Although labor unions have been celebrated in folk songs and stories as fearless champions of the downtrodden working man, this is not how economists see them. Economists who study unions—including some who are avowedly prounion—analyze them as cartels that raise wages above competitive levels by restricting the supply of labor to various firms and industries. Many unions have won higher wages and better working conditions for their members. In doing so, however, they have reduced the number of jobs available in unionized companies. That second effect occurs because of the basic law of demand: if unions successfully raise the price of labor, employers will purchase less of it. Thus, unions are a major anticompetitive force in labor markets. Their gains come at the expense of consumers, nonunion workers, the jobless, taxpayers, and owners of corporations. According to Harvard economists Richard Freeman and James Medoff, who look favorably on unions, “Most, if not all, unions have monopoly power, which they can use to raise wages above competitive levels” (1984, p. 6). Unions’ power to fix high prices for their members’ labor rests on legal privileges and immunities that they get from government, both by statute and by nonenforcement of other laws. The purpose of these legal privileges is to restrict others from working for lower wages. As antiunion economist Ludwig von Mises wrote in 1922, “The long and short of trade union rights is in fact the right to proceed against the strikebreaker with primitive violence.” Interestingly, those who are expected to enforce the laws evenhandedly, the police, are themselves heavily unionized. U.S. unions enjoy many legal privileges. Unions are immune from taxation and from antitrust laws. Companies are legally compelled to bargain with unions in “good faith.” This innocent-sounding term is interpreted by the National Labor Relations Board to suppress such practices as Boulwarism, named for a former General Electric personnel director. To shorten the collective bargaining process, Lemuel Boulware communicated the “reasonableness” of GE’s wage offer directly to employees, shareholders, and the public. Unions also can force companies to make their property available for union use. Once the government ratifies a union’s position as representing a group of workers, it represents them exclusively, whether or not particular employees want collective representation. In 2002, unions represented about 1.7 million waged and salaried employees who were not union members. Also, union officials can force compulsory union dues from employees—members and nonmembers alike—as a condition for keeping their jobs. Unions often use these funds for political purposes—political campaigns and voter registration, for example—unrelated to collective bargaining or to employee grievances, despite the illegality of this under federal law. Unions are relatively immune from payment of tort damages for injuries inflicted in labor disputes, from federal court injunctions, and from many state laws under the “federal preemption” doctrine. Nobel laureate Friedrich A. Hayek summed it up as follows: “We have now reached a state where [unions] have become uniquely privileged institutions to which the general rules of law do not apply” (1960, p. 267). Labor unions cannot prosper in a competitive environment. Like other successful cartels, they depend on government

Minimum wage laws set legal minimums for the hourly wages paid to certain groups of workers. In the United States, amendments to the Fair Labor Standards Act have increased the federal minimum wage from $.25 per hour in 1938 to $5.15 in 1997.1 Minimum wage laws were invented in Australia and New Zealand with the purpose of guaranteeing a minimum standard of living for unskilled workers. Most noneconomists believe that minimum wage laws protect workers from exploitation by employers and reduce poverty. Most economists believe that minimum wage laws cause unnecessary hardship for the very people they are supposed to help. The reason is simple: although minimum wage laws can set wages, they cannot guarantee jobs. In practice they often price low-skilled workers out of the labor market. Employers typically are not willing to pay a worker more than the value of the additional product that he produces. This means that an unskilled youth who produces $4.00 worth of goods in an hour will have a very difficult time finding a job if he must, by law, be paid $5.15 an hour. As Princeton economist David F. Bradford wrote, “The minimum wage law can be described as saying to the potential worker: ‘Unless you can find a job paying at least the minimum wage, you may not accept employment.’”2 Several decades of studies using aggregate time-series data from a variety of countries have found that minimum wage laws reduce employment. At current U.S. wage levels, estimates of job losses suggest that a 10 percent in crease in the minimum wage would decrease employment of low-skilled workers by 1 or 2 percent. The job losses for black U.S. teenagers have been found to be even greater, presumably because, on average, they have fewer skills. As liberal economist Paul A. Samuelson wrote in 1973, “What good does it do a black youth to know that an employer must pay him $2.00 per hour if the fact that he must be paid that amount is what keeps him from getting a job?”3 In a 1997 response to a request from the Irish National Minimum Wage Commission, economists for the Organization for Economic Cooperation and Development (OECD) summarized economic research results on the minimum wage: “If the wage floor set by statutory minimum wages is too high, this may have detrimental effects on employment, especially among young people.”4 This agreement over the general effect of minimum wages is long-standing. According to a 1978 article in American Economic Review, 90 percent of the economists surveyed agreed that the minimum wage increases unemployment among low-skilled workers.5 Australia provided one of the earliest practical demonstrations of the harmful effects of minimum wage laws when the federal court created a minimum wage for unskilled men in 1921. The court set the wage at what it thought employees needed for a decent living, independent of what employers would willingly pay. Laborers whose productivity was worth less than the mandated wage could find work only in occupations not covered by the law or with employers willing to break it. Aggressive reporting of violations by vigilant unions made