Tag Archives: fiscal policy

Tax Cuts in Italy

Italy’s government recently cut income taxes in order to boost the economy. The intended purpose of these tax cuts are to get more of the middle- and lower- income households spending. The cuts will go into effect next month and are expected to give up to €80 a month in extra income to three-quarters of the workforce. As foreign demand in Italy has been slowing, these tax cuts are meant to boost domestic demand and shift less dependence growth from exports.

Prime Minister Matteo Renzi intends for these tax cuts to be structural tax cuts, not just a one-time basis tax cuts. These tax cuts are much needed, as Italy’s economic output (measured in GDP per capita) has contracted even more than the output in Greece. Specifically, “Italy’s economy was growing at a 3.7% annual rate, the budget deficit was 0.9% of gross domestic product, and the public debt was 109% of GDP. Today, Italy’s economy has just begun a modest recovery after a five-year crisis that has eroded economic output by 9% and pushed the debt level up to 133% of GDP.” As debt levels are rising and Italian exports are becoming less attractive, Mr. Renzi believes that these cuts will shift resources to people most likely to spend it. Thus, maximizing economic impact.

However, some economists believe that an even more effective intervention was overlooked. This group of economists recommended that cutting business taxes levied on payrolls would have been more effective (Italian employees face pretty steep tax rates- about 50% and higher when payroll contributions are included). These economists feel that lowering the business tax on payrolls will lower Italy’s labor costs and increase job creation in the medium-run. To the contrary, Prime Minister Renzi feels that at the marginal level, targeting tax cuts at the medium and lower end of the income distribution will have a larger positive effect on consumption. Additionally, he is not opposed to the view of the other economists as well. He plans to focus on lowering business taxes by a small margin this year and then later focus more heavily on this issue in 2015.

I think that Mr. Renzi’s current proposal of tax cuts will have a positive effect in that they are structural tax cuts. Although some economists doubt the effect of the proposal at the moment, I think that strengthening the domestic reliance of Italy’s economy will prove beneficial in the long-run– maybe 15 or 20 years from now. I also think it was smart of the prime minister to address the opposite side of the argument. The main counterargument of cutting taxes is that it favors the rich because cuts can lead to reductions in government services that lower-income households generally rely on. Since the cuts only apply to workers with salaries of up to €28,000 a year, I believe that Mr. Renzi is efficiently targeting the correct demographic.

(Revised) The point of fiscal policy

Since the founding of the country or even perhaps way beyond the time horizon,one of the quintessential controversy of a state was how the government should handle citizens’ money. This has been just as much a dilemma for political scientists and philosophers as it is for economists. Even in states without a democratic institutions, it is still a big problem for monarchs, oligarchs and alike to decide where and how to spend the budget on hand. In today’s term for many countries, it is the debate of budget deficit, whether we should allow it or not, and if we do, by how much should we allow it.

For anyone who supports laissez faire, which literally means ‘let them do’ in French, signifying minimum government intervention in the economy, should really hate the advocates of ‘austerity’ and ‘growth.’ For the former, austerity supporters want near-perfect balanced budget, requiring government to tax a huge sums to reduce the budget gap. For the latter group, growth supporters are focused on short-term expansion of GDP growth, and want the government to spend over the budget.

According to a wsj article by Dan Mitchell, the two groups are missing the point. As Milton Friedman had said, the concern shouldn’t be deficit or no deficit, but the size of the government. Mitchell claims that the ‘golden fiscal rule’ is to have the government spending grow at a slower rate than the growth of private economic sector. This sounds quite intuitive. If the government can manage slower expansion in spending than the growth of private sector, the government should have enough taxes under relatively smaller government spending. Even in the times of bad supply shock, the economy can be more stable since it has room for more effective fiscal stimulus without burdening the tax payers too much. In other aspects, the article says the following:

A golden rule has several advantages over fiscal proposals based on balanced budgets, deficits or debt control. First, it correctly focuses on the underlying problem of excessive government rather than the symptom of red ink. Second, lawmakers have the power to control the growth of government spending. Deficit targets and balanced-budget requirements put lawmakers at the mercy of economic fluctuations that can cause large and unpredictable swings in tax revenue. Third, spending can still grow by 2% even during a downturn, making the proposal more politically sustainable.

