Class Plan 12/7/99
Assignment for last day of class
Go over problems from lab exercise 34
Introduce lab exercise 23
Sources of Income
Income distribution
Assignment for next Thursday
• Read Wall Street Journal article,
“Defining Poverty Up,” 11/02/99;
keywords: Defining Poverty
• Read the Instruction and Background
Information page for Lab exercise 23
• Do Lab exercise 23 by Thursday Midnight.
• Do Quiz 25 by Thursday Noon
• Study for Final Exam
Final Exam Logistics:
Wednesday, December 15, 3-5PM
Section 6: 108 Bessey Hall
Section 7: 103 Erickson Hall
Final Exam Format
Answer 60 out of 70 questions:
Questions 1-30: Exactly the same format as the first
two midterms
Questions 31-70: Four sources, from complete term:
1) from quizzes and midterms this semester
2) problems based on end of chapter exercises
3) From CD-ROM chapter summaries
4) Other known good questions
How to study
Read any chapters of the book you have only skimmed
Do problems at end of chapters. If you can not answer the
problems, reread the entire chapter.
Read chapter summaries on CD-ROM for all chapters
Do Multiple choice problems from CD-ROM. If you make
more than 2 errors, reread the entire chapter.
Retake all 4 midterms & 25 quizzes. If you miss any
questions, reread the chapter on which the question is
based.
Do practice final. If you are unsure of an answer, reread
entire chapter on which question is based.
The Grade Book
I will send the class an e-mail when everything is up
to date.
(probably Friday or Saturday)
You need to email eohrkb@msu.edu with anything
that you think is an error before the final exam.
The Wealth of Nations
Adam Smith’s questions:
What makes a country wealthy
(How do we measure a country’s wealth?)
His answer was different from others of his day:
Mercantalists:
Wealth measured by gold
To become wealthy, earn gold through selling more than you buy
Western (Modern?) concept
To be wealthy is to be able to consume a lot
Well-being is measured by the total amount of
consumption.
A country that has a high income has a high ability to
consume.
Focuses attention on determinants of income
What makes a country wealthy is also what makes a
person well-off(?)
Sources of Income
A person gains income from selling factors of
production in the resource market.
Quantity of labor (hours/year) multiplied by wage rate
per year is labor income
Quantity of capital (dollars) multiplied by return on
capital (interest rate) is capital income
Quantity of land (acres?) multiplied by rental rate on
land (per year) is land income
Elements of the study of income
What causes people to work more or less?
What determines the wages that people are paid?
What determines the distribution of capital?
What determines the rate of return to capital?
What determines the distribution of land holdings?
What determines the rent paid to land?
Demand for capital
Capital is measured in dollars
Demand for capital means demand for funds to invest in capital
You will invest in a machine if the PDV of the (net)
income from using the machine is greater than the cost
of purchasing it.
If a machine
produces $1000 per year in net profit for 10 years
costs $7000 to purchase
Should you invest?
PDV Calcualations
Year
Profit
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Sum
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
10000
PDV
at 10%
909.0909
826.4463
751.3148
683.0135
620.9213
564.4739
513.1581
466.5074
424.0976
385.5433
6144.567
PDV
at 8%
925.9259
857.3388
793.8322
735.0299
680.5832
630.1696
583.4904
540.2689
500.249
463.1935
6710.081
PDV
at 5%
952.381
907.0295
863.8376
822.7025
783.5262
746.2154
710.6813
676.8394
644.6089
613.9133
7721.735
Deciding to invest
If the interest rate is 10%, do not invest.
Cost>PDV of income
If the interest rate is 5%, do invest.
Cost<PDV of income
Invest if internal rate of return is higher than the market
interest rate.
In this case, the IRR = 7.07%
Many different investments
Interest
rate
7.07%
At 7.07 interest rates, these projects
meet the criterion for investment
These do not
$ of investment projects that are justified
Supply of Loanble Funds
Determined by savings decisions of individuals
An issue for macroeconomics
Do people save more when interest rates are higher?
Strongly affected by policies of the Federal
Reserve Board.
What determines interest rates?
Interest
rate
Equilib.
