It is quite obvious that the gains from trade are positive, but implementing a free trade agreement obviously also implies some losses, in particular for workers whose skills were locked into the industry that just opened up. The implementation of some free trade agreements includes some compensation for such workers, but it is not much used if available. Why? And why would we need such compensation schemes at all?
Indeed, Marco de Pinto points out that unemployment insurance fulfills this role remarkably well. Those who benefit the most from the free trade agreement, and work, contribute to it, while those who lost, and are unemployed, receive insurance benefits. And if the unemployment insurance is not actuarially fair, that is OK, as it corresponds to a side-payment to the losers (no pun intended). But of course, the necessary taxation is distorting to the point of destroying the gains from trade. In such a context, it appears to be better to finance the unemployment insurance with a wage tax, as it neutral on all markets, in particular because under unionized labor markets, after tax wages are unchanged in aggregate. A profit tax is worse, but better than a payroll tax because it does not reduce labor demand for low-skilled workers as much.
Showing posts with label taxes. Show all posts
Showing posts with label taxes. Show all posts
What to do when people expect the government to default on its debt
The situation in Greece is rapidly getting worse, with clear signs that a bank run is in the works, mainly because there is no party majority that would avoid a default on the public debt. In such a situation, what should the fiscal policy be? Clearly, the budgets have to be reduced dramatically as no one would be willing to lend to the government and the government can only pay with cash (which is not the new drachma, as no one will trust that either and we would have immediate hyperinflation and the complete collapse of public services). This is why the government has no choice but to honor its debts if it wants to continue offering public goods, and this is what the Greeks want, I think.
So then, what should happen if the government is committed to pay the debt, but the public does not believe it? For advice, we can turn to the recent paper by Francesco Caprioli, Pietro Rizza and Pietro Tommasino. Suppose economic agents eventually and gradually learn about the good dispositions of the government. They also believe there is a positive correlation between the level of debt and the probability of default. The consequence of these very reasonable assumptions is that government expenses need absolutely to be reduced after a negative tax revenue shock. The first reason is that the interest rate goes up and worsens the situation, the second is that the government needs to keep the debt low to avoid fueling more default expectations, not just today but also in the future due to inertia of beliefs. This is in stark contrast from a situation where the government can credibly commit to repaying the debt: then, debt can effectively be used to smooth out fluctuations in tax revenue.
Greece is so screwed.
So then, what should happen if the government is committed to pay the debt, but the public does not believe it? For advice, we can turn to the recent paper by Francesco Caprioli, Pietro Rizza and Pietro Tommasino. Suppose economic agents eventually and gradually learn about the good dispositions of the government. They also believe there is a positive correlation between the level of debt and the probability of default. The consequence of these very reasonable assumptions is that government expenses need absolutely to be reduced after a negative tax revenue shock. The first reason is that the interest rate goes up and worsens the situation, the second is that the government needs to keep the debt low to avoid fueling more default expectations, not just today but also in the future due to inertia of beliefs. This is in stark contrast from a situation where the government can credibly commit to repaying the debt: then, debt can effectively be used to smooth out fluctuations in tax revenue.
Greece is so screwed.
Tax capital *and* inheritances
I probably do not surprise anyone if I claim that how much to tax capital income and bequests is controversial. In the United States, it is due a divergent beliefs about the motivation of entrepreneurs and luck of being born in the right environment. In Europe, arguments center on fairness. The literature does not help much, with results being very sensitive to income processes, market features and preferences. Capital income is generally taxed less than labor income, often not at all, and results on bequests vary wildly, again often with zero tax results.
Thomas Piketty and Emmanuel Saez add to this bewildering literature with a tour-de-force, a very rich, yet tractable model that allows to disentangle quite a few effects and illustrate what influences these taxes, in particular parameters that can be estimated. The richness is necessary to relate the model to real world better than the extant literature which yields this unrealistic and unobserved zero tax result. It is impossible for me to summarize over 100 pages in a few paragraphs, so here is a short overview.
The model features a large degree of heterogeneity, in taste for bequests and wealth accumulation, and in labor ability. Hence labor income and inheritance are not highly correlated, allowing for a trade-off between capital and labor income taxes because, as Piketty and Saez put it, two-dimensional inequality requires two tax tools. The tax on bequests is higher if bequests represent a large fraction of output, if the aggregate elasticity of bequests with respect to their tax is high, and if the taste for bequests is low. Tax rates on bequests can go all the way to 80%, and are for most parametrizations much higher than for labor income. This is because in general labor income should be favored, as it is derived from ability, unless people really like leaving bequests a lot.
