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August 11, 2010

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Latest Posts from Economist's View

What Impact Will the Bush Tax Increases Have on High Income Households?

Posted: 11 Aug 2010 01:18 AM PDT

The Bush tax increases are scheduled to hit all households in 2011. If low income households are exempted, as they should be, what will happen to tax revenue?:

Study Looks at Tax Cut Lapse for Rich, by Jackie Calmes, NY Times: As debate heats up over President Obama's proposal to let the Bush tax cuts expire for the wealthy but to extend them for everyone else, a nonpartisan Congressional analysis circulated on Capitol Hill on Tuesday provides a look at the impact the plan would have on high-income taxpayers. ...
The president has vowed to extend the tax cuts for individuals with less than $200,000 in annual taxable income and couples with less than $250,000 — about 98 percent of American households. About 315,000 households report adjusted gross income of $1 million or more.
Taxpayers with income of more than $1 million for 2011 would still receive on average a tax cut of about $6,300... That compares, however, with the roughly $100,000 average tax cut that households with more than $1 million in income would receive under current rates.
Filers with taxable income of $500,000 to $1 million would still get on average a tax cut of $6,700 compared with pre-2001 rates... But that compares with roughly $17,500 if the top Bush tax rates were maintained.
If the president gets his way, in 2011 the top two income tax rates — now 33 percent and 35 percent — would revert to the levels before the Bush administration, 36 percent and 39.6 percent, respectively. But the four lower rates would remain 10 percent, 15 percent, 25 percent and 28 percent. ...
Democrats want to extend the tax cuts for all but the wealthy, while Republicans are fighting to maintain them for everyone. ... Extending them for the next 10 years would add about $3.8 trillion to a growing national debt... About $700 billion of that reflects the projected costs of tax cuts for those in the top 2 percent of income-earners. ...
Speaking of Republicans at a fund-raiser in a wealthy community near Dallas on Monday, Mr. Obama told Democratic donors, "What you see is a governing philosophy on their part that basically comes down to 'We're going to extend tax cuts for the wealthiest among us' — folks who don't need those tax cuts and weren't even asking for them, which would cost $700 billion."
For their part, Republicans do not emphasize the impact of extending the tax cuts for wealthy individuals. Rather, they say Mr. Obama is about to spring a big tax increase on many small-business owners who file their taxes as individuals. Analyses from the Joint Committee on Taxation and the Tax Policy Center ... show that less than 3 percent of filers with small-business income pay at the top two income tax rates, and many of those are doctors and lawyers in partnerships.

I have no objection to the tax cuts being allowed to expire for high income households, it will come largely from savings so there won't be a big impact on consumption. But as I've argued before, so long as the economy continues to have problems, the revenue gained from allowing the tax cuts to expire for high income households should be used to finance temporary tax cuts for lower income households. Those households are likely to spend the money instead of saving it, so the net effect will be a needed boost to consumption and aggregate demand (that is, this takes advantage of differences in the marginal propensity to consume). Since the tax cuts for lower income households would end once things improve, the policy would still help with the long-run budget problem.

"Cutting the Corruption Tax"

Posted: 11 Aug 2010 01:11 AM PDT

It's hard to imagine this actually happening:

