## 2 THE US ECONOMY AS A TRANSFER UNION

To borrow a phrase from Europe, the US economy is a ‘transfer union’ (though of modest proportion in comparison to European practice). Through both financial and fiscal channels, money flows of well over 10 percent of GDP (or $1.5 trillion) are transferred among different groups of economic actors. The SAM in Table 1 illustrates the magnitudes scaled to GDP in 2008. The accounting rules are straightforward. Sums of corresponding rows and columns should be equal; the sums of ‘institutional’ sectors’ levels of saving and investment toward the bottom (saving with a positive sign and investment negative) are equal at 18.1 percent of GDP as the condition for overall balance.

The sectors included are households and non-profit institutions, corporate business (non-financial and financial), the overall government sector (Federal, state, and local), and the rest of the world. For accounting purposes a fictional financial sector also appears. It collects interest and dividends disbursed by the other sectors as sources of income in a row and redistributes them in the corresponding column.^{
2
}

The first column of Table 1 gives a cost breakdown of total supply, or GDP plus imports. Supply amounts to 117.9 percent of GDP of $14.2915 trillion. The first row shows how it is split among current and capital expenditures (the latter show that households, business, and government all invest in inventories and/or physical capital). Imports are included in the first column as opposed to the first row (with a negative sign) because their costs when they cross the frontier are incorporated into the value of total supply. The other columns and rows respectively present sectoral uses and sources of income.

Table 1
US consolidated (aggregate) social accounting matrix (% GDP)
In the first column, the ‘CCA’ entries stand for capital consumption allowances or depreciation by sector. They have to be included on the cost side because depreciation makes up part of the investment outlays in the first row.

For the household sector, wages and salaries and employer contributions (to insurance and pension funds) are usually lumped together as ‘labor compensation.’ Sleight of hand, however, is involved. As highlighted in pale gray, the contributions paid as a cost of employment amount to 10.7 percent of GDP, but then 6.9 percent is passed back to the government (essentially as an employment tax) in its row for contributions received. Wages and salaries alone give a better measure of take-home pay before direct taxes. They make up only 45.8 percent of GDP.

Second, besides the employee contributions, other main sources of government income are indirect taxes (plus minor surpluses of government enterprises) and direct taxes, including 10.6 percent from households (mid-gray highlight). But then in the column for government outlays households receive 12.9 percent of GDP as transfers (mid-gray highlight, in bold font). Although 12.9 percent is small by the European standard of roughly 20 percent, it does signal that a substantial share of GDP is recycled through the direct tax/transfer system. The other major outlay is 16.7 percent of GDP ($2.387 trillion) for government purchases of goods and services.

Third, the business sector (including financial business) pays 30.9 percent of GDP to the fictional financial sector as interest and dividends (dark gray highlight, white type). Reflecting the volume of transactions among US financial firms it gets 19.2 percent back (also dark gray). The corresponding numbers in 1986 were 27.3 percent and 17.1 percent, with the increase over 22 years indicating the increasing importance of finance in the economy.

Row 1 of the table shows that the household sector is the other main recipient of financial flows at 15.2 percent (it has a 1.8 percent outlay, shown under ‘interest and dividends disbursed by households’, mid-gray highlight). In effect there is a net financial transfer from business to households of the same magnitude as the fiscal transfer. As will be seen, the impact of these transfers on the economies of households differs markedly across the size distribution of incomes.

Total government expenditures are 32.8 percent of GDP, while revenues are 30.2 percent, that is, the overall government sector dissaves 2.6 percent of GDP in its row for net lending. Negative government saving is reported as the *current* deficit in the simulations below. Adding investment expenditure of 3.5 percent boosts government net borrowing or the overall deficit to 6.1 percent of GDP or $872 billion on the BEA's reckoning.

The rest of the world's income from US imports is 17.9 percent; its purchases of exports are 12.9 percent. After taking transfers and financial flows into account, ‘foreign saving’ (or the US current-account deficit) is 4.8 percent of GDP or $686 billion.

Looking at the overall picture of net lending flows, the household sector saved more than it invested in 2008 (although the pattern varied notably across the size distribution). Business was a net borrower of 1 percent of GDP.

## 5 MODEL DESCRIPTION AND SIMULATION

To study the effects of policy, we set up a simple comparative static macroeconomic model to obtain a broad understanding of possible impacts of policy changes. Any detailed study would have to take account of the institutional set-up of the US tax and transfer system which, in contrast to Europe where transfers are typically directed through the public sector, are an *ad hoc* maze of specific programs.

