Robert Dittmar is a friend of mine from college who also happens to be an Associate Professor in the Finance Area at the Stephen M. Ross School of Business at the University of Michigan. I wanted to talk to him because he knows all kinds of things about finance and economics, an area where I think we’re often victims of simplistic thinking. I wanted to know why we shouldn’t just go ahead and tax the rich. Bob had some interesting answers.
John Warner: As you’re aware, I’m a liberal arts guy, so you’re going to have to translate your research a little for me. I know you basically spend your time looking at the stock market. What are you looking for and at?
Robert Dittmar: Financial asset markets are interesting to me because they reveal the outcome of a dynamic social system. Our job as financial economists is to try to uncover the workings of that system. Broadly speaking, my research tries to understand how people’s decisions translate into the prices that we observe. You’ve got millions of people trying to make decisions about how much they should consume today, how much they should save, and how to allocate the wealth that they do save. And then they get together in a market and set a price for financial assets. My research tries to model the way that they make these decisions, see what the model implies for prices, and then see if the implications are supported empirically. To put it a bit more specifically, I spend a lot of time trying to understand the relation between the amount of risk an asset has and its expected reward.
JW: So if I give you all my money, could you turn it into lots more money?
RD: This is the place where if this was the written transcript of an oral interview, you would have to insert [Laughs.] It depends on what you mean. I don’t think I could do a better job of it than anyone else educated in finance. My worldview (as it pertains to finance) is that if you want to make a lot of money, you have to take on a lot of risk. The problem with risk, is that sometimes you lose everything. There are all kinds of strategies that are out there that seem like they make more money than our models say they should. It has always been my contention, and a focus of my research, that the reason that they make so much money is because they are subject to some risk that we haven’t figured out how to measure yet. I’m not as hardcore of a believer in investor rationality as I used to be, but I do believe that humans are greedy enough that if there is money lying on the table, someone will grab it. And so opportunities to make more money than you should are rare, and don’t last long if they exist at all.
JW: What’s shaken or at least shifted your belief in “investor rationality?”
RD: There are several things. Some is just introspection; I know I do not behave rationally in the way that our models suggest that I should. And I have friends and associates that behave irrationally relative to our models. I always thought that cancelled out in the aggregate; that when you got to the level of a market, that prices by and large reflected rational beliefs about future outcomes. The financial crisis has done more to shake my belief in rationality than anything else. It is really hard for me to believe that the prices we built into homes and real estate-backed securities reflected an objective belief about how much that real estate would be worth in the future.
That said, and hopefully I’m not being too academic here, the word “rationality” is tossed around too loosely. It implies that there is some objective sense of future value – that we can forecast on the basis of a known set of probable outcomes what something will be worth in the future. Irrationality is thought of as a situation in which we willfully ignore those probabilities and instead use a set of probabilities that we like better. My problem with this definition of irrationality is that none of us know what “truth” is – how probable uncertain outcomes are. And, as a result, we what we generally think of as irrationality is something that we can only point to ex post. It becomes obvious to us when those expectations don’t materialize that the expectations were inflated. It’s tougher to assess whether, given that we don’t know what’s going to happen in the future, if we made rational decisions given the information at the time.
I’m going on too long here, but this is an important philosophical debate in economics and probably the social sciences in general, and one that I think is often publicly misinterpreted. So-called bubbles like the housing bubble or the dot-com bubble only reveal themselves ex post. But we can try to figure out what kind of expectations would have permitted the prices that investors were willing to pay for houses or dot-com stocks. And those expectations seem to be wildly out of line with anything that we have historically seen. As a result, it is hard to conclude that investors were pricing these things rationally.
Now I’m really going on too long here, but there are other reasons that investors may have had what appear to be irrational expectations about future values of housing. Interest rates were very low, and it was uncertain how long they would stay low. The government subsidizes housing purchases through tax incentives. And securitization provided a whole new set of incentives that are poorly understood. Given uncertainty about, and distortions to “rational” beliefs caused by these incentives, investors may have been behaving perfectly rationally – our rational models that don’t incorporate these problems may fail to capture some of the resulting deviations from rational behavior.
JW: Privately, we were talking about some interesting numbers and graphs you’d been generating. For the sake of our audience, what have you found?