Rate of
Return
Supply of Loanable Funds
Demand for Loanable Funds
$ of investment projects that are justified
Human Capital and
Discrmination
Earnings Data, different trades
Trade
Professional
specialty
Sales
Women
$27,495
Men
42,509
17,924
31,346
Clerical
20,321
27,186
Machine
Operator
15,714
23,884
Explaining pay differentials
Human capital:
Training
Skill
Experience
Affects demand curve through marginal product
Affects supply curve through limiting those willing
and able to work in a trade.
More education is required, fewer are willing to work in
this field.
Women, full-time year-round,
wages vs. age, 1996.
45000
40000
35000
30000
25000
High School
Bachelors
20000
15000
10000
5000
0
0
20
40
60
80
Men, full-time year-round, wages
vs. age, 1996.
70000
60000
50000
40000
High School
Bachelors
30000
20000
10000
0
0
20
40
60
80
The Market explanation for wage
wage
differences
Supply, Human Capital Required
Skilled
wage
Unskilled
wage
Supply no Human Capital Required
Demand, with Human
Capital requierment
Demand, no Human
Capital requierment
Worker-years
How do we know this is right?
Human capital is anything that makes you more
productive
It is not directly observable
Correlates are observable
Amount of schooling
Amount of experience
Amount of experience with the same employer
Each is correlated with wages
Market explanations for lower
women’s wages
Previously, did not have as much education
Do not spend as much time in the labor force
(due primarily to child rearing and household support
roles?)
Do not spend as much time with the same employer
(Due to following husband when he changes jobs and
moves to a different city?)
Discrimination against women?
When you control for effects of
type of occupation
education
labor force experience
job tenure
The difference between women’s and men’s wages
becomes small
Does this mean that there is no discrimination
against women?
Discrimination as a residual effect
Accept the human capital explanation for wages
Any education, training, or experience characteristic
that correlates with wages is assumed to be an
indicator of productivity.
Anything left over after human capital correlates are
accounted for is discrimination
But this may ignore the fact that access to the
characteristics that are correlated with wages are not
race and gender neutral.
Median income, full-time yearround workers, 1996
Black
White
Men
27,136
34,741
Women
21,990
25,358
Remedies for discrimination
Affirmative action:
Tries to improve access to:
education
jobs
Does this interfere with individual evaluations?
Comparable Worth
Pay different professions according to job characteristics.
What efficiency price would we have to pay?
Income Distribution and Poverty
Income distribution
Income versus Wealth
income is measured in dollars per year
wealth is measured in dollars
(Lifetime income?)
Measures of income inequality
Share going to different income quintiles
Gini coefficient
Income inequality vs. Poverty
Trends in Household Income
Measuring Income Inequality
Share going to top 5%
Gini coefficient
Relative size of area
between Lorenz curve and
full equality Lorenz curve
Higher numbers mean
more inequality
Lorenz
Curve
Cumulative % of households
Sensitivity of Gini Coefficient to
Income Definition
Money Income: Gini = .447
+ gov cash transfers + cap gains + health benefits:
Gini = .511
- taxes: Gini = .483
+ nonmeans-tested gov’t cash transfers: Gini = .416
+ means tested cash transfers: Gini= .398
+ return on home equity: Gini = .392
Poverty
The minimum amount of income necessary to pay
for necessities: food, shelter, clothing, with
nothing left over.
Usually measured as 4 times the income
necessary to buy a minimally adequate diet.
About $16,000/year for a family of 4 people.
Indicators of poverty
Live outside of metropolitan area
Black or Hispanic (Though most of the poor are
white)
Female householder, no male present
Age 15 to 20 or 70 and older
No wage earner present
Worked part time or did not work
Less than 9th grade education
The bottom 10%
The working poor
Since 1979, inflation-adjusted weekly earnings have fallen
from $292/week to $260/week.
Up from $256 last year
The first time that wages have risen in two decades
Wages of bottom 10% rose more rapidly than those of top
10%
Top 10% earns $1,149 per week.
Reasons for long-term decline
The decline in organized labor
Flood of low-skilled immigrants
Surge of imports from low-wage countries
new technologies that displaced low-skilled workers
and rewarded better-trained.