If markets are imperfect and there is risk in capital return, then tax rates of capital income and bequests start differing. The lifetime equivalent of the capital income tax is then much higher than the bequest tax rate. because return fluctuations have stronger impact on periodic capital income than bequests, which are mostly accumulated capital and labor income. Important in this is also that in all economies, most people receive very little if any at all in terms of inheritance. This makes results remarkably robust with respect to welfare criteria.
Thomas Piketty and Emmanuel Saez add to this bewildering literature with a tour-de-force, a very rich, yet tractable model that allows to disentangle quite a few effects and illustrate what influences these taxes, in particular parameters that can be estimated. The richness is necessary to relate the model to real world better than the extant literature which yields this unrealistic and unobserved zero tax result. It is impossible for me to summarize over 100 pages in a few paragraphs, so here is a short overview.
The model features a large degree of heterogeneity, in taste for bequests and wealth accumulation, and in labor ability. Hence labor income and inheritance are not highly correlated, allowing for a trade-off between capital and labor income taxes because, as Piketty and Saez put it, two-dimensional inequality requires two tax tools. The tax on bequests is higher if bequests represent a large fraction of output, if the aggregate elasticity of bequests with respect to their tax is high, and if the taste for bequests is low. Tax rates on bequests can go all the way to 80%, and are for most parametrizations much higher than for labor income. This is because in general labor income should be favored, as it is derived from ability, unless people really like leaving bequests a lot.
If markets are imperfect and there is risk in capital return, then tax rates of capital income and bequests start differing. The lifetime equivalent of the capital income tax is then much higher than the bequest tax rate. because return fluctuations have stronger impact on periodic capital income than bequests, which are mostly accumulated capital and labor income. Important in this is also that in all economies, most people receive very little if any at all in terms of inheritance. This makes results remarkably robust with respect to welfare criteria.
How to best tax by gender and marital status
It is well known that income taxes are distorting in a way that is not welfare improving, as it discourages labor supply. But as we need government revenue to finance public goods and there is support for some redistribution, we have to live with income tax. Of course, one can discuss whether it would be better to crank up sin taxes to provide revenue and provide lump-sum subsidies (or taxes) to provide for redistribution, but let us suppose we have only labor income tax available. Then it is obvious that tax rates need to be differentiated by labor supply elasticity. That is difficult to elicit from individuals, but there are some individual characteristics that can help here.
Let us focus on gender and marital status. Women have a higher labor supply elasticity, especially when married. One has therefore to be careful not to tax them too much, or they drop out of the labor force. The same applies to a much lesser degree to married men. Gender is mostly unalterable, thus it should be easy to tax by gender, but politics get in the way. It is easier to differentiate taxes by marital status, but the latter is unfortunately endogenous. All this is probably why many countries tax differently by marital status, but not by gender.
Spencer Bastani studies the question using a model where, unfortunately, marriage is exogenous and characterized by perfect assortative matching: the most productive men marry the most productive women. When married, spouse bargain over each one's consumption and labor hours. Critical here is the exogenous bargaining power of the husband. Note that it is assumed that marriage always remains viable, there is no divorce, even though divorce is a threat point. In the end, men should be taxed more than women, unless the bargaining power of the husband is high (where lump-sum payments to women are likely to be higher, so they do not lose completely. And remember, this bargaining power is exogenous, and can be changed by law). If household production has a significant public good component, there should be redistribution from couples to singles. Welfare gains from such taxation are important, especially if wage gaps between genders are large. And this is the situation where it is the most feasible: women are then secondary earners, and one can tax secondary incomes differently without causing too much of a commotion.
Let us focus on gender and marital status. Women have a higher labor supply elasticity, especially when married. One has therefore to be careful not to tax them too much, or they drop out of the labor force. The same applies to a much lesser degree to married men. Gender is mostly unalterable, thus it should be easy to tax by gender, but politics get in the way. It is easier to differentiate taxes by marital status, but the latter is unfortunately endogenous. All this is probably why many countries tax differently by marital status, but not by gender.
Spencer Bastani studies the question using a model where, unfortunately, marriage is exogenous and characterized by perfect assortative matching: the most productive men marry the most productive women. When married, spouse bargain over each one's consumption and labor hours. Critical here is the exogenous bargaining power of the husband. Note that it is assumed that marriage always remains viable, there is no divorce, even though divorce is a threat point. In the end, men should be taxed more than women, unless the bargaining power of the husband is high (where lump-sum payments to women are likely to be higher, so they do not lose completely. And remember, this bargaining power is exogenous, and can be changed by law). If household production has a significant public good component, there should be redistribution from couples to singles. Welfare gains from such taxation are important, especially if wage gaps between genders are large. And this is the situation where it is the most feasible: women are then secondary earners, and one can tax secondary incomes differently without causing too much of a commotion.
