Sunday, February 28, 2016

Free trade and war: a review of Avner Offer’s “The First World War: An Agrarian Interpretation”

People who have read my posts in the past two years might have noticed that I discussed several times the origins of World War I (here and here and here). There are two reasons why I believe this is important. First, very few people would disagree that our world is still shaped by what happened then. Not only did the war finish off semi-feudal systems in Europe, and destroyed four empires, it set the world onto Communist, and later Fascist revolutions, and likewise to decolonization. So most of what politically exists today has its origin in 1914. The second reason is that the period which preceded  World War I was a period of most complete globalization up to date, relatively free trade, and (what would be called today) neoliberal policies. Thus the similarities between that world and our own are many.

The theories of what caused the war are almost as numerous as the theories of what caused the fall of the western Roman Empire. Without going into any of them, I think they can be usefully divided into theories that stress economic factors, those that emphasize politics, and finally those that believe in accidents.  For me, and I would say for most economists, it is the former (economic theories) that we are most interested in, and perhaps because of that, find most sensible. In my new book “Global inequality: a new approach for the age of globalization”,  I use one of them, the Hobson-Lenin theory that sees the origin of the war in domestic maldistribution of income, struggle for foreign markets and the need to physically control the territories where the investments are made.

Avner Offer’s excellent book “The First World War: An Agrarian Interpretation” (published in 1991) also provides an economic, but somewhat different, explanation. Offer’s particular take on the origins of the War may not be as well known, so let me give here a summary and interpretation.

Offer starts with the repeal of the Corn Laws in 1846. The repeal of the Corn Laws opened British agriculture to foreign competition. British agriculture could not compete, so most of the food had to be supplied from overseas. This required control of the seas. The fleet became the substitute for tariffs. Britain became richer as it "allowed" the movement of labor from less productive agriculture to industry, but its economy and society became more fragile. The navy, as Offer nicely puts it, took the role of tariff rates. While the Corn Laws existed, the tariffs made sure that there was enough food for workers; without the Corn Laws, a strong navy had to make sure the food would be shipped to Britain.

Thus, Offer implies, and at times argues, specialization and international division of labor directly led to the need for a strong military. Free trade was underwritten by arms.

But this particular calculation was not limited to Britain. As other nations started to develop, especially so Germany, they faced the same trade-off. Either Germany kept a significant share of its population on land in low productivity agriculture, or it went at full speed into manufacturing for which it needed labor to move to the cities and the food to come from elsewhere. So Germany like Britain had to make sure that it could be supplied with food and raw materials which implied also a buildup of a navy and stronger control over the agricultural neighbors who produced food, mostly in the East (Russia or what is today the Ukraine), and in the Balkans. (You can see there, if you wish, the seeds of the food driven Lebensraum doctrine, a point recently made by Timothy Snyder.)

Another element came into the picture as well. As both the British and the Germans sought to ensure the safety of their food supplies, they realized that, in the case of a war, food supply was a weakest spot for both.  It was especially sensitive because neither country’s ruling class could be sure of the loyalty of its workers once the war began and food shortages spread. Socialist parties and workers’ movements, before the war, often implied as much. Either a socialist revolution or capitulation or both loomed (as indeed they eventually happened in Russia, Germany and Austria). It thus gradually dawned on both British and German military planners  that the most effective way to fight the enemy was to disrupt its food supplies and the surest way to remain invulnerable was to have a navy powerful enough to repel all such attempts by the other side.

The civilian populations became the prime war target. (Offer opens the book with the ultimate effect of this strategy: hunger  in Germany in the months before the Armistice and all the way to the signing of the Versailles peace treaty.) Each military advance in either UK or Germany gave only a temporary respite until the move was matched by the other side.  From that point onward, it was only a matter of time and opportunity when the conflict would break out.

I will not go over the very elaborate details that Offer provides on British strategy to hit Germany at its (if I can use this dubious pun) “soft belly” (food supplies).  It ranged from naval blockade of North German and Belgian and Dutch ports to land invasion of Northern Germany.  The planning took place between 1905 and 1914 but the facts were not revealed until the 1960s because they would have fallen under the rubric of preparations  for an aggressive war, which the Allies, at Versailles, claimed only Germany did before the war.

There is here one very important point to notice for the economists. Unlike those who (somewhat wrongly) interpreted Ivan Bloch and Norman Angell to have believed that increasing interaction and economic links between the countries would make the war unthinkable, Offer implicitly argues the very opposite. It is precisely the decision to specialize in the production of manufactures (that is, to produce something for which Britain or Germany possessed comparative advantage) that led to the need to have a war machine and ultimately to the war itself: "the adjustment to economic specialization was the root cause of the war" (p. 327). World War I was in effect the first war of globalization.

While international division of labor makes the costs of wars exorbitant for all participants, it also requires, in order that the system be maintained, a permanent armed underpinning. But that permanent armed underpinning by itself renders the war more likely because it leads more than one power to make the same calculation  and come to the same conclusions. If we were to replace Britain and Germany from Offer’s book by US and China today we would not be very much remiss.

More diversified, less autarkic, countries become much more productive but at the cost of being more fragile and brittle to any disruption. Our very sophisticated economic system can be brought to a complete halt by (say) one month breakdown of all electronic communications.  In 1926, Vladimir Mayakovski, after spending some time in New York, wrote this:

Exactly under Wall Street runs a metro tunnel. What would happen if it were filled with dynamite and the entire street were to blow up and disappear into the thin air? Gone too would be the registers of deposits, titles and serial numbers of innumerable shares, and the columns of data on foreign debt. (America, Gallo Nero Publishing, Madrid, 2011, p. 120).

