The Global Crisis

VOX has launched a new initiative that is intended to act as a central forum for an open-format discussion of the global crisis.  This promises to be quite interesting  (I am acting as moderator for the macroeconomics theme; Luigi Zingales on regulation;  Francesco Giavazzi on institutional reform; Dani Rodrik on development; and Richard Baldwin on open markets).  You can read more about it here.

Taxes and Incentives

The media reports suggest that ICTU has proposed a new top income tax rate of 48 percent. If various levies are added to that, the effective marginal income tax rate for high-ish earners could exceed 50 percent.

I am interested in the views of this blog’s readership on the extent to which a top tax rate in this range might adversely affect economic performance, in the specific context of the Irish economy and the Irish labour market.   For myself, I think it is important that the top tax rate in Ireland does not deviate too much from the UK top rate, which is due to be raised to 45 percent after the next election, in view of the high labour mobility between Ireland and the UK.

A not-so-modest proposal

With the massive hole in the public finances, it seems unavoidable that the tax take will rise sharply.   On the positive side, Ireland at least has more tax room than other countries.   On the negative side, near-term, large-scale increases in taxes will further harm demand leading to a further turn in the vicious cycle.   Indeed, the expectation of lower after-tax income must already be curbing household spending.    Moreover, higher taxes will undermine the incentives-based model that has underpinned Irish growth. 

What to do?  

I have previously thought Ireland was fortunate to have avoided an unfunded earnings-related state pension system.   But it is time for some new thinking in what is now a full-blown economic emergency.   Weighing the benefits against the costs, I think a “notional defined contribution” unfunded system would be a large net positive.   Under this system, benefits are rigidly linked to earlier contributions.   For a given contribution rate, contributions receive a “notional” rate of return equal to the growth rate of the wage bill.   But the system is unfunded, so that the revenues are made available to the government today.   There is effectively a “free” period where the government receives revenues but does not have to pay out benefits. 

Why is this a good idea?

First, and most immediately, it would allow for a sizable inflow of funds to the exchequer.   With a contribution rate of 6 percent and a base equal to the entire wage bill, the government would raise roughly 4 percent of GNP (assuming a labor income share of GNP of two thirds—hopefully someone can fill in the correct labor share).    This would largely meet the massive correction penciled in for 2010 and 2011 (though it might make sense to phase it in more gradually).  

Second, the disincentive effects of higher marginal tax rates would be greatly diminished by the strong link from contributions to benefits.   Indeed, it is reasonable not to refer to the contribution rate as a tax rate at all.   The alternative of dramatically higher income tax rates is likely to be a huge drag investment and enterprise going forward. 

Third, the adverse effect of the fiscal correction on expected lifetime income would be minimized as today’s contributions lead to higher future benefits   This is critical in an environment where household confidence in their future after-tax income has collapsed. 

Fourth, the decimation of many private-sector defined-benefit schemes has left many workers dangerously exposed.   At least for those earlier in their careers, this scheme could help build pension “wealth.”

One way to view the policy is as a form of long-term borrowing from current workers.   It is a response to the fact that traditional borrowing through the debt markets is, many believe, reaching its limits.   In return for their contributions, workers under this policy receive a special form of asset–a promise of future benefits that is tightly linked to their contributions.   While there is a risk that the government will renege on its benefit promise.  The recent experience with losses on financial wealth should be borne in mind in assessing the extent of risk in this system.    

A word of caution:  I think it would be critical to avoid turning this into a redistributive scheme.   Lifetime redistribution should continue to take place through the flat rate pension/proportionate PRSI contribution system.   Blurring the link between contributions and pensions would greatly undermine both the incentive and relatively benign income expectation effects of the policy.  

I think it would also be a mistake to demand employer contributions.   Unlike the employee contributions, employer contributions would be a pure labour tax, the last thing that is needed right now.   It would probably also make the policy a political non-starter in the current climate. 

I don’t pretend this is a free lunch—future generations would be stuck with it.   But it may be the closest thing to a free lunch we have.   As a general rule, it is not wise to make long-term policy such as pensions policy to deal with a crisis.   However, it is worth remembering the US Social Security system was introduced during the Great Depression.  

It is far from perfect.  But what are the alternatives?

It isn’t just the Irish Central Bank that has a problem with economics

I found this quite depressing. He doesn’t want to cut interest rates further for fear of falling into a liquidity trap???

In addition to harming the overall Eurozone economy, this sort of attitude, if it prevails, will be particularly damaging to Ireland because of its implications for exchange rates. And it will I think set in motion serious protectionist forces in this continent, with the potential to do great damage to the international economy in the years ahead.

How to Fix the Economy

Alan Ahearne is today’s contributor to the Irish Times series: “Income Tax Rates Will Need to Rise.” (As usual, headline does not give full flavour of the article.)

The fiscal plan of Fintan O’Toole is also worth reading: “Government Reaction to Crisis Needs to be Credible.” A longer version of this article would have been even more interesting, in which the economic consequences of the pay element of his plan might be explained in more detail.

Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan

I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:

As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.

Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.

5y                  10y
Port     134/144       130/150
Ital      177/187       172/182
Gree    260/290       255/285
Spa     148/158       145/160
Irel      260/300       240/290
UK      140/150       137/147
Denk    109/119       108/120
Swe      110/125       115/130
Aust      145/155       145/145
Ger           56/66            56/66
Fran          63/73             64/74
Finl           55/65             57/67
Belg     115/135       113/133
Neth     105/125        105/120
Iceland  925/975          800/1000

Source JP Morgan.

It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.

Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.

Agency Issues:  The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.

Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.

Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.