We need more tax inspectors
The question on how to best tax people according to some criterion is the fundamental question of much of public economics. But it is little explored how the willingness of people to pay their taxes matters in this, except for a small literature on the underground economy.
Philipp Doerrenberg, Clemens Fuest, Denvil Duncan and Andreas Peichl Study a model economy where households have heterogeneous tax morale. It should come to no surprised that under such circumstances and if the tax authority can discriminate in this regard, it will tax more heavily those that are more willing to pay. That seems to be the pay of least effort for the tax authority. But the model completely neglects that the government can do something about those with low tax morale: go after them. Of course, it costs some resources, but when the objective is to maximize revenue, it can be worth it.
In fact, I find it amazing how a government in a budget crunch often first reduces the budget of its fiscal authority, thereby amplifying the problem. That can be viewed as a smart political move, tax authorities are never popular, but I am not even convinced of that. Think precisely about those with high tax morale: seeing there getting off free may reduce their tax morale, making things even worse.
Philipp Doerrenberg, Clemens Fuest, Denvil Duncan and Andreas Peichl Study a model economy where households have heterogeneous tax morale. It should come to no surprised that under such circumstances and if the tax authority can discriminate in this regard, it will tax more heavily those that are more willing to pay. That seems to be the pay of least effort for the tax authority. But the model completely neglects that the government can do something about those with low tax morale: go after them. Of course, it costs some resources, but when the objective is to maximize revenue, it can be worth it.
In fact, I find it amazing how a government in a budget crunch often first reduces the budget of its fiscal authority, thereby amplifying the problem. That can be viewed as a smart political move, tax authorities are never popular, but I am not even convinced of that. Think precisely about those with high tax morale: seeing there getting off free may reduce their tax morale, making things even worse.
Congestion charges in Stockholm: Did they work?
Proposals for city congestion charges continue to be put forward (even outside cities), both as a means to make the congestion disappear, reduce pollution, make city life more bearable and generate some revenue. The pioneer, London, has some mixed results according to a previous post, although I personally feel London is now much more bearable. In some cases, the benefits are much clearer, yet voters resist because of the unknown (other previous post).
Maria Börjesson, Jonas Eliasson, Muriel Hugosson and Karin Brundell-Freij update us on Stockholm, where people should be used to taxes and be easier to convince. Yet, it was not that easy to pass it by referendum, but the electorate warmed to the idea once it was in place. Also, it has reduced traffic and let to a significant (and visible, I must say) substitution to charge-exempt alternative-fuel vehicles. There seems to be a general agreement this is a success, and one needs to find a way to overcome initial resistance.
Maria Börjesson, Jonas Eliasson, Muriel Hugosson and Karin Brundell-Freij update us on Stockholm, where people should be used to taxes and be easier to convince. Yet, it was not that easy to pass it by referendum, but the electorate warmed to the idea once it was in place. Also, it has reduced traffic and let to a significant (and visible, I must say) substitution to charge-exempt alternative-fuel vehicles. There seems to be a general agreement this is a success, and one needs to find a way to overcome initial resistance.
When is the US going to reach its fiscal limit?
Most western economies currently show large public deficits. Whether they are sustainable is subject to much debate, and if they are not there is also much debate when action should be taken, and how radical it should be. One important part of the debate is the measurement of public deficits and debt, which makes any discussion of possible scenarios difficult. And these scenarios have to make heroic assumptions about the future evolution of the economy, which may in fact be endogenous to policy. All this is very complicated, and pundits do not help at all in this.
Richard Evans, Laurence Kotlikoff and Kerk Phillips take a different approach. Take the current policies, assume they persist forever. Calculate the fiscal gap, that is, the tax rate required to balance the current debt plus the sum of discounted future non-interest liabilities less future taxes. Feed this into a DSGE model and see when it violates feasibility (when the current generation has incomes lower than the tax necessary to close the fiscal gap. In their simulations, it takes a century for the US economy to reach its fiscal limit, although there is a 35% chance this could happen within 30 years. This results fits well within Kotlikoff's decade-old message that every economy is on an unsustainable fiscal path, message he repeats on his platform as a candidate for the US presidency.
Getting back to the model at hand, I do not quite understand the result. To me, this implies that there is somewhere a dynamic inefficiency, or some transversality constraint is being violated. But I do not see where this would happen in the model economy. There is a lump sum transfer from the young to the old in each generation that corresponds to 32% of wage income. To it corresponds a promise for future transfers that may be more difficult to satisfy were the economy to be hit by adverse shocks. Thus, it seems difficulties arise accidentally when the economy is hit by a series of bad shocks and continues forging ahead without any adjustment. That seems unlikely to me.