Cutting the corruption tax, by Paul Romer, Vox EU: Many of us take it for granted that government officials will obey the law. In the US, news that the police department in New Orleans committed and covered up crimes like rape and murder reminds us that this needn't be the case. It also reminds us that living with the lawlessness of a weak state might be better than living under a strong state that officials can abuse.
Many nations live with a weak government because people fear that a strong government will abuse its power. This fear is particularly acute in a country like Greece, where people can still remember the time in the late 1960s when military officers seized control of the state and brutally suppressed dissent.
Unfortunately, the current economic crisis in Greece is too serious for its weak state to manage. In New Orleans, the mayor and community leaders asked the federal Department of Justice to intervene and reform the city's dysfunctional police department (Robertson 2010). Like the city government in New Orleans, Greece needs to reach out for help.
An achingly slow recovery from the financial crisis could threaten the foundations of Greek society. To avoid this, the people of Greece should reach out to the EU – not for more loans or for budget supervision but for assurance that new efforts to root out corruption and civil service inefficiency will be politically neutral. By working with the EU, Greece can quickly build the kind of strong, honest, and efficient state that can lead the country out of the crisis.
The situation in Greece
Corruption and bureaucratic inefficiency amount to a tax on all firms that operate in Greece's formal sector. The tax is especially onerous for start-ups and foreign firms that would like to invest there.
Here's how one business leader, call him John, described a recent encounter with a local official. The official withdrew the license of one of John's operations. It would be reinstated only if John agreed to hire the official's girlfriend as a consultant and pay her via an offshore account. John's legal recourse was limited – any case against the official would linger in the courts indefinitely. In the meantime, John's firm would not be able to operate without the license. John ended up speaking to someone higher in the government to get the local official to back down. He did not say what the higher-level official got in return.
This kind of behavior is no secret. In Transparency International's 2009 corruption rankings, Greece tied Romania and Bulgaria for the worst score in the EU. At this level, corruption has visible effects on the overall efficiency of government. Daniel Kaufmann (2010) points to a strong correlation between corruption and fiscal deficits, even in industrialized countries like Greece. The budget position in Greece suffers from tax evasion and the political patronage that bloats public payrolls with unnecessary hires. Kaufman suggests that if Greece's levels of corruption were comparable to Spain (hardly the gold standard), its budget shortfalls over the preceding five years would have averaged as little as 2.5% of GDP rather than the current 6.5%.
As Marcus Walker points out in the Wall Street Journal, roughly one-quarter of all taxes owed in Greece are not paid. Walker also notes Prime Minister George Papandreou's frustration with the many Greek politicians who promise public administration jobs to constituents to secure votes. The finance ministry estimates that the government added 27,000 people to its payrolls in the run up to the fall 2009 election, even though many of the new hires lacked an official position and an office (Walker 2010).
The costs of patronage go far beyond the salaries for unneeded civil servants. In a work environment where political patronage trumps merit, employee discipline is slack, government agencies are poorly run, and graft is widespread. One particularly important failure lies in the judicial system, which is notoriously slow at resolving cases. As the local official who demanded the payments to his girlfriend understood, this dramatically broadens the opportunities for criminal activity.
The business official who spoke to me earns a living by collecting part of the corruption tax. Foreign firms invest in Greece through his companies while he manages the demands from the officials. But his efforts come at a cost. Using data from global firm-level surveys, Kaufmann and Wei (1999) find that the managers of firms that pay more in bribes are likely to spend more time, rather than less, quibbling over red tape with bureaucrats than firms that refuse to pay bribes. They also find that bribers have a higher cost of capital.
The benefits from eliminating the corruption tax
Corruption and bureaucratic inefficiency act like the worst kind of tax – one that deters economy activity without raising any revenue. In the midst of the current crisis, cutting this tax would be a triple-win. In the long run, it will raise potential output. In the medium run, it will narrow the current-account deficit by reducing the cost of producing goods in Greece. In the short run, it will encourage investment by foreign firms and start-ups, which will bring the economy back toward full employment.
The existing approach, based on fiscal tightening, can reduce the budget deficit and, by temporarily reducing imports, help balance the current account. Some commentators suggest that a longer recession may be an unwanted side effect. In fact, prolonged recession is an essential part of this approach to reducing the current-account deficit. If Greece relies solely on fiscal tightening, a long and deep recession will be the only way to drive wages low enough to permanently change the costs of production in Greece relative to its trading partners.
To avoid the need for a long recession, many countries enact adjustment programs that combine fiscal austerity with a cut in the exchange rate. Because it is part of the Eurozone, Greece does not have this option. In this context, the tax from corruption and inefficiency is an opportune obstacle – by removing it Greece can cut costs and become a more competitive place to do business. We don't know the exact magnitude, but this tax cut might be large. A young person who is trying to grow a new business told me he would happily pay a 15% increase in the VAT if he could deal with a government that was as honest and efficient as the government in Hong Kong.
The experience in Hong Kong
Until recently, Greece had five layers of government instead of the three levels – local, state, and national – that are standard elsewhere. The extra levels of government increase opportunities for corruption and inefficiency, so the current administration has wisely chosen to consolidate. But even with fewer levels of government, corruption and inefficiency will linger in those that remain.
