NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.
After my post last week on inequality, I got a number of (surprisingly reasonable) responses. I pulled one line out of a recent comment, not to call out that particular commenter, but because it encapsulates an argument for *not* caring about inequality.
“Gates and the Waltons really did probably add more value to humanity than the janitor at my school.”
The general argument here is about incentives. Without the possibility of massive profits, people like Bill Gates or Sam Walton will not bother to innovate and create Microsoft and Walmart. So we should not raise taxes because those people deserve, in some sense, the fruits of their genius. More important, without them innovating, the economy wouldn’t grow.
But if we take seriously the incentives behind innovation, then it isn’t simply the genius of the individual that matters for growth. The scale of the economy is equally relevant. In any typical model of innovation and growth, the profits of a firm are going to be something like Profits = Q(Y)(P-MC), where (P-MC) is price minus marginal cost. Q(Y) is the quantity sold, and this depends on the aggregate size of the economy, Y.
The markup of price over marginal cost (P-MC), is going to depend on how much market power you have, and on the nature of demand for your product. This markup depends on your individual genius, in the sense that it depends on how indispensable people find your product. Apple is probably the better example here. They sell iPhones for way over marginal cost because they’ve convinced everyone through marketing and design that substitutes for iPhones are inferior.
The scale term, Q(Y) does not depend on genius. It depends on the size of the market you have to sell to. If we stuck Steve Jobs, Jon Ive, and some engineers on a remote island, they wouldn’t earn any profits no matter how many i-Devices they invented, because there would be no one to sell them to.
People like Gates and the Waltons earn profits on the scale effect of the U.S. economy, which they did not invent, innovate on, or produce. So the “rest of us”, like the janitor mentioned above, have some legitimate reason to ask whether those profits are best used in remunerating Bill Gates and the Walton family, or could be put to better use.
There isn’t necessarily any kind of efficiency loss from raising taxes on Gates, Walton, and others with large incomes. They may, on the margin, be slightly less willing to innovate. But if the taxes are put to use expanding the scale of the U.S. economy, then we might easily increase innovation by through the scale effect on profits. Investing in health, education, and infrastructure all will raise the aggregate size of the U.S. economy, and make innovation more lucrative. Even straight income transfers can raise the effective scale of the U.S. economy be transferring purchasing power to people who will spend it.
Can we argue about exactly how much of the profits are due to “genius” (the markup) and how much to scale? Sure, there is no precise answer here. But you cannot dismiss the idea of taxing high-income “makers” because their income represents the fruits of their individual genius. It doesn’t. Their incomes derive from a combination of ability and scale. And scale doesn’t belong to individuals.
The value-added of “the Waltons” is particularly relevant here. Sam Walton innovated, but the profits of Walmart are almost entirely derived from the scale of the U.S. (and world) economy. It’s the presence of thousands and thousands of those janitors in the U.S. that generates a huge portion of Walmart’s profits, not the Walton family’s unique genius.
Alice Walton is worth around $33 billion. She never worked for Walmart. She is a billionaire many times over because her dad was smart enough to take advantage of the massive scale of the U.S. economy. I’m not willing to concede that Alice has added more value to humanity than anyone in particular. So, yes, I’ll argue that Alice should pay a lot more in taxes than she does today. And no, I’m not afraid that this will prevent innovation in the future, because those taxes will help expand the scale of the economy and incent a new generation of innovators to get to work.
The Growth Economics Blog 
Why are you so envious?
Envious? I’m neither asking Alice Walton to give up 100% of her wealth and income, nor am I asking for her to give it to *me*. I’m talking about raising tax rates back to something like the mid-1990 levels, and using it to fund higher investments in education, health, and infrastructure. Explain to me how that is evidence of envy?
Profits and/or top-end incomes are a combination of individual skill and overall economic scale. This isn’t envy, it’s just how things work.
You want more money for education? Money does very little, do you really think giving more money to Washington D.C. schools will help? As for infrastructure simple privatize it.
There are effective means of increasing education that involve spending money: universal pre-k, for example. Are there ways of improving education through reforming institutions, rules, etc..? Sure. So let’s make those reforms *and* add programs like universal pre-k.
You say “simple, privatize it” as if that is somehow, you know, simple. And even if you privatize it, you realize that someone still has to pay for it, right? Through tolls, user charges, etc.. Which are a remarkably inefficient way of organizing things for lots of network things like roads. Imagine having to stop every few miles to pay a new toll to drive to work.
You should probably explain profit’s origin before you ever explain who gets it and why.
I’m stumped – what do you mean by “explain profit’s origin”?
Holy Moly! It’s a straightforward question. How do you not understand what it means to explain profit’s origin? How does it come into being? What is the source of profit?
