COMPETITION, MARKETS AND DISCRIMINATION

Professors' Gary S. Becker and Richard Posner articles on the economics of discrimination (here and here) gave me an interesting motivation to discuss some economic aspects of discrimination which is a popular question into the economic analysis.

The Framework of Labor Market

Discrimination is a relatively young and still fresh theme in economic analysis. It has been pioneered by professor Becker's The Economics of Discrimination (link). The analytical foundations of the economic analysis of discrimination can be found in the attempt to measure discrimination in the labor market and elsewhere by the empirical analysis. In a simple, two-variable model of labor market determined by wage and quantity of labor, there is not a unique equilibrium of demand and supply in the labor market. The demand for labor is downward sloping, reflecting the fact that lower wage (the price of labor) tends to induce the demand for labor. For example, if the wage for software engineer drops from 8 EUR per hour to 6,5 EUR per hour, then Google, for example, will certainly not feel reluctant to hire more skilled software engineers. It should be noted that the slope of labor demand curve is much flatter than demand curves in partial equlibrium models usually behave. The reason is that firms hire labor supply in order to maximize profits and firm's utility function. However, there is no simple marginal rate of substitution between labor and other means of production and that labor suppliers' knowledge, skills and profession determine the result of firm's production function. Also, there is not a unique picture of labor supply, since workers possess different preferences regarding the allocation of time between leisure and consumption. For example, productivity gains by Google engineers may induce them either to increase the amount of leisure time they consume or to allocate even more time to research and product development. In economics, to sketch a brief picture of labor market, we use regression analysis to depict labor demand and supply curve where the wage as an endogenous variable is determined by the inclination of demand curve and the quantity of labor as an exogenous variable. Since a decreasing wage rate induces the demand for labor, demand curve is, expectedly, downward sloping. On the other hand, labor supply is upward-sloping since employees are not reluctant to supply more free time when the rate of real wages is increasing. Even though labor market is a partial equilibrium model of employer-employee preferences, discrimination has often resulted in a two-sector labor market where skills and knowledge are traded in separate markets as shown by the picture.

How Discrimination is Motivated?

There are two types of discrimination in the labor market. First, employers discriminate when they hire labor supply with higher wage rate, even though other labor supplier are cheaper relative to their productivity than labor suppliers hired by the employer. In this case, discrimination is motivated by employer preference of future employees by race, religion, sex or other human charateristics. An employer who discriminates has a comparative disadvantage compared to employers who do not discriminate since first employer's profits are lower due to the fact that first employer's competitor scores better on productivity performance and profit while his relative market-clearing price of labor is lower. Employer discrimination can be enforced with strong cultural and institutional background. In former socialist economies, such as Slovenia, regulated and rigid labor market protected the premium of insiders while it, at the same time, increased entry and career barriers to future employees. Thus, with the lack of productivity convergence and high tax burden, employers in Slovenia are reluctant to hire high-skilled labor supply because of (1) high bargaining power of trade unions and because (2) age-determined income distribution favors older workers compared to younger workers even though older workers in infant industries do not posses high human capital skills as college graduates do. Consequently, human capital premium has been replaced by age premium. In job advertisment, employers often put experience ahead of knowledge and ideas, thus restricting job and career prospects to labor market entrants. On the other hand, employee discrimination occurs when employees, for example, refuse to work with minority workers, demanding real compensation. Regulated labor market structure is, most notably, a cause of employee discrimination since workers possessing more bargaining power tend to discriminate workers with weaker concentration of bargaining power, thus requesting higher premium enabled by the formal (trade union) or informal (intra-market nets) monopoly of existing labor supply. Nonetheless, the attempt to exterminate labor market discrimination by the exercising regulation results in information asymmetry, giving privilege to inside workers' privileges such as seniority and their bargaining power over the medium term (see: Lindbeck, Snower 2002).

