Tax cuts and incentives to work

Supply siders have argued that tax cuts increases compliance, improves the incentives, makes people to work more and thereby increases productivity. Accordingly, they have pointed to Russia's 2001 switch to a 13% flat tax (from previous rates of 20% and 30%) and the consequent increase in tax revenues by 25% in the year after the reform, as validation of their claim.

Mark Thoma points to a study by Yuriy Gorodnichenko, Jorge Martinez-Vazquez and Klara Sabirianova Peter, which looked at household level data (they use the gap between household expenditures and reported earnings as a proxy for tax evasion) to see how tax reform influenced tax evasion and real income, finds that though tax evasion decreased under the flat tax, it did little to increase real income for taxpayers. They conclude that a flat tax can produce a revenue increase where under-reporting of income is widespread. They write,

"Utilizing difference-in-difference and regression-discontinuity-type approaches, we find that large and significant changes in tax evasion following the flat tax reform are associated with changes in voluntary compliance and cannot be explained by changes in tax enforcement policies. We also find the productivity response of taxpayers to the flat tax reform is small relative to the tax evasion response. Finally, we develop a feasible framework to assess the deadweight loss from personal income tax in the presence of tax evasion based on the consumption response to tax changes. We show that because of the strong tax evasion response the efficiency gain from the Russian flat tax reform is at least 30% smaller than the gain implied by conventional approaches."

Mark Thoma sums up the debate nicely,

"The lack of a significant productivity response undercuts the main supply-side argument that cuts in taxes produce increased growth in output that generates a partial offset (some even argue a more than full offset) to the revenue lost from the tax cut. So many supply-siders have switched to the compliance argument for the US, but I doubt this effect would be large, and certainly not large enough to pay for the tax cut, and compliance can be increased in other ways such as closing loopholes and better enforcement of existing tax law."

Update 1
Austan Goolsbee examined the effects of the increases in the marginal tax rate by the Clinton administration in the early nineties and found little evidence of any distortion of incentives among the rich tax payers.

Do people save optimally?

Behavioural economists have argued that contrary to the DSGE models based predictions about people optimizing on their spending and savings behaviour, people act in a not-so-rational manner when making savings decisions and save less than what is optimal. Therefore economists like Richard Thaler have proposed innovative "nudging" solutions like "Save More Tomorrow".

It is in this context that Chris Dillow strikes a contrarian note and points to a recent study by Laurie Pounder (full paper here), and earlier studies by John Karl Scholz and Martin Lettau and Sydney Ludvigson (full paper here), which appears to show that "far from being irrationally spendthrift, people are irrationally prudent".

All these studies find that "the propensity to consume out of expected future income and net wealth was lower than the DSGE model predicts", and in exactly the opposite direction (ie. save more than spend more, or spend less and not more) than what behavioural economics would suggest.

I am inclined to believe in a small sub-plot to this analysis. In the developed economies, where average incomes are high (in comparison to what is needed to buy the basic necessities of life), consumption opportunities are large and pervasive, savings outlets are numerous (apart from the conventional savings, there are the asset increases and the ability to capture and spend a share of those increases - wealth effect), social security and medical insurance net is extensive and robust, and access to finance is easy (so that financial risks can be modulated/hedged), it could be that all the afore-mentioned tip consumers to spending more than what is required. On a macro-level, this has been borne out by the consumption binge and steep decline in savings in the US over the past three decades, and more generally the low household savings rate in the developed economies.

In contrast, in the developing economies, average incomes are closer to the subsistence incomes, consumption opportunities limited, uncertainties and risks numerous and multi-dimensional, social safety nets are porous and virtually absent, and very few people have the ability (or opportunity) to partake of the gains in asset values. In such environments, people are naturally inclined towards saving more for the rainy day. The persistently high savings rate in developing economies can be partially explained by this.

May be the aforementioned analysis has to be situated within each of these contexts for drawing more meaningful conclusions about whether people save (or consume) more or less than required.