evasion difficult. The historical record shows that unemployment remained a particular problem for unskilled laborers for the rest of the decade. At about the same time, a hospital in the United States fired a group of women after the Minimum Wage Board in the District of Columbia ordered that their wages be raised to the legal minimum. The women sued to halt enforcement of the minimum wage law. In 1923, the U.S. Supreme Court, in Adkins v. Children’s Hospital, ruled that the minimum wage law was price fixing and that it represented an unreasonable infringement on individuals’ freedom to determine the price at which they would sell their services. In addition to making jobs hard to find, minimum wage laws may also harm workers by changing how they are compensated. Fringe benefits—such as paid vacation, free room and board, inexpensive insurance, subsidized child care, and on-the-job training—are an important part of the total compensation package for many low-wage workers. When minimum wages rise, employers can control total compensation costs by cutting benefits. In extreme cases, employers convert low-wage full-time jobs with benefits to high-wage part-time jobs with no benefits and fewer hours. David Neumark and William Wascher found that a 10 percent increase in minimum wages decreased on-the-job training for young people by 1.5–1.8 percent.6 Since on-the-job training is the way most people build their salable skills, these findings suggest that minimum wage laws also reduce future opportunities for the unskilled. A particularly graphic example of benefits reduction occurred in 1990, when the U.S. Department of Labor ordered the Salvation Army to pay the minimum wage to voluntary participants in its work therapy programs. In exchange for processing donated goods, the programs provided participants, many of whom were homeless alcoholics and drug addicts, with a small weekly stipend and up to ninety days of food, shelter, and counseling. The Salvation Army said that the expense of complying with the minimum wage order would force it to close the programs. Ignoring both the fact that the beneficiaries of the program could leave to take higher-paying jobs at any time and the cash value of the food, shelter, and supervision, the Labor Department insisted that it was protecting workers’ rights by enforcing the minimum wage. After a public outcry, the Labor Department backed down.7 Its Wage and Hour Division Field Operations Handbook now contains a special section on minimum wage enforcement and the Salvation Army.8 Minimum wage increases make unskilled workers more expensive relative to all other factors of production. If skilled workers make fifteen dollars an hour and unskilled workers make three dollars an hour, skilled workers are five times as expensive as the unskilled. Imposing a minimum wage of five dollars an hour makes skilled workers relatively more attractive by making them only three times as expensive as unskilled workers. This explains why unions, whose members have historically been highly skilled and seldom hold minimum wage jobs, invariably support legislation increasing minimum wages. As in the Australian case, unions also protect themselves against competitive threats by assiduously helping labor authorities find and prosecute suspected violators. Many employers in the U.S. construction industry have found it less expensive to hire unskilled workers at low wages and train them on the job. By accepting lower wages in return for training, unskilled workers increase their expected future income. With high minimum wages like those specified for government construction by the Davis-Bacon Act, the cost of wages and training for the unskilled may rise enough to make employers prefer more productive union members. In effect, higher minimum wages reduce the competition faced by union members while leaving the unskilled unemployed. Of course, employers may also respond to minimum wage laws by decreasing overall employment, substituting machines for people, moving production abroad, or shutting down labor-intensive businesses. While those rendered unemployed by a minimum wage increase are largely invisible, it is easy to calculate the increased income enjoyed by those who keep their jobs after an increase. This asymmetry has led many advocates to mistakenly assume that increasing the minimum wage is an effective way to fight poverty. Using 1997 Census data, D. Mark Wilson found that only 11.7 percent of minimum-wage workers were the sole breadwinners in their families, and that more than 40 percent of the sole breadwinners earning the minimum wage were voluntary part-time workers.9 Richard Burkhauser used 1996 U.S. Census data to identify the likely beneficiaries from the 1996 increase in the federal minimum wage. He concluded that the “20.9 percent of minimum wage workers who lived in poor families only received 16.8 percent of the benefits.”10 Additional evidence on the distributional effect of minimum wages comes from David Neumark, Mark Schweitzer, and William Wascher. Raising the minimum wage increases both the probability that a poor family will escape poverty through higher wages and the probability that another nonpoor family will become poor as minimum wage increases price it out of the labor market. They found that the unemployment caused by minimum wage increases is concentrated among low-income families. This suggests that minimum wage increases generally redistribute income among low-income families rather than moving it from those with high incomes to those with low incomes. The authors found that although some families do benefit, minimum wage increases generally increase the proportion of families that are poor and near-poor. Minimum wage increases also decrease the proportion of families with incomes between one and a half and three times the poverty level, suggesting that they make it more difficult to escape poverty.11 In the early 1990s, after a telephone survey of 410 fast-food restaurants in New Jersey and Pennsylvania, economists David Card and Alan B. Krueger challenged the consensus view that higher minimum wages shrink employment opportunities. Their results appeared to demonstrate that a minimum wage increase resulted in increased employment.12 Because telephone survey data are notoriously prone to measurement error, Neumark and Wascher repeated Card and Krueger’s analysis using payroll records from a similar sample of restaurants over the same time period. The results from the payroll