Toward a More Prosperous, Less Polarized, Worker-Friendly Economy

It is no secret that, in spite of solid U.S. economic performance over recent decades, popular support for free markets and free trade is waning. The traditional model for addressing the problems of those left behind by the forces of competition and technological advance has relied almost entirely on the domestic tax-and-transfer system. But that model has reached its useful limits. Workers are unhappy not merely with the level of support they are getting from Washington, but with the type of support on offer. They want good jobs—and not handouts when jobs vanish. Economists and legal scholars have long warned, rightly, against policies that dull the economic incentives on which broad national prosperity depends—prosperity on which government also relies to improve the lot of the less fortunate. Targeted changes in law and policy beyond tax-and-transfer, however, can widen the distribution of prosperity without undermining its generation.

The Problems of Tax-and-Transfer

The foundation of democratic capitalism is the rule of law, and the foundation of law is the idea that rules should be neutral as between individuals. In particular, there should be but one law for both rich and poor. A CEO and a janitor should each have one vote, an equal right to free speech, and the same obligation to follow traffic laws.

But herein lies a weakness of democratic capitalism. Even the most forceful defenders of neutral law, such as the economist-philosopher Friedrich Hayek, have acknowledged that it must be set aside when it would result in “indigence” among those who would suffer it “due to circumstances beyond their control.” It has, Hayek wrote, become “accepted as a duty of the community” to provide the less fortunate with resources that must, of necessity, be taken from those who, though operating wholly within the law, come to own an abundance of them.

Redistributive policies treat people differently based on how much they earn. Yet Hayek supported redistribution on grounds of equity, despite it violating the strict principle of legal neutrality that he upheld. It is notable, though, that he could provide no more justification for it than custom and sentiment. It was Hayek who, after all, famously attacked the concept of social justice as both undefinable and a threat to actual justice—that is, justice based on the application of neutral law.

What Hayek’s muddle illustrates is the natural tension between the appeal of neutral law and what people consider to be fair and reasonable economic outcomes under such law. This tension has been growing and is fueling dangerous political polarization—polarization that needs to be checked with robust policy responses.

Given the U.S. government’s long-standing commitment to maintaining neutral laws for rich and poor, it has historically responded to this growing tension by tinkering with rules outside the realm of conventional law: that is, by way of the tax-and-transfer system. Economists and legal scholars have generally judged tax-and-transfer rules to be the best means of addressing inequity and inequality. To be sure, redistribution through tax-and-transfer distorts work incentives, as does any form of redistribution—but, critically, it introduces no further inefficiencies. In contrast, distorting laws to favor the poor and disfavor the rich—say, by applying less punitive rules of personal liability to the former—would encourage different people to behave differently in circumstances in which we wish them to behave the same. Tax-and-transfer redistribution generates no such distortion.

Government has, however, particularly over the past three decades of rising inequality, come to load more of the burden of responding to that rise onto the tax-and-transfer system than it can reasonably be expected to bear, politically. That is, the frequent changes to tax-and-transfer rules, making them alternatingly more progressive and less progressive, have merely resulted in resentment among the different segments of society, each of which feels it is getting too little, giving too much, or, more importantly, giving or getting the wrong thing—that is, government money. The underemployed may welcome transfer payments, but they—and, indeed, taxpayers generally—consider these payments a pale substitute for the security and dignity of a stable, remunerative, and satisfying career. Put simply, people prefer better jobs and higher wages to worse jobs and greater government benefits. And the evidence is clear that they are voting for their preferred mix.

The Roots of Discontent

The roots of our current era of intense political division and alienation can be traced to the triumphalist decade following the collapse of the Soviet Union in 1991. At that time, the belief took hold that democratic capitalism represented the culmination of mankind’s political evolution—the “End of History,” in the phrase made famous by the political scientist Francis Fukuyama. Leaders of both major U.S. political parties embraced the idea that free markets and free trade maximized individual opportunity and national wealth, and that society could easily afford to compensate, with government checks and retraining, those few who lost out under the benign indifference of competition.