Competitive Markets, Economic Freedom and Flexibility

For example, in the old American south, African Americans were often discriminated by local employers (link). Thus, the old South was put in a comparative disadvantage in comparison with Northern and Western states which faced higher productivity growth rates and profits. The situation led to a gap between northern-western and southern states; the latter having lower living standards because of the productivity lag as a partial result of labor market discrimination. The deregulation of labor market is essential to less discrimination since economic freedom such as freedom of trade, enterprise and labor, leads employers to relatively less beneficial discriminatory hiring preferences unless employers prefer lower profit. In Europe, where labor markets are more regulated than in countries such as the United States, Singapore, Denmark and Australia, regulated labor markets lead to lower productivity performance, except that age and experience-based discrimination substituted racial or sexual discrimation at the workplace. Consequently, the standard of living in European welfare states is significantly lower than in the United States. For example, cost decreases in child care, as a result of competition, put more mothers into the labor market in the United States and Canada (link) while the percentage of mothers in the labor market, while having child-care liabilities, is significantly lower in Europe, reflecting regulated and rigid labor market designed by the intervention of trade unions. In freer labor markets where employers have fewer discrimination preferences, firms score higher on productivity, human capital and profits, advantaging employers with non-discriminatory hiring practices while putting employers with discriminatory hiring (related to race, skin color, religion, sex or any other characteristic) in a serious relative disadvantage.

CUTTING TAXES, FALLING POVERTY

Art Laffer and Stephen Moore offer a brilliant evidence on how lower tax rates expanded income increases (here):