Although the focus here is economic growth and stability, I want to point out first the sustainable political atmosphere that is created through this strategy. Monetary policy and fiscal policies are often dampened in their magnitude due to political conflicts. Professor Kimball claimed that Obama’s failure is not being able to spend more (despite the congressional shutdown and the long talk of dangerous fiscal cliff), not spending too much.

From the vantage point of economics, I think this could be a strategy that could end many of the debates that are being discussed right now.  Government spending growing at a slower rate than private economy will ensure downsizing of the government–closest we can get to achieving laissez faire fantasy. And this is not an unproven virgin theory, but bears a lot of success stories where governments achieved balanced budget and still had high growth rate. To name a few:

Ireland (1985-89), Slovakia (2000-04), Singapore (1998-08), Italy (1996-2000), Lithuania (2008-present), Taiwan (2001-06), Israel (2002-05), Estonia (2008-11), Iceland (2008-present), and the Netherlands (1995-2000)

These countries all have enjoyed high nominal gdp growth while restoring budget balance. Currently, Congressman Kevin Brady is proposing a similar budget planning strategy for the US. I hope he can weave something that works for this country.

The point of fiscal policy

Since the founding of the country or even perhaps way beyond the time horizon, one of the roots of conflicts was how government is going to use its citizens’ money. Even in institutions without democratic state, it is still a big problem for monarchs, oligarchs and alike to decide where and how to spend money. In today’s term, it is the debate of budget deficit, whether we should allow it or not, or if we do, by how much.

For anyone who supports laissez faire approach of the government should really hate the advocates of ‘austerity’ and ‘growth.’ As for the former, austerity supporters want near perfectly balanced budget, requiring government to tax a huge lump sum and reducing the budget gap. For the latter group, growth supporters are focused on short-term expansion of GDP growth, and want the government to spend over the budget.

According to a wsj article, the two groups are missing the point. As Milton Friedman had said, the concern shouldn’t be deficit or no deficit, but the size of the government. It claims that the ‘golden fiscal rule’ is to have government spending grow at a slower rate than the growth of private economic sector. This sounds quite intuitive. If the government can manage slower expansion in spending than the growth of private sector, the government budget deficit is going to be very manageable. Even in the times of bad supply shock, the economy can be more stable since it has room for more effective fiscal stimulus without burdening the tax payers too much. In other aspects, the article says the following:

A golden rule has several advantages over fiscal proposals based on balanced budgets, deficits or debt control. First, it correctly focuses on the underlying problem of excessive government rather than the symptom of red ink. Second, lawmakers have the power to control the growth of government spending. Deficit targets and balanced-budget requirements put lawmakers at the mercy of economic fluctuations that can cause large and unpredictable swings in tax revenue. Third, spending can still grow by 2% even during a downturn, making the proposal more politically sustainable.

Although the focus here is economic growth and stability, I want to point out first the sustainable political atmosphere that is created through this strategy. Monetary policy and fiscal policies are often dampened in their magnitude due to political conflicts. Professor Kimball claimed that Obama’s failure is not being able to spend more (despite the congressional shutdown and the talk of fiscal cliff), not spending too much.

From the vantage point of economics, I think this could be a strategy that could end many of the debates that are being discussed right now.  Government spending growing at a slower rate than private economy will ensure downsizing of the government–closest we can get to achieving laissez faire fantasy. And this is not an unproven virgin theory, but bears a lot of success stories where governments achieved balanced budget and still had high growth rate. To name a few:

Ireland (1985-89), Slovakia (2000-04), Singapore (1998-08), Italy (1996-2000), Lithuania (2008-present), Taiwan (2001-06), Israel (2002-05), Estonia (2008-11), Iceland (2008-present), and the Netherlands (1995-2000)

Currently, Congressman Kevin Brady is proposing similar budget planning strategy for the US. I hope he can weave something that works for this country.

