Aggregate Effects of Minimum Wage Regulation at the Zero Lower Bound

October 20, 2018

By Andrew Glover

The Fair Minimum Wage Act of 2007 increased the U.S. nominal minimum wage by 41 percent immediately prior to nominal interest rates hitting the Zero Lower Bound in 2008. I study the interaction of these two events in an extension of the sticky-price New Keynesian model. The minimum wage dampens the contractionary effects of the ZLB by preventing rapid wage deflation, halting the deflationary spiral caused by low aggregate demand. For sufficiently persistent ZLB shocks, the minimum wage generates infinite output gains relative to flexible wages, while GDP losses are reduced by half in a calibrated economy. Increasing the minimum wage at the ZLB is expansionary: accumulated output gains are more than 15 percent in the calibrated economy.

Interesting. I can believe that increasing the minimum wage is expansionary, after all the beneficiaries have a very high propensity to consume. And this becomes particularly important when you hit the ZLB, as policy options are running out. I would not have expected this to that effective a policy.


Education policy and intergenerational transfers in equilibrium

October 17, 2018

By Brant Abbott, Giovanni Gallipoli, Costas Meghir and Giovanni L. Violante

This paper examines the equilibrium effects of alternative financial aid policies intended to promote college participation. We build an overlapping generations life cycle model with education, labor supply, and consumption/saving decisions. Cognitive and non-cognitive skills of children depend on the cognitive skills and education of parents, and affect education choice and labor market outcomes. Driven by both altruism and paternalism, parents make transfers to their children which can be used to fund education, supplementing grants, loans and the labor supply of the children themselves during college. The crowding out of parental transfers by government programs is sizable and thus cannot be ignored when designing policy. The current system of federal aid is valuable: removing either grants or loans would each reduce output by 2% and welfare by 3% in the long-run. An expansion of aid towards ability-tested grants would be markedly superior to either an expansion of student loans or a labor tax cut. This result is, in part, due to the complementarity between parental education and ability in the production of skills of future generations.

The best way to finance is an important issue and this paper shows that it matters. It also demonstrates that education should not be free, but its cost in the end should be tailored to the financial abilities of the parents. The worst outcome is if the government is not involved at all, and this even if student ability is correlated with parental wealth.

Redistributing the Gains From Trade Through Progressive Taxation

October 17, 2018

By Spencer Lyon and Michael Waugh

Should a nation’s tax system become more progressive as it opens to trade? Does opening to trade change the benefits of a progressive tax system? We answer these question within a standard incomplete markets model with frictional labor markets and Ricardian trade. Consistent with empirical evidence, adverse shocks to comparative advantage lead to labor income loses for import-competition-exposed workers; with incomplete markets, these workers are imperfectly insured and experience welfare losses. A progressive tax system is valuable as it substitutes for imperfect insurance and redistributes the gains from trade. However, it also reduces the incentives to work and for labor to reallocate away from comparatively disadvantaged locations. We find that progressivity should increase with openness to trade and that progressivity is an important tool to mitigate the negative consequences of globalization.

This is an interesting take on how to address the losers from globalization. But when you think a little about it, this is like tax progressivity helping to redistribute income during a recession, except that in the latter case you also have to tool of public deficits.

Corporate Tax Cuts and the Decline of the Labor Share

October 14, 2018

By Baris Kaymak and Immo Schott

We document a strong empirical connection between corporate taxation and the labor’s share of income in the manufacturing sector across OECD countries. The estimates indicate that the decline in corporate taxes is, on average, associated with 40% of the observed decline in labor’s share. We then present a model of industry dynamics where firms differ in their capital intensity as well as their productivity. A drop in the corporate tax rate reduces the labor share by shifting the distribution of production towards capital intensive firms. Industry con- centration rises as a result, and firm entry falls, consistent with the US experience documented in Kehrig and Vincent (2017) and Autor et al. (2017). Calibration of the model to the US economy indicates that corporate tax cuts explain at least a third of the decline in labor’s share in the US manufacturing industry.

The secular(?) decline in the labor income share is cause for a a lot of speculation, especially as it seems to happens in several countries simultaneously. This paper presents an interesting take at this question: it is to a good part due to declining corporate tax rates and the ensuing market concentration. The narrative makes sense and the numbers seem to back it up well.

Welfare Implications of Switching to Consumption Taxation

October 14, 2018

By Juan Carlos Conesa; Bo Li; Qian Li

We evaluate a reform of the US tax system switching to consumption taxation instead of income taxation. We do so in an environment that allows for progressivity of consumption taxes through differential tax rates between basic and non-basic consumption goods. The optimal tax system involves substantial subsidies to the consumption of basic goods. We find large efficiency gains in the long run, with a very small increase in inequality. However, once we consider the transitional dynamics associated to the reform, only very low productivity households and a handful of high productivity low wealth households experience welfare gains.

Thus, it appears that taxing the source of well-being of households, consumption, is worse than taxing their main source of revenue for said consumption. Of course, there is still the option to differentiate further the tax rates for the non-basic consumption goods. Sin and Pigovian taxes are welfare-enhancing after all.

Macroeconomic Implications of Modeling the Internal Revenue Code in a Heterogeneous-Agent Framework

October 10, 2018

By Rachel Moore and Brandon Pecoraro

Fiscal policy analysis in heterogeneous-agent models typically involves the use of smooth tax functions to approximate present tax law and proposed reforms. We argue that the tax detail omitted under this conventional approach has macroeconomic implications relevant for policy analysis. In this paper, we develop an alternative approach by embedding an internal tax calculator into a large-scale overlapping generations model that explicitly models key provisions in the Internal Revenue Code applied to labor income. While both approaches generate similar policy-induced patterns of economic activity, we find that the similarities mask differences in key economic aggregates and welfare due to variation in the underlying distribution of household labor supply responses. Absent sufficient tax detail, analysis of specific policy changes – particularly those involving large, discrete effects on a relatively small group of households – using heterogeneous-agent models can be unreliable.

Important lesson for those modelling taxation in some detail: do not take shortcuts, they matter.

International Medium of Exchange: Privilege and Duty

October 10, 2018

By Ryan Chahrour and Rosen Valchev

The United States enjoys an “exorbitant privilege” that allows it to borrow at especially low interest rates. Meanwhile, the dollarization of world trade appears to shield the U.S. from international disturbances. We provide a new theory that links dollarization and exorbitant privilege through the need for an international medium of exchange. We consider a two-country world where international trade happens in decentralized matching markets, and must be collateralized by safe assets — a.k.a. currencies — issued by one of the two countries. Traders have an incentive to coordinate their currency choices and a single dominant currency arises in equilibrium. With small heterogeneity in traders’ information, the model delivers a unique mapping from economic conditions to the dominant currency. Nevertheless, the model delivers a dynamic multiplicity: in steady-state either currency can serve as the international medium of exchange. The economy with the dominant currency enjoys lower interest rates and the ability to run current account deficits indefinitely. Currency regimes are stable, but sufficiently large shocks or policy changes can lead to transitions, with large welfare implications.

Many in the United States do not realize their luck, as the exorbitant privilege is quite substantial. This paper finds this advantage amounts to about of 2% consumption, in large part thanks to the ability to keep a substantially lower net asset position. While this privilege is relatively stable, one can lose it if you rock the boat too much, though.