"Honesty cafes" as anti-corruption strategy

As part of its anti-corruption drive and in an effort to nurture probity among its customers and society at large, Indonesia, one of the most corrupt countries in the world, has been opening cashier-free "honesty cafes" across the country. Customers can pick a drink and a bag of spicy cassava chips from the local honesty cafe’s shelves, and drop the prescribed charges inside an open plastic box. To begin with, these cafes are being opened only in schools and government offices, and till date some 7,456 honesty cafes have opened in 23 provinces in Indonesia.

As the NYT article writes, "the honesty cafes will nip in the bud corrupt tendencies among the young and straighten out those known for indulging in corrupt practices, starting with civil servants. By shifting the responsibility of paying correctly to the patrons themselves, the cafes are meant to force people to think constantly about whether they are being honest and, presumably, make them feel guilty if they are not".

Indonesia's problems are no different from that experienced by us in India. To start with, similar "honesty canteens" can be opened in State and Central Government Secretariats across the country to inculcate into civil servants the habit of putting honor over greed in their official work/transactions. Similar live experiments in inculcating civic sense can be done by opening small book and stationary stores and bakeries in atleast some of the larger government and private schools across the country.

Mlodinov and Thaler on Drunkard's Walk and Nudge

Two excellent recent books. Leonard Mlodinow on Drunkard's Walk : How Randomness Rules Our Lives



Richard Thaler on Nudge

Matching alumni to students

The internet has the potential to play very useful roles in matching donors, volunteers, and service providers, with their counter-party recipients, beneficiaries and buyers.

The most famous example of such internet based communities is non-profit Kiva, which lets lenders browse profiles of borrowers in the developing world, offering as little as $25 toward projects like helping a farmer buy fertilizer to increase crop yields, and which now lends about $1 million a week interest-free with a re-payment rate of 97.8%. It also channels money to borrowers through microfinance institutions in their home countries. Sometime back, I had posted about the role of SingleStop USA, a poverty fighting startup, which seeks to "connect the working poor in New York with government funds and services intended for them".

Now NYT draws attention to a newly formed non-profit organization in the US, Unithrive, which matches alumni lenders and cash-strapped students, who post photographs and biographical information and can request up to $2,000 in interest-free loans, payable within five years of graduation. It would pool a number of lenders to meet an individual’s total request, and then pay its loans directly to a university as part of a student’s tuition, so as to reduce the transactions costs.

The attraction of such donations is that alumni will have a personal connection to current students - those requesting loans list hometowns, majors and classes they have taken - and alumni can lend to students with whom they feel a bond. They are promised updates three times a year from students they support Put a face to your contribution. They also get their money back after the loan is re-paid.

Similar models of matching beneficiaries with donors can be useful to crowd in resources from private individuals and agencies, so as to supplement the resources of the government in addressing various poverty eradication and welfare challenges. There is a huge opportunity for non-government agencies to set up web-sites and organize the process of channelling such assistance from those providing it to those in need of the same. Some of the important areas where such interventions can work are
1. Funding assistance to poor students for higher education
2. Donations like furniture for schools and equipment for hospitals
3. Micro-loans for Self Help Groups (SHGs)
4. Treatment costs for poor patients, say, children suffereing from heart complaints.
5. Loans for poor small scale entrepreneurs in specific fields/sectors

Analysing the sub-prime crisis

One of the most comprehensive analysis of the global macroeconomic paradigm that caused the ongoing economic crisis is by the Brazlian economist André Lara Resende (thanks to Niranjan for sending it). While predicting a long drawn out and slow recovery during which the excessive debt is worked out, he makes several interesting points

1. The dominant macroeconomic consuensus of the past few decades has been that emerging economies had to follow restrictive fiscal and monetary policies when faced with currency and and other crisis. When faced with a halt in capital inflows, run on the currency, stagnant economic growth, and the rise of unemployment, macroeconomic policy had necessarily to be geared towards confidence (among external investors) rebuilding. Andre writes, "in case of crisis, economic policy could not be anti-cyclical, in order to attenuate its impact (reduce its social costs); it had to be perversely pro-cyclical, to rebuild confidence".