Ryan’s budget ignores reality, still might not work

Members of both parties agree the deficit spending that the federal government continues to engage in is not sustainable.  It was necessary given the recession the economy was in, but it soon could weigh on the economy.  As the United States economy limps along after the great recession, the short term decrease in output that would result from balancing the budget cold further exacerbate the situation.  The question is how much debt is too much debt.  Research as to what level of debt the negative effects would begin at has been found to be unreliable.  The budget laid out by Sen. Paul Ryan on Tuesday touts the elimination of deficit spending in 10 years.  However this Ryan’s budget is both politically and economically unfeasible.

It seems fitting that Ryan’s budget plan was released on April fools day.  This budget has no chance of ever being implemented, as even if it where to get through the house of representatives, it stands no chance in a Democratic Senate that will not even vote on it.  This is fortunate given the research the budget is based on.  Released the same day, the report from the Congressional Budget Office (CBO) claims to have examined the effects of Ryan’s budget.  While most of his assumptions are agreeable, such as using the current projected budget as an extended baseline, the source of the spending reductions are “unspecified fiscal policies” and the budget is balanced via a line item “macroeconomic fiscal impact”. The fiscal is said to be the due to increased growth that the economy would receive due to the deficit reduction.  This has not been included in previous budgets.

While this may all seem vague, it’s of little real value.  The report clarifies that “the illustrative paths do not incorporate effects from differences in incentives to work or save that might be generated directly by differences in policies relative to those of the extended baseline.”   It goes on to mention, “Chairman Ryan’s specified paths for revenues and spending would require major changes to current law.” Given Ryan’s plans, requiring massive changes to healthcare spending, there will be an effect to an individual’s choices concerning working and saving.  These effects will cancel some of the effects Ryan attributes to growth out.  The budget that Paul Ryan is pitching calls attention to an important problem, but the claims he is making may be a little exaggerated.

What can be inferred from the paper is that even in Sen. Ryan’s dreams, deficit spending could be eliminated in 10 years.  This budget shows how large the problem is.  The government must either raise revenue (taxes), or decrease spending.  Given the productivity of congress, it may take much longer then 10 years for the government to balance its budget.

 

 

 

Recovery on hold with profits overseas (revised)

The United States’ recovery from the recession of 2008 has been painfully slow. It has been a period characterized by persistent unemployment.  Companies are not adding the jobs they shed during the recession.  During this same period American companies have made healthy profits.  However, these profits have not translated into growth.  Below is the labor participation rate, which is a measure of what portion of the population is working.  The shaded areas are recessions, and coincide with drops in the participation rate.  The recoveries that follow show sharp increases in the rate.  After this most recent recession is clear that this recovery is different.

EMRATIO_Max_630_378

Many think that the economy isn’t recovering like is has in the past because there is money just sitting on the sidelines.  One way to get that money working would be to institute an electronic currency, removing the zero lower bound on interest rates by removing 0% interest on paper money, and instituting negative interest rates to draw the money out.  Unfortunately, the paradigm shift needed on the part of the public for this to take place isn’t going to occur anytime soon.  I personally think that such a shift will most likely come from a popular cry for relief from inflation as opposed to breaking the zero lower bound, since the change would be more appealing to the public then.  With electronic money and the removal of the zero lower bound firmly in the future, the United States is in need of something that can help now.  Companies like Apple, Google, and Exxon Mobile are hoarding their profits overseas (an estimated 1.9 trillion in May 2013).  The federal government should incentivize this money to come back to the US where it can work for Americans.

When multinational companies bring their profits back from over seas, the government takes what is called a repatriation tax. This tax rate is currently 35% of what ever is left after the company pays taxes in whatever country it earned them.  Since the money is taxed as soon as it is brought into the country, there will be over a third less of it when it gets here.  Further eroding these mountains of cash is the debts taken out in order to do share buy backs and pay dividends to shareholders.  Investors want some of the profits if the company isn’t going to use them.  The companies themselves would prefer the money was in the US, but current fiscal policy discourage this.  If the government is serious about stimulating the economy, it may have to get out of its own way.