data showed that “the minimum-wage increase led to a decline in employment in New Jersey fast food restaurants relative to the Pennsylvania control group.”13 After an extended academic debate, Card and Krueger retreated from their earlier position, writing that “the increase in New Jersey’s minimum wage probably had no effect on total employment in New Jersey’s fast-food industry, and possibly had a small positive effect.”14 Even without the results from the payroll data, the contrary results from the Card and Krueger study would have had a limited impact on economists’ belief that increasing the minimum wage increases unemployment. As labor economist Finis Welch pointed out, the consensus theory does not predict how any one firm or industry is affected by minimum wage increases.15 Even if nationally recognized fast-food restaurants did not reduce hiring in response to higher minimum wages, Card and Krueger were silent about what happened at less-visible businesses, such as small retailers and local pizza and sandwich shops. Furthermore, estimates of the overall effect of minimum wage increases often lead people to overlook the fact that regional and sectoral wage differentials average together to produce the national result. A federal minimum wage of $5.15 an hour may substantially reduce employment in rural areas, where it exceeds the prevailing wage, but have little effect on employment in large cities, where almost everyone earns more. Regional studies leave little doubt that substantial increases in the minimum wage can shrink local industries and inhibit job creation in areas with market wages below the new minimum. The growth of the textile industry in the southern United States, for example, was propelled by low wages. Had the federal minimum wage been set at the wage earned by northern workers, the migration of textile workers to the South might never have occurred. It is also easy to overlook the fact that raising the minimum wage applicable to a relatively small proportion of occupations will not necessarily increase measured unemployment. Some people will lose their jobs in covered occupations and withdraw from the labor market entirely. They will not be included in the unemployment statistics. Others will seek jobs at lower pay in uncovered occupations. Though the labor influx reduces wages in the uncovered sector, people do have jobs, and unemployment may not change. As minimum wage laws cover more occupations, however, the shrinking uncovered sector may not be able to absorb all of the people thrown out of work. The 1989 U.S. minimum wage legislation brought us one step closer to this possibility by extending coverage to all workers engaged in interstate commerce, regardless of employer size. The fact that gross unemployment statistics do not necessarily reflect the harm done by minimum wage laws with limited coverage probably explains the popularity of the living-wage ordinances now in vogue in American cities with strong union ties. Living-wage ordinances set minimum wages for businesses and nonprofits that receive contracts or subsidies from local government. To arrive at the appropriate minimum living wage, advocates calculate the amount required to pay for a basket of goods containing “decent” housing, child care, food, transportation, health insurance, clothing, and taxes for various family sizes. The minimum is then set at the rate that produces enough money to buy the basket when someone works forty hours a week for a year. Initial empirical studies by Neumark suggest that the trade-off between wages and employment is the same for living wages as for minimum wages.16 In San Francisco in 2001, passage of a living-wage law raised the compensation of airport skycaps from $4.75 an hour to $10.00 an hour plus health insurance.17 By the end of 2002, the Economic Policy Institute, an advocacy group supported by labor unions and liberal foundations, reported that living-wage ordinances had set minimum wages ranging from $6.25 an hour in Milwaukee to $12.00 an hour in Santa Cruz, California.18 In September 2003, the California Assembly passed a $10 minimum-wage requirement for contractors doing business with the state. By one reckoning, the total cost of the typical basket of worker necessities used to arrive at living-wage minimums exceeds the incomes of almost a third of all families in the United States.19 It will not be surprising, therefore, as the number of cities with “living-wage” laws expands, to see unskilled workers harmed by falling employment, fewer entry-level jobs, and a reduction in job-related training and educational opportunities. About the Author Linda Gorman is a senior fellow with the Independence Institute in Golden, Colorado. She was previously an economics professor at the Naval Postgraduate School in Monterey, California. Further Reading   Brown, Charles. “Minimum Wage Laws: Are They Overrated?” Journal of Economic Perspectives 2, no. 3 (1988): 133–145. Burkhauser, Richard V., Kenneth Couch, and David C. Wittenburg. “A Reassessment of the New Economics of the Minimum Wage Literature with Monthly Data from the Current Population Survey.” Journal of Labor Economics 18, no. 4 (2000): 653–680. Employment Standards Administration. U.S. Department of Labor. “History of Changes to the Minimum Wage Law.” Online at: http://www.dol.gov/esa/minwage/coverage.htm. Eccles, Mary, and Richard B. Freeman. “What! Another Minimum Wage Study?” American Economic Review 94 (May 1982): 226–232. Forster, Colin. “Unemployment and Minimum Wages in Australia, 1900–1930.” Journal of Economic History 45, no. 2 (June 1985): 383–391. Hashimoto, Masanori. “Minimum Wage Effects on Training on the Job.” American Economic Review 72, no. 5 (1982): 1070–1087. Neumark, David, Mark Schweitzer, and William Wascher. “Will Increasing the Minimum Wage Help the Poor?” Federal Reserve Bank of Cleveland Economic Commentary, February 1, 1999. Online at: http://www.clevelandfed.org/Research/com99/0201.pdf. Neumark, David, and William Wascher. “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Comment.” American Economic Review 90, no. 5 (2000): 1362–1396. Neumark, David, and William Wascher. “Minimum Wages and Training Revisited.” Journal of Labor Economics 19, no. 3 (2001): 563–595. Rottenberg, Simon, ed. The Economics of Legal Minimum Wages. Washington, D.C.: American Enterprise Institute for Public Policy Research, 1981. Welch, Finis. Minimum Wages: Issues and Evidence. Santa Monica, Calif.: RAND Corp., 1978. Wilson, D. Mark. Increasing the Mandated Minimum Wage: Who Pays the Price? Backgrounder no. 1162. Washington, D.C.: Heritage Foundation, 1998.   