Synopsis: The problems with taxation as a means to redistribute income

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Discussion:

This article discusses the problems with redistribution as a means to reduce inequality, i.e. taxing the rich to give to the poor. In economics, this works theoretically, as giving money to the penniless who will spend it immediately should boost consumption and GDP. However, if done wrong, this can cause more harm than good.

In 1920, the English economist Author Cecil Pigou argued that shifting purchasing power to the poor will do little to dampen the spending habits of the rich, but will boost output as the poor will immediately spend the money on necessity goods.

The argument rests on the assumption that the poor would spend more if they had the means and the rich would smooth over their spending patterns. To investigate this assumptions, Messrs Kaplan and Weidner of Princeton University and Violante of New York University used large microeconomic datasets to see household income and wealth across eight different economies.

They looked for families that lacked a buffer of liquid assets to offset short-term changes in income. These families were the ones who would theoretically spend immediately from a government windfall.

Herein lies the problem: this “hand-to-mouth” term is not so straightforward – many American households may not have liquidated assets, but do have large illiquid ones.

One reason why people are so short on cash is because of the housing debt. In America, those with small mortgages live less hand-to-mouth than those with large ones.

Another reason why is due to age. The research shows that those around 40 years old are most likely to be cash strapped.

The findings show that “cash shortfalls affect behaviour”, in that those with high liquid wealth spend the least from an unexpected windfall, those living “hand-to-mouth” spend more, but it is those with lots of illiquid wealth but low income that spend the most. This links in with another study by Merrs Cloyne and Surico of Bank of Britons and London Business School respectively, which shows that “taxing those with illiquid assets could cause more of a fall in spending than previously expected”.

Yet another research paper shows that the assumption that the more a worker’s wages fall the more they support redistribution rises may not be true. In fact, support for redistribution has not changed, or has fallen, as inequality has risen.

One major culprit could be age – those under 40 follow the predicted pattern but those over 65 do not, perhaps because when the survey was first conducted in the 1970s the now-65-year-olds were more cash-strapped, but they are not any more. (More on why they are not cash strapped is explained under ‘Context’.) They fear that redistribution would cut health benefits.

Overall, these findings show a few things:

1) Stimulus packages should also be aimed at the wealthy, too;

2) Taxes on the wealthiest should be phased to allow them to liquidate their assets, and;

3) Politicians betting on the popularity of redistribution among voters should realize there may be great aversion from the retirees.

Context:

1) It is worth reading my other blog post about why not to tax the rich, although it has nothing to do explicitly with inequality. This can be found here.

2) Why is it that “the chances of being wealthy but cash-strapped peak around the age of 40”? This has to do with the life cycle. The original research paper can be found here. The life cycle is explained in the previous blog post, which can be found here.

3) One question that is not answered is why “the wealthy-but-income-constrained react most, spending 30% of any windfall, suggesting they are even more cash strapped”.

4) It is important to remember for the previous point that there may not be a symmetry between windfall gains and sudden taxes or losses of income, i.e. people may not spend as much when they have windfall gains than they save when they are taxed.

Synopsis: An article on how demography (age) affects inflation.

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Discussion:

This article discusses the link between inflation and demography. Ageing populations leads to “slower growth, because a country’s potential output tends to fall as its labour force shrinks.” They also have to face heavier fiscal burdens because governments must provide for more pensioners from fewer taxes. Given its ageing population, this is a big problem for Japan.

Many economists take persistent deflation in Japan as evidence to show that prices fall when counties age, and consequently, growth slows. The Prime Minister of Japan, Shinzo Abe, has tried disproving that link by increasing inflation through aggressive quantitative easing. However, as inflation has yet to reach the targeted 2%, the tempting conclusion is that ageing populations cause deflation.

Recent research has sought to disprove that link.

It is important to not just see the links between ageing and prices, but the way they cut. In terms of the factors of production, when growth slows, businesses reduce investment so that the cost of capital can decline. However, wages should rise when the supply of workers falls. And in terms of government action, some governments reduce their spending on other projects to support pensioners, causing slow growth and sluggish inflation. Other governments, however, may decide to monetize their debt, pushing inflation up.

The article disentangles all these possibilities to descry a clearer link between an ageing population and inflation.

This article states a few main points:

1) In a recent paper by Mr. Katagiri of the Bank of Japan and Mr. Konishi of Waseda University distinguished between an ageing population caused by lower birth rates and an ageing population caused by increased longevity.

a. Fewer births would lead to a smaller tax base, encouraging governments to “embrace inflation to erode its debts and thus stay solvent”. This will be further explained under ‘context’.

b. Longer lives would cause the ranks of pensioners to swell, along with their political influence. Their influence would augur for “tighter monetary policy to prevent inflation eating into savings”. This will also be explained under ‘context’.

