Knowledge that Transforms

Under a progressive income tax, conventional wisdom is that taxing individuals rather than households is preferred from an efficiency point of view. The reason is that secondary workers, whose labor supply elasticity is high, will be taxed at a lower marginal rate than primary workers, whose labor supply elasticity is low. Here, we argue that once household production is taken into account, things are more complicated since tax design should also not distort the input of family members' time in household production. Factor input distortions as well as Ramsey considerations thus need to enter the choice of the tax unit. We provide a numerical example of an economy for which a move from an individual to a household basis in the income tax can be efficiency improving. We then use a general equilibrium model, parameterized using Australian tax rates and data, whose results clearly show that welfare gains can occur under changes from an individual to a household basis for an existing income tax. Our results thus challenge conventional wisdom and suggest that household unit taxation deserves more sympathetic consideration than is currently the case.

A recent empirical literature has shaken economists' confidence in the value of aggregate (industry-level) data to illuminate production relationships. But the statistical finding "you cannot aggregate," however well documented, is not an economic explanation. Plant-level relationships do aggregate in Depression-era blast furnace operations despite the presence of very substantial interplant heterogeneity, the most common economic cause of nonaggregability. The economic explanation of this lies in poor short-run substitutability of one plant's output for another's. Substitutability determines the importance of composition effects in understanding aggregate time series, constrains the potential cleansing effects of recessions, and therefore influences industry evolution quite broadly.

The paper offers a theory of income differences in which income inequality exists and persists despite identical tastes and talents. Teams of unskilled labor supervised by schooled managers produce goods with increasing returns to scale. Agents are assumed unable to borrow to fund the human capital investment needed to become managers. Despite ex ante identical agents, the model displays the following equilibrium phenomena: (i) risk-averse agents accept fair gambles, implying an unequal ex post distribution of unearned income; (ii) agents agree to publicly subsidize education, although those receiving the subsidy have the highest material wealth; and (iii) income and educational differences are perpetuated from generation to generation.

When formal regulation is weak or absent, communities often use other channels to induce pollution abatement by local factories in a process of 'informal regulation.' The resulting 'pollution equilibrium' reflects the relative bargaining power of the community and the plant. This note uses Indonesian data from 1989-90 on plant-level organic water pollution to test the informal regulation hypothesis. Copyright 1996 by University of Chicago Press.

This paper reports overwhelming evidence against the hypothesis that the federal funds rate follows a martingale over the two-week reserve maintenance period, establishing that banks do not regard reserves held on different days of the week to be perfect substitutes. A theoretical model of the federal funds market is proposed that could account for these empirical regularities as the result of line limits, transaction costs, and weekend accounting conventions. The paper concludes that such transaction costs lie at the heart of the liquidity effect that enables the Federal Reserve to change the interest rate on a daily basis. Copyright 1996 by University of Chicago Press.

In this article we test whether the introduction of social insurance has led to a reduction in private insurance purchases and precautionary saving by examining the introduction of workers' compensation. Our empirical analysis is based on the financial decisions of over 7,000 households surveyed for the 1917-19 Bureau of Labor Statistics Cost-of-Living study. We find that the presence of workers' compensation at least partially crowded out private accident insurance and led to a substantial reduction in precautionary saving. The introduction of workers' compensation caused private saving to fall by approximately 25 percent, with other factors held constant.

The authors introduce a dynamic and fully strategic model of wage determination in the presence of firm-specific human capital. In this model, human capital is interpreted as information. The authors show that equilibrium exists and is efficient and that it gives rise to a unique distribution of the social surplus. They show further that the equilibrium wage is determined by three factors. Consideration of these factors allows the authors to determine when and how the market mechanism enables the worker to capture some of the returns to firm-specific human capital. They relate their findings to the ongoing empirical debate concerning the return to tenure. Copyright 1996 by University of Chicago Press.

Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms that have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds to the formation of a "reputation," a valuable asset that provides an incentive for firms not to choose risky projects. The second hypothesis is that prior to the establishment of a reputation, new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838-60). The presence of a reputation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for the notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period because of technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre-Civil War system of private money issuance by banks was not plagued by problems of overissuance ("wildcat banking").