May 29 2009
Archive for May, 2009
May 28 2009
Here in Switzerland I enjoy the luxury of having to pay a relatively small federal income tax of 9.6%. In the US, at my current income level, I would be paying a 25% federal income tax. On the other hand, everything I buy here in Switzerland, from food to clothes to train tickets and bike parts, costs me an additional 7.6% of value added tax. If a product is imported, chances are there is also an additional 20% import tariff. In other words, what I save coming in (because of the low direct tax) I lose going out (through high indirect taxes).
The incentive, therefore, is to save as much of my income as possible. I shop much less than I would in the US where indirect taxes are much lower, but when I do shop prices are much higher. Much of Switzerland's government revenue comes from the value added tax and other indirect taxes, which means households keep much more of their earned income.
In the United States, where the government has not seen a balanced budget since 2001, there has been much talk about creating a national sales tax to help raise revenue to pay for many of the social plans that the Obama administration wants to pursue, such as national health care. VATs and sales taxes are regressive, which means more of the tax burden is born by low income households compared with high a direct, income tax, which is progressive, meaning the higher a household's income, the greater percentage it pays. But with budget shortfalls expected to reach $4 trillion over the next four years, new sources of tax revenue are needed.
“Everybody who understands our long-term budget problems understands we're going to need a new source of revenue, and a VAT is an obvious candidate,” said Leonard Burman, co-director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, who testified on Capitol Hill this month about his own VAT plan. “It's common to the rest of the world, and we don't have it.”
The surge of interest in a VAT is testament to the extraordinary depth of the nation's money troubles. While some conservatives have long argued that a consumption tax would provide a simpler and more efficient alternative to the byzantine U.S. income tax code, this time it's all about the money.
To counter claims that a national sales tax is regressive, advocates point out that such a tax would allow the federal government to lower income tax rates for low income Americans, giving them more disposable income to spend on goods and services, which would be more expensive because of the VAT.
Another option the government should consider is a tax on greenhouse gas emissions. Currently, Obama is advocating a carbon permit market, which would be less effective at generating income for the government as permits, once they are issued or auctioned to industry, are bought and sold by firms, creating revenue for companies and not the government. A carbon tax, on the other hand, would create new tax revenue for the federal government and help reduce the negative externalities causing global warming and encourage development of alternative “green” methods of production.
In the short-term, it is unlikely that the US government will legislate any significant new taxes. Carbon taxes have been ignored by the Obama administration and Congress, under the argument that during a recession any new tax on industry might just break the nation's manufacturing and energy sectors' backs. A VAT is just as unpopular, for the reason that any policy raising consumer prices puts even greater burden on already strapped household incomes. Tradeable carbon permits are popular for the reason that they appear to be a “market based” approach to reducing greenhouse gas emissions; but Congress is talking about putting a price ceiling on carbon permits of $28 per ton, a price at which the incentives to reduce emissions among firms is minimal.
America's long period of strong growth, low savings, and deficit financed government spending will necessitate belt-tightening in the near future as ultimately the government will have to start financing its budgets through tax revenues, not the issuing of new debt. Carbon taxes, higher marginal income taxes, or a national sales tax are all options the Obama administration can choose from. For now, it appears it's choosing none of these, and instead selling more bonds to the public, foreigners, and the Fed, increasing the moneys supply in the hope that households and firms begin spending once more. The path towards fiscal discipline is a hard one to get started on, especially during a recession when no new taxes are politically viable.
- What make's a sales tax regressive if everyone has to pay, say, 10% on top of the regular sales price of a good or service?
- How does the US government finance its massive budgets when its revenue from taxes don't even come close to equaling the amount of spending?
- Why is it important for a country, in the long-run, to achieve a balnced budget?
- What would you prefer to do: pay a higher income tax or a higher sales tax? What are the pros and cons of direct versus indirect taxes?
May 27 2009
May 20 2009
Listen to the 3 minute NPR podcast here
It's interesting to me that AP Economics has gotten two major mentions in the mainstream media recently, both asking the same question: Does high school Economics teach kids about the real world anymore?
Both the New York Times and NPR refer to a past AP Macro multiple choice question, this one from the NYT:
Policy makers concerned about fostering long-run growth in an economy that is currently in a recession would most likely recommend which of the following combinations of monetary and fiscal policy actions?
