The economic policy has always been curious and interesting. Especially because of numerous policy advisors that endorse normative judgements as policy assets. Also, many advisors often cite case studies of particular countries that are known for wise solutions. However, policy copying has never been very successful, but lessons from the episode of economic reforms and their understanding are crucial to policy creation and implementation. Ireland, for instance, had not been copying anyone during its decade of a growing prosperity and high economic growth. Instead, Irish Competitiveness Council found deep inspirations for economic reforms in Michael Porter's book called The Competitive Advantage of Nations. Several days ago, I came across the article published at Hoover Institution, written by Rupurt Darwall, comprehensively describing the outcome of pro-growth reforms in New Zealand. The article can be read here.
In a past decade, New Zealand's policymakers pursued a set of economic reforms such as market liberalization, product market deregulation, welfare system reform and a comprehensive tax reform by introducing a push from income tax to consumption-based tax. The evolution of market reforms in New Zealand emerged from various aspects of economic theory such as public choice and transaction cost theory which are, by any means, crucial to effective decision-making in economic policy. In mid-1990s, New Zealand's average economic growth rate was 4 percent and the deregulation of the labor market resulted in a robust productivity growth.
Tuesday, February 5, 2008
Learning from New Zealand's Reform Lessons
Sunday, January 27, 2008
Slovenia: Special rents are good for the state
Two Slovenian parties - Slovenian Peoples Party and Democratic Party of Retired Citizens - are trying to stop the privatisation of state owned Telekom telecommunications company and state owned Triglav insurance company. In a public statement the president of Slovenian Peoples Party Mr. Bojan Šrot declared that"Telekom has a stable income and a modern technology. It has predominant market share. This enables its owners a special rent. There are no rational reasons for the government to give away this rent."
Unfortunately journalists failed to ask the politician why governments should enjoy special rents?
Thursday, January 17, 2008
Taxpayers pay for snow
Government in Belgrade has spent public funds on purchasing snow that was used for snowboard competition. In Serbia government routinely uses public funds to finance culture, arts and sports but buying snow is really difficult to understand.
Wednesday, January 16, 2008
Taxation in pictures: Why FairTax makes sense
The New York Times made some coverage of the FairTax proposal recently. The coverage was done in a way typical of mass media trying to be "unbiased": they vaguely describe the topic being covered, and quote some people who are in favor, quote some people who are against. The arguments in favor or against are not really explained, and it is left up to the reader to perform their own research, or walk away from the issue with lingering doubts.
People who are in favor of FairTax generally say that the proposal has been designed by competent economists, and has been verified and endorsed by many more. They say that the calculations behind the proposal have been verified many times, and that the people who refute the proposal either haven't taken the time to understand it, or have vested interest in the current, horrendously complex, tax system.
People who are against FairTax generally quote some other economist who calls it "unworkable" or "a swindle" without bothering to explain why.
However, there is an easy way to comprehend why the FairTax makes sense. All it takes is a picture.Taxation in the US
The following diagram illustrates taxation in the American economy.
When you buy a $100 product, you observe being directly taxed only by the state, assuming there's a local sales tax. What you don't observe, however, is that the remaining $90 you are paying for the product has a lot of other tax built in.
How much tax in total?
Over the past 15 years, total US government receipts - federal, state and local - have summed up to about 33% of GDP (OECD, 'Tax&Non-TaxReceipts').
According to the US GPO, based on data for the year 2000, "total Federal spending accounts for 20% of the gross domestic product, while total state and local spending account for 12%".
The federal government collects a large majority of its revenue through the personal income tax (10-35%), corporate income tax (35-39%), social security (12.4%), and payroll tax (2.9%). The states get some of their revenue from the federal government, while collecting the rest through sales taxes (0-10%) and piggybacking on the federal income tax (0-10%).
Current federal budget deficits are about $480 billion, about 3.8% of GDP. This means that the federal government spends about 20% of GDP, but collects only about 16.2% in taxes. A majority of the remaining 3.8% is borrowed from the private sector, while a minority is taken from the economy as an invisible tax, by the government simply printing the money.
You don't see these taxes when you buy a product in a retail store. But out of every $100 you spend for a product, some $29 on average are taken by the government, at some point or another in the process of the product's production. Some $16 are taken by the federal government, and some $12 are taken by the states.
Due to special interests and their lobbying, there are numerous exceptions, and the effective tax level is different for every individual product and service.