Richard Evans, Laurence Kotlikoff and Kerk Phillips take a different approach. Take the current policies, assume they persist forever. Calculate the fiscal gap, that is, the tax rate required to balance the current debt plus the sum of discounted future non-interest liabilities less future taxes. Feed this into a DSGE model and see when it violates feasibility (when the current generation has incomes lower than the tax necessary to close the fiscal gap. In their simulations, it takes a century for the US economy to reach its fiscal limit, although there is a 35% chance this could happen within 30 years. This results fits well within Kotlikoff's decade-old message that every economy is on an unsustainable fiscal path, message he repeats on his platform as a candidate for the US presidency.
Getting back to the model at hand, I do not quite understand the result. To me, this implies that there is somewhere a dynamic inefficiency, or some transversality constraint is being violated. But I do not see where this would happen in the model economy. There is a lump sum transfer from the young to the old in each generation that corresponds to 32% of wage income. To it corresponds a promise for future transfers that may be more difficult to satisfy were the economy to be hit by adverse shocks. Thus, it seems difficulties arise accidentally when the economy is hit by a series of bad shocks and continues forging ahead without any adjustment. That seems unlikely to me.
How to design public block and matching grants
In most countries, there are three levels of government: national, regional and local. In Europe, there is even a fourth one, the European Union. In many instances, higher level authorities provide funds to lower levels, either through block grants (allocations for a general purpose) or matching grants (allocations that requires matching funds from the grantee). How this should occur is not well studied, especially when one considers that these funds can be used to build local public capital.
Heng-Fu Zou makes an attempt at this, with a cascading Stackelberg structure from national to regional and local governments. I do not want to mention the conclusions, though, because I think the paper is fundamentally flawed. The most interesting aspects of the problem are bypassed here: first, there is a strong redistributive aspect to block grants, hence taxation need to be part of the model, but it is only modeled as a fix lump sum payment here. Second, the very reason why there are block grant for specific purposes instead on general grants is that lower governments may be tempted to put it all in public consumption. That variable is absent from the model, everything flows into public capital.
Third, the utility function is assumed to be log-linear in all public capital and expenditures individually. This implies that all of them are essential (a government can for example not take over responsibilities from another) and in particular that private consumption or investment is completely useless. As a consequence, it is always good to increases taxes, no matter their current level. Other results also derive directly from this assumption about the utility function. Fourth, the matching grant is so poorly set up that it allows the author to claim in all seriousness that capital can go instantly to infinity if the higher authority matches at 100% the local investment. Fifth, capital does not depreciate, which matters immensely when you write about the long run. Etc.
Interesting question, horrible execution.
Heng-Fu Zou makes an attempt at this, with a cascading Stackelberg structure from national to regional and local governments. I do not want to mention the conclusions, though, because I think the paper is fundamentally flawed. The most interesting aspects of the problem are bypassed here: first, there is a strong redistributive aspect to block grants, hence taxation need to be part of the model, but it is only modeled as a fix lump sum payment here. Second, the very reason why there are block grant for specific purposes instead on general grants is that lower governments may be tempted to put it all in public consumption. That variable is absent from the model, everything flows into public capital.
Third, the utility function is assumed to be log-linear in all public capital and expenditures individually. This implies that all of them are essential (a government can for example not take over responsibilities from another) and in particular that private consumption or investment is completely useless. As a consequence, it is always good to increases taxes, no matter their current level. Other results also derive directly from this assumption about the utility function. Fourth, the matching grant is so poorly set up that it allows the author to claim in all seriousness that capital can go instantly to infinity if the higher authority matches at 100% the local investment. Fifth, capital does not depreciate, which matters immensely when you write about the long run. Etc.
Interesting question, horrible execution.
Increasing public debt is a consequence of financial liberalization and inequality
The current debt crisis is the culmination of a long process of public debt accumulation over the last three decades in developed economies. Why this trend? I do not think it has suddenly become fashionable for governments to go deeper in debt, or that suddenly we came up with policy prescription leading that way more than before.
Marina Azzimonti, Eva de Francisco and Vincenzo Quadrini think it has to do with financial liberalization and globalization. The fact that more financial instruments and opportunities are now available certainly must contribute. There is already considerable evidence that the emergence of new borrowing instruments has increased household borrowing in the US, in particular for unsecured debt (credit cards). What these authors show is that a key component in the endogenous increase in public debt is a concurrent increase in income inequality in a political equilibrium. Public debt is beneficial because allows intertemporal smoothing. But at some point, higher debt leads to interest rates too high for the good of a majority. Interestingly, the model shows that it is not necessary for inequality to increase in all countries for this to happen. Globalization leads to a world-wide market, and local interest rates are largely determined on that market.
