Month: April 2009

I have been thinking for a while that I should post to this article by Thomas Philippon and Ariell Reshef, particularly in the light of Irish (and worldwide) discussion about top bankers’ salaries and bonuses. Now Paul Krugman has based his latest column on it. The original article is worth downloading, if only for their Figure 1, which shows the ratio of the average wage in the financial industry to the average wage in the non-farm private sector. Philippon and Reshef say:

Figure 1 shows the evolution of the relative wage..and relative education..over the 20th century. The pattern that emerges is U-shaped, and suggests three distinct periods. From 1909 to 1933 the financial sector was a high-education, high-wage industry. It had 17 percent points more educated workers relative to the private sector; these workers were paid at least 50% more than in the rest of the private sector, on average. A dramatic shift occurred during the 1930s. The financial sector started to lose its human capital and its high wage status. Most of the decline occurred by 1950, but continued until 1980. By that time, the relative wage in the financial sector was approximately the same as in the rest of the economy. From 1980 onwards another dramatic shift occurred. The financial sector became a high-skill high-wage industry again. In a striking reversal, its relative wage and education went back almost exactly to their levels of the 1930s

Thee authors find that rents accounted for 30-50% of the wage differentials observed in the 1990s (“In that sense, financiers are overpaid”), and observe that “the flow of talented individuals into law and financial services might not be entirely desirable, because social returns might be higher in other occupations”.

With so much being said and written about the budget this week, forgive me for putting in my two cents worth.   From a macro perspective, the key trade-off going into the budget was always going to be between gaining credit worthiness and losing economic growth.   Oversimplifying a bit, the former called for a larger adjustment; the latter a smaller one.   However, it would be possible to improve this trade-off with a judicious composition of tax and expenditure changes.    How did Minister Lenihan do?

On size, I think the adjustment was at the upper end of the reasonable range.   Karl Whelan – and indeed the Minister himself in slightly different terms – has noted the budget restores the original 9.5 percent of GDP target if in place for a full year.   Another way to look at it is in terms of the much-maligned structural deficit.   (As an aside, it is hard to recall the star of an economic concept fading so fast as the structural deficit, with George Lee even amusingly referring to it as “voodoo economics.”)  But if you look at the macroeconomic framework document made available by the Department of Finance, it seems the structural deficit target played an essential role behind the scenes in determining the size of the adjustment.   In the update to the Stability Programme, the actual deficit was projected at 9.5 percent of GDP and the structural deficit was projected at 8.1 percent of GDP.   These projections then slipped on evidence from the most recent exchequer returns to 12.75 percent and 10.25 percent respectively.  The framework document projects that the budget brings the structural deficit back down to 8.2 percent – effectively the original target.   It is important to note that this is the projection for the structural deficit for 2009, and not what it would be if it were in place for a full year.   For this reason, the Minister has got a start – something in the order of one percent of GDP – in lowering the structural deficit from 8.2 percent in 2010.  

By the Department’s own estimate, the budget will knock a percentage point of GDP growth for 2009.  This is quite a hit given the measures will only be in place for seven months and only reflect a very short-term multiplier effect.  Even so, given the precarious state of national creditworthiness, and the credibility advantage of adhering to the stability programme’s target for the structural deficit, I see the size of the adjustment as appropriate. 

I am less impressed by the composition of the adjustment.   As has been pointed out by many commentators, the weight of empirical evidence shows that fiscal adjustments based on tax rises and capital expenditure cuts tend to be more contractionary and less durable than adjustments based on cuts to the government wage bill and transfer payments.  There is particular reason to worry about the supply-side effects of this budget.  The increase in marginal tax rates over a significant portion of the income distribution is large relative to the revenue raised.   Workers earning 52,000 euro, for example, saw their marginal tax rate rise from 44 [41 higher rate + 1 income levy + 2 health levy + 0 PRSI] percent to 51 percent [41+2+4+4].   Given that the deadweight loss of the income tax rises with the square of the marginal tax rate – which means the added burden of a given rate increase is greater that higher the tax rate is to begin with – we must worry about the large welfare cost of this rate increase.   Added to this, higher taxes are likely to impact wage setting and job search, with resulting adverse effects on competiveness and unemployment. 

Another way the trade-off could have been improved was with well-specified multi-year plan.   Without minimising the difficulty of projecting the revenues from new revenue sources such as carbon and property taxes, I think more should have been done to reduce the lingering uncertainty about how severe the ultimate adjustment is going to be. 

Finally, the Minister missed the opportunity for innovative temporary stimulus measures that a more thoroughgoing focus on the structural deficit would have allowed.   My candidates for such measures were a temporary reduction in VAT rates and a temporary reduction in employer PRSI.   I believe each would have an offsetting stimulus effect without undermining the path to a 3 percent structural deficit by 2013.  

Overall, a mixed bag. 

Pay and Employment Trends in the Public..