#BecauseMath Economics Taxation Unemployment

Will low corporate taxes bring the jobs back?

Many promises have been made that any number of conservative policies will bring jobs back to America. In this post, we’ll examine the claim that lower corporate taxes will reduce offshoring of jobs by presenting a simple example.

Imagine a multinational company, Big Widget Inc. (BWI), can make widgets either in the United States or in Mexico. In Mexico, where environmental regulations are gentler and wages lower, BWI can make widgets for $90. In the United States, they can make widgets for $95. No matter where they manufacture them, they can sell widgets for $100 in the United States.

Now, in this fictional world, let’s imagine the corporate tax rate is the same 40% in both countries. How much tax will BWI pay and to whom? Answering this requires a short primer on transfer pricing. When a company does business in 2 countries, it has a separate affiliate organization in each country. When goods manufactured by BWI Mexico are imported by BWI America, BWI assigns a “price” for those goods as if BWI Mexico sold those goods to BWI America. The price is called the transfer price. Ideally, this price will match the price that two unaffiliated companies would agree on. The terminology here is “arms length.” The tax authority in each country tries to prevent companies from gaming the transfer price, but there’s some wiggle room here.

If the two countries have the same tax rate, then BWI doesn’t care what the transfer price is. But, the two countries do. If the transfer price is $90, then BWI Mexico recognizes zero profit in Mexico and the USA collects all the taxes. If the transfer price is $100, then BWI Mexico recognizes all of the profit and Mexico collects all the taxes. In either case, BWI pays 40% of it’s $10 profit, or $4.

But Republicans tell us that reducing that corporate tax rate will bring that manufacturing back to the USA. Let’s explore that.

Imagine America cut its corporate income tax to 10% while Mexico holds its tax rate at 40%. In this scenario, BWI wants to minimize the transfer price for widgets. If the transfer price is $90, BWI can recognize the whole $10 profit in the USA and pay just $1 (10%) on its US profit. That’s a nice windfall for BWI but a big loss in tax revenue for Mexico. Mexico will probably insist on a higher transfer price. Maybe $95. At that transfer price and those tax rates, would widget manufacturing return to America?

By importing widgets at a $95 transfer price, BWI can make a $5 profit in each country. Mexico charges a 40% tax on the $5 attributed to BMI Mexico and the US charges 10% on the profit attributed to BWI America, so BWI Mexico pays $2 in taxes (40% x $5), BWI America pays $0.50 and BWI keeps a $7.50 after tax profit. That’s certainly better than the $6 after tax profit before the rate cut. But will BWI be motivated to move manufacturing to the US? In America, they can manufacture widgets for $95 and sell them for $100 and make a $4 after tax profit. BWI will still import since $7.50 beats $4. In fact, even at a transfer price of $100, which forces all profit on imported widgets to be taxed at the high Mexican rate, BWI *still* makes higher after tax profit by importing. The transfer price has to be over $105 (forcing the BMI America to sell at a loss!) before manufacturing in the US generates higher profits (Try it!).

I, myself, don’t see much reason to believe lowering the tax rate will boost American manufacturing. But, there’s another effect of this strategy that’s even more distressing. The policy fight over the transfer price rearranges some political alliances. We can see this by examining the desires of each of several parties–the US government, the Mexican government, US manufacturers and US workers. Two parties have an interest in a low transfer price. The US government wants a low transfer price so that profit is recognized in the US and can be taxed there. Manufacturing firms also want a low transfer price since they can pay less tax overall by moving profits to the low-tax US.

There are two parties in favor of high transfer prices, too. The Mexican government wants a high transfer price to keep taxable profits in Mexico. The other party interested in a high transfer price is American workers. It was only a very high transfer price that made manufacturing in the US more attractive. So, US workers and their unions will push to keep the transfer price high in order to move manufacturing from Mexico to the US. The sudden drop in the US corporate tax rate aligns US corporations and the US government in opposition to the Mexican government and US workers. The reader is left to decide for themselves who they think will win this political fight–the combined forces of multinational firms and US legislators or the Mexican government and American workers. But you can probably guess what I would predict.

This gaming of the corporate tax rate has two sets of winners, both of them powerful. But none of them are you and me.

#BecauseMath Economics Unemployment

A non-economist examines the minimum wage

There are no economists at ThisWeekInStupid. But, that’s not going to stop us from weighing in any more than it stops economic ignoramuses like Paul Ryan, Bernie Sanders or Peter Schiff. Recently, we penned a piece opposing a minimum wage hike, or at least suggesting that there were plenty of other ways to help minimum wage workers that were less apt to cause unemployment. Today, we’re going to go back on that a little. The main argument against a minimum wage involves, naturally, a supply and demand plot, like this one.