Mayakovski was as far from being an economist as every poet is but sometimes poets can see better into the future than economists.

Finally, I would like  to mention three excellent chapters iin Offer’s book on the opposition to Asian migration into Canada, US, Australia and New Zealand. They bring, very timely, all the themes with which we are familiar today: the anti-immigrant attitude of the (White) working class which saw in Asian labor a competitor against which they were bound to lose, the rise of populist politicians, inconsistent racial stereotyping (Asian were attacked both because they were “inferior” to European migrants, but also because they were “superior”, smarter and more hard-working), seizure of would-be migrants’ assets (called then the “landing fees” that Indian and Chinese workers had to pay upon entry into Canada and the US), and finally outright ban of Asian migration. Yet one additional reason not only to read the book but to reflect on how the pre-1914 period is so scarily similar to our own.

Tuesday, February 16, 2016

Are US taxes progressive all the way to the top 1%?

When we ask the question in the title, we normally go back to the annual surveys of income distribution conducted by the Census Bureau under the name of  Current Population Surveys (CPS). I am using here, to derive the figure below, the “lissified” (internationally harmonized) CPS data for 2010 and 2013.  The data very clearly show that the average tax rate (federal and state) increases in disposable income. For the top percentile, it reaches 34 percent. This is exactly what we would expect from a progressive income tax system: richer people pay higher share of their income in taxes.

            There are however two problems with these data. First, survey data underestimate income at the top (most of all, income from capital). For example, interest, dividends etc. represent only 7% of market income in survey data, but about 12% of income in IRS fiscal data. And most of capital income is received by the very rich.  (And to make things  simpler I will speak throughout of capital income like interest and dividends, not of capital gains or losses.) So if top incomes are underestimated then the calculated average tax rate (taxes/income) shown in Figure 1 is overestimated. The “true” tax rate is less. I will call the underestimation of top incomes by surveys, “top income survey bias”.  

But there is an even bigger problem: tax data shown here are only estimates, calculated by CPS from the simulations based on what people with such reported incomes should pay in taxes. CPS does not ask for taxes paid; it asks only for all types of incomes and then applies the tax rules in the simulations it runs to come up with the estimates shown in Figure 1. The bottom line is this: we really do not know how much is being paid in taxes.

Let’s move to the second source: fiscal data provided by the IRS. These are the data used, among others by Saez and Piketty to show changes in US inequality over the long-run. But while IRS provides for the recent years, a rather large sample of income data (for up to several hundred thousands of respondents)  it does not provide data on taxes paid. Moreover, the income concept used by the IRS, the so-called Adjusted Gross Income, is what should be best described as “political income”. It is whatever income the Congress decides is income. It excludes such obvious economic incomes like interest on state and local bonds. It also excludes all non-taxable transfers like social security benefits or cash value of various in-kind socials transfers, or indeed imputed income from own housing. (Obviously, if something is not subject to taxation, you are not going to report it on your tax form.) At the very top, the data are “blurred” for confidentiality reasons: some income fields are represented as means of several households. The same approach (“censoring” or “top-coding”) is used by household surveys too. Finally, IRS data do not cover the entire population because some 5-7% of people do not file tax returns.

Yet its most serious defect for our purposes is that income reported by the rich is a “castrated” income, compared to a true economic income, because it deducts all kinds of “expenses” that no economist would consider as such but which the fiscal system allows. Vacations, travels, lunches, are treated as “business expenses” with which to offset income, so that the ultimately reported fiscal or political income may be significantly lower than a real income as defined by economists. Many of us have heard of business trips to France in July, entirely written off (thus reducing the fiscal or “political” income). Such expenses should normally be classified as any other consumption item and not as an income deduction. Similar examples abound. The most important thing is that such loopholes  (as they are I think mistakenly called) are really designed and used only by the rich. Majority of people whose income is in wages do not have incentive  or wherewithal or rationale to create false companies or consultancies whose main objective is to reduce their fiscal income. So, for the top income group, we are faced here too with a significant underestimate of income. Let us call it “top income fiscal bias”.

Thus we come to the third source of data: Congressional Budget Office (CBO) that gets the data on fiscal (political) income from IRS plus some confidential data on taxes actually paid, and tries to match this information with income from household surveys. CBO is quite forthcoming about the serious data inadequacies it faces (see appendix on Data and Methods, p. 31).  

 For 2011, CBO comes up with the estimate of the overall federal tax rate (including indirect taxes and social security) by income level as shown in Figure 2.  The top 1% is estimated to have paid some 29% of their market income in taxes, a rate higher than that for other groups.

            While CBO does probably the best job possible with what it has, note that the results are based on (1) matching of information, not on actual data on taxes and incomes, and, more importantly, on (2) income data which are seriously underestimated at the top. They suffer from both survey and fiscal top income biases, in addition to another bias due to tax evasion, which I have left out of consideration altogether, but which is certainly the greatest among the top.

            Or to give a concrete example. In 2011, the average market income of households that were in the top 1% was, according to the CBO,  $1.45 million. The calculated federal tax rate was, as we have seen, 29%. But to $1.45 million, we should add income that was wiped out thanks to the political income bias plus all income that was simply not reported whether because of survey inadequacies or because of tax evasion. If these two sources add to say 50% of the officially reported income, then the average tax rate is no longer 29% but 19%. And we cannot be sure that it is the highest average tax rate assessed as we would normally expect if the system were progressive throughout.

            In conclusion, I think it is fair to say that, a century after the system of direct personal taxation was introduced in the US, one really does not know what is the tax rate paid by the very top of the income distribution. It could be that Mitt Romney’s average tax rate of 13% is not that uncommon.