Footnotes 1. Employment Standards Administration, U.S. Department of Labor, History of Changes to the Minimum Wage Law, 2003, online at: http://www.dol.gov/esa/minwage/coverage.htm.   2. “Minimum Wage vs. Supply and Demand,” Wall Street Journal, April 24, 1996.   3. Paul Samuelson, Economics, 9th ed. (New York: McGraw-Hill, 1973), pp. 393–394.   4. Organization for Economic Cooperation and Development, OECD Submission to the Irish National Minimum Wage Commission, Labour Market and Social Policy Occasional Papers no. 28, 1997, p. 15.   5. Kearl, J. R., et al., “A Confusion of Economists?” American Economic Review 69 (1979): 28–37.   6. David Neumark and William Wascher, “Minimum Wages and Training Revisited,” NBER Working Paper no. 6651, National Bureau of Economic Research, Cambridge, Mass., 1998.   7. James Bovard, “How Fair Are the Fair Labor Standards,” Regulation 18, no. 1 (1985), online at: http://www.cato.org/pubs/regulation/reg18n1d.html.   8. Section 64c06: Salvation Army says: “The Salvation Army’s position is that individuals in its rehabilitation program (called ‘beneficiaries’) are not employees under the FLSA. Although WH may not agree with this position, do not initiate C/As until receiving clearance from both the RA and the Child Labor and Special Employment Team, NO/OEP. Advise beneficiaries who complain that this WH policy has no effect on their private-action rights under section 16(b) of the FLSA” (http://www.dol.gov/esa/whd/FOH/ch64/64c06.htm).   9. D. Mark Wilson, Increasing the Mandated Minimum Wage: Who Pays the Price? Backgrounder no. 1162 (Washington, D.C.: Heritage Foundation, 1998).   10. Richard V. Burkhauser, Written testimony before the Committee on Education and the Workforce, U.S. House of Representatives, 106th Congress, April 27, 1999. See also Richard V. Burkhauser, Kenneth A. Couch, and Andrew J. Glenn, “Public Policies for the Working Poor: The Earned Income Tax Credit Versus Minimum Wage Legislation,” Research in Labor Economics 15 (1996): 65–109; Richard V. Burkhauser, Kenneth A. Couch, and David C. Wittenburg, “Who Gets What from Minimum Wage Hikes: A Re-estimation of Card and Kreuger’s Distributional Analysis in Myth and Measurement: The New Economics of the Minimum Wage,” Industrial and Labor Relations Review 49, no. 3 (1996): 547–552.   11. David Neumark, Mark Schweitzer, and William Wascher, “Will Increasing the Minimum Wage Help the Poor?” Federal Reserve Bank of Cleveland Economic Commentary, February 1, 1999, online version at: http://www.clevelandfed.org/Research/Workpaper/2004/WP04-12.pdf.   12. David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review 84, no. 4 (1994): 792. A later book expanded on these results, see David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton: Princeton University Press, 1995).   13. David Neumark and William Wascher, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Comment,” American Economic Review 90, no. 5 (2000): 1390. Researchers from the Employment Policies Institute also reported finding data errors in the Card and Krueger sample. In one Wendy’s in New Jersey, for example, there were no full-time workers and thirty part-time workers in February 1992. By November 1992, the restaurant had added thirty-five full-time workers with no change in part-timers. See David R. Henderson, “The Squabble over the Minimum Wage,” Fortune, July 8, 1996, pp. 28ff.   14. David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Reply.” American Economic Review 90, no. 5 (2000): 1419.   15. American Enterprise Institute, “The Minimum Wage and Employment: What Research Shows,” conference summaries, Washington, D.C., August 1995, online at: http://www.aei.org/cs/cs5365.htm.   16. David Neumark and Scott Adams, “Do Living Wage Ordinances Reduce Urban Poverty?” NBER Working Paper no. 7606, National Bureau of Economic Research, Cambridge, Mass., 2000; David Neumark, How Living Wages Affect Low-Wage Workers and Low Income Families (San Francisco: Public Policy Institute of California, 2002).   17. Adam Geller, “‘Living-Wage’ Laws Raise Pay for Poor but May Cost Jobs,” Associated Press, September 1, 2001, online at: http://projects.is.asu.edu/pipermail/hpn/2001-September/004534.html.   18. The Economic Policy Institute received $90,000 from the NEA in 2000–2001 (Education Policy Institute, http://216.239.33.100/search?q=cache:fYjj4PUYjiYC:www.educationpolicy.org/NEAreport2000.htm+%22Economic+Policy+Institute%22+%22Form+990%22&hl=en&ie=UTF-8), and $200,000 from the Joyce Foundation (2001 Annual Report, http://www.joycefdn.org/pdf/01_AnnualReport.pdf). For a complete list of supporters in 2000, see the institute’s annual report at: http://www.epinet.org/ar2000/AR00_RS3.htm. The rate is $11.00 if health benefits are included in the wage package.   19. Economic Policy Institute, Basic Family Budget Calculator, online at: http://epinet.org/, under Poverty and Family Budgets section. Fraction below living wage minimums from Heather Boushey, Chauna Brocht, Bethney Gunderson, and Jared Bernstein, Hardships in America: The Real Story of Working Families (Washington, D.C.: Economic Policy Institute, 2001), table 5.   (0 COMMENTS)

“Law and economics,” also known as the economic analysis of law, differs from other forms of legal analysis in two main ways. First, the theoretical analysis focuses on efficiency. In simple terms, a legal situation is said to be efficient if a right is given to the party who would be willing to pay the most for it. There are two distinct theories of legal efficiency, and law and economics scholars support