The downward sloping curve is the demand for workers. These are the employers who hire fewer workers when the wage is high. Many businesses can make money hiring workers for $4/hour. Fewer businesses can operate profitably paying $15/hour and very few can survive if they must pay $25/hour. The other curve, which slopes upward, is the supply curve. These are the workers. For $4/hour, lots of people will go back to school or live on their spouses income or live in their parents’ basement rather than work. For $15/hour many more will be willing to work. And for $25/hour, workers will come out of the woodwork. They’ll get childcare, come out of retirement, rearrange their class schedule, etc. (Note that this curve assumes all workers are equal, which is nonsense, but it may be illustrative anyway.) Where these two curves meet is the equilibrium wage. That’s where wages will naturally fall without any government interference. This next graph is decorated a little more.


In this graph, I’ve colored two regions underneath the curves. The green region represents the producers surplus–extra profit for workers. That is, there are some workers which would have been willing to work for $4/hour. They consider their hour to be worth $4. If the equilibrium wage is $6/hour, then they are $2 richer for every hour they work.

The orange area is the consumer surplus–extra profit for employers. Some employers could break even by paying workers $8/hour. If they only pay $6/hour, the employer is wealthier by $2 for every hour worked. These two areas are what make capitalism fun. Voluntary exchanges make both parties wealthier. Always. So is it ever a good idea for government to interfere with voluntary exchange? Let’s see.

The effects of a minimum wage

When a minimum wage is introduced above the equilibrium wage, a few things change. The first result is unemployment. In our curve, the equilibrium wage might be $6/hour. With a minimum wage set at $8/hour, two things happen. First, more people are seeking work. Second, fewer businesses are willing to hire. Both of these effects cause unemployment (but only the second of these effects represents a change in employment from the equilibrium situation). It’s represented by U in the plot below.


At the new wage, employers are demanding fewer workers than the total workers seeking a job. Liberals should stop denying this effect. It’s true that there are studies that found that in a subset of businesses hiring minimum wage workers, the effect on employment was weak or absent. But these studies and others also point to a stimulative effect of a minimum wage wherein wealth is transferred to poorer workers who tend to immediately spend their money. This tends to boost demand. So the question is, if there’s a boost in demand, why does employment stay the same? Why doesn’t it increase? A natural explanation is the argument above. The first order effect is the one we see on the supply and demand curve pushing employment down. The stimulative effect helps to mitigate that effect. Also, there are many careful studies which reach the conclusion that a minimum wage does decrease employment.

Returning to the supply/demand plot, let’s look at what’s happened to the green and orange regions. The wage is higher, so the green region would be the area under the supply curve up to the new minimum wage. Except that there is unemployment. Only a fraction of the workers desiring employment can find jobs. So we should reduce the green region by the unemployment. An approximation of that is the green shaded region above.

The orange region is more straightforward. Those employers who could not profit by hiring workers at the minimum wage, stopped hiring. So the orange region is the area under the demand curve above the minimum wage.

So, are the workers, collectively, better off? Certainly those workers who keep their jobs are better off. Our worker who was willing to work for $4/hour is now making $8/hour and gaining wealth at $4 for every hour worked (up from $2 before the minimum wage). But, some other workers, including some willing to work for $4/hour, have lost the chance to work. In many cases, this represents an overall gain for the workers as a whole. It’s easy to see how the new green region could be larger than the old especially if the demand is quite inelastic–that is, if demand for workers stays largely the same as wages increase. But when this is the case, it’s important to ask, where did this extra money come from?

Partly, it comes out of the profits formerly collected by the employers. In our new curve, the orange region is clearly smaller. Employers of minimum wage workers will almost always argue against a minimum wage. The first order effect is to shrink their profits.

Another source of increased wages for workers is increased prices for the end goods. Conservatives often say dumb things like, “Employers just pass the additional costs on to consumers.” This is lazy economics (just ask a non-economist!). There’s a separate supply/demand curve for whatever good or service the employer is selling. Presumably, this curve is what set the consumer price of the end good in the first place. Unless the minimum wage changes the market for end goods, the pricing strategy of the employer is unlikely to change much. Of course, the supply curve for the end goods may change as competitors with smaller profit margins who cannot afford the new higher wage, drop out of the market. This may cause prices to rise, but it will still be subject to the end consumer demand curve. Consumers will not blithely pay higher prices just because our employers’ costs rise. Research shows that something like one-third of the additional cost of a minimum wage hike is passed to consumers as higher consumer prices.