The repatriation tax is preventing corporations from bring these profits back to the United States.  Apple told them as much in 2013.   In order to stimulate the growth that the United States desperately needs, the federal government should provide a tax holiday for corporations to bring their profits home.  This could amount to taxing the profits at a lesser rate, say 10%, but also in hundreds of billions of dollars returning to the United States.  How could this be a bad thing for an economy needing further stimulation?  Opponents to this idea argue that it was tried in 2004 and didn’t lead to any tangible benefits.  While there is no guarantee the companies won’t pay healthy dividends to shareholders or pay down debt, companies will also invest some of the money in acquisitions and research.  There is a lot more money overseas now then there was in 2004, and the country wasn’t struggling to add jobs in 2004.  While opponents say it has the potential to cost the government billions in lost revenue, so does a lack luster recovery.  In addition, the analysis of the 2004 policy was done in 2011, and many positive ramifications of the investments would have been wiped out by the recession.

The money American companies are keeping overseas represent prosperity that has already been earned. The federal government may hate the idea of letting that much money in with such a small slice going in its coffers, but if the United States is going to have one of the highest corporate tax rates the world, how much of this cash does it make sense for companies even to bring back?  The United States government should provide corporations with the incentive they need to bring their profits back to the United States by providing a tax holiday for the money they are currently keeping over seas.  The existing policies should also be modified to make America competitive again with regard to corporate tax rates.  It is only driving money away from our shores (IBM, Chrysler are examples). This money and these policies could be the missing ingredient for the United States recovery.

Labor Market Improvements

Today, Ferderal Reserve chair Jane Yellen expressed her opinion on the labor market that although it is close to its 6.5% target rate, she is not satisfied with the current trend and there needs more work in the labor market. Despite constant decrease in the unemployment rate since 2009, I agree with her statement and here are some of my reasons why:

First and foremost, I have mentioned in my last blog post, about US’s unprecedented increase in the new federal minimum wage of swooping 28% to $10.10 to . From workers’ perspective, there are obviously a lot of benefits to be expected. This is especially true since the real wage in the US has been decreasing gradually until the year of 2009 where it slowly picked up again. However, on the other side of the labor market is the employer. For employers, the nominal wage increase of 28% is historically highest. Even if the employees do not receive the lowest minimum wage, there may be larger bargaining power for the workers who are paid slightly above the new minimum wage. This will discourage employers from hiring with increased cost.

Another vantage point to consider this problem is the weather. Experiencing one of the coldest weather in decades, the housing market is showing sluggish movement overall. One of the Bloomberg article stated,

“While weather helped slow ground-breaking on new projects, higher mortgage rates entering the new year limited purchases of previously owned properties, a Feb. 21 report from the National Association of Realtors is forecast to show. Existing-home sales, which reflect buying decisions months before a contract closes, may have been the weakest since mid-2012.”

I suspect that many new projects being postponed or held back would affect the employment as the workers would also have to wait for the weather to clear out. For workers, they receive less payrolls because factories are shut down, and have less disposable income. Employers had less manufacture goods and less sales. Overall, the US economic activity decelerated due to inclement weather.

Where is the beacon of hope then? I must say that despite these set backs, the US economy doing okay actually. The Michigan Consumer Sentiment Index stayed the same, beating the expectation of the decrease. The Fed, of course, made it pretty clear that they are going to see the weather as an exogenous factor and will carry out the agenda as is. Moreover, some economists says, having the extended benefit ending in last December, more of the educated workers will be returning to the work force, further having a downward pressure to the unemployment rate.

As I have laid out my worry and possible remedying factors, overall I am pretty confident that the US economy is really doing okay. Every time an economy hits a big recession like the US had several years ago, there must be a strategic combination of fiscal and monetary policy that will smooth out the contraction trough, and eventually bring it back to the natural level of output. I think US has played enough cards in the fiscal policy track as the word “fiscal cliff” has been thrown out way too many times–either for real or for political reasons– and now that we rely on monetary policy to do its job, people are anxious about every move the Fed makes. Consequently, there will always be some noise over Fed’s decision, but I praise them for boldly executing what they have to do.

Damn Taper, You Scary! Or: Coordination Problems in International Finance

So we’ve all been dissecting the Fed’s decision to continue to taper, and why that might or might not be justified. I don’t think I have much to add on that front. Yes, a lot of work remains to be done; GDP is on the rise while unemployment is still high. And that makes tapering less attractive. However, if the Fed is extraordinarily concerned about unwinding the assets it acquired under QE too quickly and causing distortions and bubbles, it might be doing the right thing. Or rather, it might be doing the rational thing given its beliefs (that unwinding will be really difficult, for example).