Until the 1980s, property and liability insurance was a small cost of doing business. But the substantial expansion in what legally constitutes liability has greatly increased the cost of liability insurance for personal injuries. The plight of the U.S. private aircraft industry illustrates the extent of these liability costs. Although accident rates for general aviation and for small aircraft declined steadily, liability costs for the industry soared, so that by the 1990s the U.S. private aircraft industry had all but ceased production. These substantial costs arose because accident victims or their survivors began to sue aircraft companies in 90 percent of all crashes, even though pilot error is responsible for 85 percent of all accidents. Only after Congress exempted planes older than eighteen years from liability by passing the General Aviation Revitalization Act of 1994 did the industry begin to increase production. Still, output is well below its level before the rise in liability costs. In 1978, 17,811 new U.S.-manufactured general aviation airplanes were shipped, but by 1994 this amount had plummeted to 928. Though shipments have since rebounded to 2,137 airplanes in 2003, that amount is still well below the peak production years. The consequences of liability can be substantial for industries, and some, such as the asbestos industry, have disappeared altogether because of liability costs. The U.S. vaccine industry has been hard hit by the costs associated with liability for adverse reactions to its vaccines. Indeed, much of the price of vaccines is attributable to costs of liability, which are largely shifted to consumers through higher prices because expected liability costs raise the costs of supplying vaccines. Ten of the thirteen companies manufacturing vaccines for the five serious childhood diseases exited the market because of rising liability costs. Negligence was at one time the dominant legal criterion for determining a firm’s liability. Firms were responsible for accidents arising from their products only if they did not provide an efficient level of safety (see law and economics for an explanation of how the term “efficient” is used in this case). Over the past three decades, however, broader liability doctrines, some of which have nothing to do with negligence, have placed greater responsibilities on product manufacturers. In the 1960s, courts adopted “strict liability,” which required producers to pay for accident costs in a much broader range of circumstances. The asbestos litigation is perhaps the best-known example of a major line of litigation that was facilitated by the adoption of the strict liability doctrine. One of the courts’ stated rationales

The marginal tax rate is the rate on the last dollar of income earned. This is very different from the average tax rate, which is the total tax paid as a percentage of total income earned. In 2003, for example, the United States imposed a 35 percent tax on every dollar of taxable income above $155,975 earned by a married taxpayer filing separately. But that tax bracket applied only to earnings above that $155,975 threshold; income below that cutoff point would still be taxed at rates of 10 percent on the first $7,000, 15 percent on the next $14,400, and so on. Depending on deductions, a taxpayer might pay a relatively modest average tax on total earnings, yet nonetheless face a 28–35 percent marginal tax on any activities that could push income higher—such as extra effort, education, entrepreneurship, or investment. Marginal decisions (such as extra effort or investment) depend mainly on marginal incentives (extra income, after taxes). The seemingly arcane topic of marginal tax rates became the central theme of a revolution in economic policy that swept the globe during the last two decades of the twentieth century, with more than fifty nations significantly reducing their highest marginal tax rates on individual income (most of which are shown in Table 1). Tax rates on corporate income (not shown) were also reduced in most cases (e.g., to 12.5 percent in Ireland). Table 1 also shows, however, that a handful of countries did comparatively little to reduce the highest, most damaging tax rates—notably, most of Western Europe, Scandinavia, Canada, and Japan. Why did so many other countries so dramatically reduce marginal tax rates? Perhaps they were influenced by new economic analysis and evidence from optimal tax theorists, new growth economics (see economic growth), and supply-side economics. But the sheer force of example may well have been more persuasive. Political authorities saw that other national governments fared better by having tax collectors claim a medium share of a rapidly growing economy (a low marginal tax) rather than trying to extract a large share of a stagnant economy (a high average tax). East Asia, Ireland, Russia, and India are a few of the economies that began expanding impressively after their governments sharply reduced marginal tax rates. Table 1 Maximum Marginal Tax Rates on Individual Income *. Hong Kong’s maximum tax (the “standard rate”) has normally been 15 percent, effectively capping the marginal rate at high income levels (in exchange for no personal exemptions). **. The highest U.S. tax rate of 39.6 percent after 1993 was reduced to 38.6 percent in 2002 and to 35 percent in 2003. 1979 1990 2002 Argentina 45 30 35 Australia 62 48 47 Austria 62 50 50 Belgium 76 55 52 Bolivia 48 10 13 Botswana 75 50 25 Brazil 55 25 28 Canada (Ontario) 58 47 46 Chile 60 50 43 Colombia 56 30 35 Denmark 73 68 59 Egypt 80 65 40 Finland 71 43 37 France 60 52 50 Germany 56 53 49 Greece 60 50 40 Guatemala 40 34 31 Hong Kong 25* 25 16 Hungary 60 50 40 India 60 50 30 Indonesia 50 35 35 Iran 90 75 35 Ireland 65 56 42 Israel 66 48 50 Italy 72 50 52 Jamaica 58 33 25 Japan 75 50 50 South Korea 89 50 36 Malaysia 60 45 28 Mauritius 50 35 25 Mexico 55 35 40 Netherlands 72 60 52 New Zealand 60 33 39 Norway 75 54 48 Pakistan 55 45 35 Philippines 70 35 32 Portugal 84 40 40 Puerto Rico 79 43 33 Russia NA 60 13 Singapore 55 33 26 Spain 66 56 48 Sweden 87 65 56 Thailand 60 55 37 Trinidad and Tobago 70 35 35 Turkey 75 50 45 United Kingdom 83 40 40 United States 70 33 39** Source: PricewaterhouseCoopers; International Bureau of Fiscal Documentation. Economic Growth by Robert J. Barro and Xavier Sala-i-Martin (MIT Press, 2004, p. 514) lists among the world’s twenty fastest-growing economies Taiwan, Singapore, South Korea, Hong Kong, Botswana, Thailand, Ireland, Malayasia, Portugal, Mauritius, and Indonesia. As Table 1 shows, all these countries either had low marginal tax rates to begin with (Hong Kong) or cut their highest marginal tax rates in half between 1979 and 2002 (Botswana, Mauritius, Singapore, Portugal, etc.). This might be dismissed as a remarkable coincidence were it not for a plethora of economic studies demonstrating several ways in which high marginal tax rates can adversely affect economic performance. Numerous studies, ably surveyed by Karabegovic et. al. (2004), have found that high marginal tax rates reduce people’s willingness to work up to their potential, to take entrepreneurial risks, and to create and expand a new business: “The evidence from economic research indicates that … high and increasing marginal taxes have serious