Working Papers

More Budget Reaction

The Budget tax cuts are being criticised for delivering larger dollar amounts to those at the upper end of the income scale.  In part, this is just a reflection of the fact that those who earn more pay more tax.  The assumption behind this criticism is that tax relief should primarily be about redistribution rather than efficiency.  The most significant welfare costs arising from taxation, however, are attributable to the top marginal rates, not those that apply further down the income scale.  The higher the rate, the greater the distortion to economic decision-making.  What I found most revealing about my experience as a taxpayer in Singapore was how little my decision-making was distorted by tax considerations compared to when I was in Australia. 

Greg Sheridan discusses how this soak-the-rich mindset damages the prospects for genuine tax reform:

Costello and most ministers privately acknowledge the top rate is too high. But if they cut it they fear the media will find some millionaire who gets a huge dollar tax cut and flay them for it. What a custardy bunch of cowards. If ever you were going to enact such a reform it would be now, in the first budget after an election. It could easily be sold on its incentive effects. And abolishing the top rate next year, when it will apply to only 3per cent of taxpayers, would only cost another $2billion.

You’d never expect Australia to compete with an equally rich society such as Singapore, with its top rate of 22per cent, but that after a decade of a free-market government we can’t even compete with the US, with a top federal rate of 35per cent, or, God help us, New Zealand, with its top rate of 39per cent, shows just how modest recent reforms have been.

For all the talk of our world-beating performance we still have a lower per capita income than many comparable countries.

This weakness in reform reflects a weak Australian conservative intellectual tradition. Nothing is a more perfect illustration of this than the ridiculous new movie Three Dollars.

Don’t miss Sheridan’s review of the film.

posted on 12 May 2005 by skirchner in Economics

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The Budget

As usual, the most insightful analysis of the Budget comes from Alan Kohler:

A large part of the source of all this Howard happiness is the tax reform of 1999-2000 - not the GST but the pay-as-you-go system for businesses, and the way it links to the GST to make avoidance very difficult. No matter what you might hear about tax avoidance being rampant among rich people, the new tax system is actually hoovering money out of business tills more efficiently than anywhere in the world.

Total government receipts were $156.6 billion in 2000-01, and they are budgeted to be $214.2 million in 2005-06 - a 36 per cent increase in five years. Over the same period the increase in the consumer price index has been less than 15 per cent.

That $57.8 billion per annum increase in revenue, net of tax cuts along the way, has been nearly all spent by John Howard.
Since 2001-02, which was the first year government cash flows were set out in detail, government spending on goods and services has risen $14 billion a year, or 37.4 per cent, grants and subsidies $8 billion a year, or 13 per cent; personal benefits $13.5 billion a year, or 21 per cent, and government salaries by $2.5 billion, or a comparatively modest 16 per cent - in line with general wage inflation.

The balance has been salted away and will now be given to some fund managers to see if they can do better than bank interest.

The proposed Future Fund raises some serious issues.  With assets potentially rising to $100 billion, the government has effectively setup a massive proprietary trading operation at the expense of taxpayers.  If the fund is not going to be a passive index fund, then its asset allocation decisions could have a significant impact on markets.  The Fund will quite likely invest in Commonwealth Government Securities, so the government will be purchasing its own liabilities.  The bond market will increasingly be divorced from any underlying government financing requirement.  The government is setting itself up as an intergenerational financial intermediary at the expense of private saving, moving us in the direction of de facto nationalisation of financial markets.  As we have argued previously, the government’s focus should instead be on economically empowering individuals to reduce their current and future dependence on the state. 

Greenspan spoke eloquently on these issues in the US context back in 2001:

These efforts would likely result in distortions in the allocation of capital that must be balanced against the benefit to the nation of the increase in saving. In fact, it is the market-driven allocation of capital and labor to their most productive uses that has fostered our recent impressive gains in productivity and encouraged inflows of capital that have enabled us to build an extraordinarily efficient capital stock despite quite modest levels of domestic savings. The effectiveness of our markets in allocating capital is one of our nation’s most valuable assets. We need to be careful not to impair their functioning.