The fact that they collect this money at so many different points, and using such a complex tax code with so many special cases and exceptions, imposes a large compliance burden nationwide. The Tax Foundation estimated that this burden was $265 billion in 2005 - about 2% of GDP. This likely means that the US would experience an immediate one-time GDP growth spurt of 2% if income taxation was eliminated, just from not having to comply with the income tax alone.
There would almost certainly be another, permanent 2% or so increase in annual growth because the government would stop taxing investment to spend it on consumption.Taxation in the EU
If you think the US has it bad, look at the following diagram for Europe.
So you thought the US rescued Europe from fascism in WWII, eh?
No such luck.
To understand, take a minute to meditate on this quote from The Big Book of Fascism by our friend Benito Mussolini:Anti-individualistic, the fascist conception of life stresses the importance of the State and accepts the individual only insofar as his interests coincide with those of the State, which stands for the conscience and the universal will of man as a historic entity.... The fascist conception of the State is all-embracing; outside of it no human or spiritual values can exist, much less have value.... Fascism is therefore opposed to that form of democracy which equates a nation to the majority, lowering it to the level of the largest number.... We are free to believe that this is the century of authority, a century tending to the 'right', a Fascist century. If the nineteenth century was the century of the individual (liberalism implies individualism) we are free to believe that this is the 'collective' century, and therefore the century of the State.
And so it is across Europe today. Just compare this sentiment to the diagram you see above. The State is everywhere.
In addition to the personal and corporate income tax, payroll tax, and social security taxes which are present in the United States, most EU countries impose the Value Added Tax, which performs essentially the service of a sales tax. The difference, as you can see from the diagram above, is that the VAT is much more convoluted, raising compliance costs across the EU and opening opportunities for scamsters to abuse the system, forcing the EU to lash back at them by raiding and closing otherwise perfectly good offshore banks.
Additionally, EU personal and corporate tax levels are higher than in the United States, bringing total government receipts of Euro area countries to a whopping 45% of GDP. Mussolini would be pleased.The FairTax
Finally, here is the diagram for the FairTax proposal.
Simple, eh? Instead of collecting taxes bit by bit, at every conceivable point where there is any kind of financial transaction, the FairTax government would focus its collection in a single place: where the consumer purchases a product or a service.
The FairTax rate of 23% is calculated to replace only federal taxes. Various US states have different approaches to taxation, and it is up to them to keep their existing systems or change to an additional sales tax on top of the FairTax.
However, if you recall that US federal taxes collect about 16.2% of gross domestic product (the remaining 3.8% is borrowed or printed), it should be apparent how a 23% FairTax rate is enough.
With a federal government that taxes about 16.2% of what the people of the United States produce; and with US consumption at 86% of GDP; a 23% consumption tax works out to 23% x 86% = 20%. Subtract the FairTax prebate - a sum of about $480 billion, or again about 3.8% of GDP - and the result is 16.2%, exactly the amount collected by current federal taxes.
For a more involved FairTax rate calculation, check out Taxing Sales Under the FairTax: What Rate Works? on the FairTax website. And see also the FairTax FAQ.
[Originally posted on denis bider's blog]
Slovenia: Trade Unions, Wages and Inflation
Slovenia's labor market is known for an extensive regulation and barriers that hinder productivity growth. According to the latest Index of Economic Freedom, Slovenia's labor market is known as the most regulated and inflexible in the European region. High labor cost, regulated working schedule, and extensive taxation are hampering the capacity of productivity performance.
Recently, trade unions in numerous fields demanded a collective wage increase that would, in their opinion, boost the growth of welfare. If those demands are not fulfilled by the government in the process of collective bargaining, trade unions promised to launch demonstrations on the streets of Ljubljana. Not surprisingly, the majority of demands come from the public sector.
Inflation is currently above the EU average and is also the No.1 political issue in the public debate.
The question is whether suggested wage increases would really boost the growth of purchasing power or broader negative consequences are inevitable, following wage increases.
Collective bargaining is a zero-sum game
In the long run, wage rate is moving together with the productivity growth. Wage increases are justified only if the value of marginal product of labor is above the actual wage rate. The value of marginal product of labor is, of course, determined by the market value of labor unit. A sudden shock such as an inconsistent wage-increasing claim would leave disastrous consequence to the output activity. If wage claims are above the productivity growth rate, then a private sector would face a significant loss and cost pressures that would be further transformed in higher prices and a decreasing probability of creating jobs in the future. In the absence of perfect competition, price increases would go above the marginal cost. Such a complex situation, does not yield an optimal outcome as firms in imperfect competition create a deadweight loss. Given the conditions of global economy such as an increasing demand for commodities in China and India, the pressure on prices would inevitably be intensified. Consequently, mark-ups on current prices would eliminate the positive effect of wage increases on the purchasing power considerably.
