the unemployment rate (u), inflation (π), and the short-term interest rate (r), which together are consistent with long-run macroeconomic equilibrium. These three equilibrium variables are generally written with “stars”—as in u*, π*, and r*—in the mathematical representation of the New Keynesian macroeconomic models used by macroeconomists to discern the direction of economic activities. Powell stated in his speech that the stars were all aligned, with the exception that the Fed probably needed to continue gradually raising the federal funds rate, as in previous expansions.

U.S. stock markets became rattled shortly after Powell’s speech because the Fed continued to signal that it intended to move gradually to “normalize” (meaning raise) interest rates over the next few years. The steep decline in stock prices in October 2018 led to a change of tone by Fed officials by the end of 2018. Fed officials at first suggested there might be no need for future interest rate increases, and then completely switched direction and cut the target range for the federal funds rate by 50 basis points in 2019, from 2.25–2.5 to 1.75–2.0.

Many academic economists and other voices across the political spectrum argued that the Fed simply misjudged the value of r* (the equilibrium short-term interest rate, which in this essay will be used interchangeably) in recent years. John C. Williams, president of the New York Fed and vice chair of the Federal Open Market Committee, has long advanced the idea that r* has declined in recent decades.201 Williams is certainly not alone, with voices from both ends of the political spectrum arguing that maintaining low interest rates is crucial for continued economic expansion.202

In terms of the macroeconomic stars invoked by Fed Chairman Powell, there is widespread agreement that the U.S. economy today seems to be at or near full employment (u=u* in mathematical parlance) and that inflation is not rising (π ≤ π*). Therefore, higher interest rates would only do harm to an otherwise well-functioning economy. In contrast, fiscal policy (government revenues and spending) is holding back the U.S. economy because needed government investments in human capital, scientific research, or infrastructure are not happening.

This is the conundrum facing the monetary policymakers at the Fed. Lowering its benchmark federal funds rate will increase asset valuations and provide some economic stimulus, but without boosting potential long-run economic growth. The Fed may have little choice because fiscal policymakers, most of whom remain mistakenly fixated on rising government spending rather than on falling government revenue, will not support the government investments needed to boost long-term economic growth and prosperity. Should a recession occur, as one eventually will, Fed efforts to boost growth by lowering the short-term interest rate will be ineffective. Thus, in the event of a downturn, fiscal policymakers may once again be forced by events to provide short-term stimulus spending, but they will likely again fail to make the real investments necessary to boost long-run growth.

In this essay, I examine why a falling r* matters to the Fed, how lower interest rates increase asset valuations in the economy without boosting necessary investments, and then why fiscal policy has to change by recognizing that it is not rising government budget deficits that are a danger to future U.S. economic growth but rather falling government revenues. In short, I argue that appropriate monetary and fiscal policies in tandem will boost the income of the many—not just the value of assets owned by the few—to create the macroeconomic conditions most suitable for sustained and road-based economic growth.

Why has r* fallen, and why does it matter?

There is an active academic literature about a declining equilibrium short-term interest rate ( r* ) and the implications for Fed policy.203 The research on why r* has fallen mostly focuses on two key determinants: productivity growth and an aging population. Through the lens of New Keynesian macroeconomic models, when productivity growth slows, the demand for investment falls, and when populations age, the supply of saving rises. Declining demand for borrowed funds along with an increasing supply of saving pushes r* down.

Accepting the proposition that r* has fallen does not mean the crucial monetary policy questions are all resolved. When r* is low, for example, monetary policymakers have to be more concerned about limits on nominal interest rates. The real interest rate—the nominal rate minus inflation—is what impacts real behavior in New Keynesian models. So, if inflation and real interest rates are both low when the economy is expanding, then there is little room for monetary policymakers to cut real rates in the event of a downturn, because zero is a natural lower bound on nominal rates.204

A second practical issue associated with lower r* is that the return to risk-free savings is reduced. Low risk-free rates of return are most important for securing retirement incomes for both individual savers and institutional funds with guaranteed pension benefits and other forms of annuities. Savers are forced to accept greater risks in order to get positive financial returns in a world with low r* or to compensate for low returns in some other way, such as saving even more.