negative consequences on economic growth, labor supply, and capital formation” (p. 15). Federal Reserve Bank of Minneapolis senior adviser Edward Prescott, corecipient of the 2004 Nobel Prize in economics, found that the “low labor supplies in Germany, France, and Italy are due to high [marginal] tax rates” (Prescott 2004, p. 7). He noted that adult labor force participation in France has fallen about 30 percent below that of the United States, which accounts for the comparably higher U.S. living standards. Even in the United States, marginal tax rates are really higher than statutory rates suggest. In a study aptly titled “Does It Pay to Work?” Jagadeesh Gokhale et al. (2002) include state and local taxes, the marginal impact of losing government benefits (such as Medicaid and food stamps) if income rises, the progressive nature of Social Security benefits (which are least generous to those who work the most), and the phasing out of deductions and exemptions as income rises. They conclude that even “those with earnings that exceed 1.5 times the minimum wage face marginal net taxes on full-time work above 50 percent” (Abstract). At higher incomes, the estimated federal, state, and local marginal tax rate is about 56–57 percent. Marginal tax rates are higher still, however, in countries where statutory rates are higher. Lifetime family work effort and entrepreneurship are not the only things affected. Nobel laureate Robert Lucas emphasized the deleterious effect on economic growth of high tax rates on capital. Philip Trostel focused on the impact on human capital, finding that high marginal tax rates on labor income reduce the lifetime reward from investing time and money in education. There are evidently many channels through which high marginal tax rates may discourage additions to personal income, and thus also discourage marginal additions to national output (i.e., economic growth). As the variety among these studies suggests, each separate effect of high marginal tax rates is typically examined separately, which makes the overall economic distortions and disincentives appear less significant than if they were all combined. Despite widespread reduction of marginal tax rates throughout the world, there remains considerable misunderstanding about what marginal tax rates are and why they matter. The common practice of measuring tax receipts as a percentage of GDP, for example, is too static. It ignores the destructive effects of tax avoidance on tax revenues, the numerator of that ratio, and on the growth of GDP, the denominator. A sizable portion of productive activity may cease, move abroad, or vanish into inefficient little “informal” enterprises. And just as so-called tax havens attract foreign investment and immigrants, countries in which the combined marginal impact of taxes and benefits is to punish success and reward indolence often face “capital flight” and a “brain drain.” OECD in Figures (2003) shows total taxes as 45.3 percent of GDP in France, compared with 29.6 percent in the United States. But it would be a mistake to conclude that the higher average tax burden in France is a result of that country’s more steeply graduated income tax. French income tax rates claim half of any extra dollar at incomes roughly equivalent to $100,000 in the United States, and exceed the highest U.S. tax rates at even middling income levels. Yet these high individual income taxes account for only 18 percent of revenues in France, about 8.2 percent of GDP, while much lower individual income tax rates in the United States account for 42.4 percent of total tax receipts, or 12.5 percent of GDP. Countries such as France and Sweden do not collect high revenues from high marginal tax rates, but from flat rate taxes on the payrolls and consumer spending of people with low and middle incomes. Revenues are also high relative to GDP partly because private GDP (the tax base) has grown unusually slowly, not because tax revenues have grown particularly fast. People react to tax incentives for the same reason they react to price incentives. Supply (of effort and investment) and demand (for government transfer payments) respond to marginal incentives. To increase income, people may have to study more, accept added risks and responsibilities, relocate, work late or take work home, tackle the dangers of starting a new business or investing in one, and so on. People earn more by producing more. Because it is easier to earn less than to earn more, marginal incentives matter. To the extent to which a country’s tax system punishes added income with high marginal tax rates, it must also punish added output—that is, economic growth. About the Author Alan Reynolds is a senior fellow with the Cato Institute and was formerly director of economic research at the Hudson Institute. Further Reading   Gokhale, Jagadeesh, Laurence Kotlikoff, and Alexi Sluchynsky. “Does It Pay to Work?” NBER Working Paper no. w9096. National Bureau of Economic Research, Cambridge, Mass., 2002. Online at: http://www.nber.org/papers/w9096. Karabegovic, Amelia, Niels Veldhuis, Jason Clemens, and Keith Godin. “Do Tax Rates Matter?” Fraser Forum, July 2004. Online at: http://www.fraserinstitute.ca/admin/books/chapterfiles/July04ffkarabeg.pdf#. Lucas, Robert E. Jr. “Supply-Side Economics: An Analytical Review.” Oxford Economic Papers 42 (April 1990): 293–316. Online at: http://ideas.repec.org/a/oup/oxecpp/v42y1990i2p293–316.html. Prescott, Edward C. “Why Do Americans Work So Much More than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review (July 2004). Online at: http://minneapolisfed.org/research/qr/qr2811.pdf. Reynolds, Alan. “Crises and Recoveries: Multinational Failures and National Success.” Cato Journal 23 (Spring/Summer 2003): 101–113. Online at: http://www.cato.org/pubs/journal/cj23n1/cj23n1–11.pdf. Reynolds, Alan. “The Fiscal-Monetary Policy Mix.” Cato Journal 21 (Fall 2001): 263–275. Online at: http://www.cato.org/pubs/journal/cj21n2/cj21n2-11.pdf. Reynolds, Alan. “International Comparisons of Taxes and Government Spending.” In Stephen E. Easton and Michael A. Walker, eds., Rating Global Economic Freedom. Vancouver: Fraser Institute, 1992. Pp. 361–388. Online at: http://oldfraser.lexi.net/publications/books/rating_econ_free/. Reynolds, Alan. “Tax Reform in Lithuania and Around the World.” Lithuanian Free Market Institute, no. 6, 1997. Online at: http://www.freema.org/NewsLetter/tax.budget/1997.6.treform.phtml. Reynolds, Alan. “Workforce 2005: The Future of Jobs in the United States and Europe.” In OECD Societies in Transition: The Future of Work and Leisure. Paris: OECD, 1994. Pp. 47–80. Online at: http://www.oecd.org/dataoecd/26/32/17780767.pdf. Trostel, Philip A. “The Effect of Taxation on Human Capital.” Journal of Political Economy 101 (1993): 327–350. Online at: http://econpapers.hhs.se/article/ucpjpolec/v_3A101_3Ay_3A1993_3Ai_3A2_3Ap_3A327-50.htm.   (0 COMMENTS)