Messrs Katagiri and Konishi believe that the latter (increased longevity in Japan) has caused deflation of about 0.6ppt over the past 40 years. Therefore, it is not just ageing that has caused deflation, it is more longevity.

2) This article then looks at the impact of ageing on financial assets. The “life-cycle theory” suggests that people average out their consumption over lifetimes: “going into debt when young, buying assets when their earnings peak and selling them to pay for retirement”. In theory, it should lead to lower asset values, but in practice, while house prices often fall, stocks rise.

One important aspect is whether the assets sold are domestic or foreign. Messrs Anderson, Botman and Hunt of the IMF found observed the decrease in Japan’s net saving rates from 15% to 0% of disposable net income from the 1990s to 2011. Many of these savings are invested in foreign assets, and when retirees repatriated their funds after selling stocks and bonds abroad, the yen appreciated. This, in turn, causes deflationary pressure by lowering the cost of imports. This can be negated by “strong monetary easing combined with a credible commitment to an inflation target”. In other words, Abenomics.

3) A recent paper by Messrs Juselius, and Takats from the Bank for International Settlements offers a vastly different explanation for how ageing affects inflation, pointing out that Japan may be quite atypical. They observed 22 advanced economies from 1955 to 2010, and found a steady correlation between deflation and demography, even though just the opposite is assumed. They found that a larger share of dependents is linked with higher inflation, while lower inflation is linked with a higher labour force. Their explanation for this is that countries that consume goods more than they produce them (i.e. with a smaller labour force) causes excess demand, and thus, inflation. However, countries that consume less than they produce causes excess supply, and thus, deflation.

This then begs the question of why Japan has such low inflation. Some possible explanations are damaged balance-sheets caused by the asset bubble pop in the 1980s, or the tentative and hesitant Abenomics.

Context:

1) Why does the government need to make “painful cuts as pensioners multiply”? And what does it mean “monetise their debt”? Number 1 is for the former, and number 2 is for the latter.

2) Why would embracing inflation erode a country’s debts? As inflation goes up, the value of the debt goes down in real terms. Therefore, the amount of debt a country owes decreases.

3) In the section, ‘Greyflation’, the article discusses a finding that explains how a larger share of dependents is linked to higher inflation, and how fewer dependents mean lower inflation. I am sceptical about this argument because, if this were the case, what should we expect in the US when baby boomers retire en masse? A spike of inflation? This is contrary to what a lot of people believe.

Synopsis: A debate between Larry Summers and Ben Bernanke about why US interest rates are so low.

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Discussion:

This article by Greg Ip details a debate between former Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Larry Summers about why interest rates in America are so low. While Summers argues that it is due to secular stagnation, Bernanke disagrees, citing “cyclical and special factors” as the reason for low interest rates.

Secular stagnation includes low growth, low inflation and low interest rates and lasts a substantial amount of time. As Ip points out, it is the real interest rate (nominal interest rate – inflation) that is important. It is the real interest rate that balances savings and investments. More about this will be explained under ‘Context’.

Summers states that the “real rate needed to balance desired saving and investment may actually be negative”, a key factor of secular stagnation.

Bernanke disagrees that the real rate may be negative and details a scenario to illustrate his point. The rough idea is that if the real interest rate was always negative, then all investments would be profitable. Due to an increase in demand for investments, the real interest rates would increase.

Greg Ip further illustrates this point by outlining a scenario with stock dividends, where, if the real interest rate were 0%, the value of the stock would theoretically be infinity, and if the real interest were negative, the equation becomes nonsensical. This will also be explained under ‘Context’.

Summers retaliates by showing that, according to Summers, “rates in America have been negative at least 30% of the time”. His reasoning behind this is that “negative real interest rates are a phenomenon that we observe in practice if not always in theory”.

How is that possible? There are a few reasons for this.

1) While government bonds, or risk-free bonds, are negative, private borrowers would often pay a positive due to the higher risk involved in giving private borrowers loans. Further, investors may demand an “even higher hurdle, especially if they expect the project’s profits to grow quite slowly in a stagnant economy”.

2) Bernanke agrees that real rates can be negative temporarily, not permanently. (Here, Ip points out that Summers never argued that the interest rate was permanently low, it could just be for a 10-15 year time period).