A capitalist begins by spending a given amount of labor and machines, buildings raw materials and so on in order to produce goods. At the end of production the price of those finished goods is greater than initial money invested purchasing labor, raw materials and so on. The difference between the beginning and end amounts of money is profit. Where does it come from? What is the source of this price augmentation between inputs and outputs? That is, what is profit’s origin? Where does it come from?
Are the questions clear now?
First, we need to be a little careful about the word “profits” – and this is partly my fault for being unclear in the original post. We like to distinguish between “economic profits” and “accounting profits”. Accounting profits are Revenues – Operating costs. This goes down on the books as accounting profit. Accounting profit is made up of two parts: economic profits and payments to capital. Payments to capital are the implied return paid to the owner/s of the firm. Reimbursement for having provided the building, machines, and other fixed capital involved in production.
Economic profits are what I was talking about in the post. This is the part of accounting profits over and above what is necessary to reimburse capital owners. If we have some kind of perfect competition, then we’d expect these economic profits to be zero, even though accounting profits could be positive.
Okay, so enough definitions. What is profits origin? I’m going to take that as “What is economic profits origin”? What allows some firm to charge a price higher than its marginal cost? I think there is one primary source: market power. The firm is the sole provider (or one of only a few) of a good or service, and has the ability to refuse to sell to people at a lower price because there is plenty of demand at a higher price. Think Apple. The MC of an iPhone is like $150, but it costs $650. Some of the extra $500 is payment to Apple for capital, but some of that $500 is economic profits from market power. You can’t buy an iPhone from anyone but Apple.
This definition of economic profits risks *explaining away* as much as it explains. I will accept that economic profits are expected to be *attracted toward* zero if we assume a static market with perfect competition. In a dynamic market with constant discovery and real world competition the economic profits act as the incentive for discovery and innovation. They are essential to economic progress.
I can buy a dozen different phones. I gladly pay Apple for their brand and universe of services. I think they are fantastic and am thankful they had the incentive to create products and services that so delight me. Their pursuit of “market power” isn’t just a good thing. It is an amazing thing and needs to be celebrated as such at risk we ever forget.
You’re an economics Ph.D., right?
Do you realize you never answered the question? You didn’t once touch on where profits originate. All you did was say they’re a mark-up on cost. However, if all capitalists buy low and sell high, then in the aggregate the profits cancel out. Thus, that’s not an explanation.
Profits originate from providing a good or service more cheaply than competitors. This may be due to skill, or be accidental or circumstantial. In a perfect market economy, profits will be competed away. There is no perfect market economy. In an imperfect market economy, profits will accrue to some competitors, due to one or more of a handful of different reasons. If this leads to a redistribution of income AWAY from the less-skilled, or away from the less-lucky, there may be an increase in inequality. That increase in inequality may have bad effects on the next generation’s knowledge, readiness, and opportunities, which may further increase that inequality. The solutions to that are: 1. higher taxation on the richest, to pay for increased opportunity for the poorest, and/or, 2. direct money-printing by the government to increase opportunity and/or employ people in non-market goods and services.
But if profits are due to adding value, then they don’t cancel out across firms. Let’s say I buy a stack of unfinished lumber for $100. I then spend the weekend in my garage building a desk. I sell that desk for $200. I just made $100 in profit by adding $100 in value to the unfinished lumber. If I had to rent some tools to make the desk, say for $50, then some of my accounting profit ($100) is a payment to capital owners (the Home Depot that rented me the tools), and I have $50 left.
Now, that $50 isn’t necessarily profit, because I could have probably done something else with my time rather than making the desk. So implicitly the cost of my labor was, say, $40 (what I could have earned doing something else). So that leaves $10. That $10 is the profit for having thought to make a desk out of some unfinished wood. I added value to unfinished lumber by nailing it together, painting it, etc.. etc..
But why that $10 profit? The only way I could earn that extra $10 is if there was no one else who was willing or able to provide a desk for less than $200. If there was someone else out there who could do the same thing, but only charged $199, then I wouldn’t be able to sell my desk for $200. So if I *do* charge $200, and earn $10 in profits, it must be because of some market power I have, or entry restrictions on other carpenters, or maybe a spatial advantage I have in that I’m the only carpenter in a 50 mile radius, or something like that. The profits come because of some market power.
I see the point you are trying to make here, with profits being a zero sum game. However that line of argument only holds true if we do not account vor the creation of value.
Furthermore I agree that the distinction between accounting profit and economic profit is essential in this context. If someone works on a piece of wood (to turn it into a table) he adds significant value. Therefore he deserves to be compensated for the work and time he puts into it. That means the carpenter should earn an accounting profit (which will not only be caused by buying low and selling high, but by actually adding value).