The basic set-up makes output a function of effective demand, with the price level determined by costs. We start our model description on the side of costs, starting with labor. For the USA, one has to deal with the vagaries of labor taxation. The ‘basic’ wage flow for household group
$i$
is
${\stackrel{~}{W}}_{i}$
, the sum of ‘wages and salaries’ and ‘employer contributions to employee … funds’ from the SAM. If
${\mathrm{\Phi}}_{i}$
is the ratio of that group's ‘employer contributions for government social insurance’ to
${\stackrel{~}{W}}_{i}$
then
${W}_{i}=(1+{\mathrm{\Phi}}_{i}){\stackrel{~}{W}}_{i}$
is the total labor cost for group
$i$
. The corresponding ‘wage’ or labor payment (total payments received divided by number
${L}_{i}$
of households in the group) is
${w}_{i}={\text{W}}_{i}/{L}_{i}$
and
${b}_{i}={L}_{i}/X$
. All of this abstracts from household structure, participation rates, etc., which would have to be accounted for in a more detailed model. The groups are defined by the base-year levels of income that define boundaries between boxes such as quintiles, deciles, etc. Tax/transfer policies shift incomes up or down in the boxes, with repercussions on the level of economic activity. Individual households of course may move into or out of a box when their income levels change. Our simulations focus on changes of income levels within boxes, ignoring possible movements across boundaries. Total per unit labor cost faced by business is
$Z=\sum {w}_{i}{b}_{i}$
with
${b}_{i}$
constant.^{
6
}

With
$P$
being the price of output (not quite equal to the GDP deflator), the overall cost decomposition is

$$PX=\mathrm{\tau}PX+ea{P}^{\ast}X+\mathrm{\Xi}PX+ZX+\mathrm{\Pi}PX,$$

in which

$\mathrm{\tau}$
is the ratio of the sum of non-labor indirect taxes (minus subsidies), government CCA, and surplus of government enterprises to output. The exchange rate is

$e$
,

$a$
is the import/output ratio, and

${P}^{\ast}$
is a price index for the rest of the world. The term

$\mathrm{\Xi}PX$
is the sum of household proprietors’ income, rental income, and CCA. Indirect taxes, imports, and proprietors’ incomes, etc., are assumed to be proportional to output. Total profits are ΠP

*X*.

For the baseline scenarios (with zero elasticity of substitution, see also footnote 8), this formulation leads naturally to a mark-up equation for
$P$
, based on per unit costs of labor and imports:

$$P=(Z+ea{P}^{\ast})/[1-\mathrm{\tau}-\mathrm{\Xi}-\mathrm{\Pi}).$$

If

$\mathrm{\rho}=e{P}^{\ast}/P$
is an index of the real exchange rate, we add a constant elasticity function for price dependency of the import coefficient

$$a=\mathrm{\alpha}{\mathrm{\rho}}^{-\mathrm{\gamma}},$$

with

$\mathrm{\gamma}>0$
which can be solved jointly with the cost function to determine the price level in the economy (in the simulations discussed below,

$\mathrm{\gamma}=0.75$
). Econometric evidence of minimum wage increases on the aggregate price level suggests very small effects (as compared to price levels of goods of low-wage industries). To capture this low (minimum) wage elasticity of the GDP deflator, the mark-up is endogenized in some simulations by assuming

$\mathrm{\Pi}={Z}_{0}{Z}^{{\mathrm{\psi}}_{1}}$
with

${\mathrm{\psi}}_{1}=-0.1$
.

With prices specified, we turn to the sectoral income-expenditure accounts, omitting various small items that might be included on one side of the accounts as ‘other’ net (positive or negative) income or expenditure
${O}_{i}.$

Aggregate household income is

$${Y}_{H}=\sum {Y}_{i},$$

with sources of income for group

*i* as

$${Y}_{i}={w}_{i}{b}_{i}X+{\mathrm{\xi}}_{i}PX+P{Q}_{i}+{U}_{i}+{O}_{i}.$$

That is, besides ‘wages’

${w}_{i}{b}_{i}X$
, household income includes proprietors’ (plus rental and CCA) income

${\mathrm{\xi}}_{i}PX$
, the value of ‘real’ government transfers

$P{Q}_{i}$
, financial receipts (interest and dividends)

${U}_{i}$
, and other net receipts

${O}_{i}$
(from the business and ROW sectors). The condition

$\sum {\mathrm{\xi}}_{i}=\mathrm{\Xi}$
applies.

Uses of income for group *i* are

$${Y}_{i}=P{C}_{i}+{\mathrm{\Gamma}}_{i}{\stackrel{~}{W}}_{i}+P{T}_{i}+{R}_{i}+{S}_{i},$$

with

${C}_{i}$
as consumption,

${\mathrm{\Gamma}}_{i}{\stackrel{~}{W}}_{i}$
as the sum of ‘employer contributions’ (for social insurance) and transfers to government,

$P{T}_{i}$
as direct taxes (so that

${T}_{i}$
is a ‘real’ tax level),

${R}_{i}$
as financial payments, and

${S}_{i}$
as saving. Transfers, financial receipts, direct taxes, and financial payments are all treated as lump-sum flows. This is the simplest way to treat them and allows us to emphasize the shifts in income distribution. Clearly, they are endogenous in the US economy.

