Former Joint Economic Committee economist speaks to Congress

Subject: Vedder's Testimony to Joint Economic Committee
Date: Thu, 1 Feb 2007 12:00:14 -0800 (PST)

CQ Congressional Testimony
January 31, 2007 Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY

LENGTH: 2652 words

COMMITTEE: SENATE JOINT ECONOMIC

HEADLINE: ECONOMIC CHALLENGES FACING THE MIDDLE CLASS

TESTIMONY-BY: RICHARD VEDDER, PROFESSOR

AFFILIATION: OHIO UNIVERSITY

BODY:
Statement of Richard Vedder Professor, Economics, Ohio University

Committee on Senate Joint Economic

January 31, 2007

Good morning Senator Schumer and members of the Committee. The JEC has just
completed 60 years of existence, and during those six decades it has
assisted importantly in the making of economic policy, and I am pleased to
be part of today's proceedings.

My distinguished colleagues on this panel have painted a somewhat
pessimistic and perhaps mildly alarming picture of the American economy. We
learn that many Americans have not shared in our nation's rising
prosperity. The income and wage gap between the rich and the poor is
growing. We are told we are becoming a more economically divided nation.

My message is somewhat more optimistic and skeptical of the analysis
suggesting that vast portions of the American populace are languishing
economically. Let me very briefly touch on three points. First, the
conventional measures that are typically cited to denote greater inequality
are fundamentally flawed and grossly overstate inequality in this nation,
and the growth in it over time. Second, even if one accepts the proposition
that America has insufficient equality of economic condition, history tells
us that public policy efforts to deal with the problem often are
ineffective. Third, some policies that conceivably might lower inequality
as conventionally measured would, if adopted, have serious adverse
consequences to the economy as a whole.

Turning to the first point, looking at conventional statistics on income
distribution, three factors lead us to overstate inequality. First, and
probably least important, those statistics are traditionally based on money
income, excluding a variety of in-kind, non-cash payments that primarily
benefit lower income persons - Medicaid benefits, food stamps, and housing
subsidies are three good examples. Any comparison of income levels or
income inequality today with, say what existed in 1960 using published
income data will tend to overstate any reported rise in inequality, and
understate any estimate of income gains for lower income Americans, since
non-cash payments have become relatively more important in the intervening
time period.

A second factor is that what we should be truly interested in is the
economic wellbeing of Americans, and a far better measure of that economic
well-being is consumption spending. Dollar for dollar, people derive more
joy from what they spend than from what they earn. As many elementary
economics textbooks point out in the first chapter, the ultimate purpose of
economic activity is consumption.

We know that in any given year consumer spending is far more equally
distributed that income. Comparing the income distribution statistics
derived from the Current Population Survey with the BLS's Consumer
Expenditure Survey is revealing. For example, the poorest one-fifth year
earned only slightly over 7 percent as much income as the richest one-fifth
in 2002, but they consumed more than 24 percent as much. Using the most
recent data for 2005, we see the richest one-fifth of the population earned
3.47 times as much as the middle quintile, but consumed only 2.31 times as
much.

Roughly speaking, conventional measures show consumption inequality is at
least one third less than for income inequality.

The third point relating to the overstatement of inequality relates to the
remarkable income mobility of the American people. For example, at the
request of this Committee, the Treasury Department in the 1990s provided
data suggesting that the overwhelming majority of persons in the bottom
quintile of the income distribution were in another quintile a decade
later, and a large percent even moved up or down the distribution from one
year to the next. Researchers at the Urban Institute and other
organizations have made similar observations. This phenomenon helps explain
the narrowness of the distribution of consumption spending relative to the
distribution of income, as observed decades ago by the late Milton Friedman
and in a different context by Albert Ando and Franco Modigliani. Failure to
consider the income mobility of people contributes to the inadequacies of
traditional measures of income distribution and also leads us to create
some inequities and inefficiencies when devising tax policies based on
single year definitions of income.