In November 1993, Vice President Al Gore told CNN’s largest-ever audience that the North American Free Trade Agreement (NAFTA) would bring two hundred thousand new jobs to the United States. Claims such as these, that trade pacts create jobs, became commonplace. But they were, and remain, misleading. Whereas trade pacts alter the mix of jobs available, and can boost overall wages and living standards, they do not create more jobs than would otherwise exist.

NAFTA’s actual effects on American jobs, though much debated, hugely underwhelmed. Even the dire estimates of job losses, however, pale in comparison with those losses deriving from China’s subsequent integration into the global trading system—an integration abetted (though not caused) by its accession to the World Trade Organization (WTO) in December 2001. In a now-famous 2016 research paper on the so-called China Shock, the economists David Autor, David Dorn, and Gordon Hanson concluded that employment in U.S. industries more exposed to the surging Chinese competition fell, whereas the expected offsetting employment gains in other industries failed to materialize. Although the authors were careful to note that sizable benefits from economic integration with China might well become apparent in time, the fact that such benefits were likely to be distributed slowly and unequally over regions helped explain the backlash over trade liberalization—a backlash that put Donald Trump, an unabashed protectionist, in the White House that year.

The Solution: More Predistribution

Part of the problem with the End of History triumphalism of the 1990s was the fact that the promised redistribution and job retraining that was to accompany globalization never actually materialized.

The main federal program enacted to help displaced workers—the Trade Adjustment Assistance (TAA) program—has been vulnerable to political currents in Washington while, even in the best of times, remaining underfunded and over-restrictive. As millions of workers lost jobs to the China Shock, only about 250,000 workers per year received TAA assistance at the height of the program’s generosity. TAA’s failure to fulfil its purpose is evident from the fact that workers in areas most affected by Chinese competition received more in government medical and disability benefits than in TAA assistance. Of the few other federal programs offering help to displaced workers writ large, none is adequately funded, and none delivers compensation remotely near that promised at the dawn of the End of History trade liberalization.

But this failure to compensate losers is only a part of the story. It was, certainly with hindsight, patronizing folly for politicians and analysts, whose jobs were never under threat from outsourcing, to believe that displaced blue-collar workers would be content with severance checks and tuition vouchers. Workers whose identities are tied up with their chosen vocations and communities vote for candidates who pledge to protect their jobs, and not those who pledge—often emptily, as we’ve seen—to compensate them for their loss.

The logic behind the argument that equity concerns are best addressed through redistribution is compelling. But this logic has limits. A singular focus on efficiency is not, on its own, a sound and complete basis upon which to ground policy. There are three reasons.

First, policy analysts have often rendered faulty judgments as to how efficient different rule regimes—such as lower trade barriers—actually are. Too often they have assumed, for example, that worker adaptation, in the form of re-education and relocation, is simpler and cheaper than it is in reality. Second, where efficiency rankings are difficult to make, distributional concerns ought to be considered valid and appropriate. Finally, and most importantly, certain distributional concerns cannot be addressed effectively through tax-and-transfer. Today in the United States, the tax-and-transfer system more than doubles the income of the bottom earnings quintile while reducing the after-tax-and-transfer income by 31 percent for the top quintile. Monetary transfers, however, even when as generous as promised, are incommensurable with the satisfaction and personal fulfillment of a chosen career. And so redistribution should sometimes give way to what has been called “predistribution”—that is, the mitigation of the sources of inequality resulting from the operation of the market. In cases where changes in market rules will do little or no damage to efficiency, predistribution is superior to redistribution.

Predistributional Policy Responses

A predistributional approach to economic policy making, as opposed to a redistributional one, asks not what can be done to compensate those who suffer from low or falling incomes, but what can be done to affect the operation of the market, without material harm to efficiency, such that incomes and opportunities for those at the bottom and lower ranks are maximized. Though policy free lunches of this sort may not be ubiquitous, they are surprisingly plentiful when we set out to look for them.