2. Over the past three decades, buoyed by the confidence of having conquered the business cycle, the specter of inflation, and overcome the limits and any binding constraints to economic growth, the first world economies emerged as issuers of reserve-currencies. This enabled them to have the capacity to finance the massive external deficits.

3. Emerging economies have relied on exports to drive economic growth and sidelined domestic consumption, and saw this as their path to integration with the world economy. They have followed excessively conservative monetary policy as "an insurance against the stubborn insecurity of (foreign) investors". This has in turn prevented domestic consumption from becoming an engine of growth and deprived businesses off access to cheaper capital. Further, to avoid "disrputive currency devaluations", these economies were also forced into accumulating massive foreign exchange reserves.

4. The high rates of growth in developed economies, based on the increase in consumption "cannot be sustained for a prolonged period, especially since they have low or no demographic growth, an inverted demographic pyramid and an already very high standard of living. The maintenance of a high rate of consumption growth depends, both on the creation of new consumption needs and on the permanent expansion of credit to families with ever higher levels of debt. The rich central countries consume, financed by ever higher levels of debt, in order to satisfy ever more artificial needs, with products made in China, which controls its labor costs and buys raw materials from emerging countries."

5. The current crisis has its origins in both deficiencies of the regulatory framework and the global macroeconomic imbalances, both complementing each other. "The macroeconomic imbalance would not have been so deep and persistent without the extraordinary development of the financial market. Indebtedness and leverage would not have reached such extremes in the world without the international macroeconomic imbalance." He cautions against an emotionally impulsive effort at regulation that is "geared to avoid errors of the past and not necessarily able to cope with the challenges of the future".

5. The driving goal of Central Banks in the aftermath of the sub-prime bubble bursting was to avoid the mistakes of the Great Depression, by flooding the system with liquidity at any cost and thereby stem the "deterioration of the value of assets". However, as Resende writes, "The speed of the deterioration of the value of assets in bank portfolios remained higher than the capacity of government agencies to provide them capital through public funds and simultaneously absorb their troubled assets... As long as the non-financial private sector has excessive debt and remains willing to save in order to reduce its indebtedness, the only likely borrowers are precisely those who are unable to repay their debts. Only those who cannot honor their previous commitments will be willing to take additional loans to roll over their debt. The reduction of the leverage exclusively in the financial sector is not sufficient to restore the normal activity of the financial system... Firms and households have to reduce their over indebtness before the system can function again." In other words, as long as excessive debt is not digested, both monetary and fiscal policies are likely to be ineffective.

6. The major difference between 1929 and now is the level of indebtedness in the economy. Then the generalized bankruptcy of banks and firms solved the problem of excessive indebtedness, and the economy was facing "thorough disorganization and massive unemployment". Further, there was a "lack of demand because there was no economic activity and no income". Today, households and firms are faced with the brunt of excessive debt, forcing them to reduce expenditures and increase savings, and the "lack of demand is the result of the exceptionally high rate of savings required to bring back private debt to reasonable levels" (and not lack of income), much like Japan in the nineties. As Irving Fisher argued, the "virtuous circle of the Keynesian expenditure multiplier" is broken as the "income generated by the increase in public spending is saved by the private sector in order to diminish its debt".

7. He sees "chronic inflation as essentially a question of excessive debt of the public sector, and deflation as a question of excessive debt of the private sector... The end of great inflations requires necessarily the reduction of public debt, either through the socially costly hyperinflation or, instead, through some form of default... The option not to throw public resources to rescue an insolvent private sector in a deflationary situation is the symmetric equivalent of letting the economy slide into open hyperinflation in a chronic inflation environment."

8. He feels that a supra-national world reserve currency, issued by a truly credible supra-national issuer, is the only sustainable solution to "reverse the asymmetry behind the large macroeconomic imbalances of the last decades". As events in the aftermath of the crisis - deleveraging and the appreciation of dollar - has shown, the dollar reigns as the most credible reserve currency for the time. But the massive US deficits and persistently high imbalance in its external account, coupled with the possibility of both inflation and devaluation of dollar (both in the interest of the US, if achieved in a controlled manner), raises major concerns among its creditors, chiefly the Central Banks of emerging economies. It is now widely acknowledged that dollar has managed to stay afloat despite the massive current account deficits only by "the force of habit and the lack of alternatives". This also raises the moral hazard for policy makers in the US to continue with their present policies without being forced into remedying the structural imbalances in the economy.