Adam Smith struggled with what came to be called the paradox of “value in use” versus “value in exchange.” Water is necessary to existence and of enormous value in use; diamonds are frivolous and clearly not essential. But the price of diamonds—their value in exchange—is far higher than that of water. What perplexed Smith is now rationally explained in the first chapters of every college freshman’s introductory economics text. Smith had failed to distinguish between “total” utility and “marginal” utility. The elaboration of this insight transformed economics in the late nineteenth century, and the fruits of the marginalist revolution continue to set the basic framework for contemporary microeconomics. The marginalist explanation is as follows: The total utility or satisfaction of water exceeds that of diamonds. We would all rather do without diamonds than without water. But almost all of us would prefer to win a prize of a diamond rather than an additional bucket of water. To make this last choice, we ask ourselves not whether diamonds or water give more satisfaction in total, but whether one more diamond gives greater additional satisfaction than one more bucket of water. For this marginal utility question, our answer will depend on how much of each we already have. Though the first units of water we consume every month are of enormous value to us, the last units are not. The utility of additional (or marginal) units continues to decrease as we consume more and more. Economists believe that sensible choice requires comparing marginal utilities and marginal costs. They also think that people apply the marginalism concept regularly, even if subconsciously, in their private decisions. In southern states, for example, a much lower fraction of people buy snow shovels than in northern states. The reason is that although snow shovels cost about the same from state to state, the marginal benefit of a snow shovel is much higher in northern states. But in discussions of public-policy issues, where most of the benefits and costs do not accrue to the individual making the policy decision (e.g., subsidies for health care), the appeal of total utility and intrinsic worth as the basis for decision can mask the insights of marginalism. Even good answers to certain grand questions give little guidance for rational public policy choices. For example, what is more important, health or recreation? If forced to choose, everyone would find health more important than recreation. But marginalism suggests that our real concern

Markets discipline producers by rewarding them with profits when they create value for consumers and punishing them with losses when they fail to create enough value for consumers. The disciplinarians are the consumers. The market for corporate control is no different in principle. It disciplines the managers of corporations with publicly traded stock to act in the best interests of shareholders. Here the disciplinarians are shareholders. Firms whose share prices are lower than they could be if managed by more talented or highly motivated managers are attractive takeover targets. By buying up enough shares to vote in a new board of directors, a bidder can then replace an inefficient or ineffectual management team. The bidder profits when the new management team gets results, which come in the form of improved corporate performance, higher profits, and, ultimately, higher share prices. Takeovers are not the only source of market discipline for companies. In particular, robust competition exists in product markets, labor markets, and capital markets for both debt and equity. Competition in these other markets disciplines managers and owners of all firms, both closely held and privately held. The market for corporate control provides an additional source of market discipline for the managers of publicly held companies. A robust, properly functioning market for corporate control is vital to the performance of a free-enterprise economy with public corporations. A public corporation is a company whose shares are owned by the public—that is, whose shares are publicly traded. Public corporations are highly efficient and socially desirable for a number of reasons (see corporations). Without an effective market for corporate control, however, public corporations are unlikely to perform as well as they would otherwise. Of course, private markets are remarkably flexible and diverse. Economic activity frequently is organized in private, closely held firms as well as in large publicly held companies. Numerous studies show that shareholders in firms that are the subject of takeovers enjoy significant profits. Gains to target shareholders average 40–50 percent above the prices at which target firms’ shares traded immediately prior to the takeover. The empirical evidence on returns to bidders, however, is more ambiguous. Early studies showed relatively small (3–5 percent) gains, but later studies have shown negligible gains, and some have shown slight losses. There are two reasons for this result. The first has to do with empirical methodology: takeovers are a surprise for the target firm, and so their share prices jump suddenly on the news of a takeover. Bidders, however, often announce their plans to embark on an acquisition strategy months before they locate a suitable target, much less make an acquisition. This means that any increase in the share price of the bidding company from a particular acquisition or series of acquisitions occurs quite gradually, and is therefore hard to measure