Some say that corruption and political cronyism are an inevitable part of "the Greek reality". As long as there is government in Greece, there will be a tax from corruption and inefficiency. In the 1970s, the same sorts of cultural pessimists thought that Hong Kong would always be corrupt. The actual experience there demonstrates just how wrong they were. Feasible policies can quickly change a culture of corruption.
As in many places, the responsibility for fighting official corruption in Hong Kong once rested with a special branch within the police force that was conveniently ineffective. In 1974, the governor general of Hong Kong vested anti-corruption responsibilities in a new elite ministry, the Independent Commission Against Corruption (ICAC). The commission was directly responsible to the governor general, who was himself an appointed rather than an elected official.
The governor general in Hong Kong was not an authoritarian leader. He answered to the democratically elected British prime minister but his position did not depend on local political contests. As a result, neither the governor general nor the commissioners that answered to him had any interest in using the substantial powers of the commission for narrow political gain. They could be trusted with strong powers because they were held accountable to an offshore democracy that wanted Hong Kong to thrive.
Unsurprisingly, the ICAC's efforts met with considerable resistance from the police. The governor general was eventually forced to grant amnesty for past crimes after the police went on strike and threatened violence. Though amnesty was viewed as a setback at the time, it meant that the commission could use all of its resources to prosecute fresh cases involving corrupt police officers and officials. This made it a much better deterrent against continued corruption.
Along with the formal prosecutions, the ICAC used education to change Hong Kong's social norms regarding corruption. It organized a broad campaign, adding anti-corruption classes to the public school curriculum and creating anti-corruption television programs. It published surveys that tracked changes in the amount of corruption over time. The commission also reviewed the rules of all ministries and modified them to reduce opportunities for corruption (Manion 2004).
So much for Hong Kong's intractable culture of corruption. According to the surveys, the frequency of requests for bribes fell very quickly. Today Hong Kong is among the least corrupt places in the world, ahead of Japan, the UK, and the US.
Guns at a fistfight?
If a commission like the one in Hong Kong could eliminate the corruption tax in Greece, and if doing that would be so beneficial in the midst of the current crisis, why hasn't one been established there? The problem is as old as Greek democracy. As Plato observed, if guardians are how we prevent lawlessness, who guards the guardians?
Government agencies that are strong enough to prosecute corruption cases and root out inefficiency in the civil service will also be susceptible to abuse. Selective prosecution and civil service dismissals could easily be used to help one political party and hurt another. Even if these powers are used in a neutral way, those who are caught will claim that the motivation for their prosecution was political. Unless such repeated assertions can be decisively rebutted, they could undermine the commission's legitimacy.
Political competition in Greece is like a fistfight in a bar. Creating a powerful new commission would be like tossing a gun into the middle of the brawl. All parties remember how strong state powers were abused during the military takeover. Left on their own, they might reasonably agree that new powers would be destabilizing and dangerous. But given the chance, they might still want to invite a new sheriff to town.
Bringing in the EU
Because of its membership in the EU, Greece has an option that is not available to most other countries in the world. By leveraging the credibility of the EU, Greece can begin the same sort of transformative fight against corruption that Hong Kong embarked on in the 1970s. If the EU can ensure that the appointment process to an anti-corruption commission is free of political influence, Greeks could remove the corruption tax without disrupting the political equilibrium.
The process could be structured in many different ways. For example, Greek political parties and members of civil society could propose names for head anti-corruption commissioner. The president of the EU could then make an appointment from the list, retaining the power to remove, replace, or reappoint the commissioner. Like a central banker, the head commissioner could have a clear mandate and wide discretion for achieving it, particularly in hiring and firing commission staff. The mandate could focus on the future, following the example of Hong Kong and specifying amnesty for past corruption.
The involvement of the EU could expire with a sunset clause. The clause might be based on a supra-majority vote in a referendum. The clause could also be triggered by objective indicators of performance, such as Transparency International's Corruption Perceptions Index or the World Bank's Control of Corruption measure.
A similarly independent commission could bring the most basic elements of management to the Greek civil service. A civil service commission could end the practice of hiring and promotion based on political patronage. People who do their jobs would be rewarded. People who don't would be advised to change, counseled out, or fired. With this kind of approach, essential government organizations like the courts and tax agencies could actually perform their functions.
What's at stake
The fate of the entire EU project – to improve all aspects of governance in its member states – hinges now on how the crisis in Greece is resolved.
Proposals for centralized oversight of EU member-state budgets are both too hard to implement and too narrow in their focus. The proposals outlined here, independent commissions that promote honesty and efficiency in government, could be implemented quickly and would be far more helpful. They can be prototyped in a way that is specific to the situation in Greece, then adapted to other countries as necessary.
Many well-established democracies in the EU have solved the problem of guarding strong guardians. Through the institutions of the EU, they can assist people who still live without the remarkable benefits that this can offer, just as the federal government in the US can assist the people of New Orleans. In Greece, as in New Orleans, all it would take is for the local government to ask.
Kaufmann, Daniel (2010), "Can Corruption Adversely Affect Public Finances in Industrialized Countries?", Brookings Institution.
Kaufmann, Daniel and Shang-Jin Wei (1999), "Does Grease Money Speed Up the Wheels of Commerce?," World Bank Policy Research Working Paper 2254.
Manion, Melanie (2004), Corruption by Design, Harvard University Press.
Robertson, Campbell (2010), "Justice Department to Review New Orleans's Troubled Police Force", The New York Times, 17 May.
Walker, Marcus (2010), "Tragic Flaw: Graft Feeds Greek Crisis", Wall Street Journal, 15 April.