Marina Azzimonti, Eva de Francisco and Vincenzo Quadrini think it has to do with financial liberalization and globalization. The fact that more financial instruments and opportunities are now available certainly must contribute. There is already considerable evidence that the emergence of new borrowing instruments has increased household borrowing in the US, in particular for unsecured debt (credit cards). What these authors show is that a key component in the endogenous increase in public debt is a concurrent increase in income inequality in a political equilibrium. Public debt is beneficial because allows intertemporal smoothing. But at some point, higher debt leads to interest rates too high for the good of a majority. Interestingly, the model shows that it is not necessary for inequality to increase in all countries for this to happen. Globalization leads to a world-wide market, and local interest rates are largely determined on that market.
About the strange response of consumers to gas tax increases
When we think of price elasticity of demand, there is no reason to think that it would be different depending on the reason the price has changed. The quantity of apples you demand will be lower by the same amount whether the price has increased due a tax increase, a lack of supply or a typo by the grocer. To a large extend it is so because you generally do not know why the price has increased. But even if you knew, would that make a difference?
Shanjun Li, Joshua Linn and Erich Muehlegger
find it does for gas prices in the US. A five cent increase in gasoline taxes reduces consumption by 1.3% in the short-run. The same increase in the after-tax price reduces it by 0.16%. How can the difference be so large? First, you have to wonder whether the tax change covaries with something that has an impact on consumption, and that was not taken into account. To be honest, I cannot think about a good reason. Second, could these estimates be very imprecisely estimated and thus not significantly different from each other? The coefficients seem rather tightly estimated. Third, tax increases are widely announced and anticipated, and consumers thus can prepare themselves by filling the tank just before the change takes effects. That is not the case with market fluctuations. Yet, some of the difference persists in the long run. Do tax changes have a signaling effect that prompts households to change habits? The paper seems to allude to that in the sense that there is a change in fuel efficiency after tax changes that is largely absent after other price changes.
Shanjun Li, Joshua Linn and Erich Muehlegger
find it does for gas prices in the US. A five cent increase in gasoline taxes reduces consumption by 1.3% in the short-run. The same increase in the after-tax price reduces it by 0.16%. How can the difference be so large? First, you have to wonder whether the tax change covaries with something that has an impact on consumption, and that was not taken into account. To be honest, I cannot think about a good reason. Second, could these estimates be very imprecisely estimated and thus not significantly different from each other? The coefficients seem rather tightly estimated. Third, tax increases are widely announced and anticipated, and consumers thus can prepare themselves by filling the tank just before the change takes effects. That is not the case with market fluctuations. Yet, some of the difference persists in the long run. Do tax changes have a signaling effect that prompts households to change habits? The paper seems to allude to that in the sense that there is a change in fuel efficiency after tax changes that is largely absent after other price changes.
The cost of US fiscal imbalance
It is obvious that the US government is currently spend more than normal. It is also obvious that the current level of deficits is not sustainable. But just how bad would it be if the current fiscal imbalance would be maintained? We have models that can calculate welfare costs of such policies, but because the current policy is not sustainable, it is impossible to solve them and get a number. The only solution we can have is to look at what it would cost to delay going back to a sustainable path.
Bertrand Gruss and José Torres do with a heterogeneous agent DSGE model. According to their results, postponing the return to a sustainable path (defined by a pre-crisis debt/GDP ratio) by two decades leads to a permanent loss of output of 17% and a consumption equivalence loss of 7%. That is gigantic. The losses come mostly from the long run, thus it is all about whether the short-term gain is worth the long-term cost. To understand this result, it is thus important to understand the model.
This is a model of occupational choice (entrepreneur/worker), with idiosyncratic employment risk, no borrowing at the individual level, distortionary taxation and lump sum government transfers. There is another public good, wasteful government spending. A major role of the government is thus to insure agents against shocks, which they can also self-insure with accumulating Treasury bonds. Everybody knows exactly the path of policy. There is no aggregate shock except for fiscal policy. To summarize, the only beneficial thing the government does is insure people against shocks, to some extend. Otherwise, the government is harmful: it takes away goods to destroy them and distorts household choices in adverse ways to finance this. It is then no surprise that almost any government spending is harmful, no matter what the circumstances. In particular, the fact that there could be, for example, a temporarily very high unemployment rate that justifies larger public expenses is ignored here.
In other words, the model ignores the potential benefits of current deficits. Not very useful.
Bertrand Gruss and José Torres do with a heterogeneous agent DSGE model. According to their results, postponing the return to a sustainable path (defined by a pre-crisis debt/GDP ratio) by two decades leads to a permanent loss of output of 17% and a consumption equivalence loss of 7%. That is gigantic. The losses come mostly from the long run, thus it is all about whether the short-term gain is worth the long-term cost. To understand this result, it is thus important to understand the model.