Even if the real rate was not negative, secular stagnation could still be a culprit in low interest rates as secular stagnation does not need rates to be negative, just low.

Next, Bernanke faults Summers for downplaying the international element of the argument. If it were true that there was a lack of profitable investments in the US, the savings would go abroad, increasing interest rates in the US. Bernanke believes that the weak recovery of 2002-06 was due to a global savings glut, as opposed to Summers’s belief that the weak recovery was due to secular stagnation. China and other countries with large trade surpluses “saved more than they invested and exported the rest to the US”. Therefore, the lack of US growth, according to Bernanke, was because imports were displacing domestic production. Since then, China’s trade surplus has decreased while Europe’s has grown, but Bernanke thinks this is a “cyclical, temporary problem”.

Paul Krugman questions Bernanke’s theory that open capital markets would not depress real interest rates by citing Japan as an example. Bernanke however argues that while interest rates were extremely low, inflation was lower, causing real interest rates to be slightly higher than that of the US.

Greg Ip then cites a few reasons why he believes interest rates are so low:

1) Worldwide monetary policy. When QE ended in the US, which had brought real rates worldwide down, ECB’s QE began, keeping the real rates down.

2) Supply side factors – slower growing labour and productivity.
a. Slowing labor can be classified as slower population growth, which depresses the supply of workers and investment, as a smaller workforce need less machinery and other equipment. It also depresses demand, as retirees consume less and aging workers save more for retirement.
b. Productivity has also slowed down worldwide, partly due to the residue of the financial crisis on capital spending, which will eventually fade. However, it also reflects a lack of innovation. And firms may invest less because they see “fewer payoffs to new technology”.  Robert Gordon, a famous economist in the productivity field, also cites education attainment no longer increasing as why growth is slowing down.

Key terms:

1. Financial bubbles: where there is an unsustainable increase in asset prices such as stocks, houses, property and even land.

2. Risk-free interest rate: The interest rate acceptable to a lender when he believes that the borrower will not default on the loan. In practice, this refers to the interest rate on US treasuries, which are considered the safest investment.

3. Hurdle: The minimum expected rate of return from a project, below which the investors will not go ahead with it.

Context:

1. Economists care about real interest rates rather than nominal interest rates. As inflation erodes the purchasing power of the interest earned by the lender, he will make lending decisions based on interest rate after deducting the inflation; in other words, the real interest rate.

2. An important idea to understand from this article is the relationship between real interest rates, savings and investments. As stated in the article, investments can be considered demand for savings, while savings can be considered supply of savings. The diagram below illustrates the relationship.

At real interest rate R2, investment is at I2 and savings is at S2, i.e. they are equal at an equilibrium point. If the real interest rate decreases from R2 to R1, investment would increase to I1 and savings would drop to S1. Similarly, if the real interest rate increases from R2 to R3­, investment would decrease to I3 and savings would increase to S3. This relationship shows that as real interest rates increase, investment decreases and savings increase.

3. Nominal interest rates cannot be negative. Given the equation that real = nominal – inflation, real can still be negative, if inflation > normal.

4. Gary Ip’s discussion of stock dividends:  A stock is worth the sum of its future dividends, discounted at an appropriate interest rate to bring them to today's present value. In other words:

Stock value = D/(1+i) + D/(1+i)^2  + D/(1+i)^3 + D/(1+i)^4 + D/(1+i)^5 ... 
(assuming that the stock pays a fixed divided of D every year and i is the interest rate).

As you can see, as the value of i falls,  the stock value increases; if the value of i reaches zero, the stock value is infinity; if the value of i goes below -1, then the equation turns nonsensical.

5.  Larry Summers states that “negative real rates are a phenomenon that we observe in practice if not always in theory”. This is an allusion to Bernanke’s earlier statement that quantitative easing works in practice if not always in theory. More about that can be read here.

6. There is a discussion about the 2002-2006 weak recovery. The context of this is that, during that time, China exported high volumes of goods to the US, and used the resulting surplus to invest back in America, which led to low real interest rates, and displaced domestic production in America.

7. One important thing to consider is why there is persistent low growth in America, as that is reason for QE and low interest rates in the first place. Some reasons for low growth to persist are:
a. The benefits of technology adoption are finished. Tyler Cowen, a professor at George-Mason university, is famous for discussing this concept in his book “The Great Stagnation”, the gist of which is that the low hanging fruits have already been plucked.
b. Retirement of baby boomers.
c. Long left over effects of the Great Financial Crisis (GFC).
d. Ageing population.