While we are talking about measurement problems, they are particularly
prevalent in our discussions of changes in earnings over time. Go to page
338 of the 2006 Economic Report of the President. We learn that average
weekly earnings of workers in private nonagricultural industries in 2005
were over eight percent less than they were in 1964, the year Lyndon
Johnson announced his Great Society initiatives. Yet turn the page, to page
340. Looking at real compensation per hour in the non-farm business sector
for the same time period, we learn it has risen 75 percent. Page 338 is
consistent with a Marxian or even Malthusian interpretation of the economy
-a tendency for wages to fall to near subsistence, and evidence of mass
exploitation of the working proletariat by exploitive capitalists. Page 340
is consistent with the view that with economic growth, the earnings of
workers have risen sharply, and also consistent with national income
accounts data that shows per capita real consumption has increased
about two percent annually.

Yet even the data on page 340 suffer from deficiencies. We learn that
productivity per hour in the non-farm business sector in 2005 was 2.28
times as great as in 1964, yet compensation rose only 1.75 times, a pretty
big difference that is inconsistent with the neoclassical economic theory
of factor prices and suggestive that owners of capital are indeed deriving
extraordinary profits as a result of paying workers less than what they
contribute to output at the margin. This should have resulted in a
significant decline in compensation of workers as a percent of national
income. Yet the national income data taken from pages 314 and 315 of the
same source show a radically different story. Compensation of employees
actually rose from 60.75 to 61.51 percent as a percent of the national
income. The share of national income accounted for by corporate profits
fell slightly in the same time period.

I am making two points here. First, interpretations of economic data can be
exceedingly misleading. Second, the analysis of broader measures of
economic performance suggests that workers as a group have shared in our
national prosperity of the past several generations. The original wage data
I cited suffer from two enormous deficiencies. First, they fail to take
account non- wage forms of compensation, particularly health care and
retirement benefits. These have soared in magnitude over time. Second, the
calculation of changing values in constant dollars is fraught with peril,
and the Consumer Price Index used in these calculations very significantly
overstates inflation in the eyes of virtually every mainstream economist,
liberal, conservative, vegetarian, Presbyterian, what have you. Similarly,
analysis of wage changes by wage or income category suffers not only from
these problems, but from the aforementioned phenomenon of the rapidly
changing economic status of individual members of our opportunity society over time.

You don't need a Ph.D. in economics to observe that never has a society had
a middle class more used to what once were considered goods and services
available only to the uber rich. Middle income Americans live in larger
homes, buy more gadgets like IPODS and cell phones, live longer, are more
if not better educated, and take nicer vacations than either their parents
did or do and their counterparts in any other major nation. I returned two
days ago from a two week cruise in the Caribbean, traveling less with top
business executives or even elite Ivy League professors than with equipment
salesmen, butchers, and teachers -ordinary folk. That simply did not happen
even 30 years ago.

My second major point relates to public policy dealing with economic
inequality. Time does not permit a detailed exegesis of past efforts. But a
reminder of some historical experiences is sobering. Policy can come from
the tax, spending or regulatory side. I will ignore regulatory matters in
the interest of time, although I would hasten to commend Senator Schumer
for recent statements showing his concerns about the abusive use of the
tort system as a growth-impeding way of redistributing income. Looking at
taxes, attempts to make the system more progressive often have unintended
effects. For example, sharp reductions in top marginal tax rates in the
1920s, 1960s, and 1980s, viewed by some as favoring the rich, actually led
to sharp increases in the tax burden of the rich relative to the poor. I
worked for this Committee during the 97th Congress in 1981 and 1982 in a
political environment much like today with divided government, with the
Republicans controlling the Executive while Congress was more under
Democratic control, yet the two branches managed to work together to
fashion a more growth oriented tax policy with lower marginal tax rates
that contributed mightily to the boom that has followed. I hope the
110th Congress is capable of similar accomplishments.

Taxes have behavioral consequences. The CBO greatly underestimated revenues
that would arise from the reducing in the top capital gains rate to 15
percent, for example.

Falling rates unlocked billions in unrealized gains that have helped fund
our rapidly expanding government. Similarly, sharp reductions in the number
of estates subject to death taxation as a result of reform in those laws
has not led to a sharp decline in revenues from that source, as some had
expected. It would be a tragedy to reverse the positive effects of the tax
reductions of the past few years that, like the Kennedy tax reductions of
the 1960s, have had a positive impact on economic activity.

On the spending side, history again shows disappointing results of many
initiatives to help the poor or middle class. As the January 20 issue of
the Economist notes, government job training programs have internationally
been largely failures.

