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.