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Though Resende's analysis is brilliant and comprehensive, I cannot but get the feeling that it may be skewed towards the most extreme assumptions on the pessimistic side. For example, Resende feels that the unconventional monetary policy responses, aimed at recapitalizing banks and making them willing to lend, will fail because the crisis has crowded out all the credit-worthy borrowers. He also discounts for any such borrowers in the financial sector. I have two issues with this line of arguement.

One, it should not be forgotten that the private sector debt burdens have been amplified many times more than the actual leverage by the precipitous fall in asset (both housing and financial instruments) values. This burden can be eased if confidence returns to atleast some parts of the financial markets and asset values rally back. Now this is not as improbable as it appears, especially with the financial markets (witness the dramatic recovery in financial markets in the emerging economies).

Second, there are still many formidable credit-worthy borrowers in the financial sector. Many of the hedge funds and private equity firms have remained relatively less affected. The numerous bankruptcies, failures and mergers have left the remaining "too-big-to-fail" institutions, which survived the crisis, in an impregnable position, with considerable bargaining power and resources to draw upon. These institutions also have the advantage of piggybacking on the huge credit expansion indulged in by governments desperate to do anything to stem the decline in the financial markets. Further, there are already signs of green shoots in many emerging economies, which opens up the possibility of many profitable investments avenues in these markets. All of these could contribute substantially towards restoring confidence in the markets and upward spiralling effect on asset values, which in turn could substantially ease the debt burdens.

Again, Resende may be taking an extreme position in assuming that all the Keynesian stimulus will end up getting saved and that all of private sector is insolvent. Fisher is right that fiscal and monetary policies does not yield the desired results when excessive debt and deflation prevails. But that is different from assuming that it does not yield any result, and this takes us back to the debate about what types of fiscal spending are more effective when the economy is faced with a deep recession. And, while it is true that Wall Street and US consumers are excessively leveraged, the same cannot be said for the US corporates. Their handicap is not debt-ridden and bankrupt balance sheets, but a credit squeeze in the financial markets and weak domestic and external demand. The dramatic credit expansion policies are aimed at least partially de-clogging these markets. The sources of revival in demand is threefold - putting money in the hands of those consumers who are likely to spend, government itself becoming the consumer of last resort by generating demand in sectors like infrastructure, and external demand looking up and driving exports. While the extent of impact of each of these debatable, there are undoubtedly enough possibilities that can tip the outcome of fiscal stimulus spending demand either way.

Also, the doomsday predictions in a deflation environment may be misplaced. After all, just a decade back, Japan experienced the same and though it experienced a decade long slow recovery, it emerged out relatively fine, despite a few important policy mistakes (raising taxes in late nineties thereby nipping the green shoots of recovery in the bud, and being slow in addressing the bad debt problem).

In both these examples, the final outcome depends on a whole lot of unforeseen and emergent circumstances. The challenge is to prevent a steep downward spiral leading to a complete economic collapse (deflation, stagnation and unemployment, bankruptcies and debt defaults, ballooning deficits, and hyper-inflation) and hope that with time things will return to normal. In any case, the most optimistic forecast would have to be for a long drawn out recovery, primarily triggered off by confidence slowly returning to the financial markets and generating a rally in asset prices.

Reith and Robbins lectures

1. Paul Krugman's Lionel Robbins Memorial Lectures series on The Return of Depression Economics at LSE was delivered in three parts early this week - The sum of all fears (slides here), The eschatology of lost decades (slides here), and The night they reread Minsky (slides here).

2. Michael Sandel has delivered BBC's annual Reith lectures for 2009. It is a seried of four lectures about the prospects of a new politics of the common good, the transcripts of the first of which is available here (podcast here).