One potential benefit in a low-r* economy is that the cost of borrowing is also lower, but that assumes the risk premium—the wedge between private and government borrowing costs—remains stable. Unfortunately, risk premia are not stable, and large increases in risk premia are generally associated with the end of an economic expansion. At the end of an expansion, investors become worried that growth will slow, and thus borrowers will have difficulty repaying their debts. Lenders are willing to supply less in the way of new loans to businesses and consumers at any given interest rate. Even if the Fed can lower the risk-free interest rate, movements in the actual cost of borrowing for businesses and consumers will depend on what is happening with risk premia.

Movements in risk premia and other economic fundamentals affecting r* point to a broader set of questions connecting risk, return, and asset values. In particular, the value of corporate stock is the discounted present value of the future profits the corporation is expected to earn. For a given stream of expected profits and a given risk premium to compensate for the uncertainty of those profits, a lower r* increases the value of a share of stock.205 If the owners of the corporation can borrow to fund their operations more cheaply, then their profits will be higher, everything else equal.

What can the current level of U.S. stock markets tell us about r* and other economic fundamentals? The famous value investor Warren Buffet has long advocated the following measure of stock market valuation: Add up all outstanding shares of corporate stock at current market values and divide by the size of the overall economy. A high ratio of stock market valuation to Gross Domestic Product indicates an overvalued market. At the end of 2018. the so-called Buffett Ratio was near the recent historical high that had occurred before the crash of 2000, and, in general, the ratio has been higher and much more volatile in recent decades. (See Figure 1.)

Figure 1

One possible explanation for a higher Buffett Ratio is more corporate investment, which will happen if people save more and capital markets convert that additional saving into real investment. Yet the other line in Figure 1 shows that accumulated investment in nonresidential capital stock relative to GDP has been stable. This means the level of interest rates and stock market valuations are not associated with greater real investments in the U.S. economy.

The share of national income going to corporate profits can also push up the Buffett Ratio because a higher profit share means the expected level of profits is higher. The ratio of measured corporate profits to GDP, however, cannot explain the increasing Buffett Ratio either, because there has been no corresponding increase in the corporate profits share.206

All of this evidence suggests that current stock market values are being maintained at historically high levels by the combination of low risk-free interest rates and low-risk premia. This ties the hands of the Fed because maintaining high asset-valuation ratios becomes essential for sustaining aggregate demand. Asset owners are willing to borrow, spend, and invest in productive capital when they feel wealthier. But if risk premia rise and asset values fall, then the resulting decreases in asset values will have disproportionate negative effects on spending and investment.207

Is U.S. monetary policy constrained by bad U.S. fiscal policy?

Evidence about asset valuation and asset price volatility suggests that describing economic fluctuations in terms of deviations from a New Keynesian equilibrium that ignores the risk premium is at best incomplete. The now-widespread belief that the Fed should simply acknowledge that r* has fallen goes hand in hand with accepting the inherent risk of keeping the economy growing by boosting the values of assets owned by the few, rather than boosting the incomes earned by the many.

This is where better fiscal policy becomes important. Although targeting a lower r* may be the best monetary policy given current fiscal policy, it is possible to change fiscal policy in ways that address the underlying reasons for declining r*. Better fiscal policy would make it possible for the Fed to conduct better monetary policy, meaning the Fed could achieve full employment and stable inflation—the U.S. central bank’s “dual mandate”—without the inherent financial market valuation issues and instability associated with a low r* equilibrium.

Examining the composition of federal spending and the composition of federal revenues relative to GDP can provide a high-level perspective on fiscal policy over the past 50 years. The data clearly reject the narrative that increased government spending is the primary reason for rising government deficits in recent years. Total spending, at about 20 percent of GDP in 2018, is close to its 50-year average. (See Figure 2.)

Figure 2

In contrast, total federal revenue relative to GDP is well below its 50-year average. (See Figure 3.)