I’d say if that’s the case, the Fed is being overly cautious, because it has the tools to stop the economy from overheating (and there’s no special case analogous to the ZLB in that direction). And if anyone doubts whether interest rate hikes are effective: ask the Turkish (also a great argument for having an independent central bank, by the way). Still, drastic increases in interest rates are never fun. Also, don’t forget that there are others who are tasked with promoting US economic performance and national welfare. While you can argue that monetary policy is easier to implement than fiscal policy (and avoids the political economy problem of reducing spending in booms), it’s not the only tool in the shed (although it may often be the sharpest). Reducing unemployment while GDP is rising may require a more hands-on approach than monetary policy. Especially interesting is that the US will retain a federal funds rate at or near zero for the foreseeable future; some would argue that this makes fiscal policy extremely effective (and efficient).

What I mainly wanted to talk about is the Fed’s impact on emerging markets. As mentioned above, Turkey, South Africa, India and a few others are seeing major impacts on their exchange rates. Yes, those economies will face increased capital outflows. However, a lot of them are already net capital exporters. Which means that they aren’t dependent on foreign capital (or at least that there’s some leeway).

By the way, it’s not as though any of the economic fundamentals of these places changed overnight. If you thought that they looked strong before the Fed announced that it would taper, there’s no reason you should suddenly change your mind and conclude that actually, those countries look really unsafe. I know that won’t stop investors from going all-out animal-spirits-herd-behavior bonkers, and that might spell trouble indeed. I am in fact a little worried about how much weight people are putting on the reactions of our oh-so-efficient stock markets to the tapering. The WSJ predicts havoc of biblical proportions. That kind of irrational fear and irrational belief in “as goes January, so goes the year” is a real issue, and a blind (sun-)spot for many economists. So yes, if everybody in the market coordinates on believing that the emerging markets are all going down the drain and that everybody needs to pull their money out as quickly as possible, that’s what’s gonna happen. It’s also avoidable, and a grade A example for collective stupidity.

But maybe, just maybe, investors can decide to stay calm. Here’s an interesting idea: what if the Fed tapered because it’s afraid that safely unwinding its assets will be really, really hard (as I asserted above). Then it’ll unwind those assets very slowly, to mitigate whatever negative effects it believes unwinding will have. In that case, it’s pretty obvious that emerging markets will get a chance to gradually adjust to the new global equilibrium that persists without QE. At the same time, that makes whatever horror stories investors are coming up with about how everything’s doomed a lot less credible. So in that case, emerging markets may still be worse off than if QE had simply continued, but they’ll certainly not be doing as badly as some people now predict they will.

In essence, I see this as a classic multiple-equilibria-coordination-problem story. There’s one equilibrium where financial markets go nuts and we have huge capital shifts in a very short time, with unclear consequences for everybody involved (including the US). Or, they manage to be collectively reasonable about this (as opposed to just individually rational), and we get a slow, gradual change and a much better equilibrium outcome.

Which is more likely? I believe that people, in general, have a tendency to be reasonable, albeit sometimes they have difficulties realizing that. That probably holds even for investment bankers, who, after all, are really smart people (or so I’m told). So I think there’s a good chance that they can keep it together, and we can all leave this taper behind us and focus on the ongoing problems we’re still facing. If that’s not what happens, well… at least we’ll get some good data for papers in international finance (and some behavioral economics, too).

A More Sensible Food Stamp Policy

If you remember to way back in September, you’ll recall that the House narrowly pushed through a bill that slashed food stamp benefits substantially (thankfully, the bill did not pass through the Senate). The House pointed to the fact that the expenditures were getting out of hand even as the economy was recovering and that the program was highly abused. In contrast, just today the house passed a more moderate bill with bipartisan support that cuts food stamps by only about 1%. This seems to me the much more sensible option because food stamps play an important role in the economy’s health.