Reasons for recent turn-about
Tight labor markets
Unemployment rate for high school dropouts is down to
7%
Increase in the minimum wage
Now $5.15/hour
Earned Income Credit has reduced taxes for this
group.
How long will these trends continue?
The return to education
In 1979, a college graduate made 60% more than a
high school dropout.
In 1995, a college graduate made 140% more than a
high school dropout.
But in the last two years, the return to education has
not been increasing.
Programs to ameliorate income
inequality and/or poverty?
Some think we should be blind to issues of need or
poverty.
An issue solely for private charity?
This is not the Judeo-Christian tradition
We are our “brother’s keeper?”
People in desperate condition need our help
A community is judged by how it treats the unfortunate?
Why don’t poor get to work?
How will they get to work?
Who will watch the kids?
How can they get marketable skills?
How can they overcome their disabilities?
How will they pay for their health care?
How can they learn the importance of punctuality
and reliability?
This is paternalism
When we help people on their feet we take away their
freedom and initiative?
Income transfers are inefficient.
How leaky is the leaky bucket?
How much do we want to tell people how to live their
lives?
Drinking rules
Drug laws
Motor Cycle helmet laws.
Yes:
Should people be forced to save
for their retirement?
We KNOW that if they don’t, they will regret it at age 65.
We as a society are not prepared to accept sick, aged, beggers
Save future taxpayers cost of taking care of them
No:
I should have freedom to decide whether to save
How do we know that they aren’t better off spending today?
Retirement programs
Pension programs give people tax incentives to save for
their retirement.
These tax savings are regressive.
Beneficiaries are learning to borrow from programs.
The social security program.
Everyone must participate
You pay about 7.5% of income (up to max)
Your contribution is matched by your employer
The tax is regressive (high wage earners pay a smaller proportion of
income.)
Social Security Payouts
Benefits from program are to a limited extent
determined by income while working.
Those who worked at low wages or for less than a
lifetime receive far more than they pay in.
Those with high incomes who have worked their entire
life get back less than they pay in.
A huge non-means tested income redistribution program.
Inter-generational transfers
Social Security is a pay-as you go system.
Income from working people is used to pay those who are
now retired.
Funds are not invested for our retirement
System works so long as there are many more working age
people than retirees.
Medical advances are keeping people alive longer
The baby bust means fewer people to pay in
They system is going broke
Now, more is being paid in than is being paid out.
Funds are used to reduce Federal deficit.
In 15-20 years, more will be paid out than will be paid in.
Options:
Raise payroll taxes
Reduce retirement benefits
Increase retirement age
Why not a negative income tax?
After Tax Income
Without neg income tax
With neg. income tax
Market Income
Pros and Cons of Negative
Income Tax
Pros:
Gets rid of welfare bureaucracy
Eliminates demeaning oversight
Reduces onerous tax rates on poor
Cons:
Naïve?
Raises taxes on those who work(?)
We do care how recipients spend their money
Increasing Taxes on Wealthy
Bush and Clinton both raised tax rates on the wealthy.
Surprise is that this group is actually paying their taxes.
Between 1993 and 1995, incomes went up by $57 Billion,
taxes went up by $18 Billion
Effective Marginal tax rate: 32%
Top marginal rate
Top marginal rate is now 39%, up from 28% in 1988,
but down from70% in 1970’s.
In Italy, it is 67.2%
In Germany, 53%
In U.S. 46.6 (including state and local taxes)
In Switzerland, 43.9%
In Mexico, 35%
Top Marginal Tax Rate
The top 5%
Family income more than $250,000/year
sports, entertainment, business superstars
Pay an average of 32% of income in federal income,
payroll, corporate and excise taxes.
Polls show most Americans consider this group undertaxed
This group got a big tax break last year when capital
gains tax fell from 28% to 20%
Tax shelters
Ordinary income is taxed at about 40%
Capital gains is taxed at about 20%
General expectation that the wealthy will try to
receive more of their income in the form of capital
gains.
E.g, stock options instead of salary.
Much of increased tax payments if from selling stock at
high market prices.
Average Tax Rates
Increase in tax progressivity
The earned income tax credit has lowered taxes for the
bottom of the income distribution.
The wealthier are paying more
The increase in tax progressivity has partly offset the
increase in income inequality over last twenty five
years.