Figure 3

A closer look at the composition of spending in Figure 2 cuts further against the narrative about rising government spending. The component of spending associated with direct government intervention in the real economy—nondefense discretionary spending—has fallen as a share of GDP in recent decades. The fastest growing categories of outlays are for programs such as Social Security, Medicare, and Medicaid, all of which are government programs generally financed by payroll taxes on the same group of low- and moderate-wage earners who also are the beneficiaries of these programs. The increase in payroll taxes used to fund these programs is evident in Figure 3. Thus, another crucial takeaway from this high-level perspective is that the overall decline in total revenues relative to GDP is because corporate, estate, gift, and income taxes have fallen even more than payroll taxes have increased.

Most analysis of fiscal policy focuses on the economic effect of deficits, without regard for why the deficits were created. The trends in the composition of spending and revenue shown above are suggestive that all deficits are not created equal. A deficit created by increased nondefense discretionary spending focused on investment in human capital, scientific research, or infrastructure has positive effects on aggregate demand and boosts productivity. Such policies have the potential to reverse the downward pressure on r*.

A deficit generated by reducing taxes on capital incomes, in contrast, has only short-run effects on aggregate demand, mostly through increased asset prices. Indeed, the effect of such fiscal policies is to reinforce a low-r* equilibrium because the after-tax return from owning stock is higher, and thus standard asset-valuation models tell us the stock should be worth more. Yet experience with those sorts of policies over the past two decades shows they do not lead to the sorts of investments that will make the U.S. economy grow and help alleviate the downward pressure on r*.208

The recent history of fiscal and monetary policies suggests that bad fiscal policy and constrained monetary policy have increasingly reinforced each other in recent decades, contributing to a slowdown in overall U.S. economic growth alongside rising income and wealth inequality and financial instability. Fiscal policymakers have abdicated their responsibility to make the investments in people, technology, and infrastructure that private investors cannot and will not make.

The good news is that a continued slowdown in economic growth and lower r* is not inevitable. Understanding how to reverse the decline in r* just involves a deeper understanding of the proper role of government in today’s economy.

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Good U.S monetary policy can’t fix bad U.S. fiscal policy

Policies for the next Congress and administration

Bad fiscal policy has increasingly constrained monetary policy, and thus the first set of policies to embrace involve rethinking government intervention more broadly. On the spending side, the federal government needs to step up and identify areas where more investment is warranted in human capital, science and technology, and infrastructure. Federal investment in these areas will not be displacing private investments because those investments are simply not happening now. These sorts of investments will increase productivity growth, providing a direct offset to the otherwise-declining r*.

Increasing government investment may involve deficit spending in the short run, thus the second policy recommendation is to transform the way policymakers and the public think about spending and taxes. When a private citizen makes an investment, the payoff is in the form of profits, dividends, or interest. When government makes an investment, the fiscal payoff is in the form of higher taxes on the additional income that is generated. Most of the policy discussion about taxes involves the negative consequences of taxing some positive outcomes, but policymakers need to remember that those positive outcomes are, sometimes in large part, the payoff on public investment. Our tax system is increasingly allowing those who have benefitted the most from public investments in science and technology to pay less in taxes.

Although better fiscal policy is the key to better monetary policy, there are some monetary policy principles the Fed can and should embrace if economic conditions deteriorate. Economic shocks generally involve both financial effects and real effects in the economy, with the wealthy experiencing declines in their net worth but the less wealthy experiencing job losses. In the past, the Fed has focused on propping up the financial system—for example, bailing out mortgage lenders but not mortgage borrowers. The Fed needs to expand their policy purview if the fiscal authorities won’t act in the interests of all the people, and make sure the next round of Quantitative Easing—Fed speak for the central bank’s purchase of financial securities in the marketplace to boost liquidity in the economy—or other extraordinary monetary policy actions do not simply rescue those who benefitted from the mistakes that led to problems in the first place.

—John Sabelhaus is a visiting scholar at the Washington Center for Equitable Growth. Previously, from 2011 to mid-2019, he was assistant director in the Division of Research and Statistics at the Board of Governors of the Federal Reserve System, and prior to that, his roles at the Federal Reserve Board included oversight of the Microeconomic Surveys and Household and Business Spending sections, including primary responsibility for the Survey of Consumer Finances.