But why, in this economy, might we cut food stamps at all? The Republicans were right to point out that there is a lot of abuse in the program — for instance, the USA Today article points out that in the past a person could automatically obtain food stamp benefits if they received as little as a dollar in heating assistance; with the new bill a person will automatically receive benefits if they receive at least $20 in assistance.

That said, the bill the House Republicans passed last year was much too drastic, and we should be glad that a more sensible bill has passed. First and foremost I would suggest this is because we have a duty to be compassionate toward the poor. But if you’re a bit — er — Scroogier, and need some extra convincing, think back to your intro macro days and recall the concept of the Keynesian multiplier.

The multiplier in its simplest form is expressed as 1/(1-mpc), where mpc, a value between 0 and 1, is a group’s marginal propensity to consume. Poor people tend to have a very high mpc because after they buy groceries, pay rent, and take care of other necessities, there is not a whole lot left over for saving. This means that for poor people, the denominator of the above fraction is very small, so the multiplier is particularly large. Thus a dollar given to the poor leads to significantly greater than a dollar of output in the overall economy.

So, big victory today. The next question is whether our legislatures will remain sensible, and whether the passing of this bill is a sign of newfound unity between the parties or a fluke in the political machine. I’m pulling for the former, though I know actually believing that would be optimistic to the point of foolishness. Still, little victories.

 

(Revised) The “Free Lunch” Fallacy

Harvard Economist Robert Barro has an article in the Wall Street Journal attacking the concept of a Keynesian multiplier (which he discusses in the context of unemployment benefits):

The [Obama] Administration claims that every $1 of jobless benefits creates $1.80 in economic growth, based on the notorious “multiplier” in Keynesian economic models. This is the theory that you can increase employment by paying more people not to work, and that you can take money out of the private economy by taxes or borrowing without cost.

He goes on to refer to the Keynesian multiplier as a “supposed free lunch.”

I won’t argue here about the effects of unemployment benefits on labor market participation (Paul Krugman has already covered that with particular shrillness), but I thought I’d weigh in on why, exactly, Barro is wrong about Keynesian multipliers in general.

First, I cannot think of any Keynesian who would claim that funding fiscal stimulus with taxes and borrowing comes without cost. Keynesian theory suggests that we pay for more consumption today by consuming less tomorrow. Whether future consumption is adequately sacrificed is another matter, but the theory behind the justification of Keynesian stimulus does indeed necessitate costs. It’s called business-cycle smoothing, and you learn it in first principles: you borrow in the bad times and pay for that borrowing in the good. The cost is clear and explicit.

Barro also expresses disdain for the idea that you can generate $1.80 worth of economic benefit by inserting $1.00 into the economy. But there is nothing illogical about the economy producing output of greater value (say $1.80) than the amount of money that the government puts into it (say $1.00). The basic intuition of why this is possible goes like this: the government gives you a dollar, and you spend a certain fraction of it, and that becomes someone else’s income, who spends a certain fraction of what they got from you, and so on. Eventually, all of that spending adds up to more than the dollar you put into the economy. Barro, apparently, sees this as getting something from nothing — how, after all, can you get more out of a system than you put into it? But his criticism is fallacy.

Imagine a field in which there are hundreds of dynamite sticks laid out in a line. You light the wick of the first stick (and safely find cover!). The first stick explodes, causing the next stick to explode, causing the next stick to explode, and so on. Have you gotten something from nothing? Of course not — the energy that causes all of the explosions was there in the nitroglycerin all along, but the dynamite had not yet been “stimulated.”

Economies work in a similar way. Call it animal spirits, call it fear, call it an inadequate supply of liquidity circulating through the economy, but sometimes the “energy” in an economy lies dormant. If you insert a dollar into an economy and, as a result, observe $1.80 worth of economic activity, that extra $0.80 did not come out of thin air; it always had the potential to be realized, but the economy was not sufficiently utilizing all of its resources to reap that benefit.

And you don’t have to like the intuition behind multipliers for them to be greater than 1: the evidence confirms it, as in this paper by Olivier Blanchard and Daniel Leigh.

So, yes, you can generate $1.80 worth of benefit by inserting $1.00 into the economy, but, no, it is not without cost, and I don’t think anyone is claiming that it is.