Knowledge that Transforms

At least since the early 1970's, it has been apparent that the cyclical variations in inflation summarized by the short-run Phillips curve are only one part of the inflation problem that confronts modern industrial economies. Another part is the relative persistence of an established rate of inflation. There is a good deal that we do not understand about this persistence. But I find the most useful way to model it is to start with the concept of a relatively stable wage norm, by which I mean a norm for the rate of wage increase. The model distinguishes sharply between the cycle and the trend in inflation, with the wage norm determining the trend. The variations in inflation of the typical business cycle take place around the existing wage norm and generate the empirical short-run Phillips curve. The wage norm itself is affected little if at all by the typical business cycle. Historically the wage norm has been shifted by prolonged departures from typical business cycles or by other extreme economic developments. Figuring out more precisely what it takes to shift wage norms, or what might keep them from shifting, is a central challenge for understanding inflation better. Before turning to its implications, let me sketch the behavioral underpinnings of the wage norm model and the empirical evidence about wage norms. The norm rate of wage increase has no allocational significance and describes the trend of nominal wages independent of real aggregate demand or relative demand effects. In this respect, it is like the anticipated rate of inflation in many familiar models. Wages are not determined in an auction-like labor market that clears over any reasonable interval of time. Rather they are established by wage-setting firms with a profit-maximizing interest in their long-run relation with their employees, in some cases in a bargaining situation with unions. Under both the implicit and explicit contracts that thus dominate wage setting, keeping up with the norm is the neutral standard for firms. An individual firm that raises wages in line with the norm neither improves nor worsens its relative position as an employer. A firm that wants to expand employment will, typically, offer a higher wage than would be required just to keep up with the norm. Relative wages and relative employment levels are thus codetermined in this process. When most firms want to expand employment, as in a cyclical upturn, the same behavior is part of the process producing the modest cyclical rise in inflation that we observe as the short-run Phillips curve. Thus the onset of cyclical inflation is not a sign that capital and labor resources are being overutilized. Nor is it a sign that inflation is on an accelerating path or even that wage norms are shifting up. In analyzing U.S. postwar data, I have found the wage norm shifted up substantially by the end of the 1960's and down again, though not by as much, by the end of the 1980-82 recession (see my 1983 paper). The first episode was a period with a historic expansion that ended with several years of very low unemployment rates. The second was a recession of unusual length and severity that ended with the highest unemployment rates since the 1930's. There is also evidence of a small shift down in the wage norm after the weak economic performance of 1957-61, which featured two recessions with only an aborted recovery in between. I also found evidence for Germany, the United Kingdom, and Japan of upward shifts in wage norms in manufacturing industries after the 1960's and downward shifts in the early 1980's (see my 1986 paper). All these episodes suggest the kinds of extreme cyclical developments that have shifted wage norms in the postwar period. *The Brookings Institution, 1775 Massachusetts Avenue, NW, Washington, D.C. 20036. In preparing this paper, I benefited from discussions with Charles Schnl t7.e

I am indebted to Edgar Browning for calling attention to some peculiarities of the data underlying the estimates in my 1985 study. He is quite right that the ratios of transfer payments to income in the files for 1975 and later years are inconsistent with the corresponding ratios in the 1966 and 1970 files and in the Consumer Population Surveys, particularly in the lower part of the income distribution. I do not believe, however, that the baby should be thrown out with the bathwater, as Browning seems to suggest. I made available to him detailed data on the tax burdens of labor income, capital income, and consumption by income classes which provided a basis for revising my calculations for 1975 and later years. Instead, he chose to draw inferences about the progressivity of U.S. taxes since 1966 on the basis of changes in the relative importance of the various taxes, which is not appropriate for this purpose. These inferences would be correct only if there were no changes in the structure of each tax and in the composition of income in the various income classes during the period studied (for example, if there were no changes in the progressivity of the individual income tax or in the distribution of dividends by income classes).' It is straightforward to improve on this procedure. Where in the income distribution the share of transfer payments in total income is too low in 1975 and later years, the shares of labor and capital income are correspondingly high, and vice versa. To arrive at more realistic estimates of the shares for labor, capital, and transfer income, I first applied the 1970 shares to adjusted family income in each income decile in 1975, 1980, and 1985, and then made proportional adjustments in the columns and the rows alternately until they added to the correct totals.2 The incidence calculations for 1980 based on the revised weights are given in table 1 of my study, which shows the effective rates of the major taxes by deciles.3 These calculations are based on the most progressive set of assumptions (variant lc) presented in my study. Variant Ic assumes that the corporation income and property taxes are borne by capital in general, the payroll tax by labor, consumption taxes by consumers, and the individual income tax by those who pay it. I believe that this variant more nearly reflects the present state of incidence theory than any of the other variants.4

Our paper in this Review (1984) aroused a controversy we did not anticipate, but no one has yet convinced us that our basic point is wrong. Joe Bell (1988, p. 282) now makes the assertion that our conclusion rests entirely upon unexplained asymmetries in mobility. This seems to us a very curious assertion indeed. The main problem with Bell's analysis is that he treats investment in capital assets as perfectly malleable. A lawyer trained to argue rate cases is not perfectly suited for other jobs when electric utility deregulation occurs. The time and effort spent by the lawyer to acquire the requisite skills are irretrievably lost. This is the point of our paper. Even though future labor can be supplied by this lawyer after deregulation, it definitionally has a lower value. Lawyering before a regulatory commission is a specialized input. When the demand for these services falls, the capital value of the intensive and extensive investments vanish. No asymmetry is implied or required. More generally, capital consumed in using the political process to secure a wealth transfer-the resources devoted to organizing coalitions, investing in lobbying activities, contributing to political campaigns, advertising a point of view, acquiring the stock of human capital necessary for dealing with regulatory bureaucracies, and so onreduces the wealth of society in opportunitycost terms. For the reasons just stated, the cost of obtaining additional output in the regulated industry following deregulation is higher. We also pointed out that the increase in marginal costs due to what Bell calls resource immobility may only be a short-term phenomenon: Over time, resources in the [deregulated] industry will adapt to the new competitive environment, and new resources coming into the industry will embody the r quisite skills for working in a competitive rather than a government-sponsored sector. Thus, after the relevant adjustment period, marginal costs in the deregulated sector may decline, but it is simply wrong to suppose that deregulation enables the capital value of resources specializing in rent-seeking activities to be used again in the production of goods. Anyway, in present-value terms it does not take very long for this adjustment process to impose significant costs on the economy. This point is covered in fn. 7 in our original paper.