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Fighting the next recession in the United States with law and regulation, not just fiscal and monetary policies

Posted on by Maria Monroe

This essay is part of Vision 2020: Evidence for a stronger economy, a compilation of 21 essays presenting innovative, evidence-based, and concrete ideas to shape the 2020 policy debate. The authors in the new book include preeminent economists, political scientists, and sociologists who use cutting-edge research methods to answer some of the thorniest economic questions facing policymakers today. 

To read more about the Vision 2020 book and download the full collection of essays, click here.

Overview

Is the United States ready for the next recession? According to many experts, the answer is no.209 Our nation’s primary recession-fighting tools—monetary stimulus by the Federal Reserve and fiscal stimulus by Congress—appear hamstrung. New policy options are desperately needed. In this essay, I outline what I call countercyclical regulatory policy as a new macroeconomic policy option. Like monetary and fiscal policy, regulatory policy affects total spending in the U.S. economy. Regulatory actions that encourage banks to lend, firms to invest, and consumers to spend can increase demand and reduce unemployment when the next recession hits—even if (as is likely) monetary and fiscal stimulus falter.

In the next recession, the Fed will be constrained in its ability to reduce interest rates to stimulate investment and consumption spending and lower unemployment. Today’s historically low rates leave the Fed little space to stimulate the economy by lowering interest rates before they hit their effective lower bound around zero. Interest rates cannot go deeply into negative territory because savers will hoard cash or prepay taxes rather than accept a negative return.210

When monetary policy is constrained during a recession, the textbook macroeconomic policy response is fiscal stimulus.211 Increases in government spending and decreases in taxes raise total spending—also known as aggregate demand—to offset the weakness in spending causing the recession. Yet partisan gridlock and fears about excessive deficits during the most recent economic downturn, the Great Recession of 2007–2009, caused the size of fiscal stimulus passed by Congress in 2009 to fall well short of what was needed to effectively relieve unemployment.212 Because partisan gridlock is, if anything, worse than a decade ago and public debt as a percentage of Gross Domestic Product has increased since 2009, we cannot depend on fiscal stimulus during the next recession.

As I explain in my latest book, Law and Macroeconomics: Legal Remedies to Recessions,213 law and regulation offer a wide variety of stimulus options in recessions across many parts of the U.S. economy. Many federal regulatory program affect the business cycle. Regulatory options are not subject to the constraints of monetary and fiscal policy. If regulators and administrators systematically favor policies promoting spending and employment in recessions, then they could collectively have an important stimulating effect on the U.S. economy. At the very least, these proposed countercyclical regulatory policy options could avoid the unintentionally pro-cyclical effects of many current laws and regulations.

What is countercyclical regulatory policy?

Countercyclical regulatory policy directs regulators to apply a rule that promotes spending during recessions and a different and more restrictive rule during periods of robust economic growth. In financial regulation, conventional wisdom favors countercyclical regulatory policy. The Basel III accords—a set of international standards of bank regulation—highlight the value of “countercyclical capital buffers,” which apply a relatively strict regulatory regime to financial institutions in good times and a more lenient one during recessions.214

Unfortunately, U.S. financial regulators have been reluctant to implement countercyclical rules in practice.215 With countercyclical monetary and fiscal policy constrained, the next administration should appoint financial regulators more willing to implement countercyclical financial regulation as a means of avoiding lending bubbles during the next boom and stimulating the economy in the next recession.

The logic of countercyclical regulation does not apply to financial regulation alone. It should apply to every regulatory regime that affects aggregate demand and unemployment, among them energy, housing, and utility regulation.

Using permits and mandates as countercyclical regulatory policy tools

Many investment projects require approval from federal regulators. The federal Bureau of Ocean Energy Management, for example, reviews applications for the construction of offshore wind turbines.216 Federal regulations grant this agency within the U.S. Department of the Interior considerable discretion over applications, authorizing rejection of projects that cause “undue harm” to other interests.217

Outside of recessions, decisions made by the Bureau of Ocean Energy Management have relatively little effect on unemployment. If unemployment is already low, then the approval of a new wind turbine project is unlikely to significantly reduce unemployment or increase investment. Instead, project approval shifts workers and capital from other uses to offshore wind turbine construction. During recessions, however, many workers are unemployed and capital lies dormant. If the agency approves an outstanding offshore turbine application during a recession that it might not have approved otherwise, then investment spending increases and unemployment decreases. Regulatory policy can stimulate the economy.