So, some of the extra worker profit comes out of employer profit and some comes from the end consumers. One important thing should be clear from the plots. The profit the workers gain from the minimum wage is always less than the profit the employers lose. That is, the first order effect of government interference is to reduce the overall wealth of the economy. This should have been obvious from the beginning. When a worker valuing his time at $4/hour works for an employer who values that same work at $10/hour, there is, in total $6/hour profit to be made and split between the employer and employee. Changing the wage shifts the allocation between the employer and employee, but does not affect that total. So the total possible surplus (consumer + producer) was fixed before the minimum wage was introduced. The minimum wage can only affect this total by prohibiting some of the exchanges, reducing the total profit.

So, isn’t a minimum wage just a terrible idea?


Not necessarily. Think of a minimum wage as a leaky pipeline that transfers wealth from wealthy employers to less wealthy workers. There are some good reasons to redistribute wealth downward. First, wealth exhibits a diminishing marginal utility. That is, each dollar improves the life of a poor person more than it does a rich person. To a poor person, $500 may mean repairing his only car or fixing his children’s teeth. Meanwhile, to a rich person, it may mean an additional Coach purse or a spectacular bottle of wine. Even though the total amount of stuff has not increased (and has, in fact, decreased) the utility of the stuff, or the happiness it produces, may increase.

The second reason to redistribute wealth applies only in a Keynesian recession. When an economy is in the doldrums due to deflation and weak demand, shifting wealth from rich to poor can boost the economy since poor people tend to spend their money more quickly and readily than rich people. This moves money through the economy faster and creates inflation. In an economy dogged by deflation due to a shrinking money supply and weak demand, this is a welcome effect. But, in an economy operating at full capacity or one experiencing supply-push inflation, this is a problem. More spending can cause inflation to run too high, distorting price signals. The great part about a fixed minimum wage is that inflation quickly makes the minimum wage irrelevant as wages are pushed above the mandated minimum. A minimum wage below the equilibrium wage is like having no minimum at all. So a mildly restrictive minimum wage is an automatic recession fighter providing stimulus when demand (and wages) fall without causing inflation when wages rise.


The final reason to redistribute wealth, especially through a minimum wage, comes from Henry George (whom modern economists ignore at their peril). George and his disciples point out that at least some of the profits employers collect are “economic rent” on the non-produced inputs to production. That is, the division between employer and employee may be partly because of something about the employer which does not make her more productive. Certain people may have better access to capital due to their birth or connections or physical characteristics or land ownership or habitus. Where these characteristics are unrelated to productivity, they amount to a contrived exclusivity, depressing the demand for workers and reducing wages. Marx would say that the separation of the workers from the means of production enables excessive profit-taking by employers. Of course, not all advantages of employers are rent taking. An employer who has labored to produce 10 shovels might reasonably hire 10 workers to use them, taking profit for providing the shovels. But, when that employer takes additional rent because she owns the land or because her father-in-law fronted her the money for the shovels or because she has an exclusive right to produce or use shovels, she’s collecting economic rent. Rent-taking reduces the efficiency of markets and destroys wealth in the same way a minimum wage does but to the disadvantage of workers. A minimum wage forbids any exchange of labor for money below a certain wage. Rent requirements forbid or discourage businesses started by otherwise productive people without the right characteristics or connections.

A brief clarification is probably a good idea here. In economic terms “rent” is not only the money you pay your landlord to continue to live in your apartment (although that’s one example). It’s also the benefit you get from being white or being the boss’s nephew or even for holding the patent on a product. Not all assets on which you collect rent are nefarious or unfair. But what makes it rent-taking is that you benefit for some other reason than that you’re more productive.

Let’s look at our supply and demand curves again. Rent requirements artificially reduce the number of potential employers. For simplicity, we represent this as a simple multiplicative reduction in the labor demand. Suppose that our rent requirement means that 15% of potential employers are pushed out of the market.


In the curve above, it’s clear that the downward shift in demand reduces the wage and increases the profits for the remaining employers. At the same time, the employment shrinks. The effect is, in fact, quite similar to the effect of a minimum wage with the increased profits for employers coming partly from decreased profits for workers.

In cases where there are rent requirements for new businesses, a minimum wage may boost wages which were artificially suppressed by rent-seekers. But, a minimum wage is a very blunt instrument. It harms both rent-seekers and naturally profitable businesses. In this curve, we can see that the combination of a minimum wage and rent requirements is better for workers than no minimum wage (or might be), but still much inferior to eliminating both the minimum wage and rent requirements.