Sudden wage increases tend to make the price elasticity of demand more inelastic. Usually, the elasticity coefficient is between 0 and 1. For example, if price elasticity coefficient is 0,31, it means that given a 1 percent increase in the price of product A, the demand for product A decreases by 0,31 percent. In this, the company has an incentive to raise the price of A, given the gain of price increase. If wage increases and productivity evidence are mismatched, the effect of wage growth on purchasing power is a zero outcome, whereas higher price level reduces (!) the overall capacity of purchasing power and therefore consumer choice and welfare.
Game theory and collective asymmetry
Distinguished economists such as John Nash successfully attempted to derive an equilibrium in non-cooperative games. In the so-called Nash Equilibrium, changing strategy is the best response in non-cooperative games with n-players. Nash equilibrium also became universally applied in national labor relations. The question is what are likely to be the preferences and strategic behavior of trade unions in the collective game. Trade unions can choose the negotiating strategy that aims to stimulate job growth. In this case, wage rate temporarily falls below the equilibrium floor, but only in the short run. Also, union's prime joker can be the maximization of wage fund for all employees. In this case, wage increase is much more sensitive to the level of productivity than in the previous case. The third option is the worst one. Under its circumstances, trade unions can move up the curve of marginal revenue, reducing labor supply and increasing labor demand. This step is called rent-seeking as union's negotiating strategy attempts to bargain the maximization of an economic rent for union members. Aftermath, the analysis of labor market shows that the overall level of welfare has not been increased after union's claims were realized. The wage rate of labor supply in non-unionized sector, is below the equilibrium line while unionized sector's claims reduce the level of employment and the pace of job creation.
How wages affect output and inflation?
In Slovenia, a sizeable proportion of the labor force is employed in the public sector. If trade unions in the public sector claim unjustified and illogical wage increases, the latter could seriously boost inflation pressures. In the negotiating circle, trade unions obviously neglect the principle of budget constraint. In Slovenia, robust economic growth originially based on diseconomies of scale, produced a positive output gap where aggregate demand raised the level of prices. By the fundamental laws of macroeconomics, the difference between potential and real GDP converged into an additional source of inflation. Employment in the public administration is funded through annual budget. Additional wage increases, of course, would have to be conducted by an increasing public spending or by an undisciplined fiscal stimulus that would infuse wage fund. In turn, an increase in aggregate demand would further raise the price level and, again, the effect of wage increases on purchasing power would disappear as the inflation rate would rise.
Proposed wage increases as a threat to macroeconomic stability
The empirial investigation has shown that an additional collective wage increase by 1 percent, would accelerate the inflation rate by 0,6-0,7 percent. Inevitably, higher inflation rate would cause an immense damage to long-term sustainable growth performance and overall macroeconomic stability.
Less than a revolution
This IMF study says that the switch to flat tax in Russia resulted in increased government revenues from personal income tax, both absolutely and as a fraction of GDP. That is, not because of the increased output, but because of the better tax collection. Here are some key findings:
The Russian flat tax experiment is particularly interesting: after the introduction of flat taxes, and effective personal income tax rate cuts, tax revenues increased substantially and almost immediately. Furthermore, they increased much faster than labor supply and output. The paper explains how tax rate cuts can increase tax revenues through tax compliance spillovers in such a manner.
This paper shows that endogenous tax compliance responses can be responsible for the massive increase in tax revenues. ...small cuts in the tax rates can lead to much larger changes in the behavior of taxpayers — most importantly, it can make them much more likely to declare their incomes honestly. These spillovers can lead to increasing tax revenues.
…taxpayers evade less tax payments when the tax rate is lower… evasion increases with the tax rate.
Libertarians were getting perhaps too romantic about the "flat tax revolution" in Eastern Europe lately. Now this study reveals a new perspective, although it is something that most Eastern Europeans have always known - that this revolution was not about downsizing government, but about expanding it. When taxpayers are evasive and the policing system disorganized as was the case in Eastern Europe, the best way to raise government revenues is the introduction of flat tax, and that was the sole purpose of introducing it. Not the enlightened politicians unleashing private initiative, and certainly not a sudden revelation about the meaning of social justice.
Is it still a good thing? Probably, as less resources are directed into hiding taxes, and then for looking for those who are hiding them. And it is simpler. But don't forget that if the study shows that the personal income tax revenues have increased, that means nothing but that the average taxpayer's de facto burden has increased. Follow the money.