"The new Census Bureau data on income and poverty reveal that many of the economic trends in this country are a lot more favorable than America's detractors seems to think. In 2007, overall real median family income increased to $50,233, up $600 from 2006. The real median income for intact families -- mother and father in the home -- rose to $78,000, an all-time high. Although incomes fell sharply in the U.S. after the dot-com bubble burst in 2000 (and still haven't fully recovered), these latest statistics reflect a 25-year trend of upward economic mobility. More important, Barack Obama is wrong when he states on his campaign Web site that the economic policies started by Ronald Reagan have rewarded "wealth not work." Based on this false claim -- that the rich have benefited by economic growth while others have not -- he intends to raise tax rates on high-income individuals. To be sure, there has been a massive amount of wealth created in America over the last 25 years. But tax rates were cut dramatically across the income spectrum, for rich and poor alike. The results?
When all sources of income are included -- wages, salaries, realized capital gains, dividends, business income and government benefits -- and taxes paid are deducted, households in the lowest income quintile saw a roughly 25% increase in their living standards from 1983 to 2005. (See chart nearby; the data is from the Congressional Budget Office's "Comprehensive Household Income.") This fact alone refutes the notion that the poor are getting poorer. They are not...Looking at the last two business cycles (first year of recovery to first year of recovery), this low-income group experienced a 10% rise in their inflation-adjusted after-tax incomes from 1983 to 1992 and then another 11% rise from 1992 to 2002). Roughly speaking, the Reagan and Clinton presidencies were equally good for them. Income gains over the last 30 years have been systematically understated due to several factors. These include:
- Fall in people per household. The gains in household income undercount the actual gains per person, because the average number of people living in low-income households has been shrinking. On a per capita basis, the real income gain for low-income households was 44% from 1983 to 2005, about 22% from 1983 to 1992 and about 18% from 1992 to 2002. These are excellent numbers by any measure. Earned income tax credit effect. The Earned Income Tax Credit (EITC) is a government payment to low income people who work. It was instituted on a small scale in 1975. In 1986, 1990, 1993 and 2001, Congress expanded the program ...Over time the EITC has multiplied the number of poor households that fill out tax forms each year and are thus counted in government income statistics. That's because to be eligible to receive the refundable EITC, a tax return must be filed ...Official tax return data show that in 1983, 19% of returns had zero tax liability; that percentage has climbed steadily, reaching 33% in 2005. (The Tax Policy Center estimates that in 2008 nearly 40% of filers will have no income tax liability.) Thus, we are now statistically counting more poorer families today than we used to. This is a major reason that median and poor household income gains appear to be a lot smaller than they have been in reality. Income mobility. In the U.S., people who had low incomes in 1983 didn't necessarily have incomes as low a decade later. People in this country have long moved up over time, and this income mobility continues to be true. While some people do remain in the lowest income group, they are the exception ...One way to quantify income mobility is to examine how many people remain in the same tax bracket over time. We compared the returns of tax filers in the lowest tax rate bracket (zero) in 1987 with their returns in 1996. Only one third of the tax filers were still in the zero tax bracket, but 25% were now in the 10% bracket, 32% had moved up to the 15% bracket and 9% were in the 25%, 28%, 33% or 35% brackets. And that was following them for a decade, not a generation ... From 1996 to 2005, we have the income mobility data for income quintiles. Of those filers who were in the lowest 20% in 1996 and who also filed in 2005, 42.4% remained in the bottom 20%, 28.6% were in the next highest quintile, 13.9% were in the middle quintile, 9.9% were in the second highest quintile, and 5.3% were in the highest quintile ...What is also striking about the data is that the poor today are, in general, not the same people who were poor even a few years ago. For example, the new Census data find that only 3% of Americans are "chronically" poor, which the Census Bureau defines as being in poverty for three years or more. Many of the people in the bottom quintile of income earners in any one year are new entrants to the labor force or those who are leaving the labor force. Obviously, there is also a significant core of truly poor people in this group, but that core is drastically less than 100%.
The data also show downward mobility among the highest income earners. The top 1% in 1996 saw an average decline in their real, after-tax incomes by 52% in the next 10 years.
America is still an opportunity society where talent and hard work can (almost always) overcome one's position at birth or at any point in time. Perhaps the best piece of news in this regard is the reduction in gaps between earnings of men and women, and between blacks and whites over the last 25 years ...Census Bureau data of real income gains from 1980 to 2005 show the rise in incomes based on gender and race. White males have had the smallest gains in income (up 9%), while black females have had by far the largest increase in income (up 79%). White females were up 74% and black males were up 34%. Income gaps within groups are rising, but the gaps among groups are declining. People are being rewarded in today's economy based on what they know and what they can do, not on the basis of who their parents are or the color of their skin ...There are of course Americans who live in poverty, as there are very affluent Americans with $25 million yachts and $10 million homes who hold ostentatious $200,000 birthday parties. But the evidence is plain that all groups across the income distribution have made solid gains during the last generation ... Taking from the rich through much higher tax rates in order to help the poor and middle class makes no sense intellectually and has seldom worked in practice. Reducing rates, on the other hand, does increase the share of taxes paid by the highest income-earning group. For example, in 1981, when the highest tax rate on the rich was 70% and the top capital gains tax rate was close to 45%, the richest 1% of Americans paid 17% of total income taxes. In 2005, with a top income tax rate of 35% and capital gains at 15%, the richest 1% of Americans paid 39%.
We suspect that Mr. Obama will discover that when you put "tax fairness" ahead of economic progress, you produce neither."

SLOVENIA: ELECTION AND THE ECONOMY

In Sunday, voters in my native Slovenia elected left-leaning political party that will presumably hold the majority in the national parliament, given favorable majority conditions for left-leaning political parties as well as the distribution of votes and preferences of political agents. Political analysts and comments have said that Slovenian voters now turned to the left. Aside from political populism of welfare state, it is time for a brief economic view on the future of Slovenian economy and consequences that left-leaning economic policy may induce.