Those economists who are arguing that the budget tax cuts will put upward pressure on interest rates should probably lose their job.  The fiscal impulse, the change in the budget balance as a share of GDP, is simply too small to be a major consideration for monetary policy.

posted on 11 May 2005 by skirchner in Economics

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More Rubbish from the AEI

Who would you expect to be a more reliable defender of market outcomes and capitalist acts between consenting adults: a right-wing American think-tank; or a former adviser to an Australian Labor Prime Minister?

The AEI’s Desmond Lachman has written to the FT, criticising John Edward’s view (canvassed on this blog previously) that Australia’s current account deficit is a benign product of an investment boom, with national saving as a share of GDP remaining little changed in recent years. 

We have previously discussed Lachman’s views on the US current account, so his take on Australia’s deficit (which unlike the US deficit is entirely the product of capitalist acts between consenting adults) should not come as a surprise.  But it is still incumbent upon Lachman to explain why he thinks there has been a market failure in relation to these outcomes.  Otherwise, he is simply imposing his own prejudices in relation to what he thinks are desirable outcomes in relation to the trade balances, dwelling investment and other macro variables.  Either way, the AEI would seem to have little respect for or appreciation of market outcomes and certainly a good deal less than a social democrat like Edwards.

posted on 10 May 2005 by skirchner in Economics

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Persistence in Forecasting

The doom-mongers are nothing if not persistent:

A lot of it has to do with timing. While many economists are willing to imagine in detail what a perfect storm would look like, virtually none will forecast precisely when - or if - it will start. And so it remains a vague and distant possibility.  Besides, adds Jeffrey Frankel, “some of us have been warning of this hard-landing scenario for more than 20 years.”

And for the next 20 too, I suspect.  Steve Ellison at Daily Speculations has an amusing list giving reasons to be bearish for every year going back to 1934!

(thanks to Jack S. for the NYT pointer).

posted on 09 May 2005 by skirchner in Economics

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The Inflation Forecast that Isn’t

The now institutionalised process of pre-Budget leaks is in full swing.  Some leaks are not as impressive as they sound.  John Garnaut writes-up the sometimes market-sensitive Budget economic forecasts:

The budget papers will also predict consumer prices will grow by 2.5 per cent next financial year, in the middle of the Reserve Bank’s inflation target zone of 2 and 3 per cent.  The benign inflation outlook is unchanged from last year’s budget forecast.

This seemingly unchanged outlook is not a coincidence.  The Treasury’s inflation forecast is more of a technical assumption that the RBA will do its job properly, rather than an actual forecast.  Inflation is not an exogenous variable under an inflation targeting regime.  The Treasury’s inflation forecast is necessarily endogenous to the RBA’s policy actions, even with a steady interest rate assumption.  There is very little scope for Treasury to present an alternative point of view without implicitly forecasting a monetary policy mistake.  This makes a nonsense of Garnaut’s claim that the Treasury’s forecast:

marks a victory for Mr Costello and Treasury in their recent tug-of-war with the Reserve Bank over interest rates.  In February the bank highlighted the risk that inflation would rise above 3 per cent next.  But yesterday the bank retreated, after tense boardroom debates involving the Treasury Secretary, Ken Henry, over assumptions used to support the bank’s inflation forecasts.

The fact that the RBA did not actually lower its inflation forecast in the May SOMP does not suggest much of a retreat to me.  This tendency to overinterpret differences between the RBA and Treasury on inflation is no doubt one of the reasons the RBA persists in presenting its forecasts in a very informal way.  The RBA is trying, not very successfully, to avoid silly beat-ups like this by making its forecasts not directly comparable with those of Treasury, while maintaining the public fiction that inflation outcomes are independent of its policy actions. 