As you can see the zero sum argument does not apply here. However it may apply to economic profit, since we also include implicit costs there (such as opportunity costs, etc.). So providing the distinction between the two does actually answer the question where profits originate from.
A more detailed explanation on the distinction can be found here: http://principles-of-economics-and-business.blogspot.com/2014/11/microeconomics-zero-profit-equilibrium.html
Are you waiting until you discover or uncover profit’s origin before you post my comment? It seems you’re a neoclassical economist so I’m not hopeful I’ll ever see it.
Question on the premise on **financial** incentives. How about ALL the scientists? Is science all rubbish, or are these people motivated by other types of incentives? (I think we can agree that scientists rarely if ever become filthy rich.)
Let me not even get going on Soviet scientists (who I hope we agree were excellent), or Soviet space program (which was 2nd in the world, for what that’s worth). I’m definitely not advocating communism, just pointing out that people respond to fame, glory, peer-pressure, hyper competitive spirit, and other non-financial incentives. Not *only* money.
So it’s worth thinking hard and rigorously studying if we can use some of these other things to incentivize our innovators…
(As an economist,) I am always surprised by how narrow economists think of incentives…
Absolutely, there are lots of other motivations for doing R&D or innovating, beyond pure profits. So I’d agree that even if there were no financial incentives to invent things, people probably would still invent things, because lots of people are just curious.
But a good portion of innovation is driven by financial incentives, and when we talk about inequality we’re talking about financial inequality. But that doesn’t mean it’s the *only* motivation for research.
You make a good argument, however when people argue against fighting inequality, I typically see an argument more like this:
“People who earn vast sums of money without contributing are very rare. Well paid executives are well paid because they contribute much more value to the company than the janitors or other workers. The ‘rent seekers’ are also the producers, the distributors, the people negotiating deals to expand the company. Thus, they deserve whatever the market wants to reward them.” Cue the rallies against the evils of communism, etc.
What would you say to either of those points? Those being:
1. Most/almost all people who earn lots of money do it through working, not absentee ownership.
2. People who are earn a lot contribute a lot, or the things they contribute are more important.
Thanks in advance for taking the time to reply.
William – the general idea of markups versus scale still holds, I think, even for people who actively work (like a CEO or a janitor). The “profits” are their total earnings. The “markup” still depends on how much market power they can command – a CEO gets a big markup because he or she is considered uniquely qualified to run a certain company. A janitor gets little or no markup because presumably there are lots of people who could be substituted into the job.
Scale, though, still matters. The total wages of a CEO are not due solely to those unique qualities they have, but also to the scale of the economy in which they work. Think again of the desert island. If you drop the CEO of GE on a deserted island, he isn’t going to produce millions of dollars worth of goods and services, no matter how talented he is.
The point is not that everyone is identical, and that all inequality is necessarily wrong. Some people contribute more economically than others, sure. But the wages and/or profits that people earn are *not* necessarily a decent measure of economic contribution, because of this scale issue.
Very important point and well said.
I’ll add too, incentive effects? The incentive is more than microscopically less to make $5 billion instead of 10 or 50? You know how absurd that sounds and is? Of course, positional externalities are monumental, and the pink elephant of economics, but if all entrepreneurs are making $5 billion instead of 10, then $5 billion is just as prestigious and awesome and quality feeling — It’s pretty much all zero-sum-game positional externality utiltiy. The intrinsic part is only tiny diminished, even if the earnings are decreased ten-fold.
And anyway, from an expert well versed in this literature, MIT economist Jonathan Gruber:
“Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation.”
– Public Finance and Public Policy, 2nd edition, 2007, page 734
That said, another thing that economics by and large ignores is the psychology of taxes. In almost all economic models (All that are published in powerful journals?), $1,000/hour worked that comes from $1,100 gross taxed at 9% will be treated the exact same as $1,000/hour that comes from $2,000 gross taxed at 50%, or $10,000 gross taxed at 90% for that matter. But in the real world, there may be substantial differences. So, there’s something to be said about background taxes like the VAT.
In any case, there’s also the income and substitution effects and backward bending labor supply curve, which any professional economist knows about, so it’s somewhat surprising to always see even non-right economists conceding an incentive effect, but just saying it’s small and outweighed.
And anyways, are you going to see successful talented people saying I’m going to work less hard, and have less prestige and accomplishment and respect, because now my after tax income is $50 million/year instead of $100 million, or even $1 million/year instead of $2 million. Or even, for that matter, $150,000 instead of $300,000, if everyone else pays the same new taxes, so your prestige and buying power ranking is the same — and keep in mind the income effect.