More than a century after his death, Karl Marx remains one of the most controversial figures in the Western world. His relentless criticism of capitalism and his corresponding promise of an inevitable, harmonious socialist future inspired a revolution of global proportions. It seemed that—with the Bolshevik revolution in Russia and the spread of communism throughout Eastern Europe—the Marxist dream had firmly taken root during the first half of the twentieth century. That dream collapsed before the century had ended. The people of Poland, Hungary, Czechoslovakia, East Germany, Romania, Yugoslavia, Bulgaria, Albania, and the USSR rejected Marxist ideology and entered a remarkable transition toward private property rights and the market-exchange system, one that is still occurring. Which aspects of Marxism created such a powerful revolutionary force? And what explains its eventual demise? The answers lie in some general characteristics of Marxism—its economics, social theory, and overall vision. Labor Theory of Value The labor theory of value is a major pillar of traditional Marxian economics, which is evident in Marx’s masterpiece, Capital (1867). The theory’s basic claim is simple: the value of a commodity can be objectively measured by the average number of labor hours required to produce that commodity. If a pair of shoes usually takes twice as long to produce as a pair of pants, for example, then shoes are twice as valuable as pants. In the long run, the competitive price of shoes will be twice the price of pants, regardless of the value of the physical inputs. Although the labor theory of value is demonstrably false,

Many people believe that employers do not care about workplace safety. If the government were not regulating job safety, they contend, workplaces would be unsafe. In fact, employers have many incentives to make workplaces safe. Since the time of Adam Smith, economists have observed that workers demand “compensating differentials” (i.e., wage premiums) for the risks they face. The extra pay for job hazards, in effect, establishes the price employers must pay for an unsafe workplace. Wage premiums paid to U.S. workers for risking injury are huge; they amount to about $245 billion annually (in 2004 dollars), more than 2 percent of the gross domestic product and 5 percent of total wages paid. These wage premiums give firms an incentive to invest in job safety because an employer who makes the workplace safer can reduce the wages he pays. Employers have a second incentive because they must pay higher premiums for workers’ compensation if accident rates are high. And the threat of lawsuits over products used in the workplace gives sellers of these products another reason to reduce risks. Of course, the threat of lawsuits gives employers an incentive to care about safety only if they anticipate the lawsuits. In the case of asbestos litigation, for example, liability was deferred by several decades after the initial exposure to asbestos. Even if firms had been cognizant of the extent of the health risk—and many were not—none of them could have anticipated the shift in legal doctrine that, in effect, imposed liability retroactively. Thus, it is for acute accidents rather than unanticipated diseases that the tort liability system bolsters the safety incentives generated by the market for safety. How well does the safety market work? For it to work well, workers must have some knowledge of the risks they face. And they do. One study of how 496 workers perceived job hazards found that the greater the risk of injury in an industry, the higher the proportion of workers in that industry who saw their job as dangerous. In industries with five or fewer disabling injuries per million hours worked, such as women’s outerwear manufacturing and the communication equipment industry, only 24 percent of surveyed workers considered their jobs dangerous. But in industries with forty or more disabling injuries per million hours, such as the logging and meat products industries, 100 percent of the workers knew that their jobs were

Junk bonds, also known less pejoratively as high-yield bonds, are bonds that are rated as “speculative” or “below investment” grade issues: below BBB for bonds rated by Moody’s and below Baa for bonds rated by Standard and Poor’s (the two main debt-rating agencies). Bond ratings measure the perceived risk that the bonds’ issuer will not make interest payments or repay the principal at maturity. The riskier a bond is, other things being equal, the lower its rating. The highest-rated nondefaulted bonds are rated AAA or Aaa, and the lowest are rated C, with defaulted bonds rated D; thus, junk bonds can be rated anywhere between Baa (BB) and D. As junk bonds are perceived to be riskier than other types of debt, they typically trade at higher yields—that is, higher rates of return—than investment-grade bonds. Over the past twenty years, this difference, or spread, between junk bonds and U.S. Treasury bonds has varied between three and nine percentage points, averaging six percentage points. The debt of 95 percent of U.S. companies with revenues over $35 million (and of 100 percent of companies with revenues less than that) is rated noninvestment grade, or junk. Today, junk bond issuers that are household names include U.S. Steel, Delta, and Dole Foods. Moreover, the use of high-yield securities for corporate financing greatly expanded after the mid-1990s in Latin America, Asia, and Europe (both in transition markets in Central and Eastern Europe and in the European Union). Many high-yield bonds issued in the United States are now placed by foreign corporations spurred by privatizations, mergers and restructurings, and new technology expansions. The history of high-yield bonds is nearly as long as the history of public capital markets, with early issuers including General Motors, IBM, J. P. Morgan’s U.S. Steel in the first few decades of the twentieth century, and the United States of America soon after the nation’s founding in the 1780s. The public market for new-issue junk bonds gradually atrophied, and for most of the twentieth century—up to the 1970s—all new publicly issued bonds were investment grade. The only publicly traded junk bonds were ones that had once been investment grade but had become “fallen angels,” having been downgraded to junk as the financial condition of the issuer deteriorated. The interest payments on these bonds were not high, but with the bonds selling at pennies on the dollar, their yields were quite high. Companies deemed speculative grade were effectively shut out of the public capital market and had to rely on more expensive and restrictive bank loans and private placements (where bonds are sold directly to investors such as insurance companies). Interestingly, even though these private placements were riskier than the public high-yield bonds of the 1980s, they were never labeled “junk.” Indeed, the label “junk” and the decision about what level of risk it applies to, though now well established, is essentially arbitrary.