The obvious solution is for both the RBA and Treasury to fully endogenise their macro forecasts to the inflation targeting regime.  This would force the RBA to present a projection for the official cash rate consistent with the maintenance of the inflation target.  By making it obvious that inflation is not an independent variable, it would reinforce the credibility of the inflation target and might even enable a lowering in nominal interest rates.

posted on 07 May 2005 by skirchner in Economics

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The Budget, the Leadership and the Spectre of Fraserism

The pre-Budget leaks suggest a continuation of the politics of redistribution that has charaterised the current government’s approach to fiscal policy.  As Paul Kelly notes, the politics of redistribution will simply no longer cut it:

The Howard Government is a victim of its success and rhetoric. It has forgotten how to talk to the people about reform and challenge. It has not told the people the truth about the globalised age - that a market-based economy needs constant structural change to renew itself and maintain growth. It has been in office so long and made such a virtue of prosperity, naturally, that it can’t spin another story.

The Government is close to embracing a “no losers” political tactic. Once a government reaches this position its political nerve is shot. The Government seems hesitant to accept the responsibility that comes with Senate control when it has no excuses left. It is so used to fudge and compromise that it now feels trapped in the spotlight.

Another Budget of fudge and compromise also does not say much for Peter Costello’s leadership aspirations, as Greg Sheridan notes:

the case for Costello seems to be simply that it’s his turn and if he doesn’t get it he’ll blow up the Government. But voters are profoundly unimpressed with the argument of any politician that it’s his turn.

The one area where Howard is weakest is in seeing the urgency of economic reform. Yet Costello has run no crusades here. The two most notable acts of economic reform of this Government are the GST and industrial relations deregulation, both intensely associated with Howard. It’s difficult to get Costello in private conversation even to admit that taking half of every additional dollar that people earn in tax is too much.

After ten Budgets, any mention of the need for fundamental tax reform is a direct challenge to Costello’s credibility.

posted on 07 May 2005 by skirchner in Economics

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Not the Federal Budget

Ahead of next week’s Federal Budget, it is worth pondering what a government serious about tax and expenditure reform could achieve.  Des Moore, under auspices of the ACCI, presents the Budget we would like to see, but almost certainly won’t:

Analysis of Commonwealth spending/revenue concessions indicates immediate potential for saving $19.5 bn pa or over 2 per cent of GDP. That would allow income tax to be reduced to a top rate of 30 per cent – and additional tax changes.

Savings can mainly be achieved by reducing benefits to higher income groups but by “compensating” most of them through tax cuts. This is possible because those groups receive 30 per cent of social security (including selected education and health) benefits and thus receive back nearly half the taxes they pay. Most of such “churning” is a useless product of a society that has become bureaucratised by political parties buying votes…

The cuts of $19.5 bn would represent a total percentage reduction of 8.2 per cent. The main potential for savings in expenditure comes from social security and welfare ($7,278 mn), health ($2,844 mn), education ($1,689 mn), housing ($1,038 mn) and industry assistance ($457 mn). This would be a percentage cut in expenditure of 8.1 per cent (including a 20 per cent cut in industry assistance). In addition it is proposed that total tax expenditures will be cut by $2,993 mn or 8.7 per cent.

posted on 05 May 2005 by skirchner in Economics

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RBA Transparency and Accountability: You Can’t Keep a Good Issue Down

Too many journalists are preoccupied with personalities and outcomes at the expense of processes when it comes to reporting on macroeconomic policy.  John Garnaut deserves some kudos for keeping the issue of RBA transparency and accountability alive, using the monthly board meeting as a hook:

The lack of Reserve Bank transparency has been cited as a factor in recent market volatility, with interest rate expectations swinging from rate cuts in January to rate rises six weeks ago and back to rate cuts last week.

“If they had a post-meeting statement … the market wouldn’t have run and priced rate cuts at the end of last year and January, the Reserve Bank wouldn’t have had to issue such a one-sided, unbalanced statement in February, and it wouldn’t have seemed inconsistent for not moving in April,” said Deutsche Bank’s chief economist, Tony Meer.