Richard – I didn’t get into that, but I think you’re spot on about the actual marginal effect of taxes. Because of positional issues, there isn’t actually that much of a response in work effort to tax changes, particularly because people know that everyone is being taxed similarly.
I retired early in great part due to tax rates. It didn’t seem worth it to give close to half my money to others. So I decided to spend time with my family, travel and surf and pursue more cerebral topics. I am just one person (I was an executive in charge of innovation and new product development) out of hundreds of millions. I would like to think that the products I built (which are still widely distributed) improved the lives of those around me and that if I had continued I could have added even more value to millions of people. But instead I was selfish and checked out.
Incentives matter, and it can’t be explained away via relative status games.
Cardiffkook,
You illustrate largely the income effect. Your after-tax income was high enough earlier that you had the luxury of enough money to retire earlier. But the empirical evidence is clear, it makes little or no difference, and lower taxes can easily make people work less and retire earlier, because they can make enough money after-tax to do so with less hours and years. And most accomplished people I know, you have to tear them away from their work and into retirement kicking and screaming; it’s not for an extra 20% per hour.
Excellent point, and strongly agree we should allow empirical models to inform us on how we should structures taxes and rates. Some of the people I worked with never wanted to retire, but most did. Indeed those who could retire usually did soon after qualifying (right at or soon after hitting 55). I lived in the age of pensions though.
There is a balance. If marginal tax rates are too high it discourages extra work, investment and risk as there is no real point to reach for the next rung on the ladder. On the other hand, higher taxes increase the need to work to meet our needs and dreams. If you have empirical evidence that marginal tax rates make no difference on long term economic growth please do share.
Of course the money is not ours to milk. Producers are not livestock. Yes it is reasonable to create mutually agreed upon benefits and obligations. I certainly support progressive taxes and inheritance taxes as a part of these social obligations. To keep things fair and avoid exploitation of politically unfavored groups I suggest competing tax units and entrance and exit options. This allows social evolution, feedback and learning. Over time, those states which choose wisely will thrive, those which choose poorly will not. And in the end, cumulative growth rates will dominate all. Those states which choose poorly will become irrelevant, or will change.
Thanks for the excellent reply to my comment on your earlier post. I pretty much agree as below:
I agree strongly that one benefit to productive “superstars” (for lack of a better term) is the existence of a large and stable market, and that it is reasonable to all parties (including the superstars themselves) to use the fruits of their productivity to sustain the health of the large market. In other words, I support progressive taxation, and think superstars would too if choosing impartially. I do think there is a point where taxation becomes exploitative and counterproductive. Though in my comment I admitted to not knowing where that point is. I suspect it is both dynamic and at least partially discoverable by economics and game theory.
I agree inheritance taxes are reasonable ways to tax compared to alternatives. Especially if we are worried about generational capital accumulation. There are lots of ways to collect taxes. I think inheritance taxes are better than most.
I do want to clarify that my main point of disagreement was toward what I deemed as hyperbole where you encouraged the superstars to pack up and leave. We do not want them to pack up and leave. We want them to continue to flourish in a productive way which enriches fellow humans. To do so we want to optimize taxes and opportunities including those related to market scale.
Roger – I think we’re on the same wavelength here on most points.
I’ll push back on one point – superstars. I’m not terribly concerned with losing superstars, because I think the idea of “superstar” entrepreneurs or innovators is way overblown. If Sam Walton never existed, Kmart or Target would be the biggest retailer in the world today. We might be slightly worse off because we didn’t get Walmart, but it’s not like there would be *zero* bargain department stores in the U.S. in the absence of Walmart. Someone else would have expanded to provide most of what Walmart provides. There is some small retailer out there who *didn’t* become Walmart because Sam Walton beat him there by a year, or a month, or a day. So if Sam Walton disappeared, that guy would have ended up providing essentially the same service. We’ve got 300 million people in this country, there is a a lot of genius out there to be had.
So hyperbole? Sure. But the essence of the argument stands. The US economy is not dependent on “superstars”, and if they left, my contention is that the US economy would grow just as fast as it did before they left.
Then we do have a degree of disagreement. Of course the particulars of who the superstars are is irrelevant. The important thing is not the names or identities, it is that individuals have the incentives to become the superstars in socially productive ways.
The opportunity and rewards of phenomenal success are essential to human flourishing in economics, science and sports. In all these fields, we have evolved institutions which incentivize zero sum competitions with positive externalities. Darwin and Einstein got superstar status within their fields, LeBron got superstar fame and fortune, as did Walton, Gates and Jobs. We got the knowledge, entertainment and higher living standards. In all cases we have constructive competitions with positive externalities.
The world would not be a better place without superstars and the potential for superstars. Indeed, it would probably be unlivable for most of us.
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