Labor Markets

Consider labor markets. Around the United States, there exist a range of laws and private rules having unintended but well-documented damaging effects on labor mobility—that is, the ability of workers to change jobs or to move to where opportunities are better. Eliminating or restricting the reach of such laws and rules is a prime example of a predistributional policy strategy that would empower workers while simultaneously boosting economic growth.

The first culprit is the proliferation of noncompete clauses in standard employment contracts. These clauses, which stop employees from working for other employers in a given sector, restrict competition for labor and suppress wages. The Federal Trade Commission (FTC) estimates that thirty million American workers—some 20 percent of the total—are subject to noncompetes, including many middle-income and low-wage workers. Some states have made noncompetes unenforceable, but employers often still use them, hoping to exploit the uninformed.

Federal action to outlaw noncompetes would have major distributional consequences. Banning them for workers earning less than $151,164 annually would, according to FTC estimates, boost their earnings by over $200 billion a year. By way of comparison, the Earned Income Tax Credit, the largest cash transfer program for low-income workers, supplements worker earnings by only a third of that.

The FTC recently issued a final rule stating that noncompete clauses violate federal antitrust laws. This rule, however, is already facing legal challenges, such as one in Texas in which the judge has indicated that the FTC lacks statutory authority to promulgate the ban. Congressional legislation to effect the ban—legislation that should attract bipartisan support—would therefore be on much firmer ground.

A second obstacle to labor mobility exists courtesy of individual states. Typically at the behest of local interest groups anxious to protect their markets, states have gone on an occupational licensing spree. Over the past six decades, the share of the U.S. labor force subject to licensing requirements has grown five-fold, and now covers a full quarter of it. Not content to regulate doctors, lawyers, and other highly skilled professions, states impose ludicrous licensing burdens on florists, manicurists, janitors, hair braiders, and eight hundred or so other occupations.

The proliferation of licensing law is an example of federalism at its worst. Federalism is the principle that political decisions should be made at the level closest to the citizen. Legal scholars and economists have long defended it on several grounds—in particular, that it enhances local accountability, that it accommodates different preferences across localities, and that it allows for experimentation. But for all its putative benefits, it comes with major costs. The proliferation of occupational licensing is a stark example of state-level rulemaking run amok. Do security guards really need three years of training? Michigan says so. Do fortune tellers need licensing? Maryland says so. We say this is costly nonsense.

Licensing reduces labor supply and depresses both occupational and geographic labor mobility. Congress has the power to preempt state licensing restrictions. Or it can induce states to harmonize their licensing regimes, as the Barack Obama administration tried to do, using the power of the purse. Either way, by eliminating state-level licensing restrictions Congress can boost the earnings power of low-wage workers and reduce the need for government to supplement their livelihoods.

The third culprit limiting mobility operates at the most local level of all. Buying or renting a home in or around New York City or San Francisco, as well as other desirable (mostly coastal) areas, can eat up a huge portion of a worker’s income. A primary reason for excessive housing cost is the lack of new construction, permits for which are severely restricted by local zoning laws. Often these laws ban low-cost multi-family housing. Over the past half-century, cities such as Houston and Atlanta that have eschewed pernicious housing codes have grown much more rapidly than others.

Restrictive zoning rules are a drag on economic growth. Recent estimates suggest that U.S. gross domestic product would be almost nine percent higher if zoning laws in just three key regions—New York, San Francisco, and San Jose—were relaxed to match those in a median American city. This translates into an additional $8,775 in average wages for all workers. Restrictive zoning also disproportionately harms low-income workers. New York–area housing, for example, eats up 21 percent of a lawyer’s earnings, but a much higher 52 percent of a janitor’s income. As a result, whereas New York–area lawyers have more discretionary income after paying for housing than those in the Deep South, New York janitors have far less.