Some Facts about Growth

In 2007 and 2008, the output of Slovenian economy grew by historically high rates, averaging around 6 percent. Economists have different views and analytical opinion what pushed growth onto such high rate. One group of economists believe that output increase is a consequence of demand boost through government spending on infrastructure that boosted economic growth, bringing demand-pull inflation as a consequence while another group of economists believe that Slovenia's economic growth is a result of higher investment rates, favorable global economic conditions such as lowering interest rate and tax cuts. After reviewing the data and forecasting assumptions, I analytically believe that the phenomena of economic growth in recent years in Slovenia has mainly been the outcome of robust investment, reductions in marginal tax rates on labor and capital, and low interest rate. However, given the state of low interest rate, capital deepening is not a key to aggregate productivity growth. What Slovenian economy experieneced was surging investment and small supply-side tax cuts that boosted output growth. In the long run, the growth of productivity is essential to economic growth. Without it, the output growth would slowly diminish in relative terms since a continious lowering of interest rate would lead to deflation trap such as experienced by Japan in 1990s. As first, I would like to refer to the pioneering work of professor Moses Abramovitz on economic growth and output trends (here, here and here). Professor found out that there are huge growth residuals in the measurement of economic growth. For example, when the emergence of new economy propelled innovation, the latter was perceived as an exogenous shock, leaving a huge part of economic growth unexplained. While the static measurement of growth was an empirical practice as long as measuring samples of output growth were based on simplified input assumptions, dynamic advancement of innovation into production, at first, seemed as a measure that is decreasing productivity growth. However, productivity paradox revealed that assumptions in the measurement of economic growth are not a static experiment but rather an experiment that needed empirical renewal. Today, we measure economic growth through endogenous growth model where engines of growth do not come from the "outside" (exogenously) but from the "inside" (endogenously). An advantage of the endogenous model of growth is that, in general, there are not many residuals since shocks are already entailed into the model of growth. However, economic policy can significantly affect the economic performance over the future horizon.

The Greed of Political Agents

In the political market, political parties are utility-maximizing agents that seek anticipated rents through time and power they aim to achieve in the political arena. Therefore, their existence depends entirely on the distribution of economically absurd promises to different interest groups and stakeholders. In Slovenia's pre-election period, political parties delivered countless promises about the prospects of economic development, inflation and other economic issues. If there's a widespread virus of economic illiteracy, then the ideas such as "inflation is a fiscal phenomena" and "government is to be blamed for poverty" can really stick to the conventional wisdom.

Economic Scoreboard

In the fiscal year 2006-2007, the Ministry of Finance launched the first tax reform in the history of independent Slovenia. Top tax rate on personal income was reduced from 50 percent to 41 percent. Also, the entire tax code was gradually reduced from 5 tax brackets to 3 tax brackets with progressive income tax structure - 16 percent, 27 percent and 41 percent. Although tax burden remained high, consuming approximately 47 percent of the GDP, there was an intial supply-side effect on jobs, investment and tax revenue that reached historic highs after tax reductions were imposed. Also, budget deficit (in percent of the GDP) has been reduced and public spending (in GDP's share) reduced as well. Some economists blame tax reductions for poverty. In Slovenia, there is a wrong perception of poverty. The latter cannot be defined by confusing income and net wealth. Using Gini coefficients, the income inequality in Slovenia is among the lowest in the EU, just behind Sweden and Denmark. Also, using Eurostat data (here) as an analytical source, the risk of poverty in Slovenia is among the lowest in the world. Also, Slovenians owe the highest share of owned tangible households in the world. Thus, the rate of poverty in Slovenia is approximately 3 percent of the individuals above the age of 15. In the last four years, the rate of economic growth reached historic highs. Even though Slovenia is a transition economy, output growth throughout transition period was among the lowest in Eastern Europe. However, in the last four years, output growth exceeded 5 percent; the most rapid economic expansion in the economic history of independent Slovenia. Unemployment shrank sharply with its natural rate averaging 4 percent. Although "higher wages" are a popular manifest nowdays, it must be recognized that, in the long run, wages and productivity correlate. In the short run, it is evident that wage growth is behind the productivity growth. Recently published data by the Eurostat have shown that Slovenian economy has not completed the convergence of productivity relative to EU27. Today's level of real labor productivity in Slovenia is 84 percent of the EU27 level, and between 60 and 70 percent of the EU15. Estonia is the regional leader in productivity convergence from 1997-2008, while Slovenia is a regional laggard. From 1997 to 2008, the overall productivity improved by 12,5 index points. For example, in 1997, the relative level of real productivity in Estonia was 38,7 percent of the EU's. In 2008, today's level of real productivity in Estonia compared to the EU is 65,4 percent. Not surprisingly, there is an obvious empirical relationship between bargining power of the unions and slow productivity growth since economies with higher bargaining power of the unions tend to have lower productivity growth. Social democrats, the winners of the election, pledged to raise taxes on productive behavior. In that case, the growth of productivity would reduce to at least 2,5 percent in the medium run. In that case, Estonia's standard of living would catch-up Slovenia's standard of living in 13-14 years, assuming Estonia's 4,5 percent average productivity growth over the medium term. Unfamously, Slovenia is known for the highest rate of inflation in the EMU. Neither the introduction of euro, neither "fiscal impulse" are the flames of inflation which is (by the way), monetary phenomena True, lower interest rate in previous periods by the ECB may have boosted output activity and, at the same time, boosted the level of prices but, in retrospect, high rate of inflation is a consequence of rigid market structure that spills supply shocks into higher prices either because of oligopolistic market structure that imposes mark-ups on input prices, spilling it into consumer prices.