This is a model of occupational choice (entrepreneur/worker), with idiosyncratic employment risk, no borrowing at the individual level, distortionary taxation and lump sum government transfers. There is another public good, wasteful government spending. A major role of the government is thus to insure agents against shocks, which they can also self-insure with accumulating Treasury bonds. Everybody knows exactly the path of policy. There is no aggregate shock except for fiscal policy. To summarize, the only beneficial thing the government does is insure people against shocks, to some extend. Otherwise, the government is harmful: it takes away goods to destroy them and distorts household choices in adverse ways to finance this. It is then no surprise that almost any government spending is harmful, no matter what the circumstances. In particular, the fact that there could be, for example, a temporarily very high unemployment rate that justifies larger public expenses is ignored here.
In other words, the model ignores the potential benefits of current deficits. Not very useful.
I do not understand US policy
The current situation in the US can be summarized in the following way: the economy is growing again, although not yet as fast as steady state, and unemployment is still high. Most sectors are doing kind of OK except for the construction sector, which operates roughly at half capacity. Budgets deficits are very high, but not at record level once you factor in cyclical effects. Inflation is moderate and on target around 2%, including its expectations. Everyone is sitting on a lot of cash and nominal interest rates are minimal. The crisis has been going on since 1997, 4.5 years.
What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.
And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.
And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.
For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.
Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.
And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.
Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.
So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.
What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.
And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.
And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.
For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.
Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.
And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.
Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.
So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.
Fiscal policy and climate change
It becomes more and more difficult to deny that something is happening to the weather and that climate change is a reality. From the point of view of the economist, this implies that there is more scope for distortionary taxation to mitigate climate change, and this brings a series of opportunities to improve the economy in indirect ways. The big fear of business is that sin taxes on pollution will curtail their production and profits. Of course, this is the whole point of these taxes, that is to internalize the effect of pollution, and that often means either reducing production or increasing production costs.
But as Benjamin Jones, Michael Keen and Jon Strand point out, this has also important benefits for businesses: the added tax revenue allows to reduce other taxes, in particular the ones that are bad for business: corporate taxes or income taxes could even be eliminated in a so-called greening of the tax code. This is one important reason one should tax polluting production or energy instead of subsidizing energy-efficient production or alternative energy, as I have already repeated at great lengths on this blog. But this is easier said than done, as the public will surely call for public expenses to cope with climate change. Politically, it is much easier to give firms technology to pollute less than have them buy it because polluting alternatives have become too expensive. But because it is easier politically does not mean it is right.
But as Benjamin Jones, Michael Keen and Jon Strand point out, this has also important benefits for businesses: the added tax revenue allows to reduce other taxes, in particular the ones that are bad for business: corporate taxes or income taxes could even be eliminated in a so-called greening of the tax code. This is one important reason one should tax polluting production or energy instead of subsidizing energy-efficient production or alternative energy, as I have already repeated at great lengths on this blog. But this is easier said than done, as the public will surely call for public expenses to cope with climate change. Politically, it is much easier to give firms technology to pollute less than have them buy it because polluting alternatives have become too expensive. But because it is easier politically does not mean it is right.
Tax rates over the business cycle
With all the talk about cyclical austerity measures, it is surprising that little is known about the cyclical behavior of tax rates. For one, the tax code is complex and it cannot be summarized by a single number. That can be done by looking at aggregates, but of course aggregate tax rates are endogenous to economic activity as soon as there is some progressivity.
This does not deter Carlos Vegh and Guillermo Vuletin who analyze various tax rates for 62 countries over 40 years, using top marginal rates for corporate and personal incomes, as well as VAT. The results are striking: there is no correlation of tax rates with the business cycle in developed economies, but they are noticeably procyclical in developing ones. Why would this be the case? A simple model can explain this. Public consumption is always procyclical, for example if private and public consumption are complements. If public consumption is a large share of national income, tax rates need to go up to sustain increased expenses in a boom. If the public consumption share is rather small, as is typically the case in developed economies, tax increases are not required.
This does not deter Carlos Vegh and Guillermo Vuletin who analyze various tax rates for 62 countries over 40 years, using top marginal rates for corporate and personal incomes, as well as VAT. The results are striking: there is no correlation of tax rates with the business cycle in developed economies, but they are noticeably procyclical in developing ones. Why would this be the case? A simple model can explain this. Public consumption is always procyclical, for example if private and public consumption are complements. If public consumption is a large share of national income, tax rates need to go up to sustain increased expenses in a boom. If the public consumption share is rather small, as is typically the case in developed economies, tax increases are not required.
Detection of wage under-reporting
The recent publication by Greece of the names of the most notorious tax cheat is the latest event in a recent trend by tax authorities across the world as they try to secure more revenue. Of course, it is difficult to evaluate how much underreported taxable income there is. One way, recently reported here, is to look at money circulation. A "natural experiment" can be much more illuminating.
