The New York Times carries an article today about whether Europe is doing enough in terms of its institutional response to the financial crisis, whether in relation to management of sovereign risk in individual countries or in relation to the economic slump: you can read the article here.
“We have reached our limits,” said Axel Weber, president of Germany’s Bundesbank, in Frankfurt on Tuesday. “The expectation that we could neutralise this synchronised recession through short-term fiscal policy measures is false. We should not even try. There will be costs.”
From this. Apparently they think that the SGP is the key to preserving monetary union, rather than, say, preventing mass unemployment.
For those of us in secure employment, this is shaping up to becoming a fascinating natural experiment in applied political economy.
Update: Christina Romer has a very nice introduction to the lessons of the Great Depression for today’s policy makers here.
It looks like the CPI will fall by a substantial amount during 2009 due to the economic slowdown, the weakness of Sterling and the cut in mortgage interest rates, amongst other factors.
This provides an opportunity to raise VAT and excise taxes, in view of the fiscal situation (less painful to raise indirect taxes when the CPI is in decline than when the CPI is increasing). The is the mirror image of the situation several years ago, when Ireland’s relatively high inflation rate led to widespread calls for cuts in indirect taxation in order to combat inflation. While there would be undoubtedly some leakage across the border, an increase in indirect taxes should be a significant source of revenue.
In a way, an increase in indirect taxes can be interpreted as a mechanism by which the government can reap some of the gains from the terms of trade improvement that is embedded in the appreciation of the euro against Sterling: this provides a real income gain for Ireland vis-a-vis other euro area countries, since Ireland imports much more from the UK than is the case for other euro area countries.
The regressive nature of indirect taxes can be taken into account in terms of the overall package of tax and welfare policies.
Various commentators and parties have recommended that landlords should not be able to deduct interest payments on debt in calculating taxable income. More generally, ending the favourable tax treatment of debt is one of the central recommendations from the IMF, in its recent analysis of how macroeconomic policies should change in the wake of the global financial crisis (paper is here). By favouring debt over other funding options, the tax deductability of interest charges encouraged excessive leverage and thereby contributed to risk in the financial system.
Accordingly, tax reform in this area has the potential to improve allocative efficiency while also raising revenue. No doubt the shift to a new system must involve a transition phase, such that the initial improvement in revenue may be limited.
In a recent post, Patrick Honohan raised the issue of what a sustainable tax system would look like, and in a follow up to that post, discussed whether a goal of keeping low income workers out of the tax net implied, with the current tax revenue requirement, tax rates on other earners that were so high as to have serious disincentive effects. In the ensuing discussion, John McHale suggested that I was being too sanguine about the incentive effects at the top of the distribution and helpfully pointed me towards a literature that I wasn’t familiar with, on the tax rate elasticity of taxable income, and particularly to a paper by Gruber and Saez (J.Pub.Econ., 2002), which finds an average elasticity of 0.4, with higher elasticities for high earners.
There are two reasons why we should be worried if income elasticities for this group are so high. First, a pragmatic one: it suggests that revenue will rise relatively little if we increase tax rates on this group. Second, a more worrying one: this group contains the job creators; if they’re discouraged from taking the risks and reduce their labour market effort, then there are far bigger knock-on effects in jobs that would have been created with lower tax rates, but now won’t be. The latter concern dominates much of the discussion on this matter – see, for example, Greg Connor’s comment here.
And so, an elasticity of 0.4 would indeed have to cause a rethink on my part. So I went off to read the paper.
The paper is fascinating. It does indeed find an elasticity of taxable income to marginal tax rates of 0.4, with an even higher elasticity of 0.57 for high earners. (Note to explain the counter-intuitive sign: this is actually an elasticity wrt the net-of-tax rate, i.e. if the marginal rate goes up by 1%, so that the net-of-tax rate goes down by 1%, this causes a 40% decrease in income). But the elasticity of ‘broad’ income – income before tax exemptions are taken out – is much lower; it is 0.12 on average, and 0.17 for high earners. The bulk of the difference between these two elasticities is due to changes in what the authors call ‘itemization behaviour’ – in other words, tax avoidance. This point is reinforced by several other analyses in the paper.
One of the two policy conclusions drawn is that
“[t]he large elasticities that we observe are driven by ‘holes’ in the tax base that allow taxpayers, particularly at higher income levels, to reduce their tax burdens. With a broader tax base we would distort behavior less and could therefore raise revenues more efficiently.”
[The second is that concern about the distorting impact of high implicit tax rates in the $10k-$50k income range due to changes in effort (hours) “…may be overblown”, and that attention should instead be paid to incentives that reward participation rather than marginal increments to hours worked.]
So the paper’s message is (i) that the effect on (potentially job-creating) effort by high fliers of increasing tax rates is not zero, but is not high and (ii) that getting rid of tax write-offs should be a priority, particularly if marginal rates on high earners are to be raised.