We need consumption functions for the
${C}_{i}$
. The main argument is disposable income,

$${D}_{i}={Y}_{i}-{\mathrm{\Gamma}}_{i}{\stackrel{~}{W}}_{i}-P{T}_{i}-{R}_{i},$$

which will be affected by taxes and transfers along with wage levels.

Aggregate consumption has to equal the sum of consumption over all groups,

$$C=\sum {C}_{i}.$$

We assume linear consumption functions of the form:

$$P{C}_{i}={A}_{i}+\left(1-{s}_{i}\right){D}_{i},$$

with the

${s}_{i}$
as the group marginal saving rates. The

${A}_{i}$
and

${s}_{i}$
parameters were adjusted to fit consumption levels to those in the base-year SAM. In the standard specification, marginal saving rates are set to equal average rates. For the bottom two quintiles, where consumption exceeds income, this implies negative autonomous consumption. In a second specification, saving rates are adjusted to ensure non-negative

${A}_{i}$
.

Business derives income from profits and interest to give

$${Y}_{B}=\mathrm{\Pi}PX+{U}_{B}.$$

Net operating surplus is

$${N}_{B}={Y}_{B}-P{\mathrm{\Delta}}_{B},$$

with

${\mathrm{\Delta}}_{B}$
as real capital consumption plus the statistical discrepancy. Spending is

$${Y}_{B}={N}_{B}+P{\mathrm{\Delta}}_{B}=P{T}_{B}+{R}_{B}+{S}_{B}+{O}_{B},$$

with

${T}_{B}$
as direct tax,

${R}_{B}$
as financial payments, and

${O}_{B}$
as omitted smaller payments. Saving

${S}_{B}$
will be the balancing item.

We use an investment function linear in output, output growth, and net operating surplus.

$${I}_{B}={\mathrm{\iota}}_{1}X+{\mathrm{\iota}}_{2}{N}_{B},$$

with

${\mathrm{\iota}}_{1}={i}_{X}+{\mathrm{\iota}}_{g}{g}_{X}$
capturing the effects of the level and growth of output on business investment described in

Fazzari et al. (2008).

Government's income is

$${Y}_{G}=\mathrm{\tau}PX+\sum {\mathrm{\Gamma}}_{i}{\stackrel{~}{W}}_{i}+P[\sum {T}_{i}+{T}_{B}]+{U}_{G},$$

with

${\mathrm{\Delta}}_{G}$
including the CCA and profits of enterprises. Its uses of income are

$${Y}_{G}=PG+\sum P{Q}_{i}+{R}_{G}+{S}_{G}+{O}_{G},$$

with

${R}_{G}$
as interest payments and

${O}_{G}$
omitted flows. Saving

${S}_{G}$
or the fiscal surplus is the balancing item.

Rest-of-world income is

$${Y}_{R}=ea{P}^{\ast}X+{U}_{R},$$

with the payment

${U}_{R}$
coming from the financial sector. Its income uses are

$${Y}_{R}=PE+{R}_{R}+{S}_{R}+{O}_{R},$$

with

${R}_{R}$
as payments to the financial sector,

${O}_{R}$
omitted flows, and

${S}_{R}$
as ‘foreign saving’ or the current-account deficit. Exports

$E$
are a constant elasticity function of unit labor cost

$Z$
(following Storm and Naastepad 2012, we set the elasticity to

$-0.12$
).

For the financial sector we have

$$\sum {R}_{i}+{R}_{B}+{R}_{G}+{R}_{R}=\sum {U}_{i}+{U}_{G}+{U}_{R}+{S}_{F}.$$

In equilibrium the sum of omitted flows has to add to zero,

$$\sum {O}_{i}+{O}_{B}+{O}_{G}+{O}_{R}+{O}_{F}=0.$$

To solve the model we need the macro balance relationship

$$\sum {C}_{i}+\left({I}_{H}+{I}_{B}+{I}_{G}\right)+G+E-X=0,$$

incorporating behavioral relationships for household consumption levels, business and household investment, imports and exports.

It is simplest to treat
$G$
and
${I}_{G}$
(but not government dis-saving
${S}_{G})$
as exogenous policy variables. Multipliers with respect to
$G$
are: output, 1.20; fiscal deficit, 0.90; trade deficit, 0.18. All values are in the conventional range for simple demand-driven models.