MONETARY POLICY…/…FISCAL POLICY
a. sell bonds…/…reduce taxes
b. sell bonds…/…raise taxes
c. no change…/…raise taxes
d. buy bonds…/…reduce spending
e. buy bonds…/…no change
The correct answer, as readers should know, is e. Buying bonds increases the money supply and lowers interest rates, while choosing not to engage in expansionary fiscal policy means no crowding out of private investment will occur and thus “fostering long-run growth” in the economy.
The NYT blogger writes:
It's true, the severity of the current recession has forced the government and Fed to create new monetary and fiscal tricks, but the fundamentals behind a response indicated in answer e. still hold true. Lowering interest rates to encourage private investment is a pro-growth policy for correcting a mild recession.
Anyway, I think it's worth listening to the podcast from NPR and reading the blog post from the NYT. Definitely read the comments on the blog post too, some interesting points are made by readers.
May 20 2009
May 16 2009
May 15 2009
May 14 2009
A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
In Krugman's words:
In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.
So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.
In AP Macroeconomics, we teach that deficit-financed government expenditure decreases the supply of loanable funds as savers take their money out of commercial banks and invest in the bond market due to the attractive interest rates on government debt. Less funds available for the private sector drives up interest rates and crowds out private investment.
If the economy is producing close to the full-employment level and interest rates are positive, the decrease in supply of loanable funds can indeed drive up equilibrium interest rates and lead to the “crowding-out” of private investment. Krugman points out in this article that when the economy is at the “zero-bound” (i.e. when nominal interest rates are as low as they can go) and the quantity supplied of savings is still greater than the quantity demanded for investment, the government can effectively borrow from the public, decreasing the supply and correcting the surplus of savings without driving up interest rates in the private market. Put another way, the equilibrium interest rate is below zero, but the “zero-bound” acts as a price floor in the loanable funds market, resulting in a surplus of savings.
Government borrowing crowding out private investment is not something we can worry about during a recession, when low confidence and expectations have driven the supply of savings up and the demand for investment down. Public spending will divert funds from the private sector to the public sector, that's true. But in today's case, savings are sitting idle in the private sector, so government borrowing is putting those fund to use when the private sector has failed to do so.
- Why does the supply of loanable funds (S in the graph above) slope upwards? Why does the demand for loanable funds (I in the graph) slope downwards?
- Deficit financed government spending decreases the supply of loanable funds. Why?
- Crowding-out is not the only possible down-side of deficit spending by the government. What are some other long-term effects of governments running budget deficits year after year?
May 12 2009
When a country's imports increase in price, while the value of its exports stays the same, the country's terms of trade are said to deteriorate. As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit.
The United States has run trade deficits for most years since 1970. Since 2004 the US has annually spent over $600 billion MORE on imports than it earned from the sale of its exports. (Balance of trade data going back to 1960 can be found here).
Usually, when a country enters a recession, it would be expected that its balance of trade would improve, since households demand fewer imports and domestic inflation decreases making the country's products more attractive to foreign households. In fact, in 2008, when the US entered its current recession, its trade deficit actually decreased. Recently, however, due to the weakness of many of its trading partners and a deterioration in terms of trade, America's recession is accompanied by a deepening trade deficit:
The U.S. trade deficit widened for the first time in eight months during March, as the price and use of imported oil both climbed.
The U.S. deficit in international trade of goods and services increased to $27.58 billion from February's revised $26.13 billion, the Commerce Department said Tuesday. Originally, the February deficit was estimated at $25.97 billion.
U.S. exports in March slipped by 2.4% to $123.62 billion from $126.63 billion as trading partners bought less consumer goods and cars from the U.S. U.S. imports fell at a lower rate, dropping 1.0% to $151.20 billion from February's $152.76 billion
- How did rising oil prices lead to an increase in America's trade deficit?
- What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?
- Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?
- Why doesn't the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?
May 12 2009
My favorite economics blog, Environmental Economics, points to an article from the Financial times that appears to make a very elementary mistake in its use of basic economics terminology. Read the excerpt and answer the questions that follow.
Shortages stir coffee and sugar prices
By Javier Blas and Jenny Wiggins in London
Published: May 10 2009
Caffeine addicts face higher prices for their daily fix as the wholesale cost of both coffee and sugar rise sharply because of poor crops and robust demand.
“We are in a dangerous situation,” Andrea Illy, chief executive of Italy’s leading coffee company, told the Financial Times, warning that prices could “explode” due to supply shortages.
- Define “shortage”.
- Does the rising price of coffee indicate that there are shortages in the market? Why or why not?
- Would “poor crops and robust demand” necessarily combine to create a shortage of coffee? Why or why not?
- What would lead to a shortage of coffee, based on the economic definition of the term “shortage”.