Péter Elek, János Köllő, Balázs Reizer and Péter Szabó look at a recent reform in Hungary, wherein a minimum contribution to social security is imposed for any wage below twice the minimum wage. Firms paying below this threshold also face more scrutiny from tax authorities. One has to understand that one feature of wage under-reporting is that it can lead to a the declaration of an official wage at the minimum wage with the rest paid under the table. The Hungarian reform had the potential to change this for cheaters, who would then want to declare twice the minimum wage.
Using a double-hurdle model, because there is also a censoring problem with the minimum wage in additions to the tax cheating selection, the authors find that about 50% of the minimum wage job before the reform were fraudulent. With about a third of workers declaring a minimum wage, that is a considerable share of cheaters. And there may of course be more, who declare more than minimum.
Péter Elek, János Köllő, Balázs Reizer and Péter Szabó look at a recent reform in Hungary, wherein a minimum contribution to social security is imposed for any wage below twice the minimum wage. Firms paying below this threshold also face more scrutiny from tax authorities. One has to understand that one feature of wage under-reporting is that it can lead to a the declaration of an official wage at the minimum wage with the rest paid under the table. The Hungarian reform had the potential to change this for cheaters, who would then want to declare twice the minimum wage.
Using a double-hurdle model, because there is also a censoring problem with the minimum wage in additions to the tax cheating selection, the authors find that about 50% of the minimum wage job before the reform were fraudulent. With about a third of workers declaring a minimum wage, that is a considerable share of cheaters. And there may of course be more, who declare more than minimum.
Differentiated carbon taxation
In the face of pollution externalities, there is no doubt that carbon taxes are the best solution. What is more tricky is to establish the level of those taxes. A particular aspect of this is whether carbon taxes need to be differentiated across countries. For example, should it be the same in developed and developing economies? For context, see the current riots and strikes in Nigeria after the removal of fuel subsidies.
Antoine d’Autumne, Katheline Schubert, Cees Withagen take on the question at an international level and argue that that optimal tax design would call for differentiated taxes with lump-sum transfers across countries. While the tax has a world-wide component, the country-specific one stems from local externalities, of course, and from the distortions from cost of public funds. If lump-sum transfers are not possible, international inequities would also have to be captured by differentiated taxes. So, yes, rich countries do need to tax carbon more, even probably even much more than poor ones.
Antoine d’Autumne, Katheline Schubert, Cees Withagen take on the question at an international level and argue that that optimal tax design would call for differentiated taxes with lump-sum transfers across countries. While the tax has a world-wide component, the country-specific one stems from local externalities, of course, and from the distortions from cost of public funds. If lump-sum transfers are not possible, international inequities would also have to be captured by differentiated taxes. So, yes, rich countries do need to tax carbon more, even probably even much more than poor ones.
The corporate tax Laffer curve
Given the mobility of the headquarters of financial holding firms, there is much more diversity in corporate tax rates than tax competition would call for. Looking at OECD countries, the effective tax rate peaks at 40% in Japan and the US, while it is half this, or below, in other countries. Given the high mobility, would it be government revenue maximizing to reduce the tax rate in the US or Japan? In other words, are these two countries to the right of the Laffer curve peak?
Kazuki Hiraga asks this question for Japan, but in a closed economy, thus ignoring international tax competition. Japan is still on the wrong side of the corporate tax Laffer curve. Decreasing the tax not only increases tax revenue, it leads to more growth through stronger capital accumulation. Add tax competition, and you have even better reasons to cut the corporate tax rate. Hence, the argument likely also applies to the US.
But wait a moment, let us have a look at the model. It is a standard real business cycle model with various distortionary taxes. The collected revenue is rebated in lump-sum fashion to households, which own the firms. In other words, this is a model where taxes a never optimal. Indeed, nothing useful is done with tax revenue, and there is no redistribution going on. No need for fancy solution techniques to understand the results...
Kazuki Hiraga asks this question for Japan, but in a closed economy, thus ignoring international tax competition. Japan is still on the wrong side of the corporate tax Laffer curve. Decreasing the tax not only increases tax revenue, it leads to more growth through stronger capital accumulation. Add tax competition, and you have even better reasons to cut the corporate tax rate. Hence, the argument likely also applies to the US.
But wait a moment, let us have a look at the model. It is a standard real business cycle model with various distortionary taxes. The collected revenue is rebated in lump-sum fashion to households, which own the firms. In other words, this is a model where taxes a never optimal. Indeed, nothing useful is done with tax revenue, and there is no redistribution going on. No need for fancy solution techniques to understand the results...