Spending initiatives in the areas of education, medical care, and public
assistance have usually brought about disappointing results. Despite
spending far more in real terms per student than a generation or two ago,
American students do not appear to be learning much more, and the education
for lower income students is particularly deficient. A tripling of federal
aid to college students since 1994 has been accompanied by a decline, not
an increase, in the proportion of students from the lowest quartile of the
income distribution attending and graduating from our finest universities,
which are increasingly becoming taxpayer subsidized country clubs for the
children of the affluent. While Medicaid has brought some increase in
medical care for the poor, it has done so at an enormous cost to society,
and the cost pressures of a highly inefficient system are leading companies
to cut back on health care benefits for working middle class Americans. As
to public assistance, it is
far greater today in real per capita or per poor person terms than in
1973, yet the current poverty rate is higher. The welfare reforms of the
1990s were an important achievement, but the overall picture is, at the
very least, mixed.

Speaking of public assistance, I have to make one statement that may sound
a bit callous or insensitive to some, but it is an important but often
neglected truism.

Comparing the rich and the poor, it is worth noting that the rich work a
lot more. Of those persons in poverty, only a tiny minority work full-time.
We have relatively few working poor in America. And it is worth noting that
employment creation is greatest in periods when the government allows the
incredible job machine generated by the competitive private sector
operating in a market environment to work. The job creation of the 1980s
was stimulated by a halt to the growth in government's share of GDP
characterizing earlier decades, and by tax reductions that stimulated the
spirit of enterprise. The job creation of the 1990s was stimulated by an
unprecedented decline in government expenditures as a percent of GDP for
eight consecutive years - a reverse crowding out phenomenon that propelled
an enormous outpouring of American creative and entrepreneurial endeavor.

Turning to my final point today, there is a temptation to do things in the
interest of protecting middle and lower income Americans that might have
highly undesirable effects on the economy as a whole. In this regard, the
rise in protectionist sentiment in Congress is appalling, particularly as
is largely centered in a party which historically has favored free trade, a
policy that has brought prosperity to almost all Americans while at the
same time has contributed enormously to eliminating global disparities in
the distribution of income and wealth. I hope the intelligent wing of the
Democratic Party, represented by able persons such as those who preceded me
on this panel, will be able to prevent a return to policies reminiscent of
that old Democratic bete noire, Herbert Hoover. The Smoot-Hawley Tariff and
rising taxes were a factor, along with Hoover's inane wage policies, for
the Great Depression of the 1930s. Let us not repeat that today. I hope the
Democratic Party will try to emulate Franklin D. Roosevelt, John F. Kennedy and Bill
Clinton in the area of trade policy, not Herbert Hoover.

At a macro level, I believe the biggest single factor in the modest
slowdown in growth rates in this decade relative to the 1980s and 1990s is
the sharp increase in government expenditures. From fiscal year 2001 to
fiscal year 2006, total federal outlays rose by 42.4 percent, or $790.1
billion. By the way, the overwhelming majority of that was for non-defense
or national security purposes. This was nearly double the percent growth in
GDP. Receipts rose well over 20 percent or roughly equal to the growth in
GDP, so the burgeoning deficit reflected a spending binge that resulted in
some crowding out of private economic initiatives. Dollar for dollar, the
evidence is crystal clear that private spending has more
productivity-enhancing effects than public spending because of the
discipline that competitive markets impose on market enterprise. The tax
cuts largely corrected for the natural tendency for taxes to rise relative
to national output.

Raising taxes again would reduce the deficit, but would have direct
unfortunate disincentive effects on human economic behavior and would also
reduce the political costs to Congress of incremental spending initiatives,
which almost certainly would have severe economic effects. I hope some
early indications of spending constraint are maintained in the months and
years ahead. While I am not the financial guru that Secretary Rubin is, an
analysis that I have conducted with Lowell Gallaway for this Committee in
the past suggests that the two best determinants of the growth of wealth as
measured in equity prices are the rate of inflation and government spending
as a percent of GDP. Rising government spending is associated with falling
market values and wealth, with all the adverse consequences that has for
pensions. And stable prices are much better than inflation. The Fed has
done a pretty good job on the inflationary front, but the Congress and the
Executive are guilty of having shown insufficient constraint with respect to federal
expenditures.

Again, I praise the JEC for providing a needed forum for the analysis of
policy possibilities informed by factual evidence. I hope the next 60 years
are as successful for this Committee as the last 60 have been.

Thank you.