The central bank’s board issues a statement when it adjusts interest rates but stays silent when it leaves rates on hold.

Graeme Thompson, who sat on the board as one of two deputy governors until 1998, said there was no obvious argument for not releasing a monthly statement. “I don’t quite see the argument against issuing some sort of statement every month for why the board came to a decision.”

Professor Adrian Pagan, a board member until 2001, also supports improved communications, including a statement each month.

It is also good to see some market economists chiming in on this for once.  Many market economists come from RBA and Treasury backgrounds and consequently tend to be rather uncritical of instituional framework for macro policy in Australia.

posted on 05 May 2005 by skirchner in Economics

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Mankiw on Bush, Social Security and More

Russ Roberts interviews Greg Mankiw over at Econlib.

posted on 04 May 2005 by skirchner in Economics

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Libertarian-Conservative Monetary Policy Doves

Alan Reynolds joins other libertarian and conservative commentators in calling into question the Fed’s tightening bias:

I have avoided complaining about the Fed being too tight since co-authoring a Wall Street Journal article to that effect in October 2000 (and before that, only in mid-1982 and 1984). If asked today if the Fed should again raise interest rates anytime soon, however, my answer is no. The domestic and global economic risks of raising dollar interest rates are real—the inflation scare is not.

There has been an interesting role reversal for libertarian and conservative think-tanks in relation to monetary policy over the last 15 years or so.  Whereas their commentary once focussed on the inflationary bias of central banks, the Fed would now appear to be a good deal more hawkish than they would like. 

The Shadow Open Market Committee now focuses much of its effort on encouraging reform of the institutional framework for US monetary policy.  This is the correct focus for debate, since improvements in this framework should generally lead to improved policy outcomes.

posted on 03 May 2005 by skirchner in Economics

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Institutional Origins of Global Imbalances: Don’t Dump on the Anglo-American Model

The argument that global imbalances are attributable to excess consumption in the Anglo-American economies is increasingly being discredited in US policy circles.  Ben Bernanke has already identified the role of forced saving in East Asia as a major driver of these imbalances.  Glenn Hubbard (free version here) extends Bernanke’s global saving glut thesis, by considering the role of dysfunctional capital market institutions in the emerging economies as a key driver of forced saving:

Key emerging-market economies like China need to absorb more of their domestic savings. Arithmetic makes a powerful case here. Last year, if reserves-rich emerging-market economies had run current account deficits equal to their inflows of foreign direct investment, the aggregate swing in their current account position would have eliminated much of the U.S. current account deficit. And given the spotlight now being cast on China, it is worth noting that such a shift for China alone would have offset about one-sixth of the U.S. current account deficits.

But economics is more than arithmetic. To increase domestic spending in a way consistent with long-term growth, domestic financial systems must be able to allocate capital to its most valued use, improving consumers’ ability to borrow and the efficiency of business investment. Such capital-market efficiency cannot be taken for granted. Consider Japan’s decade-long struggle with nonperforming loans and its current battle over cross-border M&A and the privatization of the slumbering Japan Post. More to the present situation, consider China’s massive and mounting nonperforming loan problem, as state-owned enterprises devour credit better used by entrepreneurs.

Herein lies a clue to the puzzle. If capital markets around the world matched the effectiveness of those in the U.S., one would expect capital to flow on balance from the U.S. and Europe to emerging economies like China. That flow, of course, is not materializing. In a recent economic study, Charles Himmelberg, Inessa Love and I found that weak institutions and capital-market imperfections in emerging economies can lead to very high costs of capital for productive investment at home. In this context, using American leadership to focus on exchange rates alone misses a bigger opportunity—to tackle the much larger need for financial reform that will permit imbalances to ease.