links for 2010-08-10

Posted: 10 Aug 2010 11:04 PM PDT

Is This "A Common Feature of Biological Decision-Making"?

Posted: 10 Aug 2010 05:45 PM PDT

Humans are very sophisticated, calculating, rational decision-makers:
Slime Brainless slime mould makes decisions like humans, Discover: A couple arrive at a fancy restaurant and they're offered the wine list. This establishment only has two bottles on offer, one costing £5 and the other costing £25. The second bottle seems too expensive and the diners select the cheaper one. The next week, they return. Now, there's a third bottle on the list but it's a vintage, priced at a staggering £1,000. Suddenly, the £25 bottle doesn't seem all that expensive, and this time, the diners choose it instead.
Businesses use this tactic all the time – an extremely expensive option is used to make mid-range ones suddenly seem like attractive buys. The strategy only works because humans like to compare our options, rather than paying attention to their absolute values. In the wine example, the existence of the third bottle shouldn't matter – the £25 option costs the same amount either way, but in one scenario it looks like a rip-off and in another, it looks like a steal. The simple fact is that to us, a thing's value depends on the things around it. Economists often refer to this as "irrational".
But if that's the case, we're not alone in our folly. Other animals, from birds to bees, make choices in the same way. Now, Tanya Latty and Madeleine Beekman from the University of Sydney, have found the same style of decision-making in a creature that's completely unlike any of these animals – the slime mould, Physarum polycephalum. It's a single-celled, amoeba-like creature that doesn't have a brain. ... [...continue reading...]

The FOMC Decides on a Minor Course Correction

Posted: 10 Aug 2010 11:49 AM PDT

I posted a brief reaction to the FOMC Press Release:

The FOMC Decides on a Minor Course Correction

Update: Paul Krugman reacts:

The Focal-Point Fed: The FOMC has spoken. What's my reaction? The Fed's current policy is grossly inadequate, logically bizarre, and slightly — but only slightly — encouraging.

What the FOMC announced was a slight change in policy: rather than allowing its balance sheet to shrink as the mortgage-backed securities it owns mature, it will maintain the balance sheet's size by reinvesting the proceeds in long-term government bonds. Roughly speaking, it has gone from a completely crazy policy of monetary tightening in the face of massive unemployment and incipient deflation, to a policy of standing pat in the face of same. Whoopee.

And it's a very strange decision, if you think about it. Presumably there's some optimal size of the Fed's balance sheet, given the state and prospects of the economy. What are the odds that the optimal size of that balance sheet is precisely the size it's currently at? ...

