29 Aug 2008

If Obama Wins, Can You Ask for a Raise?

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Von Pepe (not his real title) emailed me and declared:

“But, I am thinking that [redistributive] tax policy has CAUSED more income inequality. The highly productive have such high taxes that they demand much higher wages (which later gets redistributed). So, as taxes go higher the wealthy’s wages go much higher.”

He then went on to say that he is letting his boss know that if Obama wins, Von Pepe expects a big raise to cushion the blow to his take-home paycheck.

Being a trained economist, my first reaction was to scoff. After all, if your boss can afford to give you a big raise, why do you need to wait for an Obama win to ask for it?

However, even as I was typing this, I felt as if my standard analysis was leaving out some important things. First, contrary to popular belief (and which you will even see spelled out in the Greatest Economics Book Ever), in a free market workers do not get paid their marginal product. There is a tendency for this to happen, but there are all sorts of things that prevent it from literally occurring. There are obvious “frictions” from lack of perfect information and transactions costs, but even besides that, there is the fact that specialized workers are very heterogeneous, and so their marginal product at one firm (especially if they’ve been there for years) might be higher than it would be at any other firm. So for these workers, there is a surplus available that must be split according to bargaining strength.

For example, suppose there is a partner at law firm who adds $1 million in net revenue to the firm every year. That is to say, if he died, the firm’s revenues from clients would be $1 million lower. However, suppose that the next-best option he has is to work for a rival firm, whose clients he doesn’t know etc. If he worked for them, even after he found his groove, he would only add $800,000 per year.

So there is a $200k gap that he and the first firm must haggle over. Competition in the labor market will not ensure that the lawyer earns $1 million in the long-run. He will definitely earn at least $800,000 (assuming no information deficiencies or high transaction costs), but there’s no reason he needs to get all of the $200k pie.

If Von Pepe is in a situation like this, then his boss could indeed afford to give him a raise, and maybe the guilt trip of “Obama is making me pay my fair share!!” gives Von Pepe a bargaining edge that he lacked before.

There is a second issue involved in all this, however. Even if we make all the textbook assumptions, it is still the case that Von Pepe might ask for, and get, a raise if Obama wins and jacks up tax rates. This is really no different from saying that the market price of oil will rise, if Obama imposes a windfall profits tax on oil producers.

The subtlety is that Von Pepe’s marginal productivity itself might rise (indirectly), because of Obama’s tax hike. With lower after-tax returns, rich people work less. The supply of skilled labor shifts left, and so its market price rises. So those remaining in the industry get paid more in pre-tax dollars.

In conclusion, I endorse Von Pepe’s plan to ask for a raise in the event of an Obama victory. It just took us a few email exchanges for me to get past the stumbling block of my PhD in economics to see why he was right.

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