Nominal GDP can be defined as

$$VQ=\left(P-e{P}^{\ast}a\right)X=\left(P-a\right)X,$$

with

$V$
as the GDP deflator;

$X$
,

$P$
, and

$a$
as levels of output, price, and the import/output coefficient in any simulation; and

$e={P}^{\ast}=1$
initially. Real GDP is

$$Q=\left(1-a\right)X,$$

so the deflator becomes

$$V=(P-a)/(1-a).$$

These equations fully specify the economy at sectoral detail. All parameters are taken from our extended national accounts. The consumption and investment functions are behavioral equations closing the system and are explained above. While our treatment of distribution is highly aggregated, some insights can be gleaned nonetheless.

Table 2 presents macro-level impacts of shocks to the system.

Table 3 shows distributive implications for disposable incomes and numbers of households. We consider the impacts of fiscal expansion (without and with higher taxation), higher taxes linked with increased transfers, and wage increases for low-income groups.

As emphasized in connection with Figure 1, there are big differences across the size distribution in household saving behavior: average rates are negative at the bottom and positive at the top. The simulations reported here are all based on average saving rates. Modifications such as setting the marginal saving rate to zero at the bottom do not affect the results very strongly.

Row B in the Tables 2 and 3 shows the effects of an increase of 100 (billion dollars) of government purchases of goods and services from an initial level of 2381. GDP increases by 102, signaling a modest multiplier for GDP (the multiplier for total supply is 1.2). Both the fiscal and foreign deficits go up.^{
7
} On the distributive side, numbers of households in all groups increase – this response is a proxy for higher employment generated by fiscal spending. An increase in ‘*G*’ of 4.1 percent generates a rise of 0.7 percent in ‘employment,’ again a modest increment. The model specification treats direct taxes and transfers as lump-sum, fixed in real terms. Hence the percentage increases in mean disposable incomes for each group are less than total incomes, leading to a modest average income loss across the board.^{
8
}

Table 2
Macroeconomics impacts of policy shifts: level (percentage) changes
The highest-income households and the group just below pay direct taxes of 586 and 490 respectively (a total of 1076). Suppose that their (lump-sum) direct taxes are increased by 20+ percent to 150 and 100, ‘offset’ by an extra 250 in government spending (a 10.5 percent increase). Row C in Table 2 shows that GDP expands and the fiscal deficit decreases. In Table 3, employment rises while mean disposable income goes down for all four income groups (in part for the reasons discussed above). The decrease of 9 percent for the richest group is especially visible and the Palma ratio falls by 8 percent. This simulation focuses on reducing inequality by cutting disposable incomes at the top. A 20 percent tax hike, however, may well be politically out of bounds as of 2014, even though it could readily be based on wealth, capital gains, or the large financial flows illustrated in Table 1. On the other hand, a 9 percent reduction in income due to the tax increase does not go very far toward offsetting the 300 percent increase in real average income that the top 1 percent enjoyed between 1986 and 2008.

Table 3
Distributional impacts of policy shifts: level (percentage) changes
Row D shows the effects of a more modest tax increase at the top combined with a revenue recycling through higher transfers to low income groups, that is, taxes are raised on high savers’ incomes and transferred to groups with negative saving. This package is expansionary, raises disposable incomes at the bottom, and reduces incomes at the top. It cuts the fiscal deficit. A larger version would cut further into the Palma ratio by reducing the numerator and raising the denominator. Taxing the rich by offsetting transfers to the poor looks like an effective means to ameliorate inequality overall. Nevertheless, the Palma metric does not fall by very much. Raising transfers to the bottom from 708 toward a ‘European’ level of 1100 would require a 50 percent tax hike at the top, imposition of a value-added tax, or perhaps a combination thereof.

In contrast, row E concentrates on the denominator in the Palma index by raising money wages for the bottom two quintiles (by 10 percent at the bottom and 5 percent for the second quintile), broadly in line with the minimum wage increases analysed by the Congressional Budget Office (2014). In Table 2 there is a 0.55 percent increase in real GDP owing to higher consumption demand and the GDP deflator goes up by 0.7 percent. Table 3 reports a 3 percent increase in disposable income for the bottom two quintiles, with the other groups decreasing slightly. The Palma ratio falls from 39 to a bit less than 38. Potential offsets to the wage increase should also be considered.

The US transfer system effectively ‘taxes’ income increases at the bottom of the size distribution by reducing benefits. A rough estimate of the tax rate is 30 percent (Congressional Budget Office 2014). Row F in the tables shows that the low-income wage increase is less expansionary and redistributive when this limitation is taken into account.

The usual objection to a minimum wage increase is that firms will cut back on employment (or raise labor productivity) in response. Row G shows that bringing this possibility into play reduces increases in GDP and employment. Because of the latter effect, the average disposable income of the bottom group goes up.

Firms might also adjust to the wage increase by reducing mark-ups. Row H shows stronger expansion, less inflation, and stronger real income gains.

All effects are combined in row J. Raising low-income wages appears to be beneficial, but in overall macroeconomic terms the changes are minimal, in the range of a few percent of initial levels of the relevant variables.