So why freeze the size of the balance sheet right where it is? The answer is that it was, literally, the least the Fed could do. If it had continued to let the balance sheet shrink, the reaction both from Fed critics and from the markets would have been terrible. In effect, reinvesting the funds from expiring securities became a focal point, an essentially arbitrary location in the space of policy responses that nonetheless had come to have "salience", because it was what everyone was watching.

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it's a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

Part of what I said in the link above is that "It's something, and it indicates more awareness of the struggles the economy is having than some recent commentaries from FOMC members would suggest. But more aggressive action -- an actual expansion of the balance sheet -- is needed." So I certainly agree that more expansionary policy is needed, though it's probably hoping against hope for FOMC members to radically change course without external pressure. However, I have to hope anyway -- FOMC meetings are five to six weeks apart -- and pushing policy using a "meeting to Meeting" strategy of constant pressure will take forever, or so it will seem from the perspective of those waiting for an improvement in labor market conditions and hoping that their resources don't run out before they can find another job.

Pentagon Plans to Reduce Budget

Posted: 10 Aug 2010 07:38 AM PDT

The Pentagon announces a plan to cut defense spending:

Pentagon Plans Steps to Reduce Budget and Jobs, by Thom Shanker, NY Times: Defense Secretary Robert M. Gates said Monday that he would close a military command, restrict the use of outside contractors and reduce the number of generals and admirals across the armed forces as part of a broad effort to rein in Pentagon spending.
Mr. Gates did not place a dollar figure on the total savings from the cutbacks, some of which are likely to be challenged by members of Congress intent on retaining jobs in their states and districts. But they appear to be Mr. Gates's most concrete proposals to cut current spending as he tries to fend off calls from many Democrats for even deeper budget reductions...
While large headquarters have been combined and realigned over the years, Pentagon officials could not recall a time when a major command was shut down and vanished off the books, even though some jobs will probably be added elsewhere to carry on essential parts of the mission.
The White House, which is under intense political pressure to address the rapid increase in the national debt, quickly stepped in to back Mr. Gates, saying his plan would free money that could be better spent on war fighting.
"The funds saved will help us sustain the current force structure and make needed investments in modernization in a fiscally responsible way," President Obama said in a statement.
The potential savings Mr. Gates outlined are likely to be relatively modest in the context of a total Pentagon budget... The most significant step — in symbol and in substance — was his plan to close the military's Joint Forces Command in Norfolk, Va. ...
For months, Mr. Gates has been arguing that if Congress and the public allow the Pentagon budget to grow by 1 percent a year, he can find 2 percent or 3 percent in savings within the department's bureaucracy to reinvest in the military — and that will be sufficient to meet long-term national security needs. ...
Assessing his prospects for convincing Congress not to use its power over budgets to block these efforts, Mr. Gates said, "Hard is not impossible." ...
Pentagon spending has averaged a growth rate of 7 percent a year over the last decade, adjusted for inflation (or nearly 12 percent a year without adjusting), including the costs of the wars. ...

Joe Klein adds some perspective:

Pentagon Cuts, by Joe Klein: The usual suspects are whining about SecDef Robert Gates' plan to eliminate the Joint Forces Command and reduce the number of Pentagon bureaucrats and contractors. Actual military experts like Abu Mook don't seem very upset. JFCom mostly existed to expedite inter-service relations--the sort of thing that's nice but not exactly crucial.
Actually, the most important thing here is context: the JFCom budget is $240 million in a Pentagon budget of over $700 billion. Gates intends to seek annual Pentagon budget increases of 1% per year; the savings from axing JFCom would be used to help fund the actual combat services being performed. That's good, but there's a larger question: How much of that $700 billion is actually necessary these days? How many cold war weapons systems are being sustained simply to keep Congressional members happy? (It is no accident that the Virginia delegation is up in arms about the end of JFCom--which is located in Norfolk.) And wouldn't it be better if the federal government were spending money on things that might actually help the economy--infrastructure, for one--rather than anachronistic weapons systems? And, while we're at it, why does the U.S. need to deploy troops in places like Germany and Okinawa? Is it really necessary to spend more on military stuff than the entire rest of the world combined?
If the deficit situation is so dire--and the need to create real economic growth, through new programs or tax cuts, so important--aren't these questions we should be asking? ...

What about the "the actual combat services being performed"? Are those necessary?

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