RD: This was me playing amateur macroeconomist -- a lot of my research lies in the intersection of macroeconomics and finance. To kind of recap what we were discussing; a trend that bothers me is that wage and salary income has been growing at a much slower rate since 1980 than consumption. Depending on how you measure it, real per capita wages have grown by an average of about 1% per year over this time period, while real per capita consumption has grown by an average of about 2% per year. If wages aren’t growing as fast as consumption, some other source of income has to be growing faster than consumption. Hopefully this isn’t too pedantic, but there are basically four sources of income: wages, proprietors’ earnings, earnings on assets (dividends, rental income, and interest), and transfer payments from the government – welfare and social benefits. Real per capita proprietors’ income has grown by about 2% per year since 1980, real per capita dividends have grown by about 4% per year, and real per capita transfer payments have grown by about 3% per year. My casual inference from these numbers is that there has been a transfer in the sources of consumption away from wage-earners, and toward capital owners and recipients of social benefits.
JW: So, check me if I’m wrong, but what you’re saying is that according to your reading of this data, the so-called middle class of wage earners are losing ground while the “rich” who have money that can earn money, and the “poor” who receive some forms of government assistance are doing better, relatively speaking.
RD: The academic in me says that I have to be really careful here and be clear that what I’m saying is highly subject to me misinterpreting the data, and that I don’t have enough information to make a conclusive statement. In particular, I don’t know if I can say that the “poor” are doing relatively better. But my contention is that the “rich” have been getting a greater share of income, at the expense of those that are not “rich,” but it is not clear that in an economy that is driven by consumption, that this income is translating into improved consumption, and therefore economic growth.
I should also be careful and note that there is a sense in which some of this is a natural reversal of earlier trends. Up until the 1970s, wages and salaries grew much faster than consumption, while dividends grew more slowly. One could argue that in the pre-1970s period labor had too much power, and capital too little. Certainly, reforms were put into place in the 1970s and 1980s that shifted the balance of power from labor to capital. The question for me is whether those reforms “overshot” in some sense. Here I’m not going to make anyone happy with me, because I would argue that wages and standards of living grew too fast in some senses after World War II, and that some correction was necessary. I just personally believe, standing in 2012, that the correction may have gone too far, and that the pendulum may need to swing in the opposite direction.
JW: So why does this cause a finance guy like you some worry?
RD: Why does this concern me? I don’t think that consumption can continue to grow at 2% per year if wages grow by only 1% per year. I’m convinced that at least one part of the income equation can’t continue to rise at the rate that it has – social benefits. While the growth in social benefits received since 1980 has been 3% per year, the real per capita rate of growth in taxes and personal and business contributions to social insurance has been 1.35%. Some of that difference may come from income on the investment in the Social Security fund, but not all of it. That leaves dividends, which are mostly earned by wealthy individuals. Using the Survey of Consumer Expenditures, the average amount consumed by the bottom four quintiles of consumers based on income rose at the same rate as the average amount consumed by the top quintile from 1984 to 2010. These numbers leave me concerned that the trends need to reverse, or consumption will need to slow, and by extension the whole economy and the stock market will suffer.
I should make a note here; a non-trivial part of the growth in dividends has been due to the fact that in the 1980s, a large number of companies became S corporations, which allowed them to benefit from tax reform. In an S corporation, earnings are paid as dividends to the shareholders, and taxed at personal tax rates. The Tax Reform Act of 1986 reduced personal tax rates below corporate rates. However, S corporation elections do not account for all, or even most, of the growth in dividends.
Another caveat: this is all very casual inference. I have only tried some limited serious empirical exercises with these data. And I don’t doubt that someone could easily point to some place where my logic is in error. I am working on research now to try to understand whether these trends have implications for stock prices and, if so, what those implications are.
JW: Shouldn’t the capital holders who have been earning dividends be concerned about this? If consumption for wage earners can’t keep pace, doesn’t that mean we’ll be in a kind of permanent slump?
RD: That is certainly my sense. The problem, I think, is that these imbalances can persist for a long time. If you are rich, and you can maintain a certain standard of living even in the face of slow economic growth, do you care? I am curious as to whether consumption of the wealthy, especially on non-subsitence items, is more or less sensitive to business cycles. My casual observation would suggest that it is less sensitive. Even if the economy slows, it may not have much effect on the wealthy. Further, I can think of many economies that have supported a wealthy elite for a long time even while growth has stagnated and the poor have suffered.