On the ineffectiveness of a fiscal stimulus
When is a fiscal stimulus going to work? If you listen to economists these days, it would be difficult to know. One reason is that protagonists quickly become sidetracked by the associated political discourse. The other is that one would first need to define the fiscal stimulus. Depending on whether it is provided by tax rebates, public expenses or tax delays makes a big difference. Also, who is targeted matters a lot. Thus one needs to get the specifics of the fiscal stimulus to give a proper answer. The general rule, though, is that a fiscal stimulus works best if the credit or liquidity constraint households obtain additional cash. They are going to spend it right away. The other households would reduce consumption only slightly in anticipation of future increased taxes due to a wealth effect. In the aggregate, consumption would then go up, but not a lot. But there can be other circumstances where it would work better.
Thorsten Drautzburg and Harald Uhlig study a situation similar to the one now in the Unites States: nominal interest rates getting very close to zero. Then, they claim the fiscal multipliers are still rather small, but may be positive despite distortionary taxation. Now contrast this with the results of Lawrence Christiano, Martin Eichebaum and Sergio Rebelo, who argue that the fiscal multipliers become very large (and positive) when nominal interest rates are close to zero. Who is to believe? Both use a rather elaborate DSGE model, in both cases estimated. Both use the Calvo fairy. Or a Taylor rule. The first has financial frictions, while the second has investment adjustment costs, which should come to the same. If anybody can figure out why the results are so different, I would appreciate it.
It particular it would be interesting to understand why now would now be the wrong time to institute an austerity regime. To me, it would even make perfect business sense: why not build infrastructure when the cost in terms of financing and labor are low? Keep in mind that every unemployed worker that is hired does not need unemployment benefits...
Thorsten Drautzburg and Harald Uhlig study a situation similar to the one now in the Unites States: nominal interest rates getting very close to zero. Then, they claim the fiscal multipliers are still rather small, but may be positive despite distortionary taxation. Now contrast this with the results of Lawrence Christiano, Martin Eichebaum and Sergio Rebelo, who argue that the fiscal multipliers become very large (and positive) when nominal interest rates are close to zero. Who is to believe? Both use a rather elaborate DSGE model, in both cases estimated. Both use the Calvo fairy. Or a Taylor rule. The first has financial frictions, while the second has investment adjustment costs, which should come to the same. If anybody can figure out why the results are so different, I would appreciate it.
It particular it would be interesting to understand why now would now be the wrong time to institute an austerity regime. To me, it would even make perfect business sense: why not build infrastructure when the cost in terms of financing and labor are low? Keep in mind that every unemployed worker that is hired does not need unemployment benefits...
One more argument for taxing unhealthy activities
Whenever an activity exerts a negative externality on others, you want to tax it. For example, sin taxes are in place or are proposed for smoking, eating junk food or drinking soda. The reasoning is that these activities are bad for health, and thus end up costing society, even when there is no socialized health care. The fact that these unhealthy people tend to live shorter only partly offsets the direct effect of the externality.
Catarina Goulão and Agustín Pérez-Barahona explain that there is another good reason to tax unhealthy food: unhealthy eating habits are transmitted from a generation to the next even when there is no genetic reason for this to happen. This can also within a group of socially interacting people, which gives obesity or smoking the characteristics of an epidemic. To break this vicious circle of learning, the price mechanism has to come to the rescue. So let's impose more or new sin taxes. We could use the revenue, apparently.
Catarina Goulão and Agustín Pérez-Barahona explain that there is another good reason to tax unhealthy food: unhealthy eating habits are transmitted from a generation to the next even when there is no genetic reason for this to happen. This can also within a group of socially interacting people, which gives obesity or smoking the characteristics of an epidemic. To break this vicious circle of learning, the price mechanism has to come to the rescue. So let's impose more or new sin taxes. We could use the revenue, apparently.
The best solution: carbon taxes
When there is some externality, the best way to deal it is with a tax (for a negative externality like pollution) or a subsidy (for a positive externality like education). Yet, I am continuously amazed how this policy using the market mechanism has found little reception in the United States. And economists are also very fond of it: it is the most efficient way to reach an objective, and in the case of a negative externality it even allows to reduce other taxes that distort the wrong way, like income taxes.
Joseph Aldy and Robert Stavins writes a survey article about how to best deal with carbon pollution, comparing a cap-and-trade of pollution permits, clean energy standards and taxation of carbon content. And the latter is the easy winner. And as argued multiple times on this blog, alternative energy should not be subsidized.
Joseph Aldy and Robert Stavins writes a survey article about how to best deal with carbon pollution, comparing a cap-and-trade of pollution permits, clean energy standards and taxation of carbon content. And the latter is the easy winner. And as argued multiple times on this blog, alternative energy should not be subsidized.
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