Here, the minimum wage has pushed the price back out to the equilibrium price, but it cannot undo the effect of the rent requirements. An economy is much better served by finding ways to reduce rent-seeking, especially since both the minimum wage and the rent requirements drive up consumer prices. But, in markets dominated by rent requirements, a reasonable minimum wage may do more good than harm.



Economics Education Taxation Unemployment

5 Ways To Help the Poor That Beat Raising the Minimum Wage

There’s a lot of minimum wage denial out there. Some of it is well-informed. But if I could have one political wish, it would be that my Democratic friends would stop pretending like Economics 101 is a vast right-wing conspiracy. It should be taken for granted that the primary effect of raising the minimum wage is less employment for people at the bottom of the wage scale. Yes, I’ve seen the Krueger and Card study where the effects on employment cluster around zero, but I think this is evidence of my point. You see, a minimum wage puts money in the pockets of the people most likely to spend it tomorrow–the poor. So if that secondary effect helps the economy increasing employment, there must be some other factor pulling the effect back toward zero, right? The CBO’s assessment of a $10.10 minimum wage was that it would cost 500,000 jobs, but lift 900,000 people out of poverty.

There’s another reason to be suspicious of the federal minimum wage. It’s a cruelly blunt instrument. A $15 minimum wage might do nothing at all to employment in Seattle, but might cost many more jobs in rural Mississippi, where prevailing wages are substantially lower. Proponents of the minimum wage are always very excited to tax Walmart and McDonald’s–massively profitable multi-nationals. But most of the minimum wage increase is likely to be paid by businesses with 10 or fewer employees, many of which have razor-thin margins. The result there will be higher consumers prices and serious lay-offs and previously profitable businesses closing. Further, earners of the minimum wage are not all working parents. At least some minimum wage workers are middle-class teenagers, who, frankly, are getting their share of breaks as is. Almost half of minimum wage earners are between 16 and 24. I spent a lot of years working for minimum wage to earn date money, then going home to dinner and two loving, college-educated parents. That was a terrific experience, but is my upper-middle class teenage self really the most worthy recipient of wage assistance? Could we find ways to direct more of the benefits of wage assistance to the truly needy?

Now, imagine we could find other ways to help the poor make ends meet without simultaneously encouraging unemployment. Imagine these same programs could target the wealthiest people and corporations to pay for them and the poorest to receive the benefits. Terrific, right? Here are five:

Boost the Earned Income Tax Credit. While I don’t always agree with him, Milton Friedman is a man I greatly admire. Besides being a brilliant economist, he was, I think, the original compassionate conservative. His ideas on the benefits of a “negative income tax” are still extremely relevant. We owe the existence of a robust EITC partly to Friedman and he would be ashamed to see Republican efforts to dismantle this program and it’s sister, the Child Tax Credit. Both are methods of rewarding work while redistributing wealth with minimal distortion to markets. Unlike programs which can create a “poverty trap,” wherein at some income levels, you actually take home less money by working more, the EITC and CTC always reward earning income.

Invest in Poor Schools. This is a long term play to be sure, but it also has important positive short term effects. Schools that keep kids safe and feed them as well as educate them make life easier for the lower class parents who are trying to build a better life. This leads to more productive and stable workers who can then demand higher pay and better educated workers for the future.

Ditch mandatory minimum sentences for drug possession. ThisWeekInStupid is not an advocate for drug legalization, but neither do we see the logic in obligating judges to jail drug users who might do more good than harm for their families and communities at home.

Provide free, convenient English courses. This is just one example of ways to boost the skill-level of minimum wage workers. Workers who have good English literacy and basic computer and arithmetic skills are better able to know and insist on their rightful wages. And, as worker productivity grows, it lifts the whole of the economy.

Scale back right-to-work. Unions contribute to a whole host of positive changes in working conditions including raising wages. Right-to-work laws reduce the effectiveness of unions by allowing workers to free-ride, enjoying the benefits of union negotiations without paying in to the system. Freeriders result in less cooperation and worse results. However, ThisWeekInStupid thinks there are strong arguments that unions of government employees are less beneficial since government workers’ vote puts them on both sides of the negotiating table.

Raising the minimum wage is the laziest way to help the poor and not the most effective. In inflation adjusted dollars, even a $11.00 minimum wage would be the highest ever. Now, I’ll take a minimum wage over nothing, but I’d much rather pursue other angles first.