Economists Do It With Models

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Even A Stopped Clock Is Right Twice A Day, Comparative Advantage Edition…

August 11th, 2016 · 4 Comments
Econ 101 · Policy · Taxes

You guys, I’m frustrated. Yes, by this:


and by this…


But what I’m referring to is slightly less, well, dramatic, for starters. So allow me to describe one of my (admittedly many) pet peeves: When economists teach the concept of comparative advantage and gains from trade, it goes something like “hey, if you can pay somebody $20 an hour to clean your house and get paid $25 an hour at your regular job, you can specialize in your job and outsource your housecleaning and have $5 an hour left over! Everyone is better off!” Sounds great, right?

Well I tried it, and boy am I disappointed.* First off, I explained to my boss that I hired someone to clean my house and therefore I am able to spend 3 more hours per week at work. He seemed pleased with that, so I then reminded him to adjust my salary accordingly, and, well, that’s where things sort of went off the rails. Luckily, I’m a great negotiator, so he eventually came around to meet my demand. I started envisioning what I would do with that $5 an hour efficiency prize (mmmmm, Starbucks vanilla sweet cream cold brew, here I come), but when I looked at my online banking statement the numbers didn’t play out as I had expected- got paid for 3 extra hours of work, paid for 3 hours house cleaning and a grande cold brew ($4 and change IIRC) and I’m worse off than I was before? How is that possible?

Dammit, I forgot about taxes- in fairness, if my econ textbook has taught me anything, it is to ignore tax considerations when doing comparative advantage analyses. Hopefully by now you’ve identified the two logistical points that insert frictions into this specialization and gains from trade thing:

  • A lot of people don’t actually get paid by the hour (and therefore have either a zero or an unclear marginal wage), and, even when they do, they don’t usually have perfect flexibility over how many hours they work.
  • Income taxes make it such that it only makes sense to specialize if your after-tax wage is higher than what you would pay to get work done.

The first point, well, that’s one’s pretty hard to address (not everyone can have an Uber driver lifestyle I suppose), but it seems like there should be some benefits to thinking about the tax issue here. If my $25 is taxable income, the government collects tax on my $25 but doesn’t collect tax on me cleaning my own house. (Don’t go getting any ideas, government.) If my house cleaner payments were somehow not taxed, the government would lose revenue on my $20 per hour payment but would collect revenue from the person cleaning my house. Granted, this is probably a bit of a loss for the government, since the house cleaner probably pays a lower tax rate then I do, but the government would probably really like that two people are employed rather than one. (If there is slack in the labor market, it need not be the case that I pulled the house cleaner away from some other job.)

Yeah, so this doesn’t happen, and I am stuck cleaning my own house.** You’ve probably gotten out the world’s smallest violin for me at this point, perhaps because many people find there to be something unseemly about hiring people to do stuff that you don’t want to do, like cleaning the house. Economically, I guess the lack of tax abatement isn’t a huge deal, since if people are paid a fixed salary or don’t have flexibility in hours it’s not the tax issue that’s the main impediment to outsourcing one’s house cleaning on the grounds of economic efficiency anyway.

BUT…let’s pretend for a second that I had used childcare rather than cleaning in the above example. Childcare is an importantly different animal, in large part because did you know that kids exist like 24 hours a day? It’s crazy. (Also, if they’re really small you can’t leave them at home by themselves, which is kind of inconvenient.) Because of this, the tradeoff between work and child care is often more binary than in the house cleaning example- in other words, people are generally deciding between working at all and taking care of their kids, or at least deciding between part-time and full-time employment. Because of this feature, it’s a more logistically reasonable candidate for exploiting gains from trade- for example, a potential worker who could pay $10,000 per year for child care (yeah, I know I’m being optimistic compared to many real cases) could leverage trade as long as she could get a job that pays more than $10,000…after taxes. (Yes, I know her taxes as a single person wouldn’t be high, but if she has a partner her marginal tax rate on the $10,000 could be quite high.)

One obvious potential solution to alleviate inefficiency in this situation would be to make child care tax deductible- as noted above, the impact to the government’s bottom line is likely small due to those who wouldn’t have paid for child care without the deduction. On the down side, the government *would* lose revenue from households who were purchasing child care even though it wasn’t tax deductible. Also, there’s that pesky thing we talked about a couple of days ago where tax deductions don’t help lower income households in the ways that we might expect (not to mention that households only get the money back at tax time, which doesn’t help households with short-term cash flow concerns).

Now, I never thought I would say this, but Trump’s team of Steves (now with more female non-economists!) is kind of onto something:

We now know more about Trump’s proposal to subsidize child care
by Josh Barro

Donald Trump’s proposal to make child-care expenses deductible from tax became a little less vague on Thursday — and significantly more expensive.

Source: Business Insider


The relevant points are as follows:

1. The deduction would be “above the line.” That means it would appear before Line 37 on the Form 1040, and therefore the deduction would come out of your income before calculating adjusted gross income. Here’s why it matters where on the form the deduction goes: You can take “above the line” deductions on top of the standard deduction, without itemizing your other deductions. As a result, more taxpayers could take advantage of this deduction, including taxpayers who don’t make enough money to itemize. (Itemizing is generally for people who pay a significant amount of mortgage interest and/or state and local tax.)

2. The deduction would apply against one-half of payroll tax, not just income tax. Clinton and others have pointed out that a new income-tax deduction would be of no value to low-income parents who don’t make enough money to pay income tax. Making the deduction also applicable against the employee-paid half of payroll tax would provide some savings to anybody with labor income. The benefit wouldn’t be huge — it would equal 7.65% of the amount deducted — but that’s not nothing.

The article itself still criticizes the plan on the grounds that higher-income households get a larger discount, which is true, but you guys, this could actually get pretty close to a situation where comparative advantage and gains from trade work in the way that the textbook tells me that they do. Now we just need to have clear objectives and dig into the nerdy details of every other policy in order to satisfy…..HAHAHAHAHAHAHAHA, yeah, I know. I’ll instead direct you to the part where Trump confuses his employees with his hotel guests.

* I’m kidding- I’m not, it’s great (though I have an atypical work situation), but just go with me here.
** Still nope.

Tags: Econ 101 · Policy · Taxes

4 responses so far ↓

  • 1 Ken Houghton // Aug 12, 2016 at 12:44 pm

    So would it not, therefore, also reduce the SS/DI payments made to the worker(s), since their SS/DI income would be lower?

  • 2 econgirl // Aug 12, 2016 at 6:06 pm

    @Ken: I’m not sure- by your reasoning it seems like that would be the case. I was more taken by the “above the line” point, so I hadn’t fully pondered the second detail. I do like, however, that people seem interested in thinking through how these things would actually work and using that brainpower to try to head off unintended consequences.

  • 3 jcb // Aug 13, 2016 at 11:23 am

    A small point about comparative advantage which, I guess, is not the real point of your post.

    The original concept was measured in undifferentiated (therefore fungible) units of labor. Labor could be transferred from making wine to weaving wool (in England) with a saving of labor due to increased productivity. (Ignoring consumption elasticities.)

    In your example, labor skills and remuneration are segmented: You can do your housecleaner’s work, but (implicitly) she can’t do yours. Otherwise, it would pay your employer to hire her, not you.

    The minute you shift from undifferentiated labor units to differential remuneration for skills, “comparative advantage” merely means producing and buying comparable things as cheaply as possible.

    To me, at least, that’s so obvious that it’s virtually the definition of any “market.”

    What do you think?

  • 4 leena // Aug 16, 2016 at 1:44 am

    let it be

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