How to save the working and middle classes

I’ve been studying more macroeconomics lately, and I figured I would take a shot at proposing a tentative solution to the income-inequality gap—though the concept really emerges from a series of microeconomic shifts.  It is an idea, in more general terms, I’ve suggested to various friends and family members over the last few months: Close all the corporate loopholes, raise capital-gains taxes, and funnel the additional revenue back into companies replete with middle-class workers and laborers in the form of higher (real) wages. Is this a socialist, rob-peter-to-pay-paul strategy?

No, and here’s why.

Increasing aggregate demand (AD) usually translates into increased production costs because wages increase (either in the form of OT or hiring additional workers); this forces companies to raise prices, which means the additional costs are transferred to the consumer. This is essentially what happens in the situation here.

photo [3]

Within the standard LRAS/SRAS model (below), demand then shrinks, prices subsequently fall, and the price-output equilibrium is restored. Increased output under these parameters, then, can only be a temporary phenomenon. But what if the additional costs are covered by the hike in taxes on capital gains (i.e., prices remain sticky)?

photo [1]

The consumer is spared the burden of increased prices—so demand grows (AD to ADs curve) without rebounding—and wages rise for the average worker. As productivity rises (Y* to Yw)—a function of increased real wages—the company actually earns MORE money than it would have at “full” employment (i.e., at Y*). Joe CEO benefits because his company earns more money—the area of P*(Yw – Y*)—stretching his supply-demand curves to a new, better equilibrium, even though he’s initially taxed at a higher rate.  This cycle could, theoretically, continue forever IF we had unlimited stimuli that could shift the AD and LRAS curves to the right ad infinitum.

photo [2]

Such a strategy will help the overall economy: GDP will increase as productivity increases, consumption will increase (as will tax revenue), and unemployment will decrease because a company will eventually have to hire more workers. (There will be an upper bound for the productivity of Y* workers.) This will create a staggered increase in the wage-price ratio; in fact, if adjusted correctly, wages could double the rate of price increases, so real wages will grow. If a company uses price hikes—that is, P* shifts upward to Pw+n—to counterbalance increased labor output (Yw+n above) within a stimulus shift to AD, there will be a surplus of inventory, and the company is at risk for a loss.  (The shift to the new equilibrium through decreased demand is denoted by the shaded right triangle.)  But it is important to note that a company can STILL earn a profit on the surplus labor and inventory at Yw+iff


Assume such a profit exists.  (If it doesn’t, then there was a miscalculation in trying to stretch output to Yw+n.)  We can use that profit to subsidize the temporary drag of the (Yw+n)-labor surplus, and if another stimulus is introduced, we will shift the demand curve again (from ADw+n to the right) and (1) eliminate the excess inventory at a maximum price—in fact, the additional revenue would be the result of [((Pw+n) – P*)((Yw+n) – Yw)]/2)—(2) allow a maximization of productivity (at Yw+n) by increasing wages while keeping prices sticky, and (3) create another revenue bump, which will equal


Of course, we don’t need to manage the costs inherent in the increased Yw+n output; that is, as AD shifts, we could simply raise prices at Yw and maximize revenue that way—without having to deduct the costs of labor drag and inventory surplus.  This would be especially effective if output was maximized at Yw.  (Output would then increase to Yw+n during the next demand shift—with sticky prices at Pw+n—using the revenue gains from raising prices.)  In any case, this general cycle would continue until a new cost-demand equilibrium is reached—say, when total aggregate demand reaches an upper bound—and that could be a significant difference from the original price-output equilibrium.

What does this mean? The basic idea is simple: the LRAS, SRAS (long-run and short-run aggregate supplies), and demand curves shift over time to new (and higher) equilibria, stimulating business growth and minimizing inflationary measures with respect to real wages.  The best part is that it’s a win-win-win-win for everyone involved: the individual worker (higher real wage), the CEO (increased profits), the average citizen (benefiting from GDP growth), and the government (increased income-tax revenue and lower unemployment).  We can begin to close the gap if the rate of real-wage growth outpaces both the modest inflationary shifts and productivity-related profits, a likely possibility if the capital-gains rate is high enough with respect to the number of wages raised.


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