Of course, the business cycle should not be the sole determinant of regulatory decisions during recessions. The Bureau of Ocean Energy Management must still determine whether the project causes “undue harm” to other interests. Because of the stimulus value of a new investment project during a recession, however, some projects should be approved that might be rejected at other times. The economic value of the project to the economy as a whole changes with the business cycle. As a result, the determination of what is “undue harm” should change as well.

Because federal regulators are generally reviewing many billions of dollars of investment proposals at any given time, systematic countercyclical regulatory policy, in financial regulation and outside of it, offers the prospect of significant stimulus during a recession. Yet countercyclical regulatory policy does not always entail deregulation during recessions.218 In some cases, new mandates can increase spending and reduce unemployment.

Consider Section 8 housing vouchers, which provide rental assistance to low-income families. The U.S. Department of Housing and Urban Development, which oversees the program, determines a housing property’s compliance with “housing quality standards” and thus eligibility for Section 8 vouchers.219 If HUD imposed a more robust energy efficiency requirement to its housing quality standards during the next recession, then the new mandate would likely increase property investment in millions of units.

Utility regulation as a countercyclical regulatory policy tool

While countercyclical regulatory policy could deliver meaningful stimulus during a recession, the first policy task is simply to avoid making business cycles worse. Too many legal and regulatory regimes are implicitly pro-cyclical, exacerbating recessions without intending to do so. The regulation of utilities, implemented jointly by federal and state regulators, provides an example of regulation that unintentionally affects private-sector spending pro-cyclically. Ending this pro-cyclical bias and moving to a neutral or even countercyclical stance should enable tens of billions of dollars of stimulus during the next recession—without increasing the national debt.

At present, utility regulators generally approve proposed utility prices consistent with returns of 8 percent to 10 percent on invested capital per year.220 When profits fall below this baseline, regulators often permit price increases.221 In recessions, demand for utilities goes down. Utility profits follow, falling below the profit baseline used by the regulators. In response, utilities request rate increases from their regulators. The regulators oblige. Retail prices in electricity (the largest rate-regulated sector) have increased substantially amid the past two recessions. Prices in the regulated water and trash-collection sectors, set by a combination of regulation and direct government provision, also experienced their highest price increases of the past 20 years during late 2008 and 2009.222 (See Figure 1.)

Figure 1

The pro-cyclical pattern of utility prices approved by regulators exacerbates recessions. A utility rate increase resembles a tax increase, decreasing discretionary income and spending by consumers when unemployment is high. While the rate increase supports utility profits and thus benefits utility shareholders, comparatively wealthy shareholders have a much lower propensity to consume out of an additional dollar than the typical utility consumer. Higher utility prices in recessions therefore decrease spending and raise unemployment.

A better regulatory framework from a macroeconomic perspective would hold utility prices down and keep returns below 5 percent during recessions, raising consumer discretionary incomes and spending. To ensure regulated utilities earn an average return of 8 percent to 10 percent over the business cycle, regulators should allow utility returns to rise above 10 percent during booms.223 This kind of countercyclical utility regulation would shift recession risk from utility consumers to utility investors, who are better equipped to manage the risk. The existing regulatory framework, by contrast, imposes the risk of recession on utility consumers, forcing consumers to reduce their spending during a recession to stabilize utility profits.

Although state public utility commissions directly regulate electricity and other utility prices, the Federal Energy Regulatory Commission enjoys considerable supervisory authority over the process for electricity. FERC “regulates the transmission and wholesale sales of electricity in interstate commerce” and “reviews certain mergers and acquisitions and corporate transactions by electricity companies.”224 If one factor in the commission’s review of electricity mergers were the merging companies’ demonstrated ability to tolerate temporarily lower profits in recessions, then utility regulation could cease exacerbating recessions. An even more ambitious regulatory reform that used lower utility prices as a stimulus during recessions would have even greater countercyclical effects.