Looking to the Future

After the political turmoil, it is likely that left-leaning political parties will continue the statist course of economic policy with high tax burden in the share of the GDP, hostility towards financial markets (with enormously high tax rate on derivates) and foreign direct investment, postponing privatization with political management and meddling of inefficient state-owned companies. Tax rates will likely remain the highest in the region and Slovenia will, after Hungary and Croatia, remain the only country without flat-rated income tax. As in previous periods, there is little prospect for labor market deregulation that severely hampers productivity growth. In the long run, productivity is everything. After decades of market socialism, Slovenia's unique gradualist approach to economic reform, there is still much to be reformed immediately. Without tax cuts, market liberalization, reduced public spending, the economic growth, and consequently, the standard of living, would decline. Economic theory and practice teach us that there's no better welfare state than high economic growth, enabled by economic and individual freedom.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

ECONOMIC FREEDOM OF THE WORLD 2008

Cato Institute has just published recent report on the state of Economic Freedom in the World, measuring the level of economic liberty in each country (link). The freest economies in the world are: Singapore, Hong Kong and New Zealand. Slovenia, ranked 88th, performed poorly, scoring significantly low on the size of government, freedom of labor market and the security of property rights.

DOING BUSINESS 2009

World Bank has issued the recent report Doing Business 2009, comparing countries throughout the world regarding the ease of doing business and entrepreneurship (link).

WHY HUMAN CAPITAL MATTERS

Professor Glaeser of Harvard University wrote an interesting article, addressing the issue of importance of human capital for economic growth, income and welfare (here):

"Also since the mid-1970s, America has become much more unequal. Not all inequality is bad. I wouldn't mind if the guys who gave us Google earned even more, given their contributions to society. I do, however, care deeply that millions of Americans seem to have reaped, at best, modest benefits from the past 30 years of technological change... By contrast, investing in human capital offers the potential for permanent increases in earnings that encourage work. Education increases the ability to deal with innovation, so that investing in skills today will make Americans better able to weather the storms of future technological changes."

DON BOUDREAUX ON THE ECONOMICS OF PROSPERITY

Donald Boudreaux recently published an article where he discusses the emergence of prosperity (here)

THE POTENTIAL OUTCOME OF OBAMANOMICS

Tom Wilson, a British speechwriter, wrote an opinion (link) in Wall Street Journal, showing incredibly similar parallels between Obama's economic agenda and the economic agenda of Britain's Labour party in Pre-Thatcher years, that turned British economy into the sick man of European economy.

TAX CUTS IN EUROPE

Forbes reports (link) that Hungarian Prime Minister announced the abolition of 4 percent solidarity tax, a unique layer of tax on company profits that used to finance government's welfare expenditures. In addition, the government announced a decrease in corporate tax rate from 18 percent to 16 percent and payroll tax rate by 10 percentage points. However, after Slovenia and Croatia, Hungary is among the last remaining economies in Central-Eastern Europe without flat-rated income tax (link) that would boost economic growth, investment and job creation. Surprisingly, Greece introduced a gradual reduction in corporate and individual income tax by 5 percentage points over the next five years (link).