Those who blame global imbalances on Anglo-American consumption are implicitly punishing a successful economic model and endorsing failed institutional arrangements in other parts of the world.  It is a sad fact that a large part of economics-oriented blogosphere is now heavily invested in this bankrupt view of the world.

posted on 02 May 2005 by skirchner in Economics

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The May Budget and the Future Fund: Attack of the Stone

Former Treasury Secretary John Stone is unimpressed with the likely content of the May Budget and the Future Fund:

Can it really be that, apart from new spending on its welfare reforms, the Government is simply proposing to hang on to these huge surpluses quite deliberately? To lend some verisimilitude to this otherwise indefensible policy, it has devised a so-called future fund, into which it will pay these surpluses (plus most of the proceeds from Telstra and other future asset sales) to fund, over time, the present large public service superannuation accounts deficit.

It has always been hard to take the future-fund notion seriously. When it first surfaced as a broader inter-generational fund, the secretary to the Treasury, Ken Henry, was openly, and rightly, scathing about it. Now that ministers have decided to erect this nonsense on stilts at the apex of this and future budgets, he has understandably fallen silent.

Unfortunately, it is no longer the case that major tax and spending decisions are made in the context of the annual Budget.  These decisions are increasingly being tied to the political rather than the Budget cycle.  While the conventional wisdom is that the first Budget after an election is the best from the point of view of expenditure restraint, on this occasion, the government shows little interest in reducing spending.  This effectively rules out any meaningful reduction in the overall tax burden.

posted on 02 May 2005 by skirchner in Economics

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The Neutral Fed Funds Rate and the Bond Yield ‘Conundrum’

One of the main problems with the dominant neo-Wicksellian paradigm for monetary policy is that it is organised around a latent variable: the neutral or equilibrium real interest rate.  There is currently a debate as to whether the neutral real interest rate for the US has declined, implying that US monetary policy is now rather closer to neutral than past experience would suggest.  The AEI’s resident monetary policy dove, John Makin, makes an argument along these lines.

I don’t have a strong view on this, but given the role of expectations for the Fed funds rate in determining the yield curve, this strikes me as a plausible explanation for the so-called bond yield ‘conundrum.’  If the market takes the view that monetary policy settings are already neutral, while at the same time pricing further increases in the Fed funds rate, then it makes perfect sense for the market to also price a flat yield curve in the expectation that growth and inflation will moderate in the future.  In effect, the market is saying that it expects the Fed to overshoot neutral.

This is certainly a more compelling explanation for the ‘conundrum’ than the standard cop-out that bonds are experiencing a ‘bubble,’ a term now so overused as to be bereft of any analytical content.  Obviously, the Fed thinks differently, otherwise it would not be expressing puzzlement over currently observed bond yields. 

Australia is in a similar situation, with the RBA’s official cash rate still below its previous cyclical peak and with the yield curve already seeing a modest inversion.  In Australia, the market is moderating its tightening expectations, partly on the basis that an inverse yield curve implies a restrictive policy stance.

One of the ways we discover the equilibrium real rate is by either under or overshooting it.  The resulting boom or recession reveals the otherwise unobservable equilibrium rate.  Central bankers face a knowledge problem every bit as acute as that faced by any other central planner trying to fix an equilibrium price.

posted on 29 April 2005 by skirchner in Economics

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The Future Fund

The May Federal Budget should contain details of the government’s ‘Future Fund,’ which is meant to serve as a repository for the proceeds from the privatisation of the rest of Telstra and for the government’s budget surpluses, now that there is precious little Commonwealth government debt to retire.

The government is rationalising the Fund in part by arguing that it needs to provide for currently unfunded liabilities in relation to public service superannuation.  If the government were serious about this logic, then it would start provisioning for all of its unfunded contingent liabilities.  New Zealand is also attempting something similar with its inter-generational fund, although this is more a reflection of the fact that NZ actually takes public sector accounting principles seriously.