Government insurance rates as countercyclical regulatory policy tools

Utility regulation is not the only area of regulation that produces pro-cyclical prices. Government insurance programs often yield the same result. Government insurance programs maintain reserve funds to ensure that future claims will be paid. In recessions, these reserve funds shrink as claims against the funds exceed insurance premiums. In response, the administrators of these funds raise rates. As a result, government insurance fund charges are highest during recessions, reducing discretionary income and spending at precisely the worst time.

One case in point is the Federal Housing Administration’s mortgage insurance program. During the Great Recession, unexpectedly high mortgage defaults depleted the FHA’s insurance reserves. In response, the FHA raised mortgage insurance rates considerably from 2009 to 2013—when the U.S. housing market was at its weakest. Once the housing market recovered, the FHA dropped mortgage insurance rates to historical norms. (See Figure 2.)

Figure 2

This increase in mortgage insurance rates from 2009–2012 lowered borrowers’ discretionary incomes, reducing their spending at the worst possible time. Even worse, higher insurance rates discouraged borrowers from refinancing mortgages to take advantage of lower interest rates during the Great Recession and the extremely slow recovery that followed.

Instead of pro-cyclical insurance rates, the Federal Housing Agency and other government insurance programs that show similar patterns, such as unemployment insurance and deposit insurance rates set by the Federal Deposit Insurance Corporation, should strive for business cycle neutral premiums. During ordinary times, insurance premiums that exceed claims buoy insurance reserves. Program administrators and regulators need to resist the temptation to lower rates during these times. The reserves are needed for the next recession. When the next recession strikes and claims against government insurance funds rise, then program administrators should allow the insurance reserve funds to be depleted without raising rates. Keeping insurance rates low in the next recession increases discretionary incomes for the consumers of government insurance programs, raising spending and lowering unemployment.

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Fighting the next recession in the United States with law and regulation, not just fiscal and monetary policies

Coordinating countercyclical regulatory policy within overall macroeconomic policy

Predicting how a regulatory regime affects the business cycle demands expertise. So does determining when the economy needs stimulus. Every regulator and administrator acting across many different sectors of the U.S. economy cannot be expected to have that needed expertise. As a result, effective countercyclical regulatory policy requires a coordinating office staffed by a mix of experts in macroeconomics and regulation. A White House office, the Office of Management and Budget’s Office of Information and Regulatory Affairs, and one White House council, the National Economic Council, could be where that expertise could reside.

The Office of Information and Regulatory Affairs currently coordinates and supervises the implementation of microeconomic tools such as cost-benefit analysis in federal regulation. The National Economic Council currently provides overall macroeconomic policy advice to the president. A new office to coordinate countercyclical regulatory policy could be located within or alongside either of these offices. The next administration could create this office either by modifying the Executive Order creating the National Economic Council225 or by modifying the Executive Order instructing the Office of Information and Regulatory Affairs to focus on cost-benefit analysis.226 The countercyclical regulatory policy office would have two roles.

First, this new office would work with other agencies to determine how each regulatory regime affects the business cycle. This process would identify programs that offer the potential for meaningful stimulus during a recession if applied in an appropriate countercyclical fashion. It would also identify regimes that were unintentionally pro-cyclical and ripe for reform.

Second, the new office, working in conjunction with macroeconomic experts throughout government, would evaluate macroeconomic conditions and the ability of discretionary fiscal and monetary policies to respond to the business cycle, and instruct regulators to implement pre-identified countercyclical regulatory programs accordingly. By creating an office to coordinate the making of macroeconomic policy across the federal government’s many agencies, the next administration would build countercyclical policy into the regulatory framework, rather than making macroeconomic policy on an ad hoc basis.

The wide variety of policy proposals described here, ranging from bank capital requirements to utility regulation, demonstrates countercyclical regulatory policy’s potential. Every federal regulatory program affects the business cycle. The proposals here are merely representative examples. Countercyclical regulatory policy offers an infinite variety of macroeconomic policy options that are not subject to the constraints of monetary and fiscal policy. By paying attention to these effects and managing them, policymakers can stimulate the economy in the next recession.

—Yair Listokin is the Shibley Family Fund Professor of Law at Yale Law School.

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