With the United States suffering a significant shortage of affordable housing, imposing disproportionate hardship on the less well-off, the federal government needs to act. Whereas Congress cannot preempt localities on zoning law, it has tools to motivate reform. It can deny tax-free treatment of municipal bonds issued by those authorities, or by up-the-chain jurisdictions that have power to roll back zoning rules, or it can withhold federal highway funds.

Easing zoning laws, abolishing unnecessary licensing laws, and banning noncompetes in employment contracts for all but high-earners are the low-hanging fruit of a new strategy to help workers help themselves. They are also prime examples of how a focus on predistribution can lower poverty and inequality while simultaneously slashing burdens on taxpayers.

Trade

The traditional arguments in favor of free trade are highly compelling. Free trade, under normal competitive conditions, increases productivity, innovation, and choice while minimizing prices to consumers. Economists, therefore, tend rightly to oppose using trade law to ensure that jobs are never lost to foreign competition. This position should be no more controversial than opposing bans on workplace automation, which also eliminates jobs (while creating new ones).

Steel tariffs to protect U.S. steel-industry jobs are a case in point. Since steel-using firms employ fifty times more Americans than steel-producing ones, tariffs hurt American manufacturing competitiveness and employment. A study of President George W. Bush’s 2002 steel tariffs found that more Americans lost jobs owing to higher steel prices than the total number of steel jobs in the country. U.S. businesses already pay some of the steepest steel prices in the world; raising them further only harms their shareholders, employees, and customers. Steel tariffs are an example of regressive predistribution that harms workers as well as growth.

Still, the arguments for free trade break down in the exceptional cases where exporters are backed by states directing vast financial resources to political objectives, such as eliminating foreign competition. This is why U.S.-led efforts to establish a global trading regime after World War II aimed at committing nations to conducting trade solely on commercial terms and to forswearing export subsidies (commitments that the Soviet Union, quite naturally, rejected).

Today, China, the world’s second-largest economy, is using subsidized exports to sustain manufacturing overcapacity and dominate global sectors it considers strategic. In the words of the former Australian prime minister and free-trade champion Tony Abbott, there is, for China, “no such thing as a free market, no such thing as an independent business. The Chinese turn trade on and off like a tap to suit their strategic purposes.”

China’s panoply of state-support mechanisms for favored exporters mattered far less at the time of its accession to the World Trade Organization (WTO), when its economy was less than a tenth of its current size, when it accounted for a mere 2 percent of global exports, and when those exporters competed in low-value added, low-wage sectors, such as apparel. But today, with China accounting for 15 percent of global exports, those mechanisms are a threat to the solvency of cutting-edge U.S. final-goods manufacturers employing large numbers of productive and well-paid workers.

Electric vehicles (EVs) are the most salient case in point. The range and depth of Chinese state support for domestic EV firms is enormous. Even overindebted local governments in China are investing billions of dollars, and arranging billions more in cheap loans from state-owned banks, for loss-making EV firms at a time of overcapacity.

If the WTO, which was created to facilitate trade among market economies, were capable of rolling back China’s anti-competitive behavior, a strengthened role for the institution should be welcomed. But China is simply too massive a player in the global economy to have its key government objectives annulled by lawyers and technocrats in Geneva. And so U.S. trade policy needs to adapt away from assumptions of state behavior consistent with global efficiency, and toward the reality of a system in which the Chinese leadership conjures global comparative advantage in any sector it chooses by dispensing with market principles.

The nascent U.S. hybrid car and EV industry employs 52,000 Americans, and average production-line salaries range from $75,000 for autobody technicians to $116,000 for powertrain engineers. If Beijing wishes to subsidize thousands of steel-using U.S. manufacturing firms, Washington should thank it —overall, it is a boon for U.S. firms and U.S. jobs. But there is a case to be built around predistribution objectives for protecting U.S. EV jobs with duties to countervail government subsidies on Chinese EVs. The European Union recently announced such duties, which, being WTO-compliant in principle, are preferable to President Biden’s approach of simply slapping 100 percent tariffs on Chinese EV imports. Still, the economic effect of compliant and noncompliant tariffs is the same. Given that EVs are final goods, and not intermediate ones like steel, protecting jobs in the U.S. EV industry would create minimal job loss elsewhere. EVs are therefore very different from an intermediate good like steel.