That said, I can’t think of a lot of political and economic systems that have permitted this situation to persist indefinitely. Eventually, the cost of subsistence consumption for the less wealthy seems to catch up with their ability to pay for this consumption and results in a peaceful or violent revolution. I want to caution that I am not saying in any way that such a situation is present in the U.S. economy or in any way imminent. But the economic costs of such revolution seem to be great, and I would think that it would be wiser to pre-emptively shift some of the wealth gains in the economy from capital to labor, rather than endure a more sudden, and potentially damaging shift.
One reason that I am concerned is that poorer households are being forced to shift more of their consumption to items that we would consider subsistence rather than discretionary. A significant body of research, using the Bureau of Labor Statistics Survey of Consumer Expenditures has shown that people in the bottom 20% of income have had consumption grow no slower than those in the top 20%. But a recent paper by Mark Aguiar and Mark Bils documents that the type of good that the poor consume differs from the rich. A greater proportion of the consumption of poorer individuals goes toward what we consider to be necessities: housing, food, utilities, and health care.
Again, I want to emphasize that this is just opinion, not rigorous analysis.
JW: Sounds to me like maybe we should just go ahead and tax the rich.
RD: I don’t think that is really a solution. Or, perhaps, if it is a solution, the solution needs to be more nuanced. I make absolutely no claim to be an expert on tax policy. I think that the evidence suggests that merely increasing taxes on the very wealthy would do little to close structural gaps in our government’s fiscal condition. But I am also unsure that current tax policy is optimally suited to promote incentives and growth.
Mitt Romney’s disclosure of his tax returns provides an interesting case in point. Most of his income derives from dividends and capital gains rather than wage income, and his marginal tax rate is approximately that of the lowest tier of earners in the U.S. The argument in favor of his low tax rate is that lower capital gains and dividend taxes provide incentive to investment, which in turn spurs job creation and economic growth. To some extent I think this is true, but in his specific case, and in a broader context, I don’t buy the argument. I’ll try to explain why.
Suppose that I’ve got $10,000,000 that I want to invest in some startup technology. There is a huge probability (maybe 90-95%) that my business will fail. So I am taking on a huge risk. If I succeed, I will create jobs and shock the economy in a way that results in improved economic growth. I’ve taken a huge risk in the name of economic growth, and perhaps I deserve to be rewarded. If my company IPO’s at $500,000,000, I will earn capital gains if I sell out of $490,000,000. If I were taxed on that at the top marginal tax rate, my tax bill would be $171,500,000. However, because this is a long term capital gain, I am only taxed $98,000,000. One might argue that this is reasonable because I have created more than the difference of $73,500,000 in value to the overall economy. So the lower tax rate spurs innovation and economic growth.
Now suppose that it is June, 2003. I invest my $10,000,000 in Apple stock. At the end of May, 2012, I would have approximately $542,250,000. If I sell out, I have long term capital gains of $532,000,000, which are taxed at 20%, or approximately $106,450,000. If my marginal tax rate were 35%, I would have been taxed $186,270,000. The question is, have I added nearly $80,000,000 in value to the economy? You would have to believe that, had I not bought already outstanding Apple stock, Apple would not be able to innovate in the way that it has to benefit the economy. I guess I think that is a bit of a stretch.
In Mr. Romney’s case, it is even more complicated. He was involved in a business that sought to improve efficiency through cutting costs and is realizing the capital gains from those efficiency improvements. If this is really efficiency-improving, it is beneficial to the economy; it is allocating resources to the correct place. My concern is that it is not. Labor productivity has increased in the United States dramatically, and as I mentioned, wage and salary income has stagnated. This implies an inefficient resource allocation to me; workers are not being paid what they are worth. If true, that means that the capital gains are in part a transfer of what workers should be earning due to increased productivity to people like Mr. Romney.
I don’t know how much tax reforms would affect economic welfare. I bring up these examples just to emphasize that it is difficult to tease out the potential costs, benefits, and effects. So a simple answer like “tax the rich” won’t solve the problem.