In reality, the Future Fund is just a form of revenue hoarding by a government that has more money than it knows what to do with.  Alan Wood notes that the Prime Minister’s recent comments on the Fund suggest it will be little different in practice from consolidated revenue.  Even if the government had the right intentions now, the Fund would be subject to a time inconsistency problem, by which the temptation to abuse the fund would grow in line with its assets.

If the government were serious about reducing future demands on Commonwealth government spending, it could simply take the proceeds from the privatisation of Telstra and its budget surpluses and make one-off contributions to the private superannuation accounts that every working Australian already owns, where these funds would steadily and safely compound until retirement.  By economically empowering individuals, we would reduce their future dependence on the state and protect these funds from abuse by the current or future governments.  This would also prevent the many problems that are bound to arise from the Commonwealth government managing a very large asset portfolio.

posted on 28 April 2005 by skirchner in Economics

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The Bond Yield ‘Conundrum’ and Global Saving

John Quiggin sent the following comment, which is relevant to several of my previous posts on this topic:

A general comment on why so few economists trust the market on bubbles. It’s obvious that low interest rates are crucial, and that your whole argument makes sense if and only if sustained low interest rates are a market-driven response to changes in the real economy.

But in an environment with near-zero savings in the English-speaking countries, and large unfunded state obligations in the rest of the developed world, interest rates should be high, not low.

The proximate cause of low interest rates is the willingness of Asian countries to run large current account surpluses (that is, capital account deficits), but there is no convincing micro story as to why people in poor countries should want to save massive amounts to lend to fund consumption in rich countries.

The leading optimist on all this is Bernanke, but he sees the surpluses as the product of macro policy, governments building up reserves in reaction to the crises of the 1990s. This source of surpluses presumably won’t be sustained, since the countries concerned are incurring huge unrealised losses on their US dollar holdings. So the ‘global savings glut’ is a temporary one, and is being squandered by borrower nations in high levels of consumption.

I do not buy the argument that the interest rates currently observed in the US are due to purchases of US Treasuries by Asian central banks, for the simple reason that the flow of such purchases is small relative to the total market turnover in these instruments.  Foreign exchange market interventions by central banks are usually ineffective except in the very short-term for the same reason: they are simply swamped by the multi-trillion dollar turnover we see daily in these markets.  Needless to say, I don’t think the US dollar depends much on these purchases either.

I agree with John that it is perverse that we should see developing countries saving to fund investment in rich countries, but this is due to forced saving via managed exchange rate regimes.  It is indeed ridiculous that China is issuing domestic debt to fund purchases of US debt instruments, as Deepak Lal has noted, but symptomatic of its mercantilist development strategy.  I agree that this will not be sustained because fixed exchange rate regimes always come unstuck, but I see this as being more of an issue for China than for the US or Australia.  The subsidy to US and Australian consumption from China’s fixed exchange rate regime is too small relative to the overall contribution that the emergence of China is making to the expansion of our consumption possibilities.

I agree that low bond yields in the face of massive unfunded contingent liabilities associated with unsustainable welfare-statism is something of a puzzle, but this is not new.  There is not a strong cross-country empirical relationship between government budget deficits and interest rates, as many were keen to point out during the last Australian federal election campaign.  Japan has the most serious fiscal problems of the developed countries and yet also the lowest bond yields.  My view is that Japan’s low bond yields reflect the overcapitalisation of its economy due to excess saving in previous years, a legacy of its own mercantilist development strategy which has landed it with excess industrial capacity.  China risks the same fate. 

Asset prices do not follow neat linear relationships with a few simple fundamentals.  If they did, we would not need markets to tell us what prices these assets should trade at.  When market pricing disagrees with our view of fundamentals, it is tempting to assume a ‘bubble,’ but then one must come up with a persuasive case for market failure.  I am willing to concede that there are some relevant market distortions in this case, but they do not constitute a ‘bubble.’  They are instead an alternative fundamental story that needs to be taken seriously.

posted on 25 April 2005 by skirchner in Economics

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