The issues surrounding the development of the EV industry globally are complex, involving as they do questions of climate goals, national-security concerns, and the impact of Chinese retaliation. Those issues cannot be ignored in setting policy. The focus here on predistribution, however, is motivated by the experience of the earlier China shock, with its consequent negative economic, social, and political effects. It is with the aim of preventing a second one that attention should be paid to the EV sector, which will be difficult to rebuild in the U.S. once felled by Chinese competition—competition that will receive whatever aid Beijing deems necessary for its success.

Taxation of Foreign Investors

There is a third, less obvious, policy tool related to trade that would allow the United States to predistribute in favor of U.S. workers: U.S. tax rules for foreign investors.

Whereas domestic taxes are the main tool of progressive redistribution, U.S. tax rules for foreign investors have a very different function and effect. It is broadly accepted internationally that income earned in one country by residents of another country should be taxed only once. But there is no consensus on whether that tax should be imposed by the country where the income is earned, or by the country where the earner resides. None of the arguments in this long-standing debate, however, address distortions in international trade—the subject just discussed. U.S. tax rules for foreign investors should be made to work hand-in-glove with U.S. trade policy.

A trade deficit and a capital account surplus—that is, a foreign savings surplus—are two sides of the same coin. It makes little sense for Washington to counter imports considered undesirable with tariffs or other impediments while simultaneously subsidizing the corresponding inflow of foreign savings that make those imports possible. Yet a subsidy is exactly what current U.S. international tax law offers foreign investors and governments—China included.

Foreign investors in U.S. debt and equity markets pay no U.S. taxes on their capital gains, receive most of their interest income tax-free, and pay low U.S. tax rates on dividends from U.S. companies. Even these low rates can be reduced to zero using well-known strategies involving financial derivatives. The largest Chinese investor of all—China Investment Corporation, the country’s government-controlled sovereign wealth fund—pays no tax on its U.S. portfolio investments, thanks to an outdated tax law provision that does not reflect the international norm.

Tax preferences attract foreign capital, including from countries such as China that accumulate capital using unfair trade practices. Yet U.S. businesses do not need more capital—they are sitting on a multi-trillion-dollar pile of cash. Making certain foreign investments less profitable would help protect the U.S. economy from the harmful effects of China’s trade policies.

Fortunately, the relevant U.S. tax rules are mostly set in bilateral tax treaties that can, and should, be rethought on a country-by-country basis. Investment into U.S. financial markets from China need not be given the same treatment as investment from countries committed to free, market-driven trade. Removing tax subsidies for the inflow of foreign savings from specific countries, such as China, is a far more efficient way of addressing the United States’ persistent manufacturing-trade deficit than tariffs, which distort the relative prices of goods and services and disrupt supply chains. Subsidy removal would assist the revival of American manufacturing jobs, and help reduce the need for redistributive domestic taxes and compensatory transfers.

Conclusion

Much of the polarization in the United States today can be traced to the belief that the operation of the global marketplace has grown increasingly unfair, and that government benefits meant to compensate for resulting inequities are typically inadequate and, for many, degrading. This article has argued that there are many areas of law and policy where government can make constructive changes that support workers’ interests without harming economic efficiency—but policymakers need to be aware of the linkages. Both major political parties have good, principled reasons, grounded in ideals of expanding personal independence and opportunity, to embrace the sort of policies we have highlighted—policies that recognize the dignity of work and its importance in a cohesive society.

Alex Raskolnikov is the Wilbur H. Friedman Professor of Tax Law at Columbia Law School. Benn Steil is senior fellow and director of international economics at the Council on Foreign Relations and the author, most recently, of The World That Wasn’t: Henry Wallace and the Fate of the American Century.